-----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, HUzX+sSp1PeSn4rU/pYR3AYVzXQY5hJHghvScVfdef4lPjQ6m/B+IiIiSUwSJ5xP tdagmO5s/iebbGwEth6JEg== 0000893220-02-001365.txt : 20021114 0000893220-02-001365.hdr.sgml : 20021114 20021114115148 ACCESSION NUMBER: 0000893220-02-001365 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20020930 FILED AS OF DATE: 20021114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOVEREIGN BANCORP INC CENTRAL INDEX KEY: 0000811830 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTION, FEDERALLY CHARTERED [6035] IRS NUMBER: 232453088 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-16581 FILM NUMBER: 02822846 BUSINESS ADDRESS: STREET 1: 2000 MARKET ST CITY: PHILADELPHIA STATE: PA ZIP: 19103 BUSINESS PHONE: 2155574630 MAIL ADDRESS: STREET 1: PO BOX 12646 CITY: READING STATE: PA ZIP: 19612 10-Q 1 w65673e10vq.txt FORM 10-Q SOVEREIGN BANCORP, INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the quarter ended September 30, 2002 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the transition period from _______________ to ___________________. Commission File Number: 001-16581 SOVEREIGN BANCORP, INC. (Exact name of Registrant as specified in its charter) Pennsylvania 23-2453088 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1500 Market Street, Philadelphia, Pennsylvania 19103 (Address of principal executive offices) (Zip Code) Registrant's telephone number: (215) 557-4630 2000 Market Street, Philadelphia, Pennsylvania 19103 (Former name, former address and former fiscal year, if changed since last report.) 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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at November 12, 2002 - --------------------------- -------------------------------- Common Stock (no par value) 261,202,696 shares FORWARD LOOKING STATEMENTS SOVEREIGN BANCORP, INC. AND SUBSIDIARIES The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements made by or on behalf of Sovereign Bancorp, Inc. ("Sovereign"). Sovereign may from time to time make forward-looking statements in Sovereign's filings with the Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the Exhibits hereto), in its reports to shareholders (including its 2001 Annual Report) and in other communications by Sovereign, which are made in good faith by Sovereign, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Some of the disclosure communications by Sovereign, including any statements preceded by, followed by or which include the words "may," "could," "should," "pro forma," "looking forward," "will," "would," "believe," "expect," "anticipate," "estimate," "intend," "plan," "strive," "hopefully," "try," "assume" or similar expressions constitute forward-looking statements. These forward-looking statements include statements with respect to Sovereign's vision, mission, strategies, goals, beliefs, plans, objectives, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business of Sovereign, including statements relating to: - growth in cash earnings, operating earnings, net income, shareholder value and internal tangible equity generation; - growth in earnings, operating earnings and cash earnings per share; - return on equity; - return on assets; - efficiency ratio; - Tier 1 leverage ratio; - annualized net charge-offs and other asset quality measures; - fee income as a percentage of total revenue; - ratio of tangible equity to assets; - book value and tangible book value per share; and - loan and deposit portfolio compositions, employee retention, customer retention, asset quality and reserve adequacy. These forward-looking statements, implicitly and explicitly, include the assumptions underlying the statements. Although Sovereign believes that the expectations reflected in these forward-looking statements are reasonable, these FORWARD LOOKING STATEMENTS (continued) statements involve risks and uncertainties which are subject to change based on various important factors (some of which are beyond Sovereign's control). The following factors, among others, could cause Sovereign's financial performance to differ materially from its goals, plans, objectives, intentions, expectations, forecasts and projections (and the underlying assumptions) expressed in the forward-looking statements: - the strength of the United States economy in general and the strength of the regional and local economies in which Sovereign conducts operations; - the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; - inflation, interest rate, market and monetary fluctuations; - Sovereign's ability to successfully integrate any assets, liabilities, customers, systems and management personnel Sovereign acquires into its operations and its ability to realize related revenue synergies and cost savings within expected time frames; - Sovereign's timely development of competitive new products and services in a changing environment and the acceptance of such products and services by customers; - the willingness of customers to substitute competitors' products and services and vice versa; - the impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, capital, liquidity, proper accounting treatment, securities and insurance, and the application thereof by regulatory bodies and the impact of changes in and interpretation of generally accepted accounting principles; - technological changes; - changes in consumer spending and savings habits; - terrorist attacks in the United States or upon United States interests abroad, or armed conflicts relating to these attacks; - armed conflicts involving the United States military; - regulatory or judicial proceedings; - changes in asset quality; and - Sovereign's success in managing the risks involved in the foregoing. FORWARD LOOKING STATEMENTS (continued) If one or more of the factors affecting Sovereign's forward-looking information and statements proves incorrect, then its actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements. Therefore, Sovereign cautions you not to place undue reliance on any forward-looking information and statements. Sovereign does not intend to update any forward-looking information and statements, whether written or oral, to reflect any change. All forward-looking statements attributable to Sovereign are expressly qualified by these cautionary statements. Operating earnings and cash earnings which are included and defined herein, and the related ratios using these measures are not a substitute for other financial measures determined in accordance with generally accepted accounting principles. Because all companies do not calculate these measures in the same fashion, these measures as presented may not be comparable to other similarly titled measures of other companies. INDEX
Page PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets at September 30, 2002 and December 31, 2001 6 Consolidated Statements of Operations for the three-month and nine-month periods ended September 30, 2002 and 2001 7 Consolidated Statement of Stockholders' Equity for the nine-month period ended September 30, 2002 9 Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2002 and 2001 10 Notes to Consolidated Financial Statements 11 - 23 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 24- 44 Item 3. Quantitative and Qualitative Disclosures About Market Risk 44 Item 4. Controls and Procedures 44 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 45 SIGNATURES 46 CERTIFICATIONS 47 - 48 EXHIBITS INDEX 49
SOVEREIGN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED)
September 30, December 31, 2002 2001 ------------ ------------ (in thousands, except per share data) ASSETS Cash and amounts due from depository institutions $ 1,236,040 $ 907,279 Investment securities: Available-for-sale 11,067,631 9,581,679 Held-to-maturity (fair value approximates $722,922 and $883,208 at September 30, 2002 and December 31, 2001, respectively) 704,750 883,437 Loans (including loans held for sale at approximate fair value of $304,749 and $308,950 at September 30, 2002 and December 31, 2001, respectively) 22,472,806 20,399,584 Allowance for loan losses (295,259) (264,667) ------------ ------------ Net loans 22,177,547 20,134,917 ------------ ------------ Premises and equipment 280,615 251,587 Accrued interest receivable 183,773 183,913 Goodwill, net of accumulated amortization 1,025,292 954,688 Core deposit intangibles, net of accumulated amortization 362,885 389,216 Bank owned life insurance 756,518 724,242 Other assets 1,768,112 1,463,880 ------------ ------------ TOTAL ASSETS $ 39,563,163 $ 35,474,838 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Deposits and other customer accounts $ 26,535,901 $ 23,297,574 Borrowings 3,117,483 2,678,764 Long-term debt 5,997,397 6,261,006 Advance payments by borrowers for taxes and insurance 14,738 20,943 Other liabilities 589,226 409,542 ------------ ------------ TOTAL LIABILITIES 36,254,745 32,667,829 ------------ ------------ Company-obligated mandatorily redeemable preferred securities of subsidiary trust holding junior subordinated debentures of Sovereign ("Trust Preferred Securities") 397,442 404,136 ------------ ------------ Minority interests 200,268 200,392 ------------ ------------ STOCKHOLDERS' EQUITY Common stock; no par value; 400,000,000 shares authorized; 265,372,495 shares issued at September 30, 2002 and 252,386,163 shares issued at December 31, 2001 1,576,354 1,416,267 Warrants 91,500 91,500 Stock options 7,617 -- Unallocated common stock held by the Employee Stock Ownership Plan at cost; 3,626,414 shares at September 30, 2002 and 4,247,873 shares at December 31, 2001 (23,177) (30,945) Treasury stock at cost; 218,680 shares at September 30, 2002 and 108,792 shares at December 31, 2001 (2,027) (515) Unearned compensation - Restricted stock (4,228) (6,272) Accumulated other comprehensive income/(loss) 69,619 (33,135) Retained earnings 995,050 765,581 ------------ ------------ TOTAL STOCKHOLDERS' EQUITY 2,710,708 2,202,481 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 39,563,163 $ 35,474,838 ============ ============
See accompanying notes to consolidated financial statements. -6- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
Three-Month Period Nine-Month Period Ended September 30, Ended September 30, ------------------- ------------------- 2002 2001 2002 2001 ---- ---- ---- ---- (in thousands, except per share data) INTEREST INCOME: Interest-earning deposits $ 915 $ 796 $ 3,833 $ 1,650 Investment securities: Available-for-sale 161,094 157,893 460,430 385,092 Held-to-maturity 11,472 16,272 37,356 53,721 Interest and fees on loans 350,862 388,380 1,043,327 1,260,331 ---------- ---------- ---------- ---------- TOTAL INTEREST INCOME 524,343 563,341 1,544,946 1,700,794 ---------- ---------- ---------- ---------- INTEREST EXPENSE: Interest on deposits and other customer accounts 119,420 165,530 346,725 579,625 Interest on borrowings and other debt 107,373 126,991 331,737 344,546 ---------- ---------- ---------- ---------- TOTAL INTEREST EXPENSE 226,793 292,521 678,462 924,171 ---------- ---------- ---------- ---------- NET INTEREST INCOME 297,550 270,820 866,484 776,623 Provision for loan losses 38,000 22,000 110,500 65,100 ---------- ---------- ---------- ---------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 259,550 248,820 755,984 711,523 ---------- ---------- ---------- ---------- NON-INTEREST INCOME: Consumer banking fees 47,743 37,619 130,549 116,531 Commercial banking fees 24,976 21,575 71,281 57,602 Mortgage banking revenues 4,245 20,307 20,320 56,378 Capital markets revenue 4,436 2,330 9,581 8,226 Bank owned life insurance 10,722 10,296 31,655 29,963 Miscellaneous income 5,367 2,636 13,519 39,793 ---------- ---------- ---------- ---------- TOTAL FEES AND OTHER INCOME 97,489 94,763 276,905 308,493 ---------- ---------- ---------- ---------- Gain on investment securities and related derivatives transactions 12,668 4,412 37,075 17,508 ---------- ---------- ---------- ---------- TOTAL NON-INTEREST INCOME 110,157 99,175 313,980 326,001 ---------- ---------- ---------- ---------- GENERAL AND ADMINISTRATIVE EXPENSES: Compensation and benefits 91,460 78,069 269,729 236,786 Occupancy and equipment expenses 54,716 50,025 154,987 155,645 Technology expense 17,494 17,780 51,849 52,568 Outside services 12,210 12,394 36,293 40,947 Other administrative expenses 31,445 33,215 94,199 95,002 ---------- ---------- ---------- ---------- TOTAL GENERAL AND ADMINISTRATIVE EXPENSES 207,325 191,483 607,057 580,948 ---------- ---------- ---------- ----------
-7- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (continued)
Three-Month Period Nine-Month Period Ended September 30, Ended September 30, ------------------- ------------------- 2002 2001 2002 2001 ---- ---- ---- ---- (in thousands, except per share data) OTHER EXPENSES: Amortization of intangibles, including goodwill in 2001 $ 20,003 $ 32,556 $ 60,695 $ 101,420 Trust Preferred Securities and other minority interest expense 15,313 14,676 46,776 43,750 Merger-related and integration charges -- -- 15,871 -- Non-solicitation expense -- 98,809 -- 243,241 Restructuring expense -- -- -- 8,500 ---------- ---------- ---------- ---------- TOTAL OTHER EXPENSES 35,316 146,041 123,342 396,911 ---------- ---------- ---------- ---------- INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM 127,066 10,471 339,565 59,665 Income tax provision 33,927 1,855 90,664 9,755 ---------- ---------- ---------- ---------- Income before extraordinary item 93,139 8,616 248,901 49,910 Extraordinary item - Debt extinguishment (net of tax of $3,526 - 2001) -- -- -- (6,549) ---------- ---------- ---------- ---------- NET INCOME $ 93,139 $ 8,616 $ 248,901 $ 43,361 ========== ========== ========== ========== EARNINGS PER SHARE: Basic Income before extraordinary item $ .36 $ .03 $ .97 $ .20 Extraordinary item -- -- -- (.03) ---------- ---------- ---------- ---------- NET INCOME $ .36 $ .03 $ .97 $ .17 ========== ========== ========== ========== Diluted Income before extraordinary item $ .33 $ .03 $ .90 $ .20 Extraordinary item -- -- -- (.03) ---------- ---------- ---------- ---------- NET INCOME $ .33 $ .03 $ .90 $ .17 ========== ========== ========== ========== DIVIDENDS DECLARED PER COMMON SHARE $ .025 $ .025 $ .075 $ .075 ========== ========== ========== ==========
See accompanying notes to consolidated financial statements. -8- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (unaudited) (in thousands)
Common Shares Out- Common Stock Retained standing Stock Warrants options Earnings -------- ----- -------- --------- -------- Balance, December 31, 2001 247,470 $ 1,416,267 $ 91,500 $ -- $ 765,581 Comprehensive income: Net income -- -- -- -- 248,901 Other comprehensive income, net of tax: Change in unrealized net investment gains, net of reclassification adjustments -- -- -- -- -- Change in accumulated losses on derivatives, net of reclassification adjustments -- -- -- -- -- Total comprehensive income -- -- -- -- -- Acquisition of Main Street Bancorp 11,367 148,578 -- -- -- Contingent purchase payout Network Leasing 166 7 -- -- -- Exercise of stock options 1,124 7,761 -- -- -- Stock option expense -- -- -- 7,617 -- Stock issued under Dividend Reinvestment Plan and Employee Stock Purchase Plan 236 3,037 -- -- -- Dividends paid on common stock -- -- -- -- (19,432) Stock repurchased (71) -- -- -- -- Stock issued 55 140 -- -- -- Vesting and allocation of shares of restricted stock plan 182 -- -- -- -- Termination of Employee Stock Ownership Plan 621 564 -- -- -- ------- ----------- ----------- ----------- ----------- Balance, September 30, 2002 261,150 $ 1,576,354 $ 91,500 $ 7,617 $ 995,050 ======= =========== =========== =========== ===========
Unearned Accumulated Total Compensation Unallocated Other Stock- Treasury Restricted Common Stock Comprehensive holders' Stock Stock Held by ESOP Income/(Loss) Equity ----- ----- ------------ ------------- ------ Balance, December 31, 2001 $ (515) $ (6,272) $ (30,945) $ (33,135) $ 2,202,481 ----------- Comprehensive income: Net income -- -- -- -- 248,901 Other comprehensive income, net of tax: Change in unrealized net investment gains, net of reclassification adjustments -- -- -- 190,767 190,767 Change in accumulated losses on derivatives, net of reclassification adjustments -- -- -- (88,013) (88,013) ------- Total comprehensive income -- -- -- -- 351,655 ------- Acquisition of Main Street Bancorp (3,116) -- -- -- 145,462 Contingent purchase payout Network Leasing 1,993 -- -- -- 2,000 Exercise of stock options -- -- -- -- 7,761 Stock option expense -- -- -- -- 7,617 Stock issued under Dividend Reinvestment Plan and Employee Stock Purchase Plan -- -- -- -- 3,037 Dividends paid on common stock -- -- -- -- (19,432) Stock repurchased (922) -- -- -- (922) Stock issued 604 -- -- -- 744 Vesting and allocation of shares of restricted stock plan (71) 2,044 -- -- 1,973 Termination of Employee Stock Ownership Plan -- -- 7,768 -- 8,332 ----------- ----------- ----------- ----------- ----------- Balance, September 30, 2002 $ (2,027) $ (4,228) $ (23,177) $ 69,619 $ 2,710,708 =========== =========== =========== =========== ===========
See accompanying notes to consolidated financial statements. -9- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
Nine-month Period Ended September 30, ------------------- 2002 2001 ---- ---- (in thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 248,901 $ 43,361 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 110,500 65,100 Deferred taxes (28,671) (15,436) Depreciation and amortization 101,465 116,722 Net amortization of investment securities and loan premiums 15,356 9,281 Gain on sale of investment securities and related derivatives (37,075) (17,508) (Gain)/loss on real estate owned 116 (63) (Gain)/loss on sale of fixed assets 484 (1,032) Loss on the retirement of Bancorp debt -- 10,075 Restricted stock and stock option expense 9,661 -- Net change in: Loans held for sale 4,201 136,742 Accrued interest receivable 5,195 15,315 Other assets and bank owned life insurance (462,154) (434,819) Other liabilities 155,986 107,180 ----------- ----------- Net cash provided by operating activities 123,965 34,918 ----------- ----------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of investment securities: Available-for-sale 5,455,065 5,077,130 Proceeds from repayments and maturities of investment securities: Available-for-sale 1,841,286 1,154,374 Held-to-maturity 182,755 223,276 Purchases of investment securities: Available-for-sale (8,156,190) (8,646,108) Held-to-maturity (834) (1,224) Proceeds from sales of loans 1,986,329 2,972,234 Purchase of loans (1,522,652) (1,930,918) Net change in loans other than purchases and sales (1,834,234) (451,591) Proceeds from sales of premises and equipment 6,053 24,785 Purchases of premises and equipment (25,494) (10,664) Proceeds from sale of real estate owned 13,820 5,271 Cash received from acquired bank, net of cash paid 207,704 -- ----------- ----------- Net cash used in investing activities (1,846,392) (1,583,435) ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase/(decrease) in deposits and other customer accounts 1,980,278 (1,238,781) Net increase in borrowings 438,719 1,809,427 Net increase/(decrease) in long-term debt (300,593) 722,952 Proceeds from senior secured credit facility and senior and subordinated notes -- 525,000 Repayments of senior secured credit facility and senior and subordinated notes (50,000) (590,000) Net decrease in advance payments by borrowers for taxes and insurance (6,205) (6,848) Repurchases of Trust Preferred Securities (11,460) -- Cash dividends paid to stockholders (19,432) (18,494) Proceeds from issuance of common stock 11,509 153,961 Termination of ESOP 7,768 -- Other net changes in treasury stock 604 (3,041) ----------- ----------- Net cash provided by financing activities 2,051,188 1,354,176 ----------- ----------- Net change in cash and cash equivalents 328,761 (194,341) Cash and cash equivalents at beginning of period 907,279 959,643 ----------- ----------- Cash and cash equivalents at end of period $ 1,236,040 $ 765,302 =========== =========== SUPPLEMENTAL DISCLOSURES: Income taxes paid $ 142,293 $ 33,387 Interest paid $ 662,657 $ 915,346
Non cash transaction: On March 8, 2002, Sovereign Bancorp, Inc. issued 11,367,000 shares as partial consideration for the acquisition of Main Street Bancorp, Inc. (see footnote 12). See accompanying notes to consolidated financial statements. -10- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Amounts in thousands except share data, unless otherwise noted) (1) BASIS OF PRESENTATION AND ACCOUNTING POLICIES Basis of Presentation The accompanying financial statements of Sovereign Bancorp, Inc. and Subsidiaries ("Sovereign" or the "Company") include the accounts of the parent company, Sovereign Bancorp, Inc. and its wholly-owned subsidiaries: Sovereign Bank, Sovereign Delaware Investment Corporation, Sovereign Capital Trust I, Sovereign Capital Trust II, Sovereign Capital Trust III, MBNK Capital Trust I and ML Capital Trust I. All intercompany balances and transactions have been eliminated in consolidation. These financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments necessary to present fairly the consolidated balance sheet, statements of operations and cash flows for the periods indicated, and contain adequate disclosure to make the information presented not misleading. It is suggested that these consolidated financial statements be read in conjunction with the Company's latest annual report on Form 10-K. The preparation of these financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain amounts in the financial statements of prior periods have been reclassified to conform with the presentation used in current period financial statements. These reclassifications have no effect on net income. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year. Sovereign adopted the expense recognition provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123) "Accounting for Stock Based Compensation" in the third quarter for options granted in 2002 as discussed in a later section of these footnotes. -11- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (2) EARNINGS PER SHARE Basic earnings per share is calculated by dividing income before extraordinary items and net income by the weighted average common shares outstanding, excluding options and warrants. The dilutive effect of options and warrants is calculated using the treasury stock method for purposes of weighted average dilutive shares. The following table presents the computation of earnings per share for the periods indicated.
Three-Month Period Nine-Month Period Ended September 30, Ended September 30, ------------------- ------------------- 2002 2001 2002 2001 -------- -------- -------- --------- CALCULATION OF INCOME FOR BASIC AND DILUTED EPS: Income before extraordinary item $ 93,139 $ 8,616 $248,901 $ 49,910 Extraordinary item, after tax -- -- -- (6,549) -------- -------- -------- --------- Net income $ 93,139 $_ 8,616 $248,901 $ 43,361 ======== ======== ======== ========= WEIGHTED AVERAGE SHARES OUTSTANDING: Weighted average basic shares 261,015 246,922 257,506 243,792 Dilutive effect of: Warrants 17,356 14,062 17,165 9,038 Average stock options 2,636 2,439 2,628 2,019 -------- -------- -------- --------- Weighted average diluted shares 281,007 263,423 277,299 254,849 ======== ======== ======== ========= EARNINGS PER SHARE: Basic Income before extraordinary item $ .36 $ .03 $ .97 $ .20 Extraordinary item, after tax -- -- -- (.03) -------- -------- -------- --------- Net income $ .36 $ .03 $ .97 $ .17 ======== ======== ======== ========= Diluted Income before extraordinary item $ .33 $ .03 $ .90 $ .20 Extraordinary item, after tax -- -- -- (.03) -------- -------- -------- --------- Net income $ .33 $ .03 $ .90 $ .17 ======== ======== ======== =========
-12- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (3) INVESTMENT SECURITIES AVAILABLE-FOR-SALE The following table presents the composition and fair value of investment securities available-for-sale at the dates indicated:
September 30, 2002 ----------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---- ------------ ------------ ----- Investment Securities: U.S. Treasury and government agency securities $ 29,155 $ 403 $ 76 $ 29,482 Corporate debt and asset-backed securities 885,347 44,561 6,311 923,597 Equities (1) 1,048,865 5,680 160 1,054,385 State and municipal securities 29,282 603 -- 29,885 Mortgage-backed securities: U.S. government agencies 6,100,420 181,822 71 6,282,171 Non-agencies 2,671,221 77,000 110 2,748,111 ----------- ----------- ----------- ----------- Total investment securities available-for-sale $10,764,290 $ 310,069 $ 6,728 $11,067,631 =========== =========== =========== ===========
December 31, 2001 ----------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---- ------------ ------------ ----- Investment Securities: U.S. Treasury and government agency securities $ 23,109 $ 93 $ 23 $ 23,179 Corporate debt and asset-backed securities 322,813 5,357 14,310 313,860 Equities (1) 790,391 2,631 160 792,862 State and municipal securities 22,452 1,942 2 24,392 Mortgage-backed securities: U.S. government agencies 6,625,498 34,371 33,828 6,626,041 Non-agencies 1,783,485 23,062 5,202 1,801,345 ----------- ----------- ----------- ----------- Total investment securities available-for-sale $ 9,567,748 $ 67,456 $ 53,525 $ 9,581,679 =========== =========== =========== ===========
(1) Equity investments consist principally of FHLB, FHLMC, and FNMA common and preferred stock. -13- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (4) INVESTMENT SECURITIES HELD-TO-MATURITY The following table presents the composition and fair value of investment securities held-to-maturity at the dates indicated:
September 30, 2002 ----------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---- ------------ ------------ ----- Investment Securities: U.S. Treasury and government agency securities $ 1,705 $ 60 $ -- $ 1,765 State and municipal securities 2,192 28 -- 2,220 Mortgage-backed securities: U.S. government agencies 696,687 18,429 311 714,805 Non-agencies 4,166 23 57 4,132 ----------- ----------- ----------- ----------- Total investment securities held-to-maturity $ 704,750 $ 18,540 $ 368 $ 722,922 =========== =========== =========== ===========
December 31, 2001 ----------------------------------------------------------- Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---- ------------ ------------ ----- Investment Securities: U.S. Treasury and government agency securities $ 1,905 $ 55 $ -- $ 1,960 State and municipal securities 4,128 35 2 4,161 Mortgage-backed securities: U.S. government agencies 872,154 9,851 10,144 871,861 Non-agencies 5,250 47 71 5,226 ----------- ----------- ----------- ----------- Total investment securities held-to-maturity $ 883,437 $ 9,988 $ 10,217 $ 883,208 =========== =========== =========== ===========
-14- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (5) COMPOSITION OF LOAN PORTFOLIO The following table presents the composition of the loan portfolio by type of loan and by fixed and adjustable rates at the dates indicated:
September 30, 2002 December 31, 2001 ------------------------- ------------------------- Amount Percent Amount Percent ------ ------- ------ ------- Commercial real estate loans $ 3,873,405 17.2% $ 2,987,747 14.6% Commercial and industrial loans 4,849,320 21.6 4,506,198 22.1 Other 1,101,790 4.9 1,069,658 5.3 ----------- ----------- ----------- ----------- Total Commercial Loans 9,824,515 43.7 8,563,603 42.0 ----------- ----------- ----------- ----------- Home equity loans 4,747,791 21.1 3,756,621 18.4 Auto loans 3,174,409 14.2 2,880,449 14.1 Other 205,556 .9 193,692 .9 ----------- ----------- ----------- ----------- Total Consumer Loans 8,127,756 36.2 6,830,762 33.4 ----------- ----------- ----------- ----------- Residential Real Estate Loans 4,520,535 20.1 5,005,219 24.6 ----------- ----------- ----------- ----------- Total Loans $22,472,806 100.0% $20,399,584 100.0% =========== =========== =========== =========== Total Loans with: Fixed rate $12,821,989 57.1% $12,875,742 63.1% Variable rate 9,650,817 42.9 7,523,842 36.9 ----------- ----------- ----------- ----------- Total Loans $22,472,806 100.0% $20,399,584 100.0% =========== =========== =========== ===========
Loans are recorded net of loan origination fees, direct origination costs and discounts and premiums purchased. Components of recorded balances are as follows at the dates indicated:
September 30, 2002 December 31, 2001 ------------------ ----------------- Principal value $22,387,360 $20,341,303 Direct origination costs, net of deferred loan fees 38,078 35,584 Purchase premiums, net of discounts 47,368 22,697 ----------- ----------- Total Loans $22,472,806 $20,399,584 =========== ===========
Loans to related parties include loans made to certain officers, directors and their affiliated interests. At September 30, 2002 and December 31, 2001, loans made by Sovereign Bank to these parties totaled $32.0 million and $20.1 million, respectively and loans made by Sovereign Bancorp, Inc. to executives totaled $8.3 million and $8.2 million, respectively. -15- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (6) DEPOSIT PORTFOLIO COMPOSITION The following table presents the composition of deposits and other customer accounts at the dates indicated:
September 30, 2002 December 31, 2001 ------------------------------------- ------------------------------------------ Weighted Weighted Average Average Account Type Amount Percent Rate Amount Percent Rate ------ ------- ---- ------ ------- ---- Demand deposit accounts $ 4,379,088 17% --% $ 3,910,171 17% --% NOW accounts 6,067,386 23 1.58 4,162,169 18 0.87 Savings accounts 3,020,468 11 1.35 2,985,464 13 1.44 Money market accounts 5,792,529 22 2.01 4,992,163 21 1.73 Retail certificates 6,951,130 26 3.39 6,985,397 30 4.14 Jumbo certificates 325,300 1 2.44 262,210 1 3.04 ----------- --- ----------- --- Total Deposits $26,535,901 100% 1.87% $23,297,574 100% 1.99% =========== === ==== =========== === ====
(7) BORROWINGS The following table presents information regarding borrowings with original maturities of up to one year at the dates indicated:
September 30, 2002 December 31, 2001 --------------------- ---------------------- Weighted Weighted Average Average Balance Rate Balance Rate ------- ---- ------- ---- Federal funds purchased $ -- --% $ 452,002 1.75% Securities sold under repurchase agreements 467,483 1.40 297,741 1.45 FHLB advances 2,650,000 1.81 1,929,021 3.08 ---------- ---------- Total Borrowings $3,117,483 1.75% $2,678,764 2.67% ========== ==== ========== ====
(8) LONG-TERM DEBT Long-term debt with original maturities greater than one year consisted of the following:
September 30, 2002 December 31, 2001 ------------------- --------------------- Weighted Weighted Average Average Balance Rate Balance Rate ------- ---- ------- ---- Securities sold under repurchase agreements $ 155,000 4.71% $ 155,000 4.71% FHLB advances 3,892,688 5.36 4,105,929 5.28 Senior secured credit facility 175,000 4.56 225,000 5.72 Asset-backed floating rate notes 821,000 2.20 821,000 2.51 Senior and subordinated notes 953,709 9.67 954,077 9.92 ---------- ---------- $5,997,397 5.57% $6,261,006 5.63% ========== ==== ========== ====
The weighted-average interest rate, including the effect of qualifying derivative hedging contracts, on long-term debt at September 30, 2002 and December 31, 2001 was 5.57% and 5.63%, respectively. -16- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (9) COMPREHENSIVE INCOME The following table presents the components of comprehensive income, net of related tax, for the periods indicated:
Three-month Period Nine-Month Period Ended September 30, Ended September 30, ------------------- ------------------- 2002 2001 2002 2001 ---- ---- ---- ---- Net income $ 93,139 $ 8,616 $ 248,901 $ 43,361 Cumulative effect of change in accounting principle related to adoption of SFAS No. 133 -- -- -- (9,951) Change in accumulated losses on derivatives (43,142) (92,318) (88,013) (89,465) Change in unrealized gains on investment securities available-for-sale 128,180 138,809 214,742 137,160 Less reclassification adjustment: Derivatives -- (9,550) -- (9,550) Investments available-for-sale 8,120 12,409 23,975 20,954 --------- --------- --------- --------- Comprehensive income $ 170,057 $ 52,248 $ 351,655 $ 69,701 ========= ========= ========= =========
Accumulated other comprehensive income/(loss), net of related tax, consisted of net unrealized gains on securities of $198.3 million and net accumulated losses on derivatives of $128.7 million at September 30, 2002 and net unrealized gains on securities of $7.5 million and net accumulated losses on derivatives of $40.6 million at December 31, 2001. (10) DERIVATIVES Sovereign uses derivative instruments as part of its interest rate risk management process, to manage risk associated with its mortgage banking activities, and to assist its commercial banking customers with their risk management strategies. On January 1, 2001, the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". Sovereign's primary market risk is interest rate risk. Management uses derivative instruments to mitigate the impact of interest rate movements on the value of certain liabilities, assets and on probable forecasted cash flows. These instruments primarily include interest rate swaps that have underlying interest rates based on key benchmark indices. The nature and volume of the derivative instruments used to manage interest rate risk depend on the level and type of assets and liabilities on the balance sheet and the risk management strategies for the current and anticipated interest rate environment. -17- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) Fair Value Hedges. Sovereign has entered into pay-variable receive-fixed interest rate swaps to hedge changes in fair values of certain brokered CDs and senior notes, including $400 million notional amount interest rate swaps entered into in May 2002. Sovereign includes all components of each derivatives gain or loss in the assessment of hedge effectiveness. For the three and nine-months ended September 30, 2002 and September 30, 2001, no hedge ineffectiveness was required to be recognized in earnings associated with fair value hedges. Cash Flow Hedges. Sovereign hedges cash flow variability related to variable-rate liabilities, specifically FHLB advances, through the use of pay-fixed, receive variable interest rate swaps. Sovereign includes all components of each derivatives gain or loss in the assessment of hedge effectiveness. For the three and nine-months ended September 30, 2002 and 2001, no hedge ineffectiveness was required to be recognized in earnings associated with cash flow hedges. Gains and losses on derivative instruments reclassified from accumulated other comprehensive income to earnings are included in the caption in the Statement of Operations, in which the hedged cash flows are recorded. During the nine months ended September 30, 2002, the Company terminated $1.4 billion of pay-fixed interest rate swaps that were hedging the future cash flows on $1.4 billion of FHLB advances resulting in a loss of $26.5 million (after-tax). The loss will continue to be deferred in accumulated other comprehensive income and will be reclassified into earnings as the future cash flows occur unless it becomes probable that the forecasted transactions will not occur. As of September 30, 2002, Sovereign expects approximately $46.7 million of the deferred net after-tax loss on derivative instruments included in accumulated other comprehensive income to be reclassified to earnings during the next twelve months. Other Derivative Activities. Sovereign's derivative activities may also include derivative instruments not included in SFAS No. 133 hedge relationships such as interest rate swaps, interest rate futures, forward sales, mortgage banking loan commitments, foreign exchange futures, and fixed income options in accordance with Sovereign's investment policy. This policy is periodically reviewed and updated by management and is approved by Sovereign Bank's Board of Directors. Those derivatives are used by Sovereign for risk management purposes and to facilitate the risk management strategies of its customers. Net gains generated from derivative instruments executed with customers are included as capital markets revenue on the income statement and totaled $5.5 million for the nine-months ended September 30, 2002 compared with $4.2 million for the nine-months ended September 30, 2001. (11) GOODWILL AND CORE DEPOSIT INTANGIBLE ASSETS The Company adopted Statement of Financial Accounting Standards No. 142 - Goodwill and Other Intangible Assets ("SFAS No. 142") and discontinued amortizing goodwill effective January 1, 2002. Under SFAS No. 142 goodwill and indefinite lived intangible assets are no longer amortized but are reviewed annually for impairment. Separable intangible assets that are deemed to have a finite life continue to be amortized over their useful lives. No impairment charges were required to be recorded as a result of adoption of this statement. If an impairment loss is determined in the future, the loss will be reflected in expense in the statement of operations in the period in which impairment is determined. The Company's primary intangible assets include goodwill, which is deemed to have an indefinite life, and core deposit intangibles, which is deemed to have a finite life and is amortized using an accelerated method over the estimated lives of the existing deposit relationship acquired, but not exceeding 10 years. -18- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) The estimated aggregate amortization expense related to core deposit intangibles for each of the five succeeding calendar years ending December 31, is:
Calendar Remaining Year Recorded Amount Year Amount To Date To Record ---- ------ ------- --------- 2002 $80,274 $60,695 $19,579 2003 73,835 -- 73,835 2004 66,856 -- 66,856 2005 57,945 -- 57,945 2006 51,047 -- 51,047
The following table reflects the components of intangible assets:
Gross Carrying Accumulated Amount Amortization ----------------------------- ----------------------------- September 30, December 31, September 30, December 31, 2002 2001 2002 2001 ---- ---- ---- ---- Non-amortized intangible assets: Goodwill $1,156,945 $1,086,341 $ 131,653 $ 131,653 Amortized intangible assets: Core Deposit Intangibles 642,543 608,179 279,658 218,963
The following table reflects the pro forma results of operations as if SFAS No. 142 had been adopted as of January 1, 2001:
Three-months ended Nine-months ended September 30, September 30, ------------------ ----------------- 2002 2001 2002 2001 ---- ---- ---- ---- Reported income before extraordinary item $ 93,139 $ 8,616 $ 248,901 $ 49,910 Add back goodwill amortization, net of tax -- 7,547 -- 21,798 ---------- ---------- ---------- ---------- Pro forma income before extraordinary item $ 93,139 $ 16,163 $ 248,901 $ 71,708 ========== ========== ========== ========== Pro forma net income $ 93,139 $ 16,163 $ 248,901 $ 65,159 ========== ========== ========== ========== Reported diluted EPS before extraordinary item $ .33 $ .03 $ .90 $ .20 Add back goodwill amortization, net of tax -- .03 -- .09 ---------- ---------- ---------- ---------- Pro forma diluted EPS before extraordinary item $ .33 $ .06 $ .90 $ .29 ========== ========== ========== ========== Pro forma diluted EPS $ .33 $ .06 $ .90 $ .26 ========== ========== ========== ==========
-19- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (12) PURCHASE OF MAIN STREET BANCORP, INC. ("MAIN STREET") On March 8, 2002 Sovereign completed the purchase of Main Street, a commercial bank holding company headquartered in Reading, Pennsylvania, and the results of Main Street's operations are included in the accompanying financial statements subsequent to the purchase date. Collectively, Main Street shareholders elected to receive approximately 85% of the purchase price in Sovereign common stock and 15% in cash. Sovereign issued 11.4 million shares of common stock, net of Sovereign's shares held by Main Street, valued at $145.5 million and made cash payments of $31.5 million to acquire and convert all outstanding Main Street shares and pay associated fees. The value of the common stock was determined based on the average price of Sovereign's shares over the ten day period preceding closing as provided in the purchase agreement. The acquisition enhanced Sovereign's market share throughout its existing service area in eastern Pennsylvania. The purchase price was allocated to the assets and liabilities acquired of Main Street based on fair value as of March 8, 2002 (dollars in millions):
Assets Investments $ 305.9 Loans: Commercial 527.0 Consumer 152.7 Residential 165.6 -------- Total loans 845.3 Less allowance for loan losses (14.9) -------- Total loans, net 830.4 Federal funds and cash 239.3 Premises and equipment, net 26.0 Other real estate owned 0.8 Prepaid expenses and other assets 14.9 Core deposit intangible 34.4 Goodwill 69.6 -------- Total assets $1,521.3 ========
Liabilities Deposits: Core $ 700.6 Time 554.6 -------- Total deposits 1,255.2 Borrowings and long-term debt 86.9 Other liabilities 23.7 Trust preferred securities 10.0 -------- Total liabilities $1,375.8 ========
In connection with the Main Street acquisition, Sovereign recorded charges against its earnings for the three-month period ended March 31, 2002 and the nine-month period ended September 30, 2002 for an additional loan loss provision of $6.0 million pre-tax ($3.9 million net of tax) to conform Main Street's allowance for loan losses to Sovereign's reserve policies and for merger related expenses of $15.9 million pre-tax ($10.3 million net of tax). These merger-related expenses include the following: Community grants $ 1,000 Branch and office consolidations 11,338 Account conversion and other 3,533 -------- $ 15,871 ========
-20- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (13) STOCK BASED COMPENSATION Sovereign adopted the expense recognition provisions of SFAS No. 123 "Accounting for Stock Based Compensation" for stock based employee compensation awards during the third quarter ending September 30, 2002. Management made this election since it believes, in light of recent events, it is the preferable method of accounting in this area. Sovereign continues to account for all options granted prior to January 1, 2002 in accordance with the intrinsic value model of APB Opinion No. 25, "Accounting for Stock Issued to Employees." Sovereign estimates the fair value of option grants issued subsequent to January 1, 2002 using a Black-Scholes option pricing model and expenses this value over the vesting periods as required in SFAS No. 123. Reductions to compensation expense associated with forfeited options are recorded in the period that the forfeitures occur. The recognition transition provisions of SFAS No. 123 require that it be applied to all awards granted at the beginning of the fiscal year in which the statement is first applied. Previously reported results for the quarters ended June 30, 2002 and March 31, 2002 have been adjusted in accordance with the existing transition provisions of SFAS No. 123. As a result of this accounting change, Sovereign recorded non-cash after-tax charges as additional compensation expense of $2.1 million and $1.5 million for the three-month periods ended June 30, 2002 and March 31, 2002, respectively. The net income and fully-diluted earnings per share impacts of adopting this statement were $2.0 million and $0.01 for the three-months ended September 30, 2002 and $5.6 million and $0.02 per share for the nine-months ended September 30, 2002. The fair values for the 2002 option grants were estimated at the date of grant using a Black-Scholes option pricing model based on the following assumptions: Expected volatility 34.60% - 38.30% Expected life in years 6 Stock price on the date of grant $12.77 - $15.10 Exercise price $12.77 - $15.10 Weighted average exercise price $12.84 Weighted average fair value $5.28 Expected dividend yield .66% - .78% Risk-free interest rate 3.37% - 5.05% Vesting period in years 1 - 3
The following tables reflect the impact resulting from the adoption of SFAS No. 123 on our financial results for the first and second quarters:
June 30, 2002 June 30, 2002 (dollars in millions, except per share amounts) As Reported As Adjusted ----------- ----------- Other assets $ 1,425.4 $ 1,426.7 Total assets 38,237.8 38,239.1 Retained earnings 912.1 910.0 Stockholders' equity 2,540.6 2,541.9 Compensation and benefits 89.5 92.3 Net income 92.4 90.3 Diluted EPS $0.33 $0.32 Weighted average diluted shares (in millions) 282.2 281.2
-21- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (13) STOCK BASED COMPENSATION (continued)
March 31, 2002 March 31, 2002 (dollars in millions, except per share amounts) As Reported As Adjusted ----------- ----------- Other assets $ 1,376.8 $ 1,377.4 Total assets 36,833.4 36,834.0 Retained earnings 826.3 824.8 Stockholders' equity 2,402.9 2,403.4 Compensation and benefits 83.9 86.0 Net income 66.9 65.4 Diluted EPS 0.25 0.24 Weighted average diluted shares (in millions) 269.9 269.0
Since SFAS No. 123 has not been applied to awards granted in prior years, the reported results of prior periods are not comparable. The impact to our reported annual results for 2001 and 2000 is disclosed in footnote 16 in our annual report filed on Form 10-K. If Sovereign had adopted SFAS No. 123 when this pronouncement was originally issued, net income for the three-month and nine-month periods ended September 30, 2002 would have been further reduced by $0.3 million and $4.8 million. (14) RECENT ACCOUNTING PRONOUNCEMENTS In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, No. 44 and No. 64, Amendment of FASB Statement No. 13, and Technical Corrections." This statement rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishments of Debt," and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." The statement requires gains and losses from debt extinguishments to be classified as income from operations rather than as extraordinary items. The Company will adopt this statement on January 1, 2003. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement addresses the accounting for costs associated with disposal activities covered by SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", and with exit and restructuring activities previously covered by Emerging Issues Task Force ("EITF") Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity". This statement nullifies EITF No. 94-3 in its entirety and requires that a liability for all costs be recognized when the liability is incurred. This Statement also establishes a fair value objective for initial measurement of the liability. The statement will be applied prospectively to exit or disposal activities initiated after December 31, 2002. In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions, an amendment of SFAS No. 72 and SFAS No. 144 and FASB Interpretation No. 9." This Statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution that does not qualify as a business combination. The -22- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (continued) (14) RECENT ACCOUNTING PRONOUNCEMENTS (continued) acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, "Business Combinations". Since Sovereign has accounted for all of its previous bank acquisitions as business combinations, identifying core deposit intangibles separate from goodwill, the adoption of the pronouncement has no impact on our financial position or results of operations. -23- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS General Net income, including special charges discussed below, was $248.9 million, or $.90 per share, for the nine-month period ended September 30, 2002, as compared to $43.4 million, or $.17 per share, for the same period in 2001. Operating earnings, as defined below, for 2002 increased 23% to $263.1 million, or $.95 per share, as compared to $213.5 million, or $.84 per share, for 2001. Cash earnings, as defined below, for the nine-month period ended September 30, 2002 increased 10% to $311.4 million, or $1.12 per share, up from $282.7 million, or $1.11 per share, for the same period in 2001. Operating earnings exclude certain special items for 2002 and 2001. Special charges for the nine months ended September 30, 2002 and 2001 were $14.2 million and $170.2 million, respectively, after tax, and are outlined in the Reconciliation of Net Income to Operating and Cash Earnings table on the following page. Cash earnings are operating earnings excluding the net effects of amortization of intangible assets, stock option expense, and ESOP-related expense. Cash return on average equity and cash return on average total assets, excluding special charges discussed above, were 16.90% and 1.12% for the nine-month period ended September 30, 2002 compared to 18.01% and 1.11% for the same period in 2001. Effective January 1, 2002, the Company ceased to amortize goodwill in accordance with SFAS No. 142 (see Note 11 in Notes to Consolidated Financial Statements). Had SFAS No. 142 been applied as of January 1, 2001, net income and operating earnings in the prior year would have increased by $7.5 million and $21.8 million for the three-months ended and the nine-months ended September 30, 2001, respectively. In the third quarter of 2002, Sovereign adopted the expense recognition provisions of SFAS No. 123 "Accounting for Stock Based Compensation". See Note 13 in Notes to Consolidated Financial Statements for a discussion of the current year impact resulting from the adoption of this statement. Critical Accounting Policies Our significant accounting policies are described in Note 1 to the December 31, 2001 consolidated financial statements filed on Form 10-K. The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. Actual results could differ from those estimates. We have identified accounting for the allowance for credit losses, securitizations, and goodwill as our most critical accounting policies and estimates in that they are important to the portrayal of our financial condition and results, and they require management's most difficult, subjective or complex judgments as a result of the need to make estimates about the effect of matters that are inherently uncertain. These accounting policies, including the nature of the estimates and types of assumptions used, are described throughout this Management's Discussion and Analysis and the December 31, 2001 Management's Discussion and Analysis filed on Form 10-K. -24- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Reconciliation of Net Income to Operating and Cash Earnings (In thousands, except per share data - all amounts are after tax)
Three-month Period Nine-Month Period Ended September 30, Ended September 30, ------------------------------------- ------------------------------------- Total Per Share Total Per Share ------------------------------------- ------------------------------------- 2002 2001 2002 2001 2002 2001 2002 2001 ---- ---- ---- ---- ---- ---- ---- ---- Net income as reported $ 93,139 $ 8,616 $ .33 $ .03 $248,901 $ 43,361 $ .90 $ .17 Loss on the early extinguish- ment of debt -- -- -- -- -- 6,549 -- .03 Main Street Bancorp acquisition: Merger-related and integration costs -- -- -- -- 10,316 -- .04 -- Provision for loan losses -- -- -- -- 3,900 -- .01 -- Restructuring expense -- -- -- -- -- 5,525 -- .02 Non-solicitation expense -- 64,226 -- .25 -- 158,106 -- .62 -------- -------- -------- -------- -------- -------- -------- -------- Operating earnings $ 93,139 $ 72,842 $ .33 $ .28 $263,117 $213,541 $ .95 $ .84 Amortization of intangibles $ 13,545 $ 21,811 $ .05 $ .08 $ 40,851 $ 67,872 $ .14 $ .27 Stock option expense 2,020 -- .01 -- 5,583 -- .02 -- ESOP expense 641 367 -- -- 1,817 1,249 .01 -- -------- -------- -------- -------- -------- -------- -------- -------- Cash earnings $109,345 $ 95,020 $ .39 $ .36 $311,368 $282,662 $ 1.12 $ 1.11 ======== ======== ======== ======== ======== ======== ======== ======== Weighted average diluted shares 281,007 263,423 277,299 254,849
-25- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) CONSOLIDATED AVERAGE BALANCE SHEET / TAX EQUIVALENT NET INTEREST MARGIN ANALYSIS NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2002 AND 2001 (in thousands)
2002 2001 ----------------------------------------- ------------------------------------------ Tax Equivalent Yield/ Tax Equivalent Yield/ Average Balance Interest Rate Average Balance Interest Rate --------------- -------- ---- --------------- -------- ---- EARNING ASSETS INVESTMENTS $ 10,906,552 $ 513,151 6.28% $ 8,553,457 $ 447,908 6.99% LOANS: Commercial loans 9,304,899 419,063 5.98% 8,184,335 488,406 7.94% Consumer loans 7,580,167 386,394 6.82% 6,546,256 389,475 7.95% Residential loans 4,690,543 241,530 6.87% 6,681,947 386,215 7.71% ------------ ------------ ---- ------------ ------------ ---- Total loans 21,575,609 1,046,987 6.47% 21,412,538 1,264,096 7.87% Allowance for loan losses (285,155) -- -- (254,676) -- -- ------------ ------------ ---- ------------ ------------ ---- NET LOANS 21,290,454 1,046,987 6.55% 21,157,862 1,264,096 7.96% ------------ ------------ ---- ------------ ------------ ---- TOTAL EARNING ASSETS 32,197,006 1,560,138 6.46% 29,711,319 1,712,004 7.69% Other assets 4,932,536 -- -- 4,473,873 -- -- ------------ ------------ ---- ----------- ------------ ---- TOTAL ASSETS $ 37,129,542 $ 1,560,138 5.60% $34,185,192 $ 1,712,004 6.68% ============ ============ ==== =========== ============ ==== FUNDING LIABILITIES DEPOSITS: Core deposits $ 17,446,256 $ 149,798 1.15% $15,200,070 $ 229,025 2.01% Time deposits 7,460,509 196,926 3.53% 8,447,117 350,601 5.54% ------------ ------------ ---- ------------ ------------ ---- TOTAL DEPOSITS 24,906,765 346,724 1.86% 23,647,187 579,626 3.28% ------------ ------------ ---- ------------ ------------ ---- BORROWED FUNDS: FHLB advances 6,046,948 227,971 4.98% 5,832,735 232,593 5.26% Repurchase agreements 549,499 9,652 2.32% 485,439 15,273 4.15% Other borrowings 1,967,891 94,114 6.36% 1,327,571 96,680 9.72% ------------ ------------ ---- ------------ ------------ ---- TOTAL BORROWED FUNDS 8,564,338 331,737 5.13% 7,645,745 344,546 5.96% ------------ ------------ ---- ------------ ------------ ---- TOTAL FUNDING LIABILITIES 33,471,103 678,461 2.70% 31,292,932 924,172 3.93% Other liabilities 1,194,881 -- -- 793,102 -- -- ------------ ------------ ---- ------------ ------------ ---- TOTAL LIABILITIES 34,665,984 678,461 2.60% 32,086,034 924,172 3.84% STOCKHOLDERS' EQUITY 2,463,558 -- -- 2,099,158 -- -- ------------ ------------ ---- ------------ ------------ ---- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 37,129,542 $ 678,461 2.43% $ 34,185,192 $ 924,172 3.60% ============ ============ ==== ============ ============ ==== NET INTEREST INCOME $ 881,677 $ 787,832 ============ ============ NET INTEREST SPREAD (1) 3.17% 3.08% ==== ==== NET INTEREST MARGIN (2) 3.66% 3.55% ==== ====
(1) Represents the difference between the yield on total assets and the cost of total liabilities and stockholders' equity. (2) Represents taxable equivalent net interest income divided by average interest-earning assets -26- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Net Interest Income Net interest income for the three-month and nine-month periods ended September 30, 2002 was $297.6 million and $866.5 million compared to $270.8 million and $776.6 million for the same periods in 2001. This increase was attributable to an increase in the average balance of earning assets, principally investments, and improvements of 3 and 11 basis points in net interest margin for the three-month and nine-month periods ended September 30, 2002, respectively, over the same periods in 2001. Net interest margin was 3.62% and 3.66% for the three-month and nine-month periods ended September 30, 2002 compared to 3.59% and 3.55% for the same periods in 2001. Net interest margin has contracted from the prior two quarters in 2002, due to the flattening of the yield curve, the continued repricing of short duration consumer and commercial loans, a competitive deposit pricing environment and the sale of longer duration mortgage-backed securities. Although market interest rates declined in 2002, the Company's net interest margin expanded compared to the prior year as a significant portion of the growth in earning assets was funded by lower cost core deposits. Interest on investment securities and interest earning deposits was $173.5 million and $501.6 million for the three-month and nine-month periods ended September 30, 2002 compared to $175.0 million and $440.5 million for the same periods in 2001. The average balance of investment securities was $10.9 billion with an average tax equivalent yield of 6.28% for the nine-month period ended September 30, 2002 compared to an average balance of $8.6 billion with an average yield of 6.99% for the same period in 2001. Interest and fees on loans were $350.9 million and $1.0 billion for the three-month and nine-month periods ended September 30, 2002 compared to $388.4 million and $1.3 billion for the same periods in 2001. The average balance of loans was $21.6 billion with an average yield of 6.47% for the nine-month period ended September 30, 2002 compared to an average balance of $21.4 billion with an average yield of 7.87% for the same period in 2001. Average balances of commercial and consumer loans in 2002 increased $1.1 billion and $1.0 billion as compared to 2001 primarily due to loan originations and the Main Street acquisition. Average residential loans declined $2.0 billion primarily due to scheduled payments and prepayments, and a residential loan sale, offset by residential loan purchases. These changes in loan balances are consistent with Sovereign's strategy to emphasize commercial and consumer lending. The decrease in loan rates is due to declining market interest rates and the aforementioned shift in the components of the loan portfolio, which now includes more variable rate and shorter maturity assets. Interest on deposits was $119.4 million and $346.7 million for the three-month and nine-month periods ended September 30, 2002 compared to $165.5 million and $579.6 million for the same periods in 2001. The average balance of deposits was $24.9 billion with an average cost of 1.86% for the nine-month period ended September 30, 2002 compared to an average balance of $23.6 billion with an average cost of 3.28% for the same period in 2001. The increase in the balance of deposits is due to the success of product initiatives to grow core deposits and the Main Street acquisition. The decrease in average cost year to year is due primarily to declining market interest rates. -27- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Interest on borrowed funds was $107.4 million and $331.7 million for the three-month and nine-month periods ended September 30, 2002 compared to $127.0 million and $344.5 million for the same periods in 2001. The average balance of borrowings was $8.6 billion with an average cost of 5.13% for the nine-month period ended September 30, 2002 compared to an average balance of $7.6 billion with an average cost of 5.96% for the same period in 2001. Wholesale borrowings are currently an attractive source of funding. On November 6, 2002, the Federal Open Market Committee decided to lower its target for the federal funds rate by 50 basis points to 1 1/4 percent. Based on our current asset and liability position, as well as existing commitments, we do not expect that this action will have a material adverse impact on our net interest margin in the fourth quarter of 2002 or in the early part of 2003. Provision for Loan Losses The provision for loan losses is based upon credit loss experience and on the estimation of losses inherent in the current loan portfolio. The provision for loan losses for the three-month and nine-month periods ended September 30, 2002 was $38.0 million and $110.5 million, respectively compared to $22.0 million and $65.1 million for the same periods in 2001. The increase in the provision over 2001 was based on several factors: - One large commercial loan totaling $17.1 million was charged off in the amount of $15.5 million in the first and second quarter. The remaining balance on this loan has been collected. - In the first quarter, a $2.3 million charge-off was taken associated with the sale of $20.5 million in non-performing residential mortgages. - A $6.0 million provision was taken relative to the Main Street acquisition. - An increase in non-accrual commercial loans during each quarter, due to the current overall environment which remains less than favorable. - Loan growth of 10% from December 31, 2001 has also contributed to the increase in the current year provision compared with the prior year. Over the last few years, through several strategic acquisitions and internal restructuring initiatives, Sovereign has diversified its lending efforts and increased its emphasis on providing its customers with small business loans and an expanded line of commercial and consumer products, such as middle market asset-based lending and automobile loans. As a result of the increased risk inherent in these loan products and as Sovereign continues to place emphasis on commercial business and consumer lending in future periods, management will regularly evaluate Sovereign's loan portfolios, and its allowance for loan losses, and will adjust the loan loss allowance as is necessary. -28- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Sovereign's net charge-offs for the nine-month period ended September 30, 2002 were $94.8 million and consisted of charge-offs of $122.3 million and recoveries of $27.5 million. This compared to net charge-offs of $64.4 million consisting of charge-offs of $88.6 million and recoveries of $24.2 million for the nine-month period ended September 30, 2001. The increased level of charge-offs was driven by the events discussed above. The following table presents the activity in the allowance for possible loan losses for the periods indicated:
Nine-month Period Ended September 30, 2002 2001 ---- ---- Allowance, beginning of period $264,667 $256,356 Charge-offs: Residential 4,957 6,999 Commercial 64,836 31,684 Consumer 52,509 49,891 -------- -------- Total Charge-offs 122,302 88,574 -------- -------- Recoveries: Residential 353 2,145 Commercial 3,551 1,203 Consumer 23,613 20,879 -------- -------- Total Recoveries 27,517 24,227 -------- -------- Charge-offs, net of recoveries 94,785 64,347 Provision for possible loan losses 110,500 65,100 Main Street's allowance for loan losses 14,877 -- -------- -------- Allowance, end of period $295,259 $257,109 ======== ========
Non-Interest Income Total non-interest income was $110.2 million and $314.0 million for the three-month and nine-month periods ended September 30, 2002 compared to $99.2 million and $326.0 million for the same periods in 2001. Excluding securities and related derivatives transactions, total fees and other income for the three-month and nine-month periods ended September 30, 2002 were $97.5 million and $276.9 million as compared to $94.8 million and $308.5 million for the same periods in 2001. Consumer banking fees were $47.7 million and $130.5 million for the three-month and nine-month periods ended September 30, 2002 as compared to $37.6 million and $116.5 million for the same periods in 2001. Average core deposit balances have grown 14.78% over the past year due primarily to the success of recent product initiatives. The increases in consumer banking fees of $10.1 million and $14.0 million for the three-month and nine-month periods ended September 30, 2002 are attributed to the increase in the number of core deposit accounts and balances, as well as new fee products. Commercial banking fees were $25.0 million and $71.3 million for the three-month and nine-month periods ended September 30, 2002 as compared to $21.6 million and $57.6 million for the same periods in 2001. This increase of $3.4 million and $13.7 million was primarily due to higher loan volumes, increased market share and increased cash management fee income. Mortgage banking revenue was $4.2 million and $20.3 million for the three-month and nine-month periods ended September 30, 2002, respectively, as compared to $20.3 million and $56.4 million for the same periods in 2001. The principal components of mortgage banking revenues included gains from the sale of mortgage -29- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) loans, servicing fees, amortization of mortgage servicing rights and changes in the valuation allowance related to mortgage servicing rights. The reduction in revenues during the three-month period ended September 30, 2002 compared with the corresponding period in the preceding year resulted primarily from a decline in gains on loan sales by $7.5 million to $14.3 million and an increase in the valuation allowance associated with mortgage servicing rights of $7.4 million. The reduction in revenues during the nine-month period ended September 30, 2002 compared with the corresponding period in the preceding year resulted primarily from a decline in gains on loan sales by $38.4 million to $21.8 million. Our remaining mortgage servicing right capitalized asset was approximately $51 million at September 30, 2002. Capital markets revenues totaled $4.4 million and $9.6 million for the three-month and nine-month periods ended September 30, 2002 compared with $2.3 million and $8.2 million for the same periods in 2001. The reason for the increase from the prior year is due to increases in our customer base. Miscellaneous income was $5.4 million and $13.5 million for the three-month and nine-month periods ended September 30, 2002 compared to $2.6 million and $39.8 million for the same periods in 2001. The nine months ended September 30, 2001 included a $28.1 million gain related to the sale of branches located in southern New Jersey, Delaware and eastern Pennsylvania. Gain on investment securities and related derivatives transactions were $12.7 million and $37.1 million for the three-month and nine-month period ended September 30, 2002 compared to $4.4 million and $17.5 million for the same periods in 2001. The Company repositioned its investment portfolio with the sale of $2.0 billion of investment securities during the third and first quarter, resulting in gains of approximately $16.7 million and $20.0 million, respectively. The three-month period ended September 30, 2002 includes a charge of $4.0 million related to losses associated with CRA and venture capital equity investments. These investments have a book value of $23 million at September 30, 2002. General and Administrative Expenses General and administrative expenses for the three-month and nine-month periods ended September 30, 2002 were $207.3 million and $607.1 million, respectively, compared to $191.5 million and $580.9 million for the same periods in 2001, representing increases of $15.8 million and $26.2 million. The three-month period ended September 30, 2002 includes approximately $3.0 million of losses associated with sub-leasing facilities. Compensation costs increased due to insourcing of certain technology services, the 2002 impact of expensing stock options under SFAS No. 123 (see Note 13 in the Notes to Consolidated Financial Statements), and the Main Street acquisition. Expense reduction initiatives have favorably impacted occupancy and outside services. Other Expenses Other expenses were $35.3 million and $123.3 million for the three-month and nine-month periods ended September 30, 2002 compared to $146.0 million and $396.9 million for the same periods in 2001. The nine-month period ended -30- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) September 30, 2001, includes $243.2 million of expense related to payments under the non-solicitation provisions of the New England Acquisition (defined below). In 2000, Sovereign acquired certain businesses from Fleet Boston Financial as more fully described in the 2001 Annual Report on Form 10-K, the "New England Acquisition." Also during the nine-month period ended September 30, 2001, Sovereign recorded an $8.5 million charge as the last element of a restructuring initiative related to its company-wide restructuring announced in November of 2000. The restructuring, completed over the first quarter of 2001 and last quarter of 2000, resulted in elimination of over 600 positions and the closure of 14 in-store offices to consolidate efforts within our geographic footprint. Merger-related and integration charges of $15.9 million ($10.3 million or $0.04 per share, net of tax) related to the Main Street acquisition were recorded in the three-month period ended March 31, 2002. (See Note 12 to the Consolidated Financial Statements). As of September 30, 2002, substantially all costs incurred in connection with the restructuring activities have been incurred. Results for the three-month and nine-month periods ended September 30, 2002 included amortization of core deposit intangibles of $20.0 million and $60.7 million. Results for the three and nine month periods ended September 30, 2001 include $32.6 million and $101.4 million for amortization of goodwill and core deposit intangibles. Effective January 1, 2002, the Company discontinued goodwill amortization as a result of the adoption of Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" (See Notes to Consolidated Financial Statements in Part I of this document). No impairment charges were required to be recorded as a result of adoption of this statement. Income Tax Provision The income tax provision was $33.9 million and $90.7 million for the three-month and nine-month periods ended September 30, 2002 compared to $1.9 million and $9.8 million for the same periods in 2001. The effective tax rate for the three-month and nine-month periods ended September 30, 2002 was 26.7%, compared to 17.7% and 16.3% for the same periods in 2001. The current year tax rate differs from the statutory rate of 35% due to income from tax-exempt investments and income related to bank-owned life insurance. The effective tax rate for the 2001 quarters is lower than the current year rate due to the high proportion of permanent tax differences, in relation to the low level of recorded pretax income. Extraordinary Item In last year's reported results, Sovereign completed a $400 million term and revolving credit facility with Bank of Scotland of which $350 million was used to prepay an existing $350 million senior secured credit facility. In connection with this transaction, Sovereign wrote-off $6.5 million net of tax ($10.1 million pretax) of deferred issuance costs remaining from the existing line of credit. These costs were reflected net of tax as an extraordinary item in accordance with generally accepted accounting principles. -31- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) FINANCIAL CONDITION Loan Portfolio At September 30, 2002, commercial loans totaled $9.8 billion representing 44% of Sovereign's loan portfolio, compared to $8.6 billion or 42% of the loan portfolio at December 31, 2001 and $8.3 billion or 41% of the loan portfolio at September 30, 2001. The consumer loan portfolio (including home equity loans and lines of credit, automobile loans, and other consumer loans) totaled $8.1 billion at September 30, 2002, representing 36% of Sovereign's loan portfolio, compared to $6.8 billion or 33% of the loan portfolio at December 31, 2001 and $6.8 billion or 33% of the loan portfolio at September 30, 2001. The increase in the commercial and consumer portfolios is due to our increased emphasis on these loan types, decreased emphasis on residential mortgage loans and the purchase of Main Street Bancorp. Residential mortgage loans decreased $484.7 million to $4.5 billion at September 30, 2002 and now represent 20% of Sovereign's loan portfolio as compared to $5.0 billion and 25% at December 31, 2001. The decrease is consistent with the Company's strategy to de-emphasize this portfolio and resulted from scheduled payments and prepayments and a sale of non-performing residential loans, offset by residential loan purchases. At September 30, 2001 residential mortgage loans totaled $5.3 billion representing 26% of the loan portfolio. Non-Performing Assets At September 30, 2002 Sovereign's non-performing assets increased by $32.0 million to $276.7 million compared to $244.7 million at December 31, 2001. This increase is due to increases in non-performing commercial loans, offset by a decline in residential non-performing loans as a result of the sale of certain residential assets in the first quarter of 2002 and third and second quarter declines in residential non-performing assets. Non-performing assets as a percentage of total assets was .70% at September 30, 2002 and .69% at December 31, 2001. Sovereign generally places all commercial loans and residential loans with loan to values greater than 50% on non-performing status at 90 days or sooner, if management believes the loan has become impaired (unless return to current status is expected imminently). All other loans continue to accrue until they are 120 days delinquent, at which point they are either charged-off or placed on non-accrual status and anticipated losses are fully reserved, unless they are real estate loans evaluated to be well secured based on appraisals and are in the process of collection. At 180 days delinquent, anticipated losses on real estate loans are fully reserved or charged off. -32- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The following table presents the composition of non-performing assets at the dates indicated:
September 30, December 31, 2002 2001 ---- ---- Non-accrual loans: Commercial $ 127,418 $ 100,993 Commercial real estate 41,850 18,776 Consumer 31,066 28,032 Residential 53,919 76,737 ---------- ---------- Total non-accrual loans 254,253 224,538 Restructured loans 1,087 1,280 ---------- ---------- Total non-performing loans 255,340 225,818 Other real estate owned 14,128 12,076 Other repossessed assets 7,281 6,852 ---------- ---------- Total non-performing assets $ 276,749 $ 244,746 ========== ========== Past due 90 days or more as to interest or principal and accruing interest (1) $ 40,723 $ 54,599 Non-performing assets as a percentage of total assets .70% .69% Non-performing loans as a percentage of total loans 1.14% 1.11% Non-performing assets as a percentage of total loans and real estate owned 1.23% 1.20% Allowance for loan losses as a percentage of total non-performing assets 106.7% 108.1% Allowance for loan losses as a percentage of total non-performing loans 115.6% 117.2%
(1) Includes consumer and residential loans of $39.8 million and $51.0 million at September 30, 2002 and December 31, 2001, respectively. Loans ninety (90) days or more past due and still accruing interest fell by $13.8 million from December 31, 2001 to September 30, 2002. Ninety day delinquencies fell in all three categories, residential by $8.3 million, consumer by $2.8 million, and commercial by $2.7 million. Potential problem loans (loans for which management has doubts as to the borrowers ability to comply with present repayment terms, principally commercial loans delinquent more than 30 days but less than 90 days, although not currently classified as non-performing loans) amounted to approximately $71.9 million and $120 million at September 30, 2002 and December 31, 2001, respectively. -33- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses The following table presents the allocation of the allowance for loan losses and the percentage of each loan type of total loans at the dates indicated:
September 30, 2002 December 31, 2001 ------------------ ----------------- % of Loans % of Loans to to Amount Total Loans Amount Total Loans ------ ----------- ------ ----------- Allocated allowance: Commercial loans $188,472 44% $162,720 42% Consumer loans 72,417 36 59,555 33 Residential real estate mortgage loans 18,704 20 20,724 25 Unallocated allowance 15,666 n/a 21,668 n/a -------- --- -------- --- Total allowance for loan losses $295,259 100% $264,667 100% ======== === ======== ===
The adequacy of Sovereign's allowance for loan losses is regularly evaluated. Management's evaluation of the adequacy of the allowance to absorb loan losses takes into consideration the risks inherent in the loan portfolio, past loan loss experience, specific loans which have loss potential, geographic and industry concentrations, delinquency trends, economic conditions, the level of originations and other relevant factors. Management also considers loan quality, changes in the size and character of the loan portfolio, amount of non-performing loans, delinquency trends, economic conditions and industry trends when determining the allowance. Management believes the shift in loan composition from residential into commercial and consumer brings higher inherent risk. Sovereign maintains an allowance for loan losses sufficient to absorb inherent losses in the loan portfolio and believes the current allowance to be at a level adequate to cover such inherent losses. The Company gives consideration to other risk indicators when determining the appropriate allowance level. The allowance for loan losses consists of two elements: (i) an allocated allowance, which is comprised of allowances established on specific loans, and class allowances based on risk ratings, historical loan loss experience and current trends, and (ii) unallocated allowances based on both general economic conditions and other risk factors in the Company's individual markets and portfolios, and to account for a level of imprecision in management's estimation process. The specific allowance element of the allocated allowance is based on a regular analysis of criticized loans where internal credit ratings are below a predetermined classification. This analysis is performed at the relationship manager level, and periodically reviewed by the loan workout department. The specific allowance established for these criticized loans is based on a careful -34- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) analysis of related collateral value, cash flow considerations and, if applicable, guarantor capacity. The class allowance element of the allocated allowance is determined by an internal loan grading process in conjunction with associated allowance factors. These class allowance factors are updated as required and are based primarily on actual historical loss experience, peer group loss experience, and projected loss experience. While this analysis is conducted quarterly, the Company has the ability to revise the class allowance factors whenever necessary in order to address improving or deteriorating credit quality trends or specific risks associated with a given loan pool classification. Regardless of the extent of the Company analysis of customer performance, portfolio evaluations, trends or risk management processes established, certain inherent, but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions; customer fraud, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends; volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits; and the sensitivity of assumptions utilized to establish allocated allowances for homogeneous groups of loans among other factors. The Company maintains an unallocated allowance to recognize the existence of these exposures. These other risk factors are continuously reviewed and revised by management where conditions indicate that the estimates initially applied are different from actual results. A comprehensive analysis of the allowance for loan losses is performed by the Company on a quarterly basis. In addition, a review of allowance levels based on nationally published statistics is conducted on an annual basis. The Company has an Asset Review Committee, which has the responsibility of affirming allowance methodology and assessing the general and specific allowance factors in relation to estimated and actual net charge-off trends. This Committee is also responsible for assessing the appropriateness of the allowance for loan losses for each loan pool classification at Sovereign. Commercial Portfolio. The portion of the allowance for loan losses related to the commercial portfolio has increased from $162.7 million at December 31, 2001 to $188.5 million at September 30, 2002. This increase is warranted by the softening economy, the increase in non-performing and adversely classified loans in this sector and the addition of loans in part due to the Main Street acquisition. Consumer Portfolio. The allowance for the consumer loan portfolio increased from $59.6 million at December 31, 2001, to $72.4 million at September 30, 2002 due to increases in loan balances. Residential Portfolio. The allowance for the residential mortgage portfolio decreased from $20.7 million at December 31, 2001 to $18.7 million at September 30, 2002. This change was due primarily to the reduction in size of the overall residential portfolio. -35- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Unallocated Allowance. The unallocated allowance for loan losses decreased to $15.7 million at September 30, 2002 from $21.7 million at December 31, 2001. Management continuously evaluates current economic conditions and loan portfolio trends. However, this balance is subject to significant changes each reporting period due to certain inherent but undetected losses that are probable within the loan portfolio. This is due to several factors including delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions; the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends; volatility of economic or customer conditions and the sensitivity of assumptions utilized to establish allocated allowances for homogeneous groups of loans among other factors. Sovereign maintains an unallocated allowance to recognize the existence of these exposures. Investment Securities Investment securities consist primarily of mortgage-backed securities, U.S. Treasury and government agency securities, corporate debt securities and stock in the Federal Home Loan Bank of Pittsburgh ("FHLB"), Freddie Mac and Fannie Mae. Mortgage-backed securities consist of pass-throughs and collateralized mortgage obligations issued by federal agencies or private label issuers. Sovereign's mortgage-backed securities are generally either guaranteed as to principal and interest by the issuer or have ratings of "AAA" by Standard and Poor's and Moody's at the date of issuance. Sovereign purchases classes which are senior positions backed by subordinate classes. The subordinate classes absorb the losses and must be completely eliminated before any losses flow through the senior positions. The effective duration of the total investment portfolio at September 30, 2002 was 1.73 years. Total investment securities available-for-sale were $11.1 billion at September 30, 2002 and $9.6 billion at December 31, 2001. Investment securities held-to-maturity were $704.8 million at September 30, 2002 compared to $883.4 million at December 31, 2001. For additional information with respect to Sovereign's investment securities, see Notes 3 and 4 in the Notes to Consolidated Financial Statements. Goodwill and Core Deposit Intangible Assets Goodwill increased by $70.6 million and the gross carrying amount of core deposit intangibles increased by $34.4 million since December 31, 2001 primarily due to the Main Street acquisition. Year-to-date core deposit intangible amortization of $60.7 million has been recorded in 2002. Deposits Sovereign attracts deposits within its primary market area with an offering of deposit instruments including demand accounts, NOW accounts, money market accounts, savings accounts, certificates of deposit and retirement savings plans. Total deposits at September 30, 2002 were $26.5 billion compared to $23.3 billion at December 31, 2001. Sovereign continues to emphasize strategies to grow core deposits and limit higher priced time deposits. -36- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Borrowings Sovereign utilizes borrowings (original maturities of up to one year) as a source of funds for its asset growth and its asset/liability management. Collateralized advances are available from the FHLB provided certain standards related to creditworthiness have been met. Sovereign also utilizes reverse repurchase agreements, which are short-term obligations collateralized by securities fully guaranteed as to principal and interest by the U.S. Government or an agency thereof, and federal funds lines with other financial institutions. Total borrowings at September 30, 2002 and December 31, 2001 were $3.1 billion and $2.7 billion, respectively. See Note 7 in the Notes to Consolidated Financial Statements for additional information. Long-Term Debt Long-term debt (original maturities greater than one year) were $6.0 billion and $6.3 billion at September 30, 2002 and December 31, 2001, respectively. See Note 8 in the Notes to Consolidated Financial Statements for additional information. Trust Preferred Securities Sovereign has outstanding $397 million ($503 million par value) of mandatorily redeemable trust preferred obligations that have stated maturities ranging from 2027 through 2031 and have stated dividends of 7.50% to 9.875% of par value. As discussed in our 2001 annual report on Form 10-K in Note 12, Sovereign has outstanding a preferred capital security (Trust Preferred II) and associated warrants whose balance totaled $187.8 million and $91.5 million, respectively, at September 30, 2002. Sovereign may elect to redeem the Trust Preferred II securities and the warrants after November 20, 2002, if the value of Sovereign's common stock on 20 trading days out of the preceding 30 consecutive trading days and on the day the election is made exceeds $14.99. Securitization Transactions Securitization transactions contribute to Sovereign's overall funding and regulatory capital management. These transactions involve periodic transfers of loans or other financial assets to special purpose entities ("SPEs"). The SPEs are either consolidated in or excluded from Sovereign's consolidated financial statements depending on whether the transactions qualify as a sale of assets in accordance with SFAS No. 140, "Transfers of Financial Assets and Liabilities" ("SFAS No. 140"). Unconsolidated Securitizations - In certain transactions, Sovereign has transferred assets to SPEs qualifying for non-consolidation ("QSPE") and has accounted for the transaction as a sale in accordance with SFAS No. 140. Sovereign also has retained interests in the QSPEs. Off-balance sheet QSPEs had $1.4 billion of debt related to assets that Sovereign sold to the QSPEs which is not included in Sovereign's consolidated Balance Sheet at September 30, 2002. Sovereign's retained interests in such QSPEs were $100.6 million at September 30, -37- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) 2002. Sovereign does not provide contractual legal recourse to third party investors that purchase debt or equity securities issued by the QSPEs beyond the credit enhancement inherent in Sovereign's subordinated interests in the QSPEs. Securitizations Consolidated in Sovereign's Financial Statements - In a transaction consummated in November 2001, the "November 2001 transaction", Sovereign accessed the liquidity of international markets and transferred $957 million of indirect automobile loans to SPEs. The transaction is classified as a financing under SFAS No. 140, and therefore the SPEs are consolidated in Sovereign's financial statements in accordance with generally accepted accounting principles. At September 30, 2002, Sovereign had $957 million of indirect automobile loans, $821 million of debt and $64 million of minority interest reflected on its Consolidated Balance Sheet related to consolidated SPEs. See "Minority Interests" below. Additionally, Sovereign will periodically sell qualifying mortgage loans to FHLMC, GNMA, and FNMA in return for mortgage-backed securities issued by those agencies. Sovereign reclassifies the net book balance of the loans sold to such agencies from loans to investment securities held to maturity and available for sale. For those loans sold to the agencies in which Sovereign retains servicing rights, Sovereign allocates the net book balance transferred between servicing rights and investment securities based on their relative fair values. Minority Interests Minority interests represent the equity value and earnings attributable to that portion of consolidated subsidiaries which are owned by parties independent of Sovereign. Earnings attributable to minority interests are reflected in trust preferred securities and other minority interest expense on the Consolidated Statements of Operations. As part of the November 2001 transaction, Sovereign received $64 million from the sale to outside investors of controlling ownership interests in SPEs formed to issue debt and equity interests as parts of a financing transaction which raised a total of $885 million for Sovereign. See "Securitization Transactions" in the preceding sections of this document. On August 21, 2000, Sovereign received approximately $140 million of net proceeds from the issuance of $161.8 million of 12% Series A Non-cumulative Preferred Interests in Sovereign Real Estate Investment Trust ("SREIT"), a subsidiary of Sovereign Bank which holds primarily residential real estate loans. The preferred stock was issued at a discount, which is being amortized over the life of the preferred shares using the effective yield method. The preferred shares may be redeemed at any time on or after May 16, 2020, at the option of Sovereign subject to the approval of the OTS. Under certain circumstances, the preferred shares are automatically exchangeable into preferred stock of Sovereign Bank. -38- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Termination of Employee Stock Ownership Plan Sovereign discontinued in 2002, the employee stock ownership plan it assumed upon acquisition of Peoples Bancorp Inc., in 1999. The Plan repaid debt owed to Sovereign with the proceeds of unallocated Sovereign shares, which the Plan sold. Shares allocated to active plan participants will be distributed to those participants following approval of the Plan of Termination by the Internal Revenue Service. Bank Regulatory Capital The Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA") requires institutions regulated by the Office of Thrift Supervision (OTS) to have a minimum leverage capital ratio equal to 3% of tangible assets and 4% of risk-adjusted assets, and a risk-based capital ratio equal to 8% as defined. The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") requires OTS regulated institutions to have a minimum tangible capital equal to 2% of total tangible assets. The FDICIA established five capital tiers: well-capitalized, adequately-capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. A depository institution's capital tier depends upon its capital levels in relation to various relevant capital measures, which include leverage and risk-based capital measures and certain other factors. Depository institutions that are not classified as well-capitalized or adequately-capitalized are subject to various restrictions regarding capital distributions, payment of management fees, acceptance of brokered deposits and other operating activities. The OTS Order, as amended, applicable to the approval of the New England Acquisition (the "OTS Order") requires Sovereign Bank to be "Well Capitalized" and also to meet certain additional capital ratio requirements above the regulatory minimums, and other conditions. Various agreements with Sovereign's lenders also require Sovereign Bank to be "Well Capitalized" at all times and in compliance with all regulatory requirements. To be "Well Capitalized," a thrift institution must maintain a Tier 1 Leverage ratio of at least 5%, a Tier 1 risk-based capital ratio of 6% and total risk-based capital of 10%. Although OTS capital regulations do not apply to savings and loan holding companies, the OTS Order requires Sovereign to maintain certain Tier 1 capital levels. At September 30, 2002 and December 31, 2001, Sovereign and Sovereign Bank had met all quantitative thresholds necessary to be classified as well-capitalized under regulatory guidelines and the OTS Order. Federal banking laws, regulations and policies also limit Sovereign Bank's ability to pay dividends and make other distributions to Sovereign Bancorp. Sovereign Bank is required to give prior notice to the OTS before paying any dividend. In addition Sovereign Bank must obtain prior OTS approval to declare a dividend or make any other capital distribution if, after such dividend or distribution, Sovereign Bank's total distributions to the Bancorp within that calendar year would exceed 100% of its net income during the year plus retained net income for the prior two years, Sovereign Bank would not meet capital levels imposed by the OTS in connection with any order, including the OTS Order applicable to the New England Acquisition completed in -39- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) 2000, as amended, or if Sovereign Bank is not adequately capitalized at the time. In addition, OTS prior approval would be required if Sovereign Bank's examination or CRA ratings fall below certain levels or Sovereign Bank is notified by the OTS that it is a problem association or an association in troubled condition. The following schedule summarizes the actual capital balances of Sovereign Bank at September 30, 2002 and December 31, 2001 (in thousands):
TIER 1 TIER 1 TOTAL REGULATORY CAPITAL TANGIBLE LEVERAGE RISK-BASED RISK-BASED CAPITAL TO CAPITAL TO CAPITAL TO CAPITAL TO TANGIBLE TANGIBLE RISK ADJUSTED RISK ADJUSTED ASSETS ASSETS ASSETS ASSETS ------------- ------------- ------------- ------------- Sovereign Bank at September 30, 2002: Regulatory capital $ 2,791,640 $ 2,794,585 $ 2,695,770 $ 2,968,603 Minimum capital requirement (1) 758,941 2,656,500 1,117,940 2,934,593 ------------- ------------- ------------- ------------- Excess $ 2,032,699 $ 138,085 $ 1,577,830 $ 34,010 ============= ============= ============= ============= Capital ratio 7.36% 7.36% 9.65% 10.62% Sovereign Bank at December 31, 2001: Regulatory capital $ 2,464,222 $ 2,470,620 $ 2,368,893 $ 2,616,871 Minimum capital requirement (1) 685,584 2,399,545 979,792 2,571,955 ------------- ------------- ------------- ------------- Excess $ 1,778,638 $ 71,075 $ 1,389,101 $ 44,916 ============= ============= ============= ============= Capital ratio 7.19% 7.21% 9.67% 10.68%
(1) Minimum capital requirement as defined by OTS Regulations, or the OTS Order, whichever is higher. Liquidity and Capital Resources Liquidity represents the ability of Sovereign to obtain cost effective funding to meet the needs of customers, as well as Sovereign's financial obligations. Sovereign's primary sources of liquidity include retail deposit gathering, Federal Home Loan Bank (FHLB) borrowings, federal funds purchases, reverse repurchase agreements and wholesale deposit purchases. Other sources of liquidity include asset securitizations, liquid investment portfolio securities and debt and equity issuances. Factors which impact the liquidity position of Sovereign include loan origination volumes, loan prepayment rates, maturity structure of existing loans, core deposit growth levels, CD maturity structure and retention, Sovereign's credit ratings, investment portfolio cash flows, maturity structure of wholesale funding, etc. These risks are monitored and centrally managed. This process includes reviewing all available wholesale liquidity sources. As of September 30, 2002, Sovereign had $6.2 billion in available overnight liquidity in the form of unused federal funds purchased lines, unused FHLB borrowing capacity and unencumbered investment portfolio securities. Sovereign also forecasts future liquidity needs and develops strategies to ensure that adequate liquidity is available at all times. Sovereign's holding company has the following major sources of funding to meet its liquidity requirements: dividends and returns of investment from its subsidiaries, a revolving credit agreement and access to the capital markets. Sovereign Bank may pay dividends to its parent subject to approval of the OTS, as discussed above. Year-to-date Sovereign Bank declared and paid dividends to the parent company of $140 million in 2002. Sovereign also has approximately $900 million of availability under a shelf registration statement on file with the Securities and Exchange Commission permitting ready access to the public debt and -40- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) equity markets. The OTS has approved payment of up to $160 million of additional dividends throughout the remainder of 2002 as long as Sovereign and Sovereign Bank comply with the covenants contained within their dividend approval request. Cash and cash equivalents increased $328.8 million for 2002. Net cash provided by operating activities was $124 million for 2002. Net cash used by investing activities for 2002 was $1.8 billion and consisted primarily of the purchase of investments of $8.2 billion, purchase of loans of $1.5 billion and the net change in loans other than purchases and sales of $1.8 billion offset by sales, repayments and maturities of investments of $7.5 billion and proceeds from loan sales of $2.0 billion. Net cash provided by financing activities for 2002 was $2.1 billion which was primarily due to an increase in deposits. Contractual Obligations and Commercial Commitments Sovereign enters into contractual obligations in the normal course of business as a source of funds for its asset growth and its asset/liability management, to fund acquisitions, and to meet required capital needs. These obligations require Sovereign to make cash payments over time as detailed in the table below.
Contractual Obligations Payments Due by Period (in thousands of dollars) ---------------------- Less than Over 1 yr Over 3 yrs Over Total 1 year to 3 yrs to 5 yrs 5 yrs ----------- ----------- ----------- ----------- ----------- Borrowings $ 3,117,483 $ 3,117,483 $ -- $ -- $ -- Securities sold under repurchase agreements 155,000 -- -- 155,000 -- FHLB advances 3,892,688 100,000 313,450 306 3,478,932 Other debt 1,949,709 50,380 525,071 553,258 821,000 Trust Preferred securities 502,500 -- -- -- 502,500 Certificates of deposit 7,508,889 5,576,910 1,674,658 170,351 86,970 Operating leases 780,775 105,092 291,732 95,334 288,617 ----------- ----------- ----------- ----------- ----------- Total contractual cash obligations $17,907,044 $ 8,949,865 $ 2,804,911 $ 974,249 $ 5,178,019 =========== =========== =========== =========== ===========
Certain of Sovereign's contractual obligations require Sovereign to maintain certain financial ratios and to maintain a "well capitalized" regulatory status. Sovereign has complied with these covenants as of September 30, 2002 and expects to be in compliance with these covenants for the foreseeable future. However, if in the future Sovereign is not in compliance with these ratios or is deemed to be other than well capitalized by the OTS, and is unable to obtain a waiver from its lenders, the debt would be in default and callable by Sovereign's lenders. Due to cross-default provisions in certain of Sovereign's debt agreements, if more than $25 million of Sovereign's debt is in default, $875 million of senior notes and the full amount of the senior secured credit facility then outstanding will become due in full. -41- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Sovereign 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 and to manage its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, loans sold with recourse, forward contracts and interest rate swaps, caps and floors. These financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of these financial instruments reflect the extent of involvement Sovereign has in particular classes of financial instruments. Sovereign's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and loans sold with recourse is represented by the contractual amount of those instruments. Sovereign uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. For interest rate swaps, caps and floors and forward contracts, the contract or notional amounts do not represent exposure to credit loss. Sovereign controls the credit risk of its interest rate swaps, caps and floors and forward contracts through credit approvals, limits and monitoring procedures. Unless noted otherwise, Sovereign does not require and is not required to pledge collateral or other security to support financial instruments with credit risk. Amount of Commitment Expiration Per Period
Total Other Commercial Amounts Less than Over 1 yr Over 3 yrs Commitments Committed 1 year to 3 yrs to 5 yrs Over 5 yrs ----------- --------- ------ -------- -------- ---------- Commitments to extend credit $7,593,647 $4,668,988 $1,077,048 $ 361,055 $1,486,556 Standby letters of credit 885,102 295,743 171,995 396,837 20,527 Loans sold with recourse 16,870 -- -- -- 16,870 Forward contracts 1,106,037 1,101,037 5,000 -- -- ---------- ---------- ---------- ---------- ---------- Total commercial commitments $9,601,656 $6,065,768 $1,254,043 $ 757,892 $1,523,953 ========== ========== ========== ========== ==========
Asset and Liability Management Interest rate risk arises primarily through Sovereign's traditional business activities of extending loans and accepting deposits. Many factors, including economic and financial conditions, movements in market interest rates and consumer preferences, affect the spread between interest earned on assets and interest paid on liabilities. In managing its interest rate risk, Sovereign seeks to minimize the variability of net interest income across various likely scenarios while at the same time maximizing its net interest income and net interest margin. To achieve these objectives, Sovereign works closely with each business line in the company and guides new business flows. Sovereign also uses various other tools to manage interest rate risk including wholesale funding maturity targeting, investment portfolio purchase strategies, asset securitization/sale, and financial derivatives. -42- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Interest rate risk is managed centrally by the Treasury Group with oversight by the Asset and Liability Committee. Management reviews various forms of analysis to monitor interest rate risk including net interest income sensitivity, market value sensitivity, repricing frequency of assets versus liabilities and scenario analysis. Numerous assumptions are made to produce these analyses including, but not limited to, assumptions on new business volumes, loan and investment prepayment rates, deposit flows, interest rate curves, economic conditions, and competitor pricing. Sovereign simulates the impact of changing interest rates on its expected future interest income and interest expense (net interest income sensitivity). This simulation is run monthly and it includes nine different stress scenarios. These scenarios shift interest rates up and down. Certain other scenarios shift short-term rates up while holding longer-term rates constant and vice versa. This scenario analysis helps management to better understand its short-term interest rate risk and is used to develop proactive strategies to ensure that Sovereign is not overly sensitive to the future direction of interest rates. At September 30, 2002 and December 31, 2001, the general level of interest rates represented a unique economic environment in which several of Sovereign's declining interest rate simulation scenarios would not apply. At September 30, 2002, if interest rates dropped in parallel 100 basis points Sovereign estimates that net interest income would fall 4.3%. Alternatively, if interest rates rose in parallel 200 basis points, estimated net interest income would increase 6.6% Sovereign also monitors the relative repricing sensitivities of its assets versus its liabilities. Management attempts to keep assets and liabilities in balance so that when interest rates do change, the net interest income of Sovereign will not experience any significant short-term volatility as a result of assets repricing more quickly than liabilities or vice versa. As of September 30, 2002, the one year cumulative gap was 7%, compared to 9% at December 31, 2001 indicating Sovereign could benefit from rising rates. Finally, Sovereign calculates the market value of its balance sheet including all assets, liabilities and hedges. This market value analysis is very useful because it measures the present value of all estimated future interest income and interest expense cash flows of the company. Net Portfolio Value (NPV) is used to assess long-term interest rate risk. A higher NPV ratio indicates lower long-term interest rate risk and a more valuable franchise. As of September 30, 2002, the NPV as a percentage of the present value of assets was 9.61% as compared to 11.68% at December 31, 2001. Management reviews the sensitivity of NPV to changes in interest rates. As of September 30, 2002, a 200 basis point rise in interest rates would increase the NPV ratio by 1.75% as compared to 1.18% at December 31, 2001 and a 100 basis point decline in interest rates would decrease the NPV ratio by .72% as compared to .45% at December 31, 2001. Because the assumptions used are inherently uncertain, Sovereign cannot precisely predict the effect of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude and frequency of interest rate changes, the difference between actual experience and the assumed volume and characteristics of new business and behavior of existing positions, and changes in market conditions and management strategies, among other factors. -43- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Pursuant to its interest rate risk management strategy, Sovereign enters into hedging transactions that involve interest rate exchange agreements (swaps, caps, and floors) for interest rate risk management purposes. Sovereign's objective in managing its interest rate risk is to provide sustainable levels of net interest income while limiting the impact that changes in interest rates have on net interest income. Interest rate swaps are generally used to convert fixed rate assets and liabilities to variable rate assets and liabilities and vice versa. Sovereign utilizes interest rate swaps that have a high degree of correlation to the related financial instrument. At September 30, 2002, Sovereign's principal hedging transactions were to convert liabilities from floating rate to fixed rate for interest rate risk management purposes. As part of its mortgage banking strategy, Sovereign originates fixed rate residential mortgages. It sells the majority of these loans to FHLMC, FNMA, and private investors. The loans are exchanged for cash or marketable fixed rate mortgage-backed securities which are generally sold. This helps insulate Sovereign from the interest rate risk associated with these fixed rate assets. Sovereign uses forward sales, cash sales and options on mortgage-backed securities as a means of hedging loans in the mortgage pipeline that are originated for sale. To accommodate customer needs, Sovereign enters into customer-related financial derivative transactions primarily consisting of interest rate swaps, caps, and floors. Risk exposure from customer positions is managed through transactions with other dealers. Through the Company's capital markets, mortgage-banking and precious metals activities, it is subject to trading risk. The Company employs various tools to measure and manage price risk in its trading portfolios. In addition, the Board of Directors has established certain limits relative to trading positions and activities. The level of price risk exposure at any given point in time depends on the market environment and expectations of future price and market movements, and will vary from period to period. Item 3. Quantitative and Qualitative Disclosures about Market Risk Incorporated by reference from Part I, Item 2. "Management's Discussion and Analysis of Results of Operations and Financial Condition - Asset and Liability Management" hereof. Item 4. Controls and Procedures Within 90 days prior to the date of filing this report, an evaluation was performed under the supervision and the participation of the Company's management, including the principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-15. Based on that evaluation, the Company's principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures were effective as of the date the Company completed its evaluation. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the date the Company completed its evaluation. -44- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Items 1 through 5 not applicable or the responses are negative. Item 6 - Exhibits and Reports on Form 8-K. (a) Exhibits (3.1) Articles of Incorporation, as amended and restated, of Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Sovereign's Registration Statement No. 333-86961-01 on Form S-3) (3.2) By-Laws of Sovereign Bancorp, Inc., as amended and restated as of August 14, 2002. (10.1) Employment agreement by and between Sovereign Bancorp, Inc. and James J. Lynch dated September 16, 2002. (99.1) Chief Executive Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (99.2) Chief Financial Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K On August 14, 2002, the Company filed a current report on Form 8-K dated August 14, 2002, reporting information under Items 7 and 9. -45- 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. SOVEREIGN BANCORP, INC. (Registrant) Date November 14, 2002 /s/Jay S. Sidhu ---------------------------------------- Jay S. Sidhu, Chairman, Chief Executive Officer and President (Authorized Officer) Date November 14, 2002 /s/James D. Hogan ---------------------------------------- James D. Hogan Chief Financial Officer -46- CERTIFICATIONS I, Jay S. Sidhu, Chief Executive Officer of Sovereign Bancorp, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Sovereign Bancorp, Inc.; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly 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 quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures 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 quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ Jay S. Sidhu ----------------------- Jay S. Sidhu Chief Executive Officer -47- I, James D. Hogan, Chief Financial Officer of Sovereign Bancorp, Inc., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Sovereign Bancorp, Inc.; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly 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 quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures 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 quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ James D. Hogan ----------------------- James D. Hogan Chief Financial Officer -48- SOVEREIGN BANCORP, INC. AND SUBSIDIARIES EXHIBITS INDEX (3.1) Articles of Incorporation, as amended and restated, of Sovereign Bancorp, Inc. (Incorporated by reference to Exhibit 3.1 to Sovereign's Registration Statement No. 333-86961-01 on Form S-3) (3.2) By-Laws of Sovereign Bancorp, Inc., as amended and restated as of August 14, 2002. (10.1) Employment agreement by and between Sovereign Bancorp, Inc. and James J. Lynch dated September 16, 2002. (99.1) Chief Executive Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (99.2) Chief Financial Officer certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -49- EX-3.2 3 w65673exv3w2.txt BY-LAWS OF SOVEREIGN BANCORP, INC. EXHIBIT 3.2 FOURTH VERSION Amended 1/18/94, 3/22/95 and 4/24/02 and 8/14/02 BY-LAWS OF SOVEREIGN BANCORP, INC. ARTICLE ONE OFFICES 1.01. Registered Office. The registered office of the Company shall be located in such place as the Board of Directors may from time to time designate. 1.02. Other Offices. The Company may also have offices at such other places within or without the Commonwealth of Pennsylvania as the Board of Directors may from time to time designate or the business of the Company may require. ARTICLE TWO SEAL 2.01. Seal. The corporate seal shall have inscribed thereon the name of the Company, the year of its incorporation and the words "Corporate Seal, Pennsylvania," and shall be in the form imprinted immediately following this Section 2.01. ARTICLE THREE SHAREHOLDERS' MEETINGS 3.01. Place of Meeting. Meetings of shareholders shall be held at any geographic location within or without the Commonwealth of Pennsylvania as shall be fixed from time to time by the Board of Directors. In the absence of such designation, shareholders' meetings shall be held at the executive office of the Company. Shareholders shall not be permitted to participate in any meeting of shareholders by means of conference telephone or the Internet or other electronic communications technology, unless the Board of Directors, by resolution so directs with respect to such meeting. Meetings held by means of the Internet conference or telephone or other electronic communications technology shall not be required to be held at a particular geographic location and shall provide shareholders with the opportunity to read or hear the proceedings substantially concurrently with their occurrence, vote on matters submitted to the shareholders and pose questions to the directors. 3.02. Annual Meeting. The annual meeting of shareholders shall be held, commencing with the year 1988, on such day each year as may be fixed from time to time by the Board of Directors, or, if no day be so fixed, on the third Thursday of April of each year, provided, however, that if such day falls upon a legal holiday, then on the next business day thereafter. At 1 such meetings, directors shall be elected, reports of the affairs of the Company shall be considered, and any other business may be transacted which is within the powers of the shareholders. 3.03. (a) Notice of Meetings. Notice of all meetings of shareholders shall be delivered, personally, by courier service, charges prepaid, by first class, express or bulk mail, postage prepaid, facsimile transmission, e-mail or other electronic communication addressed to the shareholder at his or her postal address, facsimile number, e-mail address or other electronic communication location as it appears on the books of the Company or as supplied by such shareholder to the Company for the purpose of notice, by or at the direction of the Chief Executive Officer, the Secretary or the officer or persons calling the meeting. (b) Time of Notice. Notice of any meeting of shareholders shall be delivered not less than ten (10) days, or in the case of bulk mail not less than twenty (20) days, before the date of the meeting. If the notice is sent by mail or courier, such notice shall be deemed to be delivered when deposited in the United States mail or with a courier service for delivery to the shareholder. If the notice is sent by facsimile, e-mail or other electronic communication, such notice shall be deemed to be delivered when sent to the shareholder. (c) Contents of Notice. Notice of any meeting of shareholders shall state the day, hour and geographic location, if any, of the meeting. The notice shall also state the general nature of the business to be transacted if it is a special meeting. (d) Notice of Adjourned Meeting. When a shareholders' meeting is adjourned, it shall not be necessary to give any notice of the adjourned meeting or of the business to be transacted thereat other than by announcement at the meeting at which the adjournment is taken, unless the board of directors fixes a new record date for the new meeting. 3.04. (a) Calling of Special Meetings. Upon request in writing to the Chief Executive Officer, Vice President or Secretary, sent by registered mail or delivered to the officer in person, by any persons entitled to call a special meeting of shareholders, the Secretary of the Company shall fix as the date of the meeting a date not less than sixty (60) days after the receipt of the request, and cause notice to be delivered to the shareholders entitled to vote thereat in accordance with Section 3.03 of these By-laws. Nothing contained in this section shall be construed as limiting, fixing, or affecting the time or date when a meeting of shareholders called by action of the Board of Directors may be held. (b) Persons Entitled to Call Special Meetings. Special meetings of the shareholders may be called at any time by any of the following: (1) the Board of Directors at a duly called and held meeting of the Board of Directors or upon the unanimous written consent of the members of the Board of Directors; or (2) the Chairman of the Board or the Chief Executive Officer, but only upon receiving written direction of at least a majority of directors then in office. (c) Business of Special Meeting. Business transacted at all special meetings shall be confined to the objects stated in the notice and matters germane thereto, unless all shareholders entitled to vote are present and shall have otherwise consented. 3.05. (a) Quorum of Shareholders. The presence, in person or by proxy, of shareholders entitled to cast at least a majority of the votes which all of shareholders are entitled 2 to cast (after giving effect to any "excess shares" provision contained in the Articles of Incorporation of the Company), shall constitute a quorum at the meeting of shareholders. If a proxy casts a vote on behalf of a shareholder on any issue other than a procedural motion considered at a meeting of shareholders, the shareholder shall be deemed to be present during the entire meeting for purposes of determining whether a quorum is present for consideration of any other issue. If a quorum is present, the affirmative vote of a majority of all votes represented at the meeting shall be the act of the shareholders, unless the vote of a greater number or the voting by classes is required by the Pennsylvania Business Corporation Law, the Articles of Incorporation of the Company or these By-laws. (b) Adjournment for Lack or Loss of Quorum. In the absence of a quorum or upon the withdrawal of enough shareholders to leave less than a quorum, any meeting of shareholders may be adjourned from time to time by the affirmative vote of a majority of all votes cast at the meeting, but no other business may be transacted. Meetings at which directors are to be elected shall be adjourned only from day to day or for such longer periods not exceeding fifteen (15) days each and those shareholders who attend the second of such adjourned meetings, although less than a quorum, shall nevertheless constitute a quorum for the purpose of electing directors. 3.06. (a) Closing Transfer Books. For the purpose of determining shareholders entitled to notice of or to vote at any meeting of shareholders, or shareholders entitled to receive payment of any dividend, or in order to make a determination of shareholders for any other proper purpose, the Board of Directors may provide, or may authorize any officer to provide, that the share transfer books shall be closed for a stated period not to exceed fifty (50) days, in which case written or printed notice thereof shall be mailed at least ten (10) days before the beginning of such period to each shareholder of record at the address appearing on the books of the Company or supplied by him to the Company for the purpose of notice. (b) Record Date. In lieu of closing the share transfer books, the Board of Directors may fix in advance, or may authorize any officer to fix, a date as the record date for any such determination of shareholders, such date in any case to be not more than ninety (90) days prior to the date on which the particular action requiring such determination of shareholders is to be taken. (c) Other Determination of Shareholders. If the share transfer books are not closed and no record date is fixed for the determination of shareholders entitled to notice of or to vote at a meeting of shareholders, or shareholders entitled to receive payment of a dividend, the date fifteen (15) days after the date on which the resolution of the Board of Directors declaring such dividend is adopted shall be the record date for such determination of shareholders. (d) Adjourned Meetings. When any determination of shareholders entitled to vote at any meeting of shareholders has been made as provided in this Article, such determination shall apply to any adjournment thereof. 3.07. Inspection of Corporate Records. Every shareholder, upon written demand under oath stating the purpose thereof, shall have the right to examine, in person or by agent or attorney, during the usual hours for business for any proper purpose, the share register, books or records of account, and records of the proceedings of the shareholders and directors, and make 3 copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to such person's interest as a shareholder. In every instance where an attorney or other agent shall be the person who seeks the right of inspection, the demand under oath shall be accompanied by a power of attorney or other writing which authorizes the attorney or other agent to so act on behalf of the shareholder. In all cases, the demand under oath shall be directed to the Company at its registered office in the Commonwealth of Pennsylvania, at its principal place of business or in care of the person in charge of the actual business office of the Company. For purposes of this Section 3.07, the Company's principal place of business and its sole actual business office shall be deemed to be the location where the Chief Executive Officer maintains his or her principal office and the person in charge of that office shall be deemed to be the Chief Executive Officer. 3.08. Voting List. The officer or agent having charge of the transfer book for shares of the Company shall make, at least ten (10) days before each meeting of shareholders, a complete list of the shareholders entitled to vote at such a meeting, arranged in alphabetical order, with the address of and the number of shares held by each, which list, for a period of ten (10) days prior to such meeting, shall be kept on file at the registered office of the Company and shall be subject to inspection by any shareholder at any time during usual business hours. Such list shall also be produced and kept open at the time and place of the meeting and shall be subject to the inspection of any shareholder during the whole time of the meeting. The original share ledger or transfer book, or a duplicate thereof kept in the Commonwealth of Pennsylvania, shall be prima facie evidence as to who are the shareholders entitled to examine such list or share or transfer book or to vote at any meeting of shareholders. 3.09. Voting of Shares. Except as otherwise provided in the Articles of Incorporation of the Company, each outstanding share, regardless of class, shall be entitled to one vote on each matter submitted to a vote at a meeting of shareholders. 3.10. (a) Nominations for Directors. Nominations for the election of Directors may be made by the Board of Directors or by any shareholder entitled to vote for the election of directors. Nominations made by the shareholders entitled to vote for the election of directors shall be made by notice in writing, delivered or mailed by first class United States mail, postage prepaid, to the Secretary of the Company not less than ninety (90) days nor more than one hundred and twenty (120) days prior to any meeting of shareholders called for election of directors; provided, however, that if less than twenty-one (21) days' notice of the meeting is given to shareholders, such written notice shall be delivered or mailed, as prescribed, to the Secretary of the Company not later than the close of the seventh day following the day on which notice was mailed to shareholders. Notice of nominations, which are proposed by the Board of Directors, shall be given by the Chairman of the Board or any other appropriate officer. Each notice shall set forth (i) the name, age, business address and, if known, residence address of each nominee proposed in such notice, (ii) the principal occupation or employment of each nominee, and (iii) the number of shares of capital stock of the Company which are beneficially owned by each such nominee and the earliest date of acquisition of any of such stock. The Chairman of a meeting of shareholders may, if the facts warrant, determine and declare to the meeting that a nomination was not made in accordance with the foregoing procedure, and if he should so determine, he shall so declare to the meeting and the defective nomination shall be disregarded. (b) Agenda for Annual Meeting. Matters to be placed on the agenda for consideration at annual meetings of shareholders may be proposed by the Board of Directors or 4 by any shareholder entitled to vote for the election of Directors. Matters proposed for the agenda by shareholders entitled to vote for the election of Directors shall be made by notice in writing, delivered or mailed by first class United States mail, postage prepaid, to the Secretary of the Company not less than ninety (90) days nor more than one hundred and fifty (150) days prior to any annual meeting of shareholders; provided, however, that if less than twenty-one (21) days' notice of the meeting is given to shareholders, such written notice shall be delivered or mailed, as prescribed, to the Secretary of the Company not later than the close of the seventh day following the day on which notice of the meeting was mailed to shareholders. Notice of matters, which are proposed by the Board of Directors, shall be given by the Chairman of the Board or any other appropriate officer. Each notice given by a shareholder shall set forth a brief description of the business desired to be brought before the annual meeting. The Chairman of the meeting of shareholders may determine and declare to the meeting that a matter proposed for the agenda was not made in accordance with the foregoing procedure, and if he should so determine, he shall so declare to the meeting and the matter shall be disregarded. 3.11. Voting by Ballot. Voting by shareholders in elections for Directors shall be by ballot. No shares shall be voted at any meeting upon which any installment is due and unpaid. 3.12. Reserved 3.13. Proxies and Revocation of Proxies. Every shareholder entitled to vote at a meeting of shareholders may authorize another person or persons to act for him by proxy. Every proxy shall be executed or authenticated by the shareholder, or by his duly authorized attorney in fact, and filed or transmitted to with the Secretary of the Company A proxy, unless coupled with an interest, shall be revocable at will, notwithstanding any agreement or any provision to the contrary, but the revocation of a proxy shall not be effective until an executed or authenticated notice thereof shall have been given to the Secretary of the Company or its designated agent in writing or by electronic transmission. A telegram, telex, cablegram, datagram, e-mail, Internet communication or other means of electronic transmission from a shareholder or attorney-in-fact, or a photographic, facsimile or similar reproduction of a writing executed by a shareholder or attorney-in-fact: (1) may, at the discretion of the Secretary, be treated as properly executed or authenticated for purposes of this subsection; and (2) shall be so treated if it sets forth or utilizes a confidential and unique identification number or other mark furnished by the Company to the shareholder for the purposes of a particular meeting or transaction. No unrevoked proxy shall be valid after eleven (11) months from the date of its execution, authentication or transmission, unless a longer time is expressly provided therein, but in no event shall a proxy unless coupled with an interest, be voted on after three years from the date of its execution. A proxy shall not be revoked by the death or incapacity of the maker unless before the vote is counted or the authority is exercised, written notice of such death or incapacity is given to the Secretary of the Company or its designated agent. A shareholder shall not sell his vote or execute a proxy to any person for any sum of money or any other thing of value. A proxy coupled with an interest shall include an unrevoked proxy in favor of a creditor of a 5 shareholder and such proxy shall be valid so long as the debt owed by the shareholder to the creditor remains unpaid. 3.14. Waiver of Notice. Whenever any notice whatever is required to be given to a shareholder under the provisions of the Pennsylvania Business Corporation Law or under the provisions of the Articles of Incorporation or By-laws of the Company, a waiver thereof in writing signed by the shareholder entitled to such notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice; however, in the case of special meetings, the business to be transacted and the purpose of the meeting shall be stated in the waiver of notice. 3.15. (a) Appointment of Judges of Election. In advance of any meeting of shareholders, the Board of Directors may appoint judges of election, who need not be shareholders, to act at such meeting or any adjournment thereof. If judges of election not be so appointed, the chairman of any such meeting may, and on the request of any shareholder or his proxy shall, make such appointment at the meeting. The number of judges shall be one (1) or three (3) in number. If appointed at a meeting on the request of one (1) or more shareholders or proxies, the majority of all votes entitled to be cast shall determine whether one (1) or three (3) judges are to be appointed. No person who is a candidate for Director shall act as a judge. In case any person appointed as a judge fails to appear or fails or refuses to act, the vacancy may be filled by appointment made by the Board of Directors in advance of the convening of the meeting, or at the meeting by the person acting as chairman. (b) Duties of Judges. The judges of election shall determine the number of shares outstanding and the voting power and rights of each, the shares represented at the meeting, the existence of a quorum, the authenticity, validity, and effect of proxies, receive votes or ballots, hear and determine all challenges and questions in any way arising in connection with the right to vote, count and tabulate all votes, determine the result, and do such acts as may be proper to conduct the election or vote with fairness to all shareholders. The judges of election shall perform their duties impartially, in good faith, to the best of their ability, and as expeditiously as is practical. If there are three (3) judges of election, the decision, act or certificate of a majority shall be effective in all respects as the decision, act or certificate of all. (c) Report of Judges. On request of the chairman of the meeting, or of any shareholder or his proxy, the judges shall be made a report in writing of any challenge or question or matter determined by them, and execute a certificate of any fact found by them. 3.16. Conduct of Meetings. Unless the Board of Directors shall designate another officer or director of the Company to preside and act as the chairman at any regular or special meeting of shareholders, the Chairman of the Board, or in his absence, the Chief Executive Officer shall preside and act as the chairman at any regular or special meeting of shareholders. The chairman of the meeting, consistent with any authority, direction, restriction or limitation given to him by the Board of Directors, shall have any and all powers and authority necessary to conduct an orderly meeting, preserve order and determine any and all procedural matters, including the proper means of obtaining the floor, who shall have the right to address the meeting, the manner in which shareholders will be recognized to speak, imposing reasonable limits on the amount of time at the meeting taken up in remarks by any one shareholder or group of shareholders, the number of times a shareholder may address the meeting, and the person to 6 whom questions should be addressed. Any actions by the Chairman of the Board or any person acting in his place in adopting rules for, or in conducting, a meeting shall be fair to the shareholders. Rules adopted for use at a meeting which are approved in advance by the Board of Directors, and actions taken by the chairman in conducting the meeting pursuant to such rules shall be deemed to be fair to shareholders. The chairman shall announce at the meeting when the polls close for each matter voted upon. If no announcement is made, the ability to cast a vote will be deemed to have closed upon the final adjournment of the meeting. After the polls close, no ballots, proxies, or votes, nor any revocations or changes thereto, may be accepted. In addition, until the business to be completed at a meeting of shareholders is completed, the chairman of a meeting of the shareholders is expressly authorized to temporarily adjourn and postpone the meeting from time to time. The Secretary of the Company or in his absence, an Assistant Secretary, shall act as Secretary of all meetings of the shareholders. In the absence at such meeting of the Secretary and Assistant Secretary, the chairman of the meeting may appoint another person to act as Secretary of the meeting. 3.17. Action Without Meeting. No action required to be taken or which may be taken at any annual or special meeting of the shareholders of the Company may be taken without a meeting, and the power of the shareholders of the Company to consent in writing to action without a meeting is specifically denied. ARTICLE FOUR DIRECTORS 4.01. Directors Defined. "Directors," when used in relation to any power or duty requiring collective action, means "Board of Directors." 4.02. Powers. The business and affairs of the Company and all corporate powers shall be exercised by or under authority of the Board of Directors, subject to any limitation imposed by the Pennsylvania Business Corporation Law, the Articles of Incorporation of the Company, or these By-laws as to action which requires authorization or approval by the shareholders. 4.03. (a) Number and Classes of Directors. The number of Directors of the Company shall be not less than six (6) nor more than twenty-five (25) and the Directors shall be divided into classes and be elected for such terms of office, as provided in the Articles of Incorporation of the Company. (b) Qualifications. Directors need not be residents of the Commonwealth of Pennsylvania. Unless waived by a majority of the Directors, a majority of the Directors shall be persons who are not directors, officers, employees, agents or holders of record or beneficially of more than 5% of the voting securities, of any corporation or any other entity which holds of record or beneficially 66-2/3% or more of the issued and outstanding shares of any class of capital stock of the Company. 4.04. (a) Vacancies. Vacancies in the Board of Directors shall exist in the case of the happening of any of the following events: (i) the death or resignation of any Director; (ii) if at any annual, regular or special meeting of shareholders at which any Director is elected, the shareholders fail to elect the full authorized number of Directors to be voted for at that meeting; (iii) an increase in the number of Directors (up to a maximum of twenty-five (25)) by resolution of the Board of Directors; (iv) the removal of a Director by the affirmative vote of shareholders 7 of the Company in accordance with the Articles of Incorporation of the Company; or (v) if the Board of Directors declares vacant the office of any Director for such just cause as the Directors may determine or because such Director has not accepted the office of Director within seventy-five (75) days of being notified of his election by either responding in writing or attending any meeting of the Board of Directors. (b) Filling of Vacancies. Except as provided in the Articles of Incorporation of the Company, any vacancy occurring in the Board of Directors shall be filled by a majority of the remaining members (though less than a quorum of the Board) and each person so elected shall be a Director of the same class as his predecessor until his successor is elected by the shareholders. 4.05. Place of Meetings. All meetings of the Board of Directors shall be held at the principal office of the Company or at such place within or without the Commonwealth of Pennsylvania as may be designated from time to time by a majority of the Directors, or may be designated in the notice calling the meeting. 4.06. Regular Meetings. Regular meetings of the Board of Directors shall be held, without call or notice, immediately following each annual meeting of the shareholders of the Company, and at such other times as the Directors may determine. 4.07. (a) Call of Special Meetings. Special meetings of the Board of Directors of the Company may be called by the Chief Executive Officer, Chairman of the Board, President or by one-third of the Directors. (b) Notice of Special Meetings. Notice of the day, hour, geographic location and purpose of special meetings of the Board of Directors shall be delivered at least five (5) days before the meeting, personally, by courier service, charges prepaid, first class or express mail, postage prepaid, facsimile transmission, e-mail or other electronic communication, to the postal address, facsimile number, e-mail address or other electronic communication location supplied by the Director to the Company for the purpose of notice. Notice sent by United States mail shall be deemed to have been delivered when deposited in the United States mail or with a courier service. Notice sent by facsimile transmission, e-mail or other electronic communication shall be deemed to have been given when sent. 4.08. Validation of Meetings Defectively Called or Noticed. The transactions of any meeting of the Board of Directors, however called and noticed or wherever held, are as valid as though taken at a meeting duly held after regular call and notice, if a quorum is present and if, either before or after the meeting, each of the Directors not present signs a waiver of notice. All such waivers shall be filed with corporate records or made a part of the minutes of the meeting. Attendance of a Director at any meeting shall constitute a waiver of notice of such a meeting except where a Director attends a meeting for the express purpose of objecting to the transaction of any business because the meeting is not lawfully called or convened. 4.09. Quorum. A majority of the number of Directors in office constitutes a quorum of the Board for the transaction of business. 4.10. Majority Action. Every action or decision done or made by a majority of the Directors present at any meeting duly held at which a quorum is present is the act of the Board of 8 Directors. Each Director who is present at a meeting will be conclusively presumed to have assented to the action taken at such meeting unless his dissent to the action is entered in the minutes of the meeting, or, where he is absent from the meeting, his written objection to such action is promptly filed with the Secretary of the Company upon learning of the action. Such right to dissent shall not apply to a Director who voted in favor of such action. 4.11. Action by Consent of Board Without Meeting. Any action required by the Pennsylvania Business Corporation Law to be taken at a meeting of the Board of Directors, or any other action which may be taken at a meeting of the Board of Directors or the executive or other committee thereof, may be taken without a meeting if, prior or subsequent to the action, a consent or consents thereto by all of the Directors entitled to vote with respect to the subject matter thereof, or by all the members of such committee, as the case may be, and filed with the Secretary of the Company. 4.12. (a) Adjournment. In the absence of a quorum a majority of the Directors present may adjourn from time to time until the time fixed for the next regular meeting of the Board. (b) Notice of Adjourned Meeting. Notice of the time and place of holding an adjourned meeting, whether the meeting is a regular meeting or special meeting, need not be given to absent Directors if the time and place are fixed at the meeting adjourned. 4.13. Conduct of Meetings. At every meeting of the Board of Directors, the Chairman of the Board, the Chief Executive Officer, or in their absence, an officer of the Company designated by one of them, or in the absence of such designation, a chairman chosen by a majority of the Directors present, shall preside. The Secretary of the Company shall act as Secretary of the Board of Directors. In case the Secretary shall be absent from any meeting, the chairman of the meeting may appoint any person to act as secretary of the meeting. 4.14. Participation at Meeting. One or more Directors may participate in a meeting by means of a conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other. 4.15. Compensation. The Board of Directors, by the affirmative vote of a majority of the Directors then in office, and irrespective of any personal interest of any of its members, shall have authority to establish reasonable compensation of all Directors for services to the Company as Directors, officers, or otherwise. ARTICLE FIVE COMMITTEES 5.01. Authorization. The Board of Directors, by resolution adopted by a majority of the whole Board, may create an Executive Committee, an Audit Committee, a Nominating Committee, a Compensation Committee, and such other permanent or temporary committees as the Board deems necessary for the proper conduct of the business of the Company. Each committee shall have and may exercise such powers as shall be conferred or authorized by resolution of the Board and which are not inconsistent with these By-laws. The creation of any committee and the delegation thereto of authority shall not operate to relieve the Board of Directors of any responsibility imposed on it by law. 9 5.02. Appointment of Committees. The Chief Executive Officer shall submit to the Board of Directors, at its first meeting after the annual meeting of the shareholders, his or her recommendations for the members of and chairman of each committee. The Board shall then appoint, in accordance with such recommendations or otherwise, the members and a chairman for each committee. If the appointees accept their appointment, they shall serve for one (1) year or until their successors are appointed. The Board of Directors shall have the power to fill any vacancies occurring on any committee and to remove and replace a member of any committee. Unless otherwise provided, a Director may be a member of more than one (1) committee. If the Chief Executive Officer of the Company is a member of the Board of Directors, the Chief Executive Officer of the Company shall be appointed as a full member of the Executive Committee and as an ex-officio, non-voting member of each committee of which he or she is not a full member. 5.03. Conduct of Committees. A majority of the membership of each committee shall constitute a quorum for the transaction of business. Each committee shall meet at such times as the committee may decide or as the Board of Directors may require. Special meetings of committees may be called at any time by its chairman, or by the Chairman of the Board or by the Chief Executive Officer. Except, for its chairman, each committee may appoint a secretary and such other officers as the committee members deem necessary. Each committee shall have the power and authority to obtain from the appropriate officers of the Company all information necessary for the conduct of the proper business of the committee. If required by the Board of Directors, minutes of the proceedings shall be submitted to the Board of Directors upon its request. 5.04. Executive Committee. If created by resolution adopted by a majority of the whole Board, the Executive Committee shall meet upon five (5) days' notice. The Executive Committee shall have and may exercise all the powers of the Board of Directors in the management of the Company, except as the Board of Directors may specifically limit by resolution, or except where action by the entire Board of Directors is specifically required by law. 5.05. Audit Committee. If created by resolution adopted by a majority of the whole Board, the Audit Committee shall consist entirely of outside Directors whose emphasis and background shall preferably be in the areas of accounting, finance, or law or who have significant experience with the Company or any of its subsidiaries. The object of the Audit Committee shall be to give additional assurance of the integrity of the financial information distributed to the shareholders and the public at large. The Audit Committee shall review the internal audit controls of the Company and shall have the authority to cause and supervise such examinations and audits to be made by public accountants of the books and affairs of the Company and subsidiary companies as it, in its discretion, deems advisable. The Audit Committee shall also review audit policies, oversee internal audits, review external audits and review any federal or state examination reports. Members of management of the Company, whether or not directors of the Company, may be invited by the Audit Committee to attend meetings thereof. 5.06. Nominating Committee. If created by resolution adopted by a majority of the whole Board, the Nominating Committee shall meet at least annually to propose, for consideration by the whole Board, nominees for election as directors of the Company. 10 ARTICLE SIX OFFICERS 6.01. Number and Titles. The officers of the Company shall be a Chairman of the Board, a Chief Executive Officer, a President, a Secretary, and a Treasurer. The Company may also have, at the discretion of the Board of Directors, one (1) or more Vice Chairman, one (1) or more Executive Vice Chairman, one (1) or more Executive Vice Presidents or Vice Presidents, one (1) or more Assistant Secretaries, one (1) or more Assistant Treasurers, and such other officers and assistant officers as may be appointed in accordance with the provisions of Section 6.03 of this Article. One person may hold two (2) or more offices. No person shall, however, simultaneously hold the offices of President and Secretary. 6.02. Election. The Board of Directors shall choose, annually, either the President or Chairman of the Board to be the Chief Executive Officer of the Company. The other officers of the Company, except such officers as may be appointed in accordance with the provisions of Section 6.03 or Section 6.05 of this Article, shall be chosen annually by the Board of Directors. Each officer of the Company shall hold his office until he shall resign or shall be removed or otherwise disqualified to serve, or his successor shall be elected and qualified. 6.03. Subordinate Officers. The Chief Executive Officer may appoint, subject to the power of the Board of Directors to approve or disapprove such appointment, such other officers or agents as he may deem necessary, each of whom shall hold office for such period, have such authority and perform such duties in the management of the property and affairs of the Company as may be determined by the Chairman or the President not inconsistent with these By-laws. The Board of Directors may delegate to any officer or committee the power to appoint any subordinate officers, committees or agents to specify their duty and authority, and to determine their compensation. 6.04. Removal and Resignation. Any officer or agent may be removed by the Board of Directors whenever in its judgment the best interests of the Company will be served thereby, provided, however, that such removal shall be without prejudice to the contract rights, if any, of the person so removed. Any officer may resign at any time giving written notice to the Board of Directors, to the President or to the Secretary of the Company. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. 6.05. Vacancies. If the office of the Chairman of the Board or the Chief Executive Officer becomes vacant by reason of death, resignation, removal, or otherwise, the Board of Directors shall elect a successor who shall hold office for the unexpired term and until his successor is elected. If any other office becomes vacant by reason of death, resignation, removal or otherwise, the Chief Executive Officer shall appoint a successor who shall hold office for the unexpired term and until his successor is elected or appointed. 6.06. Chairman of the Board. The Chairman of the Board shall perform the duties of the Chief Executive Officer either when he has (i) been chosen as Chief Executive Officer by the Board of Directors or (ii) when the appointed Chief Executive Officer is legally incapable or physically unable to perform the duties of Chief Executive Officer, and shall perform such duties 11 until the Board of Directors appoints a temporary or permanent successor. The Chairman shall, if present, preside at all meetings of the Board of Directors and exercise and perform such other powers and duties as may be from time to time assigned to him by the Board of Directors or prescribed by the By-laws. 6.07. Chief Executive Officer. Subject to such supervisory powers, if any, as may be given by the Board of Directors to the Chairman of the Board, the Chief Executive Officer shall, subject to the control of the Board of Directors, have general supervision, direction and control of the business and officers of the Company, and shall have the general powers and duties of management usually vested in the office of Chief Executive of a corporation and shall have duties of a corporation, and shall have such other powers and duties as may be prescribed by the Board of Directors or the By-laws. Within this authority and in the course of his duties he shall: (a) Conduct Meeting. In the absence of the Chairman of the Board, preside at all meetings of the Board of Directors. (b) Execute Instruments. When authorized by the Board of Directors or required by law, execute in the name of the Company, deeds, conveyances, notices, leases, checks, drafts, bills of exchange, warrants, promissory notes, debentures, contracts, and other papers and instruments in writing, and unless the Board of Directors shall order otherwise by resolution, make such contracts as the ordinary conduct of the Company's business may require. (c) Hire and Fire Employees. Appoint and remove, employ and discharge, and prescribe the duties and fix the compensation of all agents, employees, and clerks of the Company other than the duly appointed officers, subject to the approval of the Board of Directors, and control, subject to the direction of the Board of Directors, all of the officers, agents, and employees of the Company. (d) Meetings of Other Corporations. Unless otherwise directed by the Board of Directors, attend in person, or by substitute appointed by him, or by proxy executed by him, and vote on behalf of the Company at all meetings of the shareholders of any corporation in which the Company holds stock. 6.08. President. The President shall perform the duties of Chief Executive Officer either when he has been chosen as Chief Executive Officer or when the Chairman of the Board is absent or unable to perform the duties of the Chief Executive Officer. The President shall have such other powers and perform such other duties from time to time as may be prescribed for him by the Board of Directors or prescribed by the By-laws. 6.09. Vice Chairman. The Vice Chairman shall have such powers and perform such duties from time to time as may be prescribed for him by the Board of Directors or prescribed by the By-laws. 6.10. Chief Financial Officer. Subject to such supervisory powers, if any, as may be given by the Board of Directors to the Chief Executive Officer, the Chief Financial Officer shall, subject to the control of the Board of Directors have general supervision, direction and control of the financial affairs of the Company, and shall have the general powers and duties of management usually vested in the office of Chief Financial Officer of a corporation, and shall 12 have such other powers and duties as may be prescribed by the Board of Directors or the By-laws. 6.11. Executive Vice President or Vice President. Except as otherwise provided in these By-laws with respect to the performance of the duties of Chief Executive Officer, in the absence or disability of the President, the Executive Vice Presidents and Vice Presidents, in order of their rank as fixed by the Board of Directors, or if not ranked, the Executive Vice President or Vice President designated by the Board of Directors, shall perform all the duties of the President, and when so acting shall have all the powers of, and be subject to all the restrictions on, the President. The Executive Vice Presidents and Vice Presidents shall have such other powers and perform such other duties as from time to time may be prescribed for them, respectively, by the Board of Directors or the By-laws. 6.12. Secretary. The Secretary shall: (a) Certify By-laws. Certify and keep at the registered office or principal place of business of the Company the original or a copy of its By-laws, including all amendments or alterations to date. (b) Minutes of Meetings. Keep the place where the certified By-laws or a copy thereof are kept, a record of the proceedings of meetings of its Directors, shareholders, Executive Committee, and other committees, with the time and place of holding, whether regular or special, and, if special, how authorized, the notice thereof given, the names of those present at Directors' meetings, the number of shares present or represented at shareholders' meetings, and the proceedings thereof. (c) Sign or Attest Documents. Sign, certify, or attest such documents as may be required by law for the business of the Company. (d) Notices. See that all notices are duly given in accordance with the provisions of these By-laws and as required by law. In case of the absence or disability of the Secretary or his or her refusal or neglect to act, notice may given and served by an Assistant Secretary or by the President or Vice Presidents, or by the Board of Directors. (e) Custodian of Records and Seals. Be custodian of the records and of the seal of the Company and see that it is engraved, lithographed, printed, stamped, impressed upon or affixed to all certificates for shares prior to their issuance, and to all documents or instruments the execution of which on behalf of the Company under its seal is duly authorized in accordance with the provisions of these By-laws, or which otherwise attested to or certified to by the Secretary. (f) Share Register. Keep at the place where the certified By-laws or a copy thereof are kept, or at the office of the transfer agent or registrar, a share register or duplicate share register giving the names of shareholders, their respective addresses, and the number of classes of shares held by each. The secretary shall also keep appropriate, complete, and accurate books or records of account at the Company's registered office or its principal place of business. (g) Reports and Statements. See that the books, reports, statements, certificates and all other documents and records required by law are properly kept and filed. 13 (h) Exhibit Records. Exhibit at all reasonable times to proper persons on such terms as are provided by law on proper application, the By-laws, the share register, and minutes of proceedings of the shareholders and Directors of the Company. (i) Other Duties. In general, perform all duties incident to the office of Secretary, and such other duties as from time to time may be assigned to him or her by the Board of Directors. (j) Absence of Secretary. In case of the absence or disability of the Secretary or his or her refusal or neglect to act, the Assistant Secretary, or if there be none, the Treasurer, acting as Assistant Secretary may perform all of the functions of the Secretary. In the absence or inability to act or refusal or neglect to act of the Secretary, the Assistant Secretary and Treasurer, any person thereunto authorized by the Chief Executive Officer or by the Board of Directors may perform the functions of the Secretary. 6.13. Assistant Secretary. At the request of the Secretary or in his or her absence or disability, the Assistant Secretary, designated as set forth in Subparagraph 6.12(j) of these By-laws, shall perform all the duties of the Secretary, and when so acting, he or she shall have all the powers of, and be subject to all restrictions on, the Secretary. The Assistant Secretary shall perform such other duties as from time to time may be assigned to him or her by the Board of Directors or the Secretary. 6.14. Treasurer. (a) Subject to such supervisory powers, if any, as may be given by the Board of Directors to the Chief Executive Officer, the Treasurer shall, subject to the control of the Board of Directors, have general supervision, direction and control of the financial affairs of the Company, and shall have the general powers and duties of management usually vested in the office of Treasurer of a corporation, and shall have such other powers and duties as may be prescribed by the Board of Directors or the By-laws. (b) The Treasurer and such other Officers as may be designated by the Board of Directors shall receive, take care of, and be responsible for all moneys, securities, and evidences of indebtedness belonging to the Company, deposit the same in the name of the Company in such depositories as the Board of Directors shall direct and shall keep a complete record of all receipts and disbursements of the Company. (c) The Treasurer shall sign drafts and such other instruments as may, under these By-laws or by direction of the Board of Directors, require his official signature, and shall keep a record thereof. (d) The Treasurer shall perform such other duties as may be required by these By-laws or by the Chief Executive Officer, or by the Board of Directors. 6.15. Assistant Treasurer. At the request of the Treasurer or in his or her absence or disability, the Assistant Treasurer shall perform all the duties of the Treasurer, and when so acting, shall have all the powers of, and be subject to all the restrictions on, the Treasurer. The Assistant Treasurer shall perform such duties as from time to time may be assigned to him or her by the Board of Directors or the Treasurer. 14 6.16. Salaries. The salaries of the officers shall be fixed from time to time by the Board of Directors, and no officer shall be prevented from receiving such salary by reason of the fact that he is also a Director of the Company. ARTICLE SEVEN ISSUANCE AND TRANSFER OF SHARES 7.01. Classes and Series of Shares. The Company may issue such shares of stock as are authorized by the Articles of Incorporation of the Company. Except as provided in the Articles of Incorporation, all shares of any one class shall have the same conversion, redemption, and other rights, preferences, qualifications, limitations, and restrictions, unless the class is authorized to be divided into series. Except as provided in the Articles of Incorporation, if a class is divided into series, all the shares of any one series shall have the same conversion, redemption and other rights, preferences, qualifications, limitations and restrictions. 7.02. Certificates for Fully Paid Shares. Neither shares nor certificates representing such shares may be issued by the Company until the full amount of the consideration has been paid. When such consideration has been paid to the Company, the certificate representing such shares shall be issued to the shareholder. 7.03. Share Certificates. The share certificates of the Company shall be numbered and registered in the share register and transfer books of the Company, as they are issued. 7.04. Consideration for Shares. The consideration for the issuance of shares may be paid, in whole or in part, in money, in other property actually received, tangible or intangible, or in labor done for the Company. Future services shall not constitute payment, or part-payment, for shares of the Company. 7.05. (a) Contents of Share Certificates. Certificates for shares shall be of such form and style, printed or otherwise, as the Board of Directors may designate, and each certificate shall state all of the following facts: (i) That the Company is organized under the laws of the Commonwealth of Pennsylvania. (ii) The name of the registered holder of the shares represented by the certificate. (iii) The number and class of shares and the designation of the series, if any, which such certificate represents. (b) Shares in Classes or Series. If the Company is authorized to issue shares of more than one class, the certificate shall set forth, either on the face or back of the certificate, a full summary or statement of all of the designations, preferences, limitations, and relative rights of the shares of each class authorized to be issued and, if the Company is authorized to issue any preferred or special class in series the variations in the relative right and preferences between the shares of each such series, so far as the same have been fixed and determined, and authority of the Board of Directors to fix and determine the relative rights and preferences of subsequent series. 15 (c) Restriction on Transfer. Any restrictions imposed by the Company on the sale or other disposition of its shares and on the transfer thereof must be noted conspicuously on each certificate representing shares to which the restriction applies. (d) Incorporation by Reference. In lieu of setting forth a full summary or statement of any provisions, other than restrictions on transfer, on the face or back of the certificate, such statement may be omitted from the certificate if it shall be set forth upon the face or back of the certificate that such statement, in full, will be furnished by the Company to any shareholder upon request and without charge. 7.06. Signing Certificates -- Facsimile Signatures. All share certificates shall be signed by such officers as the Board of Directors may determine from time to time, or, in the absence of such any determination, by the Chief Executive Officer or a Vice President and by either the Secretary, Assistant Secretary, Treasurer or Assistant Treasurer, and shall be sealed with the corporate seal, or a facsimile of the seal of the Company. If a certificate is countersigned by a transfer agent or registrar, any other signatures or countersignatures on the certificate may be facsimiles. In case any officer of the Company or any officer or employee of the transfer agent or registrar who has signed or whose facsimile signature has been placed upon such certificate ceases to be an officer of the Company, or an officer or employee of the transfer agent or registrar before such certificate is issued, the certificate may be issued by the Company with the same effect as if the officer of the Company, or the officer or employee of the transfer agent or registrar, had not ceased to be such at the date of its issue. 7.07. (a) Transfer of Shares. Transfer of shares shall be made on the books of the Company upon surrender of the certificates therefor, endorsed by the person named in the certificate or by his attorney, lawfully constituted in writing. No transfer shall be made which is inconsistent with law. (b) Transfer of Lost or Destroyed Shares. Where a share certificate has been lost, apparently destroyed, or wrongfully taken and the owner fails to notify the Company of that fact within a reasonable time after he has notice of it, and the Company registers a transfer of the share(s) represented by the certificate before receiving such notification, the owner is precluded from asserting against the Company any claim for registering the transfer or any claim to a new certificate. (c) Replacement of Lost or Destroyed Certificates. Where the holder of the share certificate claims that the certificate has been lost, destroyed, or wrongfully taken, the Company shall issue a new certificate in place of the original certificate if the owner: (i) so requests before the Company has notice that the shares have been acquired by a bona fide purchaser; (ii) files with the Company a sufficient indemnity bond; and (iii) satisfies any other reasonable requirements imposed by the Board of Directors. (d) Transfer After Replacement. If, after the issue of a new certificate as a replacement for a lost, destroyed, or wrongfully taken certificate, a bona fide purchaser of the original certificate presents it for registration of transfer, the Company must register the transfer unless registration would result in over-issue. In addition to any rights on the indemnity bond, the Company may recover the new certificate from the person to whom it was issued or any person taking under him except a bona fide purchaser. 16 7.08. Transfer Agents and Registrars. The Board of Directors may appoint one (1) or more transfer agents and one (1) or more registrars, each of which shall be an incorporated bank or trust company, either domestic or foreign, either independent or a subsidiary of the Company, which shall be appointed at such times and places as the requirements of the Company may necessitate and the Board of Directors may designate. 7.09. Conditions of Transfer. A person in whose name shares of stock stand on the books of the Company shall be deemed the owner thereof as regards the Company, provided that whenever any transfer of shares shall be made for collateral security, and absolutely, and written notice thereof shall be given to the Secretary of the Company or its transfer agent, if any, such fact shall be stated in the entry of the transfer. When a transfer of shares if requested and there is reasonable doubt as to the right of the person seeking the transfer, the Company or its transfer agent, before recording the transfer of the shares on its books or issuing any certificate therefor, may require from the person seeking the transfer reasonable proof of his right to the transfer. If there remains a reasonable doubt of the right to the transfer, the Company may refuse a transfer unless the person gives adequate security or a bond of indemnity executed by a corporate surety or by two (2) individual sureties satisfactory to the Company as to form, amount and responsibility of sureties. The bond shall be conditioned to protect the Company, its officers, transfer agents, and registrars, and any of them against any loss, damage, expense, or other liability to the owner of the shares by reason of the recordation of the transfer or the issuance of a new certificate for shares. ARTICLE EIGHT LIMITATION OF DIRECTORS' LIABILITY; INDEMNIFICATION 8.01. Limitation of Liability. To the fullest extent permitted by the Directors' Liability Act (42 Pa. C.S. 8361 et seq.) and the Business Corporation Law of the Commonwealth of Pennsylvania, a director (including a member of any advisory board) of the Company shall not be personally liable to the Company, its shareholders or others for monetary damages for any action taken or any failure to take any action unless the director has breached or failed to perform the duties of his or her office, as set forth in the Directors' Liability Act, and such breach or failure constitutes self-dealing, willful misconduct or recklessness. The provisions of this Article Eight shall not apply with respect to the responsibility or liability of a director (including a member of any advisory board) under any criminal statute or the liability of a director (including a member of any advisory board) for the payment of taxes pursuant to local, state or federal law. 8.02. (a) Indemnification. The Company shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative by reason of the fact that he is or was a director (including a member of any advisory board), officer, employee or agent of the Company, Sovereign Bank, or any other direct or indirect subsidiary of the Bank designated by the Board of directors or is or was serving at the request of the Company as a director (including a member of any advisory board), officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding, to the fullest extent authorized or permitted by the laws of the Commonwealth of Pennsylvania. 17 (b) Advance of Expenses. Expenses (including attorneys' fees) incurred in defending a civil or criminal action, suit, or proceeding shall be paid by the Company in advance of the final disposition of such action, suit, or proceeding upon receipt of an undertaking by or on behalf of the director (including a member of any advisory board), officer, employee, or agent to repay such amount if it shall be ultimately determined that he or she is not entitled to be indemnified by the Company as authorized in this Article Eight. (c) Indemnification not Exclusive. The indemnification and advancement of expenses provided by this Article Eight shall not be deemed exclusive of any other right to which persons seeking indemnification and advancement of expenses may be entitled under any agreement, vote of shareholders or disinterested directors, or otherwise, both as to actions in such persons' official capacity and as to their actions in another capacity while holding office, and shall continue as to a person who has ceased to be a director (including a member of any advisory board), officer, employee, or agent and shall inure to the benefit of the heirs, executors, and administrators of such person. (d) Insurance, Contracts, Security. The Company may purchase and maintain insurance on behalf of any person, may enter into contracts of indemnification with any person, and may create a fund of any nature (which may, but need not, be under the control of a trustee) for the benefit of any person and may otherwise secure in any manner its obligations with respect to indemnification and advancement of expenses, whether arising under this Article Eight or otherwise, whether or not the Company would have the power to indemnify such person against such liability under the provisions of this Article Eight. 8.03. Effective Date. The limitation of liability provided in Section 8.01 of this Article Eight and the right to indemnification provided in Section 8.02 of this Article Eight shall apply to any action or failure to take any action occurring on or after January 27, 1987. 8.04. Amendment, Etc. Notwithstanding anything herein contained to the contrary, this Article Eight may not be amended or repealed, and a provision inconsistent herewith may not be adopted, except by the affirmative vote of 66-2/3% of the members of the entire Board of Directors or by the affirmative vote of shareholders of the Company entitled to cast at least 80% of the votes which all shareholders of the Company are then entitled to cast, except that, if the Pennsylvania Business Corporation Law or Directors' Liability Act is amended or any other statute is enacted so as to decrease the exposure of directors (including a member of any advisory board) to liability or increase the indemnification rights available to directors (including a member of any advisory board), officers or by others, then this Article Eight and any other provisions of these By-laws inconsistent with such decreased exposure or increased indemnification rights shall be amended, automatically and without any further action on the part of the shareholders or directors, to reflect such reduced exposure or increased indemnification rights, unless such legislation expressly requires otherwise. Any repeal or modification of this Article Eight by the shareholders of the Company shall be prospective only, and shall not adversely affect any limitation on the personal liability of a director (including a member of any advisory board) of the Company or any right to indemnification from the Company with respect to any action or failure to take any action occurring prior to the time of such repeal or modification. 18 8.05. Severability. If, for any reason, any provision of this Article Eight shall be held invalid, such invalidity shall not affect any other provision not held so invalid, and each such other provision shall, to the full extent consistent with law, continue in full force and effect. If any provision of this Article Eight shall be held invalid in part, such invalidity shall in no way affect the remainder of such provision, and the remainder of such provision, together with all other provisions of this Article Eight shall, to the full extent consistent with law, continue in full force and effect. ARTICLE NINE SEVERABILITY 9.01. If a final judicial determination is made or an order is issued by a court or government regulatory agency having jurisdiction that any provision of these By-laws is unreasonable or otherwise unenforceable, such provisions shall not be rendered void, but shall be deemed amended to apply to the maximum extent as such court or government regulatory agency may determine or indicate to be reasonable. If, for any reason, any provision of these By-laws shall be held invalid, such invalidity shall not affect any other provision of these By-laws not held so invalid, and each such other provision shall, to the full extent consistent with law, continue in full force and effect. If any provision of these By-laws shall be held invalid in part, such invalidity shall in no way affect the remainder of such provisions, and the remainder of such provisions, together with all other provisions of these By-laws shall, to the full extent consistent with law, continue in full force and effect. ARTICLE TEN AMENDMENTS 10.01. Except as otherwise specified herein, the authority to make, amend, alter, change, or repeal these By-laws is hereby expressly and solely granted to and vested in the Board of Directors of the Company, subject always to the power of shareholders to change such action by the affirmative vote of shareholders of the Company entitled to cast at least 66-2/3% of the votes that all shareholders are entitled to cast thereon. ARTICLE ELEVEN CONTROL-SHARE ACQUISITIONS AND DISGORGEMENT 11.01. Control-Share Acquisitions. The Control-Share Acquisitions provisions of the Business Corporation Law of the Commonwealth of Pennsylvania (25 Pa. C.S. ss. 2561 et. seq.), as enacted by Act 36 of 1990 shall not be applicable to the Company. 11.02. Disgorgement. The Disgorgement By Certain Controlling Shareholders Following Attempt to Acquire Control Provisions of the Business Corporation Law of the Commonwealth of Pennsylvania (25 Pa. C.S. ss. 2577 et. seq.), as enacted by Act 36 of 1990 shall not be applicable to the Company. 11.03. Effective Date. The provisions of Section 11.01 of this Article Eleven and of Section 11.02 of this Article Eleven are effective as of June 19, 1990. 19 EX-10.1 4 w65673exv10w1.txt EMPLOYMENT AGREEMENT, SOVEREIGN & JAMES J. LYNCH Exhibit # 10.1 AGREEMENT THIS AGREEMENT ("Agreement") made the 16th day of September, 2002, between SOVEREIGN BANCORP, INC., a Pennsylvania business corporation ("SBI"), and JAMES J. LYNCH, an individual (the "Executive"). WITNESSETH: WHEREAS, Sovereign Bank (the "Bank") is a wholly owned subsidiary of SBI; and WHEREAS, the SBI and the Bank have created an unincorporated division of the Bank to be know as Sovereign Bank/Mid-Atlantic ("SBMA"); and WHEREAS, SBI and the Executive desire to enter in an agreement regarding, among other things, the employment of and services to be rendered by the Executive. AGREEMENT: NOW, THEREFORE, the parties hereto, intending to be legally bound hereby, agree as follows: 1. Employment. The Executive is hereby employed on the terms and conditions set forth in this Agreement. 2. Duties of Employee. The Executive shall perform and discharge well and faithfully such duties as an executive officer of SBI or SBMA as may be assigned to the Executive from time to time by the Chief Executive Officer of SBI or the Board of Directors of the Bank. The Executive shall chair the SBMA Senior Leader Group, shall be employed as Chairman and Chief Executive Officer of SBMA, shall be a member of the Office of the Chairman, the Management Credit Policy Committee and such other management committees as the Executive may choose, and shall hold such other titles as may be given to him from time to time by the Board of Directors of SBI (or of any of its affiliated companies). In addition, the Executive shall attend meetings of the Directors' Loan Committee. The Executive shall devote his full time, attention and energies to the business of SBMA and SBI (and its affiliated companies) and shall not, during the Employment Period (as defined in Section 3 hereof), be employed or involved in any other business activity, whether or not such activity is pursued for gain, profit or other pecuniary advantage; provided, however, that this Section 2 shall not be 1 construed as preventing the Executive from (a) investing the Executive's personal assets, (b) acting as a member of the Board of Directors of any other corporation or as a member of the Board of Trustees of any other organization, or (c) being involved in any other activity with the prior approval of the Chairman or Chief Executive Officer of SBI. The Executive's offices will be located at 3 Terry Drive, Suite 102, Newtown, Pennsylvania, or in such other location that is not further than 50 miles therefrom, unless otherwise explicitly agreed to by the Executive. Notwithstanding, the preceding sentence however, the parties agree that any required move of the Executive's offices to the Reading/Wyomissing, Pennsylvania area will not constitute a violation of the provision of this section. In any event, the Executive will have use of an office at the Bank's offices in the Wyomissing/Reading, Pennsylvania area. Executive will be invited to attend all regularly scheduled meetings of the Boards of Directors of the Bank and SBI. 3. Term of Employment. The Executive's employment under this Agreement shall be for a period (the "Employment Period") commencing on the date of this Agreement and ending on the date that is three (3) years subsequent thereto, provided that on the first and each subsequent annual anniversary date of this Agreement, and unless a party has given the other party written notice at least sixty (60) days prior to such anniversary date that such party does not agree to renew this Agreement, the term of this Agreement and the Employment Period shall be deemed renewed for a term ending three (3) years subsequent to such anniversary date, unless sooner terminated in accordance with this Section 5 hereof or one of the following provisions: (a) The Executive's employment under this Agreement may be terminated at any time during the Employment Period for "Cause" (as herein defined), by action of the Board of Directors of SBI, upon giving notice of such termination to the Executive at least fifteen (15) days prior to the date upon which such termination shall take effect. As used in this Agreement, "Cause" means any of the following events: (i) The Executive is convicted of or enters a plea of guilty or nolo contendere to a felony, a crime of falsehood, or a crime involving fraud or moral turpitude, or the actual incarceration of the Executive for a period of forty-five (45) consecutive days; (ii) The Executive willfully fails to follow the lawful instructions of the Chairman, Chief Executive Officer or Board of Directors of SBI after the Executive's receipt of written notice of such instructions, other than a failure resulting from the Executive's incapacity because of physical or mental illness; or 2 (iii) Any government regulatory agency recommends or orders, in either case in writing, that SBI terminate the employment of the Executive or relieve him of his duties. If the Executive's employment is terminated under the provisions of this Section 3(a), then all rights of the Executive under Section 4 hereof shall cease as of the effective date of such termination. (b) The Executive's employment under this Agreement may be terminated at any time during the Employment Period without "Cause" (as defined in Section 3(a) hereof), by action of the Board of Directors of SBI, upon giving notice of such termination to the Executive at least thirty (30) days prior to the date upon which such termination shall take effect. If the Executive's employment is terminated under the provisions of this Section 3(b), then the Executive shall be entitled to receive the compensation and benefits set forth in Section 6 or Section 7 hereof, whichever shall be applicable. To the extent the Executive becomes entitled to and receives the payment and benefits set forth in Section 6 or 7, such payments and benefits shall constitute liquidated damages for any possible breach of this Agreement by SBI or the Bank and shall represent the maximum extent of liability therefore that the Executive can claim against SBI or any of its affiliates, including the Bank. (c) If the Executive retires or dies, the Executive's employment under this Agreement shall be deemed terminated as of the date of the Executive's retirement or death, and all rights of the Executive under Section 4 hereof shall cease as of the date of such termination and any benefits payable to the Executive shall be determined in accordance with the retirement and insurance programs of SBI then in effect. (d) If the Executive is incapacitated by accident, sickness, or otherwise so as to render the Executive mentally or physically incapable of performing the services required of the Executive under Section 2 of this Agreement for a continuous period of six (6) months, then, upon the expiration of such period or at any time thereafter, by action of the Board of Directors of SBI, the Executive's employment under this Agreement may be terminated immediately upon giving the Executive notice to that effect. If the Executive's employment is terminated under the provisions of this Section 3(d), then all rights of the Executive under Section 4 hereof shall cease as of the last business day of the week in which such termination occurs and any benefits payable to the Executive shall be determined in accordance with the retirement and insurance programs of SBI then in effect. 3 4. Employment Period Compensation. (a) Salary. For services performed by the Executive under this Agreement, SBI shall pay (or cause to be paid to) the Executive a salary, during the Employment Period, at the following annual rates: From September 15, 2002 through February 28, 2003.........$400,000 From March 1, 2003 through December 31, 2003..............$450,000 From January 1, 2004 through August 31, 2004..............$500,000 Effective September 1, 2004, the Executive's salary shall be $525,000 per annum. Thereafter, SBI may, from time to time, increase the Executive's salary (or cause it to be increased), and any and all such increases shall be deemed to constitute amendments to this Section 4(a) to reflect the increased amounts, effective as of the dates established for such increases by the Board of Directors of SBI in the resolutions authorizing such increases. The Executive's salary, as provided herein, shall be payable at the same time as salaries are payable to other executive employees of SBI. (b) Bonus. Contingent upon SBI achieving the annual objectives established for it by the Chief Executive Officer or Board of Directors of SBI, the Executive, during the Employment Period, shall be eligible for a bonus to be awarded by the Board of Directors of SBI of up to a maximum of the greater of 100% of base salary at the relevant year end or $500,000 per annum. Notwithstanding the foregoing, the parties contemplate that the bonus to be paid to Executive with respect to 2002 shall, at least in part, be determined by SBI by reference to the bonus foregone by him in connection with leaving his immediately prior employment, but in no event shall such bonus be less than $230,000, or more than $250,000. In addition, SBI may, from time to time, pay such other bonus or bonuses to the Executive as SBI, in its sole discretion, deems appropriate. The payment of any such bonuses shall not reduce or otherwise affect any other obligation of SBI to the Executive provided for in this Agreement. In addition, the Executive shall be eligible, each year, to be awarded an option to purchase up to 50,000 shares of SBI common stock at an exercise price determined in accordance with the terms of SBI's existing stock option plans. (c) Other Benefits. SBI will provide the Executive, during the Employment Period, with insurance, vacation, retirement, and other fringe benefits, including the ability to participate in SBI's Deferred Bonus Recognition and Retention Program, which benefits are, in the aggregate, not less favorable than those received by all comparable executive employees of SBI. 4 (d) Stock-Based Compensation. (i) At the first SBI directors meeting following commencement of the Executive's employment under this Agreement, the Executive shall receive a non-qualified stock option award of 60,000 shares of SBI common stock under an existing SBI employee stock option plan at an exercise price determined in accordance with such plan as of the actual date of grant. The Executive shall vest in the right to exercise one hundred percent (100%) of such options (60,000 shares) upon the third anniversary of the date of grant, provided that if this Agreement is terminated prior to such third anniversary date for any reason other than as specified in Sections 3(a), (c) or (d), or as provided in Section 7 hereof, all of the 60,000 options shall immediately vest. In addition, upon a "Change in Control", as defined in Section 5(b) hereof, all of the options not previously vested shall immediately vest. (ii) Executive will be eligible to receive an award of 50,000 shares of SBI common stock, as follows: (A) 10,000 shares if SBI meets its 2004 operating earnings, "tier 1" capital and asset quality goals. (B) 15,000 shares if SBI meets its 2005 operating earnings, "tier 1" capital and asset quality goals. (C) 15,000 shares if SBI meets its 2007 operating earnings, "tier 1" capital and asset quality goals. (D) 10,000 shares if SBI meets its 2008 operating earnings, "tier 1" capital and asset quality goals. These awards will be subject to such vesting provisions as apply to other executive officers with respect to such awards, but will vest immediately in the event that there is a "change in control" (as such term is defined with respect to awards granted to other executive officers) before 2008. In addition, these awards, which are intended to be issued pursuant to a program to be adopted 5 for senior executive officers, shall be subject to such shareholder and other approval SBI deems necessary or appropriate under its corporate governance procedures or applicable law. (e) Sign-On Bonus. Within thirty (30) days after the date of this Agreement, SBI will pay to the Executive a "sign-on" bonus equal to $108,333. (f) Other Matters. (i) The Executive shall be entitled to the use of an automobile and/or automobile allowances consistent with his title and responsibilities. (ii) The Executive shall be paid or reimbursed for two country club dues and business-related expenses. (iii) The Executive shall be paid or reimbursed for Union League dues and business expenses. (iv) Within thirty (30) days of the presentation to SBI of a copy of an invoice for services rendered in connection with his counsel's review and negotiation of this Agreement, SBI will reimburse the Executive for the legal fees actually incurred by him, but not in excess of $2,000. 5. Resignation of the Executive for Good Reason. (a) The Executive may resign for "Good Reason" (as herein defined) at any time during the three year period following a "Change in Control" (as defined in Section 5(b) hereof), as hereinafter set forth. As used in this Agreement, "Good Reason" means any of the following: (i) Any reduction in title, change in reporting structure or significant reduction in the Executive's responsibilities or authority, including such responsibilities and authority as the same may be increased at any time during the term of this Agreement, or the assignment to the Executive of duties inconsistent with the Executive's status as Chairman and Chief Executive Officer of SBMA; (ii) Any reassignment of the Executive which requires the Executive to move his principal residence; 6 (iii) Any removal of the Executive from office or any adverse change in the terms and conditions of the Executive's employment, except for any termination of the Executive's employment under the provisions of Section 3(a) hereof; (iv) Any reduction in the Executive's annual base salary as in effect on the date hereof or as the same may be increased from time to time; (v) Any failure of SBI to provide the Executive with benefits at least as favorable as those enjoyed by the Executive under any of the retirement, life insurance, medical, health and accident, disability or other employee plans of SBI in which the Executive participated at the time of the Change in Control, or the taking of any action that would materially reduce any of such benefits in effect at the time of the Change in Control unless such reduction is part of a reduction applicable to all employees; (vi) Any failure to obtain a satisfactory agreement from any successor to assume and agree to perform this Agreement, as contemplated in Section 15 hereof; (vii) Any breach of this Agreement of any nature whatsoever on the part of SBI; or (viii) Termination of the Executive's membership in the Office of the Chairman (or any successor group of individuals). At the option of the Executive, exercisable by the Executive within 90 days after the occurrence of the event constituting "Good Reason" the Executive may resign from employment under this Agreement by a notice in writing (the "Notice of Termination") delivered to SBI (or its successor) and the provisions of Section 6 hereof shall thereupon apply. (b) As used in this Agreement, "Change in Control" means a change of control of a nature that would be required to be reported in response to Item 6(e) of Schedule 14A of Regulation 14A promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as enacted and in force on the date hereof, whether or not SBI is then subject to such reporting requirement; provided, however, that, without limitation, such a Change in Control shall be deemed to have occurred if: (i) Any "person" (including a group acting in concert, as the term "person" is defined in Section 13(d) of the Exchange Act, as 7 enacted and in force on the date hereof) becomes the beneficial owner" (as that term is defined in Rule 13d-3, as enacted and in force on the date hereof, under the Exchange Act) of securities of SBI representing 19.9% or more of the combined voting power of SBI's securities then outstanding; (ii) There occurs a merger, consolidation or other business combination or reorganization to which SBI or the Bank is a party, whether or not approved in advance by the Board of Directors of SBI or the Bank (as the case may be) in which (A) the members of the Board of Directors of SBI or the Bank (as the case may be) immediately preceding the consummation of such transaction do not constitute a majority of the members of the Board of Directors of the resulting corporation and of any parent corporation thereof immediately after the consummation of such transaction, and (B) the shareholders of the acquired corporation immediately before such transaction do not hold 51% or more of the voting power of securities of the resulting corporation; (iii) There occurs a sale, exchange, transfer, or other disposition of substantially all of the assets of SBI or the Bank to another entity, whether or not approved in advance by the Board of Directors of SBI; (iv) A plan of liquidation or dissolution, other than pursuant to bankruptcy or insolvency, is adopted; or (v) During a period of two consecutive years, individuals who at the beginning of such period constitute the Board of Directors of SBI cease to constitute a majority of such Board (unless the election or nomination of each new director was approved by a vote of at least 51% of directors who were directors at the beginning of such period). 6. Rights in Event of Termination of Employment After Change in Control. In the event that Executive resigns from employment for Good Reason following a Change in Control, by delivery of a Notice of Termination to SBI, or Executive's employment is terminated by SBI without Cause after a Change in Control, Executive shall be absolutely entitled to receive the amounts and benefits set forth in this section. (a) For a period of three (3) years from the date of termination of employment, Executive shall be paid his Current Compensation at Termination. 8 (i) For purposes of this section, the term "Current Compensation at Termination" means the sum of (A) the greatest of the Executive's base salary as of the date of termination of employment (or prior to any reduction thereof resulting in Good Reason for resignation) and for any of the three (3) immediately preceding calendar years, and (B) a dollar amount equal to the highest of the awards Executive received as bonuses in any of the three (3) calendar years preceding the year in which the termination of employment occurs. (ii) Amounts required to be paid to Executive under Section 6(a) shall be paid in equal monthly installments, beginning on the later of thirty (30) days following the date of termination of employment or the receipt by SBI of the approval of payment of such amounts by the Office of Thrift Supervision or such other regulatory agency to the extent such approval is required at that time. (b) For a period of three (3) years from the date of termination of employment, Executive shall receive a continuation of all life, disability, medical insurance and other normal welfare benefits in effect with respect to Executive during the two (2) calendar years prior to his termination of employment, or, if SBI cannot provide such benefits because Executive is no longer an employee, a dollar amount equal to the cost after-tax to Executive of obtaining such benefits (or substantially similar benefits). (c) In the event that the amounts and benefits payable under this Agreement, when added to other amounts and benefits which may become payable to the Executive by SBI and any affiliated company, are such that he becomes subject to the excise tax provisions of Section 4999 of the Internal Revenue Code of 1986, as amended (the "Code"), SBI shall pay him such additional amount or amounts as will result in his retention (after the payment of all federal, state and local excise, employment and income taxes on such payments and the value of such benefits) of a net amount equal to the net amount he would have retained had the initially calculated payments and benefits been subject only to income and employment taxation. For purposes of the preceding sentence, the Executive shall be deemed to be subject to the highest marginal federal, relevant state and relevant local tax rates. All calculations required to be made under this subsection shall be made by SBI's independent public accountants, subject to the right of Executive's representative to review the same. All such amounts required to be paid shall be paid at the time any withholding may be required under applicable law, and any additional amounts to which the Executive may be entitled shall be paid or reimbursed no later than fifteen (15) days following confirmation 9 of such amount by SBI's accountants. In the event any amounts paid hereunder are subsequently determined to be in error because estimates were required or otherwise, the parties agree to reimburse each other to correct such error, as appropriate, and to pay interest thereon at the applicable federal rate (as determined under Code Section 1274 for the period of time such erroneous amount remained outstanding and unreimbursed). The parties recognize that the actual implementation of the provisions of this subsection are complex and agree to deal with each other in good faith to resolve any questions or disagreements arising hereunder. 7. Rights in Event of Termination of Employment Without Cause in Absence of Change in Control. In the event that Executive's employment is terminated by SBI without Cause and no Change in Control shall have occurred at the date of such termination, Executive shall be entitled to receive the amounts and benefits set forth in this section. (a) For a period of the greater of one (1) year from the date of termination of employment or the remaining term of this Agreement, Executive shall be paid his Current Compensation. (i) For purposes of this section, the term "Current Compensation at Termination" means the sum of (A) Executive's base salary as of the date of termination of employment (or prior to any reduction thereof preceding termination of employment), and (B) a dollar amount equal to the average of the awards Executive received as bonuses for each of the three (3) calendar years preceding the year in which the termination of employment occurs. (ii) Amounts required to be paid to Executive under Section 6(a) shall be paid in equal monthly installments, beginning on the later of thirty (30) days following the date of termination of employment or the receipt by SBI of the approval of payment of such amounts by the Office of Thrift Supervision or such other regulatory agency to the extent such approval is required at that time. (b) For a period of the greater of one (1) year from the date of termination of employment or the remaining term of this Agreement, Executive shall receive a continuation of all life, disability, medical insurance and other normal welfare benefits in effect with respect to Executive during the two (2) calendar years prior to his termination of employment, or, if SBI cannot provide such benefits because Executive is no longer an employee, a dollar amount equal 10 to the cost after-tax to Executive of obtaining such benefits (or substantially similar benefits). (c) Executive shall not be required to mitigate the amount of any payment provided for in this section by seeking employment or otherwise. 8. Covenant Not to Compete; Non-Solicitation of Customers and Employees. If Executive voluntarily leaves employment hereunder during the term of this Agreement, Executive agrees that, for a period of twelve (12) months following the date of the termination of his employment, Executive shall not work directly or indirectly for or on behalf of another bank that offers products or services similar or equivalent to those offered by the Bank in the geographic area in which SBI or its affiliates, including the Bank, are conducting such business at the date of termination of Executive's employment. Nor during such period shall Executive solicit customers or employees of SBI or any of its affiliates, including the Bank, to cease doing business, in whole or in part, or cease employment with SBI, or any of its affiliates, including the Bank. 9. Arbitration. SBI and the Executive recognize that in the event a dispute should arise between them concerning the interpretation or implementation of this Agreement, lengthy and expensive litigation will not afford a practical resolution of the issues within a reasonable period of time. Consequently, each party agrees that all disputes, disagreements and questions of interpretation concerning this Agreement are to be submitted for resolution to the American Arbitration Association (the "Association") in Philadelphia, Pennsylvania. SBI, or the Executive, may initiate an arbitration proceeding at any time by giving notice to the others in accordance with the rules of the Association. The Association shall designate a single arbitrator to conduct the proceeding, but SBI, and the Executive, may, as a matter of right, require the substitution of a different arbitrator chosen by the Association. Each such right of substitution may be exercised only once. The arbitrator shall not be bound by the rules of evidence and procedure of the courts of the Commonwealth of Pennsylvania but shall be bound by the substantive law applicable to this Agreement. The decision of the arbitrator, absent fraud, duress, incompetence or gross and obvious error of fact, shall be final and binding upon the parties and shall be enforceable in courts of proper jurisdiction. Following written notice of a request for arbitration, SBI, and the Executive, shall be entitled to an injunction restraining all further proceedings in any pending or subsequently filed litigation concerning this Agreement, except as otherwise provided herein. 10. Legal Expenses. SBI shall pay to the Executive all reasonable legal fees and expenses when incurred by the Executive in successfully obtaining or enforcing any right or benefit provided by this Agreement. 11 11. Notices. Any notice required or permitted to be given under this Agreement shall be deemed properly given if in writing and if mailed by registered or certified mail, postage prepaid with return receipt requested, to the residence of the Executive, in the case of notices to the Executive, and to the principal office of SBI, in the case of notices to SBI. 12. Waiver. No provision of this Agreement may be modified, waived, or discharged unless such waiver, modification, or discharge is agreed to in writing and signed by the Executive and an executive officer of SBI specifically designated by the Board of Directors of SBI. No waiver by any party hereto at any time of any breach by any other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time. 13. Assignment. This Agreement shall not be assignable by either party hereto, except by SBI to any successor in interest to the business of SBI. 14. Entire Agreement. This Agreement contains the entire agreement of the parties relating to the subject matter of this Agreement and supersedes any prior agreement of the parties. 15. Successors, Binding Agreement. (a) SBI will require any successor (whether direct or indirect, by purchase, merger, consolidation, or otherwise) to all or substantially all of the business and/or assets of SBI to expressly assume and agree to perform this Agreement in the same manner and to the same extent that SBI would be required to perform it if no such succession had taken place. Failure by SBI to obtain such assumption and agreement prior to the effectiveness of any such succession shall constitute a breach of this Agreement and the provisions of Section 6 hereof shall apply. As used in this Agreement, "SBI" shall mean SBI as hereinbefore defined and any successor to the respective business and/or assets of SBI as aforesaid which assumes and agrees to perform this Agreement by operation of law, or otherwise. (b) This Agreement shall inure to the benefit of and be enforceable by the Executive's personal or legal representatives, executors, administrators, heirs, distributees, devisees, and legatees. If the Executive should die while any amount is payable to the Executive under this Agreement if the Executive had continued to live, all such amounts, unless otherwise provided herein, shall be paid in accordance with the terms of this Agreement to the 12 Executive's devisee, legatee, or other designee, or, if there is no such designee, to the Executive's estate. 16. Termination. Any termination of the Executive's employment under this Agreement or of this Agreement shall not affect the provisions of Sections 6, 7 or 8 hereof which shall survive any such termination and remain in full force and effect in accordance with their respective terms. 17. Validity. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. 18. Applicable Law. This Agreement shall be governed by and construed in accordance with the domestic laws (but not the law of conflict of laws) of the Commonwealth of Pennsylvania. 19. Headings. The headings of the Sections of this Agreement are for convenience only and shall not control or affect the meaning or construction or limit the scope or intent of any of the provisions of this Agreement. 20. Effective Date; Termination of Prior Agreement. This Agreement shall become effective immediately, upon the execution and delivery of this Agreement by the parties hereto. Upon the execution and delivery of this Agreement by the parties hereto, any prior agreement relating to the subject matter hereof, shall be automatically terminated and be of no further force or effect. 21. Allocation of Costs Generally. SBI and the Bank agree that, as between themselves, they shall bear their respective costs incurred under this Agreement in such manner as is determined on a mutually satisfactory basis. Notwithstanding the preceding sentence, regardless of any internal cost allocation arrangements between SBI and the Bank, SBI shall remain primarily obligated to Executive for the payments and benefits to which he may become entitled hereunder. 22. Guaranty and SBI and Bank Representation. To the extent permitted by law, the Bank hereby irrevocably and unconditionally guarantees to the Executive the full and timely performance by SBI of each and every obligation of SBI set forth in this Agreement. SBI and the Bank represent to the Executive that this Agreement has been fully authorized by all necessary corporate action and is fully enforceable in accordance with its terms. 23. Cooperation Covenant. Both during and after the Employment Period, the Executive shall cooperate fully with SBI and with any legal counsel, 13 expert or consultant it may retain to assist it in connection with any judicial proceeding, arbitration, administrative proceeding, governmental investigation or inquiry or internal audit in which SBI or any affiliate thereof, including the Bank, may be or become involved, including full disclosure of all relevant information and truthfully testifying on SBI's behalf (or, at the request of SBI, on behalf of such affiliate of SBI, including the Bank) in connection with any such proceeding or investigation. 24. Tax Withholding. All payments made and benefits provided hereunder shall be subject to required tax withholding, the cost of which, except as otherwise specifically provided herein, shall be borne by the Executive. In the case of a noncash benefit, SBI may require the Executive, as a condition of the receipt of such benefit, to deposit sufficient funds with SBI to discharge any required withholding obligation. 25. Representation of Executive. As an inducement to entering into this Agreement, the Executive represents to SBI and the Bank that his execution of and performance under this Agreement will not constitute a violation by him of any written or other contract, understanding, arrangement, duties or other obligation pertaining to his performance of personal services, solicitation of employees or customers, or other conduct on his part contemplated by this Agreement. [This space intentionally left blank.] 14 IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written. SOVEREIGN BANCORP, INC. By /s/ Jay S. Sidhu --------------------------------- Jay S. Sidhu President (SEAL) Attest: /s/ John R. Merva ---------------------------- John R. Merva Assistant Secretary ("SBI") Witness: /s/ James J. Lynch (SEAL) ------------------------------------ James J. Lynch ("Executive") Agreed to as of the date of this Agreement. SOVEREIGN BANK By /s/ Jay S. Sidhu ---------------------------- Jay S. Sidhu President 15 EX-99.1 5 w65673exv99w1.txt CHIEF EXECUTIVE OFFICER CERTIFICATION EXHIBIT 99.1 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 Sovereign Bancorp, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2002, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Jay S. Sidhu, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (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 in material respects, the financial condition and result of operations of the Company. /s/ Jay S. Sidhu - ----------------------- Jay S. Sidhu Chief Executive Officer November 14, 2002 EX-99.2 6 w65673exv99w2.txt CHIEF FINANCIAL OFFICER CERTIFICATION EXHIBIT 99.2 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 Sovereign Bancorp, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2002, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, James D. Hogan, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (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 result of operations of the Company. /s/ James D. Hogan - ----------------------- James D. Hogan Chief Financial Officer November 14, 2002 -----END PRIVACY-ENHANCED MESSAGE-----