-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, POLIcj39oautNjFWDhaEz6OCZjuI8a5082Qpl1G6mWCWyq18n3VMjQjBX8YUl/TE mG7IX8CJ8v7/oqWU+mU/RQ== 0001169232-04-001697.txt : 20040312 0001169232-04-001697.hdr.sgml : 20040312 20040312104744 ACCESSION NUMBER: 0001169232-04-001697 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 17 CONFORMED PERIOD OF REPORT: 20031231 FILED AS OF DATE: 20040312 FILER: COMPANY DATA: COMPANY CONFORMED NAME: COMMUNITY BANK SYSTEM INC CENTRAL INDEX KEY: 0000723188 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 161213679 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-13695 FILM NUMBER: 04664480 BUSINESS ADDRESS: STREET 1: 5790 WIDEWATERS PKWY CITY: DEWITT STATE: NY ZIP: 13214 BUSINESS PHONE: 8007242262 MAIL ADDRESS: STREET 1: 5790 WIDEWATERS PARKWAY CITY: DEWITT STATE: NY ZIP: 13214 10-K 1 d58827_10-k.txt FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| FOR ANNUAL AND TRANSITIONAL REPORTS PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2003 Commission file number 0-11716 [LOGO] COMMUNITY BANK SYSTEM, INC. (Exact name of registrant as specified in its charter) New York Stock Exchange (Name of Each Exchange on Which Registered) Delaware 16-1213679 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation) 5790 Widewaters Parkway, DeWitt, New York 13214-1883 (Address of principal executive offices) (Zip Code) (315) 445-2282 Registrant's telephone number, including area code Securities registered pursuant to Section 12(b) of the Act: Common Stock, No Par Value Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during all the preceding 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 |_|. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No |_|. The aggregate market value of the voting stock held by non-affiliates of the Registrant on June 30, 2003 determined using the closing price per share on that date of $38.00, as reported on the New York Stock Exchange was approximately $316,000,000. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 14,315,773 shares of Common Stock, no par value, were outstanding on March 10, 2004. DOCUMENTS INCORPORATED BY REFERENCE. List hereunder the following documents if incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) any annual report to security holders; (2) any proxy or information statement; and (3) any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. Portions of Definitive Proxy Statement for Annual Meeting of Shareholders to be held on May 19, 2004 (the "Proxy Statement") is incorporated by reference in Part III of this Annual Report on Form 10-K. Exhibit Index is located on page 71 of 74 TABLE OF CONTENTS PART I Page ---- Item 1. Business ................................................................................ 3 Item 2. Properties .............................................................................. 7 Item 3. Legal Proceedings ....................................................................... 7 Item 4. Submission of Matters to a Vote of Security Holders ..................................... 7 Item 4a. Executive Officers of the Registrant .................................................... 8 PART II Item 5. Market for Registrant's Common Stock, Related Shareholders Matters and Issuer Purchases of Equity Securities ........................................................ 10 Item 6. Selected Financial Data ................................................................. 10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ............................................................................ 12 Item 7a. Quantitative and Qualitative Disclosures about Market Risk .............................. 38 Item 8. Financial Statements and Supplementary Data: Consolidated Statements of Condition ............................................... 40 Consolidated Statements of Income .................................................. 41 Consolidated Statements of Changes in Shareholders' Equity ......................... 42 Consolidated Statements of Comprehensive Income .................................... 43 Consolidated Statements of Cash Flows .............................................. 44 Notes to Consolidated Financial Statements ......................................... 45 Report of Independent Auditors ..................................................... 68 Two Year Selected Quarterly Data ........................................................ 69 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .... 69 Item 9a. Controls and Procedures ................................................................. 69 PART III Item 10. Directors and Executive Officers of the Registrant ...................................... 70 Item 11. Executive Compensation .................................................................. 70 Item 12. Security Ownership of Certain Beneficial Owners and Management .......................... 70 Item 13. Certain Relationships and Related Transactions .......................................... 70 Item 14. Principal Accountant Fees and Services .................................................. 70 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ........................ 71 Signatures ......................................................................................... 74
2 Part I This Annual Report on Form 10-K contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set forth herein under the caption "Forward-Looking Statements." Item 1. Business Community Bank System, Inc. ("the Company") was incorporated on April 15, 1983, under the Delaware General Corporation Law. Its principal office is located at 5790 Widewaters Parkway, DeWitt, New York 13214. The Company maintains a web-site at communitybankna.com. Annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, are available on the Company's web-site free of charge as soon as reasonably practicable after such reports or amendments are electronically filed with or furnished to the Securities and Exchange Commission. The information on the web-site is not part of this filing. The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers. Community Bank System, Inc. is a single bank holding company which wholly-owns four subsidiaries: Community Bank, N.A. ("the Bank"), Benefit Plans Administrative Services, Inc. ("BPA"), CFSI Closeout Corp. ("CFSICC"), and First of Jermyn Realty Co. ("FJRC"). BPA owns two subsidiaries, Benefit Plans Administrative LLC and Harbridge Consulting Group LLC. BPA provides administration, consulting and actuarial services to sponsors of employee benefit plans. CFSICC and FJRC are inactive companies. The Company also wholly-owns three unconsolidated subsidiary business trusts formed for the purpose of issuing mandatorily redeemable preferred securities which are considered Tier I capital under regulatory capital adequacy guidelines. The Bank operates 126 customer facilities throughout twenty-two counties of Upstate New York and five counties of Northeastern Pennsylvania offering a range of commercial and retail banking services. The Bank owns the following subsidiaries: Community Investment Services, Inc. ("CISI"), CBNA Treasury Management Corporation ("TMC"), CBNA Preferred Funding Corporation ("PFC"), Elias Asset Management, Inc. ("EAM") and First Liberty Service Corp. ("FLSC"). CISI provides broker-dealer and investment advisory services. TMC operates the cash management, investment, and treasury functions of the Bank. PFC primarily is an investor of residential real estate loans. EAM provides asset management services to individuals, corporate pension and profit sharing plans, and foundations. FLSC provides banking related services to the Pennsylvania branches of the Bank. Acquisition History (1999-2003) First Heritage Bank On January 6, 2004, the Company announced an agreement to acquire First Heritage Bank in an all-stock transaction valued at approximately $74 million. Headquartered in Wilkes-Barre, Pa., First Heritage is a closely held $275 million-asset bank with three branches in Luzerne County. First Heritage's three branches will operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The acquisition is expected to close during the second quarter of 2004, pending both customary regulatory and First Heritage shareholder approval. Grange National Banc Corp. On November 24, 2003, the Company acquired Grange National Banc Corp. ("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa. Grange's 12 branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The Company issued approximately 1,147,000 shares of its common stock to certain of the former shareholders at a cost of $47.94 per share. The remaining shareholders received $42.50 in cash or approximately $20.9 million. In addition, Grange stock options representing $5.4 million of fair value were exchanged for options of the Company. Peoples Bankcorp Inc. On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a $29-million-asset savings and loan holding company based in Ogdensburg, New York. Peoples' single branch is being operated as a branch of the Bank's network of branches in Northern New York. The purchase price of the transaction approximated $4.0 million in cash. 3 Harbridge Consulting Group On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York Global Human Resource Solutions consulting group for a purchase price of approximately $7.1 million in cash. This practice has been renamed Harbridge Consulting Group ("Harbridge") and is a leading provider of retirement and employee benefits consulting services throughout Upstate New York, and is complementary to Benefit Plans Administrative Services, Inc., the Company's defined contribution plan administration subsidiary. FleetBoston Financial Corporation branches On November 16, 2001, the Company acquired 36 branches from FleetBoston Financial Corporation with $470 million in deposits and $177 million in loans. The branches are located in the Southwestern and Finger Lakes Regions of New York State. First Liberty Bank Corp. On May 11, 2001, the Company completed its acquisition of the $648-million-asset First Liberty Bank Corp. ("First Liberty"). Pursuant to the terms of the merger, each share of First Liberty stock was exchanged for .56 shares of the Company's common stock, which amounted to approximately 3.6 million shares. The merger constituted a tax-free reorganization and has been accounted for as a pooling of interests under APB Opinion 16. Accordingly, the consolidated financial statements for the periods presented have been restated to include the combined results of operations, financial position and cash flows of the Company and First Liberty. Certain reclassifications were made to First Liberty's prior year financial statements to conform to the Company's presentation. Citizens National Bank of Malone On January 26, 2001, the Company acquired the $111-million-asset Citizens National Bank of Malone, a commercial bank with five branches throughout Franklin and St. Lawrence counties in New York State. The Company issued 952,000 shares of its common stock to the former shareholders at a cost of $26.50 per share. All of the 648,100 shares held in the Company's treasury were issued in this transaction. Elias Asset Management, Inc. On April 3, 2000, the Company acquired all the stock of Elias Asset Management, Inc. (EAM) for cash of $6.5 million. Additional consideration of $3.0 million was recognized in 2001 based upon performance targets set forth within the stock purchase agreement. EAM, based in Williamsville, NY, is a nationally recognized firm that manages assets for individuals, corporate pension and profit sharing plans, and foundations. Services The Bank is a community retail bank committed to the philosophy of serving the financial needs of customers in local communities. The Bank's branches are generally located in small towns and villages within its geographic market areas of Upstate New York and Northeastern Pennsylvania. The Company believes that the local character of business, knowledge of the customer and customer needs, and comprehensive retail and small business products, together with responsive decision-making at the branch and regional level, enable the Bank to compete effectively. The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank of New York ("FHLB"), and its deposits are insured by the FDIC up to applicable limits. Competition The financial services business is highly competitive. The Company competes actively with national and state banks, thrift institutions, credit unions, securities dealers, mortgage bankers, finance companies, insurance companies, and other regulated and unregulated providers of financial services. 4 The table below summarizes the Bank's deposits and market share by the twenty-seven counties of New York and Pennsylvania in which it has customer facilities. Market share is based on deposits of all commercial banks, credit unions, savings and loan associations, and savings banks.
Number of ---------------------------------------------- Towns Where Deposits Company 6/30/2003 Market Has 1st or 2nd County State (000's) (1) Share Facilities ATM's Towns Market Position - ----------------------------------------------------------------------------------------------------------- Allegany NY $ 197,975 48.9% 10 8 9 9 Lewis NY 78,786 37.9% 4 1 3 3 Seneca NY 127,261 34.5% 4 3 4 3 Susquehanna PA 170,994 33.7% 2 1 2 2 Yates NY 79,681 29.9% 3 2 2 2 Cattaraugus NY 258,049 28.6% 10 7 7 6 Wyoming PA 99,290 27.1% 4 2 4 3 St. Lawrence NY 341,240 26.2% 15 8 11 10 Franklin NY 82,954 16.5% 5 3 4 4 Chautauqua NY 195,875 14.2% 12 10 10 6 Schuyler NY 16,393 13.1% 1 1 1 0 Jefferson NY 141,765 12.3% 5 5 4 2 Steuben NY 168,020 11.3% 10 6 8 5 Lackawanna PA 440,663 11.0% 11 14 8 4 Tioga NY 36,670 9.8% 2 2 2 1 Livingston NY 48,366 8.2% 3 3 3 2 Ontario NY 82,080 6.2% 3 4 3 1 Wayne NY 51,586 5.9% 2 1 1 0 Herkimer NY 30,006 5.3% 1 1 1 1 Oswego NY 46,094 4.6% 2 2 2 2 Cayuga NY 29,728 3.6% 2 1 2 2 Luzerne PA 95,285 1.6% 8 7 5 2 Bradford PA 13,063 1.6% 2 2 1 0 Oneida NY 59,377 1.5% 2 1 1 1 Chemung NY 16,254 1.3% 1 1 1 0 Onondaga NY 9,690 0.1% 1 1 1 0 Erie NY 24,729 0.1% 1 0 1 1 - ----------------------------------------------------------------------------------------------------------- 27 Total $2,941,874 5.1% 126 97 101 72 ===========================================================================================================
(1) Deposit market share data as of June 30, 2003, the most recent information available, calculated by Sheshunoff Information Services, Inc. Includes all branches acquired from Peoples Bankcorp Inc. and Grange National Banc Corp. during 2003. Employees As of December 31, 2003 and 2002 the Company employed 1,259 and 1,120 full-time equivalent employees, respectively. The Company offers a variety of employment benefits and considers its relationship with its employees to be good. 5 Supervision and Regulation Bank holding companies and national banks are regulated by state and federal law. The following is a summary of certain laws and regulations that govern the Company and the Bank. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the actual statutes and regulations thereunder. Federal Bank Holding Company Regulation The Company is registered under, and is subject to, the Bank Holding Company Act of 1956, as amended. This Act limits the type of companies that Community Bank System, Inc. may acquire or organize and the activities in which it or they may engage. In general, the Company and the Bank are prohibited from engaging in or acquiring direct or indirect control of any corporation engaged in non-banking activities unless such activities are so closely related to banking as to be a proper incident thereto. In addition, the Company must obtain the prior approval of the Board of Governors of the Federal Reserve System ("the FRB") to acquire control of any bank; to acquire, with certain exceptions, more than five percent of the outstanding voting stock of any other corporation; or, to merge or consolidate with another bank holding company. As a result of such laws and regulation, the Company is restricted as to the types of business activities it may conduct and the Bank is subject to limitations on, among others, the types of loans and the amounts of loans it may make to any one borrower. The Financial Modernization Act of 1999 created, among other things, a new entity, the "financial holding company". Such entities can engage in a broader range of activities that are "financial in nature", including insurance underwriting, securities underwriting and merchant banking. Financial holding companies can be established relatively easily through a notice filing with the FRB, which acts as the "umbrella regulator" for such entities. The Company may determine to become a financial holding company in the future. Federal Reserve System The Company is required by the Board of Governors of the Federal Reserve System to maintain cash reserves against its deposits. After exhausting all other sources of funds, the Company may request to borrow from the Federal Reserve. Bank holding companies registered with the FRB are, among other things, restricted from making direct investments in real estate. Both the Company and the Bank are subject to extensive supervision and regulation, which focus on, among other things, the protection of depositors' funds. The Federal Reserve System also regulates the national supply of bank credit in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits, and affect the interest rates charged on loans or paid for deposits. Fluctuations in interest rates, which may result from government fiscal policies and the monetary policies of the Federal Reserve System, have a strong impact on the income derived from loans and securities, and interest paid on deposits. While the Company and the Bank strive to anticipate changes and adjust their strategies for such changes, the level of earnings can be materially affected by economic circumstances beyond their control. The Bank is subject to minimum capital requirements established, respectively, by the FRB and the FDIC. For information on these capital requirements and the Company's and the Bank's capital ratios see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital" and Note P to the Financial Statements. Office of Comptroller of the Currency The Bank is supervised and regularly examined by the Office of the Comptroller of the Currency ("the OCC"). The various laws and regulations administered by the OCC affect corporate practices such as payment of dividends, incurring debt, and acquisition of financial institutions and other companies. It also affects business practices, such as payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices. There are no regulatory orders or outstanding issues resulting from regulatory examinations of the Bank. Sarbanes-Oxley Act of 2002 On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") was signed into law. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity or debt securities registered under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act establishes: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial 6 statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (v) new and increased civil and criminal penalties for violation of the securities laws. Sections 302(a) and 906 of Sarbanes-Oxley Act, require the Company's chief executive officer and chief financial officer to certify that the Company's Quarterly and Annual Reports do not contain any untrue statement of a material fact or omit to state a material fact, that the Quarterly and Annual Reports comply with the Securities and Exchange Act of 1934 and that the information in the Report fairly presents the financial condition and results of operations of the Company. The rules have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company's internal controls; they have made certain disclosures to the Company's auditors and the audit committee of the Board of Directors about the Company's internal controls; and they have included information in the Company's Quarterly and Annual Reports about their evaluation and whether there have been significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation. The Company believes it is in compliance with all effective sections of the Sarbanes-Oxley Act. Item 2. Properties The Company has 131 properties, 88 are owned and 43 are located in long-term leased premises. Of the 131 properties, 126 are considered customer facilities. The remaining facilities include its administrative offices at 5790 Widewaters Parkway, DeWitt, New York, its loan and deposit operation centers located in Olean and Canton, New York, respectively, its commercial lending center located in Corning New York, and a training center located in Ogdensburg, New York. Real property and related banking facilities owned by the Company at December 31, 2003 had a net book value of $44.0 million and none of the properties was subject to any material encumbrances. For the year ended December 31, 2003, rental fees of $1.9 million were paid on facilities leased by the Company for its operations. Item 3. Legal Proceedings The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability, if any, arising out of litigation pending against the Company or its subsidiaries will have a material effect on the Company's consolidated financial position or results of operations. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of the shareholders during the quarter ended December 31, 2003. In February 2004, the Company mailed a proxy statement to shareholders related to the approval of an amendment to the Certificate of Incorporation of the Company to increase its total authorized shares from 20 million to 50 million. The vote on this amendment will be held at a Special Meeting of Shareholders on March 26, 2004. 7 Item 4a. Executive Officers of the Registrant The following table sets forth certain information about the executive officers of the Company and the Bank, each of whom is elected by the Board of Directors and each of whom holds office at the discretion of the Board of Directors. Name and Age Position ------------ -------- Sanford A. Belden Director, President and Chief Executive Age 61 Officer of the Company and the Bank Mark E. Tryniski Treasurer of the Company, and Executive Age 43 Vice President, Chief Operating Officer and Chief Financial Officer of the Bank Michael A. Patton President, Financial Services Age 58 James A. Wears President, New York Banking Age 54 Thomas A. McCullough President, Pennsylvania Banking Age 57 Steven R. Tokach Senior Vice President and Chief Credit Age 57 Administrator Brian D. Donahue Senior Vice President and Chief Credit Age 47 Officer W. Valen McDaniel Senior Vice President and Chief Risk Age 57 Officer Timothy J. Baker Senior Vice President and Senior Age 52 Operations Officer Sanford A. Belden (Director, President and Chief Executive Officer of the Company and the Bank). Mr. Belden has been Director, President and Chief Executive Officer of the Company and the Bank since October 1, 1992. Mr. Belden was formerly Manager, Eastern Region, Rabobank Nederland, New York, New York from 1990 to 1992 and prior thereto served as President, Community Banking, for First Bank System, Minneapolis, Minnesota, a multi-state bank holding company. Mark E. Tryniski (Treasurer of the Company, Executive Vice President, Chief Operating Officer and Chief Financial Officer of the Bank). Mr. Tryniski joined the Company in June 2003. Prior to his position with the Company, Mr. Tryniski was a partner in the Syracuse office of PricewaterhouseCoopers LLP, with eighteen years of experience working with SEC registrants in banking and other industries. Michael A. Patton (President, Financial Services). Mr. Patton was the President and Chief Executive Officer of The Exchange National Bank, a former subsidiary of the Company, from 1984 until January 1992, when, in connection with the consolidation of the Company's five subsidiary banks into Community Bank, N.A., he was named President, Southern Region. He assumed his current position in February 2000. James A. Wears (President, New York Banking). Mr. Wears served as Senior Vice President of the St. Lawrence National Bank, a former subsidiary of the Company, from 1988 through January 1991 and as President and Chief Executive Officer from January 1991 until January 1992. Following the January 1992 consolidation of the Company's five subsidiary banks into Community Bank, N.A., Mr. Wears was named President, Northern Region. He assumed his current position in February 2000. Thomas A. McCullough (President, Pennsylvania Banking). Mr. McCullough joined the Company in November 2003 and serves as President of Banking of First Liberty Bank & Trust, a division of Community Bank, N.A. He was previously employed by Grange National Banc Corp., having joined that organization in 1977 as Vice President and Commercial Loan Officer. He was promoted to President and Chief Executive Officer in 1989 and served in that capacity until the merger of Grange with the Company in November 2003. Steven R. Tokach (Senior Vice President and Chief Credit Administrator). Mr. Tokach assumed the Credit Administrator position in March 2003. Prior to this, Mr. Tokach was President of First Liberty Bank & Trust since May 8 2001, when First Liberty Bank Corp. was acquired by the Company. He was Executive Vice President of First Liberty Bank Corp. and First Liberty Bank & Trust from 1998-2001, and from 1993-1998, served as Vice President of Guaranty Bank, N.A. and Executive Vice President of First Eastern Bank, both in Pennsylvania. Brian D. Donahue (Senior Vice President and Chief Credit Officer). Mr. Donahue began his career with Fleet Bank (via its merger with First Trust Union Bank) in Western New York in early 1980. While there he held various positions which included Team Leader in the Middle Market Commercial Lending unit as well as heading up the Small Business Bank division until his departure in 1992 to join the Company. Mr. Donahue has a diversified background with other areas of expertise including human resources, branch management, and retail indirect and mortgage lending. W. Valen McDaniel (Senior Vice President and Chief Risk Officer). Mr. McDaniel joined the Company in 1991 as Vice President and Corporate Auditor & Risk Manager. He assumed his current position in January 2004. Mr. McDaniel was formerly Vice President & Corporate Auditor for 1st Nationwide Bank, Westfield, NJ. Timothy J. Baker (Senior Vice President and Senior Operations Officer). Mr. Baker joined the St. Lawrence County National Bank (predecessor to Community Bank, N.A.) in October 1971. Mr. Baker's areas of responsibility have included head of the Credit Department and Loan Processing from 1973 to 1977; Vice President, Commercial and Consumer lending group, and Manager of Loan Application conversions from 1977 to 1983; Merger and Acquisition team leader for loans from 1983 to 1985; and Chief Financial Officer of the St. Lawrence National Bank from 1985 to 1992. He assumed his current position in 1992. 9 Part II Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters and Issuer Purchases of Equity Securities The Company's common stock has been trading on the New York Stock Exchange under the symbol "CBU" since December 31, 1997. Prior to that, the common stock traded over-the-counter on the NASDAQ National Market under the symbol "CBSI" beginning on September 16, 1986. There were 14,165,156 shares of common stock outstanding on December 31, 2003, held by approximately 9,413 registered shareholders of record and shareholders whose shares are held in nominee name at brokerage firms and other financial institutions. The following table sets forth the high and low prices for the common stock, and the cash dividends declared with respect thereto, for the periods indicated. The prices do not include retail mark-ups, mark-downs or commissions. Closing Price High Low --------------------- Quarterly Year / Qtr Price Price Amount % Change Dividend - -------------------------------------------------------------------------------- 2003 4th $50.95 $43.95 $49.00 11.6% $ 0.32 3rd $46.35 $37.33 $43.91 15.6% $ 0.32 2nd $38.76 $31.02 $38.00 20.9% $ 0.29 1st $34.23 $30.87 $31.43 0.3% $ 0.29 2002 4th $33.09 $27.20 $31.35 5.8% $ 0.29 3rd $32.55 $26.50 $29.63 -8.1% $ 0.29 2nd $34.21 $29.80 $32.25 7.0% $ 0.27 1st $30.32 $25.93 $30.15 15.1% $ 0.27 The Company has historically paid regular quarterly cash dividends on its common stock, and declared a cash dividend of $0.32 per share for the first quarter of 2004. The Board of Directors of the Company presently intends to continue the payment of regular quarterly cash dividends on the common stock, as well as to make payment of regularly scheduled dividends on the trust preferred stock when due, subject to the Company's need for those funds. However, because substantially all of the funds available for the payment of dividends by the Company are derived from the Bank, future dividends will depend upon the earnings of the Bank, its financial condition, its need for funds and applicable governmental policies and regulations. The following table provides information as of December 31, 2003 with respect to shares of common stock that may be issued under the Company's existing equity compensation plans:
Number of Weighted Securites to be Average Number of Issued upon Exercise Price Securites Remaining Exercise of on Shares Available for Plan category Oustanding Options Outstanding Future Issuance - ------------------------------------------------------------------------------------------------------------------------------------ Equity compensation plans approved by security holder: 1994 Long Term Incentive Plan 1,216,287 $ 25.56 755,079 Equity compensation plans not approved by security holder: Citizens Advisory Council Plan 2,000 $ 32.05 3,000 - ------------------------------------------------------------------------------------------------------------------------------------ Total 1,218,287 $ 25.57 758,079 ====================================================================================================================================
Item 6. Selected Financial Data The following table sets forth selected consolidated historical financial data of the Company as of and for each of the years in the five-year period ended December 31, 2003. The historical "Income Statement Data" and historical "Balance Sheet Data" are derived from the audited financial statements. The "Average Balance Sheet Data", "Capital and Related Ratios", "Selected Performance Ratios" and "Asset Quality Ratios" for all periods are unaudited. All financial information in this table should be read in conjunction with the information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and with the Consolidated Financial Statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. 10 SELECTED CONSOLIDATED FINANCIAL INFORMATION
Years Ended December 31, --------------------------------------------------------------------------- In thousands, except per share data 2003 2002 2001 2000 1999 - ------------------------------------------------------------------------------------------------------------------------------- Income Statement Data: Interest income $ 191,129 $ 205,093 $ 198,492 $ 189,665 $ 166,581 Interest expense 59,301 77,243 101,837 99,232 78,581 Net interest income 131,828 127,850 96,655 90,433 88,000 Provision for loan losses 11,195 12,222 7,097 7,722 5,856 Net interest income after provision for loan losses 120,633 115,628 89,558 82,711 82,144 Non-interest income before security gains & debt extinguishment 37,679 30,133 26,092 23,284 18,153 (Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113) (159) (413) Total non-interest income 34,981 31,806 25,979 23,125 17,740 Recurring operating expenses 101,963 94,330 80,430 70,534 66,778 Acquisition and unusual expenses 498 700 8,164 400 0 Total operating expense 102,461 95,030 88,594 70,934 66,778 Income before income taxes 53,153 52,404 26,943 34,902 33,106 Provision for income taxes 12,773 13,887 7,814 10,003 9,444 Net income $ 40,380 $ 38,517 $ 19,129 $ 24,899 $ 23,662 Net income - operating (1) $ 42,332 $ 37,926 $ 24,052 $ 25,230 $ 23,906 Diluted earnings per share $ 2.99 $ 2.93 $ 1.62 $ 2.32 $ 2.18 Diluted earnings per share - operating (1) $ 3.13 $ 2.88 $ 2.03 $ 2.35 $ 2.20 Balance Sheet Data: Cash and cash equivalents $ 103,923 $ 113,531 $ 106,554 $ 76,456 $ 126,750 Investment securities 1,329,534 1,286,583 1,150,713 930,509 817,524 Loans, net of unearned discount 2,128,509 1,806,905 1,732,870 1,515,877 1,425,773 Allowance for loan losses (29,095) (26,331) (23,901) (20,035) (18,528) Intangible assets 196,111 134,828 142,342 55,234 54,150 Other assets 126,415 121,731 104,787 93,598 89,274 Total assets $ 3,855,397 $ 3,437,247 $ 3,213,365 $ 2,651,639 $ 2,494,943 Deposits $ 2,725,488 $ 2,505,356 $ 2,545,970 $ 1,948,557 $ 1,844,752 Borrowings 667,786 543,575 357,931 471,053 462,762 Other liabilities 57,295 63,278 41,484 30,238 21,724 Shareholders' equity 404,828 325,038 267,980 201,791 165,705 Total liabilities and shareholders' equity $ 3,855,397 $ 3,437,247 $ 3,213,365 $ 2,651,639 $ 2,494,943 Average Balance Sheet Data: Investment securities $ 1,185,487 $ 1,266,070 $ 1,042,726 $ 900,250 $ 826,708 Loans 1,885,604 1,759,564 1,580,870 1,484,945 1,343,652 Total interest-earning assets 3,071,091 3,025,634 2,623,596 2,385,195 2,170,360 Total assets 3,471,689 3,393,164 2,888,760 2,556,638 2,356,085 Interest-bearing deposits 2,090,749 2,100,960 1,783,938 1,613,918 1,588,481 Borrowings 508,392 507,893 482,583 447,105 280,806 Total interest-earning liabilities 2,599,141 2,608,853 2,266,521 2,061,023 1,869,287 Shareholders' equity $ 342,679 $ 294,856 $ 239,368 $ 174,498 $ 174,479 Capital and Related Ratios: Tier I leverage ratio 7.26% 7.05% 6.73% 6.67% 6.76% Total risk-based capital to risk-adjusted assets 13.01% 13.32% 11.83% 11.70% 12.10% Tangible equity to tangible assets 5.70% 5.76% 4.09% 5.64% 4.57% Cash dividends declared per share $ 1.22 $ 1.12 $ 1.08 $ 1.04 $ 0.96 Dividend payout ratio 40.2% 37.7% 65.7% 40.6% 40.4% Book value per share $ 28.58 $ 25.04 $ 20.77 $ 19.11 $ 15.55 Tangible book value per share $ 14.73 $ 14.66 $ 9.74 $ 13.88 $ 10.47 Market capitalization (in millions) $ 694 $ 407 $ 338 $ 261 $ 247 Period end common shares outstanding 14,165 12,979 12,903 10,560 10,658 Diluted weighted average shares outstanding 13,517 13,167 11,825 10,737 10,861 Selected Performance Ratios: Return on assets 1.16% 1.14% 0.66% 0.97% 1.00% Return on assets - operating (1) 1.22% 1.12% 0.83% 0.99% 1.01% Return on equity 11.78% 13.06% 7.99% 14.27% 13.56% Return on equity - operating (1) 12.35% 12.86% 10.05% 14.46% 13.70% Net interest margin 4.69% 4.62% 3.96% 4.06% 4.32% Non-interest income/operating income 20.7% 17.7% 20.1% 19.4% 16.2% Efficiency ratio 53.3% 52.0% 56.7% 54.6% 55.5% Asset Quality Ratios: Allowance for loan loss/loans outstanding 1.37% 1.46% 1.38% 1.32% 1.30% Non-performing loans/loans outstanding 0.62% 0.64% 0.53% 0.49% 0.51% Allowance for loan loss/non-performing loans 220% 226% 263% 271% 253% Net charge-offs/average loans 0.54% 0.56% 0.42% 0.42% 0.33% Loan loss provision/net charge-offs 109.1% 124.8% 107.8% 124.2% 133.5% Non-performing assets/loans outstanding plus OREO 0.67% 0.69% 0.61% 0.58% 0.62%
1) Operating earnings excludes the effects of certain items the Company considers to be non-operating, including acquisition expenses, the results of securities transactions, and debt restructuring activities. See Table 1 in "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a reconciliation of GAAP-based earnings results to operating-based earnings results. 11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc., and its subsidiaries ("CBSI" or "the Company") for the past two years, although in some circumstances a period longer than two years is covered in order to comply with Securities and Exchange Commission disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 11and the Company's Consolidated Financial Statements and related notes that appear on pages 40 through 67. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole. All financial results reflect the 2001 acquisition of First Liberty Bank Corp. ("First Liberty") in accordance with the pooling of interests method of accounting. Unless otherwise noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. The term "this year" and equivalent terms refer to results in calendar year 2003, "last year" and equivalent terms refer to calendar year 2002, and all references to income statement results correspond to full-year activity unless otherwise noted. Lastly, all references to "peer banks" pertain to a group of 78 bank holding companies nationwide having $3 billion to $10 billion in assets and their associated composite financial results for the nine months ending September 30, 2003 (the most recently available disclosure), as provided by the Federal Reserve Board's Division of Banking Supervision and Regulation in the Bank Holding Company Performance Report. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption "Forward-Looking Statements" on page 37. Critical Accounting Policies As a result of the complex and dynamic nature of the Company's business, management must exercise judgement in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that the critical accounting estimates include: o Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change. o Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Table 8 on page 23 shows the impact of a one percentage point increase and decrease of each of these assumptions. Specific discussion of the assumptions used by management is discussed in Note K on pages 60 through 62. o Provision for income taxes- The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgements used to record tax related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations. o Fair value of certain investment securities- Fair values of investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. 12 o Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators. A summary of the accounting policies used by management is disclosed in Note A (Summary of Significant Accounting Policies) starting on page 45. Executive Summary The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers. The Company's core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, (ii) build high-quality, profitable loan portfolios using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services businesses, and (iv) utilize technology to deliver customer-responsive products and services and to reduce operating costs. Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, non-interest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services business units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology enhancements, market share, peer comparisons, and the performance of acquisition and integration activities. In 2003, the Company reported record earnings as a result of strong net interest margins and significant increases in non-interest income. On an operating basis (see Table 1 and related narrative), return on assets increased over 2002, while return on equity declined slightly due to strengthened capital levels. Excluding acquisition activity, revenues generated by the financial services businesses declined slightly in 2003, principally as a result of the effects of a challenging retail investment environment over the past three years. Operating expenses and the efficiency ratio increased due to acquisition activity as well as increased benefit costs. Asset quality improved in 2003, with reductions in delinquency, charge-off and non-performing loan ratios over 2002. Excluding acquisition activity, the Company experienced strong loan growth in consumer mortgage and indirect installment lending, with declines in the commercial and direct installment portfolios. On a geographical basis, the New York markets reported growth in all portfolios except consumer indirect. The Pennsylvania markets reported an increase in consumer indirect, with declines in other portfolios. Excluding acquisition activity, total deposits declined slightly from 2002. The Company completed three acquisitions in 2003, including: (1) Harbridge Consulting Group, an actuarial and benefits consulting firm based in Syracuse, NY that was acquired from PricewaterhouseCoopers in July, (2) Peoples Bankcorp Inc., a $29 million-asset single branch bank in Ogdensburg, NY acquired in September, and (3) Grange National Banc Corp., a $280 million-asset bank with twelve branches in five counties of Northeastern PA, acquired in November. In January 2004, the Company announced an agreement to acquire First Heritage Bank, a $275 million-asset commercial bank based in Wilkes-Barre PA that is expected to close in May 2004. Net Income and Profitability Net income for 2003 was $40.4 million, up $1.9 million or 4.8% from the prior year. Earnings per share of $2.99 in 2003 were 2.0% higher than 2002's results. The growth rate of EPS was below that of net income due to higher weighted average diluted shares outstanding. The increase in diluted shares was primarily driven by the 1.1 million of common shares issued in conjunction with the acquisition of Grange National Banc Corp. ("Grange") in November 2003, an increased level of option grants and exercises, and a higher average common share price (refer to the "Earnings per Share" section of Note A on page 48 for information regarding the impact of share price on diluted shares). The 2003 results were impacted by $2.7 million of net losses from debt and security transactions, including $2.6 million of debt restructuring charges associated with the early retirement of higher-rate, medium-term borrowings. In contrast, 2002 earning per share benefited from net security and debt transaction gains of $1.7 million. 13 Net income and earnings per share for 2002 were $38.5 million and $2.93, up 101% and 81%, respectively, from 2001 results. The improvement in earnings in 2002 was primarily driven by a reduced level of acquisition expenses, which fell from $8.2 million in 2001 to $0.7 million in 2002. This was due to the fact that two of the Company's three acquisitions in 2001 were completed in the first half of the year (see Note B - "Acquisitions"), and consequently the vast majority of deal-related expenses were incurred during 2001. In addition, the 2002 results include the benefit of adopting SFAS 147, an accounting standard that eliminates the regular amortization of goodwill related to the Company's branch acquisitions, and SFAS 142, which eliminates the requirement to regularly amortize goodwill related to its whole-company acquisitions. SFAS 142 and SFAS 147 were effective January 1, 2002 and increased 2002 earnings per share by $0.06 and $0.28, respectively, versus 2001 EPS. Earnings per share for 2002 rose by a lesser percentage than net income versus 2001 because of 11% higher weighted average diluted shares outstanding, principally due to 1.3 million common shares issued in November 2001 to partially fund the acquisition of 36 branches from FleetBoston Financial. In addition to the earnings results presented above in accordance with GAAP, the Company provides earnings results on a non-GAAP, or operating basis. The determination of operating earnings excludes the effects of certain items the Company considers to be non-operating, including acquisition expenses, the results of securities transactions, and debt restructuring activities. Performance as measured by operating earnings is considered by management to be a useful measure for gauging the underlying performance of the Company by eliminating the volatility caused by voluntary, transaction-based items. Diluted operating earnings per share for 2003 were $3.13, up 8.7% from the $2.88 reported in 2002. The growth in earnings in 2003 was principally due to increased deposit service fee income, consumer mortgage growth, a higher net interest margin and a lower effective income tax rate. These improvements to earnings were partially offset by higher personnel, occupancy and volume-driven expenses and a planned reduction of investment portfolio balances. A reconciliation of GAAP-based earnings results to operating-based earnings results is as follows: Table 1: Reconciliation of GAAP EPS to Operating EPS
Years Ended December 31, ----------------------------------------------------------- (000's omitted) 2003 2002 2001 2000 1999 ----------------------------------------------------------------------------------------------- Net income $40,380 $ 38,517 $ 19,129 $24,899 $23,662 Eliminate after-tax impact of: Net securities losses/(gains) 33 (1,575) (1,514) 94 244 Loss on debt restructuring 1,615 559 1,581 0 0 Acquisition expenses 304 425 4,856 237 0 ----------------------------------------------------------------------------------------------- Net income - operating $42,332 $ 37,926 $ 24,052 $25,230 $23,906 ===============================================================================================
Excluding the aforementioned benefits from adopting SFAS 142 and 147 in 2002, operating earnings per share of $2.54 last year were 25% higher than the operating EPS generated in 2001. The resulting $0.51 improvement largely reflects the full-year impact of the FleetBoston branch acquisition, an improved net interest margin, a larger securities portfolio and a lower effective income tax rate. Table 2: Summary Income Statements
Years Ended December 31, ------------------------------------- (000's omitted, except per share data) 2003 2002 2001 ---------------------------------------------------------------------------------------------------- Net interest income (FTE) $ 143,918 $139,921 $ 103,985 Provision for loan losses 11,195 12,222 7,097 Non-interest income 37,679 30,133 26,092 (Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113) Operating expenses 101,963 94,330 80,430 Acquisition and unusual expenses 498 700 8,164 ---------------------------------------------------------------------------------------------------- Income before taxes (FTE) 65,243 64,475 34,273 Fully tax-equivalent adjustment 12,090 12,071 7,330 Income taxes 12,773 13,887 7,814 ---------------------------------------------------------------------------------------------------- Net income $ 40,380 $ 38,517 $ 19,129 ==================================================================================================== Diluted earnings per share $ 2.99 $ 2.93 $ 1.62 Diluted earnings per share-operating $ 3.13 $ 2.88 $ 2.03
The primary factors explaining 2003 performance are discussed in detail in the remaining sections of this document and are summarized as follows: 14 o As shown in Table 2 above, net interest income increased 2.9% or $4.0 million due to a $45 million increase in average earning assets and a seven-basis point improvement in the net interest margin. The relative contribution of changing balances and better margins were relatively balanced at 53% and 47%, respectively (see Table 5 on page 19). The net interest margin benefited from the rates on deposits and borrowings declining more than the yields earned on investments in the low interest rate environment. Average loans grew $126 million (7.2%), primarily due to a record year for consumer mortgage volume as well as the impact of the acquisitions of Grange and Peoples Bankcorp Inc. ("Peoples"). Average investments declined $81 million (6.4%) in 2003 as a result of a de-leveraging strategy undertaken in the first half of the year. The growth in earning assets was funded by $22 million (0.8%) more average deposits and slightly higher average borrowings (up $499,000 or 0.1%). o The loan loss provision decreased $1.0 million or 8.4% from the prior year level. Net charge-offs increased by $0.5 million primarily as a result of a larger loan portfolio, as evidenced by a two-basis point decrease in the net charge-off ratio (net charge-offs / total average loans) to 0.54%. The loan loss provision decreased despite the higher net charge-offs because the overall risk profile of the loan portfolio improved, in part due to a higher proportion of relatively low-risk consumer mortgages being added through organic growth and acquisitions. The improved asset quality position in 2003 was evident in standard metrics such as non-performing loans as a percentage of total loans (down two basis points), non-performing assets as a percentage of loans and other real estate owned (down two basis points) and delinquent loans (30+ days through non-accruing) as a percentage of total loans (down 12 basis points). Additional information on trends and policy related to asset quality is provided in the asset quality section on pages 28 through 31. o Non-interest income (excluding net gains and losses on investment security transactions and debt prepayment) for 2003 of $37.7 million increased by $7.5 million (25%) from 2002's level, the tenth consecutive year of growth. Banking services accounted for $6.5 million of the improvement, as overdraft volume increased significantly and income related to secondary market mortgage activity rose. Overdraft fee income benefited from the implementation of the Overdraft Freedom(TM) program (described in non-interest income section on pages 20 through 22) in December 2002, an increase of the fee charged for overdrafts in mid-2002 and a larger number of customer accounts due primarily to the two bank acquisitions. Financial services revenue was $1.0 million higher mostly as a result of the acquisition of PricewaterhouseCoopers' Upstate New York Global Human Resource Solutions consulting group (renamed Harbridge Consulting Group) at the end of July 2003 and strong growth at the Company's retirement plan administration business, Benefits Plans Administrative Services. As previously noted, 2003 included $2.6 million of debt prepayment charges and $0.1 million of net losses on investment security sales versus $2.6 million of gains on the sale of securities and a $925,000 charge for the early retirement of debt in 2002. The $4.4 million negative variance from security and debt transactions caused total non-interest income of $35.0 million in 2003 to rise by a lesser $3.2 million amount. o Total operating expenses rose $7.4 million or 7.8% in 2003 to $102.5 million. Excluding acquisition expenses in both years, 2003 operating expenses rose $7.6 million or 8.1%. A majority of the increase was due to increased personnel expenses, as merit increases, new hires, higher pension and medical expense rates and employees added through the three acquisitions drove these expenses higher. In addition, volume-related expenses such as checking charges (write-off of overdraft balances and fees) and customer processing expenses for the consumer mortgage business rose significantly in 2003 due to record levels of activity. Net occupancy expenses also increased because of a larger number of facilities due to acquisitions, current and prior year renovations, higher property tax and utility rates and a rise in various weather-related costs. o The Company's combined effective federal and state tax rate decreased 2.5 percentage points in 2003 to 24.0%, primarily as a result of an increased proportion of pre-tax income from tax-exempt investments and loans. Selected Profitability and Other Measures Return on average assets, return on average equity, dividend payout and equity to asset ratios for the years indicated are as follows: Table 3: Selected Ratios
2003 2002 2001 ----------------------------------------------------------------------- Return on assets 1.16% 1.14% 0.66% Return on assets - operating 1.22% 1.12% 0.83% Return on equity 11.78% 13.06% 7.99% Return on equity - operating 12.35% 12.86% 10.05% Dividend payout ratio 40.2% 37.7% 65.7% Average equity to average assets 9.87% 8.69% 8.29%
15 As displayed in Table 3 above, the return on average assets improved in 2003 in comparison to both 2002 and 2001. This was primarily a result of higher net interest margins, a greater proportion of earnings generated from non-interest income and improved operational efficiencies. Based on operating earnings, the return on assets was up 10 basis points in 2003. Reported return on equity in 2003 was down from 2002's level. This was mainly a result of the build-up of equity capital this year from the retention of net profits and the common shares issued in conjunction with the acquisition of Grange National Banc Corp., and the $4.4 million swing in net gains and losses from security and debt transactions. Consequently, average shareholders' equity increased 16.2% this year, well above the 4.8% increase in reported (GAAP) net income. Based on operating earnings, the return on equity in 2003 fell by a lesser 51 basis points. The return on equity improved in 2002 versus 2001 despite significantly higher equity levels (stock issuance and market value appreciation in the investment portfolio) because of much higher profits. The strengthening of the Company's equity capital position over the past two years is reflected in the 40 and 118 basis-point increases in the average equity to average total assets ratios in 2002 and 2003, respectively. The dividend payout ratio for 2003 was above 2002's level based on reported net income mostly due to the security and debt transactions previously mentioned. On an operating basis, the dividend payout ratio for 2003 was essentially equal to the prior year (38.4% vs. 38.2%), as operating net income grew at approximately the same rate (11.6%) as dividends declared (11.9%). The dividend payout ratio spiked temporarily in 2001 due to a short-term drop in earnings as the Company worked through the integration of three major acquisitions, and the related 2.3 million increase in the number of shares outstanding that caused the dollar amount of declared dividends to rise significantly. Net Interest Income Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest bearing funds as a percentage of earning assets. As disclosed in Table 4, net interest income (with non-taxable income converted to a fully tax-equivalent basis) totaled $143.9 million in 2003, up $4.0 million or 2.9% over the prior year. The increase was due to a favorable shift in the mix of interest-earning assets and interest-bearing balances and improved margins, which had positive impacts of $2.1 million and $1.9 million on net interest income, respectively (see Table 5 on page 19). CBSI's net interest margin increased seven basis points from 4.62% in 2002 to 4.69% this year. The 68-basis point decrease in the rate on average interest-bearing funds and a greater proportion of funding from non-interest-bearing deposits had a greater impact than the 56-basis point decline in the yield on interest-earning assets. Downward re-pricing of the Company's interest-bearing deposits, a shift in deposit mix from higher-rate accounts to low and non-interest bearing accounts and greater utilization of low-rate, short-term borrowings, combined with a relatively stable yield on the investment portfolio led to the improvement in the margin. The Company's net interest margin ranked in the very favorable 86th peer bank percentile for the nine months ending September 30, 2003. The net interest margin declined in each of the quarters of 2003, ending with a 4.59% margin for the fourth quarter. This trend was mostly attributable to the level and changes in market interest rates during 2003. Falling market rates early in the year allowed the Company to reduce rates on non-time deposit interest-bearing accounts in the first two quarters that were not reproduced in the second half of 2003. The overall low level of interest rates resulted in loan yields and time deposit rates declining throughout the year. However, due to the larger size and substantial growth of the loan portfolio in 2003 (versus a decline in average time deposit balances), the decline in loan yields had a greater negative impact on the margin in 2003 ($15.0 million) than the benefit derived from time deposit rate reductions ($9.5 million). Another reason the net interest margin declined later in the year was that the de-leveraging of the investment portfolio in the first half of 2003 allowed the Company to avoid adding low-yielding securities during that time period. However, investment purchases were made in the second half of 2003 that will provide incremental net interest income in the coming years and help protect the Company from falling interest rates, but also contributed somewhat to the contraction of the net interest margin later in 2003. As shown in Table 4, total interest income decreased by $13.9 million or 6.4% in 2003. Table 5 shows that lower rates contributed a negative variance of $17.2 million, partially offset by a positive impact of $3.2 million from $45.5 million higher average earning assets and changes in the mix of funding sources. Average loans grew a total of $126.0 million in 2003, with the vast majority coming from organic consumer mortgage and consumer indirect loan growth. The addition of $15.1 million of loans through the acquisition of Peoples in early September 2003 and $171.1 million from the late-November 2003 acquisition of Grange had a positive, but less substantial impact on average loan growth due to the timing of the transactions. Interest and fees on loans decreased $5.9 million or 4.5%. An 82-basis point drop in loan yields due to falling capital market rates had more of an impact (negative $15.0 million) than growth in average loans (positive $9.0 million). 16 In early fourth quarter 2002, management instituted an investment de-leveraging strategy, allowing the portfolio to run down and using the proceeds to pay down borrowings due to the lack of investment opportunities offering acceptable yields. This approach was in effect through June 2003, when it was decided that investment purchases should be reinitiated to take advantage of more attractive medium and long-term rates and a steep yield curve, as well as protect the Company from its interest rate exposure to falling rates. Due to the de-leveraging strategy being in place for approximately half of 2003 versus less than a quarter of 2002, average investment balances for 2003 were down $80.6 million versus the year-earlier period, primarily in the mortgage-backed securities ("MBS") and collateralized mortgage obligations ("CMOs") segments of the portfolio (refer to the "Investments" section of the MD&A on pages 34 through 36 for further information). Investment interest income in 2003 of $77.4 million was $8.0 million or 9.4% lower than the prior year as a result of the smaller portfolio (negative $4.5 million impact) and a decrease in the average investment yield from 6.74% to 6.53% (negative $3.5 million impact). The decrease in the yield was principally driven by significant declines in market interest rates from early 2001 through mid-2003. Consequently, the Company was unable to replace the run-off of longer-held, higher-yielding securities with equivalent-rate investments, and the purchase of securities in the relatively low-interest rate conditions in the second half of 2003 led to yield declines. However, the net spread on these medium-term investment purchases were comparable because they were funded by very low-rate, short-term borrowings. In addition, the performance of the investment portfolio in 2003 was strong given the interest rate environment. The Company was able to maintain its yields to a great extent primarily because of two important strategies: the addition of a substantial amount of call-protected securities in 2001 and first half of 2002 when rates were higher, and foregoing security purchases in the late-2002 to mid-2003 period as rates were falling significantly. The success of these actions was evident in CBSI's exceptional 97th percentile ranking within its peer group for tax-equivalent investment yield for the nine months ended September 2003. The average earning asset yield fell 56 basis points to 6.62% in 2003 because of the previously mentioned decrease in investment and loan yields and the fact that the yields on the overall loan portfolio have converged with those of the investment portfolio. In 2002 the yield on the loan portfolio was 75 basis points higher than the yield on investments. Loan yields were only 14 basis points above those produced by investments in 2003. Consequently, the shift in the mix of average earning assets towards a higher proportion of loans in 2003 (61.4% vs. 58.2%) due to significant consumer mortgage growth, acquired loans and the reduced size of the investment portfolio, did not provide the usual yield advantage it would have under more normalized interest rate conditions. Total average fundings (deposits and borrowings) grew by $22.1 million in 2003, with $21.6 million of the increase coming from deposits, mostly attributable to the acquisitions of Grange and Peoples, and $0.5 million from additional external borrowings. All of the increase in external funding came from short-term borrowings. Long-term debt was reduced through normal pay-downs and the pre-payment of $25 million of medium-term FHLB borrowings in the fourth quarter of 2003, which was replaced with much lower-rate, short-term funding from the Federal Home Loan Bank. Total interest expense decreased by $17.9 million to $59.3 million in 2003. As shown in Table 5, lower rates on deposits and external borrowings accounted for $17.7 million, or almost all of the decrease. Interest expense as a percentage of earning assets fell by 62 basis points to 1.93%. The rate on interest bearing deposits fell 73 basis points to 1.83%, due largely to steady declines in time deposit rates throughout 2003 and periodic reduction of rates on other interest-bearing deposit products. The rate on external borrowings declined 47 basis points to 4.13% because of substantially lower market rates and the previously mentioned shift in funding mix towards short-term borrowings. As shown in Table 4, net interest income for 2003 was $39.9 million higher than 2001's level due to a number of factors. Interest-earning assets have grown by $447 million (17%) through a combination of acquired loans, organic loan growth and effective management of a larger investment portfolio. The net interest margin in 2003 was 73 basis points higher than two years ago in most part due to earning-asset yields declining 123 basis points versus a 221 basis-point decline in interest-bearing liabilities and an 197-basis point decrease in the cost of funds (includes demand deposits). The yield on earning-assets benefited greatly over the last two years by the relative stability of the investment portfolio yield, which declined only 48 basis points over this period despite a significant drop in market interest rates. The cost of funding was aided by the change in the make-up of both the deposit base and external borrowings. The fall of market interest rates over the last two years not only enabled a significant reduction of interest-bearing deposit rates, but also caused many customers to shift their funds from time deposits to less restrictive accounts such as savings and demand deposits due to the greatly diminished rate spread between the two groups of accounts. This is demonstrated by the percentage of average deposits that were in time deposit accounts dropping from 52% in 2001 to 43% in 2003, accounting for a portion of the reduced funding costs beyond the absolute drop in rates. The Company also changed the proportion of long-term funding in average external borrowings from 71% in 2001 to 58% in 2003 to take advantage of historically low short-term rates, providing further funding cost savings. 17 The following table sets forth certain information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon for the years ended December 31, 2003, 2002 and 2001. Interest income and resultant yield information in the tables are on a fully tax-equivalent basis using marginal income tax rates of 38.9% in 2003, 39.3% in 2002 and 40.5% in 2001. Averages are computed on daily average balances for each month in the period divided by the number of days in the period. Yields and amounts earned include loan fees. Nonaccrual loans have been included in interest-earning assets for purposes of these computations. Table 4: Average Balance Sheet
(000's omitted, except yields and rates) Year Ended December 31, 2003 Year Ended December 31, 2002 - ---------------------------------------- ------------------------------------------ ------------------------------------------ Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid - ---------------------------------------- ------------------------------------------ ------------------------------------------ Assets Interest-earning assets: Time deposits in other banks $ 346 $ 4 1.16% $ 525 $ 6 1.14% Taxable investment securities (2) 779,107 48,212 6.19% 906,902 58,458 6.45% Non-taxable investment securities (2) 406,034 29,148 7.18% 358,643 26,899 7.50% Loans (net of unearned discount)(1) 1,885,604 125,855 6.67% 1,759,564 131,801 7.49% -------------------------- -------------------------- Total interest-earning assets 3,071,091 203,219 6.62% 3,025,634 217,164 7.18% Non-interest earning assets 400,598 367,530 ---------- ---------- Total assets $3,471,689 $3,393,164 ========== ========== Liabilities and Shareholders' Equity Interest-bearing liabilities: Interest checking, savings and money market deposits $1,000,238 6,769 0.68% $ 969,664 11,416 1.18% Time deposits 1,090,511 31,519 2.89% 1,131,296 42,462 3.75% Short-term borrowings 212,512 2,685 1.26% 141,024 2,586 1.83% Long-term borrowings 295,880 18,328 6.19% 366,869 20,779 5.66% Total interest-bearing liabilities 2,599,141 59,301 2.28% 2,608,853 77,243 2.96% Non-interest bearing liabilities: Demand deposits 473,568 441,800 Other liabilities 56,301 47,655 Shareholders' equity 342,679 294,856 ---------- ---------- Total liabilities and shareholders' equity $3,471,689 $3,393,164 ========== ========== Net interest earnings $143,918 $139,921 ======== ======== Net interest spread 4.34% 4.22% Net interest margin on interest-earnings assets 4.69% 4.62% Fully tax-equivalent adjustment on $ 12,090 $ 12,071 Investments and loans (000's omitted, except yields and rates) Year Ended December 31, 2001 - ---------------------------------------- ------------------------------------------ Avg. Average Yield/Rate Balance Interest Paid - ---------------------------------------- ------------------------------------------ Assets Interest-earning assets: Time deposits in other banks $ 4,874 $ 549 11.26% Taxable investment securities (2) 822,285 56,808 6.91% Non-taxable investment securities (2) 215,567 15,759 7.31% Loans (net of unearned discount)(1) 1,580,870 132,706 8.39% -------------------------- Total interest-earning assets 2,623,596 205,822 7.85% Non-interest earning assets 265,164 ---------- Total assets $2,888,760 ========== Liabilities and Shareholders' Equity Interest-bearing liabilities: Interest checking, savings and money market deposits $ 683,088 12,783 1.87% Time deposits 1,100,850 60,380 5.48% Short-term borrowings 141,772 6,738 4.75% Long-term borrowings 340,811 21,936 6.44% ---------- -------- ----- Total interest-bearing liabilities 2,266,521 101,837 4.49% Non-interest bearing liabilities: Demand deposits 343,173 Other liabilities 39,698 Shareholders' equity 239,368 ---------- Total liabilities and shareholders' equity $2,888,760 ========== Net interest earnings $103,985 ======== Net interest spread 3.36% Net interest margin on interest-earnings assets 3.96% Fully tax-equivalent adjustment on $ 7,330 Investments and loans
(1) The impact of interest not recognized on non-accrual loans and interest income that would have been recorded if the restructured loans had been current in accordance with their original terms was immaterial. (2) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes. 18 As discussed above, the change in 2003 net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category. Table 5: Rate/Volume
2003 Compared to 2002 2002 Compared to 2001 Increase (Decrease) Due to Change in (1) Increase (Decrease) Due to Change in (1) ---------------------------------------- ---------------------------------------- Net Net (000's omitted) Volume Rate Change Volume Rate Change - --------------------------------------- ---------------------------------------- ---------------------------------------- Interest earned on: Time deposits in other banks ($2) $0 ($2) ($271) ($272) ($543) Taxable investment securities (7,981) (2,265) (10,246) 5,609 (3,959) 1,650 Nontaxable investment securities 3,439 (1,190) 2,249 10,721 419 11,140 Loans (net of unearned discount) 9,033 (14,979) (5,946) 14,173 (15,078) (905) Total interest-earning assets (2) $3,222 ($17,167) ($13,945) $29,814 ($18,472) $11,342 Interest paid on: Interest checking, savings and $349 ($4,996) ($4,647) $4,307 ($5,674) ($1,367) money market deposits Time deposits (1,483) (9,460) (10,943) 1,627 (19,545) (17,918) Short-term borrowings 1,058 (959) 99 (35) (4,117) (4,152) Long-term borrowings (4,274) 1,823 (2,451) 1,599 (2,756) (1,157) Total interest-bearing liabilities (2) ($286) ($17,656) ($17,942) $13,771 ($38,365) ($24,594) Net interest earnings (2) $2,117 $1,880 $3,997 $17,207 $18,729 $35,936
(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of change in each. (2) Changes due to volume and rate are computed from the respective changes in average balances and rates of the totals; they are not a summation of the changes of the components. 19 Non-interest Income The Company's sources of non-interest income are of three primary types: general banking services related to loans, deposits and other core customer activities typically provided through the branch network; financial services, comprised of retirement plan administration and employee benefit trusts (Benefit Plans Administrative Services or BPA), employee benefit actuarial and consulting services (Harbridge Consulting Group or Harbridge), personal trust, investment and insurance products (Community Investment Services, Inc. or CISI) and investment management (Elias Asset Management or EAM); and periodic transactions, most often net gains (losses) from the sale of investments and prepayment of term debt. Table 6: Non-interest Income
Years Ended December 31, ------------------------------------ (000's omitted) 2003 2002 2001 --------------------------------------------------------------------------------------------------- Banking services: Electronic banking $ 2,604 $ 2,375 $ 1,469 Mortgage banking 518 175 653 Deposit service charges 5,374 5,310 4,183 Overdraft fees 13,476 6,937 5,183 Credit life and disability insurance 856 1,082 835 Commissions and other fees 2,042 2,243 2,259 Miscellaneous (93) 163 89 --------------------------------------------------------------------------------------------------- Total banking services 24,777 18,285 14,671 Financial services: Retirement plan administration and trust fees 4,668 3,845 3,585 Benefit plan actuarial and consulting fees 1,552 0 0 Asset advisory and management fees 1,890 2,606 3,643 Investment and insurance product commissions 3,339 3,715 2,372 Personal trust 1,453 1,682 1,821 --------------------------------------------------------------------------------------------------- Total financial services 12,902 11,848 11,421 --------------------------------------------------------------------------------------------------- Sub-total 37,679 30,133 26,092 (Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113) --------------------------------------------------------------------------------------------------- Total non-interest income $ 34,981 $31,806 $ 25,979 =================================================================================================== Non-interest income/operating income (FTE) 20.7% 17.7% 20.1%
As displayed in Table 6, total non-interest income in 2003 increased by 10.0% to $35.0 million, largely as a result of significantly higher overdraft volume, the acquisition of Harbridge and growth at BPA. These improvements were offset by substantially higher losses on the early retirement of long-term borrowings, the absence of gains on the sale of securities and weakness in the other financial services group businesses. Non-interest income, excluding transactions related to investment securities and debt obligations, rose for the tenth consecutive year to $37.7 million in 2003, a $7.5 million or 25% improvement over 2002. Non-interest income, excluding net gains (losses) from the sale of securities and early retirement of debt, as a percent of operating income (FTE basis) was 20.7% in 2003, up 3.0 percentage points from the prior year, and an all-time high for the Company. This increase was primarily driven by the aforementioned strong growth in overdraft fees and BPA revenue, as well as the acquisition of Harbridge. This ratio is considered an important measure for determining the progress the Company is making on one of its primary long-term strategies, expansion of non-interest income in order to diversify its revenue sources and reduce reliance on net interest margins that may be strongly impacted by general interest rate and other market conditions. The largest segment of the Company's recurring non-interest income is the wide variety of fees earned from general banking services, which reached $24.8 million in 2003, up 36% from the prior year. This segment contributed 66% of 2003 non-interest income, excluding net gains and losses from security sales and debt extinguishment. A large portion of the income growth was attributable to overdraft fees, up $6.5 million (94%) over 2002's level, which benefited from the implementation of the Company's Overdraft Freedom(TM) program in December 2002, additional accounts added through acquisitions and the full-year impact of a fee increase implemented in June 2002. Overdraft Freedom(TM) is a program currently offered to retail customers whereby the Company may pay overdrawn amounts for qualified customers up to a 20 certain predetermined limit, for which they are charged a standard overdraft fee. This program is a courtesy service to customers in good standing that may allow them to avoid late and non-payment penalties from creditors and vendors and help them in their effort to avoid the negative consequences of returned checks. This type of deposit account service has become prevalent throughout much of the banking industry. Income derived from activity associated with the secondary market mortgage portfolio rose to $518,000 in 2003, up $343,000 from the prior year. One of the main reasons for the increase was that $67 million of consumer mortgages were sold on the secondary market in 2003 versus $9 million in 2002. The selling of secondary mortgages was resumed in October 2002 after a one-year suspension, and continued through September 2003. The combination of increased sales and fluctuations in interest rates was the primary driver of gains of $627,000 on loans sold and $372,000 from the establishment of and valuation of mortgage servicing rights. This compares to $64,000 of gains on loans sold and a $163,000 write-down of mortgage servicing rights in 2002. These income improvements were offset by a $795,000 unrealized loss on mortgage loan commitments. Certain loan commitments that had been categorized as held-for-sale were reclassified as portfolio loans commitments after the decision was made to discontinue the sale of twenty-year and longer mortgages. Market loss on these commitments was recognized in earnings concurrent with the reclassification. Higher secondary sales partially offset by increased levels of mortgage prepayments resulted in the loan-servicing portfolio rising from $103.7 million at the end of 2002 to $126.3 million at year-end 2003. This growth was the primary reason why a fourth component of secondary market activity, loan-servicing fees, rose 14.5% to $313,000 in 2003. As disclosed in Table 6, non-interest income from the financial services segment rose $1.0 million or 8.9% in 2003 to $12.9 million. Financial services revenue now comprises 34% of total non-interest income, excluding net gains (losses) on the sale of investment securities and retirement of debt. This compares to 39% in 2002, with the decline primarily due to the tremendous success of the Company's new overdraft program this year. The acquisition of Harbridge at the end of July 2003 resulted in $1.6 million of incremental revenue for the financial services group in the current year. Another impressive year of revenue growth at BPA (up $823,000 or 21%) was driven by a significant number of new plans and growth in the market value of client assets. These two businesses are part of the Company's Benefits Plan Administrative Services, Inc. ("BPAS") subsidiary, and operate collaboratively to offer clients a full array of employee benefits, recordkeeping and consulting services throughout much of the country. BPAS revenue of $6.2 million was $2.4 million higher than prior year results. The other financial services businesses, CISI, Elias Asset Management and personal trust were all negatively impacted by the challenging retail investment market conditions of the past few years. A significant drop in interest rates this year resulted in much lower annuity volume and commission rates for CISI, accounting for most of the $376,000 decline in their revenue to $3.3 million. An extended period of weak performance by US equities from late-2000 through early 2003 had an adverse impact on EAM's assets under management, as lower valuations and the loss of assets reduced their main driver of revenue generation. Consequently, EAM's revenue was down $716,000 to $1.9 million in 2003. However, significantly improved market conditions and investor confidence in the latter part of 2003 directly benefited EAM's performance, as higher equity valuations and new client acquisition resulted in 15% higher revenues in the second half of the year versus the first half. Lastly, the personal trust business experienced a $229,000 decline in revenue to $1.5 million, primarily due to the timing of estate settlements. Assets under management from the Company's financial services businesses rose considerably to $1.807 billion at the end of 2003 compared to $1.364 billion at year-end 2002. Market-driven gains in equity-based assets were augmented by attraction of new client assets. BPA in particular was very successful at growing its asset base, as demonstrated by the $312 million or 69% increase in its assets under administration. The total financial services group contributed $1.6 million (excluding allocation of indirect corporate expense) or 2.9% of the Company's pretax income this year, reflecting nearly a 12% margin. In 2002, financial services' contribution was $2.2 million or 4.2% of total pretax income, with a margin of 18%. The lower earnings and margin were the result of up-front, transaction-related expenses absorbed by Harbridge and cost-cutting efforts at EAM and CISI not keeping pace with revenue shortfalls. In addition, most of the expenses for the personal trust unit are fixed in nature and therefore its margins and pre-tax contribution tend to fluctuate to a large degree with variability of their traditionally uneven revenue stream. The decline in percentage contribution was primarily due to the banking business's success at growing net interest income, non-interest income and reducing the loan loss provision in 2003. In addition, the near-term profitability challenges faced by the financial services group due to market conditions, amortization of intangible assets and unusual expenses are expected to diminish over time and be more than offset by top-line growth. There was a total net loss on security and debt transactions of $2.7 million this year compared to $1.7 million of net gains in 2002. The loss in 2003 was primarily composed of $2.6 million of charges associated with the early retirement of $25 million of longer-term FHLB borrowings that were replaced with lower rate, short-term borrowings, which is expected to provide a long-term earnings benefit as well as reduce interest rate risk. Current year results also included $0.1 million of 21 losses from a variety of smaller security and debt transactions. The net gain in 2002 included $2.6 million of gains on $80 million of investment sales, and a $0.9 million prepayment penalty on the retirement of approximately $11 million of intermediate-term FHLB borrowings in the fourth quarter. The security and debt gains and losses taken over the last two years are illustrative of the Company's active management of its investment portfolio and external borrowings to achieve a desirable total return through the combination of net interest income, transaction gains/losses and changes in market value across financial market cycles. Excluding gains and losses from security sales and debt retirement, non-interest income for 2003 was up $11.6 million or 44% from 2001's level, driven by strong growth of 15% and 25% in 2002 and 2003, respectively. The increase in 2002 came from both the banking and financial services segments. The acquisition of 36 FleetBoston branches in November 2001 contributed a significant amount of incremental banking fees in 2002. Prior year non-interest income also benefited greatly from substantial business expansion at BPA, which has provided consistent revenue growth since it was acquired in July 1996, and CISI which successfully shifted it focus to annuity sales in 2002 to provide growth in a very difficult year for equity-based products. As previously noted, the impressive increase in recurring non-interest income in 2003 was driven by deposit service fees, income related to the secondary mortgage market, the acquisition of Harbridge and another year of robust growth at BPA. Total non-interest income for 2003 was up a lesser $9.0 million from 2001's level, due primarily to debt repayment penalties that will provide future benefits and very limited security sales in comparison to the earlier periods. Operating Expenses As shown in Table 7, operating expenses rose $7.4 million or 7.8% in 2003 to $102.5 million. Excluding acquisition expenses related to Harbridge, Peoples and Grange in 2003 and the FleetBoston branches in 2002, operating expenses were up $7.6 million or 8.1% in 2003, reflective mostly of incremental expenses from the operations of the acquired businesses listed above, as well as increases in pension, medical and volume-driven costs. This year's operating expenses as a percent of average assets were 2.95%, up from 2.80% in 2002 and lower than the 3.07% in 2001. The increase in this ratio for 2003 was principally due to the acquisition of a financial services unit whose revenue is not driven by earning assets (Harbridge), and the charge-offs resulting from higher overdraft volume, another significant revenue generating tool with a limited underlying asset base. This ratio was elevated in 2001 primarily as a result of the high level of acquisition expenses in that year. CBSI's operating expenses to average asset ratio of 2.94% (annualized) for the nine months ended September 2003 was slightly below the median of 2.95% for peer banks. The efficiency ratio, a performance measurement tool widely used by banks, is defined by the Company as operating expenses (excluding acquisition expenses and intangible amortization) divided by operating income (fully tax-equivalent net interest income plus non-interest income, excluding net securities and debt gains and losses). Lower ratios correspond to higher efficiency. In 2003 the efficiency ratio increased by 1.3 percentage points to 53.3%. This was primarily a result of net interest income being tempered for much of the year due to the investment de-leveraging strategy, rising pension and medical expenses and the impact from reduced pre-tax margins in the financial services segment in 2003, as discussed earlier. The efficiency ratio for 2003 was significantly lower than the ratio of 56.7% for 2001, as initiatives undertaken in 2001, such as the consolidation of the Company's loan and deposit operations centers and cost take-outs at First Liberty, have provided ongoing efficiency improvements. Table 7: Operating Expenses
Years Ended December, ---------------------------------- (000's omitted) 2003 2002 2001 ------------------------------------------------------------------------ Salaries and employee benefits $ 53,164 $47,864 $40,930 Occupancy 9,297 8,154 6,122 Equipment and furniture 7,828 7,538 6,075 Legal and professional fees 3,183 3,272 2,789 Data processing 6,800 6,574 4,727 Amortization of intangible assets 5,093 5,953 6,679 Office supplies 1,996 2,321 1,995 Foreclosed property 561 902 1,059 Deposit insurance premiums 388 440 346 Other 13,653 11,312 9,708 ------------------------------------------------------------------------ Total recurring expenses 101,963 94,330 80,430 Acquisition and unusual expenses 498 700 8,164 ------------------------------------------------------------------------ Total operating expenses $102,461 $95,030 $88,594 ======================================================================== Operating expenses/average assets 2.95% 2.80% 3.07% Efficiency ratio 53.3% 52.0% 56.7%
22 Higher personnel expenses accounted for 69% of 2003's increase in operating costs, excluding acquisition expenses, as they increased 11.1%, mostly as a result of the three acquisitions. The remainder of the increases in personnel expense reflect higher pension (discussed in further detail below) and medical rates, merit increases and new hiring activity. Total full-time equivalent staff at the end of 2003 was 1,259 compared to 1,120 at year-end 2002. Medical expenses were up in 2003 due to a general rise in the cost of medical care, administration and insurance, as well as a greater number of insured employees. Qualified and non-qualified pension expenses increased significantly in 2003 principally due to a reduction of the discount rate applied to future payments to 6.10% from 6.75% (increases current expenses in present value terms) and additional obligations for employees added through acquisition and organic growth. In addition, a $1.2 million adjustment was recorded in the fourth quarter of 2003 to reflect the proper actuarial impact of indexing salary levels associated with certain benefits frozen in 1988. The three assumptions that have the largest impact on the calculation of annual pension expense are the aforementioned discount rate, the rate applied to future compensation increases and the expected rate of return on plan assets. Table 8 contains the results of a sensitivity analysis conducted to determine what the impact of a 1.0 percentage point increase and decrease in these three assumptions would have on the annual pension expense for the two plans. Also, see Note K to the financial statements for further information concerning the pension plan. Table 8: Pension Plan Sensitivity Analysis One Percentage Point ---------------------- (000's omitted) Increase Decrease ----------------------------------------------------------- Discount rate ($834) $ 949 Rate of compensation increase $451 ($430) Expected return on plan assets ($360) $ 360 Total non-personnel expenses increased $2.1 million or 4.5% in 2003. Excluding acquisition-related expenses, non-personnel expenses were up $2.3 million or 5.0% from 2002's level. As displayed in Table 7, this was largely caused by higher occupancy expense (up $1.1 million) and other expenses (up $2.3 million), and partially offset by lower intangible amortization (down $0.9 million), office supplies (down $0.3 million) and foreclosed property expenses (down $0.3 million). The increase in occupancy expense in 2003 was mainly due to incremental costs from recently acquired facilities, expenses arising from renovations and repairs, the effect of higher rates and severe weather on maintenance and utilities expenses and the general increase in property taxes in many of the municipalities we do business in. Other expenses include two volume-driven expense items that were up considerably due to record levels of business activity, mortgage processing expenses and checking charges related to overdraft activity. In 2003 non-recurring expenses associated with the retirement of a senior executive also impacted other expenses. Intangible amortization in 2003 was down versus the prior year because the drop in accelerated amortization of core deposit intangibles from the FleetBoston branch acquisition had a greater impact than the amortization of intangibles added as a result of the three acquisitions completed this year. Office supply expenses declined primarily because of improved purchasing cost controls in 2003 and escalated expense levels in early 2002 arising from the integration of the acquired FleetBoston branches. Acquisition and unusual expenses totaled $498,000 in 2003, down from $700,000 in 2002. These expenditures were primarily comprised of legal and consulting fees of $213,000, $191,000 of system conversion costs and $94,000 of other general administrative expenses. The majority of these expenses was incurred in conjunction with the Company's largest acquisition of 2003, Grange National Banc Corp., in November 2003. As displayed in Table 7 above, recurring operating expenses in 2002 increased $13.9 million or 17% in comparison to 2001. As was the case in 2003, the rise in 2002 was predominately caused by incremental expenses from acquired operations. The increase in 2002 was substantially higher than the 8.1% rise this year primarily due to 2002 including ten and a half months of additional expenses from a large scale acquisition (FleetBoston branches), versus 2003 having only one and half months of incremental expenses from a relatively large acquisition, Grange. In addition, the two acquisitions made under the purchase method of accounting in 2002 (Citizens and the FleetBoston branches) were larger than the three acquisitions made this year ($949 million of assets and deposits vs. $600 million). The cumulative effect of these six acquisitions was the major contributor to the $21.5 million of increased recurring operating expenses in 2003 in comparison to 2001, a modest increase in light of the $51.5 million growth in recurring operating income over the same time period. Income Taxes The Company estimates its tax expense based on the amount it expects to owe the respective tax authorities, plus the impact of deferred tax items. Taxes are discussed in more detail in Note I of the Consolidated Financial Statements on page 58. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account 23 statutory, judicial and regulatory guidance in the context of the Company's tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required. The effective tax rate for 2003 declined by 2.5 percentage points to 24.0%. This decline was primarily due to the benefits realized on a larger proportion of income from tax-exempt investment securities. In addition, the amount of nondeductible merger expenses declined in 2003. The effective tax rate for 2002 of 26.5% was down from the 29.0% rate in 2001. This decline was primarily due to the benefits realized on a larger proportion of income from tax exempt investment securities, which mitigated the effect of the near doubling of income before tax. In addition, the adoption of SFAS 142 and 147, the reduced level of nondeductible merger expenses in 2002 compared with 2001, and a federal low-income housing tax credit claimed in 2002, all contributed to the decline in the effective tax rate last year. Capital Shareholders' equity ended 2003 at $405 million, up $79.8 million or 25% from one year earlier. This increase reflects $60.4 of common stock issued in conjunction with the acquisition of Grange, net income of $40.4 and $6.4 million from the issuance of shares through employee stock plans. These factors were partially offset by common dividends declared of $16.2 million, treasury share purchases of $8.5 million and a $2.6 million decline in the market value adjustment ("MVA", represents the after-tax, unrealized change in value of available-for-sale securities in the Company's investment portfolio). Excluding the MVA in both 2003 and 2002, capital rose by $82 million or 29%. Shares outstanding rose by 1,187,000 during the year, comprised of 1,147,000 issued to Grange shareholders and 248,000 added through employee stock plans, offset by the purchase of 208,000 treasury shares. The Company's ratio of tier I capital to assets (or tier I leverage ratio), the basic measure for which regulators have established a 5% minimum to be considered "well-capitalized," increased 21 basis points in 2003 to 7.26%. This was due to the net issuance of common stock and the capital-building contribution from retained earnings (net income less dividends declared) more than offsetting both the organic and acquired growth of the investment and loan portfolios. The tangible equity/tangible assets ratio was 5.70% at the end of 2003 versus 5.76% one year earlier, with the decline in MVA having a negative 17-basis point impact on this ratio (MVA is excluded from tier I ratios). CBSI manages organic and acquired growth in a manner that enables it to continue to build upon its strong capital base, and maintain the company's ability to take advantage of future strategic growth opportunities. Cash dividends declared on common stock in 2003 of $16.2 million represented an increase of 11.9% over the prior year. This growth was mostly a result of dividends per share of $1.22 for 2003 increasing from $1.12 in 2002 due to quarterly dividends per share being raised from $0.29 to $0.32 (+10.3%) in the third quarter of 2003 and from $0.27 to $0.29 (+7.4%) in the third quarter of 2002. The increase in dollar amount of dividends declared also reflects an increase in the number of shares outstanding at the end of this year, primarily a result of the 1.1 million shares issued in November 2003 to Grange shareholders. The dividend payout ratio for this year was 40.2% compared to 37.7% in 2002 and 65.7% in 2001, and near the top of CBSI's targeted payout range for dividends on common stock of 30-40%. The Company's payout ratio has historically been high relative to peers, and for first nine months of 2003 the ratio of 36.9% was well above the peer median of 31.4%. As previously noted, the primary reason for the higher payout ratio in 2003 versus 2002 was the charges for early retirement of debt in 2003 and the significant increases in the dividends per share in the third quarters of both years. The payout ratio was substantially lower in 2002 than in 2001 despite higher dividends per share ($1.12 vs. $1.08). This was a result of the 101% increase in net income in 2002, which was largely due to higher interest earning assets, an improved net interest margin in 2002, and considerably more acquisition-related expenses in 2001. Liquidity Due to the potential for unexpected fluctuations in deposits and loans, active management of the Company's liquidity is critical. In order to respond to these circumstances, adequate sources of both on and off-balance sheet funding are in place. The Bank's primary approach to measuring liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities); and second, a projection of subsequent cash availability over an additional 60 days. The minimum policy level of liquidity under the Basic Surplus/Deficit approach is 7.5% of total assets for both the 30 and 90-day time horizons. As of December 31, 2003, this ratio was 15.1% and 14.9% for the respective time periods, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank and other sources. 24 There is currently $194 million in additional Federal Home Loan Bank borrowing capacity based on the Bank's year-end collateral levels. Additionally, the Bank has $25 million in unused capacity at the Federal Reserve Bank and $10 million in unused capacity from an unsecured line of credit with First Tennessee Bank, N.A. To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how liquidity levels could change over time. This five-year measure reflects ample liquidity for loan growth over the next five years. Intangible Assets Intangible assets at the end of 2003 of $196 million were up $61 million from the prior year-end due to the additional intangible assets arising from the acquisitions from Peoples, Harbridge and Grange, offset by $5.1 million of amortization during the year. Intangible assets consist of goodwill, core deposit value and customer relationships arising from acquisitions. Goodwill represents the excess cost of an acquisition over the fair value of the net assets acquired. Goodwill at December 31, 2003 equaled $160 million, comprised of $149 million related to banking acquisitions and $11 million arising from the acquisition of financial services businesses. Goodwill is subjected to an annual impairment analysis to determine whether the carrying value of the acquired net assets exceeds their fair value, which would necessitate a write-down of the goodwill. The Company completed its goodwill impairment analyses during 2003 and 2002 and no adjustments were necessary. The impairment analysis was based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators. Management believes that there is very low probability of future impairment with regard to the goodwill associated with whole-bank acquisitions. The performance of Elias Asset Management weakened subsequent to its acquisition in 2000 as a result of adverse market conditions in 2001 and 2002. Continued declines in EAM's operating results may result in impairment to its recorded goodwill of $7.3 million. Core deposit intangibles represent the premium the Company has paid for deposits acquired in excess of the cost incurred had the funds been purchased in the capital markets. Core deposit intangibles are amortized on either an accelerated or straight-line basis over periods ranging from seven to nineteen years. The recognition of a customer relationship intangible arose due to the acquisition of Harbridge. This asset was determined based on a methodology that calculates the present value of the projected future revenue derived from the acquired customer base. This asset is being amortized over eleven years on an accelerated basis. Loans The Company's loans outstanding, by type, as of December 31 are as follows: Table 9: Loans Outstanding
(000's omitted) 2003 2002 2001 2000 1999 - ------------------------------------------------------------------------------------------------------------------- Consumer mortgage $ 739,593 $ 510,309 $ 443,767 $ 416,160 $ 380,886 Business lending 689,436 629,874 643,834 576,887 539,110 Consumer indirect 325,304 287,453 248,718 256,793 250,536 Consumer direct 374,258 379,385 396,769 267,039 256,660 - ------------------------------------------------------------------------------------------------------------------- Gross loans 2,128,591 1,807,021 1,733,088 1,516,879 1,427,192 Less: unearned discount 82 116 218 1,002 1,419 - ------------------------------------------------------------------------------------------------------------------- Net loans 2,128,509 1,806,905 1,732,870 1,515,877 1,425,773 Allowance for loan loss 29,095 26,331 23,901 20,035 18,528 - ------------------------------------------------------------------------------------------------------------------- Loans, net of allowance for loan losses $2,099,414 $1,780,574 $1,708,969 $1,495,842 $1,407,245 ===================================================================================================================
As disclosed in Table 9 above, loans outstanding, net of unearned discount, reached a record level of $2.129 billion as of year-end 2003, up $322 million or 18% compared to twelve months earlier. The acquisitions of Grange and Peoples accounted for $186 million of that growth. Excluding the impact of these acquisitions (at time of completion), total loans rose $136 million or 7.5%. This growth was attributable to the New York market, with the Pennsylvania market experiencing a net decline in loans outstanding. Based on overall asset/liability analysis, the decision was made to discontinue selling secondary market-eligible mortgages with terms greater than 20 years in the third quarter of 2003 (mortgages with shorter terms were already being held in 25 portfolio). The secondary market activity in the first half of 2003 resulted in $67 million of sales versus $9 million in the latter part of last year. Had these loans not been sold in 2003, loan growth (excluding acquisitions) would have been $203 million or 11.1%. The compounded annual growth rate ("CAGR") for CBSI's total loan portfolio between 1999 and 2003 was 10.5%, with approximately 6% of the growth coming from whole bank and branch acquisitions and the balance from organic growth. The greatest overall expansion occurred in the consumer mortgage segment, which grew at an 18% CAGR (including the impact of acquisitions) over that time frame. The consumer mortgage growth was primarily driven by record mortgage refinancing volumes over the last two years, as well as the acquisition of consumer oriented banks in the intervening period. The other loan categories grew at compounded annual growth rates of between 6% and 10% from 1999 to 2003. As a consequence, the consumer mortgages segment accounted for 35% of the total loan portfolio at year-end 2003 versus 27% at the end of 1999. The weighting of retail lending in the Company's loan portfolio enables it to be highly diversified. Approximately 68% of loans outstanding at the end of 2003 were made to consumers borrowing on an installment and residential mortgage loan basis. This proportion increased from 65% at year-end 2002 and 63% at the end of 2001. This was principally due to the strong growth of residential mortgages in 2002 and 2003, the addition of People's loan portfolio (100% consumer) and the tempered organic growth in the business lending segment over the last few years due to soft economic conditions in our primary markets. There is also a high degree of diversification within the business lending segment of the portfolio. The Company's business loans are typically for amounts under $100,000, which account for about 81% of the number of business loans and approximately 24% of business loan balances as of December 31, 2003. Approximately 41% of the business portfolio is comprised of loans between $100,000 and $750,000 (about 17% of the number of loans), while loans over $750,000 account for the remaining 35% of ending balances (2% of the number of loans). The commercial portfolio is also broadly diversified by industry type as demonstrated by the following distributions at year-end 2003: real estate development (16%), healthcare (11%), general services (10%), motor vehicle and parts dealers (9%), agriculture (8%), restaurant & lodging (7%), retail trade (7%), construction (6%), manufacturing (5%) and wholesale trade (4%). A variety of other industries with less than a 3% share of the total portfolio comprise the remaining 17%. Table 9 breaks down the Company's loan portfolio into four major lines of business. Including loans added through acquisitions, $322 million of loan growth in 2003 was comprised of increases of $229 million in consumer mortgages, $60 million in business loans and $38 million in consumer indirect loans, offset by a $5 million decrease in consumer direct loans outstanding. Excluding the impact of acquisitions, the increase in consumer mortgages contributed $128 million of the $136 million in total loan growth in 2003, and consumer indirect loans accounted for $38 million. Conversely, consumer direct and business loan balances were down $22 million and $8 million from year-end 2002 levels, respectively. The consumer mortgage segment of the Company's loan portfolio is comprised of fixed (95%) and adjustable rate (5%) residential lending. Approximately $102 million of the $229 million growth in consumer mortgages was attributable to the acquisition of Grange and Peoples. Excluding the impact of these acquisitions, this segment was up $127 million or 25% in 2003 due to record mortgage volumes driven by this year's historically low interest rate environment. All of the organic growth was generated in the New York market, as Pennsylvania experienced net run-off in 2003 despite a significant volume of new originations. Growth in the consumer mortgage portfolio would have been 38% if the sale of longer-term, fixed-rate mortgages in the secondary market had not been conducted in the first three quarters of 2003. These mortgages were sold in the secondary market to improve the Company's interest rate risk position. The combined total of general-purpose business lending, dealer floor plans, mortgages on commercial property, and farm loans is characterized as the Company's business lending activity. Approximately $68 million in business loans added through the Grange acquisition offset the $8 million (1.3%) decrease from ongoing operations in 2003. All of this decrease was attributable to the Pennsylvania market before the acquisition of Grange, with the New York market generating marginal increases. Lending efforts in First Liberty's traditional markets (excluding Grange's coverage) continue to be challenged by a slow economic recovery, diminished capital spending levels in the commercial sector and an extremely competitive pricing environment. Management has worked aggressively to address the loan generation challenges in Pennsylvania by adding lending talent, resources, and strong business relationships via completed (Grange) and pending (First Heritage) acquisitions. The enhanced scale and coverage of the Pennsylvania business combined with the new management team's re-focused commitment to business development efforts, should position them to fully take advantage of growth opportunities in this key market as economic conditions improve and increased capital spending leads to expanded borrowing activity in the commercial sector. Installment loans indirectly originated through automobile and recreational vehicle dealers increased by 13% or $38 million in 2003. All of the consumer indirect loan growth was organic in nature (acquired banks did not provide these loans), 26 primarily reflecting successful business development efforts that have increased both the number and strength of the Company's dealer relationships and ability to deliver attractive financing rates. Ninety-two percent of this loan segment is comprised of automobile loans (75% of the vehicles are used and 25% are new). Consumer indirect loan growth was generated in both the New York and Pennsylvania markets. Consumer direct loans are comprised of conventional installment loans, personal loans, student loans (which are sold once principal repayment begins), and variable and fixed-rate home equity loans and lines of credit. This loan segment decreased 1.3% or $5 million in 2003. Excluding the addition of $17 million of consumer direct loans through the acquisition of Grange and Peoples, this segment was down 5.8% or $22 million. Loan balances fell in both the New York and Pennsylvania markets, as installment loans were paid off during the year through the use of funds made available through mortgage refinancing. Competitive conditions are quite intense in this loan category, particularly with regard to home equity lending. Management is dedicated to developing new marketing and pricing strategies in order to generate significant new business in this attractive segment of the market. The following table shows the maturities of loans as of December 31, 2003: Table 10: Loan Maturities
Maturing in Maturing After Maturing After Maturing One Year or One But Within Five But Within After Total Book (000's omitted) Less Five Years Fifteen Years Fifteen Years Value ------------------------------------------------------------------------------------------------------------- Consumer mortgage $ 1,104 $ 22,966 $426,706 $288,817 $ 739,593 Business lending 185,469 246,184 221,537 36,246 689,436 Consumer indirect 5,555 279,232 39,542 912 325,241 Consumer direct 32,636 148,481 115,184 77,938 374,239 ------------------------------------------------------------------------------------------------------------- Total loans $224,764 $696,863 $802,969 $403,913 $2,128,509 =============================================================================================================
As displayed in Table 10 above, 11% of the loan portfolio at December 31, 2003 is scheduled to mature in one year or less, 33% of loans have maturities in the one to five-year range, and approximately 56% mature after five years. This is consistent with the 12%, 34% and 54% mix for the equivalent maturity categories at year-end 2002, respectively. The proportional increase in loans maturing after five years was due to the growth in the consumer mortgage segment of the portfolio, which generally carry longer weighted average maturities. The following table sets forth the profile of the loan portfolio with regard to maturity and the type of interest rate: Table 11: Loan Sensitivity
At December 31, 2003 ------------------------------------------------ (000's omitted) Fixed Rate Variable Rate Total ------------------------------------------------------------------------------------------------------- Due in one year or less $ 48,580 $176,184 $ 224,764 Due after one year but within five years 606,429 90,433 696,862 Due after five years but within fifteen years 590,548 114,744 705,292 Due after fifteen years 289,163 212,428 501,591 ------------------------------------------------------------------------------------------------------- Total loans $1,534,720 $593,789 $2,128,509 =======================================================================================================
Table 11 above reflects the nature of the Company's loan portfolio in relation to the mix of maturities and interest rate characteristics. At year-end 2003 72% of loans had fixed interest rates, and the 28% that have variable rates consist primarily of home equity and commercial loans. This is very close to the 71% / 29% mix profile of the loan portfolio at the end of 2002. There was relatively even distribution of the portfolio between loans with maturities below and above 5 years at 43% and 57% at December 31, 2003, respectively. Refer to the market risk/interest rate risk section of the MD&A on page 38 for specific information regarding the interest rate sensitivity of the Company's asset and liability position at year-end 2003. 27 Asset Quality The following table presents information concerning non-performing assets: Table 12: Non-performing Assets
As of December 31, --------------------------------------------------------- (000's omitted) 2003 2002 2001 2000 1999 ------------------------------------------------------------------------------------------------------------------------ Non-accrual loans $11,940 $ 9,754 $ 7,186 $5,473 $6,112 Accruing loans 90+ days delinquent 1,307 1,890 1,914 1,930 1,201 ------------------------------------------------------------------------------------------------------------------------ Total non-performing loans 13,247 11,644 9,100 7,403 7,313 Restructured loans 28 43 75 116 122 Other real estate 1,077 704 1,427 1,293 1,442 ------------------------------------------------------------------------------------------------------------------------ Total non-performing assets $14,352 $12,391 $10,602 $8,812 $8,877 ======================================================================================================================== Allowance for loan losses to total loans 1.37% 1.46% 1.38% 1.32% 1.30% Allowance for loan losses to non-performing loans 220% 226% 263% 271% 253% Non-performing loans to total loans 0.62% 0.64% 0.53% 0.49% 0.51% Non-performing assets to total loans and other real estate 0.67% 0.69% 0.61% 0.58% 0.62%
The Company places a loan on nonaccrual status when the loan becomes ninety days past due (or sooner, if management concludes collection of interest is doubtful), except when, in the opinion of management, it is well-collateralized and in the process of collection. As shown in Table 12 above, non-performing loans, defined as non-accruing loans plus accruing loans 90 days or more past due, ended 2003 at $13.2 million, up approximately $1.6 million or 13.8% from one year earlier. This was primarily due to the addition of acquired loans as well as increases in existing commercial loan non-accruals. The ratio of non-performing loans to total loans declined two basis points from twelve months earlier to 0.62%. As of September 30, 2003, when the non-performing loan ratio stood at 0.70%, the Company's position was favorable to the peer level of 0.87%. The ratio of non-performing assets (which includes troubled debt restructuring and other real estate, or OREO, in addition to non-performing loans) to total loans plus OREO decreased to 0.67% at year-end 2003, down two basis points from one-year earlier. The improvement in both ratios was driven by improvements in the economy, enhanced collection and recovery efforts, the charge-off of problem loans over the last two years, a reduced proportion of commercial loans, and the acquisition of Grange, which had a lower level of non-performing assets than the overall portfolio. Had nonaccrual loans as of December 31, 2003 been current in accordance with their original terms, interest income of approximately $925,000 would have been recorded. Total delinquencies, defined as loans 30 days or more past due or in nonaccrual status, finished the current year at 1.76% of total loans outstanding versus 1.88% at the end of 2002. As of year-end 2003, total delinquency ratios for commercial loans, installment loans, and real estate mortgages were 2.18%, 2.40%, and 1.10%, respectively. These measures were 2.31%, 1.80% and 0.98% as of September 30, 2003, and compared to median peer levels of 2.30%, 1.79%, and 1.43%, respectively. The total delinquency ratio of 1.64% was slightly favorable to the peer ratio of 1.69% at September 30, 2003. Delinquency levels, particularly in the 30 to 89 days category tend to be somewhat volatile due to them being measured at a point in time, and therefore it is useful to look at this ratio over a longer period. The total average delinquency ratio for the Company for the end of the last three months of 2003 was 1.72%, five basis points below the previous three-month period, and the average ratio for the four quarters of 2003 (end of period basis) was 1.76% versus 1.83% in the prior year. 28 The changes in the allowance for loan losses for the last five years is as follows: Table 13: Allowance for Loan Loss Activity
Years Ended December 31, ------------------------------------------------------------------ (000's omitted) 2003 2002 2001 2000 1999 ----------------------------------------------------------------------------------------------------------------------------- Amount of loans outstanding at end of period $2,128,509 $1,806,905 $1,732,870 $1,515,877 $1,425,773 Daily average amount of loans (net of unearned discount) $1,885,604 $1,759,564 $1,580,870 $1,484,945 $1,343,652 Allowance for loan losses at beginning of year $ 26,331 $ 23,901 $ 20,035 $ 18,528 $ 17,059 Charge-offs: Business lending 5,521 5,071 2,310 3,423 996 Consumer mortgage 239 221 282 93 23 Consumer direct 2,897 3,013 2,382 1,644 2,280 Consumer indirect 4,454 3,710 3,688 2,320 2,665 ----------------------------------------------------------------------------------------------------------------------------- Total charge-offs 13,111 12,015 8,662 7,480 5,964 Recoveries: Business lending 417 281 313 181 146 Consumer mortgage 78 119 56 72 3 Consumer direct 773 603 614 379 764 Consumer indirect 1,580 1,220 1,095 633 664 ----------------------------------------------------------------------------------------------------------------------------- Total recoveries 2,848 2,223 2,078 1,265 1,577 ----------------------------------------------------------------------------------------------------------------------------- Net charge-offs 10,263 9,792 6,584 6,215 4,387 Provision for loan losses 11,195 12,222 7,097 7,722 5,856 Allowance on acquired loans (1) 1,832 0 3,353 0 0 ----------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of year $ 29,095 $ 26,331 $ 23,901 $ 20,035 $ 18,528 ============================================================================================================================= Net charge-offs to average loans outstanding 0.54% 0.56% 0.42% 0.42% 0.33%
(1) This reserve addition is attributable to loans purchased from Peoples Bankcorp Inc. and Grange National Banc Corp in 2003 and Citizens National Bank of Malone and FleetBoston Financial Corporation in 2001. As displayed in Table 13 above, total net charge-offs in 2003 were $10.3 million, up $0.5 million from the prior year. This increase was primarily driven by the significantly higher average loan balances resulting from both organic and acquired loan growth in 2003, as well as business loans reserved for in prior periods being charged-off during the year. Net charge-offs in 2002 were $3.2 million above 2001's level, and were also impacted by the vastly increased size of the average loan portfolio, due mostly to the acquisition of 36 FleetBoston branches in November 2001. In addition, a prolonged period of economic weakness from late 2000 through early 2003 impacted the net charge-off levels in both 2002 and 2003, with the greatest impact being realized in the business loan segment. Due to the significant increase in average loan balances in 2002 and 2003 as a result of the factors mentioned above, net charge-offs as a percent of average loans ("net charge-off ratio") offers a clearer representation of asset quality trends. The net charge-off ratio for 2003 was down two basis points from last year to 0.54%. This year's ratio benefited from improved recovery performance, as evidenced by the $0.6 million increase in recoveries to $2.8 million, representing 22.7% of average gross charge-offs for the latest two years, compared to 21.5% in 2002. The net charge-off ratio for the current year was also positively impacted by a higher proportion of low-risk consumer mortgages in the portfolio, primarily due to the exceptionally strong growth of this segment of the portfolio in 2003. Consumer mortgages accounted for 30% of total average loans in 2003 versus 27% in 2002. For the nine months ended September 30, 2003, the Company's total net charge-off ratio of 0.55% was in the 78th percentile of the distribution surrounding a peer median of 0.32%. Business loan net charge-offs increased in 2003, totaling $5.1 million or 0.80% of average business loans outstanding versus $4.8 million and 0.75% in 2002. The primary reason for the increased net charge-off ratio for business loans was the lagged effect of an extended period of soft economic conditions in the markets served by the Company, and the charge-off of a number of large business loans that had been identified as weak and had been specifically reserved for in previous periods. Consumer direct loan net charge-offs declined to $2.1 million this year from $2.4 million in 2002, resulting in a five-basis point drop in the net charge-off ratio to 0.57%. Net charge-offs in the consumer indirect segment were up $0.4 million to $2.9 million in 2003, but this was primarily due to loan growth as supported by the net charge-off ratio rising only one basis point to 0.94%. The risk profile of new installment loans booked in 2003 was consistent with 2002 in relation to the credit quality of the borrowers. Seventy-five percent of new installment lending volume in 2003 was rated as A and B paper, the two highest rankings in the standard A to D credit categories of FICO scores considered by regulators to 29 be prime borrowers. This is comparable to the 77% of installment loan originations rated as A and B in 2002, and well above the 63% of new loan volume in 2001. Consumer mortgage net charge-offs rose $60,000 to $161,000 due to the much larger size of the portfolio, and consequently the extremely low net charge-off ratio of 0.03% was essentially flat with the prior year (0.02%). All the primary asset quality metrics deteriorated in 2002 in comparison to the 1999 to 2001 period. This was principally due to the weakened economic conditions in our markets, and was manifested most strongly in the business loan portfolio. Based on almost all measurements, the asset quality profile of the Company improved in 2003 in conjunction with gradually improving economic conditions and strengthened credit administration and loan review resources. Significant changes and enhancements were made to these functions and related processes in 2003, and these improvements began to have a positive impact on credit management performance over the course of the year. Management continually evaluates the credit quality of the Company's loan portfolio and conducts a formal review of the allowance for loan loss adequacy on a quarterly basis. The two primary components of the loan review process that are used to determine proper allowance levels are specific and general loan loss allocations. Measurement of specific loan loss allocations is typically based on expected future cash flows, collateral values and other factors that may impact the borrower's ability to pay. Impaired loans greater than $500,000 are evaluated for specific loan loss allocations, as defined in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended. Consumer mortgages and consumer direct and indirect loans are considered smaller balance homogeneous loans and are evaluated collectively. The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts according to the contractual terms of the loan agreement or the loan is delinquent 90 days or more. The second component of the allowance establishment process, general loan loss allocations, is composed of two calculations that are computed on the four main loan segments: commercial, consumer direct, consumer indirect and residential real estate. The first calculation determines an allowance level based on the latest three years of historical net charge-off data for each loan category. The second calculation is qualitative and takes into consideration five major factors affecting the level of loan loss risk: portfolio risk migration patterns (internal credit quality trends); the growth of the segments of the loan portfolio; economic and business environment trends in the Bank's markets (includes review of bankruptcy, unemployment, population, consumer spending and regulatory trends); industry, geographical and product concentrations in the portfolio; and the perceived effectiveness of managerial resources and lending practices and policies. These two allowance calculations are added together to determine the general allocation ratio, which is applied to the four homogenous loan pools (excluding commercial loan balances with specific loan loss allocations). The allowance levels computed from the specific and general loan loss allocation methods are combined to derive the necessary allowance for loan loss to be reflected on the Consolidated Statement of Condition. The loan loss provision is calculated by subtracting the previous period allowance for loan loss, net of the interim period net charge-offs, from the current required allowance level. This provision is then booked as an expense in the income statement for that period. The loan review department, senior credit officers, executive management and the loan committee of the Board of Directors all examine the results of the allowance for loan loss process in detail and determine if it is adequate each quarter. Management is committed to continually improving the credit assessment and risk management capabilities of the Bank and will dedicate the resources necessary to ensure advancement in this critical area of operations. The allowance for loan loss was increased to $29.1 million at year-end 2003 from $26.3 million at the end of 2002. The $2.8 million increase was mostly due to $322 million more loans outstanding, offset by less risk in the loan portfolio due to a higher mix of consumer mortgages and an overall improvement in the Company's asset quality position. This change in the risk profile is reflected in the ratio of the allowance for loan loss to total loans, which decreased to 1.37% for year-end 2003 versus 1.46% at the end of last year. As of September 30, 2003, the Company's reserve ratio of 1.41% was 15 basis points below the peer median, while the coverage of non-performing loans (allowance for loan loss / non-performing loans) at 200% was in the 53rd percentile. Management believes the year-end 2003 allowance for loan losses to be adequate in light of the probable losses inherent in the Company's loan portfolio. The loan loss provision decreased by $1.0 million or 8.4% in 2003 as a result of management's assessment of the probable losses in the loan portfolio as discussed above. The loan loss provision as a percentage of average loans decreased from 0.69% in 2002 to 0.59% this year in most part due to the provision last year being elevated to cover higher risk levels in the business loan segment of the portfolio. The loan loss provision covered net charge-offs by 109% this year versus 125% in 2002, reflective of the shift in loan mix and asset quality trends during the year. 30 The net charge-off ratios of the last two years were above the Company's long-term historical levels, which were more consistent with the ratios of the 1999 to 2001 period, as shown in Table 13 above. As previously noted, there is a strong correlation between the increased level of net charge-offs in 2002 and 2003 and the performance of the overall economy. The Company's net charge-off ratio was also above 50 basis points during the 1990 to 1992 period, when the ratio fluctuated between 51 and 59 basis points. Not surprisingly, similar to the last three years, that time frame included a recession and the first stage of an economic recovery. The net charge-off ratio dropped significantly in the years immediately following that period. One of management's primary goals is to steadily bring the net charge-off ratio back to a range that is consistent with historical performance. The following table shows management's allocation of the allowance for loan losses by loan type as of December 31: Table 14: Allowance for Loan Losses by Loan Type
2003 2002 2001 -------------------- -------------------- -------------------- Amount of Loan Amount of Loan Amount of Loan (000's omitted) Allowance Mix Allowance Mix Allowance Mix - ---------------------------- -------------------- -------------------- -------------------- Consumer mortgage $ 1,724 34.7% $ 479 28.2% $ 406 25.6% Business lending 15,549 32.4% 16,765 34.9% 14,417 37.2% Consumer direct and indirect 11,112 32.9% 8,978 36.9% 8,970 37.2% Unallocated 710 109 108 - ---------------------------- -------------------- -------------------- -------------------- Total $29,095 100.0% $26,331 100.0% $23,901 100.0% ============================ ==================== ==================== ==================== 2000 1999 -------------------- -------------------- Amount of Loan Amount of Loan (000's omitted) Allowance Mix Allowance Mix - ---------------------------- -------------------- -------------------- Consumer mortgage $ 1,483 27.5% $ 1,752 26.7% Business lending 7,386 38.0% 5,850 37.8% Consumer direct and indirect 8,314 34.5% 7,655 35.5% Unallocated 2,852 3,271 - ---------------------------- -------------------- -------------------- Total $20,035 100.0% $18,528 100.0% ============================ ==================== ====================
As demonstrated in Table 14 above and discussed previously, the risk inherit in the consumer mortgage portfolio is much lower than that of the other segments of the loan portfolio. The risk differential is illustrated by the average net charge-off ratio of 0.03% over the last three years for consumer mortgages compared to the 0.67% average for the rest of the portfolio over the same time frame. This is manifested in the comparatively small $1,724 allowance attributable to consumer mortgages, representing only 0.2% of the their ending balance versus 2.0% for the remaining portion of the loan portfolio. Table 14 also shows that the weighting of consumer mortgages has increased from an average of 27% of total loans in 2001 and 2002 to 35% in 2003 (average balance basis) due to strong organic growth in this segment in 2002 and 2003. As demonstrated by the factors noted above, this shift in the mix of loans toward low-risk mortgages has been beneficial to the Company's credit risk profile and has helped offset some of the weakness that developed in the business portion of the portfolio, primarily due to difficult economic conditions. Funding Sources The Company utilizes a variety of funding sources to support the earning asset base as well as to achieve targeted growth objectives. CBSI's overall funding is comprised of three primary sources that possess a variety of maturity, stability, and price characteristics: deposits of individuals, partnerships and corporations (IPC deposits); collateralized municipal deposits (public funds); and external borrowings. The average daily amount of deposits and the average rate paid on each of the following deposit categories is summarized below for the years indicated: Table 15: Average Deposits
2003 2002 2001 ----------------------- ----------------------- ----------------------- Average Average Average Average Average Average (000's omitted, except rates) Balance Rate Paid Balance Rate Paid Balance Rate Paid - ------------------------------------ ----------------------- ----------------------- ----------------------- Non-interest-bearing demand deposits $ 473,568 0.00% $ 441,800 0.00% $ 343,173 0.00% Interest-bearing demand deposits 274,689 0.24% 262,313 0.47% 186,032 0.71% Regular savings deposits 430,264 0.80% 402,728 1.32% 344,906 2.11% Money market deposits 295,287 0.89% 304,623 1.60% 152,150 2.76% Time deposits 1,090,511 2.89% 1,131,296 3.75% 1,100,850 5.48% - ------------------------------------ ---------- ---------- ---------- Total deposits $2,564,319 1.49% $2,542,760 2.12% $2,127,111 3.44% ==================================== ========== ========== ==========
As displayed in Table 15 above, total average deposits for 2003 equaled $2.564 billion, up $22 million or 0.8% from the prior year. The acquisitions of People and Grange did not have a significant impact on full-year average deposit levels because they were completed relatively late in the year. Average deposits in 2002 were up significantly versus 2001 ($416 million or 20%) primarily as a result of the acquisition of 36 FleetBoston branches in November 2001 that added $470 million of deposits. 31 The Company's funding composition continues to benefit from a high level of IPC deposits, which reached an all-time high in 2003 with a fourth quarter average of $2.485 billion, an increase of $107 million or 4.5% over the comparable 2002 period. This was largely due to the $242 million in IPC deposits added in conjunction with the acquisitions of Peoples and Grange in September and November 2003, respectively. IPC deposits are frequently considered to be a bank's most attractive source of funding because they are generally stable, do not need to be collateralized, have a relatively low cost, and provide a strong customer base for which a variety of loan, deposit and other financial service-related products can be sold. Full-year average deposits of local municipalities decreased $7 million or 3.8% during 2003, despite the additional public funds acquired through the Grange transaction. Under New York State Municipal Law, the Company is required to collateralize all local government deposits with marketable securities from its investment portfolio. Because of this stipulation, management considers this source of funding to be equivalent to external borrowings. As such, CBSI endeavors to price these deposits at or below alternative external borrowing rates. Municipal deposits decreased due to the favorability of the aforementioned external borrowing rates in comparison to competitive pricing of the public fund deposits. It should be noted that utilization of municipal deposits has generally been flat to down over the last few years as a percent of total funding sources. The mix of CBSI's average deposits in 2003 changed slightly in comparison to 2002. The weightings of demand deposit, interest checking and savings account balances all increased from their 2002 levels, while money market and time deposit weightings decreased. This change in mix largely reflects less willingness by certain customers to being locked into low CD rates and accounts with higher minimum balance requirements (money market) given the market-driven contraction of interest rate spreads between these accounts and less restrictive ones, such as demand deposits and savings. This shift in the deposit mix resulted in a greater drop in the overall cost of funds on deposits than would have been achieved through the reduction of interest rates alone. As a result of market interest rates remaining at historically low levels for an extended period of time, spreads between these groups of accounts have stabilized and customers appear to be more willing to hold term deposits given the lack of viable alternatives with similar risk/return characteristics. This factor combined with the Company's ongoing commitment to continually expand its advantageous IPC deposit base to fund earning-asset growth, prompted the development of a new CD product in September that has been an effective tool for attracting new time deposits. The remaining maturities of time deposits in amounts of $100,000 or more outstanding as of December 31 are as follows: Table 16: Time Deposit > $100,000 Maturities (000's omitted) 2003 2002 -------------------------------------------------------- Less than three months $ 60,504 $ 63,891 Three months to six months 24,351 28,255 Six months to one year 48,306 29,646 Over one years 35,080 35,337 -------------------------------------------------------- Total $168,241 $157,129 ======================================================== External borrowings are defined as funding sources available on a national market basis, generally requiring some form of collateralization. Borrowing sources for the Company include the Federal Home Loan Bank of New York and Federal Reserve Bank of New York, as well as access to the national repurchase agreement market through established relationships with primary market security dealers. The Company also had approximately $80 million in fixed and floating- rate subordinated debt outstanding at the end of 2003 that is held by unconsolidated subsidiary trusts. External borrowings averaged $508 million or 17% of total funding sources for all of 2003, essentially equivalent to 2002 levels. As shown in Table 17 below, at year-end 2003, $397 million or 59% of external borrowings had remaining terms of one year or less, up considerably from $248 million and 46% at the end of 2002. This change in external funding mix was undertaken to take advantage of an extremely steep yield curve and protect the Company from falling interest rates, its greatest interest rate risk exposure. During fourth quarter 2003, $25 million in longer-term Federal Home Loan Bank borrowings were retired early and replaced with significantly lower rate, short-term debt, resulting in an earnings charge of $2.6 million. A similar strategy was executed in fourth quarter 2002 when approximately $11 million of intermediate-term FHLB borrowings were prepaid, resulting in a prepayment penalty of $925,000. Both of these strategies were implemented because the projected cost of the replacement debt, including prepayment charges, was favorable on a long-term, economic basis in comparison to holding the existing borrowings. As displayed in Table 4 on page 18, the overall mix of funding has shifted somewhat over the past two years as a result of two major factors. First, the acquisitions completed during the 2001 to 2003 period supplied a substantial amount of 32 deposits, but added insignificant levels of external borrowings, enabling the Company to fund the majority of its earning-asset growth with this favorable funding source. Consequently, the percentage of funding derived from deposits was 83.5% in 2003 on a full-year average balance basis, 2.0 percentage points higher than it was in 2001. This was despite the fact that the most recent acquisition, Grange did not close until late November 2003, and therefore its impact on the average funding mix was less pronounced in 2003 than it will be in 2004. A second major development was that from January 2001 through mid-2003 market interest rates declined significantly, largely influenced by the Federal Reserve actions designed to stimulate a weakened US economy. In addition, short-term interest rates declined by a much greater degree than long rates, resulting in a much steeper yield curve. Management effectively responded to the changes in the interest rate environment by reducing deposit rates in a timely manner and greatly increasing the weighting of short-term borrowings in the external funding portion of the balance sheet. These moves contributed significantly to the 1.8 percentage-point drop in external borrowing costs and 2.2 percentage-point decline in the cost of total interest-bearing liabilities from 2001 to 2003. The following table summarizes the outstanding balance of short-term borrowings of the Company as of December 31: Table 17: Short-term Borrowings
(000's omitted, except rates) 2003 2002 2001 --------------------------------------------------------------------------------- Federal funds purchased $ 36,300 $ 33,000 $ 14,200 Term borrowings at banks (original term) 90 days or less 361,000 215,000 31,100 Over 90 days 1,000 Capital lease obligations 96 241 354 --------------------------------------------------------------------------------- Balance at end of period $397,396 $248,241 $ 46,654 ================================================================================= Daily average during the year $212,512 $141,024 $141,772 Maximum month-end balance $397,396 $244,000 $268,600 Weighted average rate during the year 1.26% 1.83% 4.75% Year-end average rate 1.28% 1.50% 4.16%
The following table shows the maturities of various contractual obligations as of December 31, 2003: Table 18: Maturities of Contractual Obligations
Amount Amount Maturing Maturing After After Three Amount One Years Amount Maturing Year but but Maturing Within Within Within After One Year Three Five Five (000's omitted) or Less Years Years Years Total - -------------------------------------------------------------------------------------------------------------------------------- Time deposits $ 817,550 $271,582 $ 84,827 $ 393 $1,174,352 Federal funds purchased 36,300 36,300 Federal Home Loan Bank advances 361,000 15,000 175,000 551,000 Subordinated debt held by unconsolidated subsidiary trusts 80,390 80,390 Other borrowings 96 96 Operating leases 2,114 3,599 2,488 4,286 12,487 - -------------------------------------------------------------------------------------------------------------------------------- Total $1,217,060 $275,181 $102,315 $260,069 $1,854,625 ================================================================================================================================
Financial Instruments with Off-Balance Sheet Risk The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party. The credit risk associated with commitments to extend credit and standby letters of credit is essentially the same as that involved with the 33 extending loans to customers and is subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The contract amount of these off-balance sheet financial instruments as of December 31 is as follows: Table 19: Off-Balance Sheet Financial Instruments (000's omitted) 2003 2002 ------------------------------------------------------ Standby letters of credit $ 19,163 $ 19,728 Commitments to extend credit 315,898 332,422 ------------------------------------------------------ Total $335,061 $352,150 ====================================================== Investments The objective of CBSI's investment portfolio is to hold low-risk, high-quality earning assets that provide favorable returns and another effective tool to actively manage its asset/liability position to maximize future net interest income production. This must be accomplished within the following constraints: (a) implementing certain interest rate risk management strategies which achieve a relatively stable level of net interest income; (b) providing both the regulatory and operational liquidity necessary to conduct day-to-day business activities; (c) considering investment risk-weights as determined by the regulatory risk-based capital guidelines; and (d) generating a favorable return without undue compromise of the other requirements. As displayed in Table 20 below, the book value of CBSI's investment portfolio increased $49 million or 4.0% during the year to $1.271 billion as a result of $249 million of strategic capital market purchases made primarily in the second half of 2003, offset by planned investment run-off and very limited sales. Average investment balances (book value basis) for 2003 were down $81 million or 6.4% versus the prior year. This decline was primarily a result of the de-leveraging policy that was in place in the first half of 2003, whereby investments were allowed to run-off and the proceeds were used to pay down external borrowing until investments opportunities became more attractive. This approach enabled the Company to avoid adding investments at unfavorable spreads while also building its capital position in order to improve its ability to make future strategic investments. Investment interest income in 2003 was $8.0 million or 9.4% lower than the prior year as a result of the reduced average balances in the portfolio, and the drop in the average investment yield from 6.74% to 6.53%. The decline in the yield was primarily due to the general run-off of securities from the portfolio that been issued in the higher interest rate environments of previous periods and were partially replaced in the second half of the year with investments that carry comparatively lower yields. This was inevitable given the fact that longer-term market interest rates, despite modest increases in the third quarter of 2003, were still at historically low levels. However, the impact of lower investment yields was mostly offset by the funding of the purchases with very low rate short-term borrowings, resulting in similar net spreads. In an annual study conducted by Investment Performance Digest ("IPD") on banking results nationwide, CBSI ranked in the 96th percentile for one-year total returns (yield plus change in market value) on its investment portfolio. In order to protect the Company against its exposure to falling interest rates, the vast majority of the investment purchases in 2003 were in intermediate-term US Agency securities with average call protection in excess of six years. Investments sales in the current year totaled less than $27 million and were all related to securities inherited from acquired companies, and resulted in an immaterial amount of net losses. The sales were based on the Company's total return strategy (see below) or to remove securities that no longer adhere to investment policy guidelines. Those proceeds that were reinvested resulted in an improved interest rate risk position. As of December 31, 2003 the investment portfolio had a weighted average life of 6.6 years. The investment portfolio has very limited credit risk due to the composition continuing to heavily favor U.S. Agency debentures, U.S. Agency mortgage-backed pass-throughs, U.S. Agency CMOs and municipal bonds insured by third parties. As of year-end 2003, these four AAA-rated (highest possible rating) security types accounted for 98% of the portfolio's total book value, excluding Federal Home Loan Bank stock and Federal Reserve Bank stock, or 48%, 6%, 7% and 37% respectively. These four security types also comprised 98% of total investments as of December 31, 2002 at 32%, 11%, 20% and 35%, respectively. The change in the investment mix reflects management's strategy over the last two years of primarily purchasing medium-term, call-protected US Agency and municipal bonds that offer both attractive yields and are free from short-term reinvestment risk. MBS and CMO securities typically possess a high level of this latter risk, particularly in periods with high levels of mortgage refinancing such as have existed over the last few years in the extremely low interest rate environment. As a consequence, the Company has avoided investing in these types of securities during this period, and this fact combined with high run-off rates explains the significant drop in their weighting in the total investment portfolio. 34 Since 1997, the Company has utilized total return as its primary methodology for managing investment portfolio assets. Under this analytical method, shareholder value is maximized through both interest income and market value appreciation. The commitment to this approach is reflected in the fact that no security sales were conducted in 2003 outside of minor transactions associated with the investments of acquired banks, despite the significant level of market gains in the portfolio (see MVA discussion in the following paragraph). Management chose not to take gains in the current year to increase short-term earnings at the expense of profitability in future periods. The effectiveness of the Company's strategic long-term planning focus is evidenced by its total return of 7.81% for the five-year period ending September 30, 2003, which placed it in the extremely favorable 98th peer percentile of the IPD study referenced above. In recent years nearly all of the Company's investments were classified as available-for sale, but in 2003 a majority of the purchases made in the second half of the year were categorized as held-to-maturity investments. Eighty-nine percent of the investment portfolio was classified as available-for-sale at year-end 2003 versus 99% at the end of the two previous years. The net pre-tax market value gain over book value as of December 31, 2003 was $58.9 million, $5.7 million lower than it was one year earlier, but $41.5 million higher than the MVA at the end of 2001. The following table sets forth the amortized cost and market value for the Company's investment securities portfolio: Table 20: Investment Securities
2003 2002 ------------------------- ------------------------- Amortized Amortized Cost/Book Market Cost/Book Market (000's omitted) Value Value Value Value - --------------------------------------------------- ------------------------- ------------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 127,635 $ 125,003 $ 0 $ 0 Obligations of state and political subdivisions 7,459 7,677 7,412 7,666 Other securities 3,558 3,558 3,018 3,018 - --------------------------------------------------- ------------------------- ------------------------- Total held-to-maturity portfolio 138,652 136,238 10,430 10,684 - --------------------------------------------------- ------------------------- ------------------------- Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. Government corporations and agencies 456,913 479,454 380,243 411,278 Obligations of state and political subdivisions 443,930 470,210 404,864 420,605 Corporate securities 27,712 30,251 27,972 30,225 Collateralized mortgage obligations (CMO's) 89,566 93,552 235,286 245,368 Mortgage-backed securities 76,628 80,177 131,755 137,211 - --------------------------------------------------- ------------------------- ------------------------- Sub-total 1,094,749 1,153,644 1,180,120 1,244,687 Equity securities (1) 29,185 29,185 25,814 25,814 Federal Reserve Bank common stock 8,053 8,053 5,652 5,652 - --------------------------------------------------- ------------------------- ------------------------- Total available-for-sale portfolio 1,131,987 $1,190,882 1,211,586 $1,276,153 ========== ========== Net unrealized gain on available-for-sale portfolio 58,895 64,567 - --------------------------------------------------- ---------- ---------- Total carrying value $1,329,534 $1,286,583 ========== ========== 2001 ------------------------- Amortized Cost/Book Market (000's omitted) Value Value - --------------------------------------------------- ------------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 0 $ 0 Obligations of state and political subdivisions 7,608 7,832 Other securities 2,532 2,532 - --------------------------------------------------- ------------------------- Total held-to-maturity portfolio 10,140 10,364 - --------------------------------------------------- ------------------------- Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. Government corporations and agencies 192,111 203,501 Obligations of state and political subdivisions 282,109 277,593 Corporate securities 43,392 44,399 Collateralized mortgage obligations (CMO's) 400,100 403,780 Mortgage-backed securities 173,978 179,786 - --------------------------------------------------- ------------------------- Sub-total 1,091,690 1,109,059 Equity securities (1) 25,863 25,863 Federal Reserve Bank common stock 5,652 5,652 - --------------------------------------------------- ------------------------- Total available-for-sale portfolio 1,123,205 $1,140,574 ========== Net unrealized gain on available-for-sale portfolio 17,369 - --------------------------------------------------- ---------- Total carrying value $1,150,714 ==========
(1) Includes $28,365, $24,575, and $24,700 of FHLB common stock at December 31, 2003, 2002, and 2001, respectively. 35 The following table sets forth as of December 31, 2003, the maturities of investment securities and the weighted-average yields of such securities, which have been calculated on the cost basis, weighted for scheduled maturity of each security, and adjusted to a fully tax-equivalent basis: Table 21: Maturities of Investment Securities
Amount Amount Amount Maturing Maturing Maturing After One After Five Amount Total Within Year but Years but Maturing Amortized One Year Within Within After Cost/Book (000's omitted, except rates) or Less Five Years Ten Years Ten Years Value - --------------------------------------------------------------------------------------------------------------------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 0 $ 0 $ 99,267 $ 28,368 $ 127,635 Obligations of state and political subdivisions 4,582 2,390 487 0 7,459 Other securities 3,558 3,558 - --------------------------------------------------------------------------------------------------------------------------------- Total held-to-maturity portfolio $4,582 $ 2,390 $ 99,754 $ 31,926 $ 138,652 ================================================================================================================================= Weighted Average Yield for Year(1) 4.20% 6.44% 4.72% 5.47% 4.91% Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. Government corporations and agencies $2,000 $ 5,401 $297,334 $152,178 $ 456,913 Obligations of state and political subdivisions 2,283 23,013 172,959 245,675 443,930 Corporate securities 0 142 8,384 19,186 27,712 Collateralized mortgage obligations (CMO's) 0 1,478 29,892 58,196 89,566 Mortgage-backed securities 46 4,555 2,512 69,515 76,628 - --------------------------------------------------------------------------------------------------------------------------------- Total available-for-sale portfolio $4,329 $34,589 $511,081 $544,750 $1,094,749 ================================================================================================================================= Weighted Average Yield for Year(1) 6.18% 6.75% 6.03% 6.71% 6.39%
(1) Weighted average yields on the tax-exempt obligations have been computed on a fully tax equivalent basis assuming a marginal federal tax rate of 38.9%. These yields are an arithmetic computation of accrued income divided by average balance; they may differ from the yield to maturity, which considers the time value of money. Impact of Inflation and Changing Prices The Company's financial statements have been prepared in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effect of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Notwithstanding this, inflation can directly affect the value of loan collateral, in particular real estate. New Accounting Pronouncements In March 2003, the SEC issued Regulation G, Conditions for Use of Non-GAAP Financial Measures. As defined in Regulation G, a non-GAAP financial measure is a numerical measure of a company's historical or future performance, financial position, or cash flow that excludes or includes amounts or adjustments that are included or excluded in the most directly comparable measure calculated in accordance with generally accepted accounting principles (GAAP). Companies that present non-GAAP financial measures must disclose a numerical reconciliation to the most directly comparable measurement using GAAP. This disclosure requirement applies to earnings releases and similar announcements made after March 28, 2003. The Company adopted Regulation G in 2003. See Accounting Pronouncement Section of Note A of the notes to the consolidated financial statements on page 50 for additional accounting pronouncements. 36 Forward-Looking Statements This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Moreover, the Company's plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company's control). Factors that could cause actual results to differ from those discussed in the forward-looking statements include: (1) risks related to credit quality, interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business; (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (4) inflation, interest rate, market and monetary fluctuations; (5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing products and services; (6) changes in consumer spending, borrowing and savings habits; (7) technological changes; (8) any acquisitions or mergers that might be considered or consumated by the Company and the costs and factors associated therewith; (9) the ability to maintain and increase market share and control expenses; (10) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and accounting principles generally accepted in the United States; (11) changes in the Company's organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets; (12) the costs and effects of litigation and of any adverse outcome in such litigation; (13) other risk factors outlined in the Company's filings with the Securities and Exchange Commission from time to time; and (14) the success of the Company at managing the risks of the foregoing. The foregoing list of important factors is not exclusive. Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made. If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. 37 Item 7a. Quanitative and Qualitative Disclosures about Market Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk. Credit risk associated with the Company's loan portfolio has been previously discussed in the asset quality section of Management's Discussion and Analysis of Financial Condition and Results of Operations. Although more than a third of the securities portfolio at year-end 2003 was invested in municipal bonds, management believes that the tax risk of the Company's municipal investments associated with potential future changes in statutory, judicial and regulatory actions is minimal. The Company has an insignificant amount of credit risk in its investment portfolio because essentially all of the fixed-income securities in the portfolio are AAA-rated (highest possible rating). Therefore, almost all the market risk in the investment portfolio is related to interest rates. The ongoing monitoring and management of both interest rate risk and liquidity, in the short and long term time horizons is an important component of the Company's asset/liability management process, which is governed by limits established in the policies reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out the policies to the Asset/Liability Committee (ALCO) which meets each month and is made up of the Company's senior management as well as regional and line-of-business managers who oversee specific earning asset classes and various funding sources. As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools which enable it to identify and quantify sources of interest rate risk in varying rate environments. The primary tool used by the Company in managing interest rate risk is income simulation. While a wide variety of strategic balance sheet and treasury yield curve scenarios are tested on an ongoing basis, the following reflects the Company's one-year net interest income sensitivity based on: o Asset and liability levels using December 31, 2003 as a starting point. o There are assumed to be conservative levels of balance sheet growth-- low to mid single digit growth in loans, investments and deposits, augmented by necessary changes in borrowings and retained earnings, with no growth in other major portions of the balance sheet. o The prime rate and federal funds rates are assumed to move up 200 basis points and down 100 basis points over a 12-month period while flattening the long end of the treasury curve to spreads over federal funds that are more consistent with historical norms. Deposit rates are assumed to move in a manner that reflects the historical relationship between deposit rate movement and changes in the federal funds rate, generally reflecting 10%-70% of the movement of the federal funds rate. o Cash flows are based on contractual maturity, optionality and amortization schedules along with applicable prepayments derived from internal historical data and external sources. Net Interest Income Sensitivity Model Calculated increase (decrease) in Projected Net Interest Income at December 31 Change in ------------------------------------------- Interest Rates 2003 2002 ----------------------------------------------------------------- + 200 basis points ($3,900,000) $2,800,000 - 100 basis points ($2,100,000) ($3,000,000) The change from 2002 largely reflects the increase in intermediate term US Agency investments with an average call protection of greater than 6 years. The addition of these investments which were funded relatively short reduced the net interest income as rates rise but improves the net interest income if rates were unchanged or decline. In the 2003 model, both the rising and falling rate environments reflect a reduction in net interest income (NII) from a flat rate environment due to the assumed flattening of the yield curve. The modeled NII in a falling rate environment is initially more favorable than if rates were to rise due to a faster initial reaction from core deposit pricing and short-term capital market borrowing rates. Over a longer time period, however, the growth in NII improves significantly in a rising rate environment as a result of lower yielding earning assets running off and being replaced at increased rates. The analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions: the nature and timing of interest rate levels (including yield curve shape), prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and other factors. While the assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive 38 nature of these assumptions, including how customer preferences or competitor influences might change. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates. Item 8. Financial Statements and Supplementary Data The following consolidated financial statements and independent auditor's reports of Community Bank System, Inc. and subsidiaries are contained on pages 40 through 68 of this item. o Consolidated Statements of Condition, December 31, 2003 and 2002 o Consolidated Statements of Income, Years ended December 31, 2003, 2002, and 2001 o Consolidated Statements of Changes in Shareholders' Equity, Years ended December 31, 2003, 2002, and 2001 o Consolidated Statements of Comprehensive Income, Years ended December 31, 2003, 2002, and 2001 o Consolidated Statements of Cash Flows, Years ended December 31, 2003, 2002, and 2001 o Notes to Consolidated Financial Statements, December 31, 2003 o Report of Independent Auditor Quarterly Selected Data (Unaudited) for 2003 and 2002 are contained on page 69. 39 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CONDITION (In Thousands, Except Share Data)
December 31, December 31, 2003 2002 - ---------------------------------------------------------------------------------------------------------------------- Assets Cash and due from banks $ 103,923 $ 113,531 Held-to-maturity investment securities 138,652 10,430 Available-for-sale investment securities 1,190,882 1,276,153 - ---------------------------------------------------------------------------------------------------------------------- Total investment securities (fair value of $1,327,120 and $1,283,819) 1,329,534 1,286,583 Loans 2,128,509 1,806,905 Allowance for loan losses 29,095 26,331 - ---------------------------------------------------------------------------------------------------------------------- Net loans 2,099,414 1,780,574 Premises and equipment, net 61,705 56,997 Accrued interest receivable 25,851 22,793 Core deposit intangibles, net 33,998 30,769 Goodwill, net 159,596 104,059 Other intangibles, net 2,517 0 - ---------------------------------------------------------------------------------------------------------------------- Intangible assets, net 196,111 134,828 Other assets 38,859 41,941 - ---------------------------------------------------------------------------------------------------------------------- Total Assets $ 3,855,397 $ 3,437,247 ====================================================================================================================== Liabilities and Shareholders' Equity Liabilities: Non-interest bearing deposits $ 498,195 $ 439,075 Interest bearing deposits 2,227,293 2,066,281 - ---------------------------------------------------------------------------------------------------------------------- Total deposits 2,725,488 2,505,356 Federal funds purchased 36,300 33,000 Borrowings 551,096 430,241 Subordinated debt held by unconsolidated subsidiary trusts 80,390 80,334 Accrued interest and other liabilities 57,295 63,278 - ---------------------------------------------------------------------------------------------------------------------- Total Liabilities 3,450,569 3,112,209 - ---------------------------------------------------------------------------------------------------------------------- Commitment and contingencies (see Note N) Shareholders' equity: Preferred stock $1.00 par value, $100.00 stated value; 500,000 shares authorized, 0 shares issued Common stock no par $1.00 stated value, 20,000,000 shares authorized; 14,373,306 and 12,978,554 shares issued for 2003 and 2002, respectively 14,373 12,979 Additional paid-in capital 144,440 79,058 Retained earnings 218,628 194,483 Accumulated other comprehensive income 35,958 38,551 Treasury stock, at cost (208,150 shares) (8,490) 0 Employee stock plan - unearned (81) (33) - ---------------------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 404,828 325,038 - ---------------------------------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $ 3,855,397 $ 3,437,247 ======================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 40 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In Thousands, Except Per-Share Data)
Years Ended December 31, ------------------------------------- 2003 2002 2001 - ------------------------------------------------------------------------------------------------------------------ Interest income: Interest and fees on loans $ 125,256 $130,860 $ 132,014 Interest and dividends on taxable investments 47,047 57,133 56,204 Interest and dividends on non-taxable investments 18,826 17,100 10,274 - ------------------------------------------------------------------------------------------------------------------ Total interest income 191,129 205,093 198,492 - ------------------------------------------------------------------------------------------------------------------ Interest expense: Interest on deposits 38,288 53,878 73,163 Interest on federal funds purchased 298 511 883 Interest on short-term borrowings 2,387 2,075 5,855 Interest on subordinated debt held by unconsolidated subsidiary trusts 5,632 5,985 5,182 Interest on long-term borrowings 12,696 14,794 16,754 - ------------------------------------------------------------------------------------------------------------------ Total interest expense 59,301 77,243 101,837 - ------------------------------------------------------------------------------------------------------------------ Net interest income 131,828 127,850 96,655 Less: provision for loan losses 11,195 12,222 7,097 - ------------------------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses 120,633 115,628 89,558 - ------------------------------------------------------------------------------------------------------------------ Non-interest income: Deposit service fees 23,124 16,480 12,737 Other banking services 1,653 1,805 1,934 Trust, investment and asset management fees 6,682 8,003 7,836 Benefit plan administration, consulting and actuarial fees 6,220 3,845 3,585 (Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113) - ------------------------------------------------------------------------------------------------------------------ Total non-interest income 34,981 31,806 25,979 - ------------------------------------------------------------------------------------------------------------------ Operating expenses: Salaries and employee benefits 53,164 47,864 40,930 Occupancy 9,297 8,154 6,122 Equipment and furniture 7,828 7,538 6,075 Amortization of intangible assets 5,093 5,953 6,679 Legal and professional fees 3,183 3,272 2,789 Data processing 6,800 6,574 4,727 Office supplies 1,996 2,321 1,995 Acquisition and unusual expenses 498 700 8,164 Other 14,602 12,654 11,113 - ------------------------------------------------------------------------------------------------------------------ Total operating expenses 102,461 95,030 88,594 - ------------------------------------------------------------------------------------------------------------------ Income before income taxes 53,153 52,404 26,943 Income taxes 12,773 13,887 7,814 - ------------------------------------------------------------------------------------------------------------------ Net Income $ 40,380 $ 38,517 $ 19,129 ================================================================================================================== Basic earnings per share $ 3.07 $ 2.97 $ 1.64 Diluted earnings per share $ 2.99 $ 2.93 $ 1.62 Dividends declared per share $ 1.22 $ 1.12 $ 1.08
The accompanying notes are an integral part of the consolidated financial statements. 41 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended December 31, 2001, 2002 and 2003 (In Thousands, Except Share Data)
Common Stock ------------------------------ Additional Shares Amount Paid-In Retained Outstanding Issued Capital Earnings - ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2000 10,559,897 $11,208 $37,711 $163,917 Net income 19,129 Other comprehensive income, net of tax Dividends declared: Common, $1.08 per share (12,574) Issuance of common stock 1,308,800 1,309 30,755 Common stock issued under employee stock plan, including tax benefits of $6 82,546 83 1,338 Fractional shares redeemed (431) (1) (12) Stock issued for acquisition 952,000 304 7,918 - ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2001 12,902,812 $12,903 $77,710 $170,472 Net income 38,517 Other comprehensive income, net of tax Dividends declared: Common, $1.12 per share (14,506) Common stock issued under employee stock plan, including tax benefits of $219 75,742 76 1,348 - ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2002 12,978,554 $12,979 $79,058 $194,483 Net income 40,380 Other comprehensive loss, net of tax Dividends declared: Common, $1.22 per share (16,235) Common stock issued under employee stock plan, including tax benefits of $1,410 247,661 247 6,161 Stock and options issued for acquisition 1,147,091 1,147 59,221 Treasury stock purchased (208,150) - ------------------------------------------------------------------------------------------------------------ Balance at December 31, 2003 14,165,156 $14,373 $144,440 $218,628 ============================================================================================================ Accumulated Other Employee Comprehensive Treasury Stock Plan Income Stock -Unearned Total - ---------------------------------------------------------------------------------------------------------- Balance at December 31, 2000 $5,966 ($17,006) ($5) $201,791 Net income 19,129 Other comprehensive income, net of tax 1,315 1,315 Dividends declared: Common, $1.08 per share (12,574) Issuance of common stock 32,064 Common stock issued under employee stock plan, including tax benefits of $6 (381) 1,040 Fractional shares redeemed (13) Stock issued for acquisition 17,006 25,228 - ---------------------------------------------------------------------------------------------------------- Balance at December 31, 2001 $7,281 $0 ($386) $267,980 Net income 38,517 Other comprehensive income, net of tax 31,270 31,270 Dividends declared: Common, $1.12 per share (14,506) Common stock issued under employee stock plan, including tax benefits of $219 353 1,777 - ---------------------------------------------------------------------------------------------------------- Balance at December 31, 2002 $38,551 $0 ($33) $325,038 Net income 40,380 Other comprehensive loss, net of tax (2,593) (2,593) Dividends declared: Common, $1.22 per share (16,235) Common stock issued under employee stock plan, including tax benefits of $1,410 (48) 6,360 Stock and options issued for acquisition 60,368 Treasury stock purchased (8,490) (8,490) - ---------------------------------------------------------------------------------------------------------- Balance at December 31, 2003 $35,958 ($8,490) ($81) $404,828 ==========================================================================================================
See Note A "Earnings Per Share" concerning an announced two-for-one stock split. The accompanying notes are an integral part of the consolidated financial statements. 42 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In Thousands)
Years Ended December 31, ------------------------------------- 2003 2002 2001 - -------------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, before tax: Change in minimum pension liability adjustment $ 92 $ 4,919 ($5,016) Unrealized (loss) gain on securities: Unrealized holding (losses) gains arising during period (5,727) 49,796 9,638 Reclassification adjustment for losses (gains) included in net income 54 (2,598) (2,546) - -------------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, before tax (5,581) 52,117 2,076 Income tax benefit (expense) related to other comprehensive (loss) income 2,988 (20,847) (761) - -------------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, net of tax (2,593) 31,270 1,315 Net income 40,380 38,517 19,129 - -------------------------------------------------------------------------------------------------------------------- Comprehensive income $ 37,787 $ 69,787 $ 20,444 ====================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 43 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars, except Share Data)
Years Ended December 31, ------------------------------------ 2003 2002 2001 - ------------------------------------------------------------------------------------------------------------------------------------ Operating Activities: Net income $ 40,380 $ 38,517 $ 19,129 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 7,139 6,596 5,049 Amortization of intangible assets 5,093 5,953 6,679 Net amortization of premiums and discounts on securities and loans 2,303 3,256 2,030 Amortization of unearned compensation and discount on subordinated debt 172 443 276 Provision for loan losses 11,195 12,222 7,097 Provision for deferred taxes 835 4,458 (835) Loss (gain) on sale of investment securities and early retirement of long-term borrowings 2,698 (1,673) 113 Loss (gain) on loans and other assets 350 (28) (283) Proceeds from the sale of loans held for sale 67,482 9,103 43,802 Origination of loans held for sale (61,036) (14,858) (43,350) Change in other operating assets and liabilities (3,541) (11,815) 8,191 - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 73,070 52,174 47,898 - ------------------------------------------------------------------------------------------------------------------------------------ Investing Activities: Proceeds from sales of available-for-sale investment securities 41,227 96,294 141,959 Proceeds from maturities of held-to-maturity investment securities 5,229 4,521 6,172 Proceeds from maturities of available-for-sale investment securities 242,614 197,928 205,135 Purchases of held-to-maturity investment securities (133,517) (4,577) (5,946) Purchases of available-for-sale investment securities (141,658) (383,598) (514,132) Net (increase) decrease in loans outstanding (151,520) (77,906) 12,155 Cash paid for acquisitions (net of cash acquired of $23,986, $0, $212,353) (9,630) 0 210,523 Capital expenditures (8,322) (8,831) (7,730) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash (used) provided by investing activities (155,577) (176,169) 48,136 - ------------------------------------------------------------------------------------------------------------------------------------ Financing Activities: Net change in demand deposits, NOW accounts, and savings accounts 39,745 25,005 206,490 Net change in time deposits (68,220) (65,619) (166,998) Net change in federal funds purchased 3,300 18,800 (34,530) Net change in borrowings 117,356 165,976 (92,642) Issuance of common stock 4,819 1,151 32,837 Purchase of treasury stock (8,490) 0 0 Cash dividends paid (15,466) (14,228) (10,980) Other financing activities (145) (113) (113) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided (used) by financing activities 72,899 130,972 (65,936) - ------------------------------------------------------------------------------------------------------------------------------------ Change in cash and cash equivalents (9,608) 6,977 30,098 Cash and cash equivalents at beginning of year 113,531 106,554 76,456 - ------------------------------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of period $ 103,923 $ 113,531 $ 106,554 ==================================================================================================================================== Supplemental Disclosures of Cash Flow Information: Cash paid for interest $ 60,062 $ 79,250 $ 104,306 Cash paid for income taxes $ 13,095 $ 6,429 $ 8,082 Supplemental Disclosures of Non-cash Financing and Investing Activities: Dividends declared and unpaid $ 4,529 $ 3,760 $ 3,482 Gross change in unrealized gains on available-for-sale investment securities ($5,673) $ 47,198 $ 7,092 Change in minimum pension liability adjustment ($92) ($4,919) $ 5,016 Acquisitions: Fair value of assets acquired, excluding acquired cash $ 327,530 $ 0 $ 382,560 Fair value of liabilities assumed $ 257,532 $ 0 $ 569,685 Common stock and options issued, including treasury stock of $17,006 in 2001 $ 60,376 $ 0 $ 25,228 ====================================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 44 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES NOTE A: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations Community Bank System, Inc. is a single bank holding company which wholly-owns four consolidated subsidiaries: Community Bank, N.A. (the Bank), Benefit Plans Administrative Services, Inc. (BPA), CFSI Closeout Corp. (CFSICC), and First of Jermyn Realty Co. (FJRC). BPA owns two subsidiaries, Benefit Plans Administrative LLC and Harbridge Consulting Group LLC. BPA provides administration, consulting and actuarial services to sponsors of employee benefit plans. CFSICC and FJRC are inactive companies. The Bank operates 126 customer facilities throughout twenty-two counties of Upstate New York and five counties of Northeastern Pennsylvania. The Bank owns the following subsidiaries: Community Investment Services, Inc. (CISI), CBNA Treasury Management Corporation (TMC), CBNA Preferred Funding Corporation (PFC), Elias Asset Management, Inc. (EAM) and First Liberty Service Corp. (FLSC). CISI provides broker-dealer and investment advisory services. TMC operates the cash management, investment, and treasury functions of the Bank. PFC primarily is an investor inresidential real estate loans. EAM provides asset management services to individuals, corporate pension and profit sharing plans, and foundations. FLSC provides banking related services to the Pennsylvania branches of the Bank. The Company wholly-owns three unconsolidated subsidiary business trusts formed for the purpose of issuing mandatorily redeemable preferred securities which are considered Tier I capital under regulatory capital adequacy guidelines (see Note A - Accounting Pronouncements and Notes H and P). Basis of Presentation All amounts except share, per-share and rates are presented in thousands. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform with the current period presentation. Critical Accounting Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates include the allowance for loan losses, actuarial assumptions associated with the pension, post-retirement and other employee benefit plans, the provision for income taxes, the fair value of certain investment securities, and the carrying value of goodwill and other intangible assets. Risk and Uncertainties In the normal course of its business, the Company encounters economic and regulatory risks. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, from its interest-earning assets. The Company's primary credit risk is the risk of default on the Company's loan portfolio that results from the borrowers' inability or unwillingness to make contractually required payments. Market risk reflects potential changes in the value of collateral underlying loans, the fair value of investment securities, and loans held for sale. The Company is subject to regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies which may subject it to further changes with respect to asset valuations, amounts of required loan loss allowances, and operating restrictions resulting from the regulators' judgements based on information available to them at the time of their examinations. 45 Business Combinations Since the Financial Accounting Standards Board (FASB) issued SFAS 141, "Business Combinations," business combinations initiated after June 30, 2001 are required to be accounted for under the purchase method. Under the purchase method, net assets of the business acquired are recorded at their estimated fair value as of the date of acquisition with any excess of the cost of the acquisition over the fair value of the net tangible and intangible assets acquired recorded as goodwill. Results of operations of the acquired business are included in the income statement from the date of acquisition. Prior to SFAS 141, certain business combinations were accounted for under the pooling-of-interests method, which required the retroactive combining of the assets, liabilities, shareholders' equity, and results of operations of the merged entity with the Company's respective accounts at historical amounts. Prior period financial statements were restated to give effect to business combinations accounted for under this method. Revenue Recognition The Company recognizes income on an accrual basis. CISI recognizes fee income when investment and insurance products are sold to customers. EAM provides asset management services to brokerage firms and clients and recognizes income ratably over the contract period during which service is performed. Revenue from BPA's administration and recordkeeping services is recognized ratably over the service contract period. Revenue from consulting and actuarial services in recognized when services are rendered. All inter-company revenue and expense among related entities are eliminated in consolidation. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks. The carrying amounts reported in the balance sheet for cash and cash equivalents approximate those assets' fair values. Investment Securities The Company has classified its investments in debt and equity securities as held-to-maturity or available-for-sale. Held-to-maturity securities are those for which the Company has the positive intent and ability to hold to maturity, and are reported at cost, which is adjusted for amortization of premiums and accretion of discounts. Debt securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair market value with net unrealized gains and losses reflected as a separate component of shareholders' equity, net of applicable income taxes. None of the Company's investment securities has been classified as trading securities. Equity securities are stated at cost and include stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York. Investment securities are reviewed regularly for other than temporary impairment. Where there is other than temporary impairment, the carrying value of the investment security is reduced to the estimated fair value, with the impairment loss recognized in the consolidated statements of income as non-interest income. The average cost method is used in determining the realized gains and losses on sales of investment securities. Premiums and discounts on securities are amortized and accreted, respectively, on a systematic basis over the period to maturity, estimated life, or earliest call date of the related security. Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans Loans are stated at unpaid principal balances, net of unearned income. Mortgage loans held for sale are carried at the lower of cost or fair value and are included in loans as the balance of such loans was not significant. Fair values for variable rate loans that reprice frequently are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest approximates its fair value. Interest on loans is accrued and credited to operations based upon the principal amount outstanding. Unearned discount on installment loans is recognized as income over the term of the loan, principally by the interest method. Non-refundable loan fees and related direct costs are included in the loan balances and are deferred and amortized over the life of the loan as an adjustment to loan yield using the effective interest method. Premiums and discounts on purchased loans are amortized on an accelerated method over the life of the loans. 46 Impaired and Other Nonaccrual Loans The Company places a loan on nonaccrual status when the loan becomes ninety days past due (or sooner, if management concludes collection of interest is doubtful), except when, in the opinion of management, it is well-collateralized and in the process of collection. A loan may be placed on nonaccrual status earlier than ninety days past due if there is deterioration in the financial position of the borrower or if other conditions of the loan so warrant. When a loan is placed on nonaccrual status, uncollected accrued interest is reversed against interest income. Interest income during the period the loan is on nonaccrual status is recorded on a cash basis. Nonaccrual loans are returned to accrual status when management determines that the borrower's performance has improved and that both principal and interest are collectible. This generally requires a sustained period of timely principal and interest payments. Commercial loans greater than $500,000 are evaluated individually for impairment in accordance with FASB No. 114, "Accounting by Creditors for Impairment of a Loan." A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based upon the present value of expected future cash flows, except that all collateral-dependent loans are measured for impairment based on fair value of the collateral. The Company's charge-off policy by loan type is as follows: o Commercial loans and commercial loans secured by real estate are generally charged-off to the extent outstanding principal exceeds the fair value of estimated proceeds from collection efforts, including liquidation of collateral. The charge-off is recognized when the loss becomes reasonably quantifiable, but no later than 120 days after an uncured delinquency. o Consumer installment loans are generally charged-off to the extent outstanding principal balance exceeds the fair value of collateral, and are recognized by the end of the month in which the loan becomes 120 days past due. o Loans secured by 1-4 family residential real estate are generally charged-off to the extent outstanding principal exceeds the fair value of the property, and are recognized when the loan becomes 180 days past due. Allowance for Loan Losses The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change. When appropriate, an impaired loan is assigned a specific allowance. Specific loan loss allocations for certain commercial loans are considered and revised as necessary. Charge-off of these commercial loans are taken against the specific allocations before being applied against the general reserve. General allocations on the commercial, residential and consumer loan portfolios are reviewed and recalculated quarterly based on historical loss experience and various qualitative judgement factors. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. Intangible Assets Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions. Goodwill is evaluated at least annually for impairment. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 7 to 19 years. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Computer software costs that are capitalized only include external direct costs of obtaining and installing the software. The annual provision for depreciation is computed using the straight-line method over the assets' estimated useful lives. Maintenance and repairs are charged to expense as incurred. Other Real Estate Properties acquired through foreclosure, or by deed in lieu of foreclosure, are carried at the lower of the unpaid loan balance or fair value less estimated costs of disposal. At December 31, 2003 and 2002, other real estate, included in other assets, amounted to $1,077 and $704, respectively. 47 Mortgage Servicing Rights Originated mortgage servicing rights are recorded at their allocated fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the period of estimated net servicing income or loss. The Company uses a valuation model that calculates the present value of future cash flows to determine the fair value of servicing rights. In using this valuation method, the Company incorporates assumptions that market participants would use in estimating future net servicing income, which includes estimates of the servicing cost per loan, the discount rate, and prepayment speeds. The carrying value of the originated mortgage servicing rights is periodically evaluated for impairment using these same market assumptions. Deposits The fair value of deposit obligations are based on current market rates for alternative funding sources, principally the Federal Home Loan Bank of New York. The carrying value of accrued interest approximates fair value. Borrowings The carrying amounts of federal funds purchased and short-term borrowings approximate their fair values. Fair values for long-term borrowings are estimated using discounted cash flows and interest rates currently being offered on similar borrowings. Since the Company considers debt extinguishments to be a component of its interest rate risk management, any related gains or losses are not deemed extraordinary and are presented in the non-interest income section of the consolidated statements of income. Treasury Stock On June 9, 2003, the Company announced a twelve-month authorization to repurchase up to 700,000 of its outstanding shares in open market or privately negotiated transactions. The repurchases will be for general corporate purposes, including those related to acquisition and stock plan activities. As of December 31, 2003, the Company has repurchased 208,150 shares at an aggregate cost of $8,490 or $40.79 per share. Income Taxes Provisions for income taxes are based on taxes currently payable or refundable, and deferred taxes which are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. Retirement Benefits The Company has established tax-qualified retirement plans covering substantially all full-time employees and certain part-time employees. The Company also provides post-retirement benefits for eligible retired employees and dependents. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans. In addition, the Company has unfunded deferred compensation and supplemental executive retirement plans for selected current and former employees and officers that provide benefits that cannot be paid from a qualified retirement plan due to Internal Revenue Code restrictions. These plans are nonqualified under the Internal Revenue Code, and assets used to fund benefit payments are not segregated from other assets of the Company. Assets Under Management or Administration Assets held in fiduciary or agency capacities for customers are not included in the accompanying consolidated statements of condition as they are not assets of the Company. Substantially all fees associated with providing asset management services are recorded on an accrual basis of accounting and are included in non-interest income. Assets under management or administration at December 31, 2003 and 2002 were $1,807,000 and $1,364,000, respectively. Earnings Per Share Basic earnings per share is computed based on the weighted-average common shares outstanding for the period. Diluted earnings per share is based on the weighted-average shares outstanding adjusted for the dilutive effect of the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method. 48 The treasury stock method determines the number of common shares that would be outstanding if all in-the-money options (average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. There were no anti-dilutive stock options for the year ended December 31, 2003. On January 21, 2004, the Company announced a two-for-one stock split, subject to shareholder approval of an increase in its authorized shares. The split will be effected in the form of a 100% stock dividend, which the Company expects to be payable on or about April 12, 2004, to shareholders of record on or about March 17, 2004. The Company will seek approval of an amendment to increase its total authorized shares from 20 million to 50 million shares at a special Meeting of Shareholders to be held on March 26, 2004. Accumulated Other Comprehensive Income Accumulated other comprehensive income includes unrealized holding gains on investment securities of $35,961, $38,610 and $10,330 and a minimum pension liability adjustment of ($3), ($59) and ($3,049) as of December 31, 2003, 2002 and 2001, respectively. Stock-Based Compensation The Company accounts for stock awards issued to directors, officers and key employees using the intrinsic value method. This method requires that compensation expense be recognized to the extent that the fair value of the stock exceeds the exercise price of the stock award at the grant date. The Company generally does not recognize compensation expense related to stock awards because the stock awards generally have fixed terms and exercise prices that are equal to or greater than the fair value of the Company's common stock at the grant date. SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use the "intrinsic value method" to account for stock compensation plans to provide pro forma disclosures of the net income and earnings per share effect of stock options using the "fair value method." Under this method, the fair value of the option on the date of grant is recognized ratably as compensation expense over the vesting period of the option. Management estimated the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not necessarily a precise indicator of the value of an option, but it is commonly used for this purpose. The Black-Scholes model requires several assumptions, which management developed based on historical trends and current market observations. These assumptions include: 2003 2002 2001 - ------------------------------------------------------------------------------- Weighted-average expected life 7.55-8.76 6.74 7.02 Future dividend yield 3.00% 3.00% 3.00% Share price volatility 25.59%-27.58% 27.82% 28.14% Weighted average risk-free interest rate 3.82%-4.03% 3.81%-5.16% 5.11% =============================================================================== If these assumptions are not accurate, the estimated fair value used to derive the information presented in the following table also will be inaccurate. Moreover, the model assumes that the estimated fair value of an option is amortized over the option's vesting period and would be included in salaries and employee benefits on the income statement. The pro forma impact of applying the fair value method of accounting for the years shown below may not be indicative of the pro forma impact in future years.
2003 2002 2001 - ------------------------------------------------------------------------------------------- Net income, as reported $40,380 $38,517 $19,129 Less: stock-based compensation expense determined under fair value method, net of tax 779 692 796 - ------------------------------------------------------------------------------------------- Pro forma net income $39,601 $37,825 $18,333 =========================================================================================== Earnings per share as reported: Basic $ 3.07 $ 2.97 $ 1.64 Diluted $ 2.99 $ 2.93 $ 1.62 Pro forma earnings per share: Basic $ 3.01 $ 2.92 $ 1.57 Diluted $ 2.93 $ 2.87 $ 1.55 ===========================================================================================
49 Fair Values of Financial Instruments The Company determines fair values based on quoted market values where available or on estimates using present values or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS 107, "Disclosures about Fair Value of Financial Instruments," excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The fair values of investment securities, loans, deposits, and borrowings have been disclosed in footnotes C, D, G, and H, respectively. Accounting Pronouncements In December 2003, the SEC staff announced its intention to release a Staff Accounting Bulletin that would require all registrants to account for mortgage loan interest rate lock commitments related to loans held for sale as written options, effective no later than for commitments entered into after March 31, 2004. The Company periodically enters into such commitments with customers in connection with residential mortgage loan applications. At December 31, 2003 there were no loans held for sale. In December 2003, the FASB revised SFAS No. 132, "Employer Disclosures about Pensions and Other Post-retirement Benefits". This statement retains the disclosures required by the original SFAS No. 132 and requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension and post-retirement plans. In addition, this statement requires interim period disclosure of the components of net periodic benefit cost and contributions if significantly different from previously reported amounts. The Company adopted the provisions of this statement as of December 31, 2003 (see Note K). In October 2003, the FASB preliminarily concluded that companies will be required to charge stock-option costs against earnings beginning in 2005. The new standard is to be exposed for public comment in early 2004, with a final rule expected to be issued in the second half of 2004. In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability, including certain preferred securities. Effective July 1, 2003, the Company adopted this pronouncement, which had no impact on the historical measurement or classification of financial instruments, or on the financial condition or results of operations of the Company. In April 2003, the FASB issued SFAS No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003 and is effective for hedging relationships designated after June 30, 2003. Provisions of SFAS No. 149 that relate to SFAS No. 133 implementation issues that had been effective for fiscal quarters that began prior to June 15, 2003 should continue to be applied in accordance with their respective dates. All provisions of SFAS No. 149 should be applied prospectively, except for paragraphs 7(a) and 23(a), which relate to forward purchases or sales of "when-issued" securities or other securities that do not yet exist, which should be applied to both existing contracts and new contracts entered into after June 30, 2003. The provisions of SFAS No. 149 did not have a material impact on the Company's consolidated financial statements. In January 2003, the FASB issued Interpretation No. 46 ("FIN"), "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51", which establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE entity is the entity that absorbs the majority of the VIE's expected losses, receives a majority of the VIE's expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN No. 46, VIE were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after June 15, 2003. In December 2003, the FASB issued FIN 46R "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51," which modifies and clarifies FIN 46. Application of this guidance was effective for interests in certain VIE's commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. 50 During the fourth quarter 2003, the Company retroactively applied the provisions of FIN 46 to three wholly-owned subsidiary trusts that issued preferred securities to third-party investors. The application of FIN 46 resulted in the de-consolidation of the three wholly-owned subsidiary trusts. The assets and liabilities of the subsidiary trusts that were de-consolidated totalled $82,410 and $79,891 at December 31, 2003, and $82,461 and $79,938 at December 31, 2002. See Note H for further information on the adoption of FIN No. 46 and its impact on the Company's consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," which provides guidance on how to transition from the intrinsic value method of accounting for stock-based employee compensation under APB 25 to the fair value method under SFAS No. 123, if a company so elects. SFAS No.148 also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation and amends APB Opinion No. 28, "Interim Financial Reporting," to require disclosure about those effects in interim financial information. Since the Company did not adopt the fair value method of accounting under SFAS No. 123, this pronouncement has had no impact on its consolidated financial statements. In November 2002, FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" was issued. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that is has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company has complied with the disclosure requirements. The recognition and measurement provisions were adopted effective January 1, 2003, and had no material impact on the Company's financial condition or results of operations. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." Among other things, SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and Losses From Extinguishment of Debt", which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. The provisions of SFAS No. 145 related to the rescission of FASB Statement No. 4 are effective for fiscal years beginning after May 15, 2002, with early application encouraged. The Company adopted this pronouncement as of July 1, 2002. As a result, gains and losses from debt extinguishments have been presented in the non-interest income section of the consolidated statements of income and all prior periods have been reclassified. See Note F for discussion of recent accounting pronouncements related to goodwill and intangible assets. NOTE B: ACQUISITIONS First Heritage Bank On January 6, 2004, the Company announced an agreement to acquire First Heritage Bank in an all-stock transaction valued at approximately $74 million. Headquartered in Wilkes-Barre, Pa., First Heritage is a closely held $275 million-asset bank with three branches in Luzerne County. First Heritage's three branches will operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The acquisition is expected to close during the second quarter of 2004, pending both customary regulatory and First Heritage shareholder approval. Grange National Banc Corp. On November 24, 2003, the Company acquired Grange National Banc Corp. ("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa. Grange's 12 branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The Company issued approximately 1,147,000 shares of its common stock to certain of the former shareholders at a cost of $47.94 per share. The remaining shareholders received $42.50 in cash or approximately $20.9 million. In addition, Grange stock options representing $5.4 million of fair value were exchanged for options of the Company. The results of Grange's operations have been included in the consolidated financial statements since that date. Peoples Bankcorp Inc. On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a $29-million-asset savings and loan holding company based in Ogdensburg, New York. Peoples' single branch is being operated as a branch of the Bank's network of branches in Northern New York. The purchase price of the transaction approximated $4.0 million in cash. The results of Peoples' operations have been included in the consolidated financial statements since that date. 51 Harbridge Consulting Group On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York Global Human Resource Solutions consulting group for a purchase price of approximately $7.1 million in cash. This practice has been renamed Harbridge Consulting Group ("Harbridge") and is a leading provider of retirement and employee benefits consulting services throughout Upstate New York, and is complementary to Benefit Plans Administrative Services, Inc., the Company's defined contribution plan administration subsidiary. The results of Harbridge's operations have been included in the consolidated financial statements since that date. FleetBoston Financial Corporation branches On November 16, 2001, the Company acquired 36 branches from FleetBoston Financial Corporation with $470 million in deposits and $177 million in loans. The branches are located in the Southwestern and Finger Lakes Regions of New York State. The acquisition has been accounted for under the purchase method of accounting. Citizens National Bank of Malone On January 26, 2001, the Company acquired the $111-million-asset Citizens National Bank of Malone, a commercial bank with five branches throughout Franklin and St. Lawrence counties in New York State. The Company issued 952,000 shares of its common stock to the former shareholders at a cost of $26.50 per share. All of the 648,100 shares held in the Company's treasury were issued in this transaction. The acquisition has been accounted for under the purchase method of accounting. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed, including capitalized acquisition costs, as of the dates the acquisitions were consumated:
Grange Peoples Harbridge FleetBoston Citizens National Bankcorp Consulting Financial National Bank Banc Corp. Inc. Group Corporation of Malone - -------------------------------------------------------------------------------------------------------------------------------- Cash and due from banks $ 14,558 $ 9,428 $ 0 $ 5,028 $ 3,777 Available-for-sale investment securities 62,941 2,650 0 0 46,029 Loans, net of allowance for loan losses 170,224 14,871 0 174,449 57,981 Premises and equipment, net 3,306 400 0 9,600 1,495 Other assets 5,808 84 618 1,255 1,355 Goodwill 49,366 2,192 3,980 48,985 13,311 Other intangible assets 7,942 397 2,750 28,100 0 - -------------------------------------------------------------------------------------------------------------------------------- Total assets acquired 314,145 30,022 7,348 267,417 123,948 Deposits 225,175 23,682 0 470,250 87,671 Borrowings 0 1,000 0 0 9,950 Other liabilities 6,517 1,158 0 715 1,099 - -------------------------------------------------------------------------------------------------------------------------------- Total liabilities assumed 231,692 25,840 0 470,965 98,720 - -------------------------------------------------------------------------------------------------------------------------------- Net assets acquired/(liabilities assumed) $ 82,453 $ 4,182 $7,348 ($203,548) $ 25,228 ================================================================================================================================
First Liberty Bank Corp. On May 11, 2001, the Company completed its acquisition of the $648-million-asset First Liberty Bank Corp. ("First Liberty"). Pursuant to the terms of the merger, each share of First Liberty stock was exchanged for .56 shares of the Company's common stock, which amounted to approximately 3.6 million shares. The merger constituted a tax-free reorganization and has been accounted for as a pooling of interests under APB Opinion 16. Accordingly, the consolidated financial statements for the periods presented have been restated to include the combined results of operations, financial position and cash flows of the Company and First Liberty. Certain reclassifications were made to First Liberty's prior year financial statements to conform to the Company's presentation. Results of operations for the separate companies and the combined amounts presented in the consolidated financial statements for the four months ended April 30, 2001 are as follows: Net Interest Net Income Income - --------------------------------------------------------------------------- Community Bank System, Inc. $24,742 $5,874 First Liberty Bank Corp 6,112 1,765 - --------------------------------------------------------------------------- Combined $30,854 $7,639 =========================================================================== 52 Acquisition and Unusual Expenses The Company incurred certain expenses in connection with the above acquisitions. The following table shows the components of acquisition and unusual expenses which are presented in the consolidated statements of income for the years ended December 31: 2003 2002 2001 - -------------------------------------------------------------------------------- Acquisition expenses: Legal and professional fees $213 $455 $2,742 Severance and employee benefits 0 97 1,462 Equipment write-downs 0 0 934 Data processing 191 16 330 Customer check repurchase 10 61 811 Other 84 71 1,051 - -------------------------------------------------------------------------------- Total acquisition expenses 498 700 7,330 Unusual expenses: Legal and professional fees 0 0 395 Other 0 0 439 - -------------------------------------------------------------------------------- Total unusual expenses 0 0 834 - -------------------------------------------------------------------------------- Total acquisition and unusual expenses $498 $700 $8,164 ================================================================================ NOTE C: INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities as of December 31 are as follows:
2003 -------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value - ---------------------------------- -------------------------------------------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 127,635 $ 235 $ 2,867 $ 125,003 Obligations of state and political subdivisions 7,459 218 0 7,677 Other securities 3,558 0 0 3,558 - ---------------------------------- -------------------------------------------------------- Total held-to-maturity portfolio 138,652 453 2,867 136,238 - ---------------------------------- -------------------------------------------------------- Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies 456,913 22,638 97 479,454 Obligations of state and political subdivisions 443,930 26,291 11 470,210 Corporate securities 27,712 2,539 30,251 Collateralized mortgage obligations (CMO's) 89,566 3,987 1 93,552 Mortgage-backed securities 76,628 3,668 119 80,177 - ---------------------------------- -------------------------------------------------------- Sub-total 1,094,749 59,123 228 1,153,644 Equity securities 37,238 37,238 - ---------------------------------- -------------------------------------------------------- Total available-for-sale portfolio 1,131,987 $59,123 $ 228 $1,190,882 ====================================== Net unrealized gain on available for-sale portfolio 58,895 - ---------------------------------- ---------- Total carrying value $1,329,534 ================================== ========== 2002 ------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value - ---------------------------------- ------------------------------------------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 0 $ 0 $ 0 $ 0 Obligations of state and political subdivisions 7,412 254 0 7,666 Other securities 3,018 0 0 3,018 - ---------------------------------- ------------------------------------------------------- Total held-to-maturity portfolio 10,430 254 0 10,684 - ---------------------------------- ------------------------------------------------------- Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies 380,243 31,035 0 411,278 Obligations of state and political subdivisions 404,864 15,781 40 420,605 Corporate securities 27,972 2,253 0 30,225 Collateralized mortgage obligations (CMO's) 235,286 10,082 0 245,368 Mortgage-backed securities 131,755 5,457 1 137,211 - ---------------------------------- ------------------------------------------------------- Sub-total 1,180,120 64,608 41 1,244,687 Equity securities 31,466 0 0 31,466 - ---------------------------------- ------------------------------------------------------- Total available-for-sale portfolio 1,211,586 $64,608 $ 41 $1,276,153 ====================================== Net unrealized gain on available for-sale portfolio 64,567 - ---------------------------------- ---------- Total carrying value $1,286,583 ================================== ==========
All of the gross unrealized losses have been outstanding for less than twelve months. Management does not believe any individual unrealized loss as of December 31, 2003 represents an other than temporary impairment. The unrealized losses reported for the agency and mortgage-backed securities relate primarily to securities issued by FHLB, FNMA and FHLMC and are currently rated AAA by Moody's and S&P. These unrealized losses are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold these securities for the time necessary to recover the amortized cost. 53 The amortized cost and estimated fair value of debt securities at December 31, 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Held-to-Maturity Available-for-Sale ----------------------- --------------------------- Carrying Market Carrying Market Value Value Value Value - -------------------------------------------------------------- ----------------------- --------------------------- Due in one year or less $ 4,580 $ 4,609 $ 4,283 $ 4,367 Due after one through five years 2,390 2,524 28,557 29,684 Due after five years through ten years 99,756 98,224 478,677 501,519 Due after ten years 31,926 30,881 417,038 444,345 - -------------------------------------------------------------- ----------------------- --------------------------- Total 138,652 136,238 928,555 979,915 Collateralized mortgage obligations (CMO's) 0 0 89,566 93,552 Mortgage-backed securities 0 0 76,628 80,177 - -------------------------------------------------------------- ----------------------- --------------------------- Total $138,652 $136,238 $1,094,749 $1,153,644 ============================================================== ======================= ===========================
Proceeds from sales of investment securities during 2003, 2002, and 2001 were $41,227, $197,928 and $141,959, respectively. Gross gains of approximately $11, $2,593, and $2,964 for 2003, 2002, and 2001, respectively, and gross losses of $65, $0, and $418, in 2003, 2002, and 2001, respectively, were realized on those sales. Investment securities with a carrying value of $563,341 and $685,102 at December 31, 2003 and 2002, respectively, were pledged to collateralize certain deposits and borrowings. NOTE D: LOANS Major classifications of loans at December 31 are summarized as follows: 2003 2002 - -------------------------------------------------------------------------------- Consumer mortgage $ 739,593 $ 510,309 Business lending 689,436 629,874 Consumer indirect 325,304 287,453 Consumer direct 374,258 379,385 - -------------------------------------------------------------------------------- Gross loans 2,128,591 1,807,021 Unearned discount 82 116 - -------------------------------------------------------------------------------- Net loans 2,128,509 1,806,905 Allowance for loan losses 29,095 26,331 - -------------------------------------------------------------------------------- Loans, net of allowance for loan losses $2,099,414 $1,780,574 ================================================================================ The estimated fair value of loans at December 31, 2003 and 2002 was $2,140,000 and $1,841,000, respectively. Non-accrual loans of $11,940 and $9,754 and accruing loans ninety days past due of $1,307 and $1,890 at December 31, 2003 and 2002, respectively, are included in net loans. Changes in loans to directors and officers and other related parties for the years ended December 31 are summarized as follows: - -------------------------------------------------------------------------------- 2003 2002 - -------------------------------------------------------------------------------- Balance at beginning of year $ 15,735 $ 15,674 New loans 3,313 287 Payments (4,210) (226) - -------------------------------------------------------------------------------- Balance at end of year $ 14,838 $ 15,735 ================================================================================ Mortgage loans serviced for others are not included in the accompanying consolidated statements of condition. The unpaid principal balances of mortgage loans serviced for others were $126,324, $103,663, and $119,838 at December 31, 2003, 2002, and 2001, respectively. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately and $773 and $717 at December 31, 2003 and 2002, respectively. At December 31, 2003 and 2002, mortgage servicing rights, included in other assets, amounted to $456 and $283, respectively. 54 Changes in the allowance for loan losses for the years ended December 31 are summarized as follows: 2003 2002 2001 - -------------------------------------------------------------------------------- Balance at beginning of year $ 26,331 $ 23,901 $ 20,035 Provision for loan losses 11,195 12,222 7,097 Reserve on acquired loans 1,832 0 3,353 Charge-offs (13,110) (12,015) (8,662) Recoveries 2,847 2,223 2,078 - -------------------------------------------------------------------------------- Balance at end of year $ 29,095 $ 26,331 $ 23,901 ================================================================================ As of December 31, 2003 and 2002, the Company had impaired loans of $5,682 and $8,703, respectively. The specifically allocated allowance for loan loss recognized on these impaired loans was $1,825 and $3,200 at December 31, 2003 and 2002, respectively. For the year ended December 31, 2003 the Company had average impaired loans of $7,100 for which $46 of interest income recognized. NOTE E: PREMISES AND EQUIPMENT Premises and equipment consist of the following at December 31: 2003 2002 - -------------------------------------------------------------------------------- Land and land improvements $ 8,616 $ 8,270 Bank premises owned 53,560 47,129 Equipment 42,146 39,577 - -------------------------------------------------------------------------------- Premises and equipment, gross 104,322 94,976 Allowance for depreciation (42,617) (37,979) - -------------------------------------------------------------------------------- Premises and equipment, net $ 61,705 $ 56,997 ================================================================================ NOTE F: INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted SFAS 142, "Goodwill and Other Intangible Assets," which addresses financial accounting and reporting for acquired goodwill and other intangible assets and supercedes APB Opinion 17, "Intangible Assets". The statement requires that the Company subject goodwill and other intangible assets to an annual impairment analysis to assess the need to write down the balances and recognize an impairment loss. In addition, amortization of goodwill is no longer being recorded in accordance with this statement. Core deposit intangibles will continue to be amortized. In October 2002, the FASB issued SFAS 147, "Accounting for Certain Acquisitions of Banking and Thrift Institutions," which addresses financial accounting and reporting for certain intangibles associated with branch acquisitions. This statement removes acquisitions of financial institutions from the scope of SFAS 72 and FASB Interpretation 9. It reclassifies as goodwill certain "unidentified intangible assets" associated with the Company's branch acquisitions dating as far back as 1994. Financial statements are retroactively restated to January 1, 2002 to remove amortization recorded on other intangible assets. Previously, these intangible assets were being regularly amortized. As discussed above, under FASB 142, goodwill is not required to be amortized, but as an asset, is periodically reviewed for impairment. 55 The pro forma disclosures on net income and earnings per share of SFAS 142 and SFAS 147 for the twelve months ended December 31, 2003, 2002 and 2001 are as follows: Twelve Months Ended December 31, - -------------------------------------------------------------------------------- 2003 2002 2001 - -------------------------------------------------------------------------------- Reported net income $40,380 $38,517 $19,129 Plus: Goodwill amortization 2,945 - -------------------------------------------------------------------------------- Adjusted net income $40,380 $38,517 $22,074 ================================================================================ Basic earnings per share: Reported net income $ 3.07 $ 2.97 $ 1.64 Plus: Goodwill amortization 0.25 - -------------------------------------------------------------------------------- Adjusted net income $ 3.07 $ 2.97 $ 1.89 ================================================================================ Diluted earnings per share: Reported net income $ 2.99 $ 2.93 $ 1.62 Plus: Goodwill amortization 0.25 - -------------------------------------------------------------------------------- Adjusted net income $ 2.99 $ 2.93 $ 1.87 ================================================================================ The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:
As of December 31, 2003 As of December 31, 2002 --------------------------------------- --------------------------------------- Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying Amount Amortization Amount Amount Amortization Amount - --------------------------------- --------------------------------------- --------------------------------------- Amortizing intangible assets: Core deposit intangibles $ 55,455 ($21,457) $ 33,998 $ 47,366 ($16,597) $ 30,769 Other intangibles 2,750 (233) 2,517 0 0 0 - --------------------------------- --------------------------------------- --------------------------------------- Total amortized intangibles 58,205 (21,690) 36,515 47,366 (16,597) 30,769 Non-amortizing intangible assets: Goodwill 177,969 (18,373) 159,596 122,432 (18,373) 104,059 - --------------------------------- --------------------------------------- --------------------------------------- Total intangible assets, net $236,174 ($40,063) $196,111 $169,798 ($34,970) $134,828 ================================= ======================================= =======================================
As shown in Note B the increases in the gross carrying amount of core deposit intangibles, other intangibles and goodwill relate to the 2003 acquisition of Grange National Banc Corp. ($49,366 in goodwill), Peoples Bankcorp Inc. ($2,192 in goodwill) and Harbridge Consulting Group ($3,980 in goodwill). No goodwill impairment adjustments were recognized in 2003 and 2002. The estimated aggregate amortization expense for each of the five succeeding fiscal years ended December 31 is as follows: 2004 $ 6,571 2005 5,754 2006 4,862 2007 4,700 2008 4,535 Thereafter 10,093 - ----------------------------- Total $36,515 ============================= NOTE G: DEPOSITS Deposits consist of the following at December 31: 2003 2002 - -------------------------------------------------------------------------------- Demand $ 498,195 $ 439,075 Savings 1,052,941 962,056 Time 1,174,352 1,104,225 - -------------------------------------------------------------------------------- Total deposits $2,725,488 $2,505,356 ================================================================================ 56 The estimated fair value of deposits at December 31, 2003 and 2002 was approximately $2,536,000 and $2,523,000, respectively. At December 31, 2003 and 2002, time certificates of deposit in denominations of $100 and greater totaled $168,241 and $157,129, respectively. The approximate maturities of time deposits at December 31, 2003 are as follows: 2004 $ 894,215 2005 145,307 2006 49,609 2007 59,232 2008 25,595 Thereafter 394 - ------------------------------------ Total $1,174,352 ==================================== NOTE H: BORROWINGS Outstanding borrowings at December 31 are as follows:
2003 2002 - -------------------------------------------------------------------------------------- Short-term borrowings: Federal funds purchased $ 36,300 $ 33,000 Federal Home Loan Bank advances 361,000 215,000 Other borrowings 96 241 - -------------------------------------------------------------------------------------- Total short-term borrowings 397,396 248,241 Long-term borrowings: Federal Home Loan Bank advances 190,000 215,000 Subordinated debt held by unconsolidated subsidiary trusts, net of discount of $1,519 and $1,575 80,390 80,334 - -------------------------------------------------------------------------------------- Total long-term borrowings 270,390 295,334 - -------------------------------------------------------------------------------------- Total borrowings $667,786 $543,575 ======================================================================================
The weighted-average interest rates on short-term borrowings for the years ended December 31, 2003 and 2002 were 1.26% and 1.83%, respectively. Federal Home Loan Bank advances are collateralized by a blanket lien on the Company's residential real estate loan portfolio and mortgage-backed securities portfolio. Long-term borrowings at December 31, 2003 have maturity dates as follows: Weighted Amount Average Rate - -------------------------------------------------------------------------------- January 23, 2008 $ 10,000 5.44% January 28, 2008 5,000 5.48% April 14, 2010 25,000 6.35% September 27, 2010 50,000 5.88% October 12, 2010 50,000 5.84% November 1, 2010 50,000 5.77% February 3, 2027 30,772 9.75% July 16, 2031 25,085 5.12% July 31, 2031 24,533 4.92% - -------------------------------------------------------------------------------- Total $270,390 6.15% ================================================================================ The estimated fair value of long-term borrowings at December 31, 2003 and 2002 was approximately $314,000 and $345,000 respectively. In December 2003, the Company prepaid $25,000 of Federal Home Loan Bank ("FHLB") advances with maturity dates ranging from January 30, 2008 to February 4, 2008 and a weighted-average rate of 5.31%. In December 2002, the Company prepaid $11,000 of FHLB advances with maturity dates ranging from December 15, 2003 to December 31, 2004 57 and a weighted-average rate of 6.17%. In September 2001, the Company prepaid $95,000 of FHLB advances with maturity dates ranging from December 17, 2002 to February 23, 2004 and a weighted-average rate of 5.38%. As a result of these prepayments, the Company incurred penalties of $2,600, $925 and $2,659 in 2003, 2002 and 2001, respectively. These penalties have been reflected in the consolidated statements of income as gain (loss) on investment securities and early retirement of long-term borrowings. The Company sponsors three business trusts, Community Capital Trust I, Community Capital Trust II, and Community Statutory Trust III, of which 100% of the common stock is owned by the Company. The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company. The debentures held by each trust are the sole assets of that trust. Distributions on the preferred securities issued by each trust are payable semi-annually at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees. The terms of the preferred securities of each trust are as follows:
Issuance Preferred Interest Maturity Call Call Trust Date Securities Rate Date Provision Price - ------------------------------------------------------------------------------------------------------------------------------------ I 2/3/1997 30,000 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017 II 7/16/2001 25,000 six-month LIBOR plus 3.75% 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011 III 7/31/2001 24,450 three-month LIBOR plus 3.58% 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011 ====================================================================================================================================
In the fourth quarter 2003, as a result of applying the provisions of FIN 46, as discussed in Note A, the Company was required to de-consolidate these subsidiary trusts from its financial statements. The de-consolidation of the net assets and results of operations of the trusts had an immaterial impact on the Company's financial statements. The Company continues to be obligated to repay the debentures held by the trusts and guarantees repayment of the preferred securities issued by the trusts. The reported consolidated debt obligation related to the trusts increased from $77,931 to $80,390 at December 31, 2003 and $77,375 to $80,334 at December 31, 2002, as a result of de-consolidation, with the difference representing the Company's common ownership interest in the trusts that is now reported as an investment. The preferred securities held by the trusts qualify as Tier 1 capital for the Company under Federal Reserve Board guidelines. As a result of the issuance of FIN 46, the Federal Reserve Board is currently evaluating whether de-consolidation of the trusts will affect the qualification of the preferred securities as Tier 1 capital. If it is determined that the preferred securities no longer qualify as Tier 1 capital, the Company would still exceed the regulatory required minimum for capital adequacy purposes. NOTE I: INCOME TAXES The provision (benefit) for income taxes for the years ended December 31 is as follows: 2003 2002 2001 - -------------------------------------------------------------------------------- Current: Federal $11,534 $ 9,268 $ 8,301 State 341 161 348 Deferred: Federal 758 3,764 (691) State 140 694 (144) - -------------------------------------------------------------------------------- Total income taxes $12,773 $13,887 $ 7,814 ================================================================================ 58 Components of the net deferred tax liability, included in other assets/liabilities, as of December 31 are as follows: 2003 2002 - -------------------------------------------------------------------------------- Allowance for loan losses $ 10,537 $ 10,112 Employee benefits 1,610 1,430 Goodwill 0 978 Other 2,009 1,935 - -------------------------------------------------------------------------------- Total deferred tax asset 14,156 14,455 - -------------------------------------------------------------------------------- Investment securities 24,216 27,089 Goodwill 4,910 0 Loan origination costs 3,324 2,462 Depreciation 3,526 2,809 Pension 1,586 3,111 Mortgage servicing rights 178 110 - -------------------------------------------------------------------------------- Total deferred tax liability 37,740 35,581 - -------------------------------------------------------------------------------- Net deferred tax liability ($23,584) ($21,126) ================================================================================ The Company has determined that no valuation allowance is necessary as it is more likely than not that deferred tax assets will be realized through carryback of future deductions to taxable income in prior years, future reversals of existing temporary differences, and through future taxable income. A reconciliation of the differences between the federal statutory income tax rate and the effective tax rate for the years ended December 31 is shown in the following table: 2003 2002 2001 - -------------------------------------------------------------------------------- Federal statutory income tax rate 35.0% 35.0% 35.0% Increase (reduction) in taxes resulting from: Tax-exempt interest (11.2%) (9.9%) (11.1%) State income taxes, net of federal benefit 0.1% 0.6% 0.7% Other 0.1% 0.8% 4.5% - -------------------------------------------------------------------------------- Effective income tax rate 24.0% 26.5% 29.1% ================================================================================ NOTE J: LIMITS ON DIVIDENDS AND OTHER REVENUE SOURCES The Company's ability to pay dividends to its shareholders is largely dependent on the Bank's ability to pay dividends to the Company. In addition to state law requirements and the capital requirements discussed below, the circumstances under which the Bank may pay dividends are limited by federal statutes, regulations, and policies. For example, as a national bank, the Bank must obtain the approval of the Office of the Comptroller of the Currency (OCC) for payments of dividends if the total of all dividends declared in any calendar year would exceed the total of the Bank's net profits, as defined by applicable regulations, for that year, combined with its retained net profits for the preceding two years. Furthermore, the Bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts, as defined by applicable regulations. At December 31, 2003, the Bank had approximately $19,531 in undivided profits legally available for the payments of dividends. In addition, the Federal Reserve Board and the OCC are authorized to determine under certain circumstances that the payment of dividends would be an unsafe or unsound practice and to prohibit payment of such dividends. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings. There are also statutory limits on the transfer of funds to the Company by its banking subsidiary, whether in the form of loans or other extensions of credit, investments or assets purchases. Such transfer by the Bank to the Company generally is limited in amount to 10% of the Bank's capital and surplus, or 20% in the aggregate. Furthermore, such loans and extensions of credit are required to be collateralized in specific amounts. 59 NOTE K: BENEFIT PLANS The Company has a noncontributory defined benefit pension plan covering the majority of its employees and retirees. The benefits are based on years of service and the participant's average compensation, as defined in the Plan. The Company also provides health and life insurance benefits for eligible retired employees and dependents. The Company funds this plan as costs are incurred. The Company accrues for the estimated cost of these benefits through charges to expense during the years that the employees earn these benefits. Using a measurement date of December 31, the following table shows the funded status of the Company's plans reconciled with amounts reported in the Company's consolidated statements of condition:
Pension Benefits Post-retirement Benefits ----------------------- ------------------------ 2003 2002 2003 2002 - ---------------------------------------------- ----------------------- --------------------- Change in benefit obligation Benefit obligation at the beginning of year $ 31,520 $ 29,039 $ 4,159 $ 3,378 Service cost 1,674 1,173 275 159 Interest cost 1,953 1,779 260 241 Participant contributions 0 0 186 161 Plan amendment/acquisition 1,726 0 220 0 Other loss 1,218 0 0 0 Deferred actuarial loss 3,387 699 391 491 Benefits paid (1,345) (1,170) (408) (271) - ---------------------------------------------- ----------------------- --------------------- Benefit obligation at end of year 40,133 31,520 5,083 4,159 - ---------------------------------------------- ----------------------- --------------------- Change in plan assets Fair value of plan assets at beginning of year 29,133 21,084 0 0 Actual return of plan assets 6,815 (2,781) 0 0 Participant contributions 0 0 186 161 Employer contributions 2,181 12,000 222 110 Benefits paid (1,345) (1,170) (408) (271) - ---------------------------------------------- ----------------------- --------------------- Fair value of plan assets at end of year 36,784 29,133 0 0 - ---------------------------------------------- ----------------------- --------------------- Unfunded status (3,349) (2,387) (5,083) (4,159) Unrecognized actuarial loss 13,234 15,122 615 232 Unrecognized prior service cost (benefit) 1,361 (397) 361 391 Unrecognized transition (asset) liability 0 (4) 369 410 - ---------------------------------------------- ----------------------- --------------------- Prepaid (accrued) benefit cost $ 11,246 $ 12,334 ($3,738) ($3,126) ============================================== ======================= =====================
In 2003, the Company amended its defined benefit pension plan to provide certain benefits that were previously accrued under supplemental retirement plans. The accumulated benefit obligation for the pension plan was $35,025 and $26,845 as of December 31, 2003 and 2002, respectively. The Company does not anticipate making a contribution to its defined benefit pension plan in 2004. The weighted-average assumptions used to determine the benefit obligations as of December 31 are as follows: Pension Benefits Post-retirement Benefits ------------------ ------------------------ 2003 2002 2003 2002 - ------------------------------ ------------------ ------------------------ Discount rate 5.90% 6.10% 5.90% 6.10% Expected return on plan assets 9.00% 9.00% 0.00% 0.00% Rate of compensation increase 4.00% 4.00% 0.00% 0.00% ============================== ================== ======================== 60 The net periodic benefit cost as of December 31 is as follows:
Pension Benefits Post-retirement Benefits -------------------------------- ------------------------ 2003 2002 2001 2003 2002 2001 - -------------------------------------- -------------------------------- ------------------------ Service cost $ 1,674 $ 1,173 $ 1,121 $275 $159 $165 Interest cost 1,953 1,779 1,650 260 241 210 Expected return on plan assets (2,567) (2,268) (1,921) 0 0 0 Net amortization and deferral 1,027 402 218 8 0 0 Amortization of prior service cost (33) (33) (114) 31 30 30 Amortization of transition obligation (4) (19) (19) 41 41 41 Other expense 1,218 0 0 0 0 0 - -------------------------------------- -------------------------------- ------------------------ Net periodic benefit cost $ 3,268 $ 1,034 $ 935 $615 $471 $446 ====================================== ================================ ========================
Other expense represents a $1.2 million adjustment recorded in the fourth quarter of 2003 to reflect the proper actuarial impact of indexing salary levels associated with certain benefits frozen in 1988. The weighted-average assumptions used to determine the net periodic pension cost for the years ended December 31 are as follows:
Pension Benefits Post-retirement Benefits ----------------------------- ----------------------------- 2003 2002 2001 2003 2002 2001 - ------------------------------ ----------------------------- ----------------------------- Discount rate 6.10% 6.75% 7.00% 6.10% 6.75% 7.00% Expected return on plan assets 9.00% 9.00% 9.00% 0.00% 0.00% 0.00% Rate of compensation increase 4.00% 4.00% 4.00% 0.00% 0.00% 0.00% ============================== ============================= =============================
The expected long-term rate of return was estimated by reviewing historical returns on the pension investment portfolio, considering the current target asset allocations. The asset allocation for the defined benefit pension plan as of December 31, by asset category, is as follows: % of Plan Assets ----------------------- 2003 2002 - -------------------------------------------------------------------------------- Mutual funds 42% 20% Equity securities 28% 39% Debt securities 20% 21% Cash 10% 20% - -------------------------------------------------------------------------------- Total 100% 100% ================================================================================ Equity securities include $2,230 and $1,426 of Community Bank System, Inc. stock at December 31, 2003 and 2002, respectively. The investment objective for the defined benefit pension plan is to achieve an average annual total return over a five-year period equal to the assumed rate of return used in the actuarial calculations. At a minimum performance level, the portfolio should earn the return obtainable on high quality intermediate-term bonds. The Company's perspective regarding portfolio assets combines both preservation of capital and moderate risk-taking. Asset allocation favors equities, with a target allocation of approximately 75% equity securities, 20% fixed income securities and 5% cash. Due to the volatility in the market, the target allocation is not always desirable and asset allocations will fluctuate between acceptable ranges. Prohibited transactions include purchase of securities on margin, uncovered call options, short sale transactions, and use of real estate, unlisted limited partnerships, derivative products or venture capital loans as fixed income investment vehicles. The assumed health care cost trend rate used in the post-retirement health plan at December 31 is as follows: 2003 - -------------------------------------------------------------------------------- Health care cost trend rate for next year 9.50% Rate to which the cost trend rate is assumed to decline (ultimate trend rate) 5.00% Year the rate reaches the ultimate trend rate 2013 ================================================================================ 61 Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in the assumed health care cost trend rate would have the following effect: 1% Point 1% Point Increase Decrease - -------------------------------------------------------------------------------- Effect on total of service and interest cost components 29 (22) Effect on post-retirement benefit obligation 188 (166) ================================================================================ In December 2003, a bill was signed into law that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies which sponsor post-retirement benefit plans that provide prescription drug coverage. FASB Staff Position 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" permits deferring the recognition of the new Medicare provisions' impact due to lack of specific authoritative guidance on accounting for the federal subsidy. The Company has elected to defer accounting for the effects of this new legislation until the specific authoritative guidance is issued. Accordingly, the post-retirement benefit obligations and net periodic costs reported in the accompanying financial statements and notes do not reflect the impact of this legislation. The accounting guidance, when issued, could require changes to previously reported financial information. The Company anticipates its benefit costs after 2006 will be somewhat lower as a result of the new Medicare provisions, however, the adoption of this standard is not expected to have a material impact on results of operations, financial position, or liquidity of the Company. The Company has a 401(k) Employee Stock Ownership Plan that is qualified under Section 401(k) of the Internal Revenue Code. Employees can contribute from 1% to 90% of eligible compensation, with up to 6% being eligible for matching contributions in the form of Company common stock. The Plan also permits the Company to distribute a discretionary profit-sharing component in the form of Company common stock to all participants except certain executive employees. The expense recognized under this plan for the years ended December 31, 2003, 2002 and 2001, was $733, $666, and $528, respectively. The Company also has a Deferred Compensation Plan for Certain Executive Employees that is unqualified under Section 401(k) of the Internal Revenue Code. Under this Plan, participants may contribute 15% of their eligible compensation less any amounts contributed to the 401(k) Employee Stock Ownership Plan. Any discretionary profit-sharing amounts that the executive receives from the Company must be contributed to the Deferred Compensation Plan in the form of Company common stock. The Company incurs no expense related to this plan. The Company has nonqualified deferred compensation and supplemental retirement plans for several current and former directors, officers, and key employees. The liability arising from these plans is being accrued over the participant's remaining period of service so that at the expected retirement date, the then present value of the annual payments will have been expensed. All benefits provided under these plans are unfunded and payments to plan participants are made by the Company. At December 31, 2003 and 2002, the Company has recorded a liability of $6,020 and $3,690, respectively. The expense recognized under these plans for the years ended December 31, 2003, 2002, and 2001 was $1,585, $952, and $469, respectively. Directors may defer all or a portion of their director fees under the Deferred Compensation Plan for Directors. Under this plan, there is a separate account for each participating director which is credited with the amount of shares which could have been purchased with the director's fees as well as any dividends on such shares. On the distribution date, the director will receive common stock equal to the accumulated share balance in his account. As of December 31, 2003 and 2002, there were 28,451 and 25,510 shares credited to the participants' accounts, for which a liability of $894 and $781 was accrued, respectively. The expense recognized under the plan for the years ended December 31, 2003, 2002 and 2001, was $113, $126, and $164, respectively. The Company has a Stock Balance Plan for non-employee directors who have completed six months of service. The Plan is a nonqualified, noncontributory defined benefit plan. The Plan provides benefits for service prior to January 1, 1996 based on a predetermined formula and benefits for service after January 1, 1996 based on the performance of the Company's common stock. Participants become fully vested after six years of service. The directors can elect to receive offset stock options that may reduce the Company's liability under the Plan. These options vest immediately and expire one year after the date the director retires or two years in the event of death. Benefits are payable in the form of cash and/or Company stock (as elected by the director) on January 1st of the year after the director retires from the Board. As of December 31, 2003 and 2002, the accrued pension liability was $251 and $379, respectively. The expense recognized under this plan for the years ended December 31, 2003, 2002 and 2001, was $38, $69, and $4, respectively. The expense and related liability were calculated using a dividend rate of 3.00%, stock price appreciation of 6.00%, and a discount rate of 5.9% for 2003, 6.10% for 2002, and 6.75% for 2001. 62 NOTE L: STOCK-BASED COMPENSATION PLANS The Company has a long-term incentive program for directors, officers, and key employees. Under this program the Company authorized 2,537,000 shares of Company common stock for the grant of incentive stock options, restricted stock awards, nonqualified stock options, retroactive stock appreciation rights, and offset options to its Stock Balance Plan (see Note K). The offset options vest and become exercisable immediately and expire one year after the date the director retires or two years in the event of death. The remaining options have a ten-year term. They vest and become exercisable on a grant by grant basis, ranging from immediate vesting to ratably over a five-year period. Activity in these plans is as follows:
Weighted Average Exercise Price Options Range of Option Shares of Options Outstanding Price Per Share Exercisable Outstanding - ---------------------------------------------------------------------------------------------------- December 31, 2000 774,426 $6.75 - $34.81 542,703 $24.57 Granted 272,979 24.90 Exercised (65,851) 7.50 - 26.50 Forfeited (5,488) 19.13 - 31.31 - ---------------------------------------------------------------------------------------------------- December 31, 2001 976,066 $6.75 - $34.81 652,114 $25.37 Granted 206,702 26.20 - 31.35 Exercised (96,018) 6.75 - 29.31 Forfeited (1,988) 24.75 - 26.20 - ---------------------------------------------------------------------------------------------------- December 31, 2002 1,084,762 $12.13 - $34.81 707,405 $26.16 Granted 423,565 5.34 - 47.85 Exercised (284,104) 7.29 - 31.35 Forfeited (5,936) 23.13 - 31.31 - ---------------------------------------------------------------------------------------------------- December 31, 2003 1,218,287 $5.34 - $47.85 757,901 $25.57 ====================================================================================================
Options granted in 2003 include approximately 193,000 options exchanged in connection with the Grange acquisition. At December 31, 2003 the range of exercise prices and other information relating to the Company's stock options is as follows:
Options Outstanding Options Exercisable ----------------------------------------- ---------------------- Weighted Weighted Weighted Average Average Average Range of Exercise Remaining Exercise Exercise Price Shares Price Life (years) Shares Price - --------------- ----------------------------------------- ---------------------- $5.34 - $9.74 126,579 $ 7.66 2.2 126,579 $ 7.66 $9.74 - $14.61 18,609 11.91 2.7 18,609 11.91 $14.61 - $19.48 76,348 17.90 3.7 76,348 17.90 $19.48 - $24.35 103,282 23.09 6.0 69,846 23.08 $24.35 - $29.22 376,088 25.47 7.5 163,106 25.30 $29.22 - $34.09 361,635 30.87 7.3 157,167 30.41 $34.09 - $38.96 153,746 34.96 8.6 146,246 34.81 $38.96 - $43.83 1,000 41.02 9.6 0 0.00 $43.83 - $47.85 1,000 47.85 10.0 0 0.00 - --------------- ----------------------------------------- ---------------------- Total 1,218,287 $25.57 6.6 757,901 $23.97 =============== ========================================= ======================
On February 21, 1995, the Company adopted a Stockholder Protection Rights Agreement. Under the Plan, each stockholder received one right, representing the right to purchase one share of common stock for $42.50 for each share of stock owned. All of the rights expire on February 21, 2005, but the Company may redeem the rights earlier for $.005 per right, subject to certain limitations. Rights will become exercisable if a person or group acquires 15% or more of the Company's outstanding shares. Until that time, the rights will trade with the common stock; any transfer of common stock will also constitute a transfer of the associated right. If the rights become exercisable, they will begin to trade apart from the common stock. If one of a number of "flip-in events" occurs, each right will entitle the holder to purchase common stock having a market value equivalent of two times the exercise price. 63 NOTE M: EARNINGS PER SHARE The following is a reconciliation of basic to diluted earnings per share for the years ended December 31: Per Share Income Shares Amount - -------------------------------------------------------------------------------- Year Ended December 31, 2003 Basic EPS $40,380 13,149 $3.07 Stock options 368 - ---------------------------------------------------------------- Diluted EPS $40,380 13,517 $2.99 ================================================================ Year Ended December 31, 2002 Basic EPS $38,517 12,973 $2.97 Stock options 194 - ---------------------------------------------------------------- Diluted EPS $38,517 13,167 $2.93 ================================================================ Year Ended December 31, 2001 Basic EPS $19,129 11,681 $1.64 Stock options 144 - ---------------------------------------------------------------- Diluted EPS $19,129 11,825 $1.62 ================================================================ NOTE N: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party. The credit risk associated with commitments to extend credit and standby letters of credit is essentially the same as that involved with the extending loans to customers and is subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The contract amount of commitment and contingencies as of December 31 is as follows: 2003 2002 - -------------------------------------------------------------------------------- Standby letters of credit $ 19,163 $ 19,728 Commitments to extend credit 315,898 332,422 - -------------------------------------------------------------------------------- Total $335,061 $352,150 ================================================================================ The fair value of these financial instruments approximates carrying value. The Company has an unused line of credit of $10,000 at December 31, 2003. The Company has unused borrowing capacity of approximately $194,000 through collateralized transactions with the Federal Home Loan Bank and $24,590 through collateralized transactions with the Federal Reserve Bank. As of December 31, 2003, the Company has a letter of credit of approximately $12,669 that expires on June 16, 2004. The Company is required to maintain a reserve balance, as established by the Federal Reserve Bank of New York. The required average total reserve for the 14-day maintenance period ended December 31, 2003 was $52,336, of which $2,000 was required to be on deposit with the Federal Reserve Bank of New York. The remaining $50,336 was represented by cash on hand. 64 NOTE O: LEASES The Company leases buildings and office space under agreements that expire in various years. Rental expense included in operating expenses amounted to $1,940, $1,896, and $1,414 in 2003, 2002 and 2001, respectively. The future minimum rental commitments as of December 31, 2003 for all non-cancelable operating leases are as follows: 2004 $ 2,114 2005 1,878 2006 1,721 2007 1,498 2008 990 Thereafter 4,286 - --------------------------------- Total $12,487 ================================= NOTE P: REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Under capital adequacy guidelines the Company must maintain minimum total core capital to risk weighted assets of 8%, and tier I capital to risk weighted assets and tier I capital to average assets of 4%. Management believes, as of December 31, 2003 and December 31, 2002, that the Company and Bank meets all capital adequacy requirements to which it is subject and is "well capitalized" under the regulatory framework of prompt corrective action. To be categorized as "well capitalized," the Bank must maintain minimum total core capital to risk weighted assets of 10%, tier I capital to risk weighted assets of 6% and tier I capital to average assets of 5%. The capital ratios and amounts of the Company and the Bank as of December 31 are presented below:
2003 2002 ------------------------ ------------------------ Company Bank Company Bank - ------------------------------------------------------------------------ ------------------------ Tier 1 capital to average assets Amount $249,641 $245,809 $228,947 $213,786 Ratio 7.26% 7.28% 7.05% 6.59% Minimum required amount $137,607 $134,977 $129,848 $129,777 Tier 1 capital to risk weighted assets Amount $249,641 $245,809 $228,947 $213,786 Ratio 11.76% 11.63% 12.07% 11.29% Minimum required amount $ 84,916 $ 84,576 $ 75,863 $ 76,772 Total core capital to risk weighted assets Amount $276,177 $272,339 $252,654 $237,465 Ratio 13.01% 12.88% 13.32% 12.54% Minimum required amount $169,831 $169,151 $151,725 $151,545
65 NOTE Q: PARENT COMPANY STATEMENTS The condensed balance sheet of the parent company at December 31 is as follows: 2003 2002 - -------------------------------------------------------------------------------- Assets: Cash $ 24,429 $ 16,999 Investment securities 2,747 2,523 Investment in and advances to subsidiaries 482,407 389,945 Other assets 3,161 2,336 - -------------------------------------------------------------------------------- Total assets $512,744 $411,803 ================================================================================ Liabilities and shareholders' equity: Accrued interest and other liabilities $ 7,526 $ 6,431 Borrowings 100,390 80,334 Shareholders' equity 404,828 325,038 - -------------------------------------------------------------------------------- Total liabilities and shareholders' equity $512,744 $411,803 ================================================================================ The condensed statement of income of the parent company for the years ended December 31 is as follows:
2003 2002 2001 - ----------------------------------------------------------------------------------------- Revenues: Dividends from subsidiaries $42,771 $29,587 $18,373 Interest on investments 6 10 57 - ----------------------------------------------------------------------------------------- Total revenues 42,777 29,597 18,430 - ----------------------------------------------------------------------------------------- Expenses: Interest on long term notes and debentures 5,765 6,112 5,041 Other expenses 84 9 48 - ----------------------------------------------------------------------------------------- Total expenses 5,849 6,121 5,089 - ----------------------------------------------------------------------------------------- Income before tax benefit and equity in undistributed net income of subsidiaries 36,928 23,476 13,341 Income tax benefit 1,364 1,572 1,419 - ----------------------------------------------------------------------------------------- Income before equity in undistributed net income of subsidiaries 38,292 25,048 14,760 Equity in undistributed net income of subsidiaries 2,088 13,469 4,369 - ----------------------------------------------------------------------------------------- Net income $40,380 $38,517 $19,129 =========================================================================================
66 The statements of cash flows of the parent company for the years ended December 31 is as follows:
2003 2002 2001 - ----------------------------------------------------------------------------------------------------- Operating Activities: Net income $ 40,380 $ 38,517 $ 19,129 Adjustments to reconcile net income to net cash provided by operating activities Equity in undistributed net income of subsidiaries (2,088) (13,469) (4,369) Net change in other assets and other liabilities 1,633 (886) 5,109 - ----------------------------------------------------------------------------------------------------- Net cash provided by operating activities 39,925 24,162 19,869 - ----------------------------------------------------------------------------------------------------- Investing Activities: Purchase of investment securities (227) (76) (210) Sale of investment securities 0 0 500 Capital contributions to subsidiaries (33,131) (831) (80,399) - ----------------------------------------------------------------------------------------------------- Net cash used in investing activities (33,358) (907) (80,109) - ----------------------------------------------------------------------------------------------------- Financing Activities: Net change in borrowings 20,000 (6,100) 0 Proceeds from junior subordinated debentures 0 0 50,981 Issuance of common stock, net of issuance costs 4,819 1,151 32,837 Purchase of treasury stock (8,490) 0 0 Cash dividends paid (15,466) (14,228) (10,980) - ----------------------------------------------------------------------------------------------------- Net cash provided (used) by financing activities 863 (19,177) 72,838 - ----------------------------------------------------------------------------------------------------- Change in cash and cash equivalents 7,430 4,078 12,598 Cash and cash equivalents at beginning of year 16,999 12,921 323 - ----------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 24,429 $ 16,999 $ 12,921 ===================================================================================================== Supplemental disclosures of cash flow information: Cash paid for interest $ 5,841 $ 6,412 $ 3,883 Supplemental disclosures of non-cash financing activities Dividends declared and unpaid $ 4,529 $ 3,760 $ 3,482 =====================================================================================================
On November 16, 2001 and December 12, 2001, the Company issued 1,200,000 and 108,800 shares of common stock at a price of $26.35. Proceeds from the issuance of common stock, net of issuance costs, were $32,064. 67 Report of Independent Auditors Board of Directors and Shareholders Community Bank System, Inc. In our opinion, the accompanying consolidated statements of condition and the related consolidated statements of income, shareholders' equity, comprehensive income and cash flows present fairly, in all material respects, the financial position of Community Bank System, Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years then ended in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note F to the consolidated financial statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards Nos. 142 "Goodwill and Other Intangible Assets" and 147 "Accounting for Certain Acquisitions of Banking and Thrift Institutions." /s/ Pricewaterhousecoopers LLP Syracuse, New York January 26, 2004 68 TWO YEAR SELECTED QUARTERLY DATA
2003 RESULTS 4th 3rd 2nd 1st Quarter Quarter Quarter Quarter Total - ----------------------------------------------------------------------------------------------------------------------- Net interest income $34,703 $32,539 $32,102 $32,484 $131,828 Provision for loan losses 3,093 2,029 2,673 3,400 11,195 - ----------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 31,610 30,510 29,429 29,084 120,633 Non-interest income 7,618 9,725 8,891 8,747 34,981 Operating expenses 27,799 25,152 25,123 24,387 102,461 - ----------------------------------------------------------------------------------------------------------------------- Income before income taxes 11,429 15,083 13,197 13,444 53,153 Income taxes 2,759 3,354 3,165 3,495 12,773 - ----------------------------------------------------------------------------------------------------------------------- Net income $ 8,670 $11,729 $10,032 $ 9,949 $ 40,380 ======================================================================================================================= Basic earnings per share $ 0.64 $ 0.90 $ 0.77 $ 0.76 $ 3.07 Diluted earnings per share $ 0.62 $ 0.87 $ 0.75 $ 0.75 $ 2.99 ======================================================================================================================= 2002 RESULTS 4th 3rd 2nd 1st Quarter Quarter Quarter Quarter Total - ----------------------------------------------------------------------------------------------------------------------- Net interest income $33,848 $32,397 $31,437 $30,168 $127,850 Provision for loan losses 5,042 2,278 3,384 1,518 12,222 - ----------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 28,806 30,119 28,053 28,650 115,628 Non-interest income 7,846 7,882 8,516 7,562 31,806 Operating expenses 23,807 22,864 23,883 24,476 95,030 - ----------------------------------------------------------------------------------------------------------------------- Income before income taxes 12,845 15,137 12,686 11,736 52,404 Income taxes 3,206 4,087 3,416 3,178 13,887 - ----------------------------------------------------------------------------------------------------------------------- Net income $ 9,639 $11,050 $ 9,270 $ 8,558 $ 38,517 ======================================================================================================================= Basic earnings per share $ 0.74 $ 0.85 $ 0.71 $ 0.66 $ 2.97 Diluted earnings per share $ 0.73 $ 0.84 $ 0.70 $ 0.65 $ 2.93 =======================================================================================================================
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9a. Controls and Procedures As of December 31, 2003, the Chief Executive Officer and Chief Financial Officer of the Company evaluated the Company's disclosure controls and procedures related to the recording, processing, summarization and reporting of information in the Company's reports that it files with the Securities and Exchange Commission (SEC). These disclosure controls and procedures have been designed to ensure that (a) material information relating to the Company, including its consolidated subsidiaries, is made known to the Company's management, including their officers, by other employees of the Company and its subsidiaries, and (b) this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the SEC's rules and forms. Based upon this evaluation, these officers concluded that the design and effectiveness of the disclosure controls and procedures is sufficient to accomplish their purpose. There have been no significant changes in the Company's internal controls or other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. 69 Part III Item 10. Directors and Executive Officers of the Registrant The information concerning Directors of the Company required by this Item 10 is incorporated herein by reference to the sections entitled "Nominees for Director and Directors Continuing in Office" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement. The information concerning executive officers of the Company required by this Item 10 is incorporated by reference to Item 4A of this Annual Report on Form 10-K. The Company has adopted a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The text of the code of ethics is posted on the Company's web-site at www.communitybankna.com. The Company intends to satisfy the requirements under Item 10 of Form 8-K regarding an amendment to, or a waiver from, the code of ethics that relates to certain elements thereof, by posting such information on its web-site referenced above. In addition, information concerning Audit Committee Financial Expert is included in the Proxy Statement under the caption "Audit Committee Report" and is incorporated herein by reference. Item 11. Executive Compensation The information required by this Item 11 is incorporated herein by reference to the section entitled "Compensation of Executive Officers" in the Company's Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item 12 is incorporated herein by reference to the section entitled "Nominees for Director and Directors Continuing in Office" in the Company's Proxy Statement. Item 13. Certain Relationships and Related Transactions The information required by this Item 13 is incorporated herein by reference to the section entitled "Transactions with Management" in the Company's Proxy Statement. Item 14. Principal Accountant Fees and Services The information required by this Item 14 is incorporated herein by reference to the section entitled "Audit Fees" in the Company's Proxy Statement. 70 Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K A. Documents Filed 1. The following consolidated financial statements of Community Bank System, Inc. and subsidiaries are included in Item 8: - Consolidated Statements of Condition, December 31, 2003 and 2002 - Consolidated Statements of Income, Years ended December 31, 2003, 2002, and 2001 - Consolidated Statements of Changes in Shareholders' Equity, Years ended December 31, 2003, 2002, and 2001 - Consolidated Statements of Comprehensive Income, Years ended December 31, 2003, 2002, and 2001 - Consolidated Statement of Cash Flows, Years ended December 31, 2003, 2002, and 2001 - Notes to Consolidated Financial Statements, December 31, 2003 - Independent Auditor's Report - Quarterly selected data, Years ended December 31, 2003 and 2002 (unaudited) 2. Schedules are omitted since the required information is either not applicable or shown elsewhere in the financial statements. 3. The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed below: 2.1 Amended and Restated Agreement and Plan of Merger, dated June 7, 2003, by and between Community Bank System, Inc. and Grange National Banc Corp. Incorporated by reference to Annex A to the proxy statement/prospectus included in the Registration Statement on Form S-4 (Reg. No. 333-107949) filed on August 20, 2003, as amended. 2.2 Agreement and Plan of Merger, dated May 6, 2003, by and among the Registrant, PB Acquisition Corp. and Peoples Bankcorp, Inc. Incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K of the Registrant filed on May 8, 2003). 2.3 Agreement and Plan of Merger, dated November 29, 2000, by and between Community Bank System, Inc. and First Liberty Bank Corp. Incorporated by reference to Exhibit No. 2.1 to the Current Report on Form 8-K filed on December 20, 2000 (File No. 001-13695). 2.4 Agreement regarding the Agreement and Plan of Merger, dated September 26, 2000, by and between Community Bank, N.A. and The Citizens National Bank of Malone. Incorporated by reference to Exhibit No. 10.1 to the Registration Statement on Form S-4 filed on October 20, 2000 (Registration No. 333-48374). 2.5 Purchase and Assumption Agreement, dated December 6, 1994, by and between Community Bank System, Inc. and The Chase Manhattan Bank, N.A. Incorporated by reference to Exhibit No. 10.01 to the Registration Statement on Form S-2 filed on April 11, 1995 (Registration No. 033-58539). 71 3.1 Certificate of Incorporation of Community Bank System, Inc., as amended. Incorporated by reference to Exhibit No. 3.1 to the Registration Statement on Form S-4 filed on October 20, 2000 (Registration No. 333-48374). 3.2 Bylaws of Community Bank System, Inc., as amended. Incorporated by reference to Exhibit No. 3.2 to the Registration Statement on Form S-4 filed on October 20, 2000 (Registration No. 333-48374). 4.1 Junior Subordinated Deferrable Interest Debentures, dated as February 3, 1997, by and between Community Bank System, Inc. and The Chase Manhattan Bank. Incorporated by reference to Exhibit No. 4.1 to the Registration Statement on Form S-4 filed on June 25, 1997 (Registration No. 333-30045). 4.2 Amended and Restated Declaration of Trust of Community Capital Trust I, dated as February 3, 1997, by and between Community Bank System, Inc. and The Chase Manhattan Bank. Incorporated by reference to Exhibit No. 4.5 to the Registration Statement on Form S-4 filed on June 25, 1997 (Registration No. 333-30045). 4.3 Form of Common Stock Certificate. Incorporated by reference to Exhibit No. 4.1 to the Amendment No. 1 to the Registration Statement on Form S-3 filed on October 24, 2001 (Registration No. 333-68866). 10.1 Employment Agreement, effective March 1, 2004, by and between Community Bank System, Inc. and Sanford A. Belden.* ** 10.2 Supplemental Retirement Plan Agreement, effective March 1, 2004, by and between Community Bank System Inc. and Sanford A. Belden. * ** 10.3 Agreement dated December 23, 2002, by and between Community Bank System, Inc., Community Bank N.A. and David G. Wallace. Incorporated by reference to Exhibit 10.2 to the Annual Report on 10-K for the year ended December 31, 2002. ** 10.4 Employment Agreement, effective March 8, 2004, by and between Community Bank System, Inc. and Mark E. Tryniski. * ** 10.5 Supplemental Retirement Plan Agreement, effective July 1, 2003, by and between Community Bank System Inc. and Mark E. Tryniski. * ** 10.6 Employment Agreement, effective March 20, 2003, by and between Community Bank System, Inc. and James A. Wears. * ** 10.7 Supplemental Retirement Plan Agreement, effective February 1, 2004, by and between Community Bank System Inc. and James A. Wears. * ** 10.8 Employment Agreement, effective March 20, 2003, by and between Community Bank System, Inc. and Michael A. Patton. * ** 10.9 Supplemental Retirement Plan Agreement, effective February 1, 2004, by and between Community Bank System Inc. and Michael A. Patton. * ** 10.10 Employment Agreement, effective November 21, 2003, by and between Community Bank System, Inc. and Thomas A. McCullough. * ** 10.11 Supplemental Retirement Plan Agreement, effective March 26, 2003, by and between Community Bank System Inc. and Thomas McCullough. * ** 10.12 Employment Agreement, effective April 3, 2000, by and between Community Bank System, Inc. and David J. Elias. * ** 72 10.13 1994 Long-Term Incentive Compensation Program, as amended. Incorporated by reference to Appendix B to the Definitive Proxy Statement on Schedule 14A filed on April 3, 2001 (File No. 001-13695). ** 10.14 Stock Balance Plan for Directors, as amended. Incorporated by reference to Annex I to the Definitive Proxy Statement on Schedule 14A filed on March 31, 1998 (File No. 001-13695). 10.15 Deferred Compensation Plan for Directors, as amended. Incorporated by reference to Annex I to the Definitive Proxy Statement on Schedule 14A filed on March 31, 1998 (File No. 001-13695). 21.1 Subsidiaries of Community Bank System, Inc. Jurisdiction Name of Incorporation ---- ---------------- Community Bank, N.A New York Community Capital Trust I Delaware Community Capital Trust II Delaware Community Statutory Trust III Connecticut Community Financial Services, Inc. New York Benefit Plans Administrative Services, Inc. New York Benefit Plans Administrative Services LLP New York Harbridge Consulting Group LLP New York CBNA Treasury Management Corporation New York Community Investment Services, Inc. New York CBNA Preferred Funding Corp. Delaware CFSI Close-Out Corp. New York Elias Asset Management, Inc. Delaware First Liberty Service Corporation Delaware First of Jermyn Realty Co. Delaware 23.1 Consent of PricewaterhouseCoopers LLP. * 31.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. * 31.2 Certification of Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. * 32.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * 32.2 Certification of Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * * Filed herewith **Denotes management contract or compensatory plan or arrangement B. Reports on Form 8-K Form 8-K related to quarterly earnings press release was filed on October 21, 2003. C. Not applicable 73 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden --------------------------- Sanford A. Belden President, Chief Executive Officer and Director March 12, 2004 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 15th day of March 2004. /s/ James A. Gabriel - ------------------------------- James A. Gabriel, Director and Chairman of the Board of Directors /s/ Mark E. Tryniski - ------------------------------- Mark E. Tryniski Treasurer, Chief Operating Officer and Chief Financial Officer Directors: /s/ Brian R. Ace - ------------------------------- Brian R. Ace, Director /s/ John M. Burgess - ------------------------------- John M. Burgess, Director /s/ Paul M. Cantwell, Jr. - ------------------------------- Paul M. Cantwell, Jr., Director /s/ William M. Dempsey - ------------------------------- William M. Dempsey, Director /s/ Nicholas A. DiCerbo - ------------------------------- Nicholas A. DiCerbo, Director /s/ Lee T. Hirschey - ------------------------------- Lee T. Hirschey, Director /s/ Harold S. Kaplan - ------------------------------- Harold S. Kaplan, Director /s/ Saul Kaplan - ------------------------------- Saul Kaplan, Director /s/ David C. Patterson - ------------------------------- David C. Patterson, Director /s/ Peter A. Sabia - ------------------------------- Peter A. Sabia, Director /s/ William N. Sloan - ------------------------------- William N. Sloan, Director /s/ Sally A. Steele - ------------------------------- Sally A. Steele, Director 74 EX-10.1 3 d58827_ex10-1.txt SANFORD A. BELDEN EMPLOYMENT AGREEMENT Exhibit 10.1 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of March 1, 2004 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) SANFORD A. BELDEN, an individual currently residing at 9 Lynacres Boulevard, Fayetteville, New York ("Employee"). This Agreement supersedes the amended and restated Employment Agreement between the parties dated as of April 1, 2002, which provided for employment for a term ending on December 31, 2007. This Agreement is effective as of March 1, 2004. W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall continue to employ Employee, and Employee shall continue to serve, as Director, President and Chief Executive Officer of Employer for a forty-six month term commencing on March 1, 2004 and ending on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. (b) Salary. During the period of March 1, 2004 through December 31, 2004, Employer shall pay Employee base salary at the annual rate in effect for Employee on February 29, 2004 ("Base Salary"). Employee's Base Salary for calendar years after 2004 shall be increased at the same rate as the rate applied by the Employer in its merit pool for salary increases to be paid for the applicable calendar year. Employee's Base Salary is payable in accordance with Employer's regular payroll practices for executive employees. (c) Incentive Compensation. Employee shall be entitled to annual incentive compensation opportunities pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer. Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c), 3(g) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of active employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, in the case of a termination upon Employee's disability pursuant to subparagraph 3(c), the date the Disability Period began. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of Employer's Board of Directors, for the supervision of all aspects of Employer's business and operations, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by Employer's Board of Directors. Employee shall report to the Board of Directors of Employer. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's ability and devote all of Employee's working time and attention, knowledge, experience, energy and skill to the business of Employer, except that Employee may affiliate with professional associations, business and civic organizations. Employee shall serve on the Board of Directors of, or as an officer of Employer's affiliates, without additional 2 compensation if requested to do so by the Board of Directors of Employer. Employee shall receive only the compensation and other benefits described in this Agreement for Employee's duties as a Director of Employer. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability 3 to perform Employee's duties hereunder by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. (d) Termination for Cause. Employer may terminate Employee's employment immediately for "cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "cause" if the termination results from any of the following events: (i) Material breach of this Agreement; 4 (ii) Documented misconduct as an executive or director of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder including, but not limited to, misappropriating any funds or property of any such company, or attempting to obtain any personal profit (x) from any transaction to which such company is a party or (y) from any transaction with any third party in which Employee has an interest which is adverse to the interest of any such company, unless, in either case, Employee shall have first obtained the written consent of the Board of Directors of Employer; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days; (iv) Conviction of a crime involving moral turpitude; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; (vi) Documented failure to follow the reasonable, written instructions of the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or (vii) Any documented violation of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. 5 (e) Termination For Reasons Other Than Cause. In the event Employer terminates Employee prior to December 31, 2007 for reasons other than cause, Employee shall be entitled to a severance benefit equal to the greater of (i) the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal monthly or semi-monthly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in monthly or semi-monthly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right determined without regard to Employee's termination of employment; (v) fully fund the grantor trust created pursuant to paragraph 1(i) of the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for benefits payable pursuant to that separate agreement; and (vi) cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's retired employees. Notwithstanding the foregoing, if Employer terminates Employee prior to December 31, 2007 for reasons other than cause and under circumstances that entitle Employee to payments and benefits under paragraph 6 of this Agreement (regarding "Change of Control"), 6 then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by payments made to Employee under paragraphs 6(a)(i) and (ii). (f) Employer shall have the right of first refusal to purchase from Employee or Employee's estate, shares of CBSI stock acquired pursuant to the exercise of stock options after the date of Employee's termination of employment for any reason, in the event Employee or Employee's estate elects to dispose or transfer such acquired shares. Such right of first refusal shall expire ten years from the date of termination. (g) Early Retirement or Expiration of Term. Employee may terminate employment with Employer voluntarily prior to December 31, 2007 by providing Employer with written notice of Employee's early retirement at least six months prior to the date of retirement. In the event of Employee's retirement pursuant to this paragraph 3(g), or in the event Employee remains employed pursuant to this Agreement through December 31, 2007 and retires on that date, Employer shall: (i) Continue the payment of Employee's Base Salary through the date of retirement; (ii) Pay Employee a pro rata portion (based on Employee's complete months of active employment in the year of retirement) of all incentive compensation and bonuses that are payable with respect to the year of retirement; (iii) Permit Employee to dispose of any restricted stock granted to Employee; (iv) Treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until 7 the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment; (v) Fully fund the grantor trust created pursuant to paragraph 1(i) of the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for benefits payable pursuant to that separate agreement; (vi) Cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's retired employees; and (vii) Enter into a separate Consulting Agreement with Employee pursuant to which Employer shall retain Employee, on an independent contractor basis, as a consultant to Employer for a period of 36 months at a compensation rate of $4,000 per month, with consulting services to be provided at such times and at such locations as the parties may reasonably agree. If and to the extent requested to do so by the Board of Directors of CBSI, Employee shall resign as a member of Employer's Board of Directors, and as a member of any other Employer board or committee, as of the date of Employee's retirement. 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of its executive employees. Participation in any of Employer's benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other 8 conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for other employees not covered by employment agreements. (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the Personnel Committee of Employer's Board of Directors for review on a quarterly basis. (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: (i) Paid vacation of 4 weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer paid membership for Employee at the Century Club and the Onondaga Country Club, subject to nondeductible tax treatment by Employer or a reimbursement to Employee for taxes owed by Employee in connection with such benefit; (iv) The use of an Employer-owned automobile of Employee's choice, the purchase and replacement of which shall be subject to the approval of the Personnel Committee of the Board of Directors of Employer; and 9 (v) Reimbursement of the purchase price of a car telephone and all Employer-related business charges incurred in connection with the use of such telephone. (d) Supplemental Retirement Benefits. The terms and conditions for the payment of Supplemental Retirement Benefits are set forth in a separate written agreement between the parties dated March 1, 2004. 5. Stock Options. Employer shall cause the Personnel Committee of the Board of Directors of Employer to review whether Employee should be granted options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a successor program or independently, as the Personnel Committee shall determine. Reviews shall be conducted no less frequently than annually. 6. Change of Control. (a) If Employee's employment with Employer (as an employee) shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 6(c) below), but not including Employee's termination for "cause" (as described in paragraph 3(d)) or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Retain the services of Employee, on an independent contractor basis, as a consultant to Employer for a period of no less than 36 months at an annual consulting fee rate equal to the total of Employee's Base Salary in effect at the time of Employee's termination plus an amount equal to the Management Incentive paid to the Employee in the year prior to the "Change of Control"; 10 (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits, identical to those described in paragraph 4(a) for the period during which Employee is retained as a consultant pursuant to (i) above. To the extent the benefits provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock granted to Employee; and (iv) Pay to Employee the difference between the total purchase price paid by Employee for the home owned by him in the Syracuse area and the proceeds of the sale of such home by Employee following the termination of his employment not later than December 31, 2007 if he elects to move outside of the metropolitan Syracuse area and he establishes to the satisfaction of the Board of Directors of Employer that he is unable despite reasonable efforts to sell the home within one year from the termination of his employment for a sum equal to the purchase price, or, in lieu thereof, Employer will purchase the home for a sum equal to the price Employee paid for it. (v) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(vi) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of 11 Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this paragraph 6, then payments shall be made without restructuring. Subject to paragraph 6(a)(vi), the amount of any payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such payment. (vi) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 (except for the benefit set forth in paragraph 6(a)(iv) which shall continue pursuant to its terms) in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were 12 directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. (c) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in : (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; (ii) An involuntary and material relocation of the office from which Employee is expected to perform his duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all necessary income and employment taxes and any other similar sums required by law to be withheld. 13 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except as required in the course of his employment by Employer, any confidential business or technical information or trade secret acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or disclosure of any trade secret or any confidential information concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in Paragraph 8(c) below, Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer, in the states of New York and Pennsylvania. Employee shall keep Employer fully advised as to any 14 activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in Paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the final payment is made pursuant to the terms of this Agreement and shall end on the date that is 18 months after the date the final payment is made pursuant to the terms of this Agreement. (d) Certain Affiliates of Employer. It is understood that Employee may have access to technical knowledge, trade secrets and customer lists of affiliates of Employer or companies which Employer's parent may acquire in the future and may serve as a member of the board of directors or as an officer or employee of an affiliate of Employer. 15 Employee covenants that he shall not, during the term of his employment by Employer or for the period specified in 8(c) above, in any way, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise aid or assist anyone else in any business or operation which competes with or engages in the business of such an affiliate. (e) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer may offset and/or recover from Employee immediately any and all amounts paid to Employee under this Agreement in addition to any and all other remedies available to Employer under the law or in equity. 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 10. Rules, Regulations and Policies. Employee shall abide by and comply with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee affirms and represents that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 16 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the term hereof, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the amended and restated Employment Agreement made effective as of April 1, 2002. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court 17 of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ SANFORD A. BELDEN 18 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Sanford A. Belden, dated as of March 1, 2004 ("Agreement"), I, Sanford A. Belden, hereby designate Elizabeth G. Belden, my wife, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is 9 Lynacres Boulevard, Fayetteville, New York. Contingent Beneficiary: Please see attached Contingent Beneficiary Designation Form. Dated: _____________ ____________________________________ Sanford A. Belden _____________________________ Witness 19 CONTINGENT BENEFICIARY DESIGNATION FORM I, Sanford A. Belden, hereby designate the following contingent beneficiaries of amounts payable upon my death in accordance with paragraph 3(b) of the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Sanford A. Belden, dated as of March 1, 2004:
- ------------------------------------------------------------------------------------------ Contingent Beneficiary Share ---------------------- ----- - ------------------------------------------------------------------------------------------ The Trustees of the Child's Trust created for the benefit of my daughter, Jean Belden Bertschmann, under Article IV of the Last Will and Testament 33.33% of Sanford A. Belden, and under Article IV of the Last Will and Testament of Elizabeth Belden, both of which are dated the 16th day of October 2002 - ------------------------------------------------------------------------------------------ The Trustees of the Child's Trust created for the benefit of my son, Douglas Belden, under Article IV of the Last Will and Testament of 33.33% Sanford A. Belden, and under Article IV of the Last Will and Testament of Elizabeth Belden, both of which are dated the 16th day of October 2002 - ------------------------------------------------------------------------------------------ The Trustees of the Child's Trust created for the benefit of my daughter, Kathryn Belden LeGrand, under Article IV of the Last Will and Testament 33.33% of Sanford A. Belden, and under Article IV of the Last Will and Testament of Elizabeth Belden, both of which are dated the 16th day of October 2002 - ------------------------------------------------------------------------------------------
Dated: _____________ ____________________________________ Sanford A. Belden _____________________________ Witness 20 EX-10.2 4 d58827_ex10-2.txt SANFORD A. BELDEN RETIREMENT PLAN Exhibit 10.2 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth an amendment and restatement of the Supplemental Retirement Plan Agreement made effective as of April 1, 2002 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) SANFORD A. BELDEN, an individual currently residing at 9 Lynacres Boulevard, Fayetteville, New York ("Employee"). This amended and restated Agreement supersedes the April 1, 2002 version of this Agreement, and is entered into pursuant to paragraph 4(d) of the Employment Agreement between the parties, effective as of March 1, 2004 and as amended ("Employment Agreement"). This amended and restated Agreement is effective as of March 1, 2004. WITNESSETH IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the product of (i) 5% times Employee's number of years of service, considering only the Employee's first 10 years of service, plus 2% times Employee's number of years of service in excess of ten years, times (ii) Employee's final average compensation, with the product of (i) times (ii) reduced by Employee's other retirement benefits. Notwithstanding the foregoing, except in the event of Employee's voluntary termination of employment prior to July 1, 2006, the product of (i) times (ii) above shall not be less than the product that would be derived if Employee remained employed pursuant to the Employment Agreement through December 31, 2007 and received the Base Salary (including increases) and Management Incentive Plan payments (assuming a minimum 50 percent incentive payment under Employer's Management Incentive Plan) described in the Employment Agreement. (b) For purposes of this paragraph 1, and subject to paragraph 2, "years of service" shall be credited to Employee in the same manner as years of service are credited to Employee under the Community Bank System, Inc. Pension Plan, as amended through December 31, 2001 ("Pension Plan"); and no more than 15 years of service will be taken into account under paragraphs 1 and 2. (c) For purposes of this paragraph 1, and except as provided in the last sentence of paragraph 1(a) and in paragraph 2(a)(iii), Employee's "final average compensation" shall be the annual average of Employee's Base Salary (as defined in the Employment Agreement) and cash incentive payment awarded during the five consecutive calendar years preceding Employee's termination. (d) For purposes of this paragraph 1, Employee's "other retirement benefits" shall mean the sum of (i) the annual benefit payable to Employee from the Pension Plan, plus (ii) 50 percent of the estimated annual benefit payable to Employee pursuant to the Federal Social Security Act, plus -2- (iii) the annual benefit that could be provided by Employer contributions (other than elective deferrals) made on Employee's behalf under (A) the Community Bank System, Inc. 401(k) Employee Stock Ownership Plan, and (B) the Deferred Compensation Plan for Certain Executive Employees of Community Bank System, Inc., plus earnings on contributions under (A) and (B) at an assumed rate of 8% per year, if such contributions and earnings were converted to a benefit payable at the same time and in the same form as the benefit paid under this paragraph 1, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin under this paragraph 1. (e) For purposes of paragraph 1, Employee's Social Security Benefit ("Benefit") will be valued by the actual Benefit Employee receives or is qualified to receive at the time Employee elects to receive the supplemental retirement benefit, or if Employee has not yet qualified for the Benefit, the Benefit will be valued by the maximum benefit available to a then 62 year old individual. (f) For the purposes of paragraph 1, Employee's Pension Plan Benefit will be Employee's accrued benefit under the Plan, determined as of the date Employee elects to receive the supplemental retirement plan benefit, adjusted for the timing and form of benefit. (g) The supplemental retirement benefit described in paragraph 1 shall be payable commencing on the first day of the month following the later of (i) Employee's receipt of all payments due under the terms of his Employment Agreement, or (ii) termination of employment as an employee of Employer. -3- (h) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced Joint and 100% Survivor benefit with Employee's spouse as survivor annuitant; provided, however, that: (i) If Employee simultaneously commences receipt of Employee's Pension Plan benefit, then the benefit under this paragraph 1 shall be paid in the same form as Employee's Pension Plan benefit; (ii) If Employee shall receive payment of Employee's benefit under the Pension Plan in a form other than a single life annuity for Employee's life, then the supplement retirement benefit under this paragraph 1 shall be converted to the same form of payment, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin; and (iii) If Employee or his beneficiaries shall receive payment of Employee's benefit under the Pension Plan prior to Employee's attainment of age 62, then the supplement retirement benefit under this paragraph 1 shall be subject to the same early retirement reduction, using the factors applied to determine early retirement benefits under the Pension Plan at the time payments begin. Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 100% survivor benefit determined as if Employee retired on the day prior to his death and immediately commenced receipt of payments under both this paragraph 1 (including any adjustment required by the last sentence of paragraph 1(a)) and the Pension Plan in the form of an actuarially reduced Joint and 100% Survivor benefit with his spouse as survivor annuitant. If -4- Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (i) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's retirement (including Employee's voluntary early retirement), disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the Employment Agreement), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date of Employee's termination of employment or the effective date of the Change of Control, as applicable. (j) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or -5- other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. 2. Change of Control (a) If Employee's employment with Employer shall cease for any reason, including Employee's voluntary termination for "good reason," but not including Employee's termination for "cause" or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control", (as those quoted terms are defined in the Employment Agreement), Employer shall: (i) Credit Employee under this Agreement with the greater of 3 years of service or the years of service Employee is retained as a consultant under the terms of paragraph 6 of the Employment Agreement for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and (ii) Credit Employee under this Agreement with two additional years of service for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and (iii) Determine Employee's "final average compensation" under paragraph 1(c) by considering the years of service Employee is retained as a consultant under the terms of the Employment Agreement as service that precedes Employee's termination and considering amounts paid to Employee during that period as Base Salary and cash incentive payments to Employee. (b) Subject to paragraph 2(c) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" constitutes an "excess parachute -6- payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. The amount of any payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such payment. (c) Notwithstanding the foregoing of this paragraph 2, if the Board of Directors of Employer elects to make a single lump sum payment to Employee pursuant to paragraph 6(a)(vi) of the Employment Agreement, Employer shall pay all benefits due Employee pursuant to this Agreement in an actuarial equivalent single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. -7- 4. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the April 1, 2002 version of this Agreement. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. -8- The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ SANFORD A. BELDEN -9- EX-10.4 5 d58827_ex10-4.txt MARK E. TRYNISKI EMPLOYMENT AGREEMENT Exhibit 10.4 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of March 8, 2004 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) MARK E. TRYNISKI, an individual currently residing at 1964 Penfold Way, Baldwinsville, New York ("Employee"). This Agreement is effective as of March 8, 2004 and supersedes the Employment Agreement between the parties dated as of June 1, 2003. W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall employ Employee, and Employee shall serve, as Chief Operating Officer and Executive Vice President of Community Bank System, Inc. and Community Bank, N.A. for a term commencing on March 8, 2004 and ending on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. In addition, until Employer appoints a successor to Employee as Employer's Chief Financial Officer, Employee shall continue to serve as Employer's Chief Financial Officer. 1 (b) Salary. Through December 31, 2004, Employer shall pay Employee base salary at the annual rate of $250,000.00 ("Base Salary"). Employee's Base Salary for calendar years after 2004 shall be reviewed and adjusted in accordance with Employer's regular payroll practices for executive employees. (c) Incentive Compensation. Employee shall be entitled to annual incentive compensation opportunities pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer. Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of active employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, in the case of a termination upon Employee's disability pursuant to subparagraph 3(c), the date the Disability Period began. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of Employer's Board of Directors or the authorized designee of the Board of Directors, for the supervision of all assigned aspects of Employer's business and operations, including all banking, operations, financial services, technology, treasury management and human resources activities, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by Employer's Board of Directors or the authorized designee of the Board of Directors. Employee shall report to the President and Chief Executive Officer of Employer. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's 2 ability and devote all of Employee's working time and attention, knowledge, experience, energy and skill to the business of Employer, except that Employee may affiliate with professional associations, business and civic organizations. Employee shall serve on the Board of Directors of, or as an officer of Employer's affiliates, without additional compensation if requested to do so by the Board of Directors of Employer. Employee shall receive only the compensation and other benefits described in this Agreement for Employee's duties as a Director of Employer. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the 3 original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability to perform Employee's duties hereunder by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. 4 (d) Termination for Cause. Employer may terminate Employee's employment immediately for "cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "cause" if the termination results from any of the following events: (i) Material breach of this Agreement; (ii) Documented misconduct as an executive or director of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder including, but not limited to, misappropriating any funds or property of any such company, or attempting to obtain any personal profit (x) from any transaction to which such company is a party or (y) from any transaction with any third party in which Employee has an interest which is adverse to the interest of any such company, unless, in either case, Employee shall have first obtained the written consent of the Board of Directors of Employer; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days; (iv) Conviction of a crime involving moral turpitude; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; (vi) Documented failure to follow the reasonable, written instructions of the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or 5 (vii) Any documented violation of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. (e) Termination For Reasons Other Than Cause. In the event Employer terminates Employee prior to December 31, 2007 for reasons other than cause, Employee shall be entitled to a severance benefit equal to the greater of (i) 200 percent of the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal biweekly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in biweekly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right determined without regard to Employee's termination of employment; (v) fully fund the grantor trust created pursuant to paragraph 1(i) of the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for 6 benefits payable pursuant to that separate agreement; and (vi) cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's retired employees. If Employer's Board of Directors shall determine, in its sole discretion, to appoint someone other than Employee to succeed Sanford A. Belden as Employer's President and Chief Executive Officer, and if Employee shall remain employed until the effective date of the successor's appointment, then (x) Employee's employment with Employer shall terminate automatically upon the effective date of the successor's appointment without any further action by either Employee or Employer, unless a new employment agreement is reached between Employee and Employer, and (y) Employee's termination under such circumstances shall be treated as a termination for reasons other than cause as described in this paragraph 3(e) (resulting in Employee's entitlement to the benefits described in the first paragraph of this paragraph 3(e)). Notwithstanding the foregoing, if Employee's employment ends prior to December 31, 2007 for reasons other than cause and under circumstances that entitle Employee to payments and benefits under paragraph 6 of this Agreement (regarding "Change of Control"), then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by payments made to Employee under paragraphs 6(a)(i) and (ii). (f) Expiration of Term Without Renewal. In the event that Employee's employment ends on December 31, 2007 solely because Employer chooses not to renew or extend this Agreement beyond December 31, 2007 for reasons other than cause, then Employee shall be entitled to a severance benefit equal to the sum of (i) 200 percent of the annual Base Salary in effect at the time of termination, and (ii) the most recent payment to 7 Employee under the Management Incentive Plan, such sum to be payable in equal biweekly installments over the six-month period following Employee's termination of employment. Amounts payable under this paragraph 3(f) shall be reduced by any payments made to Employee under paragraphs 6(a)(i) and (ii). (g) Employer shall have the right of first refusal to purchase from Employee or Employee's estate, shares of CBSI stock acquired pursuant to the exercise of stock options after the date of Employee's termination of employment for any reason, in the event Employee or Employee's estate elects to dispose or transfer such acquired shares. Such right of first refusal shall expire ten years from the date of termination. 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of its executive employees. Participation in any of Employer's benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for other employees not covered by employment agreements. 8 (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the President and CEO of Employer for review on a quarterly basis. (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: (i) Paid vacation of 4 weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer paid memberships for Employee at a golf club and a social club in the Syracuse, New York area, subject to the approval of the President and Chief Executive Officer of Employer and subject to nondeductible tax treatment by Employer or a reimbursement to Employee for taxes owed by Employee in connection with such benefit; (iv) The use of an Employer-owned automobile of Employee's choice, the purchase and replacement of which shall be subject to the approval of the President and Chief Executive Officer of Employer; and (v) Reimbursement of the purchase price of a car telephone, a cellular telephone and all Employer-related business charges incurred in connection with the use of such telephones. 9 (d) Supplemental Retirement Benefits. The terms and conditions for the payment of supplemental retirement benefits are set forth in a separate written agreement between the parties. 5. Stock Options. Employer shall cause the Compensation Committee of the Board of Directors of Employer to review whether Employee should be granted options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a successor plan, or independently, as the Compensation Committee shall determine. Reviews shall be conducted no less frequently than annually. 6. Change of Control. (a) If Employee's employment with Employer (as an employee) shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 6(c) below), but not including Employee's termination for "cause" (as described in paragraph 3(d)) or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Retain the services of Employee, on an independent contractor basis, as a consultant to Employer for a period of no less than 36 months at an annual consulting fee rate equal to the total of Employee's Base Salary in effect at the time of Employee's termination plus an amount equal to the Management Incentive paid to the Employee in the year prior to the "Change of Control"; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits, identical to those described in paragraph 4(a) for the period during 10 which Employee is retained as a consultant pursuant to (i) above. To the extent the benefits provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; and (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock granted to Employee. (iv) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(v) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this paragraph 6, then payments shall be made without restructuring. Subject to paragraph 6(a)(v), Employee shall be responsible for all taxes that are payable by Employee as a result of Employee's receipt of an "excess parachute payment." (v) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due 11 Employee pursuant to this paragraph 6 in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; 12 (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. (c) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in: (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; (ii) An involuntary and material relocation of the office from which Employee is expected to perform his duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all necessary income and employment taxes and any other similar sums required by law to be withheld. 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except as required in the course of his employment by Employer, any confidential business or technical information or trade secret acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully 13 compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or disclosure of any trade secret or any confidential information concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in paragraph 8(c) below, Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer, in the states of New York and Pennsylvania. Employee shall keep Employer fully advised as to any activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted 14 to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the first payment is made pursuant to the terms of this Agreement and shall end on the earlier of (i) the date that is 18 months after the date the final payment is made pursuant to the terms of this Agreement, or (ii) December 31, 2007. (d) Certain Affiliates of Employer. It is understood that Employee may have access to technical knowledge, trade secrets and customer lists of affiliates of Employer or companies which Employer's parent may acquire in the future and may serve as a member of the board of directors or as an officer or employee of an affiliate of Employer. Employee covenants that he shall not, during the term of his employment by Employer or for the period specified in 8(c) above, in any way, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an 15 officer, employee, partner, director, individual proprietor, lender, consultant or otherwise aid or assist anyone else in any business or operation which competes with or engages in the business of such an affiliate. (e) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer may offset and/or recover from Employee immediately any and all amounts paid to Employee under this Agreement in addition to any and all other remedies available to Employer under the law or in equity. 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 10. Rules, Regulations and Policies. Employee shall abide by and comply with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee affirms and represents that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the term hereof, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 16 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ MARK E. TRYNISKI 18 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Mark E. Tryniski, dated as of March 8, 2004 ("Agreement"), I, Mark E. Tryniski, hereby designate _________________, my __________, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is _____________________________________. Dated: _____________ _________________________________ Mark E. Tryniski _____________________________ Witness 19 EX-10.5 6 d58827_ex10-5.txt MARK E. TRYNISKI RETIREMENT PLAN Exhibit 10.5 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth the Supplemental Retirement Plan Agreement made effective as of July 1, 2003 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) MARK E. TRYNISKI, an individual currently residing at 1964 Penfold Way, Baldwinsville, New York ("Employee"). RECITALS A. Employer maintains the Community Bank System, Inc. Pension Plan, as may be amended from time to time ("Pension Plan"). B. Employee is expected to become a participant in the Pension Plan beginning July 1, 2004. C. Internal Revenue Code Section 401(a)(17) ("Section 401(a)(17)") limits the amount of a participant's compensation that may be taken into account under the Pension Plan for purposes of calculating the participant's Pension Plan benefit. D. Employee is expected to receive compensation from Employer in the form of "Base Salary" that exceeds the limit in effect from time to time under Section 401(a)(17). E. Employer wishes to provide Employee with a supplemental retirement benefit that is based upon the portion of Employee's "Base Salary" that cannot be taken into account under the Pension Plan due to the limitation imposed on the Pension Plan by Section 401(a)(17). TERMS IN CONSIDERATION of the premises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the excess (if any) of (i) the annual benefit that Employee would have earned pursuant to the Pension Plan if 100 percent of Employee's annual compensation that is disregarded for Pension Plan purposes solely because of the limit imposed by Section 401(a)(17) is added to the amount of Employee's annual Base Salary actually taken into account pursuant to the Pension Plan and if Internal Revenue Code Section 415 is disregarded, minus (ii) the annual benefit actually payable to Employee pursuant to the Pension Plan. (b) For the purposes of paragraph 1, Employee's actual Pension Plan benefit will be Employee's accrued benefit under the Pension Plan, expressed in the form of a single life annuity for Employee's life beginning at age 65 and determined as of the date Employee begins -2- to receive the supplemental retirement plan benefit (but without regard to whether payments of the Pension Plan benefit have commenced). (c) The supplemental retirement benefit described in paragraph 1 shall be payable in monthly installments commencing on the first day of the month following the latest of (i) Employee's receipt of all payments due under the terms of the Employment Agreement between Employee and Employer, (ii) Employee's termination of employment with Employer, or (iii) Employee's 55th birthday. (d) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced joint and 50 percent survivor benefit with Employee's spouse as survivor annuitant; provided, however, that: (i) If Employee simultaneously commences receipt of Employee's Pension Plan benefit, then the benefit under this paragraph 1 shall be paid in the same form as Employee's Pension Plan benefit; (ii) If Employee shall receive payment of Employee's benefit under the Pension Plan in a form other than a single life annuity for Employee's life, then the supplement retirement benefit under this paragraph 1 shall be converted to the same form of payment, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin; and (iii) If Employee or his beneficiaries shall receive payment of Employee's benefit under the Pension Plan prior to Employee's attainment of age 62, then the supplement retirement benefit under this paragraph 1 shall be subject to the same early retirement reduction, using the factors applied to determine early retirement benefits under the Pension Plan at the time payments begin. -3- Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 50 percent survivor benefit determined as if Employee retired on the latest date described in (c) above and immediately commenced receipt of payments under both this paragraph 1 and the Pension Plan in the form of an actuarially reduced joint and 50 percent survivor benefit with his spouse as survivor annuitant. If Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (e) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's retirement, disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the employment agreement between Employee and Employer), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date -4- of Employee's termination of employment or the effective date of the Change of Control, as applicable. (f) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. 2. Change of Control (a) Subject to paragraph 2(b) below, if any portion of the amounts paid to, or value received by, Employee following a Change of Control constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. Employee shall be responsible for all taxes and penalties payable by Employee as a result of Employee's receipt of an "excess parachute payment." (b) Notwithstanding the foregoing of this paragraph 2, if the Board of Directors of Employer elects to make a single lump sum payment to Employee pursuant to paragraph 6(a)(v) of the Employment Agreement between Employee and Employer, Employer shall pay all benefits due Employee pursuant to this Agreement in an actuarial equivalent single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the -5- foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from any tax liability attributable to such single lump sum payment. 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. 4. Governing Law. This Agreement was executed and delivered in the State of New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties. 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent -6- jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ MARK E. TRYNISKI -7- EX-10.6 7 d58827_ex10-6.txt JAMES A. WEARS EMPLOYMENT AGREEMENT Exhibit 10.6 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of March 20, 2003 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) JAMES A. WEARS, an individual currently residing at 322 Hamilton Street, Ogdensburg, New York ("Employee"). This Agreement supersedes the amended and restated Employment Agreement between the parties dated as of June 14, 2000, which provided for employment for a term ending on December 31, 2004. This Agreement is effective as of March 20, 2003. W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall continue to employ Employee, and Employee shall continue to serve, as President, New York Banking of Community Bank, N.A. for a fifty-seven month term commencing on April 1, 2003 and ending on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. (b) Salary. During the period of April 1, 2003 through December 31, 2003, Employer shall pay Employee base salary at the annual rate in effect for Employee on March 31, 2003 ("Base Salary"). Employee's Base Salary for calendar years after 2003 shall be increased at least at the same rate as the rate applied by the Employer in its merit pool for salary increases to be paid for the applicable calendar year. Employee's Base Salary is payable in accordance with Employer's regular payroll practices for executive employees. (c) Incentive Compensation. Employee shall be entitled to annual incentive compensation opportunities pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer. Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of active employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, in the case of a termination upon Employee's disability pursuant to subparagraph 3(c), the date the Disability Period began. (d) During the Period of Employment, Employee shall be entitled to perform his services for Employer from an office in Canton, New York. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of Employer's Board of Directors or the authorized designee of the Board of Directors, for the supervision of all assigned aspects of Employer's business and operations, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by Employer's Board of Directors or the 2 authorized designee of the Board of Directors. Employee shall report to the Board of Directors of Employer or the authorized designee of the Board of Directors. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's ability and devote all of Employee's working time and attention, knowledge, experience, energy and skill to the business of Employer, except that Employee may affiliate with professional associations, business and civic organizations. Employee shall serve on the Board of Directors of, or as an officer of Employer's affiliates, without additional compensation if requested to do so by the Board of Directors of Employer. Employee shall receive only the compensation and other benefits described in this Agreement for Employee's duties as a Director of Employer. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer 3 and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability to perform Employee's duties hereunder by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance 4 of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. (d) Termination for Cause. Employer may terminate Employee's employment immediately for "cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "cause" if the termination results from any of the following events: (i) Material breach of this Agreement; (ii) Documented misconduct as an executive or director of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder including, but not limited to, misappropriating any funds or property of any such company, or attempting to obtain any personal profit (x) from any transaction to which such company is a party or (y) from any transaction with any third party in which Employee has an interest which is adverse to the interest of any such company, unless, in either case, Employee shall have first obtained the written consent of the Board of Directors of Employer; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days; (iv) Conviction of a crime involving moral turpitude; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; 5 (vi) Documented failure to follow the reasonable, written instructions of the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or (vii) Any documented violation of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. (e) Termination For Reasons Other Than Cause. In the event Employer terminates Employee prior to December 31, 2007 for reasons other than cause, Employee shall be entitled to a severance benefit equal to the greater of (i) the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal monthly or semi-monthly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in monthly or semi-monthly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the 6 original grant of the option right determined without regard to Employee's termination of employment; (v) fully fund the grantor trust created pursuant to paragraph 1(i) of the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for benefits payable pursuant to that separate agreement; and (vi) cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's former employees. Notwithstanding the foregoing, if Employer terminates Employee prior to December 31, 2007 for reasons other than cause and under circumstances that entitle Employee to payments and benefits under paragraph 6 of this Agreement (regarding "Change of Control"), then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by payments made to Employee under paragraphs 6(a)(i) and (ii). (f) Expiration of Term Without Renewal. In the event that Employee's employment ends on December 31, 2007 solely because Employer chooses not to renew or extend this Agreement beyond December 31, 2007 for reasons other than cause, then Employee shall be entitled to a severance benefit equal to the sum of (i) 175 percent of the annual Base Salary in effect at the time of termination, and (ii) the most recent payment to Employee under the Management Incentive Plan, such sum to be payable in equal biweekly installments over the six-month period following Employee's termination of employment. Amounts payable under this paragraph 3(f) shall be reduced by any payments made to Employee under paragraphs 6(a)(i) and (ii). (g) Employer shall have the right of first refusal to purchase from Employee or Employee's estate, shares of CBSI stock acquired pursuant to the exercise of stock 7 options after the date of Employee's termination of employment for any reason, in the event Employee or Employee's estate elects to dispose or transfer such acquired shares. Such right of first refusal shall expire ten years from the date of termination. 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of its executive employees. Participation in any of Employer's benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for other employees not covered by employment agreements. (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the President and CEO of Employer for review on a quarterly basis. 8 (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: (i) Paid vacation of 4 weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer paid memberships for Employee at the St. Lawrence Country Club and at the Partridge Run Golf Course, subject to nondeductible tax treatment by Employer or a reimbursement to Employee for taxes owed by Employee in connection with such benefit; (iv) The use of an Employer-owned automobile of Employee's choice, the purchase and replacement of which shall be subject to the approval of the Compensation Committee of the Board of Directors of Employer; and (v) Reimbursement of the purchase price of a car telephone and all Employer-related business charges incurred in connection with the use of such telephone. (d) Supplemental Retirement Benefits. The terms and conditions for the payment of supplemental retirement benefits are set forth in a separate written agreement between the parties. 5. Stock Options. Employer shall cause the Compensation Committee of the Board of Directors of Employer to review whether Employee should be granted options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a 9 successor plan, or independently, as the Compensation Committee shall determine. Reviews shall be conducted no less frequently than annually. 6. Change of Control. (a) If Employee's employment with Employer (as an employee) shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 6(c) below), but not including Employee's termination for "cause" (as described in paragraph 3(d)) or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Retain the services of Employee, on an independent contractor basis, as a consultant to Employer for a period of no less than 36 months at an annual consulting fee rate equal to the total of Employee's Base Salary in effect at the time of Employee's termination plus an amount equal to the Management Incentive paid to the Employee in the year prior to the "Change of Control"; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits, identical to those described in paragraph 4(a) for the period during which Employee is retained as a consultant pursuant to (i) above. To the extent the benefits provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; and (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the 10 original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock granted to Employee. (iv) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(v) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this paragraph 6, then payments shall be made without restructuring. Subject to paragraph 6(a)(v), Employee shall be responsible for all taxes that are payable by Employee as a result of Employee's receipt of an "excess parachute payment." (v) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: 11 (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. (c) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in: (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; 12 (ii) An involuntary and material relocation of the office from which Employee is expected to perform his duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all necessary income and employment taxes and any other similar sums required by law to be withheld. 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except as required in the course of his employment by Employer, any confidential business or technical information or trade secret acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or disclosure of any trade secret or any confidential information concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. 13 (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in paragraph 8(c) below, Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer, in the states of New York and Pennsylvania. Employee shall keep Employer fully advised as to any activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of 14 this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the final payment is made pursuant to the terms of this Agreement and shall end on the earlier of (i) the date that is 18 months after the date the final payment is made pursuant to the terms of this Agreement, or (ii) December 31, 2007. (d) Certain Affiliates of Employer. It is understood that Employee may have access to technical knowledge, trade secrets and customer lists of affiliates of Employer or companies which Employer's parent may acquire in the future and may serve as a member of the board of directors or as an officer or employee of an affiliate of Employer. Employee covenants that he shall not, during the term of his employment by Employer or for the period specified in 8(c) above, in any way, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise aid or assist anyone else in any business or operation which competes with or engages in the business of such an affiliate. (e) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer may offset and/or recover from Employee immediately any and all amounts paid to Employee under this Agreement in addition to any and all other remedies available to Employer under the law or in equity. 15 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 10. Rules, Regulations and Policies. Employee shall abide by and comply with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee affirms and represents that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the term hereof, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 16 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the amended and restated Employment Agreement made effective as of June 14, 2000. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the 17 prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ JAMES A. WEARS 18 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) James A. Wears, dated as of March 20, 2003 ("Agreement"), I, James A. Wears, hereby designate _________________, my __________, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is _____________________________________. Dated: _____________ _________________________________ James A. Wears _____________________________ Witness 19 EX-10.7 8 d58827_ex10-7.txt JAMES A. WEARS RETIREMENT PLAN Exhibit 10.7 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth the Supplemental Retirement Plan Agreement made effective as of February 1, 2004 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) JAMES A. WEARS, an individual currently residing at 322 Hamilton Street, Ogdensburg, New York ("Employee"). This Agreement supersedes the Supplemental Retirement Plan Agreement between the parties dated as of January 1, 2001. RECITALS A. Employer maintains the Community Bank System, Inc. Pension Plan, as may be amended from time to time ("Pension Plan"). B. Employee is a participant in the Pension Plan. C. Internal Revenue Code Section 401(a)(17) ("Section 401(a)(17)") limits the amount of a participant's compensation that may be taken into account under the Pension Plan for purposes of calculating the participant's Pension Plan benefit. D. Employee has received, and may in the future receive, compensation from Employer that exceeds the limit in effect from time to time under Section 401(a)(17). E. Employer wishes to provide Employee with a supplemental retirement benefit that is based upon the portion of Employee's compensation that cannot be taken into account under the Pension Plan due to the limitation imposed on the Pension Plan by Section 401(a)(17). TERMS IN CONSIDERATION of the premises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the excess (if any) of (i) the annual benefit that Employee would have earned pursuant to the Pension Plan if 100 percent of Employee's annual compensation that is disregarded for Pension Plan purposes solely because of the limit imposed by Section 401(a)(17) is added to the amount of Employee's annual compensation actually taken into account pursuant to the Pension Plan and if Internal Revenue Code Section 415 is disregarded, minus (ii) the annual benefit actually payable to Employee pursuant to the Pension Plan. For purposes of calculating the annual benefit described in clause (i) of this paragraph 1(a), the provisions of the Pension Plan that describe a minimum normal retirement benefit for Employee shall be disregarded. Any such -2- minimum annual benefit actually payable pursuant to the Pension Plan, however, shall be taken into account for purposes of clause (ii) of this paragraph 1(a). (b) For the purposes of paragraph 1, Employee's actual Pension Plan benefit will be Employee's accrued benefit under the Pension Plan, expressed in the form of a single life annuity for Employee's life beginning at age 65 and determined as of the date Employee begins to receive the supplemental retirement plan benefit (but without regard to whether payments of the Pension Plan benefit have commenced). (c) The supplemental retirement benefit described in paragraph 1 shall be payable in monthly installments commencing on the first day of the month following the later of (i) Employee's receipt of all payment due under the terms of his employment agreement with Employer, or (ii) Employee's termination of employment with Employer. (d) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced joint and 50 percent survivor benefit with Employee's spouse as survivor annuitant; provided, however, that: (i) If Employee simultaneously commences receipt of Employee's Pension Plan benefit, then the benefit under this paragraph 1 shall be paid in the same form as Employee's Pension Plan benefit; (ii) If Employee shall receive payment of Employee's benefit under the Pension Plan in a form other than a single life annuity for Employee's life, then the supplement retirement benefit under this paragraph 1 shall be converted to the same form of payment, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin; and -3- (iii) If Employee or his beneficiaries shall receive payment of Employee's benefit under the Pension Plan prior to Employee's attainment of age 62, then the supplement retirement benefit under this paragraph 1 shall be subject to the same early retirement reduction, using the factors applied to determine early retirement benefits under the Pension Plan at the time payments begin. Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 50 percent survivor benefit determined as if Employee retired on the day prior to his death and immediately commenced receipt of payments under both this paragraph 1 and the Pension Plan in the form of an actuarially reduced joint and 50 percent survivor benefit with his spouse as survivor annuitant. If Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (e) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's -4- retirement, disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the employment agreement between Employee and Employer), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date of Employee's termination of employment or the effective date of the Change of Control, as applicable. (f) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. 2. Change of Control (a) Subject to paragraph 2(b) below, if any portion of the amounts paid to, or value received by, Employee following a Change of Control constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. Employee shall be responsible for all taxes and penalties payable by Employee as a result of Employee's receipt of an "excess parachute payment." (b) Notwithstanding the foregoing of this paragraph 2, if the Board of Directors of Employer elects to make a single lump sum payment to Employee pursuant to -5- paragraph 6(a)(v) of the employment agreement between Employee and Employer, Employer shall pay all benefits due Employee pursuant to this Agreement in an actuarial equivalent single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from any tax liability attributable to such single lump sum payment. 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. 4. Governing Law. This Agreement was executed and delivered in the State of New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the January 1, 2001 Supplemental Retirement Plan Agreement between the parties. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties. -6- 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ JAMES A. WEARS -7- EX-10.8 9 d58827_ex10-8.txt MICHAEL A. PATTON EMPLOYMENT AGREEMENT Exhibit 10.8 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of March 20, 2003 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) MICHAEL A. PATTON, an individual currently residing at Hayden Road, Olean, New York ("Employee"). This Agreement supersedes the amended and restated Employment Agreement between the parties dated as of June 14, 2000, which provided for employment for a term ending on December 31, 2004. This Agreement is effective as of March 20, 2003. W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall continue to employ Employee, and Employee shall continue to serve, as President, Financial Services of Community Bank, N.A. for a fifty-seven month term commencing on April 1, 2003 and ending on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. (b) Salary. During the period of April 1, 2003 through December 31, 2003, Employer shall pay Employee base salary at the annual rate in effect for Employee on March 31, 2003 ("Base Salary"). Employee's Base Salary for calendar years after 2003 shall be increased at least at the same rate as the rate applied by the Employer in its merit pool for salary increases to be paid for the applicable calendar year. Employee's Base Salary is payable in accordance with Employer's regular payroll practices for executive employees. (c) Incentive Compensation. Employee shall be entitled to annual incentive compensation opportunities pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer. Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c), 3(g) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of active employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, in the case of a termination upon Employee's disability pursuant to subparagraph 3(c), the date the Disability Period began. (d) During the Period of Employment, Employee shall be entitled to perform his services for Employer from Employee's present office in Olean, New York. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of Employer's Board of Directors or the authorized designee of the Board of Directors, for the supervision of all assigned aspects of Employer's business and operations, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by Employer's Board of Directors or the authorized designee of the Board of Directors. Employee shall report to the Board of Directors of Employer or the authorized designee of the Board of Directors. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's 2 ability and devote all of Employee's working time and attention, knowledge, experience, energy and skill to the business of Employer, except that Employee may affiliate with professional associations, business and civic organizations. Employee shall serve on the Board of Directors of, or as an officer of Employer's affiliates, without additional compensation if requested to do so by the Board of Directors of Employer. Employee shall receive only the compensation and other benefits described in this Agreement for Employee's duties as a Director of Employer. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the 3 original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability to perform Employee's duties hereunder by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. 4 (d) Termination for Cause. Employer may terminate Employee's employment immediately for "cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "cause" if the termination results from any of the following events: (i) Material breach of this Agreement; (ii) Documented misconduct as an executive or director of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder including, but not limited to, misappropriating any funds or property of any such company, or attempting to obtain any personal profit (x) from any transaction to which such company is a party or (y) from any transaction with any third party in which Employee has an interest which is adverse to the interest of any such company, unless, in either case, Employee shall have first obtained the written consent of the Board of Directors of Employer; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days; (iv) Conviction of a crime involving moral turpitude; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; (vi) Documented failure to follow the reasonable, written instructions of the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or (vii) Any documented violation of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. 5 Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. (e) Termination For Reasons Other Than Cause. In the event Employer terminates Employee prior to December 31, 2007 for reasons other than cause, Employee shall be entitled to a severance benefit equal to the greater of (i) the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal monthly or semi-monthly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in monthly or semi-monthly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right determined without regard to Employee's termination of employment; (v) fully fund the grantor trust created pursuant to paragraph 1(i) of the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for benefits payable pursuant to that separate agreement; and (vi) cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's retired employees. 6 Notwithstanding the foregoing, if Employer terminates Employee prior to December 31, 2007 for reasons other than cause and under circumstances that entitle Employee to payments and benefits under paragraph 6 of this Agreement (regarding "Change of Control"), then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by payments made to Employee under paragraphs 6(a)(i) and (ii). (f) Employer shall have the right of first refusal to purchase from Employee or Employee's estate, shares of CBSI stock acquired pursuant to the exercise of stock options after the date of Employee's termination of employment for any reason, in the event Employee or Employee's estate elects to dispose or transfer such acquired shares. Such right of first refusal shall expire ten years from the date of termination. (g) Voluntary Early Retirement by Employee. Employee may terminate employment with Employer voluntarily by providing Employer with written notice of Employee's early retirement at least six months prior to the date of retirement. In the event of Employee's retirement pursuant to this paragraph 3(g), Employer shall: (i) Continue the payment of Employee's Base Salary through the date of retirement; (ii) Pay Employee a pro rata portion (based on Employee's complete months of active employment in the year of retirement) of all incentive compensation and bonuses that are payable with respect to the year of retirement; (iii) Permit Employee to dispose of any restricted stock granted to Employee; (iv) Treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit 7 Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment; (v) Fully fund the grantor trust created pursuant to the separate "Supplemental Retirement Plan Agreement" between Employee and Employer, as amended, for benefits payable pursuant to that separate agreement; and (vi) Cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's retired employees. If and to the extent requested to do so by the Board of Directors of CBSI, Employee shall resign as a member of Employer's Board of Directors, and as a member of any other Employer board or committee, as of the date of Employee's retirement. 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of its executive employees. Participation in any of Employer's benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which 8 Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for other employees not covered by employment agreements. (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the President and CEO of Employer for review on a quarterly basis. (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: (i) Paid vacation of 4 weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer paid membership for Employee at the Bartlett Country Club, subject to nondeductible tax treatment by Employer or a reimbursement to Employee for taxes owed by Employee in connection with such benefit; (iv) The use of an Employer-owned automobile of Employee's choice, the purchase and replacement of which shall be subject to the approval of the Compensation Committee of the Board of Directors of Employer; and (v) Reimbursement of the purchase price of a car telephone and all Employer-related business charges incurred in connection with the use of such telephone. 9 (d) Supplemental Retirement Benefits. The terms and conditions for the payment of supplemental retirement benefits are set forth in a separate written agreement between the parties. 5. Stock Options. Employer shall cause the Compensation Committee of the Board of Directors of Employer to review whether Employee should be granted options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a successor plan, or independently, as the Compensation Committee shall determine. Reviews shall be conducted no less frequently than annually. 6. Change of Control. (a) If Employee's employment with Employer (as an employee) shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 6(c) below), but not including Employee's termination for "cause" (as described in paragraph 3(d)) or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Retain the services of Employee, on an independent contractor basis, as a consultant to Employer for a period of no less than 36 months at an annual consulting fee rate equal to the total of Employee's Base Salary in effect at the time of Employee's termination plus an amount equal to the Management Incentive paid to the Employee in the year prior to the "Change of Control"; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits, identical to those described in paragraph 4(a) for the period during which Employee is retained as a consultant pursuant to (i) above. To the extent the benefits 10 provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; and (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock granted to Employee. (iv) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(v) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this paragraph 6, then payments shall be made without restructuring. Subject to paragraph 6(a)(v), Employee shall be responsible for all taxes that are payable by Employee as a result of Employee's receipt of an "excess parachute payment." (v) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a 11 single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. 12 (c) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in : (i) An involuntary and material adverse change in Employee's title, duties, reporting structure, responsibilities (including policies and procedures), or total remuneration; (ii) An involuntary and material relocation of the office from which Employee is expected to perform his duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all necessary income and employment taxes and any other similar sums required by law to be withheld. 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except as required in the course of his employment by Employer, any confidential business or technical information or trade secret acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or disclosure of any trade 13 secret or any confidential information concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in paragraph 8(c) below, Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer, in the states of New York and Pennsylvania. Employee shall keep Employer fully advised as to any activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by 14 Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the final payment is made pursuant to the terms of this Agreement and shall end on the earlier of (i) the date that is 18 months after the date the final payment is made pursuant to the terms of this Agreement, or (ii) December 31, 2007. (d) Certain Affiliates of Employer. It is understood that Employee may have access to technical knowledge, trade secrets and customer lists of affiliates of Employer or companies which Employer's parent may acquire in the future and may serve as a member of the board of directors or as an officer or employee of an affiliate of Employer. Employee covenants that he shall not, during the term of his employment by Employer or for the period specified in 8(c) above, in any way, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise aid or assist anyone else in any business or operation which competes with or engages in the business of such an affiliate. (e) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer may offset and/or recover from Employee immediately any and all amounts paid to Employee under this Agreement in addition to any and all other remedies available to Employer under the law or in equity. 15 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 10. Rules, Regulations and Policies. Employee shall abide by and comply with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee affirms and represents that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the term hereof, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 16 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the amended and restated Employment Agreement made effective as of June 14, 2000. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. 17 The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ MICHAEL A. PATTON 18 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Michael A. Patton, dated as of March 20, 2003 ("Agreement"), I, Michael A. Patton, hereby designate ___________________, my __________, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is ______________________________________. Dated: _____________ _________________________________ Michael A. Patton _____________________________ Witness 19 EX-10.9 10 d58827_ex10-9.txt MICHAEL A. PATTON RETIREMENT PLAN Exhibit 10.9 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth the Supplemental Retirement Plan Agreement made effective as of February 1, 2004 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) MICHAEL A. PATTON, an individual currently residing at Hayden Road, Olean, New York ("Employee"). This Agreement supersedes the Supplemental Retirement Plan Agreement between the parties dated as of January 1, 2001. RECITALS A. Employer maintains the Community Bank System, Inc. Pension Plan, as may be amended from time to time ("Pension Plan"). B. Employee is a participant in the Pension Plan. C. Internal Revenue Code Section 401(a)(17) ("Section 401(a)(17)") limits the amount of a participant's compensation that may be taken into account under the Pension Plan for purposes of calculating the participant's Pension Plan benefit. D. Employee has received, and may in the future receive, compensation from Employer that exceeds the limit in effect from time to time under Section 401(a)(17). E. Employer wishes to provide Employee with a supplemental retirement benefit that is based upon the portion of Employee's compensation that cannot be taken into account under the Pension Plan due to the limitation imposed on the Pension Plan by Section 401(a)(17). TERMS IN CONSIDERATION of the premises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the excess (if any) of (i) the annual benefit that Employee would have earned pursuant to the Pension Plan if 100 percent of Employee's annual compensation that is disregarded for Pension Plan purposes solely because of the limit imposed by Section 401(a)(17) is added to the amount of Employee's annual compensation actually taken into account pursuant to the Pension Plan and if Internal Revenue Code Section 415 is disregarded, minus (ii) the annual benefit actually payable to Employee pursuant to the Pension Plan. For purposes of calculating the annual benefit described in clause (i) of this paragraph 1(a), the provisions of the Pension Plan that describe a minimum normal retirement benefit for Employee shall be disregarded. Any such -2- minimum annual benefit actually payable pursuant to the Pension Plan, however, shall be taken into account for purposes of clause (ii) of this paragraph 1(a). (b) For the purposes of paragraph 1, Employee's actual Pension Plan benefit will be Employee's accrued benefit under the Pension Plan, expressed in the form of a single life annuity for Employee's life beginning at age 65 and determined as of the date Employee begins to receive the supplemental retirement plan benefit (but without regard to whether payments of the Pension Plan benefit have commenced). (c) The supplemental retirement benefit described in paragraph 1 shall be payable in monthly installments commencing on the first day of the month following the later of (i) Employee's receipt of all payment due under the terms of his employment agreement with Employer, or (ii) Employee's termination of employment with Employer. (d) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced joint and 50 percent survivor benefit with Employee's spouse as survivor annuitant; provided, however, that: (i) If Employee simultaneously commences receipt of Employee's Pension Plan benefit, then the benefit under this paragraph 1 shall be paid in the same form as Employee's Pension Plan benefit; (ii) If Employee shall receive payment of Employee's benefit under the Pension Plan in a form other than a single life annuity for Employee's life, then the supplemental retirement benefit under this paragraph 1 shall be converted to the same form of payment, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin; and -3- (iii) If Employee or his beneficiaries shall receive payment of Employee's benefit under the Pension Plan prior to Employee's attainment of age 62, then the supplement retirement benefit under this paragraph 1 shall be subject to the same early retirement reduction, using the factors applied to determine early retirement benefits under the Pension Plan at the time payments begin. Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 50 percent survivor benefit determined as if Employee retired on the day prior to his death and immediately commenced receipt of payments under both this paragraph 1 and the Pension Plan in the form of an actuarially reduced joint and 50 percent survivor benefit with his spouse as survivor annuitant. If Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (e) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's -4- retirement, disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the employment agreement between Employee and Employer), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date of Employee's termination of employment or the effective date of the Change of Control, as applicable. (f) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. 2. Change of Control (a) Subject to paragraph 2(b) below, if any portion of the amounts paid to, or value received by, Employee following a Change of Control constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. Employee shall be responsible for all taxes and penalties payable by Employee as a result of Employee's receipt of an "excess parachute payment." (b) Notwithstanding the foregoing of this paragraph 2, if the Board of Directors of Employer elects to make a single lump sum payment to Employee pursuant to -5- paragraph 6(a)(v) of the employment agreement between Employee and Employer, Employer shall pay all benefits due Employee pursuant to this Agreement in an actuarial equivalent single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from any tax liability attributable to such single lump sum payment. 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. 4. Governing Law. This Agreement was executed and delivered in the State of New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the January 1, 2001 Supplemental Retirement Plan Agreement between the parties. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties. -6- 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ MICHAEL A. PATTON -7- EX-10.10 11 d58827_ex10-10.txt THOMAS A. MCCULLOUGH EMPLOYMENT AGREEMENT Exhibit 10.10 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) THOMAS A. McCULLOUGH, an individual currently residing at Laceyville, Pennsylvania ("Employee"). This Agreement shall become effective upon the closing of the merger of Community Bank System, Inc. and Grange National Banc Corp. W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall employ Employee, and Employee shall serve, as President, Pennsylvania Banking for Community Bank System, Inc. and Community Bank, N.A. for the period that begins on the date of the closing of the merger of Community Bank System, Inc. and Grange National Banc Corp. and that ends on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. 1 (b) Salary. From the effective date of this Agreement through December 31, 2004, Employer shall pay Employee base salary at the annual rate of not less than $185,000 ("Base Salary"). Employee's Base Salary for calendar years after 2004 shall be reviewed and adjusted annually in accordance with Employer's regular payroll practices for executive employees; provided that the annual Base Salary rate shall be at least $185,000. (c) Incentive Compensation. Employee shall be entitled to annual incentive compensation opportunities pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer; provided that, for 2003 and 2004, Employee shall be entitled to a minimum incentive bonus of $45,000 (prorated for 2003, based on the number of weeks of Employee's employment with Employer in 2003). Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of active employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, in the case of a termination upon Employee's disability pursuant to subparagraph 3(c), the date the Disability Period began. (d) Signing Bonus. Employer shall pay Employee $430,000 (less applicable withholding), as a one-time signing bonus, within 10 days of the commencement of Employee's employment with Employer. Employee acknowledges that the payment made pursuant to this paragraph 1(d) is in satisfaction of and replaces all "Change in Control" payments and benefits Employee might have been entitled to pursuant to the March 25, 1998 Employment Agreement between Employee, Grange National Bank and Grange National Banc 2 Corp. ("Grange Employment Agreement"). Employee agrees that he will not make any claim for Change in Control payments or benefits described in the Grange Employment Agreement. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of Employer's Board of Directors or the authorized designee of the Board of Directors, for the supervision of substantially all aspects of Employer's business and operations in the State of Pennsylvania, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by Employer's Board of Directors or the authorized designee of the Board of Directors. Employee shall report to the President and Chief Executive Officer of Employer. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's ability and devote all of Employee's working time and attention, knowledge, experience, energy and skill to the business of Employer, except that Employee may affiliate with professional associations, and business, civic and charitable organizations, provided that such affiliations do not interfere with the performance of Employee's duties under this Agreement. Employee shall serve on the Board of Directors of, or as an officer of Employer's affiliates, without additional compensation if requested to do so by the Board of Directors of Employer. Employee shall receive only the compensation and other benefits described in this Agreement for Employee's duties as a Director of Employer. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a 3 written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability to perform Employee's duties hereunder by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and 4 conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. (d) Termination for Cause. Employer may terminate Employee's employment immediately for "cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "cause" if the termination results from any of the following events: (i) Material breach of this Agreement; (ii) Documented misconduct as an executive or director of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder including, but not limited to, misappropriating any funds or property of any such company, or attempting to obtain any personal profit (x) from any transaction to which such company is a party or (y) from any transaction with any third party in which Employee has an 5 interest which is adverse to the interest of any such company, unless, in either case, Employee shall have first obtained the written consent of the Board of Directors of Employer; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days; (iv) Conviction of a crime involving moral turpitude; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; (vi) Documented failure to follow the reasonable, written instructions of the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or (vii) Any documented intentional violation by Employee of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. (e) Termination For Reasons Other Than Cause. If Employee is involuntarily replaced by Employer as President, Pennsylvania Banking for Community Bank System, Inc. and Community Bank, N.A. prior to December 31, 2007 for reasons other than cause, or if Employer terminates Employee prior to December 31, 2007 for reasons other than 6 cause, then Employee shall be entitled to a severance benefit equal to the greater of (i) the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal monthly or semi-monthly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in monthly or semi-monthly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right determined without regard to Employee's termination of employment; (v) fully fund the grantor trust created to provide a source of funds to pay benefits payable pursuant to the separate "Supplemental Executive Retirement Agreement" between Employee and Employer, as amended; and (vi) cover Employee and his eligible dependents under all Employer benefit plans and programs available to Employer's former employees. Notwithstanding the foregoing, if Employer terminates Employee prior to December 31, 2007 for reasons other than cause and under circumstances that entitle Employee to payments and benefits under paragraph 6 of this Agreement (regarding "Change of Control"), then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by payments made to Employee under paragraphs 6(a)(i) and (ii). 7 (f) Expiration of Term Without Renewal. In the event that Employee's employment ends on December 31, 2007 solely because Employer chooses not to renew or extend this Agreement beyond December 31, 2007 for reasons other than cause, then Employee shall be entitled to a severance benefit equal to the sum of (i) 175 percent of the annual Base Salary in effect at the time of termination, and (ii) the most recent payment to Employee under the Management Incentive Plan, such sum to be payable in equal biweekly installments over the six-month period following Employee's termination of employment. Amounts payable under this paragraph 3(f) shall be reduced by any payments made to Employee under paragraphs 6(a)(i) and (ii). (g) Employer shall have the right of first refusal to purchase from Employee or Employee's estate, shares of CBSI stock acquired pursuant to the exercise of stock options after the date of Employee's termination of employment for any reason. In the event Employee or Employee's estate elects to dispose or transfer such acquired shares, Employee or Employee's estate shall provide Employer with 30 days advance written notice of his or its intention to sell or transfer the shares. Employer may exercise its right of first refusal to purchase by providing Employee or Employee's estate with written notice of such exercise within 30 days of Employer's receipt of the written notice from Employee or Employee's estate. If Employer exercises its right to purchase, the purchase shall be completed within 10 days following Employee's or Employee's estate's receipt of Employer's notice of exercise and the purchase price per share shall equal the closing price per share of CBSI stock on the immediately preceding date on which CBSI stock was traded on a national exchange. Such right of first refusal shall expire ten years from the date of termination. 8 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of its executive employees. Participation in any of Employer's benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for other employees not covered by employment agreements. (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the President and Chief Executive Officer of Employer for review on a quarterly basis. (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: 9 (i) Paid vacation of 4 weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer paid membership for Employee at a country club in the Scranton/Wilkes Barre, Pennsylvania area, subject to the approval of the President and Chief Executive Officer of Employer. Although it is contemplated that the membership shall be utilized for marketing and promotion of Employer's business interests, in the event that any part of this membership shall be treated as taxable compensation to Employee, Employer shall reimburse Employee for any federal, state or local income tax owed by Employee, including such taxes owed as a result of any reimbursement under this subparagraph (iii), in connection with such membership. (iv) The use of an Employer-owned automobile of Employee's choice, the purchase and replacement of which shall be subject to the approval of the Compensation Committee of the Board of Directors of Employer; (v) Reimbursement of the purchase price of a car telephone and all Employer-related business charges incurred in connection with the use of such telephone; (vi) Continuation of the March 13, 1991 Split Dollar Insurance Agreement between Grange National Banc Corp., Grange National Bank and Employee; and (vii) Reimbursement, up to an aggregate maximum of $10,000, for the following relocation expenses, contingent upon the completion of Employee's relocation 10 to the Clarks Summit, Pennsylvania area within six weeks of the effective date of this Agreement: (A) the cost of moving Employee's normal household goods from Employee's Laceyville, Pennsylvania residence to the Clarks Summit, Pennsylvania area; (B) the closing costs on the purchase of a residence in the Clarks Summit, Pennsylvania area, which for this purpose shall mean legal fees, abstract and title fees, city, county and state stamps, survey fee, loan application fees, termite inspection fee, engineering inspection fee, title search fee, and title insurance premium; and (C) the closing costs on the sale of Employee's Laceyville, Pennsylvania residence, which for this purpose shall mean legal fees, appraisal costs, and licensed real estate broker's commission up to six percent of the gross selling price of Employee's Wyalusing, Pennsylvania residence. (viii) Reimbursement, up to an aggregate monthly maximum of $350, for reasonable travel expenses incurred by Employee through June 2005 to permit Employee's son, Luke McCullough, to complete high school in Wyalusing, Pennsylvania. (d) Supplemental Retirement Benefits. The terms and conditions for the payment of supplemental retirement benefits are set forth in a separate "Amended and Restated Supplemental Executive Retirement Agreement," dated January 17, 2003 and amended as of March 26, 2003, between Employee and Grange National Bank, which agreement shall be assumed and continued by Employer; provided that the parties agree that the Amended and 11 Restated Supplemental Executive Retirement Agreement shall be amended further to include offsets for contributions and benefits provided to Employee pursuant to Employer's tax-qualified retirement plans. 5. Stock Options. Employer shall cause the Compensation Committee of the Board of Directors of Employer to review whether Employee should be granted options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a successor plan, or independently, as the Compensation Committee shall determine. Reviews shall be conducted no less frequently than annually. 6. Change of Control. (a) If Employee's employment with Employer (as an employee) shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 6(c) below), but not including Employee's termination for "cause" (as described in paragraph 3(d)) or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Retain the services of Employee, on an independent contractor basis, as a consultant to Employer for a period of no less than 36 months at an annual consulting fee rate equal to the total of Employee's Base Salary in effect at the time of Employee's termination plus an amount equal to the Management Incentive paid to the Employee in the year prior to the "Change of Control"; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits, identical to those described in paragraph 4(a) for the period during 12 which Employee is retained as a consultant pursuant to (i) above. To the extent the benefits provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; and (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock granted to Employee. (iv) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(v) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G, with any restructured payments being made to Employee as soon as practicable. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this paragraph 6, then payments shall be made without restructuring. Subject to paragraph 6(a)(v), Employee shall be responsible for all taxes that are payable by Employee as a result of Employee's receipt of an "excess parachute payment." Notwithstanding the foregoing, Employee shall have the option of receiving a portion of the amounts otherwise required to be paid to, or the value otherwise required to be received by, 13 Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise), as determined by Employee, so that aggregate present value of such portion, as determined under Internal Revenue Code 280G, of the amounts otherwise required to be paid to, or the value otherwise required to be received by, Employee is equal to 2.99 of Employee's "base amount" of compensation within the meaning of Internal Revenue Code Section 280G. (v) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment, including, but not limited to, all taxes that are payable by Employee as a result of Employee's receipt of an "excess parachute payment" and as a result of any payment made to Employee pursuant to this sentence. (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were 14 directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. (c) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in: (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; (ii) An involuntary and material relocation of the office from which Employee is expected to perform his duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 15 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all necessary income and employment taxes and any other similar sums required by law to be withheld. 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except as required in the course of his employment by Employer, any confidential business or technical information or trade secret acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or disclosure of any trade secret or any confidential information concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in paragraph 8(c) below, Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or 16 have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer, in the states of New York and Pennsylvania. Employee shall keep Employer fully advised as to any activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the first payment is made pursuant to the terms of this Agreement and shall end on the earlier of (i) the date that is 18 17 months after the date the final payment is made pursuant to the terms of this Agreement, or (ii) December 31, 2007. (d) Certain Affiliates of Employer. It is understood that Employee may have access to technical knowledge, trade secrets and customer lists of affiliates of Employer or companies which Employer's parent may acquire in the future and may serve as a member of the board of directors or as an officer or employee of an affiliate of Employer. Employee covenants that he shall not, during the term of his employment by Employer or for the period specified in 8(c) above, in any way, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise aid or assist anyone else in any business or operation which competes with or engages in the business of such an affiliate. (e) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer may offset immediately any and all amounts payable to Employee under this Agreement in addition to any and all other remedies available to Employer under the law or in equity. 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by overnight mail, or by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 18 10. Rules, Regulations and Policies. Employee shall abide by and comply with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee affirms and represents that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the term hereof, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 19 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the Grange Employment Agreement. Employee hereby waives all claims Employee may have under the Grange Employment Agreement. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. 20 The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By:____________________________ Its:___________________________ COMMUNITY BANK, N.A. By:____________________________ Its:___________________________ _______________________________ THOMAS A. McCULLOUGH 21 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Thomas A. McCullough ("Agreement"), I, Thomas A. McCullough, hereby designate _________________, my __________, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is _____________________________________. Dated: _____________ _________________________________ Thomas A. McCullough ______________________________ Witness 22 EX-10.11 12 d58827_ex10-11.txt THOMAS A. MCCULLOUGH RETIREMENT PLAN Exhibit 10.11 FIRST AMENDMENT TO THE GRANGE NATIONAL BANK AMENDED AND RESTATED SUPPLEMENTAL EXECUTIVE RETIREMENT AGREEMENT This First Amendment to the Grange National Bank Amended and Restated Supplemental Executive Retirement Agreement is entered into as of March 26,2003 by and between GRANGE NATIONAL BANK, a nationally-chartered commercial bank located in Laceyville, Pennsylvania (the "Company"), and THOMAS A. McCULLOUGH (the "Executive"). On January 17,2003, the Company and the Executive entered into an Amended and Restated Supplemental Retirement Agreement (the "Agreement"). The parties now desire to amend the Agreement as set forth herein. The parties hereto, intending to be legally bound hereby, agree as follows: 1. Section 2.5 of the Agreement is amended by adding the following sentence at the end of the Section: Notwithstanding any other provisions to the contrary in this Section 2.5, the Company shall not pay the Change of Control Benefit but shall instead pay the Early Retirement Benefit in the amounts and at the times provided in Section 2.3 hereof if (a) the payment of the Change of Control Benefit would cause the amount of any other payments that the Executive otherwise has the right to receive from the Company to be reduced as a result of such other payments and the Change of Control Benefit being limited to the largest amount as will result in no portion of them being subject to excise tax imposed under Section 4999 of the Code, or (b) the payment of the Change of Control Benefit would cause the sum of (i) any other payments that the Executive has the right to receive from the Company and (ii) the Change in Control Benefits to be a "parachute payment," as defined by Section 280G of the Code. 2. All other terms and conditions of the Agreement remain in full force and effect. IN WITNESS WHEREOF, the Company and the Executive have caused this First Amendment to be duly executed as of the date first above written. EXECUTIVE GRANGE NATIONAL BANK /s/ Thomas A. McCullough By: /s/ Sally A. Steele, Secretary - ------------------------------ --------------------------------- Thomas A. McCullough Sally A. Steele As its Secretary (C) 2002 Clark/Bardes Consulting-Banking Practice This document is provided to assist your legal counsel in documenting your specific arrangement. The laws of the various states may differ considerably, and this specimen is for general information only. It is not a form to be signed, nor is it to be construed as legal advice. Failure to accurately document your arrangement could result in significant losses, whether from claims of those participating in the arrangement, from the heirs and beneficiaries of Executives, or from regulatory agencies such as the Internal Revenue Service, the Department of Labor, or bank examiners. License is hereby granted to your legal counsel to use these materials in documenting solely your arrangement. GRANGE NATIONAL BANK AMENDED AND RESTATED SUPPLEMENTAL EXECUTIVE RETIREMENT AGREEMENT GRANGE NATIONAL BANK AMENDED AND RESTATED SUPPLEMENTAL EXECUTIVE RETIREMENT AGREEMENT This Agreement is entered into this January 17, 2003, by and between GRANGE NATIONAL BANK, a nationally-chartered commercial bank located in Laceyville, Pennsylvania (the "Company"), and THOMAS A. MCCULLOUGH (the "Executive"). On January 1, 1996, the Company and the Executive entered into an Executive Supplemental Income Agreement (the "Prior Agreement"). Pursuant to its powers to amend the Prior Agreement, the Company hereby amends and restates the Prior Agreement in its entirety. The purpose of this Agreement is to provide specified benefits to the Executive, a member of a select group of management or highly compensated employees who contribute materially to the continued growth, development and future business success of the Company. This Agreement shall be unfunded for tax purposes and for purposes of Title I of ERISA. ARTICLE 1 DEFINITIONS The following words and phrases shall have the following meanings, unless the context requires otherwise: 1.1 "Accrual Balance" means the liability accrued on the books of the Company for the Company's obligation for the Normal Retirement Benefit, using generally accepted accounting principles. 1.2 "Beneficiary" means each designated person, or the estate of the Executive, entitled to benefits, if any, upon the death of the Executive determined pursuant to Article 3. 1.3 "Beneficiary Designation Form" means the form established from time to time by the Plan Administrator that the Executive completes, signs and returns to the Plan Administrator to designate one or more Beneficiaries. 1.4 "Board" means the Board of Directors of the Company as from time to time constituted. 1.5 "Change of Control" means (a) A change in the ownership of the capital stock of the Company or the Corporation, whereby another corporation, person, or group acting in concert (hereinafter this Agreement shall collectively refer to any combination of these three [another corporation, person, or group acting in concert] as a "Person") as described in Section 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), acquires, directly or indirectly, beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of a number of shares of capital stock of the Company or the Corporation which constitutes fifty percent (50%) or more of the combined voting power of the Company's or the Corporation's then outstanding capital stock then entitled to vote generally in the election of directors; or (b) The persons who were members of the Board of Directors of the Company or the Corporation's immediately prior to a tender offer, exchange offer, contested election or any combination of the foregoing, cease to constitute a majority of the Board of Directors; or (c) The adoption by the Board of Directors of the Company or the Corporation of a merger, consolidation or reorganization plan involving the Company or the Corporation in which the Company or the Corporation is not the surviving entity, or a sale of all or substantially all of the assets of the Company or the Corporation. For purposes of this Agreement, a sale of all or substantially all of the assets of the Company or the Corporation shall be deemed to occur if any Person acquires (or during the 12-month period ending on the date of the most recent acquisition by such Person, has acquired) gross assets of the Company or the Corporation that have an aggregate fair market value equal to fifty percent (50%) or more of the fair market value of all of the respective gross assets of the Company or the Corporation immediately prior to such acquisition or acquisitions; or (d) A tender offer or exchange offer is made by any Person which results in such Person beneficially owning (within the meaning of Rule 13d-3 promulgated under the Exchange Act) either fifty percent (50%) or more of the Company's or the Corporation's outstanding shares of Common Stock or shares of capital stock having fifty percent (50%) or more the combined voting power of the Company's or the Corporation's then outstanding capital stock (other than an offer made by the Company or the Corporation), and sufficient shares are acquired under the offer to cause such person to own fifty percent (50%) or more of the voting power; or (e) Any other transactions or series of related transactions occurring which have substantially the same effect as the transactions specified in any of the preceding clauses of this Section I.5. Notwithstanding the above, certain transfers are permitted within Section 318 of the Code and such transfers shall not be deemed a Change of Control under this Section 1.5. 1.6 "Code" means the Internal Revenue Code of 1986, as mended. 1.7 "Compensation" means the annual compensation, including bonuses, commissions, overtime, relocation expenses, incentive payments, non-monetary awards, and including automobile allowances paid to the Executive for employment services rendered to the Company, before reduction for compensation deferred pursuant to all qualified, non-qualified and Code ss. 125 plans of the Company. 1.8 "Corporation" means Grange National Banc Corp., a Pennsylvania corporation. 1.9 "Disability" means a condition whereby the Executive, because of a physical or mental sickness, accident or injury, is or will be unable to perform the duties of the Executive's customary position of employment with the Company or any other employer. The Board, in its sole discretion, shall determine whether the Executive is disabled and may require the Executive to submit to a physical examination in order to determine disability. 1.10 "Disability Benefit" means the benefit as set forth in Section 2.4. 1.12 "Early Retirement Benefit" means the benefit as set forth in Section 2.3. 1.13 "Effective Date" means 1/1/96. 1.14 "Final Compensation" means the average of the Executive's Compensation for his or last five calendar years of employment (including the annualized compensation for the calendar year in which the event that entitled the Executive to a distribution of benefits under this Agreement occurred). 1.15 "Normal Retirement Age" means the Executive's sixty-second (62nd)birthday. 1.16 `Normal Retirement Benefit" means the benefit as set forth in Section 2.2, 1.17 "Normal Retirement Date" means the later of the Normal Retirement Age or Termination of Employment. 1.18 "Pension Benefit" means the balance in the Executive's 401(k) (as of the date any benefits are being determined) attributed to all Company contributions, plus the return on those contributions, amortized over a two hundred forty (240) month period with interest calculated on the unpaid balance at an annual rate of eight ' percent (8%), compounded monthly. 1.19 "Plan Administrator" means the plan administrator described in Article 5. 1.20 "Plan Year" means the twelve (12) month period from January 1 to December 3I. 1.21 "Termination for Cause" means termination of the Executive's employment for: (a) gross negligence or gross neglect of duties; (b) commission of a felony or of a gross misdemeanor involving moral turpitude; or (c) actions inimical to the interests of the Company, including but not limited to fraud, disloyalty, dishonesty or willful violation of any law or significant Company policy committed in connection with the Executive's employment and resulting in a material adverse effect on the Company. 1.22 "Termination of Employment" means the date on which the Executive (i) retires, resigns or ceases to be an employee; (ii) dies while in the active employ of the Company; or (iii) departs from the service of the Company for any reason; provided, that the Executive will not be deemed to have terminated the Executive's employment solely by reason of a leave of absence duly approved by the Company. 1.23 "Years of Service" means the twelve consecutive month period beginning on the Executive's date of hire and any twelve (12) month anniversary thereof, during the entirety of which time the Executive is an employee of the Company. The Plan Administrator in its discretion may also grant additional Years of Service in such circumstances where it deems such additional service appropriate. ARTICLE 2 RETIREMENT AND DEATH BENEFITS 2.1 Agreement Benefits. The Executive's benefits under this Agreement shall be limited to those described in this Article 2, and shall be subject to any conditions and limitations set forth in Article 4 and contained elsewhere in this Agreement. 2.2 Normal Retirement Benefit. Upon the Normal Retirement Date, the Company shall pay to the Executive an annual Normal Retirement Benefit equal to eighty- five percent (85%) of the Executive's Final Compensation reduced by the (a) Pension Benefit, and (b) fifty percent (50%) of the Social Security benefit that would be receivable by the Executive calculated as if the Executive's Normal Retirement Age were also his normal retirement age or age at which unreduced Social Security benefits were available under the Social Security law (regardless of whether any Social Security benefits are actually payable currently on the Executive's Normal Retirement Date). The Company shall pay the Normal Retirement Benefit to the Executive in twelve (12) equal monthly installments commencing as of the first day of the month following the Executive's Normal Retirement Date and payable during the Executive's lifetime on or around the first day of each successive month thereafter until the Executive has received one hundred eighty (180) installments. Upon making all of such installments, the Company's obligation to provide such payments will cease. No further benefit under this Agreement is to be provided. 2.3 Earls Retirement Benefit Upon the Executive's Termination of Employment before the Normal Retirement Date, the Company shall pay to the Executive an annual Early Retirement Benefit, determined by amortizing the Accrual Balance over one hundred eighty (180) equal monthly installments at an annual rate of interest equal to the Prime Rate as published in the Wall Street Journal on the last business day immediately preceding the Executive's Termination of Employment. The Company shall pay the Early Retirement Benefit to the Executive commencing as of the first day of the month following the Executive's Termination of Employment and payable during the Executive's lifetime on or around the first day of each successive month thereafter until the Executive has received one hundred eighty (180) installments. Upon making all of such installments, the Company's obligation to provide such payments will cease. No further benefit under this Agreement is to be provided. 2.4 Disability Benefit. Upon Termination of Employment due to Disability prior to Normal Retirement Age, the Company shall pay to the Executive an annual Disability Benefit, determined by amortizing the Accrual Balance over one hundred eighty (180) equal monthly installments at an annual rate of interest equal to the Prime Rate as published in the Wall Street Journal on the last business day immediately preceding the Executive's Termination of Employment. The Company shall pay the Disability Benefit to the Executive commencing as of the first day of the month following the Executive's Termination of Employment and payable during the Executive's lifetime on or around the first day of each successive month thereafter until the Executive has received one hundred eighty (180) installments. Upon making all of such installments, the Company's obligation to provide such payments will cease. No further benefit under this Agreement is to be provided. 2.5 Chance of Control Benefit. Following a Change of Control, upon the Executive's Termination of Employment for reasons other than death, Disability or attaining Normal Retirement Age, the Company shall pay to the Executive an annual Change of Control Benefit equal to eighty-five percent (85%)of the Executive's Final Compensation reduced by the (a) Pension Benefit, and (b) fifty percent (50%) of the Social Security benefit that would be receivable by the Executive calculated as if the Executive's age at Termination of Employment were also his normal retirement age or age at which unreduced Social Security benefits were available under the Social Security law (regardless of whether any Social Security benefits are actually payable currently on the Executive's Normal Retirement Date). The Company shall pay the Change of Control Benefit to the Executive in twelve (12) equal monthly installments commencing as of the first day of the month following the Executive's Termination of Employment and payable during the Executive's lifetime on or around the first day of each successive month thereafter until the Executive has received one hundred eighty (180) installments. Upon making all of such installments, the Company's obligation to provide such payments will cease. No further benefit under this Agreement is to be provided. 2.6 Pre-Retirement Death Benefit. If the Executive dies while in the active employ by the Company, the Company shall pay to the Beneficiary the following benefits: Year 1: 100% of Compensation Years 2-5: 75% of Compensation Years 6-15: 50% of Compensation The Company shall pay the Pre-Retirement Death Benefit to the Beneficiary in twelve (12) monthly installments commencing as of the first day of the month following the Executive's death and on or around the first day of each successive month thereafter until the Executive's beneficiary has received one hundred eighty (180) installments. Upon making all of such installments, the Company's obligation to provide such payments will cease. No further benefit under this Agreement is to be provided. 2.7 Post-Commencement Death Benefit. If the Executive dies after any benefit payments have commenced under this Article but before receiving all such payments, the Company shall pay to the Beneficiary the remaining benefits at the same time, for such duration and in the same amounts they would have been paid to the Executive had the Executive survived. 2.8 Post-Retirement, Commencement Death Benefit. If the Executive is entitled to a benefit under this Article, but dies prior to the commencement of said benefit payments, the Company shall pay the same benefit payments to the Beneficiary that the Executive was entitled to prior to death except that the benefit payments shall commence on the first day of the month following the date of the Executive's death. 2.9 Withholding and Payroll Taxes. The Company shall withhold from any and all benefits made under this Article 2, all federal, state and local income taxes, employment and other taxes required to be withheld by the Company in connection with the benefits hereunder, in amounts to be determined in the sole discretion of the Company. ARTICLE 3 BENEFICIARIES 3.1 Beneficiary. The Executive shall have the right, at any time, to designate a Beneficiary(ies) to receive any benefits payable under this Agreement to a beneficiary upon the death of the Executive. The Beneficiary designated under this Agreement may be the same as or different from the Beneficiary designation under any other plan of the Company in which the Executive participates. 3.2 Beneficiary Designation; Change. The Executive shall designate a Beneficiary by completing and signing the Beneficiary Designation Form, and delivering it to the Plan Administrator or its designated agent. The Executive's beneficiary designation shall be deemed automatically revoked if the beneficiary predeceases the Executive or if the Executive names a spouse as beneficiary and the marriage is subsequently dissolved. The Executive shall have the right to change a Beneficiary by completing, signing and otherwise complying with the terms of the Beneficiary Designation Form and the Plan Administrator's rules and procedures, as in effect from time to time. Upon the acceptance by the Plan Administrator of a new Beneficiary Designation Form, all Beneficiary designations previously filed shall be cancelled. The Plan Administrator shall be entitled to rely on the last Beneficiary Designation Form filed by the Executive and accepted by the Plan Administrator prior to the Executive's death. 3.3 Acknowledgement. No designation or change in designation of a Beneficiary shall be effective until received, accepted and acknowledged in writing by the Plan Administrator or its designated agent. 3.4 No Beneficiary Designation. If the Executive dies without a valid beneficiary designation, or if all designated Beneficiaries predecease the Executive, then the Executive's spouse shall be the designated Beneficiary. If the Executive has no surviving spouse, the benefits shall be made to the personal representative of the Executive's estate. 3.5 Facility of Payment. If the Plan Administrator determines in its discretion that a benefit is to be paid to a minor, to a person declared incompetent, or to a person incapable of handling the disposition of that person's property, the Plan Administrator may direct payment of such benefit to the guardian, legal representative or person having the care or custody of such minor, incompetent person or incapable person. The Plan Administrator may require proof of incompetence, minority or guardianship as it may deem appropriate prior to distribution of the benefit. Any payment of a benefit shall be a payment for the account of the Executive and the Executive's Beneficiary, as the case may be, and shall be a complete discharge of any liability under the Agreement for such payment amount. ARTICLE 4 GENERAL LIMITATIONS ON BENEFITS 4.1 Termination for Cause. If there is a Termination for Cause by the Company of the Executive, the Executive shall cease participation hereunder as of the date of such termination and no benefits shall be paid to the Executive or the Executive's Beneficiary. 4.2 Requirement of Non-Competition. The Company shall not pay to the Executive any benefit under this Agreement if, during the term that benefits payments are being made, the Executive, without the prior written consent of the Board engages in, becomes interested in, directly or indirectly, as a sole proprietor, as a partner in a partnership, or as a substantial shareholder in a corporation, or becomes associated with, in the capacity of employee, director, officer, principal, agent, trustee or in any other capacity whatsoever, any enterprise conducted within twenty-five (25) miles of any office of the Company existing as of the date of the Executive's Termination of Employment, which enterprise is, or may deemed to be, competitive with any business carried on by the Company as of the date of the Executive's Termination of Employment. This section shall not apply following a Change of Control. 4.3 Services. Payment of the Early Retirement Benefit or Normal Retirement Benefit is conditioned upon the Executive, while receiving payments under this Agreement, rendering such reasonable business consulting and advisory services to the Company as requested by the Board. Such services shall not require the Executive to be active in the Company's day-to-day activities, and the Executive shall be compensated for such services in an amount to be then agreed upon, and shall be reimbursed for all expenses incurred in performing such services. 4.4 Executive's Suicide or Misstatement. The Company shall not pay any benefit under this Agreement if the Executive commits suicide within two years of the Effective Date of this Agreement. In addition, the Company shall not pay any benefit under this Agreement if the Executive has made any material misstatement of fact on any application for insurance or any benefits provided by the Company to the Executive. ARTICLE 5 ADMINISTRATION OF AGREEMENT 5.1 Plan Administrator Duties. This Agreement shall be administered by a Plan Administrator which shall consist of the Board, or such committee as the Board shall appoint. The Executive may be a member of the Plan Administrator. The Plan Administrator shall also have the discretion and authority to (i) make, amend, interpret and enforce all appropriate rules and regulations for the administration of this Agreement and (ii) decide or resolve any and all questions including interpretations of this Agreement, as may arise in connection with the Agreement. 5.2 Agents. In the administration of this Agreement, the Plan Administrator may employ agents and delegate to them such administrative duties as it sees fit, (including acting through a duly appointed representative), and may from time to time consult with counsel who may be counsel to the Company. 5.3 Binding Effect of Decisions. The decision or action of the Plan Administrator with respect to any question arising out of or in connection with the administration, interpretation and application of the Agreement and the rules and regulations promulgated hereunder shall be final and conclusive and binding upon all persons having any interest in the Agreement. 5.4 Indemnity of Plan Administrator. The Company shall indemnify and hold harmless the members of the Plan Administrator against any and all claims, losses, damages, expenses or liabilities arising from any action or failure to act with respect to this Agreement, except in the case of willful misconduct by the Plan Administrator or any of its members. 5.5 Company Information. To enable the Plan Administrator to perform its functions, the Company shall supply full and timely information to the Plan Administrator on all matters relating to the compensation of the Executive, the date and circumstances of the retirement, Disability, death or Termination of Employment of the Executive, and such other pertinent information as the Plan Administrator may reasonably require. ARTICLE 6 CLAIMS AND REVIEW PROCEDURE 6.1 For all claims other than Disability benefits: 6.l.1 Claims Procedure. Any individual ("Claimant") who has not received benefits under this Agreement that he or she believes should be paid shall make a claim for such benefits as follows: 6.1.1.1 Initiation - Written Claim. The Claimant initiates a claim by submitting to the Company a written claim for the benefits. 6.1.1.2 Timing of Company Response. The Company shall respond to such Claimant within 90 days after receiving the claim. If the Company determines that special circumstances require additional time for processing the claim, the Company can extend the response period by an additional 90 days by notifying the Claimant in writing, prior to the end of the initial 90-day period, that an additional period is required. The notice of extension must set forth the special circumstances and the date by which the Company expects to render its decision. 6.1.1.3 Notice of Decision. If the Company denies part or all of the claim, the Company shall notify the Claimant in writing of such denial. The Company shall write the notification in a manner calculated to be understood by the Claimant. The notification shall set forth (a) The specific reasons for the denial, (b) A reference to the specific provisions of this Agreement on which the denial is based, (c) A description of any additional information or material necessary for the Claimant to perfect the claim and an explanation of why it is needed, (d) An explanation of this Agreement's review procedures and the time limits applicable to such procedures, and (e) A statement of the Claimant's right to bring a civil action under ERISA Section 502(a) following an adverse benefit determination on review. 6.1.2 Review Procedure. If the Company denies part or all of the claim, the Claimant shall have the opportunity for a full and fair review by the Company of the denial, as follows: 6.1.2.4 Initiation - Written Request. To initiate the review, the Claimant, within 60 days after receiving the Company's notice of denial, must file with the Company a written request for review. 6.1.2.5 Additional Submissions - Information Access. The Claimant shall then have the opportunity to submit written comments, documents, records and other information relating to the claim. The Company shall also provide the Claimant, upon request and free of charge, reasonable access to, and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the Claimant's claim for benefits. 6.1.2.6 Considerations on Review. In considering the review, the Company shall take into account all materials and information the Claimant submits relating to the claim, without regard to whether such information was submitted or considered in the initial benefit determination. 6.1.2.7 Timing of Company Response. The Company shall respond in writing to such Claimant within 60 days after receiving the request for review. If the Company determines that special circumstances require additional time for processing the claim, the Company can extend the response period by an additional 60 days by notifying the Claimant in writing, prior to the end of the initial 60-day period, that an additional period is required. The notice of extension must set forth the special circumstances and the date by which the Company expects to render its decision. 6.1.2.8 Notice of Decision. The Company shall notify the Claimant in writing of its decision on review. The Company shall write the notification in a manner calculated to be understood by the Claimant. The notification shall set forth: (a) The specific reasons for the denial, (b) A reference to the specific provisions of this Agreement on which the denial is based, (c) A statement that the Claimant is entitled to receive, upon request and free of charge, reasonable access to, and copies of, all documents, records and other information relevant (as defined in applicable ERISA regulations) to the Claimant's claim for benefits, and (d) A statement of the Claimant's right to bring a civil action under ERISA Section 502(a). 6.2 For Disability claims: 6.2.1 Claims Procedures. Any individual ("Claimant") who has not received benefits under this Agreement that he or she believes should be paid shall make a claim for such benefits as follows: 6.2.1.2 Initiation - Written Claim. The Claimant initiates a claim by submitting to the Company a written claim for the benefits. 6.2.1.3 Timing of Company Response. The Company shall notify the Claimant in writing or electronically of any adverse determination as set out in this Section. 6.2.1.4 Notice of Decision. If the Company denies part or all of the claim, the Company shall notify the Claimant in writing of such denial. The Company shall write the notification in a manner calculated to be understood by the Claimant. The notification shall set forth: (a) The specific reasons for the denial, (b) A reference to the specific provisions of this Agreement on which the denial is based, (c) (c) A description of any additional information or material necessary for the Claimant to perfect the claim and an explanation of why it is needed, (d) An explanation of the Agreement's review procedures and the time limits applicable to such procedures, (e) A statement of the Claimant's right to bring a civil action under ERISA Section 502(a) following an adverse benefit determination on review, (f) [See ss.2560.503-l(g)(v) Any internal rule, guideline, protocol, or other similar criterion relied upon in making the adverse determination, or a statement that such a rule, guideline, protocol, or other similar criterion was relied upon in making the adverse determination and that the Claimant can request and receive free of charge a copy of such rule, guideline, protocol or other criterion from the Company, and (g) If the adverse benefit determination is based on a medical necessity or experimental treatment or similar exclusion or limit, either an explanation of the scientific or clinical judgment for the determination, applying the terns of this Agreement to the Claimant's medical circumstances, or a statement that such explanation will be provided free of charge upon request. 6.2.1.5 Timing of Notice of Denial/Extensions. The Company shall notify the Claimant of denial of benefits in writing or electronically not later than 45 days after receipt of the claim by the Company. The Company may elect to extend notification by two 30-day periods subject to the following requirements: (a) For the first 30-day extension, the Company shall notify the Claimant (1) of the necessity of the extension and the factors beyond the Company's control requiring an extension; (2) prior to the end of the initial 45-day period; and (3) of the date by which the Company expects to render a decision. (b) If the Company determines that a second 30-day extension is necessary based on factors beyond the Company's control, the Company shall follow the same procedure in (a> above, with the exception that the notification must be provided to the Claimant before the end of the first 30-day extension period. (c) For any extension provided under this section, the Notice of Extension shall specifically explain the standards upon which entitlement to a benefit is based, the unresolved issues that prevent a decision on the claim, and the additional information needed to resolve those issues. The Claimant shall be afforded 45 days within which to provide the specified information. 6.2.2 Review Procedures - Denial of Benefits. If the Company denies part or all of the claim, the Claimant shall have the opportunity for a full and fair review by the Company of the denial, as follows: 6.2.2.1 Initiation of Appeal. Within 180 days following notice of denial of benefits, the Claimant shall initiate an appeal by submitting a written notice of appeal to Company. 6.2.2.2 Submissions on Appeal - Information Access. The Claimant shall be allowed to provide written comments, documents, records, and other information relating to the claim for benefits. The Company shall provide to the Claimant, upon request and free of charge, reasonable access to, and copies of, all documents, records, and other information relevant (as defined in applicable ERISA regulations) to the Claimant's claim for benefits. 6.2.2.3 Additional Company Responsibilities on Appeal. On appeal, the Company shall: (a) [See ss.2560.503-1(h)(3)(i)-(v)] Take into account all materials and information the Claimant submits relating to the claim, without regard to whether such information was submitted or considered in the initial benefit determination; (b) Provide for a review that does not afford deference to the initial adverse benefit determination and that is conducted by an appropriate named fiduciary of the Company who is neither the individual who made the adverse benefit determination that is the subject of the appeal, nor the subordinate of such individual; (c) In deciding an appeal of any adverse benefit determination that is based in whole or in part on a medical judgment, including determinations with regard to whether a particular treatment, drug, or other item is experimental, investigational, or not medically necessary or appropriate, consult with a health care professional who has appropriate training and experience in the field of medicine involved in the medical judgment; (d) Identify medical or vocational experts whose advise was obtained on behalf of the Company in connection with a Claimant's adverse benefit determination, without regard to whether the advice was relied upon in making the benefit determination; and (e) Ensure that the health care professional engaged for purposes of a consultation under subsection (c) above shall be an individual who was neither an individual who was consulted in connection with the adverse benefit determination that is the subject of the appeal, nor the subordinate of any such individual. 6.2.2.4 Timing of Notification of Benefit Denial - Appeal Denial. The Company shall notify the Claimant not later than 45 days after receipt of the Claimant's request for review by the Company, unless the Company determines that special circumstances require an extension of time for processing the claim. If the Company determines that an extension is required, written notice of such shall be furnished to the Claimant prior to the termination of the initial 45-day period, and such extension shall not exceed 45 days. The Company shall indicate the special circumstances requiring an extension of time and the date by which the Company expects to render the determination on review. 6.2.2.5 Content of Notification of Benefit Denial. The Company shall provide the Claimant with a notice calculated to be understood by the Claimant, which shall contain: (a) The specific reason or reasons for the adverse determination; (b) Reference to the specific plan provisions on which the benefit determination is based; (c) A statement that the Claimant is entitled to receive, upon request and free of charge, reasonable access to, and copies of all documents, records, and other relevant information (as defined in applicable ERISA regulations); (d) A statement of the Claimant's right to bring an action under ERISA Section 502(a); (e) [See ss.2560.503-1(j)(5)] Any internal rule, guideline, protocol, or other similar criterion relied upon in making the adverse determination, or a statement that such a rule, guideline, protocol, or other similar criterion was relied upon in making the adverse determination and that the Claimant can request and receive free of charge a copy of such rule, guideline, protocol or other criterion from the Company; (f) If the adverse benefit determination is based on a medical necessity or experimental treatment or similar exclusion or limit, either an explanation of the scientific or clinical judgment for the determination, applying the terms of this Agreement to the Claimant's medical circumstances, or a statement that such explanation will be provided free of charge upon request; and (g) The following statement: "You and your Company may have other voluntary alternative dispute resolution options such as mediation. One way to find out what may be available is to contact your local U.S. Department of Labor Office and your state insurance regulatory agency." ARTICLE 7 AMENDMENT AND TERMINATION OF THE AGREEMENT 7.1 Amendment and Termination. Subject to Article 4, prior to the commencement of benefit payments under this Agreement, the Company reserves the right to amend or terminate this Agreement at any time by the action of the Board. ARTICLE 8 MISCELLANEOUS 8.1 Unsecured General Creditor. The Executive and the Executive's Beneficiaries, successors and assigns shall have no legal or equitable rights, interests or claims in any property or assets of the Company. Any and all of the Company's assets shall be, and remain, the general, unpledged unrestricted assets of the Company. The Company's obligation under the Agreement shall be merely that of an unfunded and unsecured promise to pay money in the future. 8.2 Not a Contract of Employment. The terms and conditions of this Agreement shall not be deemed to constitute a contract of employment between the Company and the Executive. Such employment is hereby acknowledged to be an "at will" employment relationship that can be terminated at any time for any reason, with or without cause, unless expressly provided in a written employment agreement. Nothing in this Agreement shall be deemed to give a Executive the right to be retained in the service of the Company or to interfere with the right of the Company to discipline or discharge the Executive at any time. 8.3 Participation in Other Plans. Nothing herein contained shall be construed to alter, abridge, or in any manner affect the rights and privileges of the Executive to participate in and be covered by any pension, profit sharing, group insurance, bonus or similar employee plans which the Company may now or hereafter maintain. 8.4 Alienability. Neither the Executive nor any Beneficiary under this Agreement shall have any power or right to transfer, assign, anticipate, hypothecate, mortgage, commute, modify, or otherwise encumber in advance any of the benefits payable hereunder, nor shall any of said benefits be subject to seizure for the payment of any debts, judgments, alimony, or separate maintenance owed by the Executive or the Executive's Beneficiary or any of them, to be transferable by operation of law in the event of bankruptcy, insolvency, or otherwise. In the event the Executive or any Beneficiary attempts assignment, commutation, hypothecation, transfer, or disposal of the benefit hereunder, the Company's liabilities shall forthwith cease and terminate. 8.5 Successors. The provisions of this Agreement shall bind and inure to the benefit of the Company and its successors and assigns and the Executive and the Executive's Beneficiary. 8.6 Reorganization. The Company shall not merge or consolidate into or with another corporation, or reorganize, or sell substantially all of its assets to another corporation, firm, or person unless and until such succeeding or continuing corporation, firm, or person agrees to assume and discharge the obligations of the Company under this Agreement. Upon the occurrence of such event, the term "Company" as used in this Agreement shall be deemed to refer to such succeeding or continuing company, firm, or person. 8.7 Interpretation. Wherever the fulfillment of the intent and purpose of this Agreement requires, and the context will permit, the use of the masculine gender includes the feminine and use of the singular includes the plural. 8.8 Alternative Action. In the event it shall become impossible for the Company or the Plan Administrator to perform any act required by this Agreement, the Company or Plan Administrator may in its discretion perform such alternative act as most nearly carries out the intent and purpose of this Agreement and is in the best interests of the Company. 8.9 Applicable Law. Subject to ERISA, the provisions of this Agreement shall be construed and interpreted in accordance with the laws of the state of Pennsylvania, without regard to its conflict of law principles. 8.10 Headings. Article and section headings are for convenient reference only and shall not control or affect the meaning or construction of any of its provisions. 8.11 Furnishing Information. The Executive or the Executive's Beneficiary will cooperate with the Plan Administrator by furnishing any and all information requested by the Plan Administrator and take such other actions as may be requested in order to facilitate the administration of the Agreement and the payments of benefits hereunder, including but not limited to taking such physical examinations as the Plan Administrator may deem necessary. 8.12 Validity. In case any provision of this Agreement shall be illegal or invalid for any reason, said illegality or invalidity shall not affect the remaining parts hereof, but this Agreement shall be construed and enforced as if such illegal and invalid provision has never been inserted herein. 8.13 Notice. Any notice or filing required or permitted to be given to the Plan Administrator under this Agreement shall be sufficient if in writing and hand- delivered, or sent by registered or certified mail, to the address below: 198 E. TIOGA ST. TUNKHANNOCK PA. 18657 Such notice shall be deemed given as of the date of delivery or, if delivery is made by mail, as of the date shown on the postmark or the receipt for registration or certification. Any notice or filing required or permitted to be given to the Executive under this Agreement shall be sufficient if in writing and hand-delivered, or sent by mail, to the last known address of the Executive. 8.14 Signed Copies. This Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original, and such counterparts taken together shall constitute one (1) and the same instrument. IN WITNESS WHEREOF, the Company and the Executive have caused this Agreement to be duly executed as of the Effective Date above. EXECUTIVE GRANGE NATIONAL BANK /s/ Thomas A. McCullough By: - ------------------------------ /s/ Sally A. Steele --------------------------------- Thomas A. McCullough As its Secretary - ------------------------ BENEFICIARY DESIGNATION FORM I designate the following as beneficiary of benefits under this Agreement payable following my death: Primary: Helen T. McCullough ------------------------------------------------------------------------ - -------------------------------------------------------------------------------- Contingent: Thomas A. McCullough, Jr., Matthew H. McCullough, Mark M. McCullough, ------------------------------------------------------------------------ John P. McCullough, Luke M. McCullough each 20% - -------------------------------------------------------------------------------- Note: To name a trust as beneficiary, please provide the name of the trustee(s) and the exact name and date of the trust agreement. I understand that I may change these beneficiary designations by filing a new written designation with the Plan Administrator. I further understand that the designations will be automatically revoked if the beneficiary predeceases me, or, if I have named my spouse as beneficiary and our marriage is subsequently dissolved. Signature /s/ Thomas A. McCullough ------------------------ Thomas A. McCullough Date January 17, 2003 Acknowledged by the Plan Administrator this 11 day of February, 2003 By /s/ [Illegible] ------------------------------- Title ____________________________ EX-10.12 13 d58827_ex10-12.txt DAVID J. ELIAS EMPLOYMENT AGREEMENT Exhibit 10.12 EMPLOYMENT AND NON-COMPETITION AGREEMENT THIS EMPLOYMENT AND NON-COMPETITION AGREEMENT is made and entered into this 3rd day of April, 2000 by and among David Elias ("Employee"), Elias Asset Management, Inc., a Delaware corporation (the "Company"), and Community Bank, National Association, a national banking association ("CBNA"). W I T N E S S E T H: WHEREAS, the Employee is party to a Stock Purchase Agreement (the "Purchase Agreement") dated as of January 28, 2000, among the Employee, the Company, and CBNA, pursuant to which CBNA has agreed to acquire from Employee all of the outstanding capital stock of the Company. All initially capitalized terms which are used but not otherwise defined herein shall have the meanings specified in the Purchase Agreement; WHEREAS, the Employee is the sole shareholder and a director, officer and employee of the Company, and, as a result, the Employee has developed valuable relations with the Company's clients, vendors, and others with which the Company has business relations and has learned and developed valuable and proprietary information relating to its business and operations; WHEREAS, the Employee will continue as an officer and director of the Company, and to oversee the direction of the operation of the Company, following the acquisition by CBNA; and WHEREAS, in order to protect CBNA's interest in the Company, CBNA's obligation to consummate the transactions contemplated by the Purchase Agreement is conditioned upon the Employee entering into this Agreement and agreeing to the covenants contained herein; and WHEREAS, the Employee, in order to obtain the balance of the purchase price for the sale of the Company to CBNA, must be provided with necessary assurances that he would be given appropriate autonomy in directing the operations of the Company to the extent that such direction is in the shared interests of the Employee and CBNA to maximize the revenues and earnings of the Company. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants and agreements contained herein, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows: 1. Employment and Duties. On the terms and subject to the conditions set forth herein, the Company hereby employs the Employee to serve as the President, Chief Executive Officer and Chief Investment Officer of the Company. The Employee shall report to Michael A. Patton, Regional President/Trust Officer of CBNA or, in his absence, Sanford A. Belden, President and Chief Executive Officer of CBNA. The Employee shall perform the regular duties of his position and such other incidental and customary duties commensurate with his position, as well as any other duties consistent with his position, duties and responsibilities prior to the date of this Agreement, as from time to time reasonably assigned to the Employee by the Board of Directors of the Company, and have the requisite power and authority to fulfill his obligations which are consistent with his general authority, power, duties and responsibilities prior to the date of this Agreement. Additionally, Employee shall be requested to serve on the Board of Directors of the Company throughout his employment tenure. Consistent with his responsibilities prior to the date of the Agreement, Employee's duties shall include the oversight of overall direction of the Company, including serving as the Chief - 2 - Investment Officer and lead sales person for Company; the promotion and retention of client relationships; the training, selection and education of staff; administrative duties consistent with his position; and serving as lead person for business development and consideration of future acquisitions by the Company. The Employee shall perform his duties to the best of his abilities and devote his full working time and attention (except for reasonable activities with professional and civic organizations consistent with his position and past practice) to the business and affairs of the Company, and act in good faith in the Company's best interests but consistent with his objective of receiving the portion of the Purchase Price for the Shares that has been withheld pursuant to the Purchase Agreement. The Company shall maintain its principal office in the Amherst-Williamsville, New York area, and in no event will the Employee be required to relocate from that area without his consent, provided, that the Company may move its principal office in the greater Buffalo, New York area if there is a substantial business reason to do so. 2. Base Salary. The Employee shall receive a base salary of $300,000 per year, payable by the Company in accordance with its usual payroll policies for the term of this Agreement. The amount of base salary will be reviewed annually to determine any appropriate increases but will not be decreased during the term of this Agreement (as adjusted, the "Base Salary"). 3. Incentive Compensation. The Employee shall be entitled to receive incentive compensation in accordance with the following provisions: (a) Annual Incentive Bonus. The Employee shall be entitled to an annual incentive bonus during his employment under this Agreement based on a percentage of the Company's "Annual Adjusted Net Income" calculated as follows: - 3 - (i) For each fiscal calendar year including and following the Closing Date, the Company shall budget and allocate an amount equal to 40% of the "Gross Revenues of the Company" (defined below), which amount shall be available for distribution to the Company's parent ("CBNA Revenue Portion"); (ii) Upon the completion and delivery by independent auditors of Community Bank System, Inc., a Delaware corporation and the parent bank holding company of CBNA ("CBSI"), of the annual audited consolidated financial statements of CBSI and its subsidiaries (the "Audited Financial Statements") but no later than April 5th of each fiscal calendar year, Employee shall be entitled to an annual incentive bonus equal to the following percentages of the Company's "Annual Adjusted Net Income" (defined below): "Annual Adjusted Net Income" Employee CBNA (Parent) ---------------------------- -------- ------------- First $500,000 100% None Above $500,000 60% 40% Employee shall be deemed to have earned such bonuses, if at all, on the first day of the calendar fiscal year (or the first day immediately succeeding the applicable Interim Period) after the calendar fiscal year (or the Interim Period) to which each such bonus relates. If at any time during the term of this Agreement, there shall occur a substantial change in the business of the Company (including without limitation, as a result of any material corporate restructuring of the Company) as compared to the business conducted by it during the five-year period immediately preceding the Closing Date, which change as a whole Employee reasonably believes would materially and adversely affect the ability of the Employee to earn all or any - 4 - portion of the annual incentive bonuses, then CBNA and Employee shall negotiate in good faith for the determination of whether adjustments to the calculation of Annual Adjusted Net Income and the percentages in the table above to equitably account for any such change in the business of the Company are warranted and, if so, the amount of such adjustments, provided that no such adjustments, as a whole, shall adversely affect the ability of Employee to earn annual incentive bonuses in any material respects. In the event that the Company and Employee cannot agree on whether such an adjustment is warranted or on the amount of such adjustment within sixty (60) days of the consummation of such a substantial change, the dispute shall be submitted to a mutually acceptable nationally recognized independent accounting firm (other than a firm then used by the Company or Employee or their respective affiliates, unless otherwise agreed to by the parties) (the "Firm"). The parties shall instruct the Firm to determine, no later than sixty (60) days after submission, whether appropriate adjustments to the calculation of Annual Adjusted Net Income and the percentages in the table above are warranted and, if so, the amount of such adjustments, to equitably account for such change in the business of the Company. The determination of the Firm shall be binding upon the parties. The Employee and the Company shall each pay one-half of the fees and expenses of the Firm incurred in connection with such determination. In addition, in the event that, as a result of any such change in the business of the Company, the Company proposes to modify the duties and responsibilities of the Employee such that the Employee is reasonably expected to devote substantially more working time in his performance of such duties and responsibilities as compared to those before such modification, then the Company and Employee shall negotiate in good faith with respect to such modification - 5 - (and the Company shall not so modify except with the consent of the Employee) and, to the extent that Employee's duties and responsibilities hereunder are substantially modified, for adjustments to the Base Salary under this Agreement to properly compensate the Employee for such modification. (iii) "Annual Adjusted Net Income" for purposes on this Agreement shall mean the Company's net income as determined consistent with its past practice in connection with the preparation of its financial statements (subject to the change in the Company's accounting methods to the accrual basis and the related adjustments) in accordance with generally accepted accounting principles ("GAAP") consistently applied, but with the following adjustments being made: (1) A deduction shall be made in an amount equal to CBNA Revenue Portion (defined in Section 3(a)(i)) for the applicable fiscal year in calculating the Annual Adjusted Net Income; (2) No deduction will be made in the calculation of the net income (i) with respect to the amortization of goodwill or other intangible assets (if any) arising from, or costs incurred by the Company in connection with, the acquisition of the Company by CBNA, (ii) for income taxes applicable to the Company's operations, or (iii) for the accrual or payment of any annual incentive bonuses payable to Employee, or grant by CBSI of options or stock to Employee; (3) No expense will be charged in the calculation of net income with respect to premiums for key-man life and disability insurance policies; - 6 - (4) Only an amount equal to the incremental increase in policy premiums resulting from the extension of coverage under CBSI's D&O and professional liability insurance policies to directors, officers, and employees of the Company but in no event more than $5,500 per annum will be charged to the Company's net income during the first two years of this Agreement (thereafter, any increase in such amount shall be based solely upon loss experience and the growth of the business of the Company); and (5) No deduction shall be made for any inter-company charge made by CBNA (or any of its affiliates) to the Company, to the extent that such charge exceeds the arm's-length charge for the same or similar goods or services. (iv) "Gross Revenues of the Company" for purposes of this Agreement shall mean all revenues of the Company as determined in accordance with GAAP consistently applied, recognizing the need for transitional adjustments to be made by the parties in the first year in order to cause the accounting of the Company to conform to the requirements of GAAP. In determining Gross Revenues of the Company, reimbursement for closed accounts and fees paid in fee sharing arrangements shall be excluded. (v) Unless partially or fully deferred by Employee pursuant to Section 3(b) below, the annual incentive bonus determined above shall be paid to Employee no later than April 5th of the calendar year following the applicable calendar year of determination. (For example, the Annual Incentive Bonus for calendar year 2000 shall be paid no later than April 5, 2001.) (vi) Notwithstanding anything to the contrary in this Section, the amount of the annual incentive bonus, if any, with respect to (A) the period between the Closing - 7 - Date and the end of the calendar year in which the Closing takes place, or (B) except as otherwise expressly provided in this Agreement, any period during the term of this Agreement where the remaining term shall be less than a full calendar year (each period described in clause (A) or (B), an "Interim Period"), shall be determined by adjusting on a consistent basis all of the figures and parameters used in the calculation set forth in this Section, as well as the amount of annual incentive bonuses, on a pro rata basis, based upon the number of days in the Interim Period in question and 365 days per calendar year (366 days if any Interim Period shall occur in calendar year 2000 or 2004). (b) Deferral of Payments. At the option of Employee, he may elect to defer receipt of all or part of the annual incentive bonus determined in Section 3(a) by filing with Employer a written election to defer receipt of the bonus, provided that the written deferral election is received by the Company prior to the applicable year during which the bonus will be earned. (For example, to defer receipt of annual incentive bonus payable with respect to calendar year 2001, Employee must file a written deferral election with Employer prior to January 1, 2001.) Amounts deferred pursuant to this subsection may be invested in such vehicles and upon such terms as are generally available to senior management officers of CBNA or CBSI through its Deferred Compensation Plan for Executives. (c) Incentive Stock Options and Awards. The Employee shall participate in CBSI's 1994 Long-Term Incentive Compensation Program ("Program"), as amended or replaced from time-to-time and as administered by the Personnel Committee. Awards shall be made in such amounts and under such terms and conditions as determined solely by the Personnel Committee pursuant to the terms of the Program, and awards ordinarily will reflect Employee's - 8 - Base Salary in effect at the time of the award. Employee shall be eligible to receive stock options and other incentive compensation awards starting in January, 2001 consistent with the current administration of the Program. 4. Fringe Benefits. (a) Benefit Plans The Employee shall be entitled to participate in all standard employee benefit plans offered to full-time management employees of CBNA and CBSI. The Employee's eligibility for and participation in such plans shall be governed by and subject to the terms and conditions of the official plan documents of each plan except that for all purposes of this Agreement and for eligibility, vesting and benefit accruals under CBSI's and CBNA's employee benefit and welfare plans, Employee shall be given past service credit for previous service with the Company. (b) Expenses. The Company shall reimburse the Employee for reasonable business expenses incurred by the Employee in the performance of his duties hereunder upon submission of expense statements or vouchers and such other reasonable supporting information as may be required. Reimbursed expenses may be reviewed by the Company's Board of Directors on a quarterly basis. (c) Other Benefits. During the term of this Agreement, Employee shall also be entitled to receive the following benefits: (i) Paid vacation of four weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any public holidays provided to employees of the Company in accordance with its holiday policy; (ii) Reasonable sick leave; - 9 - (iii) Reimbursement of membership fees incurred by Employee at clubs to which Employee currently belongs, consisting of the Buffalo Club, Union Club of Cleveland (non-resident member fees only), Canterbury Golf Club (non-resident member fees only) and the Country Club of Buffalo; (iv) The use of a Company owned or leased automobile similar to his current vehicle, with the selection of a comparable replacement being subject to the consent of the President and CEO of CBSI; and (v) The rights to continue health coverage for the Employee and his spouse under the health insurance plan in effect prior to the date hereof, namely Traditional Blue Cross / Blue Shield. 5. Term and Termination. (a) The Employee's employment under the terms set forth shall commence on the date hereof and shall continue for a period of five (5) years; provided, however, that the Employee's employment shall terminate earlier upon the occurrence of (i) the Employee's death; (ii) the Employee's Disability (as defined below); (iii) the Company's termination of the Employee's employment for Cause (as defined below); (iv) the Company's termination of the Employee's employment without Cause, (v) the Employee's voluntary termination of his employment for any reason upon thirty (30) days' prior written notice to the Company; or (vi) Employee's termination for Good Reason (as defined below). (b) For purposes of this Agreement: (i) "Cause" means (A) the Employee's material breach of any material provision of this Agreement; (B) the Employee's fraud, dishonesty, theft or embezzlement - 10 - involving any material injury to the Company, including without limitation, its reputation; (C) the Employee's willful and knowing misconduct in performing his duties hereunder that results or could result in material harm to the Company; (D) the Employee's refusal to perform or substantial neglect of any duties hereunder; (E) the Employee's violation of any reasonable written directions of the Company's Board of Directors consistent with the terms of this Agreement; (F) knowing participation (whether before or after execution of this Agreement) in a violation of the Investment Advisers Act of 1940, as amended, or the rules and regulations thereunder, which results in material injury to the Company, including without limitation, its reputation, and/or (G) the Employee's indictment, conviction, guilty plea or plea of nolo contenders of a crime punishable as (1) a felony or misdemeanor involving conversion, misappropriation, larceny, theft, embezzlement or (2) any other felony which could reasonably be expected to cause a material injury to the Company (including without limitation, its reputation), in case of either clause (1) or (2), regardless of whether such crime involves the Company; provided, however, that the Company shall not be entitled to terminate the Employee for Cause under clauses (A), (C), (D) or (E) above unless it has provided the Employee with written notice specifying the nature of the activity or omission constituting Cause and the Employee has failed to commence, within 15 days after receipt of such notice, his good faith, reasonable effort to cure the same, or has failed to complete the cure within 60 days after receipt of such notice; it being understood that, with respect for any specific circumstance or fact constituting a reason for termination for Cause, the Company shall only be obligated to provide notice and an opportunity to cure only one time under this Agreement; and - 11 - (ii) "Disability" means (A) being declared physically or mentally disabled by either a disability insurance carrier which provides disability insurance for the Employee or by a licensed physician who has examined or is treating the Employee, and such disability continues for a total of 180 days in any 12-month period, and subject to any statutory duty to reasonably accommodate Employee's disability; or (B) the Employee being, for any physical or mental reason, unable to maintain full-time active participation in the Company's business for a total of 180 days in any 12-month period; provided, however, that nothing in this Agreement shall require, result in or permit termination by reason of Disability in violation of applicable law, including, without limitation, the Americans with Disabilities Act and any statutory duty to reasonably accommodate Employee's disability. (iii) "Good Reason" means resignation by the Employee based on the occurrence of one of the following events, in each case without the consent of Employee, with respect to which event Employee gave written notice of the existence of facts or circumstances forming the basis thereof, and the Company shall have failed to begin its good faith, reasonable efforts to cure the same within 15 days of receipt of the notice or failed to complete the cure within 60 days of the receipt of the notice: (A) a material change in the nature or scope of Employee's authority or responsibility (as compared to his authority or responsibility prior to such change) or removal from the Company's Board of Directors, or (B) a reduction in Employee's total compensation (including Base Salary, incentive bonus, and benefits) which Employee is entitled to under the term of this Agreement, or - 12 - (C) a change in the general location where employee is required to perform services, unless the location of the Company's principal offices is moved pursuant to Section 1, in which case the general location where Employee shall perform his duties and responsibilities under this Agreement shall be at the new location of such principal offices, or (D) any material breach of this Agreement by the Company, or (E) the relocation of the Company's principal office from Amherst-Williamsville, New York, except as permitted by Section 1; or (F) any diminution in the title of Employee, or (G) if Employee does not report directly to either Messrs. Belden or Patton, or neither of such persons hold executive positions with CBSI, CBNA or their respective successors, except as a result of the death of Messrs. Belden or Patton. (c) If Employee's employment is terminated pursuant to Section 5(a)(i), (ii), (iii) or (v), the Employee shall be paid hereunder only for the period up to the date of such termination (the "Termination Date") as well as compensation, including incentive bonuses, that is vested, accrued or earned and not previously paid and/or as provided in the benefit plans referred to in Section 4 above. (d) If Employee's employment is terminated by the Company without Cause pursuant to Section 5(a)(iv) or if Employee terminates his employment with the Company for Good Reason pursuant to Section 5(a)(vi), the Company shall, at its sole option, either (1) pay Employee severance pay equal to the Base Salary and Estimated Incentive Bonuses (as defined below) that Employee would have otherwise received during the remaining term of this Agreement (the "Severance Period"), which severance shall be paid commencing with the date of - 13 - termination at the times and in the amounts such Base Salary and annual incentive bonuses would have been paid in accordance with the Company's normal payroll practices or pursuant to this Agreement, or (2) the Company shall unconditionally release Employee from the obligations under Section 7(a) of this Agreement. As used in this Agreement, "Estimated Incentive Bonus" means the average annual incentive bonuses per annum paid by the Company to Employee in respect of the previously completed fiscal calendar year(s) or, if none, an amount provided in Section 6(a)(ii). Notwithstanding anything to the contrary, in the event that Employee shall breach Section 7 hereof, in addition to any other remedies the Company may have, all of the Company's obligations to make payments pursuant to this Section 5(d) shall cease and Employee's rights thereto shall immediately terminate and shall be forfeited in all respects. Payment made in accordance with this Section 5(d) shall operate to fully discharge and release the Company and its affiliates and agents from any further liability or obligation with respect to Employee's employment and termination of employment. The payment of amounts under this Section 5(d) shall be conditioned upon the delivery by the Employee to the Company of a release in form and substance reasonably satisfactory to the Company. 6. Change of Control. (a) In the event that Employee's employment with the Company is terminated during the term of this Agreement for Good Reason by Employee or without Cause by the Company, in each case within 2 years following a "Change of Control" (defined in Section 6(c) below), then, subject to the limitation in Section 6(b) below, the Company shall: (i) Pay the Employee an amount equal to 2.9 times his Base Salary in effect at the time of the Employee's termination under this Section 6(a); - 14 - (ii) Pay the Employee an amount equal to 2.9 times the average annual incentive bonus earned by Employee pursuant to Section 3(a) during the term of this Agreement prior to Employee's termination under this Section 6(a) (any annual incentive bonus earned with respect to an Interim Period shall be annualized on a per diem basis for the purposes of this Section 6(a)(ii)); provided, however, that if such termination occurs prior to July 1, 2002, the average annual incentive bonus shall be deemed to be THREE HUNDRED THOUSAND DOLLARS ($300,000) per annum; (iii) Provide Employee with benefits, or cash equivalent of such benefits, which were being provided to Employee for a period of 2 years following Employee's termination under this Section 6(a); and (iv) Fully vest, and treat as immediately exercisable, all unexpired stock options in CBSI common stock that are not otherwise exercisable or that have not been exercised. Amounts payable under this Section 6(a) shall be paid to Employee in a lump sum (subject to any applicable payroll or other taxes required to be withheld) as soon as practicable following his termination. (b) If any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this Section or otherwise), constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not - 15 - payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an Agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Section, then payment amounts shall be limited to the extent necessary to avoid application of Internal Revenue Code Section 280G. (c) For purposes of this Section, a "Change of Control" shall be deemed to have occurred if: (i) Any person, including a group as determined in accordance with Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of CBSI representing 30% or more of the combined voting power of CBSI's then outstanding securities; (ii) As a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of CBSI before the Transaction shall cease to constitute a majority of the Board of Directors of CBSI or any successor to CBSI; (iii) CBSI is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of CBSI (other than affiliates within the meaning of the Exchange Act, or any party to the merger or consolidation); (iv) A tender offer or exchange offer is made and consummated for the ownership of securities of CBSI representing 30% or more of the combined voting power of CBSI's then outstanding voting securities; - 16 - (v) CBSI transfers substantially all of its assets to another corporation that is not controlled by CBSI; or (vi) The control or ownership of a majority of the stock or substantial portion of the assets or business of the Company is transferred to an entity which is not controlled by or under common control of CBSI. (d) The Employee shall not be required to mitigate the amount of any payment provided for in this Agreement by seeking other employment or otherwise. The Change of Control payments provided for in this Section shall be in lieu of any and all other severance benefits which Employee might be entitled to under any severance policy applicable to employees of the Company in general. (e) The non-compete provisions of Section 7(a) shall not be applicable if Employee's employment with the Company is terminated by Employee for Good Reason or by the Company without Cause, in each case within 2 years of a Change of Control under Section 6(a). 7. Non-Competition and Non-Solicitation. (a) Non-Compete. The Employee agrees that during the term of this Agreement and (1) for a period of 12 months following the date of termination of his employment under this Agreement (the "Date of Termination") for any reason (other than for Good Reason, whether or not there was a Change of Control within 2 years thereof, or without Cause), (2) if Employee was terminated by the Company without Cause or if Employee terminated his employment hereunder for Good Reason, and in each case the Company elected to make payments under Section 5(d), then for a period equal to the duration of the Severance Period, or - 17 - (3) if the parties do not renew this Agreement, and the Employee ceases to be employed by the Company, then for so long as the Company is making severance payments under Section 12, the Employee shall not, directly or indirectly, own, manage, operate, control or participate in the ownership (except for an equity interest of less than 5% in a publicly traded entity, provided that he is not a director or officer thereof), management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the business conducted by the Company in any area or market where such business is being conducted on the Date of Termination, unless authorized in writing by the Board of Directors of CBNA; provided, however, if termination of his employment for any reason occurs after the fifth anniversary of the date of this Agreement, the covenant shall expire, unless otherwise expressly provided herein. If requested from time to time by the Board of Directors of the CBNA and to the extent reasonably necessary or desirable to determine the violation of this Section 7 by Employee, Employee shall inform the Board with respect to any activity, interest, or investment that he is aware of in a Competitive Operation within the banking or investment industry in reasonable detail. The parties agree that public speaking, writing and communications regarding investments and economic activities do not constitute per se a Competitive Operation, so long as Seller is not providing management, investment or advisory services to any other Person (as such term is defined in the Purchase Agreement) (other than tax-exempt not-for-profit organizations) which conducts any business similar to the business then conducted by the Company, without regard to the area or market in which such business is being conducted by such Person. - 18 - (b) Non-Soflicitation. The Employee shall not directly or indirectly (i) hire any employee of the Company, CBNA, or CBSI (or any affiliated entity of CBNA or CBSI), or induce or attempt to induce any such employee to leave the employ of his or her employer, or in any way interfere with the relationship between the Company, CBNA or CBSI, or affiliate of CBNA or CBSI and any employee thereof; or (ii) induce or attempt to induce any client, customer, supplier, licensee, licensor, distributor or other entity with a business relation with the Company to cease doing business with the Company or in any way interfere with the relationship between any such customer, supplier, licensee , distributor or business relation and the Company (including, without imitation, making any negative statements or communications about the Company) or, for a period of two (2) years after the termination of Employee's employment hereunder for any reason, directly or indirectly, conduct business in a Competitive Operation with any client or customer of the Company or any other prospective client or customer specifically and individually solicited by the Company (or its employees or agents) at any time during the one-year period immediately preceding the date of termination. For purposes of this Section 7(b)(i), Employee's spouse shall not be deemed an employee of the Company. (c) In the event of (i) a material breach by the Company of its obligations under this Agreement provided that the Employee has not materially breached this Agreement, and (ii) the Company's material breach is not cured within 30 days after the Company receives written notice from the Employee of such material breach (provided that if such material breach relates to the payment of compensation, the Company shall have only 3 days after its receipt of written notice from Employee to cure such breach), in each case after giving effect to any cure - 19 - period afforded to the Company with respect to such breached obligation under this Agreement, the Employee, in addition to all other remedies available to him, shall be relieved of his obligations under Section 7(a) with respect to any portion of the non-competition period, provided that any issue raised by the Company as to whether a material breach under this Section has occurred has been the subject of a final adjudication by expedited arbitration, pursuant to the rules of the American Arbitration Association for commercial arbitration. (d) The Employee acknowledges that the restrictions set forth in Section 7 are reasonable in scope and essential to the preservation of the operations and proprietary interests of the Company. (e) Nothing contained in this Agreement shall in any event limit the duration and enforceability of the non-competition provisions of the Purchase Agreement, which provisions were critical to the Company's determination to enter into the Purchase Agreement and to consummate the transactions contemplated by the Purchase Agreement. 8. Revision. If, at the time of enforcement of this Agreement, a court shall hold that the duration, scope, geographic area or other restrictions stated herein are unreasonable under circumstances then existing, the parties agree that the maximum duration, scope, geographic area or other restrictions deemed reasonable under such circumstances by such court shall be substituted for the stated duration, scope, geographic area or other restrictions. If the court shall hold that such a provision is wholly unenforceable, then such provision shall be severed from this Agreement, and the Agreement shall be enforced as if such provision never existed. 9. Remedies. The Employee recognizes and agrees that in the event of a breach of Section 7 of this Agreement, money damages would be inadequate and the Company would have - 20 - no adequate remedy at law. Accordingly, the Employee agrees that the Company shall have the right, in addition to any other rights and remedies existing in its favor, to enforce its rights and the Employee's obligations under this Agreement not only by an action or actions for damages, but also by an action or actions for specific performance, injunctive and/or other equitable relief, in either case without posting a bond or other security, in order to enforce or prevent any violations of Section 7 of this Agreement. 10. Key Man Life Insurance. CBNA has heretofore obtained key man life insurance coverage on the life of Employee, subject to the consummation of the transaction contemplated by the Purchase Agreement. Employee shall cooperate and take all necessary and appropriate actions to maintain such coverage during the term of this Agreement. The premiums for such insurance shall be borne by CBNA and not included as an expense of the Company in the calculation of "Annual Adjusted Net Income" as set forth in Section 3(a)(iii). 11. Rules, Regulations and Policies. The Employee shall abide by and comply with all reasonable rules, regulations and policies of the Company applicable to executives, including without limitation compliance with all laws and regulations to the extent the same are consistent with the terms of this Agreement. 12. Renewal. Beginning no later than six months prior to the expiration of this Agreement, the parties shall commence good faith negotiations, to be completed by the expiration of this Agreement, for the Employee's continued employment by the Company. If Employee and Company cannot agree on the terms of Employee's continued employment by the expiration of this Agreement, and Employee ceases to be employed by Company, Employee shall be entitled to be paid as severance compensation and as additional consideration for the non-compete - 21 - provisions set forth in Section 7 (the sufficiency of which is hereby acknowledged), one year of Base Salary based on the last full year of employment payable in equal installments in accordance with the Company's regular payroll practice over the year following termination of employment. In such event, the Employee shall also be entitled to receive an amount equal to one year of the Estimated Incentive Bonus, which amount shall be payable in a lump sum as soon as practicable after the termination of employment. If Employee's employment by Company is not continued after expiration of this Agreement as a result of Employee's decision not to accept a "bona fide offer" from Company, or Employee provides written notice of a lack of interest in extending the term of this Agreement, the Company shall not be obligated to continue to pay Employee's Base Salary as severance compensation. A "bona fide" offer from the Company shall be defined as a one year agreement with renewal option under substantially the same terms and substantially the same total compensation as provided for under the final year of this Agreement. Payments of Base Salary as severance compensation pursuant to this Section shall be reduced dollar for dollar to the extent Employee receives wages or self-employed income during the severance compensation period. For any period during which Employee's Base Salary is continued as severance compensation, Employee shall be eligible to continue to participate in Company's group-term life insurance plan and group health benefit plan as if Employee were an active, full-time employee of the Company. Employee's right to "COBRA" continuation coverage under Company's group health benefit plan shall commence as of the end of the period during which Base Salary is continued as severance compensation. - 22 - 13. Miscellaneous. (a) Assignment; Binding Agreement. This Agreement is personal to each of the parties hereto, and neither party may assign or delegate any of its rights or obligations hereunder without the prior written consent of the other party, except that the Agreement shall be binding upon both parties and inure to the benefit of the Company's successor through a merger or corporate reorganization. Subject to the foregoing, this Agreement shall be binding upon the parties hereto and their respective heirs, administrators, legal representatives, successors, and assigns. (b) Waiver. No delay or omission in the exercise of any right, power or remedy hereunder shall impair any such right, power or remedy or be construed to be a waiver or any default or any acquiescence therein. (c) Entire Agreement; Amendment. This instrument and the non-competition provisions set forth in the Purchase Agreement contain the entire agreement of the parties with regard to the subject matter hereof, and this Agreement may not be amended except by an agreement in writing signed by the parties hereto. (d) Notices and Other Communications. All notices or other communications hereunder shall be in writing and shall be deemed to have been duly given if delivered personally (including delivery by courier service), transmitted by telecopy, or mailed by registered or certified mail, postage prepaid, return receipt requested, as follows: (i) If to the Company or CBNA, notice shall be provided to the President and CEO of CBNA at: - 23 - Community Bank, NA 5790 Widewaters Parkway Dewitt, New York 13214 Telephone: (315) 445-2282 Facsimile: (315) 495-2997 Attention: Sanford A. Belden, President and CEO with a copy to: Bond, Schoeneck & King, LLP One Lincoln Center Syracuse, New York 13202 Attention: George J. Getman, Esq. Telephone: (315) 422-0121 Facsimile (315) 422-3598 (ii) If to the Employee, to: Mr. David Elias 31 Halston Parkway E. Amherst, New York 14051 Telephone: (716) 688-4491 Facsimile: same as above (call first) with a copy to: Phillips, Lytle, Hitchcock, Blaine & Huber LLP 3400 HSBC Center Buffalo, New York 14203 Attention: Frederick G. Attea, Esq. Telephone: (716) 847-8400 Facsimile: (716) 852-6100 or to such other address as the party to whom notice is to be given may have previously furnished to the other party in writing in accordance herewith. Notice shall be deemed given on the date received (or if receipt thereof is refused, on the date of such refusal). (e) Return of Property. Upon termination of this Agreement, Employee shall forthwith return to Employer all documents and other property of any nature belonging to the Company. - 24 - (f) Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York, without regard to its conflict of law rules. (g) Counterparts. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original but which together shall constitute one and the same agreement. IN WITNESS WHEREOF, the parties have duly executed this Agreement on the date first above written. EMPLOYEE: ______________________________________ David Elias COMMUNITY BANK, NA By: __________________________________ Name: Sanford A. Belden Title: President and CEO ELIAS ASSET MANAGEMENT INC. By: __________________________________ Name: David Elias Title: President and Chief Investment Officer - 25 - EX-23.1 14 d58827_ex23-1.txt CONSENT OF INDEPENDENT AUDITOR Exhibit 23.1 PRICEWATERHOUSECOOPERS [LOGO] - -------------------------------------------------------------------------------- PricewaterhouseCoopers LLP One Lincoln Center Syracuse NY 13202 Telephone (315) 474 8541 Facsimile (315) 473 1385 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (Nos. 333-61916, 333-61672, 333-17011, 333-16635, 033-60607) of Community Bank System, Inc. of our report dated January 26, 2004 relating to the financial statements, which appears in this Form 10-K. /s/ PricewaterhouseCoopers LLP Syracuse, New York March 11, 2004 EX-31.1 15 d58827_ex31-1.txt CEO CERTIFICATION Exhibit 31.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Sanford A. Belden, certify that: 1. I have reviewed this annual report on Form 10-K of Community Bank System, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15e and 15d-15e) for the registrant and we have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 12, 2004 /s/ Sanford A. Belden - --------------------- Sanford A. Belden, President, Chief Executive Officer and Director 75 EX-31.2 16 d58827_ex31-2.txt CFO CERTIFICATION Exhibit 31.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Mark E. Tryniski, certify that: 1. I have reviewed this annual report on Form 10-K of Community Bank System, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15e and 15d-15e) for the registrant and we have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Dated: March 12, 2004 /s/ Mark E Tryniski - -------------------------- Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer 76 EX-32.1 17 d58827_ex32-1.txt CEO CERTIFICATION Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Community Bank System, Inc. (the "Company") on Form 10-K for the year ended December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Sanford A. Belden, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Sanford A. Belden - --------------------------- Sanford A. Belden President, Chief Executive Officer and Director March 12, 2004 77 EX-32.2 18 d58827_ex32-2.txt CFO CERTIFICATION Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Community Bank System, Inc. (the "Company") on Form 10-K for the year ended March 15, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Mark E. Tryniski, Chief Operating Officer and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Mark E. Tryniski - ------------------------ Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer March 12, 2004 78 -----END PRIVACY-ENHANCED MESSAGE-----