-----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, NxFRVygwbvIsP9fTrEg+K5sQRdChnnLwJVCt/EXk7RfcupQ0Q+Vab9et5AJ9UAHi RdpqnaEgOLJYO21qEts74w== 0001169232-04-003885.txt : 20040804 0001169232-04-003885.hdr.sgml : 20040804 20040804164218 ACCESSION NUMBER: 0001169232-04-003885 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20040630 FILED AS OF DATE: 20040804 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13695 FILM NUMBER: 04952150 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-Q 1 d60258_10q.txt QUARTERLY REPORT United States SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2004 Commission file number 001-13695 [LOGO] COMMUNITY BANK SYSTEM, INC. (Exact name of registrant as specified in its charter) Delaware 16-1213679 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.) 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) 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 the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.). |X| Yes |_| No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). |X| Yes |_| No Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Common Stock, $1.00 par value - 30,574,561 shares outstanding as of July 27, 2004 TABLE OF CONTENTS Page ---- Part I. Financial Information Item 1. Financial Statements (Unaudited) Consolidated Statements of Condition June 30, 2004 and December 31, 2003 .............................. 3 Consolidated Statements of Income Three and six months ended June 30, 2004 and 2003 ................ 4 Consolidated Statement of Changes in Shareholders' Equity Six months ended June 30, 2004 ................................... 5 Consolidated Statements of Comprehensive Income Three and six months ended June 30, 2004 and 2003 ................ 6 Consolidated Statements of Cash Flows Six months ended June 30, 2004 and 2003 .......................... 7 Notes to the Consolidated Financial Statements June 30, 2004 .................................................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................................ 14 Item 3. Quantitative and Qualitative Disclosure about Market Risk ........ 31 Item 4. Controls and Procedures .......................................... 32 Part II. Other Information Item 1. Legal Proceedings ................................................ 33 Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases of Equity Securities ............................................. 33 Item 3. Defaults upon Senior Securities .................................. 33 Item 4. Submission of Matters to a Vote of Securities Holders ............ 33 Item 5. Other Information ................................................ 33 Item 6. Exhibits and Reports on Form 8-K ................................. 33 2 Part 1. Financial Information Item 1. Financial Statements COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CONDITION (Unaudited) (In Thousands, Except Share Data)
June 30, December 31, 2004 2003 - -------------------------------------------------------------------------------------------------------------- Cash and due from banks $101,410 $103,923 Available-for-sale investment securities 1,445,560 1,190,882 Held-to-maturity investment securities 138,793 138,652 - ------------------------------------------------------------------------------------------------------------ Total investment securities (fair value of $1,578,867 and $1,327,120, 1,584,353 1,329,534 respectively) Loans 2,346,735 2,128,509 Allowance for loan losses 32,040 29,095 - ------------------------------------------------------------------------------------------------------------ Net loans 2,314,695 2,099,414 Premises and equipment, net 63,899 61,705 Accrued interest receivable 28,071 25,851 Core deposit intangibles, net 37,803 33,998 Goodwill 190,732 159,596 Other intangibles, net 2,248 2,517 - ------------------------------------------------------------------------------------------------------------ Intangible assets, net 230,783 196,111 Other assets 34,543 38,859 - ------------------------------------------------------------------------------------------------------------ Total assets $4,357,754 $3,855,397 ============================================================================================================ Liabilities: Non-interest bearing deposits $547,632 $498,195 Interest bearing deposits 2,387,301 2,227,293 - ------------------------------------------------------------------------------------------------------------ Total deposits 2,934,933 2,725,488 Federal funds purchased 21,600 36,300 Borrowings 831,250 551,096 Subordinated debt held by unconsolidated subsidiary trusts 80,418 80,390 Accrued interest and other liabilities 48,156 57,295 - ------------------------------------------------------------------------------------------------------------ Total liabilities 3,916,357 3,450,569 - ------------------------------------------------------------------------------------------------------------ Commitment and contingencies (See Note H) Shareholders' equity: Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued Common stock, $1.00 par value, 50,000,000 shares authorized; 31,736,528 and 28,746,612 shares issued in 2004 and 2003, respectively 31,737 28,747 Additional paid-in capital 185,257 130,066 Retained earnings 232,410 218,628 Accumulated other comprehensive income 16,287 35,958 Treasury stock, at cost (1,119,287 and 416,300 shares, respectively) (23,850) (8,490) Employee stock plan - unearned (444) (81) - ------------------------------------------------------------------------------------------------------------ Total shareholders' equity 441,397 404,828 - ------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $4,357,754 $3,855,397 ============================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 3 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In Thousands, Except Per-Share Data)
Three Months Ended Six Months Ended June 30, June 30, ------------------- ------------------ 2004 2003 2004 2003 - ------------------------------------------------------------------------- ------------------- ------------------ Interest income: Interest and fees on loans $33,259 $30,986 $65,776 $62,201 Interest and dividends on taxable investments 13,149 11,362 25,371 23,736 Interest and dividends on non-taxable investments 5,728 4,671 10,910 9,353 - ------------------------------------------------------------------------- ------------------- ------------------- Total interest income 52,136 47,019 102,057 95,290 - ------------------------------------------------------------------------- ------------------- ------------------- Interest expense: Interest on deposits 8,521 9,933 17,155 20,569 Interest on federal funds purchased 101 84 187 169 Interest on short-term borrowings 1,176 344 2,211 821 Interest on subordinated debt held by unconsolidated subsidiary trusts 1,393 1,412 2,784 2,836 Interest on long-term borrowings 3,488 3,144 6,309 6,309 - ------------------------------------------------------------------------- ------------------- ------------------- Total interest expense 14,679 14,917 28,646 30,704 - ------------------------------------------------------------------------- ------------------- ------------------- Net interest income 37,457 32,102 73,411 64,586 Less: provision for loan losses 2,300 2,673 4,350 6,073 - ------------------------------------------------------------------------- ------------------- ------------------- Net interest income after provision for loan losses 35,157 29,429 69,061 58,513 - ------------------------------------------------------------------------- ------------------- ------------------- Non-interest income: Deposit service fees 6,201 5,740 11,985 10,945 Other banking services 246 475 896 1,344 Trust, investment and asset management fees 2,062 1,530 3,764 3,207 Benefit plan administration, consulting and actuarial fees 2,275 1,202 4,659 2,303 Gain (loss) on investment securities & debt extinguishment 135 0 145 (45) - ------------------------------------------------------------------------- ------------------- ------------------- Total non-interest income 10,919 8,947 21,449 17,754 - ------------------------------------------------------------------------- ------------------- ------------------- Operating expenses: Salaries and employee benefits 15,392 12,318 30,559 25,018 Occupancy 2,500 2,328 5,130 4,749 Equipment and furniture 2,150 1,977 4,302 3,881 Amortization of intangible assets 1,759 1,251 3,398 2,532 Legal and professional fees 970 859 1,967 1,578 Data processing 1,924 1,740 3,804 3,359 Office supplies 577 466 1,098 1,052 Acquisition expenses 411 5 1,381 5 Other 4,092 4,235 7,892 7,452 - ------------------------------------------------------------------------- ------------------- ------------------- Total operating expenses 29,775 25,179 59,531 49,626 - ------------------------------------------------------------------------- ------------------- ------------------- Income before income taxes 16,301 13,197 30,979 26,641 Income taxes 4,160 3,165 7,683 6,660 - ------------------------------------------------------------------------- ------------------- ------------------- Net income $12,141 $10,032 $23,296 $19,981 ========================================================================= =================== =================== Basic earnings per share $0.41 $0.38 $0.80 $0.77 Diluted earnings per share $0.40 $0.38 $0.77 $0.75 Dividends declared per share $0.16 $0.145 $0.32 $0.29
The accompanying notes are an integral part of the consolidated financial statements. 4 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) Six Months Ended June 30, 2004 (In Thousands, Except Share Data)
Common Stock Accumulated --------------------- Additional Other Employee Shares Amount Paid-In Retained Comprehensive Treasury Stock Plan Outstanding Issued Capital Earnings Income Stock -Unearned Total - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2003, as previously reported 14,165,156 $14,373 $144,440 $218,628 $35,958 ($8,490) ($81) $404,828 Two-for-one stock split 14,165,156 14,374 (14,374) 0 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2003, as restated 28,330,312 28,747 130,066 218,628 35,958 (8,490) (81) 404,828 Net income 23,296 23,296 Other comprehensive loss, net of tax (19,671) (19,671) Dividends declared: Common, $.32 per share (9,514) (9,514) Common stock issued under employee stock plan 397,703 398 3,064 (363) 3,099 Stock and options issued for acquisition 2,592,213 2,592 52,127 54,719 Treasury stock purchased (702,987) (15,360) (15,360) - ----------------------------------------------------------------------------------------------------------------------------------- Balance at June 30, 2004 30,617,241 $31,737 $185,257 $232,410 $16,287 ($23,850) ($444) $441,397 ===================================================================================================================================
See Note B "Stock Split" concerning two-for-one stock split. The accompanying notes are an integral part of the consolidated financial statements. 5 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (In Thousands)
Three Months Ended Six Months Ended June 30, June 30, --------------------- --------------------- 2004 2003 2004 2003 - --------------------------------------------------------------------------- --------------------- --------------------- Other comprehensive (loss) income, before tax: Change in minimum pension liability adjustment $0 $0 $0 $97 Unrealized (losses) gains on securities: Unrealized holding (losses) gains arising during period (51,231) 14,779 (32,174) 21,311 Reclassification adjustment for gains included in net income (135) 0 (145) 0 - --------------------------------------------------------------------------- --------------------- --------------------- Other comprehensive (loss) income, before tax (51,366) 14,779 (32,319) 21,408 Income tax benefit (expense) related to other comprehensive (loss) income 20,069 (5,756) 12,648 (7,521) - --------------------------------------------------------------------------- --------------------- --------------------- Other comprehensive (loss) income, net of tax (31,297) 9,023 (19,671) 13,887 Net income 12,141 10,032 23,296 19,981 - --------------------------------------------------------------------------- --------------------- --------------------- Comprehensive (loss) income ($19,156) $19,055 $3,625 $33,868 =========================================================================== ===================== =====================
The accompanying notes are an integral part of the consolidated financial statements. 6 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In Thousands)
Six Months Ended June 30, ------------------------- 2004 2003 - --------------------------------------------------------------------------------------------------------------- Operating activities: Net income $23,296 $19,981 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 3,960 3,482 Amortization of intangible assets 3,398 2,532 Net amortization of premiums and discounts on securities and loans 816 1,142 Amortization of unearned compensation and discount on subordinated debt 127 58 Provision for loan losses 4,350 6,073 (Gain) loss on investment securities and debt extinguishment (145) 45 Loss (gain) on loans and other assets 25 (470) Proceeds from the sale of loans held for sale 0 61,561 Origination of loans held for sale 0 (56,407) Change in other operating assets and liabilities 2,200 690 - --------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 38,027 38,687 - --------------------------------------------------------------------------------------------------------------- Investing activities: Proceeds from sales of available-for-sale investment securities 35,755 10,725 Proceeds from maturities of held-to-maturity investment securities 2,203 2,510 Proceeds from maturities of available-for-sale investment securities 94,383 130,816 Purchases of held-to-maturity investment securities (2,418) (2,459) Purchases of available-for-sale investment securities (373,771) (5,923) Net increase in loans outstanding (15,483) (60,643) Cash received for acquisition (net of cash paid of $7,026) 406 0 Capital expenditures (3,310) (3,352) - --------------------------------------------------------------------------------------------------------------- Net cash (used) provided by investing activities (262,235) 71,674 - --------------------------------------------------------------------------------------------------------------- Financing activities: Net change in demand deposits, NOW accounts, and savings accounts 40,373 65,859 Net change in time deposits (42,992) (29,241) Net change in federal funds purchased (14,700) (28,300) Net change in short-term borrowings 91,528 (110,000) Change in long-term borrowings (net of payments of $40 and $5) 169,002 (5,000) Issuance of common stock 3,005 1,509 Purchase of treasury stock (15,360) (1,209) Cash dividends paid (9,113) (7,535) Other financing activities (48) (77) - --------------------------------------------------------------------------------------------------------------- Net cash provided (used) by financing activities 221,695 (113,994) - --------------------------------------------------------------------------------------------------------------- Change in cash and cash equivalents (2,513) (3,633) Cash and cash equivalents at beginning of period 103,923 113,531 - --------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $101,410 $109,898 =============================================================================================================== Supplemental disclosures of cash flow information: Cash paid for interest $26,788 $29,968 Cash paid for income taxes $5,730 $6,946 Supplemental disclosures of non-cash financing and investing activities: Dividends declared and unpaid $4,930 $3,784 Gross change in unrealized (losses) gains on available-for-sale investment securities ($32,319) $21,311 Acquisition: Fair value of assets acquired, excluding acquired cash and intangibles $259,551 $0 Fair value of liabilities assumed $235,528 $0 Common stock and options issued $54,719 $0
The accompanying notes are an integral part of the consolidated financial statements. 7 COMMUNITY BANK SYSTEM, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) June 30, 2004 NOTE A: BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These financial statements may not include all information and footnotes necessary to constitute a complete set of financial statements under generally accepted accounting principles applicable to annual periods and accordingly should be read in conjunction with the financial information contained in the Form 10-K. Management believes these unaudited consolidated financial statements reflect all adjustments of a normal recurring nature which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period. NOTE B: ACQUISITION AND OTHER MATTERS First Heritage Bank On May 14, 2004, the Company acquired First Heritage Bank ("Heritage"), a closely held bank headquartered in Wilkes-Barre, Pa with three branches in Luzerne County, Pennsylvania. First Heritage's three branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration included 2,592,213 shares of common stock with a fair value of $52 million, stock options with a fair value of $3.0 million, and $6.0 million of cash. The results of Heritage's operations have been included in the consolidated financial statements since that date. The estimated purchase price allocation of the assets acquired and liabilities assumed, including capitalized acquisition costs is as follows: (000's omitted) - ----------------------------------------------------- Cash and due from banks $7,432 Available-for-sale investment securities 43,811 Loans, net of allowance for loan losses 204,120 Premises and equipment, net 3,074 Other assets 1,114 Goodwill 30,788 Core deposit intangibles 6,934 - ----------------------------------------------------- Total assets acquired 297,273 Deposits 212,064 Borrowings 19,672 Other liabilities 3,792 - ----------------------------------------------------- Total liabilities assumed 235,528 - ----------------------------------------------------- Net assets acquired $61,745 ===================================================== Stock Repurchase Program On May 21, 2004, the Company announced the continuation of a stock repurchase program previously announced in June 2003. The program provides for the repurchase of up to 1,400,000 outstanding shares in open market or privately negotiated transactions through June 2005. The repurchases will be for general corporate purposes, including those related to acquisition and stock plan activities. As of June 30, 2004, the Company has purchased 1,119,287 shares at an aggregate cost of $23.9 million and an average price per share of $21.31. Stock Split At a special meeting of the shareholders held on March 26, 2004, the shareholders approved an amendment to the certificate of incorporation of the Company to increase the number of authorized shares of common stock to 50 million. This amendment was effected in connection with the previously announced two-for-one stock split of the Company's common stock. The stock split was effected in the form of a 100 percent stock dividend, and was paid on April 12, 2004 to shareholders of record on March 17, 2004. Accordingly, all share, option and per-share amounts have been adjusted in the consolidated financial statements to reflect the stock split. 8 NOTE C: ACCOUNTING POLICIES Critical Accounting Policies Allowance for Loan Losses Management continually evaluates the credit quality of its loan portfolio, and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis. The allowance reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. The Company's allowance methodology consists of two broad components. The first component includes a determination of estimated general losses in accordance with SFAS No. 5, "Accounting for Contingencies". This general allowance component reflects inherent probable losses related to pools of homogeneous loans that are evaluated collectively, including consumer mortgage loans, consumer direct and indirect loans, and business loans that are not impaired. Allowance levels for these loan pools are based principally on historical loss factors, as well as qualitative factors that are expected to affect loss experience, including delinquency, underwriting and economic trends and conditions. The second component of the allowance reflects specific losses related to individual business loans that are both greater than $500,000 and in a non-accruing status with respect to interest. Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral. 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. Intangible Assets Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 7 to 20 years. Goodwill is evaluated at least annually for impairment. 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 use of 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. Retirement Benefits The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. 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, including discount rate, rate of future compensation increases and expected return on plan assets. 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: 9 2004 2003 - ---------------------------------------------------------------------- Weighted-average expected life 7.79 8.43 Future dividend yield 3.00% 3.00% Share price volatility 25.47%-25.59% 27.42% Weighted average risk-free interest rate 4.02%-4.05% 4.03% ====================================================================== 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 periods shown below may not be indicative of the pro forma impact in future years.
Three Months Ended Six Months Ended June 30, June 30, -------------------------------------------------- (000's omitted except per share amounts) 2004 2003 2004 2003 - --------------------------------------------------------------------------------------------------------------- Net income, as reported $12,141 $10,032 $23,296 $19,981 Less: stock-based compensation expense determined under fair value method, net of tax 207 162 625 454 - --------------------------------------------------------------------------------------------------------------- Pro forma net income $11,934 $9,870 $22,671 $19,527 =============================================================================================================== Earnings per share: As reported: Basic $0.41 $0.38 $0.80 $0.77 Diluted $0.40 $0.38 $0.77 $0.75 Pro forma: Basic $0.40 $0.38 $0.78 $0.75 Diluted $0.39 $0.37 $0.75 $0.73 ===============================================================================================================
As of June 30, 2004 there were 2,692,955 stock options granted and outstanding. New Accounting Pronouncements 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 that sponsor post-retirement benefit plans that provide prescription drug coverage. In May 2004, the Financial Accounting Standards Board ("FASB") issued Staff Position No. FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." This staff position provides guidance on accounting for the effects of the new Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D. It also contains basic guidance on related income tax accounting and complex rules for transition that permit various alternative prospective and retroactive transition approaches. This guidance is effective for the third quarter of 2004. The Company's accumulated benefit obligation and net periodic benefit cost do not reflect an amount associated with this subsidy because it has not yet determined if its plan provides a drug benefit that is actuarially equivalent to the Medicare Part D benefit. 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. In March 2004, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments." This staff accounting bulletin deals with loan commitments a Company originates with the intention of selling. It requires that fair-value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. The Company periodically enters into such commitments with customers in connection with residential mortgage lending. The Company has not sold any of its originated loans during 2004 and thus this standard does not have any impact on its financial condition or results of operations. In March 2004, the FASB issued an exposure draft, "Share-Based Payment: an amendment of FASB No. 123 and 95." This proposed Statement addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. This proposed Statement would eliminate the accounting for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees," and generally would require instead that such transactions be accounted for using a fair-value-based method. A final statement is expected to be issued during the fourth quarter of 2004 and will be effective as of January 1, 2005. Management does not expect the impact of the adoption of this exposure draft to be materially different from the pro forma impacts disclosed under SFAS No. 123. 10 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 standard 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 interim disclosure provisions of this statement as of March 31, 2004 (see Note G). NOTE D: 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 of accounting. The treasury stock method determines the number of common shares that would be outstanding if all the dilutive 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 435,868 and 307,492 anti-dilutive stock options outstanding as of June 30, 2004 and 2003, respectively. The following is a reconciliation of basic to diluted earnings per share for the three and six months ended June 30, 2004 and 2003. Per Share (000's omitted, except per share data) Income Shares Amount - ------------------------------------------------------------------------- Three Months Ended June 30, 2004 Basic EPS $12,141 29,821 $0.41 Stock options 849 - ------------------------------------------------------------- Diluted EPS $12,141 30,670 $0.40 ============================================================= Three Months Ended June 30, 2003 Basic EPS $10,032 26,113 $0.38 Stock options 580 - ------------------------------------------------------------- Diluted EPS $10,032 26,693 $0.38 ============================================================= Six Months Ended June 30, 2004 Basic EPS $23,296 29,200 $0.80 Stock options 916 - ------------------------------------------------------------- Diluted EPS $23,296 30,116 $0.77 ============================================================= Six Months Ended June 30, 2003 Basic EPS $19,981 26,085 $0.77 Stock options 506 - ------------------------------------------------------------- Diluted EPS $19,981 26,591 $0.75 ============================================================= NOTE E: INTANGIBLE ASSETS The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:
As of June 30, 2004 As of December 31, 2003 ------------------------------------ ------------------------------------ Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying (000's omitted) Amount Amortization Amount Amount Amortization Amount - -------------------------------------------------------------------------- ------------------------------------ Amortizing intangible assets: Core deposit intangibles $62,389 ($24,586) $37,803 $55,455 ($21,457) $33,998 Other intangibles 2,750 (502) 2,248 2,750 (233) 2,517 - -------------------------------------------------------------------------- ------------------------------------ Total amortizing intangibles 65,139 (25,088) 40,051 58,205 (21,690) 36,515 Non-amortizing intangible assets: Goodwill 190,732 0 190,732 159,596 0 159,596 - -------------------------------------------------------------------------- ------------------------------------ Total intangible assets, net $255,871 ($25,088) $230,783 $217,801 ($21,690) $196,111 ========================================================================== ====================================
11 As described in Note B, the increases in the gross carrying amount of core deposit intangibles and goodwill primarily reflect to the May 2004 acquisition of First Heritage Bank. No goodwill impairment adjustments were recognized in 2004 and 2003. The estimated aggregate amortization expense for each of the succeeding fiscal years ended December 31 is as follows: (000's omitted) Amount - ----------------------------- July-Dec 2004 $4,016 2005 6,953 2006 5,794 2007 5,440 2008 5,154 Thereafter 12,694 - ----------------------------- Total $40,051 ============================= NOTE F: SUBORDINATED DEBT 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 securities is owned by the Company. In accordance with FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51", these business trusts are not consolidated with the financial statements of 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 and were $82,439,000 and $82,410,000 at June 30, 2004 and December 31, 2003, respectively. 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 million 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017 II 7/16/2001 $25 million Six-month LIBOR plus 3.75% 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011 III 7/31/2001 $24.45 million Three-month LIBOR plus 3.58% 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011 ====================================================================================================================================
NOTE G: BENEFIT PLANS The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides supplemental pension retirement benefits for several current and former key employees. The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits. The components of the net periodic benefit cost are as follows:
Pension Benefits Post-retirement Benefits -------------------------------------------- ----------------------------------------- Three Months Ended Six Months Ended Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, -------------------- -------------------- ------------------- ------------------- (000's omitted) 2004 2003 2004 2003 2004 2003 2004 2003 - ------------------------------------------------------------ -------------------- ------------------- ------------------- Service cost $480 $356 $960 $711 $69 $45 $156 $90 Interest cost 592 471 1,184 943 92 63 163 127 Expected return on plan assets (790) (642) (1,580) (1,284) 0 0 0 0 Net amortization and deferral 218 216 436 431 13 0 18 0 Amortization of prior service cost 107 (8) 213 (16) 1 8 15 15 Amortization of transition obligation 0 (1) 0 (2) 10 10 20 21 - ------------------------------------------------------------ -------------------- ------------------- ------------------- Net periodic benefit cost $607 $392 $1,213 $783 $185 $126 $372 $253 ============================================================ ==================== =================== ===================
12 Supplemental Benefits --------------------------------------- Three Months Ended Six Months Ended June 30, June 30, ------------------ ------------------ (000's omitted) 2004 2003 2004 2003 - ----------------------------------------------------------- ------------------ Service cost $88 $33 $175 $65 Interest cost 39 47 78 95 Expected return on plan assets 0 0 0 0 Net amortization and deferral 44 25 89 49 Amortization of prior service cost (34) 40 (68) 81 Amortization of transition obligation 0 0 0 0 - ----------------------------------------------------------- ------------------ Net periodic benefit cost $137 $145 $274 $290 =========================================================== ================== The Company does not anticipate making a contribution to its defined benefit plan in 2004. NOTE H: 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 an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The fair value of these commitments is immaterial for disclosure in accordance with FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". The contract amount of commitment and contingencies are as follows: June 30, December 31, (000's omitted) 2004 2003 - ------------------------------------------------------------ Commitments to extend credit $430,600 $315,898 Standby letters of credit 21,093 19,163 - ------------------------------------------------------------ Total $451,693 $335,061 ============================================================ 13 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction 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. ("the Company" or "CBSI") for the three and six months ended June 30, 2004 and 2003, although in some circumstances the first quarter of 2004 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 13 and the Annual Report on Form 10-K for the year ended December 31, 2003. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole. All references to "peer banks", unless otherwise noted, 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 three months ending March 31, 2004 (the most recently available disclosure) as provided by the Federal Reserve Board in the Bank Holding Company Performance Report. Unless otherwise noted, the term "this year" refers to results in calendar year 2004, "second quarter" refers to the quarter ended June 30, 2004, earnings per share ("EPS") figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. All common share and common share-based amounts reflect the two-for-one stock split effected as a 100% stock dividend on April 12, 2004. This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 29. 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 critical accounting estimates include: o Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. 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. 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 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 use of 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" on pages 61 - 67 of the most recent Form 10-K (fiscal year ended December 31, 2003). 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 branch network operates in New York as Community Bank, N.A., and in Pennsylvania as First Liberty Bank & Trust. The Company 14 also operates five financial services businesses, which provide a broad array of wealth management and benefits administration and consulting services to bank and non-bank customers. The Company's core operating objectives are to: (i) grow the branch network, primarily through a disciplined acquisition and de novo 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 advancements, market share, peer comparisons, and the performance of acquisition and integration activities. Second quarter and June year-to-date ("YTD") earnings per share were both $0.02 above their respective prior year periods, as higher net interest income and non-interest income and a lower loan loss provision were partially offset by higher operating expenses and a greater number of common shares outstanding. On an operating basis (see Table 1 and related narrative), second quarter and June YTD return on assets were equivalent to the same periods of 2003, while return on equity declined slightly due to higher capital levels. Excluding acquisition activity, revenue generated by the financial services businesses was up for the current quarter and first six months of the year, as a result of strong revenue growth at all of the units. Operating expenses for the quarterly and YTD periods increased primarily due to acquisitions and higher compensation and benefits costs. The efficiency ratio for the second quarter improved as a result of net interest income and recurring non-interest income growing at a faster pace than operating expenses (excluding acquisition costs and intangible amortization). The YTD efficiency ratio was up marginally year-over-year, mostly due to the percentage growth of net interest income being slightly below that of operating expenses. Asset quality improved over the last year, with reductions in delinquency, net charge-off and non-performing loan ratios. Excluding acquisition activity, the Company experienced strong year-over-year loan growth in consumer mortgage and indirect lending, with slight declines in the business and consumer direct portfolios. On a geographical basis, loan growth in the New York markets mirrored the results for the Company, with the Pennsylvania markets reporting an increase in consumer indirect loans and declines in other portfolios. Excluding acquisitions, total average deposits for the quarter and first six months of 2004 declined slightly from the levels that existed for the same periods last year. On May 14, 2004, the Company completed its acquisition of First Heritage Bank ("First Heritage"), a $275 million-asset, three-branch commercial bank based in Wilkes-Barre, PA. The Company completed three acquisitions in 2003, including: (1) Harbridge Consulting Group ("Harbridge"), an actuarial and benefits consulting firm based in Syracuse, NY that was acquired from PricewaterhouseCoopers in July, (2) Peoples Bankcorp Inc. ("Peoples"), a $29 million-asset single branch bank in Ogdensburg, NY acquired in September, and (3) Grange National Banc Corp. ("Grange"), a $280 million-asset bank with twelve branches in five counties of Northeastern PA, acquired in November. Net Income and Profitability As shown in Table 2, second quarter and June YTD earnings per share of $0.40 and $0.77, respectively, were $0.02 higher than the EPS generated in the same periods of last year. Net income for the quarter of $12.1 million was up 21% over second quarter 2003, and net income of $23.3 million for the first six months of 2004 increased 17% from the amount earned in the equivalent period of last year. Net interest income for the second quarter of $41.1 million and $80.4 million for the first half of 2004, were up 17% and 14.0% from their respective prior year periods. Second quarter non-interest income (excluding net gains from investment securities sales and debt prepayment costs) of $10.8 million was up 21% from second quarter 2003, and the YTD amount of $21.3 million rose 20% from the prior year level. Operating expenses of $29.8 million for the quarter and $59.5 million for the first six months of 2004 were up 18% and 20%, respectively, from the equivalent periods of 2003, a portion of which related to acquisition expenses that rose $0.4 million for the quarter and $1.4 million on a YTD basis. In addition to the earnings results presented above in accordance with generally accepted accounting principles ("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. Operating earnings per share for the second quarter were $0.40, up 5.3% from the $0.38 reported in the equivalent period of 2003. On a year-to-date basis, operating EPS of $0.80 increased $0.05 or 6.7% versus the first six months of 2003. As reflected in Table 2, the primary reasons for the improved earnings for both time periods were higher net interest income and non-interest income and a lower 15 loan loss provision, offset by higher operating expenses and an increased level of weighted average diluted shares. Net interest income increased because of higher earning-asset levels derived from the acquisitions of Peoples, Grange and First Heritage, organic consumer mortgage and indirect loan growth, and investment leverage. The increase in non-interest income for both time frames was mostly attributable to incremental revenue from Harbridge, strong growth at the other financial services units, and additional banking fees generated in the 16 branches added through the three whole-bank acquisitions. A significant decrease in net charge-offs and general improvement in other asset quality metrics were the primary drivers of the decrease in the loan loss provision, despite a significant increase in the size of the total loan portfolio. The quarterly and YTD performance improvements were partially offset by a growth in operating expenses, in most part due to the four acquisitions made in the intervening time period, as well as higher compensation and benefit expenses. A reconciliation of GAAP-based earnings results to operating-based earnings results and a condensed income statement are as follows: Table 1: Reconciliation of GAAP Net Income to Operating Net Income
Three Months Ended June 30, Six Months Ended June 30, --------------------------- ------------------------- (000's omitted) 2004 2003 2004 2003 - ----------------------------------- -------------------------- ------------------------- Net income $12,141 $10,032 $23,296 $19,981 After-tax operating adjustments: Net securities (gains)/losses (82) 0 (89) 0 Debt prepayment costs 0 0 0 27 Acquisition expenses 252 3 847 3 - ----------------------------------- -------------------------- ------------------------- Net income - operating $12,311 $10,035 $24,054 $20,011 =================================== ========================== =========================
Table 2: Summary Income Statements
Three Months Ended June 30, Six Months Ended June 30, --------------------------- --------------------------- (000's omitted, except per share data) 2004 2003 2004 2003 - ----------------------------------------------------------- --------------------------- --------------------------- Net interest income (FTE) $41,083 $35,064 $80,372 $70,528 Loan loss provision 2,300 2,673 4,350 6,073 Non-interest income 10,784 8,947 21,304 17,799 Gain (loss) on investment securities & debt extinguishment 135 0 145 (45) Operating expenses 29,364 25,174 58,150 49,621 Acquisition expenses 411 5 1,381 5 - ----------------------------------------------------------- --------------------------- --------------------------- Income before taxes (FTE) 19,927 16,159 37,940 32,583 Fully tax-equivalent adjustment 3,626 2,962 6,961 5,942 Income taxes 4,160 3,165 7,683 6,660 - ----------------------------------------------------------- --------------------------- --------------------------- Net income $12,141 $10,032 $23,296 $19,981 =========================================================== =========================== =========================== Diluted earnings per share $0.40 $0.38 $0.77 $0.75 Diluted earnings per share-operating $0.40 $0.38 $0.80 $0.75
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 shown in Table 3, net interest income (with non-taxable income converted to a fully tax-equivalent basis) for second quarter 2004 was $41.1 million, up $6.0 million or 17% from the same period last year. A $715 million increase in average earning-assets more than offset $611 million higher interest-bearing liabilities and a 25-basis point decrease in the net interest margin. As reflected in Table 4, the volume changes mentioned above drove net interest income to rise $8.1 million, while the lower net interest margin had a lesser $2.1 million negative impact on net interest income. June 2004 YTD net interest income of $80.4 million was up $9.8 million or 14.0% from the year-earlier period. A $548 million increase in average earning-asset levels had a greater positive effect than a $455 million rise in interest-bearing liabilities and a 19-basis point decline in the net interest margin. Interest-bearing asset and liability volume changes resulted in $12.6 million more net interest income, partially offset by a lower net interest margin that had a negative $2.7 million impact on net interest income. Higher second quarter and June YTD average loan balances were primarily attributable to the $393 million of loans acquired in the three bank transactions and $96 million of organic loan growth over the past 12 months, driven principally by strong consumer 16 mortgage demand. Average investments (book value basis) rose $326 million for the second quarter and $202 million for the YTD period in comparison to the same periods of last year. The Company made a substantial amount of security purchases in the third quarter of 2003 and second quarter of 2004 to enhance its interest rate sensitivity and earnings profile. Investments were at below average levels in the first half of 2003 because the Company had instituted a de-leveraging strategy from third quarter 2002 through second quarter 2003, whereby proceeds from the run-off of investment securities were used to pay down borrowings until more favorable investment market conditions arose. Total average deposits were up 13.5% and 10.9% for the quarter and YTD periods in relation to the previous year, respectively, principally due to the deposits added through the Peoples, Grange and First Heritage acquisitions. External borrowings were increased to fund organic loan growth and investment purchases over the last 12 months, resulting in average borrowings that were up $365 million for the quarter and $261 million for the first half of 2004 in comparison to the year-earlier periods. The 4.49% net interest margin in the second quarter dropped 25 basis points versus the same quarter last year, and the June YTD margin of 4.58% was down 19 basis points from the prior year. These declines were primarily attributable to the reduced level of interest rates over the last 12 months having a greater impact on earning-asset yields (quarter down 66 basis points, YTD down 64 basis points), than on the cost of funds (quarter down 41 basis points, YTD down 44 basis points). The reduction of earning-asset yields was mostly driven by declines in loan yields of 77 basis points for the quarter and 80 basis points for the YTD period. Loan originations over much of the last year were at rates that reflected the record-low rates prevalent in the market at the time, particularly in the mortgage, home equity and auto financing businesses. Investment portfolio yields were comparatively more stable (down 50 basis points for the quarter and 37 basis points YTD), as they benefited from significant call protection and investment purchases that were concentrated in periods of higher long-term rates. The Company's net interest margin for the first three months of 2004 was 70 basis points above the average for peer companies, driven by a very favorable earning-asset yield (+85 basis points), partially offset by a slightly higher ratio of interest expense to average earning assets (+15 basis points). The second quarter cost of funds was down versus the same quarter of 2003 due to a 39-basis point drop in deposit costs and a 155-basis point decline in the average interest rate paid on external borrowings. The decline in the YTD costs of funds was driven by a 41-basis point fall in deposit costs and borrowing rates that were down 130 basis points. The deposit costs for both time periods were impacted to the greatest extent by time deposits rolling-over at lower current rates, but were also favorably affected by an increase in the percentage of deposit funding provided by demand deposits and a decline in the proportion of time deposits. The improvement in borrowing costs for the quarterly and YTD periods was primarily driven by a shift in the mix of external funding from higher-rate, longer-term borrowings to low-rate, short-term debt. A portion of this change was contributed by the prepayment of $25 million of longer-term FHLB obligations in the fourth quarter of 2003, which were replaced with short-term borrowings at much lower rates. The shift in the profile of borrowings not only lowered funding costs, but also serves to reduce the Company's risk exposure to falling interest rates. In addition, a significant amount of intermediate-term borrowings at favorable rates were added in the current quarter to fund investment purchases and organic loan growth, further reducing the overall borrowing rate due to their below-average cost. 17 Table 3 and 3A below sets forth information relating to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using a marginal income tax rate of 38.70% in 2004 and 38.94% in 2003. Average balances are computed by summing the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include non-accrual loans. Table 3: Quarterly Average Balance Sheet
Three Months Ended Three Months Ended (000's omitted except yields and rates) June 30, 2004 June 30, 2003 - ---------------------------------------------------------------------------------------------- ----------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid ----------------------------------- ----------------------------------- Interest-earning assets: Time deposits in other banks $629 $1 0.64% $219 $1 1.83% Taxable investment securities (2) 948,470 13,526 5.74% 727,936 11,608 6.40% Non-taxable investment securities (2) 506,950 8,881 7.05% 401,535 7,229 7.22% Loans (net of unearned discount)(1) 2,222,827 33,354 6.04% 1,834,610 31,143 6.81% ---------------------- ---------------------- Total interest-earning assets 3,678,876 55,762 6.10% 2,964,300 49,981 6.76% Non-interest earning assets 467,079 395,627 ---------- ---------- Total assets $4,145,955 $3,359,927 ========== ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $1,122,467 1,512 0.54% $984,553 1,800 0.73% Time deposits 1,197,563 7,009 2.35% 1,088,845 8,133 3.00% Short-term borrowings 416,767 1,277 1.23% 132,775 428 1.29% Long-term borrowings 376,350 4,881 5.22% 295,533 4,556 6.18% ---------------------- ---------------------- Total interest-bearing liabilities 3,113,147 14,679 1.90% 2,501,706 14,917 2.39% Non-interest bearing liabilities: Demand deposits 550,683 456,176 Other liabilities 51,465 59,214 Shareholders' equity 430,660 342,831 ---------- ---------- Total liabilities and shareholders' equity $4,145,955 $3,359,927 ========== ========== Net interest earnings $41,083 $35,064 ========== ========== Net interest spread 4.20% 4.37% Net interest margin on interest-earnings assets 4.49% 4.74% Fully tax-equivalent adjustment on investments and loans $3,626 $2,962
(1) The impact of interest not recognized on non-accrual loans 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 Table 3A: Year to Date Average Balance Sheet
Six Months Ended Six Months Ended (000's omitted except yields and rates) June 30, 2004 June 30, 2003 - ---------------------------------------------------------------------------------------------- ----------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid ----------------------------------- ----------------------------------- Interest-earning assets: Time deposits in other banks $716 $2 0.56% $221 $1 0.91% Taxable investment securities (2) 882,585 26,121 5.95% 758,775 24,234 6.44% Non-taxable investment securities (2) 479,943 16,920 7.09% 402,003 14,466 7.26% Loans (net of unearned discount)(1) 2,167,108 65,975 6.12% 1,821,323 62,531 6.92% ---------------------- ---------------------- Total interest-earning assets 3,530,352 109,018 6.21% 2,982,322 101,232 6.85% Non-interest earning assets 463,177 393,366 ---------- ---------- Total assets $3,993,529 $3,375,688 ========== ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $1,088,502 3,057 0.56% $985,617 3,734 0.76% Time deposits 1,185,501 14,098 2.39% 1,094,934 16,835 3.10% Short-term borrowings 386,465 2,398 1.25% 151,950 990 1.31% Long-term borrowings 323,414 9,093 5.65% 296,653 9,145 6.22% ---------------------- ---------------------- Total interest-bearing liabilities 2,983,882 28,646 1.93% 2,529,154 30,704 2.45% Non-interest bearing liabilities: Demand deposits 535,770 452,717 Other liabilities 53,139 57,613 Shareholders' equity 420,738 336,204 ---------- ---------- Total liabilities and shareholders' equity $3,993,529 $3,375,688 ========== ========== Net interest earnings $80,372 $70,528 ========== ========== Net interest spread 4.28% 4.40% Net interest margin on interest-earnings assets 4.58% 4.77% Fully tax-equivalent adjustment $6,961 $5,942
(1) The impact of interest not recognized on non-accrual loans 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. 19 As discussed above and disclosed in Table 4 below, the year-over-change in quarterly and YTD 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 4: Rate/Volume
2nd Quarter 2004 versus 2nd Six Months Ended June 30, Quarter 2003 2004 versus 2003 Increase (Decrease) Due to Increase (Decrease) Due to Change in (1) Change in (1) ------------------------------- ------------------------------- Net Net (000's omitted) Volume Rate Change Volume Rate Change - ---------------------------------------------------------------------------------------- ------------------------------- Interest earned on: Time deposits in other banks $1 ($1) $0 $2 ($1) $1 Taxable investment securities 3,241 (1,323) 1,918 3,754 (1,867) 1,887 Non-taxable investment securities 1,851 (199) 1,652 2,753 (299) 2,454 Loans (net of unearned discount) 6,096 (3,885) 2,211 11,030 (7,586) 3,444 Total interest-earning assets (2) $11,191 ($5,410) $5,781 $17,476 ($9,690) $7,786 Interest paid on: Interest checking, savings and money market deposits $229 ($517) ($288) $365 ($1,042) ($677) Time deposits 757 (1,881) (1,124) 1,308 (4,045) (2,737) Short-term borrowings 871 (22) 849 1,457 (49) 1,408 Long-term borrowings 1,121 (796) 325 788 (840) (52) Total interest-bearing liabilities (2) $3,235 ($3,473) ($238) $4,987 ($7,045) ($2,058) Net interest earnings (2) $8,069 ($2,050) $6,019 $12,558 ($2,714) $9,844
(1) The change in interest due to both rate and volume has been allocated 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 and are not a summation of the changes of the components. 20 Non-interest Income The Company's sources of non-interest income are of three primary types: 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), actuarial and employee benefit 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 5: Non-interest Income
Three Months Ended June 30, Six Months Ended June 30, --------------------------- ------------------------- (000's omitted) 2004 2003 2004 2003 -------------------------------------------------------- --------------------------- ------------------------- Banking services: Electronic banking $626 $617 $1,155 $1,163 Mortgage banking 4 268 261 957 Deposit service charges 1,355 1,345 2,692 2,641 Overdraft fees 3,682 3,391 7,134 6,301 Credit life and disability insurance 86 65 141 126 Commissions and other fees 611 459 1,197 1,005 Miscellaneous 83 70 301 96 -------------------------------------------------------- --------------------------- ------------------------- Total banking services 6,447 6,215 12,881 12,289 -------------------------------------------------------- --------------------------- ------------------------- Financial services: Retirement plan administration and trustee fees 1,422 1,202 2,866 2,303 Actuarial and benefit plan consulting fees 853 0 1,793 0 Asset advisory and management fees 593 369 1,092 878 Investment and insurance product commissions 1,072 808 1,827 1,601 Personal trust 397 353 845 728 -------------------------------------------------------- --------------------------- ------------------------- Total financial services 4,337 2,732 8,423 5,510 -------------------------------------------------------- --------------------------- ------------------------- Sub-total 10,784 8,947 21,304 17,799 Gain (loss) on investment securities & debt prepayment 135 0 145 (45) -------------------------------------------------------- --------------------------- ------------------------- Total non-interest income $10,919 $8,947 $21,449 $17,754 ======================================================== ========================== ========================= Non-interest income/operating income (FTE) 20.8% 20.3% 21.0% 20.2%
As displayed in Table 5, non-interest income (excluding net securities gains and debt prepayment costs) was $10.8 million in the second quarter and $21.3 million for the first half of 2004. This corresponded to increases of $1.8 million (21%) for the quarter and $3.5 million (20%) for the YTD period in comparison to one-year earlier. A majority of the growth in both time intervals was attributable to the $1.6 million and $2.9 million increases in financial services revenue for the quarterly and YTD periods, respectively. Recurring banking fees were up 3.7% for the current quarter and 4.8% for the first six months of 2004 versus year-earlier levels. A majority of the growth in banking non-interest income for both periods was due to the three whole-bank acquisitions completed over the last nine months, with a majority of the increase derived from higher overdraft fees. The $291,000 and $833,000 rise in overdraft income for the quarter and first half of 2004, respectively, was further enhanced by the conversion of a majority of the acquired retail accounts to the Company's successful Overdraft FreedomTM program. In addition, the $205,000 increase in miscellaneous non-interest income for the first half of 2004 benefited from higher cash surrender values derived from acquired life insurance policies. These improvements were offset by a year-over-year decline in mortgage banking income for the quarter (down $264,000) and first six months of 2004 (down $696,000), which was primarily attributable to the discontinuation of the sale of longer-term mortgages in the secondary market in the fourth quarter of 2003. A material amount of gains on the sale of mortgages were earned in the first half of 2003 as declining long-term rates increased the market value of mortgages that had been held for sale. More than half of the increase in financial services revenue for the second quarter and first six months of the year was driven by the acquisition of Harbridge, which accounted for $853,000 and $1,793,000 of the quarterly and YTD variances, respectively. Strong growth at each of the other financial services units for both periods also contributed significantly to the year-over-year increases. BPA generated revenue growth of $220,000 (18%) for the quarter and $563,000 (24%) for first half of 2004, primarily achieved through obtaining a significant number of new client relationships and their associated investment assets. Essentially all of the year-over-year growth at CISI and EAM was achieved in the current quarter. CISI was up $264,000 for the quarter and was positively impacted by an 21 increased volume of annuity sales in response to higher interest rates and additional client relationships developed in the new markets opened up by the Company's banking acquisitions. Second quarter revenue for EAM increased $224,000 over the prior year quarter as appreciation in the U.S. equity markets and the attraction of net new client assets over the past 12 months drove significant growth (61%). Second quarter and June YTD revenue for the personal trust business was up 13% and 16% versus the prior year, respectively, as the unit benefited from increased fees attributable to higher equity asset valuations and new business generation. The ratio of non-interest income to operating income (FTE basis, excluding net security gains and debt prepayment costs) was 20.8% for the second quarter and 21.0% for the first half of the year, 0.5 and 0.8 percentage points higher than the same periods of last year. The significant growth of the financial services group was the primary reason non-interest income outpaced net interest income growth. There was $145,000 of net security gains in the first half of 2004 from the sale of securities that were inherited through acquisitions. This compared to $45,000 of debt prepayment costs in the first six months of 2003 associated with the retirement of $500,000 of the Company's 9.75% fixed-rate subordinated debentures. Operating Expenses Table 6 below sets forth the quarterly and YTD results of the major operating expense categories for the current and prior year, as well as the efficiency ratio (defined below), a standard measure of overhead utilization used in the banking industry. Table 6: Operating Expenses
Three Months Ended June 30, Six Months Ended June 30, --------------------------- ---------------------------- (000's omitted) 2004 2003 2004 2003 ----------------------------------- --------------------------- ---------------------------- Salaries and employee benefits $15,392 $12,318 $30,559 $25,018 Occupancy 2,500 2,328 5,130 4,749 Equipment and furniture 2,150 1,977 4,302 3,881 Legal and professional fees 970 859 1,967 1,578 Data processing 1,924 1,740 3,804 3,359 Amortization of intangible assets 1,759 1,251 3,398 2,532 Office supplies 577 466 1,098 1,052 Foreclosed property 212 (9) 443 158 Other 3,880 4,244 7,449 7,294 ----------------------------------- --------------------------- ---------------------------- Total recurring expenses 29,364 25,174 58,150 49,621 Acquisition expenses 411 5 1,381 5 ----------------------------------- --------------------------- ---------------------------- Total operating expenses $29,775 $25,179 $59,531 $49,626 =================================== =========================== ============================ Operating expenses/average assets 2.85% 3.01% 2.93% 2.96% Efficiency ratio 53.2% 54.4% 53.8% 53.3%
As shown in Table 6, second quarter operating expenses were $29.8 million, up $4.6 million (18%) from the prior year level, and year-to-date operating expenses of $59.5 million rose $9.9 million or 20% compared to 2003. The increases for both periods were primarily attributable to the incremental recurring operating expenses associated with the acquisitions of Peoples, Grange, Harbridge and First Heritage during the intervening time period. In addition, $1.4 million of acquisition expenses were incurred in the first six months of 2004 versus an immaterial amount in the previous year (no acquisitions were completed in 2002 and the first half of 2003). A large portion of the acquisition expenses were associated with $0.9 million of deferred compensation costs that were recorded in first quarter 2004 but should have been recognized in 1996 by a bank that was acquired by First Liberty Bank & Trust, prior to its acquisition by the Company in 2001. The balance of the acquisition expenses was primarily attributable to professional fees and system conversion costs that arose due to the acquisitions of First Heritage and Grange. Recurring operating expenses (excludes acquisition expenses) of $29.4 million for the quarter and $58.2 million for the first half of 2004 were both up 17% versus the equivalent prior year periods. As previously mentioned, these increases were mainly driven by the four acquisitions completed since the end of June 2003, which affected virtually all expense categories, and amortization of intangible assets in particular. The year-over-year rise in personnel expenses, $3.1 million for the second quarter and $5.5 million for the June YTD period, was also impacted by merit increases, hiring activity and higher pension and medical costs. Year-to-date legal and professional fees increased versus prior year in most part due to the increased responsibilities associated with complying with new governance and regulatory requirements. Lastly, other expenses in the second quarter were down versus the same period last year primarily because of costs associated with the retirement of a senior executive in the second quarter of 2003. 22 The Company's efficiency ratio (recurring operating expenses excluding intangible amortization divided by the sum of net interest income (FTE) and recurring non-interest income) was 53.2% for the second quarter, 1.2 percentage points below the comparable period of 2003. Recurring operating income grew 18% versus the 15% increase in core operating expenses (as defined above). Organic income expansion generated principally through loan growth, investment leverage and increased revenue from the financial services segment resulted in higher margins due to the significant proportion of fixed costs inherent in the Company's expense structure. The efficiency ratio of 53.8% for the first half of 2004 was up 0.5 percentage points from a year-earlier due to core operating expenses increasing 16%, while recurring operating income grew at a lesser, 15% pace. First quarter 2004 year-over-year net interest income growth lagged the percentage increase in operating expenses primarily due to a lower net interest margin and the escalation of certain employee benefit costs. Income Taxes The June YTD effective income tax rate was raised 0.8 percentage points to 24.8% in the second quarter of 2004 principally as a result of a higher proportion of income being generated from fully taxable loans and investments. The YTD effective tax rate was only slightly below (0.2 percentage points) the rate for the first half of 2003. The full six-month impact of the tax rate increase was incurred in the current quarter, and therefore the rate of 25.5% was above the YTD and projected full year rate. The quarterly tax rate was 1.5 percentage points above the tax rate for second quarter 2003, when the YTD rate lowered from 26.0% to 25.0%. 23 Investments As reflected in Table 7 below, the book value (excludes unrealized gains) of investments at the end of the quarter increased $287 million from year-end 2003 and was up $473 million versus June 30, 2003. As previously mentioned, the year-over-year and quarterly growth in the book value of the investment portfolio was driven by strategic security purchases made over the last four quarters to enhance the Company's interest rate sensitivity profile and take advantage of improved investment market conditions. In addition, the strong capital positions and excess deposits held by the three banks the Company acquired over the past nine months provided further support for investment purchases. The investment portfolio at the end of second quarter 2003 was at a reduced level due to the de-leveraging strategy that had been in place for more than three quarters. During that time frame the Company used cash flow from the run-off of investments to support loan growth and repay borrowings until reinvestment opportunities became more attractive. The carrying value of investments (includes unrealized gains on available-for-sale securities) was $1.6 billion at the end of the second quarter, up $255 million from December 31, 2003 and $414 million higher than the end of second quarter 2003. The increases in carrying value were well below that of the book value changes for the equivalent six and twelve-month periods because of the decline in the value of unrealized gains (market value adjustment or "MVA"), caused primarily by the significant rise in interest rates during second quarter 2004. The MVA at June 30, 2004 of $26.6 million was down $32 million (-55%) from year-end 2003 and was $59 million (-69%) lower than its level at the end of second quarter 2003, despite the increased size of the underlying portfolio. Table 7: Investments
June 30, 2004 December 31, 2003 June 30, 2003 ------------------------ ------------------------ ------------------------ Amortized Amortized Amortized Cost/Book Market Cost/Book Market Cost/Book Market (000's omitted) Value Value Value Value Value Value - ------------------------------------------------------------------------------- ------------------------ ------------------------ Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $127,563 $121,957 $127,635 $125,003 $0 $0 Obligations of state and political subdivisions 7,653 7,773 7,459 7,677 6,818 7,108 Other securities 3,577 3,577 3,558 3,558 3,559 3,559 - ------------------------------------------------------------------------------- ------------------------ ------------------------ Total held-to-maturity portfolio 138,793 133,307 138,652 136,238 10,377 10,667 - ------------------------------------------------------------------------------- ------------------------ ------------------------ Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies 637,166 646,271 456,913 479,454 356,392 389,910 Obligations of state and political subdivisions 543,574 555,393 443,930 470,210 403,837 440,359 Corporate securities 42,177 43,552 27,712 30,251 27,646 31,451 Collateralized mortgage obligations (CMO's) 82,003 84,205 89,566 93,552 163,951 170,819 Mortgage-backed securities 60,182 62,257 76,628 80,177 100,092 105,256 - ------------------------------------------------------------------------------- ------------------------ ------------------------ Sub-total 1,365,102 1,391,678 1,094,749 1,153,644 1,051,918 1,137,795 Equity securities (1) 44,026 44,026 29,185 29,185 16,543 16,543 Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,656 5,656 - ------------------------------------------------------------------------------- ------------------------ ------------------------ Total available-for-sale portfolio 1,418,984 1,445,560 1,131,987 1,190,882 1,074,117 1,159,994 Net unrealized gain on available-for-sale portfolio 26,576 0 58,895 0 85,877 0 - ------------------------------------------------------------------------------- ------------------------ ------------------------ Total carrying value $1,584,353 $1,578,867 $1,329,534 $1,327,120 $1,170,371 $1,170,661 ======================== ======================== ========================
24 Loans As shown in Table 8, loans ended the first quarter at $2.3 billion, up $218 million (10.3%) year-to-date and $489 million (26%) higher than one year earlier. Most of the YTD and year-over-year increases in loan balances was attributable to acquisitions, which added $206 million to the loan portfolio in 2004 and $393 million over the last 12 months. Excluding the impact of acquisitions, total loans grew $12 million or 0.5% in the first half of 2004 and $96 million or 5.2% over the past year. All of the loan growth for both periods was produced in the consumer mortgage and consumer indirect lines of business. The organic loan growth for the six and 12-month intervals was generated in the New York markets, with declines in Pennsylvania. Over the last year the mix of loans has become more weighted towards consumer mortgages because of the strong growth in that segment, and business lending due to the high proportion of commercial loans in First Heritage's portfolio. Table 8: Loans
(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003 --------------------- -------------------- -------------------- ------------------- Consumer mortgage $780,550 33% $739,593 35% $545,828 29% Business lending 853,034 36% 689,436 32% 637,985 34% Consumer indirect 340,868 15% 325,241 15% 305,549 17% Consumer direct 372,283 16% 374,239 18% 368,653 20% --------------------- ------------------- ------------------- ------------------- Total loans $2,346,735 100% $2,128,509 100% $1,858,015 100% ===================== =================== =================== ===================
Total consumer mortgages increased $41 million in the first six months of 2004 and $235 million year-over year. Excluding the impact of acquisitions, consumer mortgages were up $20 million (2.7%) over the last two quarters and $112 million (21%) over the last year. The year-over-year growth rate would have been even higher had $14 million of longer-term mortgages not been sold in the secondary market in the third quarter of 2003. Volumes have slowed in the past six months as the record levels of refinancing activity that were driven by 40-year low mortgage rates in 2003 have diminished in a rising interest rate environment. The growth for both the six and 12-month time frames was derived principally from activity in the New York markets. Business loans rose $164 million over the latest six months and were up $215 million from one year ago. All of the growth for both periods came from the loans acquired in the First Heritage transaction in May 2004. Excluding those loans, business lending was down $6 million or 0.9% from December 2003's level. Excluding the impact of all three bank acquisitions, business loans fell $23 million or 3.5% over the last 12 months. The New York markets were down year-over-year but increased over the past six months, while the Pennsylvania markets experienced declines over both periods. A relatively slow economic recovery in our primary markets, restricted capital spending by companies, competitive conditions and the desire to maintain solid asset quality standards have limited growth in certain of our markets. However, business loans continue to grow on an organic basis, as the sequential increase produced in the second quarter of 2004 was the highest it has been in two and a half years. Consumer indirect loans, largely borrowings originated in automobile, marine and recreational vehicle dealerships, rose $16 million (4.8%) in the last six months and $35 million (11.6%) on a year-over-year basis. Only an immaterial amount of consumer indirect loans was added in the three bank acquisitions. Historically low interest rates, aggressive dealer and manufacturer incentives on new vehicles, and very competitive pricing on used vehicles have helped maintain solid growth in auto, boat and recreational vehicle sales over the last year. These market factors as well as the Company's addition of new originating dealers, strong relationships with current dealers and ability to offer competitive rates have contributed to 10 straight quarters of consumer indirect lending growth. Consumer indirect loans increased in both the New York and Pennsylvania markets during the six and 12-month time frames. Consumer direct loans are comprised of 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 segment declined by $2 million in the first half of 2004 and was up $4 million from one year ago. Excluding loans added through acquisition, consumer direct loans were down $18 million (-4.8%) from year-end 2003 and declined $29 million (-7.9%) versus June 30, 2003. A certain amount of consumer installment and home equity loans continue to be paid off through conventional mortgage refinancings. Promotional rates, the reduction of rates on larger loans and marketing campaigns were initiated in the current quarter to promote new home equity volume, but extremely competitive conditions in this segment has made it difficult to grow this part of the loan portfolio at profitable yield levels. Total consumer direct loans were down for both periods in the New York and Pennsylvania markets. 25 Asset Quality Table 9 below exhibits the major components of non-performing loans and assets and key asset quality metrics for the periods ending June 30, 2004 and 2003 and December 31, 2003. Table 9: Non-performing Assets
(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003 ------------------------------------------------------------ -------------- ------------------ -------------- Non-accrual loans $11,142 $11,940 $12,678 Accruing loans 90+ days delinquent 1,234 1,307 2,457 Restructured loans 856 28 30 ------------------------------------------------------------ -------------- ------------------ -------------- Total non-performing loans 13,232 13,275 15,165 Other real estate 1,044 1,077 943 ------------------------------------------------------------ -------------- ------------------ -------------- Total non-performing assets $14,276 $14,352 $16,108 ============================================================ ============== ================== ============== Allowance for loan losses to total loans 1.37% 1.37% 1.48% Allowance for loan losses to non-performing loans 242% 219% 181% Non-performing loans to total loans 0.56% 0.62% 0.82% Non-performing assets to total loans and other real estate 0.61% 0.67% 0.87% Delinquent loans (30 days + to non-accruing) to total loans 1.50% 1.77% 1.79% Net charge-offs to average loans outstanding (quarterly) 0.26% 0.54% 0.57% Loan loss provision to net charge-offs (quarterly) 160% 113% 103%
As displayed in Table 9, non-performing assets at June 30, 2004 were $14.3 million, a decrease of $0.1 million versus year-end 2003 and $1.8 million below the level at the end of second quarter 2003. The improvement over the last six months was due to a reduction in installment 90+ day delinquencies and commercial non-accrual levels despite the addition of First Heritage's portfolio, contributing to a six-basis point drop in the ratio of non-performing assets to total loans. The decline in non-performing assets over the last year was primarily attributable to non-performing commercial loans falling by $2.0 million. This improvement combined with the substantial increase in the size of the loan portfolio resulted in the ratio of non-performing assets to total loans plus OREO to decline 26 basis points versus June 30, 2003 to 0.61%, reflecting an overall improvement in asset quality. Non-performing loans were 0.56% of total loans outstanding at the end of the second quarter versus 0.62% at year-end 2003 and 0.82% at June 30, 2003. This ratio improved in comparison to year-end 2003 and one year ago due to the aforementioned positive developments in the commercial and installment portfolios over the last year. The Company's non-performing loan ratios for the second and first (0.66%) quarters of 2004 compared very favorably to the peer bank mean of 0.78% at the end of first quarter 2004. The allowance for loan loss to non-performing loans ratio, a general measure of coverage adequacy, was 242% at the end of the second quarter, up from the coverage ratios of 219% at year-end 2003 and 181% at June 30, 2003. Delinquent loans (30 days through non-accruing and restructured loans) as a percent of total loans was 1.50% at the end of the second quarter, its lowest level since first quarter 2001. This ratio improved 27 basis points in comparison to year-end 2003 and 29 basis points versus June 30, 2003. The reduction of the delinquency ratio from its level six months ago was driven by the non-performing loan improvements discussed above as well as significant declines in installment and real estate loans 30 to 89 days past due. The decrease in the delinquency ratio in comparison to one-year earlier was again attributable to commercial loans, which experienced a decline in loans 30 to 89 days delinquent in addition to the improved non-performing metrics. As of March 31, 2004, the median peer bank delinquency ratio of 1.57% was seven basis points above the Company's second quarter ratio and eight basis points lower than its ratio at that time. 26 Table 10: Allowance for Loan Loss Activity
Three Months Ended June 30, Six Months Ended June 30, ---------------------------- ---------------------------- (000's omitted) 2004 2003 2004 2003 ---------------------------------------------------------- ---------------------------- ---------------------------- Amount of loans outstanding at end of period $2,346,735 $1,858,015 $2,346,735 $1,858,015 Daily average amount of loans (net of unearned discount) $2,222,827 $1,834,610 $2,167,108 $1,821,323 Allowance for loan losses at beginning of period $28,821 $27,350 $29,095 $26,331 Charge-offs: Business lending 613 1,522 1,732 2,702 Consumer mortgage 34 46 130 87 Consumer direct 686 701 1,444 1,388 Consumer indirect 1,154 980 2,205 2,054 ---------------------------------------------------------- ---------------------------- ---------------------------- Total charge-offs 2,487 3,249 5,511 6,231 Recoveries: Business lending 437 56 579 122 Consumer mortgage 10 4 22 8 Consumer direct 187 189 371 405 Consumer indirect 415 394 777 709 ---------------------------------------------------------- ---------------------------- ---------------------------- Total recoveries 1,049 643 1,749 1,244 ---------------------------------------------------------- ---------------------------- ---------------------------- Net charge-offs 1,438 2,606 3,762 4,987 Provision for loan losses 2,300 2,673 4,350 6,073 Allowance on acquired loans 2,357 0 2,357 0 ---------------------------------------------------------- ---------------------------- ---------------------------- Allowance for loan losses at end of period $32,040 $27,417 $32,040 $27,417 ========================================================== ============================ ============================ Net charge-offs to average loans outstanding 0.26% 0.57% 0.35% 0.55%
As displayed in Table 10, net charge-offs during the second quarter were $1.4 million, $1.2 million less than the equivalent 2003 period, driven by significant declines in the business lending segment. This decrease occurred despite a $388 million increase in average loan balances, and resulted in a 31-basis point drop in the net charge-off ratio (net charge-offs as a percentage of average loans outstanding) to 0.26%, its lowest quarter-end level in more than four years. On a year-to-date basis net charge-offs were down $1.2 million versus the prior year period, while average loans were up $346 million for the same period, resulting in a 20-basis point decline in the YTD net charge-off ratio to 0.35%. Lower business loan net charge-offs were again the main contributor to this substantial improvement, reflecting strengthening economic conditions and the effectiveness of increased credit risk management resources. The increased proportion of comparatively low-risk consumer mortgages in the loan portfolio (35% of total average loans in first half of 2004 versus 29% one year earlier) also helped reduce the overall level of charge-offs in relation to total average loan balances. The business lending net charge-off ratio for the quarter declined 84 basis points versus prior year to 0.09%, and on a year-to-date basis was down 50 basis points to 0.32% of average business loans. The second quarter consumer indirect net charge-off ratio was up 11 basis points versus the same quarter of 2003 to 0.90%, but the June YTD ratio of 0.88% improved by five basis points in comparison to prior year. The consumer direct net charge-off ratio of 0.55% for the quarter was equal to the year earlier period and the ratio of 0.59% for the first half of 2004 was up six basis points versus the same time interval last year. The net charge-off ratio for consumer mortgages was 0.01% and 0.03% for the second quarter and first six months of 2004, respectively, in line with the equivalent periods of 2003. This ratio has averaged only 0.04% of average consumer mortgage balances over the last eight quarters. A required loan loss allowance of $32.0 million was determined as of June 30, 2004, resulting in a $2.3 million loan loss provision for the quarter compared to $2.7 million one year earlier. The second quarter loan loss provision was $0.9 million higher than net charge-offs mainly due to the additional allowance needed to cover the $35 million of organic loan growth in the quarter, the downgrade of risk ratings on certain business loans, and an increase in the historical loss factors for installment loans. The loan loss provision for the first half of 2004 of $4.4 million was down $1.7 million or 28% versus the prior year, driven by the overall improvement in asset quality. The allowance for loan losses rose $4.6 million or 17% over the last 12 months, versus a 26% increase in loans outstanding. Consequently, the ratio of allowance for loan loss to loans outstanding declined 11 basis points to 1.37%. The reduction in this ratio reflects a higher proportion of high-credit quality consumer mortgages in the loan portfolio and improving trends in net charge-off, non-performing and delinquency ratios. 27 Deposits As shown in Table 11, average deposits of $2.9 billion in the second quarter were up $224 million compared to fourth quarter 2003 and increased $341 million versus the same quarter of last year. Deposits of $212 million were added in the second quarter as a result of the acquisition of First Heritage, and approximately $249 million of deposits were acquired in conjunction with the Peoples and Grange transactions in the second half of 2003. Excluding the impact of these acquisitions, average deposits for the quarter were down approximately 1% from their level in the second and fourth quarters of 2003. Over the past year the deposit mix continued to shift towards demand deposits and more liquid interest-bearing deposits (interest checking and savings accounts). This shift in deposit mix may have reflected customers' unwillingness to be locked into CD rates for extended periods of time and hold money in accounts with higher minimum balance requirements at low interest rates, especially given the diminished interest rate spread between these accounts and shorter-term or less restrictive interest-bearing accounts. The greatly reduced opportunity cost of holding money in non-interest and low-interest bearing accounts contributed to the average balances for demand deposit, interest checking and savings accounts increasing to 48% of total deposits in second quarter 2004 versus 45% in the same quarter last year. This shift in mix, combined with CDs being rolled over at lower interest rates and periodic reductions of other interest-bearing deposit rates, helped drive down the second quarter cost of deposits by 39 basis points on a year-over-year basis. Excluding the impact of acquisitions, average IPC (individuals and businesses) deposits in the current quarter decreased 1.8% from fourth quarter 2004's level and 1.7% from one year ago. This mostly reflects the competitive conditions in our primary markets and the relative attractiveness of alternative funding sources. Average second quarter public funds deposits were up 9.1% and 15% and from the second and fourth quarters of 2003, respectively, excluding acquired deposits. On a total deposit basis, however, this funding source only accounted for 6.7% of average deposits in second quarter 2004, comparable to the ratio one year earlier, in part due to the minimal amount of public funds held by the three banks acquired by the Company over the last year. Table 11: Average Deposits Three Months Ended --------------------------------------- June 30, December 31, June 30, (000's omitted) 2004 2003 2003 ---------------------------- ----------- ------------ ----------- Demand deposits $550,683 $505,015 $456,176 Interest checking deposits 301,509 283,752 269,110 Savings deposits 516,507 448,064 425,580 Money market deposits 304,451 300,558 289,863 Time deposits 1,197,563 1,109,350 1,088,845 ---------------------------- ----------- ------------ ----------- Total deposits $2,870,713 $2,646,739 $2,529,574 ============================ =========== ============ =========== IPC deposits $2,678,002 $2,485,165 $2,362,357 Public fund deposits 192,711 161,574 167,217 ---------------------------- ----------- ------------ ----------- Total deposits $2,870,713 $2,646,739 $2,529,574 ============================ =========== ============ =========== Borrowings At the end of the first quarter, borrowings of $933 million increased $265 million from December 31, 2003 and were up $533 million from the June 30, 2003 level. The increases over both the six and 12-month periods were dictated by organic loan growth, investment security purchases and organic deposit declines. In the first half of 2004 short-term borrowings increased $96 million and long-term borrowings were up $169 million. Over the last 12 months, short-term borrowings increased $389 million and long-term borrowings rose by $144 million. A higher proportion of short-term borrowings has been utilized in comparison to one year ago due to the significant amount of longer-term, core deposits added through acquisitions, to take advantage of an unusually steep yield curve, to reduce the Company's sensitivity to falling interest rates and to provide more flexibility with regard to altering future debt levels. The percentage of long-term borrowings increased in the current quarter due to the addition of a substantial amount of eighteen month FHLB borrowings that were used to fund securities purchases. These borrowings still carry relatively short maturities and help provide funding cost stability for a period of time that is complementary to our asset/liability profile. Shareholders' Equity At a special meeting of the shareholders held on March 26, 2004, the shareholders approved an amendment to the certificate of incorporation of the Company to increase the number of authorized shares of common stock from 20 million to 50 million shares. This amendment was adopted in connection with the previously announced two-for-one stock split of the Company's common stock. The split was effected in the form of a 100% stock dividend that was paid on April 12, 2004 to shareholders of record as of March 17, 2004. 28 The Company announced on May 21, 2004 that its Board of Directors had approved the continuation of a stock repurchase program previously announced on June 9, 2003. The program provides for the purchase of up to 1,400,000 of its shares, which may be repurchased from time to time, in open market or privately negotiated transactions over the course of the subsequent 12 months. All reacquired shares will become treasury shares and will be used for general corporate purposes. As of the end of the second quarter, 1,119,287 shares had been repurchased through this program at an aggregate cost of $23.9 million and an average price per share of $21.31. Total common shares of 30.6 million were outstanding as of June 30, 2004, up 2.3 million from year-end 2003 and 4.6 million higher than the level at the end of second quarter 2003. The increase over the last twelve months was comprised of 4.9 million shares issued in conjunction with the Grange and First Heritage acquisitions and 0.7 million shares issued through the employee stock plan, partially offset by 1.0 million of treasury stock purchases. Total shareholders' equity equaled $441 million at the end of the second quarter, $37 million higher than the balance at December 31, 2003. This increase consisted of $55 million of common stock and options issued in the First Heritage acquisition, net income of $23 million and $3 million from shares issued under the employee stock plan, partially offset by a $20 million decline in the after-tax investment market value adjustment (a component of other comprehensive income), treasury stock purchases of $15 million and dividends declared of $9 million. Over the past 12 months total shareholders' equity increased by $90 million as shares issued in the Grange and First Heritage acquisitions and employee stock plan and capital growth from net income more than offset declines caused by a drop in the market value adjustment, dividends declared and treasury stock purchases. The Company's Tier I leverage ratio, a primary measure of regulatory capital for which 5% is the requirement to be "well-capitalized," was 6.98% at the end of the second quarter, down 28 basis points from year-end 2003 and 79 basis points lower than its level one year ago. These declines were primarily caused by the treasury share purchases made over the last 12 months and increased investment levels prompted by a more favorable interest rate environment. The tangible equity-to-assets ratio declined 60 basis points versus year-end 2003 and was down 1.7 percentage points in comparison to June 30, 2003. A decline in the market value adjustment due to a significant rise in interest rates in the current quarter was the primary driver of the drop in this ratio in addition to the factors discussed above. The decline in the tangible equity-to-assets ratio was more pronounced than that of the Tier I leverage ratio primarily because the market value adjustment component of equity is excluded from that regulatory ratio. The dividend payout ratio (dividends declared divided by net income) for the first half of 2004 was 40.8%, up 3.0 percentage points from one year ago. The ratio rose because dividends declared increased 26%, higher than the 17% growth in net income. The rise in dividends declared was caused by shares outstanding increasing 18%, mostly attributable to the Grange and First Heritage acquisitions, and dividends per share being raised 10.3% in third quarter 2003, from $0.145 to $0.160. Liquidity Management of the Company's liquidity is critical due to the potential for unexpected fluctuations in deposits and loans. Adequate sources of both on and off-balance sheet funding are in place to effectively respond to such unexpected fluctuations. 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 June 30, 2004, this ratio was 14.6% for both time periods, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank. To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how current liquidity levels could change over time. This five-year measure reflects adequate liquidity to fund loan and other asset growth over the next five years. 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 29 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 consummated 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 would make additional updates or corrections with respect thereto or with respect to other forward-looking statements. 30 Item 3. Quantitative and Qualitative Disclosure 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. 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 June 30, 2004 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 components 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 annualized increase (decrease) in Change in interest projected net interest rates income at June 30, 2004 ------------------------------------------------ + 200 basis points (2.4%) - 100 basis points (1.6%) In the 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 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 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. 31 Item 4. Controls and Procedures As of June 30, 2004, 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. 32 Part II. Other Information Item 1. 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 2. Changes in Securities, Use of Proceeds and Issuer Repurchases of Equity Securities. (e) On May 21, 2004, the Company announced the continuation of a stock repurchase program previously announced in June 2003. The program provides for the repurchase of up to 1,400,000 of its outstanding shares in open market or privately negotiated transactions through June 2005. The repurchases will be for general corporate purposes, including those related to acquisition and stock plan activities. The following table shows treasury stock purchases under this authorization during the first six months 2004. Total Number Number of Shares Number of Average Price of Shares Remaining to be Shares Purchased Per share Purchased Purchased - -------------------------------------------------------------------------------- January 2004 0 $0.00 416,300 983,700 February 2004 0 0.00 416,300 983,700 March 2004 122,800 22.29 539,100 860,900 April 2004 40,958 22.69 580,058 819,942 May 2004 131,642 21.07 711,700 688,300 June 2004 407,587 21.88 1,119,287 280,713 - --------------------------------------------------------------------------- Total 702,987 $21.85 1,119,287 280,713 =========================================================================== Item 3. Defaults Upon Senior Securities. Not applicable. Item 4. Submission of Matters to a Vote of Securities Holders. At the annual meeting of the shareholders held on May 19, 2004, the shareholders elected four nominees of the Board of Directors and approved the Community Bank System, Inc. 2004 Long-Term Incentive Compensation Program.
For Against/Abstain Unvoted ---------------------------------------- John M. Burgess 12,580,183 395,355 0 Nicholas A. DiCerbo 12,584,263 391,275 0 James A. Gabriel 12,584,299 391,239 0 Harold S. Kaplan 12,527,018 448,520 0 2004 Long-Term Incentive Compensation Program 5,619,366 4,822,907 2,533,265
Item 5. Other Information. Not applicable Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description - ----------- ----------- 10.1 2004 Long-Term Incentive Compensation Program. Incorporated by reference to Appendix A to the Definitive Proxy Statement on Schedule 14A filed on April 15, 2004 (File No. 001-13695). ** 10.2 Employment Agreement, effective May 1, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and Steven R. Tokach. * ** 33 10.3 Employment Agreement, effective August 2, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and Scott A. Kingsley. * ** 10.4 Supplemental Retirement Plan Agreement, effective August 2, 2004, by and between Community Bank System, Inc. and Scott A. Kingsley. * ** 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 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 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: o Form 8-K related to quarterly earnings press release was filed on April 22, 2004. o Form 8-K related to additional information about fees paid to the Company's independent accountants as reported in the 2004 proxy statement was filed on May 6, 2004. 34 SIGNATURES Pursuant to the requirements 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. Date: August 4, 2004 /s/ Sanford A. Belden --------------------- Sanford A. Belden, President, Chief Executive Officer and Director Date: August 4, 2004 /s/ Mark E. Tryniski -------------------- Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer 35 EX-10.2 2 d60258_ex10-2.txt EMPLOYMENT AGREEMENT Exhibit 10.2 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of May 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) STEVEN R. TOKACH, an individual currently residing at Mountaintop, Pennsylvania ("Employee"). 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 Chief Credit Administrator of Employer for a forty-three month term commencing on May 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 May 1, 2004 through December 31, 2004, Employer shall pay Employee base salary at the annual rate in effect for Employee on April 30, 2004 ("Base Salary"). Employee's Base Salary for calendar years after 2004 shall be determined by the Board of Directors of Employer ("Board"), or an authorized committee of the Board, in accordance with Employer's regular practice for reviewing and adjusting base salary for executive employees. 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 term includes any successor plan or incentive compensation arrangement) which has been approved by the Board 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 the Scranton, Pennsylvania area. 2. Duties during the Period of Employment. Employee shall have full responsibility, subject to the control of the Board and Employer's Chief Operating Officer, for the supervision of all aspects of Employer's credit analysis, loan work-out, and credit administration operations, and the discharge of such other duties and responsibilities to Employer as may from time to time be reasonably assigned to Employee by the Board or Employer's Chief Operating Officer. Employee shall report to the Chief Operating Officer of Employer or the Chief Operating Officer's designee. 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 2 the business of Employer, except that Employee may affiliate with professional associations, business and civic organizations. 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 to perform Employee's duties hereunder by reason of physical or mental illness or 3 injury for a period of 26 successive weeks, or such longer waiting/elimination period provided pursuant to Employer's group long-term disability policy (the "Disability Period") shall constitute disability. The determination of disability shall be made by a majority vote of a physician selected by Employer, a physician selected by Employee and a third physician selected by the other two physicians. 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). Thereafter, 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 of Employer, or any subsidiary or affiliate of Employer for which Employee is performing services hereunder 4 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; (iii) Unreasonable neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days following Employee's receipt of written notice to Employee of such neglect or refusal; (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 and material failure to follow the reasonable, written instructions of the Board or the Chief Operating Officer of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or (vii) Any material and 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, 5 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 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 over the 12-month period following Employee's termination. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; and (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. 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 and benefits provided to Employee under paragraphs 6(a)(i) and (ii). (f) Employer shall have the right of first refusal to purchase from Employee, or from Employee's beneficiary or estate, shares of CBSI stock (but not outstanding options) 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 beneficiary or estate, elects to dispose or transfer such acquired shares. Any purchase made pursuant to this 6 subparagraph shall be made at a price per share equal to the closing price per share of CBSI Stock (on the principal public market on which CBSI Stock is traded; currently the New York Stock Exchange) on the trading day that immediately precedes the date of purchase. The right of first refusal described in this subparagraph shall expire ten years from the date of Employee's termination of employment. 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 Compensation Committee of the Board for review on a quarterly basis. 7 (c) Other Benefits. During the Period of Employment, Employee also shall 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 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, Pennsylvania area, subject to the approval of the Chief Operating Officer of Employer. Although it is contemplated that the membership shall be utilized for marketing and promotion of Employer's business interest, 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; and (iv) The use of an Employer-owned or Employer-leased automobile of Employee's choice, the selection and replacement of which shall be subject to the approval of the Compensation Committee of the Board. 5. Stock Options. Employer shall cause the Compensation Committee of the Board 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 Personnel Committee shall determine. Reviews shall be conducted no less frequently than annually. 8 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(e) 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 Employee's Base Salary in effect at the time of Employee's termination, plus an amount equal to the Management Incentive Plan payment made to Employee in the year previous to the Change of Control; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits (equal to Employer's cost for 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 9 (iv) Permit Employee to dispose of any restricted stock granted to Employee. (b) Subject to Employer's right to make the single lump sum payment described in paragraph 6(c) 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 over the 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 between Employer and Employee 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(c), Employee shall be responsible for all taxes and penalties payable by Employee as a result of Employee's receipt of an "excess parachute payment." (c) Notwithstanding the foregoing of this paragraph 6, the Board may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 in a single lump sum payment 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 marginal income and employment tax liability created by the single lump sum payment (i.e., the income and employment tax liability that exceeds the income and employment tax liability that would have been incurred by Employee if payments were made in the manner and during the periods otherwise described in this paragraph 6). 10 (d) 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 or the board of directors of 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. (e) For purposes of this paragraph 6, "good reason" shall mean action taken by Employer that results in: 11 (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; or (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. By way of example, and not limitation, the following changes, if involuntary, would constitute "good reason" for purposes of this Agreement: (A) reducing or eliminating Employee's authority and responsibility to implement the duties of Chief Credit Administrator as described in paragraph 2; or (B) requiring Employee to perform his services for Employer at an office located outside of Lackawanna County, Pennsylvania. 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, publicly 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 such disclosure or use and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce this provision. This provision with respect to injunctive relief shall not, 12 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 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 13 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. 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 date the final payment is made pursuant to the terms of this Agreement; provided, however, that the non-competition period shall end on the date Employee's employment ends in the event of Employee's termination for good reason (as defined in paragraph 6(e)), or Employee's termination without cause (as defined in paragraph 3(d)), within two years following a Change of Control that occurs during the Period of Employment. (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. 14 (e) Termination of Payments. Upon Employee's receipt of written notice to Employee of the breach by Employee of any covenant under this paragraph 8, Employer may withhold, offset and/or recover from Employee 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 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; 15 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 Employment Agreement between the parties that is scheduled to expire effective May 11, 2004. 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. 16 The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By: ------------------------------ Its: ------------------------------ COMMUNITY BANK, N.A. By: ------------------------------ Its: ------------------------------ ---------------------------------- STEVEN R. TOKACH 17 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Steven R. Tokach, dated as of May 1, 2004 ("Agreement"), I, Steven R. Tokach, 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 _________________________, ________, Pennsylvania. My contingent beneficiary is __________________, my __________________. My contingent beneficiary's address is ________________________________. Dated: _____________ ------------------------------ Steven R. Tokach - ----------------------------- Witness 18 EX-10.3 3 d60258_ex10-3.txt EMPLOYMENT AGREEMENT Exhibit 10.3 EMPLOYMENT AGREEMENT This sets forth the terms of the Employment Agreement made effective as of August 2, 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) SCOTT A. KINGSLEY, an individual currently residing at 961 Ashbrooke Way, Hudson, Ohio ("Employee"). This Agreement is effective as of August 2, 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 employ Employee, and Employee shall serve, as Chief Financial Officer of Community Bank System, Inc. and Community Bank, N.A. for a term commencing on August 2, 2004 and ending on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. (b) Salary. Through December 31, 2004, Employer shall pay Employee base salary at the annual rate of $235,000.00 ("Base Salary"). Employee's Base Salary for calendar 1 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 finance, accounting, and investor relations 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 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 2 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 original grant of the option right, determined without regard to Employee's death or termination of employment. 3 (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 or any other 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 6 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"), 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 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. 7 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: (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; 8 (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) Reimbursement of the purchase price of a cellular telephone and all Employer-related business charges incurred in connection with the use of such telephone; and (v) Reimbursement for the following relocation expenses, subject to the approval of Employer's President and Chief Executive Officer (or his designee) and contingent upon the completion of Employee's relocation to the Syracuse, New York area within 90 days following the effective date of this Agreement: (A) the cost of moving Employee's normal household goods from Employee's current residence in Hudson, Ohio to the Syracuse, New York area, subject to Employee obtaining (and providing Employer with copies of) at least two quotes for such service; (B) up to $2,000 per month for reasonable interim housing in the Syracuse, New York area, if necessary, for a period of up to 90 days following the effective date of this Agreement; (C) the reasonable costs of up to three two-day house hunting trips for Employee and his spouse to the Syracuse, New York area; 9 (D) the reasonable closing costs on the sale of Employee's Hudson, Ohio 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 Hudson, Ohio residence; (E) the reasonable closing costs on the purchase of a residence in the Syracuse, New York 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, mortgage recording tax and title insurance premium; and (F) a tax gross-up payment with respect to reimbursements described in (A) - (E) above which are taxable to Employee. (d) Supplemental Retirement Benefits. The terms and conditions for the payment of supplemental retirement benefits shall be 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 grant to Employee an option to purchase 15,000 shares of common stock of CBSI pursuant to (and subject to) the terms of the Community Bank System, Inc. 2004 Long-Term Incentive Compensation Program. Such option grant shall be effective as of the first 10 day of the Period of Employment and, subject to Employee's continued employment by Employer, shall become exercisable in cumulative 20 percent increments on each of the first five anniversaries of the date of grant. In addition, 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. 2004 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 provided to 11 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 12 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; (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 13 (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. 14 (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 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 15 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 16 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 date the final payment is made pursuant to the terms of this Agreement; provided, however, that the non-competition period shall end on the date Employee's employment ends in the event of Employee's termination for "good reason" (as defined in paragraph 6(c)), or Employee's termination without cause (as defined in paragraph 3(d)), within two years following a Change of Control that occurs during the Period of Employment. (d) 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. 17 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. 18 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. 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. 19 The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By: ----------------------------- Its: ----------------------------- COMMUNITY BANK, N.A. By: ----------------------------- Its: ----------------------------- --------------------------------- SCOTT A. KINGSLEY 20 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Scott A. Kingsley, dated as of August 2, 2004 ("Agreement"), I, Scott A. Kingsley, 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: _____________ ------------------------------ Scott A. Kingsley - ----------------------------- Witness 21 EX-10.4 4 d60258_ex10-4.txt SUPPLEMENTAL RETIREMENT PLAN AGREEMENT Exhibit 10.4 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth the Supplemental Retirement Plan Agreement made effective as of August 2, 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) SCOTT A. KINGSLEY, an individual currently residing at 961 Ashbrooke Way, Hudson, Ohio ("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, 2005. 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 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. (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 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 (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: ----------------------------- --------------------------------- SCOTT A. KINGSLEY -7- EX-31.1 5 d60258_ex31-1.txt 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 quarterly report on Form 10-Q 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: August 4, 2004 /s/ Sanford A. Belden - --------------------- Sanford A. Belden, President, Chief Executive Officer and Director EX-31.2 6 d60258_ex31-2.txt 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 quarterly report on Form 10-Q 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: August 4, 2004 /s/ Mark E Tryniski - ------------------- Mark E. Tryniski, Treasurer, Chief Operating Officer and Chief Financial Officer EX-32.1 7 d60258_ex32-1.txt 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 Quarterly Report of Community Bank System, Inc. (the "Company") on Form 10-Q for the quarter ended June 30, 2004 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 August 4, 2004 EX-32.2 8 d60258_ex32-2.txt 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 Quarterly Report of Community Bank System, Inc. (the "Company") on Form 10-Q for the quarter ended June 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Mark E. Tryniski, 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 August 4, 2004 -----END PRIVACY-ENHANCED MESSAGE-----