-----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, QI7Tspnoli/kPqnBfTrGt2kBq4lvnz4v4Yn1hlvmWmDA4naAc4UaP7Hn97awn0Ev BUBszE9OX6BonncDNtojmA== 0001169232-05-001651.txt : 20050315 0001169232-05-001651.hdr.sgml : 20050315 20050315082602 ACCESSION NUMBER: 0001169232-05-001651 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 12 CONFORMED PERIOD OF REPORT: 20041231 FILED AS OF DATE: 20050315 DATE AS OF CHANGE: 20050315 FILER: COMPANY DATA: COMPANY CONFORMED NAME: COMMUNITY BANK SYSTEM INC CENTRAL INDEX KEY: 0000723188 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 161213679 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-13695 FILM NUMBER: 05680065 BUSINESS ADDRESS: STREET 1: 5790 WIDEWATERS PKWY CITY: DEWITT STATE: NY ZIP: 13214 BUSINESS PHONE: 8007242262 MAIL ADDRESS: STREET 1: 5790 WIDEWATERS PARKWAY CITY: DEWITT STATE: NY ZIP: 13214 10-K 1 d62959_10-k.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| FOR ANNUAL AND TRANSITIONAL REPORTS PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004 Commission file number 001-13695 ---------------------------------------------------------------- [LOGO] COMMUNITY BANK SYSTEM, INC. (Exact name of registrant as specified in its charter) ---------------------------------------------------------------- New York Stock Exchange (Name of Each Exchange on Which Registered) Delaware 16-1213679 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation) 5790 Widewaters Parkway, DeWitt, New York 13214-1883 (Address of principal executive offices) (Zip Code) (315) 445-2282 Registrant's telephone number, including area code Securities registered pursuant to Section 12(b) of the Act: Common Stock, $1.00 Par Value Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_|. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No |_|. The aggregate market value of the voting stock held by non-affiliates of the registrant on June 30, 2004 determined using the closing price per share on that date of $22.79, as reported on the New York Stock Exchange was approximately $636,000,000. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 30,312,681 shares of Common Stock, $1.00 par value, were outstanding on March 9, 2005. DOCUMENTS INCORPORATED BY REFERENCE. List hereunder the following documents if incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) any annual report to security holders; (2) any proxy or information statement; and (3) any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act of 1933. Portions of Definitive Proxy Statement for Annual Meeting of Shareholders to be held on May 11, 2005 (the "Proxy Statement") is incorporated by reference in Part III of this Annual Report on Form 10-K. Exhibit Index is located on page 69 of 74 TABLE OF CONTENTS
PART I Page ---- Item 1. Business ............................................................................ 3 Item 2. Properties .......................................................................... 7 Item 3. Legal Proceedings ................................................................... 7 Item 4. Submission of Matters to a Vote of Security Holders ................................. 7 Item 4A. Executive Officers of the Registrant ................................................ 7 PART II Item 5. Market for Registrant's Common Stock, Related Shareholders Matters and Issuer Purchases of Equity Securities .................................................... 8 Item 6. Selected Financial Data ............................................................. 9 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ........................................................................ 11 Item 7A. Quantitative and Qualitative Disclosures about Market Risk .......................... 35 Item 8. Financial Statements and Supplementary Data: Consolidated Statements of Condition ........................................... 38 Consolidated Statements of Income .............................................. 39 Consolidated Statements of Changes in Shareholders' Equity ..................... 40 Consolidated Statements of Comprehensive Income ................................ 41 Consolidated Statements of Cash Flows .......................................... 42 Notes to Consolidated Financial Statements ..................................... 43 Management's Report on Internal Control over Financial Reporting ............... 65 Report of Independent Registered Public Accounting Firm ........................ 66 Two Year Selected Quarterly Data .................................................... 67 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 67 Item 9A. Controls and Procedures ............................................................. 67 Item 9B. Other Information ................................................................... 67 PART III Item 10. Directors and Executive Officers of the Registrant .................................. 68 Item 11. Executive Compensation .............................................................. 68 Item 12. Security Ownership of Certain Beneficial Owners and Management ...................... 68 Item 13. Certain Relationships and Related Transactions ...................................... 68 Item 14. Principal Accounting Fees and Services .............................................. 68 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K .................... 69 Signatures .................................................................................... 73
2 Part I This Annual Report on Form 10-K contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set forth herein under the caption "Forward-Looking Statements." The share and per-share information in this document has been adjusted to give effect to a two-for-one stock split of the Company's common stock effected as of April 12, 2004. Item 1. Business Community Bank System, Inc. ("the Company") was incorporated on April 15, 1983, under the Delaware General Corporation Law. Its principal office is located at 5790 Widewaters Parkway, DeWitt, New York 13214. The Company maintains a web-site at communitybankna.com and firstlibertybank.com. Annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, are available on the Company's web-site free of charge as soon as reasonably practicable after such reports or amendments are electronically filed with or furnished to the Securities and Exchange Commission. The information on the web-site is not part of this filing. The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers. Community Bank System, Inc. is a single bank holding company which wholly-owns four subsidiaries: Community Bank, N.A. ("the Bank"), Benefit Plans Administrative Services, Inc. ("BPAS"), CFSI Closeout Corp. ("CFSICC"), and First of Jermyn Realty Co. ("FJRC"). BPAS owns two subsidiaries, Benefit Plans Administrative Services LLC (BPA) and Harbridge Consulting Group LLC. BPAS provides administration, consulting and actuarial services to sponsors of employee benefit plans. CFSICC and FJRC are inactive companies. The Company also wholly-owns three unconsolidated subsidiary business trusts formed for the purpose of issuing mandatorily redeemable preferred securities which are considered Tier I capital under regulatory capital adequacy guidelines. The Bank operates 125 customer facilities throughout twenty-two counties of Upstate New York and five counties of Northeastern Pennsylvania offering a range of commercial and retail banking services. The Bank owns the following subsidiaries: Community Investment Services, Inc. ("CISI"), CBNA Treasury Management Corporation ("TMC"), CBNA Preferred Funding Corporation ("PFC"), Elias Asset Management, Inc. ("EAM") and First Liberty Service Corp. ("FLSC"). CISI provides broker-dealer and investment advisory services. TMC operates the cash management, investment, and treasury functions of the Bank. PFC primarily is an investor in residential real estate loans. EAM provides asset management services to individuals, corporate pension and profit sharing plans, and foundations. FLSC provides banking related services to the Pennsylvania branches of the Bank. Acquisition History (1999-2004) Dansville Branch Acquisition On December 3, 2004, the Company completed the purchase of a branch office in Dansville, N.Y. ("Dansville") from HSBC Bank USA, N.A with deposits of $32.6 million. First Heritage Bank On May 14, 2004, the Company acquired First Heritage Bank ("First Heritage"), a closely held bank headquartered in Wilkes-Barre, PA with three branches in Luzerne County, Pennsylvania. First Heritage's three branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration included 2,592,213 shares of common stock with a fair value of $52 million, employee stock options with a fair value of $3.0 million, and $7.0 million of cash (including capitalized acquisition costs of $1.0 million). Grange National Banc Corp. On November 24, 2003, the Company acquired Grange National Banc Corp. ("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa. Grange's 12 branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The Company issued approximately 2,294,000 shares of its common stock to certain of the former shareholders at a cost of $23.97 per share. The remaining shareholders received $21.25 per share in cash or approximately $20.9 million. In addition, Grange stock options representing $5.4 million of fair value were exchanged for options of the Company. 3 Peoples Bankcorp Inc. On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a $29-million-asset savings and loan holding company based in Ogdensburg, New York. Peoples' single branch is being operated as a branch of the Bank's network of branches in Northern New York. Harbridge Consulting Group On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York Global Human Resource Solutions consulting group. This practice has been renamed Harbridge Consulting Group ("Harbridge") and is a leading provider of retirement and employee benefits consulting services throughout Upstate New York, and is complementary to BPA, the Company's defined contribution plan administration subsidiary. FleetBoston Financial Corporation branches On November 16, 2001, the Company acquired 36 branches from FleetBoston Financial Corporation with $470 million in deposits and $177 million in loans. The branches are located in the Southwestern and Finger Lakes Regions of New York State. First Liberty Bank Corp. On May 11, 2001, the Company completed its acquisition of the $648-million-asset First Liberty Bank Corp. ("First Liberty"). Pursuant to the terms of the merger, each share of First Liberty stock was exchanged for 1.12 shares of the Company's common stock, which amounted to approximately 7.2 million shares. The merger constituted a tax-free reorganization and was accounted for as a pooling of interests under APB Opinion 16. Citizens National Bank of Malone On January 26, 2001, the Company acquired the $111-million-asset Citizens National Bank of Malone, a commercial bank with five branches throughout Franklin and St. Lawrence counties in New York State. The Company issued 1,904,000 shares of its common stock to the former shareholders at a cost of $13.25 per share. All of the 1,296,200 shares then held in the Company's treasury were issued in this transaction as part of the total 1,904,000 shares. Elias Asset Management, Inc. On April 3, 2000, the Company acquired all the stock of Elias Asset Management, Inc. (EAM) for cash of $6.5 million. Additional consideration of $3.0 million was recognized in 2001 based upon performance targets set forth within the stock purchase agreement. EAM, based in Williamsville, NY, is a nationally recognized firm that manages assets for individuals, corporate pension and profit sharing plans, and foundations. Services The Bank is a community retail bank committed to the philosophy of serving the financial needs of customers in local communities. The Bank's branches are generally located in small towns and villages within its geographic market areas of Upstate New York and Northeastern Pennsylvania. The Company believes that the local character of business, knowledge of the customer and customer needs, and comprehensive retail and small business products, together with responsive decision-making at the branch and regional level, enable the Bank to compete effectively. The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank of New York ("FHLB"), and its deposits are insured by the FDIC up to applicable limits. Competition The financial services business is highly competitive. The Company competes actively with national and state banks, thrift institutions, credit unions, retail brokerage firms, mortgage bankers, finance companies, insurance companies, and other regulated and unregulated providers of financial services. 4 The table below summarizes the Bank's deposits and market share by the twenty-seven counties of New York and Pennsylvania in which it has customer facilities. Market share is based on deposits of all commercial banks, credit unions, savings and loan associations, and savings banks.
Number of -------------------------------------------- Towns Where Deposits Company 6/30/2004 Market Has 1st or 2nd County State (000's) (1) Share Facilities ATM's Towns Market Position - ----------------------------------------------------------------------------------------------------- Allegany NY $ 193,624 48.6% 10 8 9 9 Lewis NY 80,637 37.7% 4 1 3 3 Yates NY 76,378 32.2% 3 2 2 2 Seneca NY 106,485 30.4% 4 3 4 3 Cattaraugus NY 262,982 30.4% 11 7 7 6 St. Lawrence NY 343,673 26.6% 13 8 11 10 Wyoming PA 76,592 23.5% 3 2 3 2 Franklin NY 83,558 16.9% 5 3 4 4 Chautauqua NY 195,187 13.9% 12 10 10 7 Schuyler NY 18,147 13.8% 1 1 1 0 Jefferson NY 135,393 12.1% 5 5 4 2 Steuben NY 164,712 11.4% 9 6 8 5 Tioga NY 35,724 9.5% 2 2 2 1 Livingston NY 48,106 8.2% 3 3 3 2 Susquehanna PA 38,045 7.3% 3 1 3 3 Lackawanna PA 446,679 6.3% 11 13 8 4 Ontario NY 77,931 5.7% 3 4 3 1 Herkimer NY 30,495 5.5% 1 1 1 1 Wayne NY 47,904 5.3% 2 1 1 0 Luzerne PA 291,214 4.7% 9 8 5 1 Oswego NY 45,446 4.3% 2 2 2 2 Cayuga NY 27,571 3.4% 2 1 2 1 Bradford PA 15,055 1.8% 2 2 2 1 - ----------------------------------------------------------------------------------------------------- Subtotal 2,841,538 10.0% 120 94 98 70 Oneida NY 58,592 1.4% 2 1 1 1 Chemung NY 12,292 1.3% 1 1 1 0 Onondaga NY 10,106 0.1% 1 1 1 0 Erie NY 26,407 0.1% 1 0 1 1 - ----------------------------------------------------------------------------------------------------- 27 Total $2,948,935 4.6% 125 97 102 72 =====================================================================================================
(1) Deposit market share data as of June 30, 2004, the most recent information available, calculated by Sheshunoff Information Services, Inc. Employees As of December 31, 2004 and 2003 the Company employed 1,301 and 1,259 full-time equivalent employees, respectively. The Company offers a variety of employment benefits and considers its relationship with its employees to be good. 5 Supervision and Regulation Bank holding companies and national banks are regulated by state and federal law. The following is a summary of certain laws and regulations that govern the Company and the Bank. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the actual statutes and regulations thereunder. Federal Bank Holding Company Regulation The Company is registered under, and is subject to, the Bank Holding Company Act of 1956, as amended. This Act limits the type of companies that Community Bank System, Inc. may acquire or organize and the activities in which it or they may engage. In general, the Company and the Bank are prohibited from engaging in or acquiring direct or indirect control of any corporation engaged in non-banking activities unless such activities are so closely related to banking as to be a proper incident thereto. In addition, the Company must obtain the prior approval of the Board of Governors of the Federal Reserve System ("the FRB") to acquire control of any bank; to acquire, with certain exceptions, more than five percent of the outstanding voting stock of any other corporation; or, to merge or consolidate with another bank holding company. As a result of such laws and regulation, the Company is restricted as to the types of business activities it may conduct and the Bank is subject to limitations on, among others, the types of loans and the amounts of loans it may make to any one borrower. The Financial Modernization Act of 1999 created, among other things, a new entity, the "financial holding company". Such entities may engage in a broader range of activities that are "financial in nature", including insurance underwriting, securities underwriting and merchant banking. Bank holding companies which are well capitalized and well managed under regulatory standards may convert to financial holding companies relatively easily through a notice filing with the FRB, which acts as the "umbrella regulator" for such entities. The Company may seek to become a financial holding company in the future. Federal Reserve System The Company is required by the Board of Governors of the Federal Reserve System to maintain cash reserves against its deposits. After exhausting other sources of funds, the Company may seek borrowings from the Federal Reserve for such purposes. Bank holding companies registered with the FRB are, among other things, restricted from making direct investments in real estate. Both the Company and the Bank are subject to extensive supervision and regulation, which focus on, among other things, the protection of depositors' funds. The Federal Reserve System also regulates the national supply of bank credit in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits, and affect the interest rates charged on loans or paid for deposits. Fluctuations in interest rates, which may result from government fiscal policies and the monetary policies of the Federal Reserve System, have a strong impact on the income derived from loans and securities, and interest paid on deposits. While the Company and the Bank strive to anticipate changes and adjust their strategies for such changes, the level of earnings can be materially affected by economic circumstances beyond their control. The Bank is subject to minimum capital requirements established, respectively, by the FRB and the FDIC. For information on these capital requirements and the Company's and the Bank's capital ratios see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital" and Note P to the Financial Statements. Office of Comptroller of the Currency The Bank is supervised and regularly examined by the Office of the Comptroller of the Currency ("the OCC"). The various laws and regulations administered by the OCC affect corporate practices such as payment of dividends, incurring debt, and acquisition of financial institutions and other companies. It also affects business practices, such as payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices. There are no regulatory orders or outstanding issues resulting from regulatory examinations of the Bank. Sarbanes-Oxley Act of 2002 The Sarbanes Oxley Act of 2002 (the "Sarbanes-Oxley Act") implemented a broad range of corporate governance, accounting and reporting reforms for companies that have securities registered under the Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established, among other things: (i) new requirements for audit and other key 6 committees involving independence, expertise levels, and specified responsibilities; (ii) additional responsibilities regarding financial statement oversight for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) the creation of an independent accounting oversight board for the accounting industry; (iv) new standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (v) increased disclosure and reporting obligations for the reporting company and their directors and executive officers including accelerated reporting of company stock transactions; (vi) a prohibition of personal loans to directors and officers, except certain loans made by insured financial institutions on nonpreferential terms and in compliance with other bank regulator requirements; and (vii) a range of new and increased civil and criminal penalties for fraud and other violation of the securities laws. Item 2. Properties The Company has 136 properties, 90 are owned and 46 are located in long-term leased premises. Real property and related banking facilities owned by the Company at December 31, 2004 had a net book value of $46.5 million and none of the properties was subject to any material encumbrances. For the year ended December 31, 2004, rental fees of $2.5 million were paid on facilities leased by the Company for its operations. Item 3. Legal Proceedings The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability, if any, arising out of litigation pending against the Company or its subsidiaries will have a material effect on the Company's consolidated financial position or results of operations. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of the shareholders during the quarter ended December 31, 2004. Item 4A. Executive Officers of the Registrant The executive officers of the Company and the Bank which are elected by the Board of Directors are as follows:
Name Age Position ---- --- -------- Sanford A. Belden 62 Director, President and Chief Executive Officer of the Company and the Bank. Mr. Belden has held this position since he joined the Company in October 1992. Mark E. Tryniski 44 Executive Vice President and Chief Operating Officer of the Bank. Mr. Tryniski joined the Company in June 2003 as the Treasurer and Chief Financial Officer. In March 2004 he assumed his current position. He previously served as a partner in the Syracuse office of PricewaterhouseCoopers LLP, with eighteen years of experience working with SEC registrants in banking and other industries. Scott A. Kingsley 40 Treasurer of the Company, and Executive Vice President and Chief Financial Officer of the Bank. Mr. Kingsley joined the Company in August 2004 in his current position. He served as Vice President and Chief Financial Officer of Carlisle Engineered Products, Inc., a subsidiary of the Carlisle Companies, Inc., from 1997 until joining the Company. Brian D. Donahue 48 Executive Vice President and Chief Banking Officer. Mr. Donahue assumed his current position in August 2004. He served as the Bank's Chief Credit Officer from February 2000 to July 2004 and as the Senior Lending Officer for the Southern Region of the Bank from 1992 until June 2004. Michael A. Patton 59 President, Financial Services. Mr. Patton assumed his current position in February 2000 and previously served as the President of the Southern Region of the Bank from January 1992 to January 2000. James A. Wears 55 President, New York Banking. Mr. Wears assumed his current position in February 2000 and previously served as the President of the Northern Region of the Bank from January 1992 to January 2000. Thomas A. McCullough 58 President, Pennsylvania Banking. Mr. McCullough joined the Company in November 2003 in his current position. He was previously the President and Chief Executive Officer of Grange National Banc Corp. from 1989 until they merged with the Company. Steven R. Tokach 58 Senior Vice President and Chief Credit Administrator. Mr. Tokach assumed the Credit Administrator position in March 2003. He was previously the President of our Pennsylvania franchise since May 2001, when the Company acquired First Liberty Bank Corp. He was Executive Vice President of First Liberty Bank Corp. and First Liberty Bank & Trust from 1998 to 2001.
7
Name Age Position ---- --- -------- Timothy J. Baker 53 Senior Vice President and Director of Special Projects. Mr. Baker assumed his current position in August 2004. He was previously the Senior Operations Officer of the Bank responsible for bank operations, special projects and technology innovation since from 1995. W. Valen McDaniel 58 Senior Vice President and Chief Risk Officer. Mr. McDaniel assumed his current position in January 2004. He served as the Company's corporate auditor and risk manager since joining the Company in 1992. He is responsible for the audit function, compliance, loan review, facilities, and security of the bank and all subsidiaries. Joseph J. Lemchak 43 Senior Vice President and Chief Investment Officer. Mr. Lemchak joined the Company in 1990 and since May 1991 he has served in the duel capacity of Chief Investment Officer and Asset/Liability Manager for the Bank. J. David Clark 50 Senior Vice President and Chief Credit Officer. Mr. Clark assumed his current position in October 2004. He was previously the Commercial Market Manager in the Bank's Corning, New York market since April 1993. Robert P. Matley 53 Executive Vice President and Senior Lending Officer, PA Banking. Mr. Matley joined the Company in 2004. He was previously employed by First Heritage Bank, having joined that organization in 1994 as Executive Vice President and Senior Lending Officer. He was promoted to President and Chief Operating Officer in 2003 and served in that capacity until the merger with the Company in 2004. Bernadette R. Barber 43 Senior Vice President and Chief Human Resources Officer. Ms. Barber joined the Company in February 2005 in her current position. She has served since 1997 as Vice President of Human Resources and Administration for The Penn Traffic Company. Harold M. Wentworth 40 Senior Vice President and Director of Sales and Marketing. Mr. Wentworth assumed his current position in January 2005. He was previously a manager in the Bank's treasury department and was responsible for asset liability management and product development. J. Michael Wilson 34 Senior Vice President and Chief Technology Officer. Mr. Wilson joined the Company in June 2002 as Vice President of Information Technology and assumed his current position in October 2004. He previously held the position of Director of Technology Services for Unizan Bank in Ohio.
Part II Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters and Issuer Purchases of Equity Securities The Company's common stock has been trading on the New York Stock Exchange under the symbol "CBU" since December 31, 1997. Prior to that, the common stock traded over-the-counter on the NASDAQ National Market under the symbol "CBSI" beginning on September 16, 1986. There were 30,641,591 shares of common stock outstanding on December 31, 2004, held by approximately 3,760 registered shareholders of record. The following table sets forth the high and low prices for the common stock, and the cash dividends declared with respect thereto, for the periods indicated. The prices do not include retail mark-ups, mark-downs or commissions. The information below has been adjusted to reflect the two-for-one stock split of the Company's common stock effected on April 12, 2004. Closing Price High Low ------------------ Quarterly Year / Qtr Price Price Amount % Change Dividend - ------------------------------------------------------------------------------- 2004 4th $28.66 $25.06 $28.25 12.4% $ 0.18 3rd $26.00 $20.87 $25.13 10.3% $ 0.18 2nd $23.85 $18.86 $22.79 (1.5%) $ 0.16 1st $25.39 $21.76 $23.14 (5.6%) $ 0.16 2003 4th $25.48 $21.98 $24.50 11.6% $ 0.16 3rd $23.18 $18.67 $21.96 15.6% $ 0.16 2nd $19.38 $15.51 $19.00 20.9% $ 0.15 1st $17.12 $15.44 $15.72 0.3% $ 0.15 8 The Company has historically paid regular quarterly cash dividends on its common stock, and declared a cash dividend of $0.18 per share for the first quarter of 2005. The Board of Directors of the Company presently intends to continue the payment of regular quarterly cash dividends on the common stock, as well as to make payment of regularly scheduled dividends on the trust preferred stock when due, subject to the Company's need for those funds. However, because substantially all of the funds available for the payment of dividends by the Company are derived from the Bank, future dividends will depend upon the earnings of the Bank, its financial condition, its need for funds and applicable governmental policies and regulations. The following table provides information as of December 31, 2004 with respect to shares of common stock that may be issued under the Company's existing equity compensation plans:
Number of Weighted Securities to be Average Number of Issued upon Exercise Price Securities Remaining Exercise of on Options Available for Plan Category Outstanding Options (1) Outstanding Future Issuance - ------------------------------------------------------------------------------------------------------------------------------- Equity compensation plans approved by security holder: 1994 Long Term Incentive Plan 2,409,650 $15.62 0 2004 Long Term Incentive Plan 24,100 $23.24 3,973,900 Equity compensation plans not approved by security holder: Citizens Advisory Council Plan (2) 2,000 $16.03 6,000 - ------------------------------------------------------------------------------------------------------------------------------- Total 2,435,750 $15.70 3,979,900 ===============================================================================================================================
(1) The number of securities includes unvested restricted stock issued of 34,818. (2) In connection with the acquisition of Citizens National Bank, the Company formed an advisory council comprised of the former directors of Citizens National Bank for the purpose of advising the Bank on banking activities in Citizens National Bank's market area, the transition of business relationships after the merger, and the continued development of business relationships throughout Northern New York State. In consideration for serving on this council, the members have been granted shares of restricted stock that vest over two years. Item 6. Selected Financial Data The following table sets forth selected consolidated historical financial data of the Company as of and for each of the years in the five-year period ended December 31, 2004. The historical information set forth under the captions "Income Statement Data" and "Balance Sheet Data" is derived from the audited financial statements while the information under the captions "Average Balance Sheet Data", "Capital and Related Ratios", "Selected Performance Ratios" and "Asset Quality Ratios" for all periods is unaudited. All financial information in this table should be read in conjunction with the information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and with the Consolidated Financial Statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K. 9 SELECTED CONSOLIDATED FINANCIAL INFORMATION
In thousands except per share data Years Ended December 31, - -------------------------------------------------------------------------------------------------------------------------------- 2004 2003 2002 2001 2000 Income Statement Data: Interest income $ 212,795 $ 191,129 $ 205,093 $ 198,492 $ 189,665 Interest expense 61,752 59,301 77,243 101,837 99,232 Net interest income 151,043 131,828 127,850 96,655 90,433 Provision for loan losses 8,750 11,195 12,222 7,097 7,722 Net interest income after provision for loan losses 142,293 120,633 115,628 89,558 82,711 Other income 44,373 37,929 30,389 26,252 23,200 Gain (loss) on investment securities & early retirement of LT borrowings 72 (2,698) 1,673 (113) (159) Total non-interest income 44,445 35,231 32,062 26,139 23,041 Salaries and employee benefits 61,146 53,164 47,864 40,930 36,743 Occupancy and equipment 18,813 17,125 15,692 12,197 10,308 Amortization of intangible assets 7,414 5,093 5,953 6,679 4,891 Acquisition expenses 1,704 498 700 8,164 400 Other expenses 30,822 26,831 25,077 20,784 18,508 Total operating expense 119,899 102,711 95,286 88,754 70,850 Income before income taxes 66,839 53,153 52,404 26,943 34,902 Provision for income taxes 16,643 12,773 13,887 7,814 10,003 Net income $ 50,196 $ 40,380 $ 38,517 $ 19,129 $ 24,899 Diluted earnings per share (2) $ 1.64 $ 1.49 $ 1.46 $ 0.81 $ 1.16 Diluted earnings per share - cash (1) $ 1.78 $ 1.61 $ 1.60 $ 0.98 $ 1.29 Balance Sheet Data: Cash and cash equivalents $ 118,345 $ 103,923 $ 113,531 $ 106,554 $ 76,456 Investment securities 1,584,339 1,329,534 1,286,583 1,150,713 930,509 Loans, net of unearned discount 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877 Allowance for loan losses (31,778) (29,095) (26,331) (23,901) (20,035) Intangible assets 232,500 196,111 134,828 142,342 55,234 Other assets 131,932 126,415 121,731 104,787 93,598 Total assets $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639 Deposits $2,928,978 $2,725,488 $2,505,356 $2,545,970 $1,948,557 Borrowings 920,511 667,786 543,575 357,931 471,053 Other liabilities 69,714 57,295 63,278 41,484 30,238 Shareholders' equity 474,628 404,828 325,038 267,980 201,791 Total liabilities and shareholders' equity $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639 Average Balance Sheet Data: Investment securities $1,454,278 $1,185,487 $1,266,070 $1,042,726 $ 900,250 Loans 2,264,857 1,885,604 1,759,564 1,580,870 1,484,945 Total interest-earning assets 3,719,135 3,071,091 3,025,634 2,623,596 2,385,195 Total assets 4,196,821 3,471,689 3,393,164 2,888,760 2,556,638 Interest-bearing deposits 2,316,696 2,090,749 2,100,960 1,783,938 1,613,918 Borrowings 824,003 508,392 507,893 482,583 447,105 Total interest-earning liabilities 3,140,699 2,599,141 2,608,853 2,266,521 2,061,023 Shareholders' equity $ 440,627 $ 342,679 $ 294,856 $ 239,368 $ 174,498 Capital and Related Ratios: Tier 1 leverage ratio 6.94% 7.26% 7.05% 6.73% 6.67% Total risk-based capital to risk-adjusted assets 13.18% 13.01% 13.32% 11.83% 11.70% Tangible equity to tangible assets 5.82% 5.70% 5.76% 4.09% 5.64% Cash dividend declared per share (2) $ 0.68 $ 0.61 $ 0.56 $ 0.54 $ 0.52 Dividend payout ratio 40.9% 40.2% 37.7% 65.7% 40.6% Book value per share (2) $ 15.49 $ 14.29 $ 12.52 $ 10.38 $ 9.55 Tangible book value per share (2) $ 7.90 $ 7.37 $ 7.33 $ 4.87 $ 6.94 Market capitalization (in millions) $ 866 $ 694 $ 407 $ 338 $ 261 Period end common shares outstanding (2) 30,642 28,330 25,957 25,806 21,120 Diluted weighted average shares outstanding (2) 30,670 27,035 26,334 23,650 21,474 Selected Performance Ratios: Return on assets 1.20% 1.16% 1.14% 0.66% 0.97% Return on equity 11.39% 11.78% 13.06% 7.99% 14.27% Net interest margin 4.45% 4.69% 4.62% 3.96% 4.06% Non-interest income/operating income 21.2% 19.7% 18.6% 20.1% 19.2% Efficiency ratio 52.8% 53.4% 52.0% 56.8% 54.6% Asset Quality Ratios: Allowance for loan loss/loans outstanding 1.35% 1.37% 1.46% 1.38% 1.32% Non-performing loans/loans outstanding 0.55% 0.62% 0.65% 0.53% 0.50% Allowance for loan loss/non-performing loans 245% 219% 225% 261% 266% Net charge-offs/average loans 0.37% 0.54% 0.56% 0.42% 0.42% Loan loss provision/net charge-offs 104% 109% 125% 108% 124% Non-performing assets/loans outstanding plus OREO 0.62% 0.67% 0.69% 0.61% 0.58%
(1) Cash earnings exclude the after-tax effect of the amortization of intangible assets. (2) All share and share-based amounts reflect the two-for-one stock split effected as a 100% stock dividend on April 12, 2004. 10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc. ("the Company") for the past two years, although in some circumstances a period longer than two years is covered in order to comply with Securities and Exchange Commission disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 10 and the Company's Consolidated Financial Statements and related notes that appear on pages 38 through 64. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole. All financial results reflect the 2001 acquisition of First Liberty in accordance with the pooling of interests method of accounting. Unless otherwise noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. The term "this year" and equivalent terms refer to results in calendar year 2004, "last year" and equivalent terms refer to calendar year 2003, and all references to income statement results correspond to full-year activity unless otherwise noted. Lastly, all references to "peer banks" pertain to a group of 84 bank holding companies nationwide having $3 billion to $10 billion in assets and their associated composite financial results for the nine months ending September 30, 2004 (the most recently available disclosure), as provided by the Federal Reserve Board's Division of Banking Supervision and Regulation in the Bank Holding Company Performance Report. All share and share-based amounts reflect the two-for-one stock split effected as a 100% stock dividend on April 12, 2004. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption "Forward-Looking Statements" on page 33. Critical Accounting Policies As a result of the complex and dynamic nature of the Company's business, management must exercise judgement in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that the critical accounting estimates include: o Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change. o Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Table 7 on page 20 shows the impact of a one percentage point increase and decrease of each of these assumptions. Specific discussion of the assumptions used by management is discussed in Note K on pages 56 through 59. o Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgements used to record tax-related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations. o Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the 11 amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators. A summary of the accounting policies used by management is disclosed in Note A (Summary of Significant Accounting Policies) starting on page 43. Executive Summary The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers. The Company's core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan portfolios using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and to reduce operating costs. Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, non-interest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services business units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology enhancements, market share, peer comparisons, and the performance of acquisition and integration activities. In 2004, the Company reported record earnings as a result of acquired and organic growth in earning asset levels, strong growth in non-interest income and improved asset quality, despite a lower net interest margin. Return on assets improved slightly over 2003, to 1.20%. Return on equity declined slightly to 11.4%, due to strengthened capital levels. Non-interest income, excluding a loss on early retirement of debt in 2003, increased 17% over 2003 with strong growth from banking sources, as well as from the Company's employee benefits and wealth management businesses. The Company's efficiency ratio improved to 52.8% for the year. Asset quality improved in 2004, with reductions in delinquency, charge-off and non-performing loan ratios versus 2003. Excluding acquisition activity, the Company experienced loan growth in consumer mortgage and consumer direct and indirect lending, with declines in the business portfolio. On a geographical basis, the New York markets reported strong growth in consumer mortgage and consumer direct and indirect loans, with slight declines in business lending. Excluding acquisitions, the Pennsylvania markets reported declines in all portfolios. Excluding acquisition activity, total deposits declined slightly from 2003. The Company completed two acquisitions in 2004: (1) First Heritage Bank, a $275 million-asset commercial bank with three branches based in Wilkes-Barre, PA, acquired in May, and (2) a bank branch in Dansville, NY, from HSBC Bank USA, N.A., acquired in December with deposits of $32.6 million. Net Income and Profitability Net income for 2004 was $50.2 million, up $9.8 million or 24% from the prior year. Earnings per share of $1.64 in 2004 were 10.1% higher than 2003's results. The growth rate of EPS was below that of net income due to higher weighted average diluted shares outstanding. The increase in diluted shares was primarily driven by the 2.6 million and 2.3 million shares of common stock issued in conjunction with the acquisition of First Heritage in May 2004 and Grange in November 2003, an increased level of option grants and exercises, and a higher average common share price (refer to the "Earnings per Share" section of Note A on page 47 for information regarding the impact of share price on diluted shares). In addition to the earnings results presented above in accordance with GAAP, the Company provides cash earnings per share, which excludes the after-tax effect of the amortization of intangible assets. Management believes that this information helps investors understand the effect of acquisition activity in reported results. Cash earnings per share for 2004 were $1.78, up 10.6% from $1.61 for the year ended December 31, 2003. Net income and earnings per share for 2003 were $40.4 million and $1.49, up 4.8% and 2.1%, respectively, from 2002 results. The 2003 results were impacted by $2.6 million of debt restructuring charges associated with the early retirement of higher-rate, medium-term borrowings. In contrast, 2002 earning per share benefited from net security and debt 12 transaction gains of $1.7 million. In addition, banking services accounted for $6.5 million of the improvement in 2003, as overdraft volume and the related fees increased significantly in response to the implementation of the Overdraft FreedomTM program. Table 1: Condensed Income Statements
Years Ended December 31, -------------------------------- (000's omitted, except per share data) 2004 2003 2002 ------------------------------------------------------------------------- Net interest income $151,043 $131,828 $127,850 Loan loss provision 8,750 11,195 12,222 Non-interest income 44,445 35,231 32,062 Operating expenses 119,899 102,711 95,286 ------------------------------------------------------------------------- Income before taxes 66,839 53,153 52,404 Income taxes 16,643 12,773 13,887 ------------------------------------------------------------------------- Net income $ 50,196 $ 40,380 $ 38,517 ========================================================================= Diluted earnings per share $ 1.64 $ 1.49 $ 1.46 Diluted earnings per share-cash (1) $ 1.78 $ 1.61 $ 1.60
(1) Cash earnings exclude the after-tax effect of the amortization of intangible assets. The primary factors explaining 2004 performance are discussed in detail in the remaining sections of this document and are summarized as follows: o As shown in Table 1 above, net interest income increased 14.6% or $19 million due to a $648 million increase in average earning assets, partially offset by a 24 basis point decrease in the net interest margin. Average loans grew $379 million (20%), primarily due to strong consumer mortgage growth as well as the impact of the acquisitions of First Heritage in May 2004 and Grange and Peoples in 2003. Average investments increased $268 million (23%) in 2004 primarily as a result of a leveraging strategy that began in the third quarter of 2003 and ended during the second quarter of 2004. The growth in earning assets was funded by $311 million (12.1%) more average deposits and $316 million (62%) higher average borrowings. o The loan loss provision of $8.8 million decreased $2.4 million, or 22%, from the prior year level. Net charge-offs of $8.4 million decreased by $1.8 million from 2003, reducing the net charge-off ratio (net charge-offs / total average loans) to 0.37% for the year. The improved asset quality position in 2004 was evident in standard metrics such as non-performing loans as a percentage of total loans (down seven basis points), non-performing assets as a percentage of loans and other real estate owned (down five basis points) and delinquent loans (30+ days through non-accruing) as a percentage of total loans (down 32 basis points). Additional information on trends and policy related to asset quality is provided in the asset quality section on pages 25 through 28. o Non-interest income for 2004 of $44.4 million increased by $9.2 million (26%) from 2003's level, the eleventh consecutive year of growth. Banking services accounted for $2.6 million of the improvement, primarily due to the three whole bank acquisitions over the last 18 months. Financial services revenue was $3.8 million (30%) higher mostly as a result of the acquisition of Harbridge at the end of July 2003 and strong growth at the Company's retirement plan administration business, Benefit Plans Administrative Services. Gain (loss) on investment securities and debt prepayment transactions was $72,000 in 2004 as compared to a loss of $2.7 million in 2003. The 2003 loss included $2.6 million of debt restructuring charges associated with the early retirement of higher-rate, medium-term borrowings. o Total operating expenses rose $17.2 million or 17% in 2004 to $119.9 million. Excluding acquisition expenses in both years, 2004 operating expenses rose $16.0 million or 16%. A majority of the increase was due to increased personnel expenses associated with the acquisitions in late 2003 and 2004, as well as merit increases, new hires, and higher costs in employee health and welfare programs. In addition, higher legal and professional expenses were incurred with a substantial portion of the increase due to compliance with recently promulgated reporting requirements. Net occupancy expenses also increased because of a larger number of facilities due to acquisitions, current and prior year renovations, and slightly higher property tax and utility rates. In addition, amortization of intangible assets increased $2.3 million, or 46% over 2003 due to the amortization of core deposit and customer relationship intangibles arising from the 2003 and 2004 acquisitions. 13 o The Company's combined effective federal and state tax rate increased 0.9 percentage points in 2004 to 24.9%, primarily as a result of a higher proportion of income being generated from fully taxable loans and investments. Selected Profitability and Other Measures Return on average assets, return on average equity, dividend payout and equity to asset ratios for the years indicated are as follows: Table 2: Selected Ratios 2004 2003 2002 ----------------------------------------------------------- Return on average assets 1.20% 1.16% 1.14% Return on average equity 11.39% 11.78% 13.06% Dividend payout ratio 40.9% 40.2% 37.7% Average equity to average assets 10.50% 9.87% 8.69% As displayed in Table 2 above, the return on average assets improved in 2004 in comparison to both 2003 and 2002. This was primarily a result of a greater proportion of earnings generated from non-interest income and improved operational efficiencies. Reported return on equity in 2004 was down slightly from 2003's level. This was mainly a result of the build-up of equity capital this year from the retention of net profits and the common shares issued in conjunction with the acquisitions of First Heritage in May 2004 and Grange in November 2003. Consequently, average shareholders' equity increased 29% this year, as compared to a 24% increase in reported net income. For similar reasons average shareholder's equity increased 16% in 2003 well above the 4.8% increase in net income for the same period, resulting in a decrease in return on equity in 2003 as compared to 2002. The strengthening of the Company's equity capital position over the past two years is reflected in the 63 and 118 basis-point increases in the average equity to average total assets ratios in 2004 and 2003, respectively. Net Interest Income Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest bearing funds as a percentage of earning assets. As disclosed in Table 3, net interest income (with non-taxable income converted to a fully tax-equivalent basis) totaled $165.6 million in 2004, up $21.6 million or 15% over the prior year. A $648 million increase in average earning-assets more than offset a $542 million increase in average interest-bearing liabilities and a 24 basis point decrease in the net interest margin. As reflected in Table 4, the volume changes mentioned above drove net interest income to rise $29.1 million, while the lower net interest margin had a $7.5 million negative impact on net interest income. The net interest margin declined in each of the quarters of 2004, from 4.67% for the first quarter, ending with a 4.32% margin for the fourth quarter. This trend was mostly attributable to the level and changes in market interest rates during 2004. Falling market rates early in the year allowed the Company to reduce or hold steady rates on deposit interest-bearing accounts in the first three quarters of 2004. The fourth quarter of 2004 saw interest rates on money market and time deposit accounts rise slightly in response to increasing market rates. Similarly, the yield on loans decreased throughout the first three quarters of the year. The decline in loan yields had a greater negative impact on the margin in 2004 ($12.1 million) than the benefit derived from deposit rate reductions ($7.2 million). Yields on investments declined 35 basis points during 2004 from 6.53% to 6.18% as investment purchases were at lower rates. Lastly, the average interest rate paid on borrowings decreased 83 basis points from 4.13% for 2003 to 3.30% for 2004. The net interest margin for 2003 increased seven basis points from 4.62% in 2002 to 4.69%. Falling market rates prevailed throughout the year. However, the decline in total average earning asset yields of 56 basis points was less than the benefit derived from a decline in the cost of funds of 60 basis points, resulting in the increased net interest margin. As shown in Table 3, total interest income increased by $24.1 million or 11.9% in 2004. Table 4 shows that higher average earning assets contributed a positive $40.5 million variance, partially offset by lower yields with a negative impact of $16.4 million. Average loans grew a total of $379 million in 2004, the majority being the result of the $207 million loans acquired in the First Heritage acquisition in May of 2004 and the $186 million of loans acquired in the Peoples and Grange acquisitions in late 2003. Interest and fees on loans increased $11.6 million or 9.2%. The increase was attributable to higher average loan balances (positive $23.7 million), partially offset by a 60-basis point drop in loan yields (negative $12.1 million) due to falling capital market rates. Average loans grew $126 million in 2003, with the vast majority coming 14 from organic consumer mortgage and consumer indirect loan growth. Interest and fees on loans decreased $5.9 million or 4.5% in 2003 as compared to 2002. An 82-basis point drop in loan yields due to falling interest rates had more of an impact (negative $15.0 million) than growth in average loans (positive $9.0 million). In early fourth quarter 2002, management instituted an investment de-leveraging strategy, allowing the portfolio to run down and using the proceeds to pay down borrowings due to the lack of investment opportunities offering acceptable yields. This approach was in effect through June 2003, when it was decided that investment purchases should be reinitiated to take advantage of more attractive medium and long-term rates and a steep yield curve, as well as protect the Company from its interest rate exposure to falling rates. Due to the de-leveraging strategy being in place for approximately half of 2003 versus a leveraging strategy for most of 2004, average investment balances for 2004 were up $268.3 million versus the year-earlier period, primarily in the U.S. treasury and agency securities and obligations of state and political subdivision segments of the portfolio (refer to the "Investments" section of the MD&A on pages 31 through 33 for further information). Investment interest income in 2004 of $89.8 million was $12.5 million or 16% higher than the prior year as a result of a larger portfolio (positive $16.9 million impact) partially offset by a decrease in the average investment yield from 6.53% to 6.18% (negative $4.5 million impact). The decrease in the yield was principally driven by significant declines in market interest rates from early 2001 through mid-2003. Consequently, the Company was unable to replace the run-off of longer-term, higher-yielding securities with equivalent-rate investments, and the purchase of securities in the relatively low-interest rate environment in the second half of 2003 and 2004 led to yield declines. However, the net spread on these medium-term investment purchases were comparable because they were funded with a mixture of short to medium term low-rate, borrowings. In addition, the performance of the investment portfolio in 2004 was strong given the interest rate environment. The Company was able to maintain its yields to a great extent primarily because of two important strategies: the addition of a substantial amount of call-protected securities in 2001 and first half of 2002 when rates were higher, and foregoing security purchases in the late-2002 to mid-2003 period as rates were falling significantly. The success of these actions was evident in the Company's exceptional 98th percentile ranking within its peer group for tax-equivalent investment yield for the nine months ended September 2004. Investment interest income in 2003 of $77.4 million was $8.0 million or 9.4% lower than the prior year as a result of the smaller portfolio (negative $4.5 million impact) and a decrease in the average investment yield from 6.74% to 6.53% (negative $3.5 million impact). The average earning asset yield fell 51 basis points to 6.11% in 2004 because of the previously mentioned decrease in investment and loan yields and the fact that the yields on the overall loan portfolio have converged with those of the investment portfolio. In 2002 the yield on the loan portfolio was 75 basis points higher than the yield on investments. Loan yields were only 14 basis points above those produced by investments in 2003 and in 2004 the yield on the investment portfolio was 11 basis points higher than the yield on the loan portfolio. Total average funding (deposits and borrowings) grew by $626.5 million in 2004, with $310.9 million of the increase coming from deposits, mostly attributable to the acquisitions of First Heritage, Grange and Peoples. External borrowings were increased to fund organic loan growth and investment purchases over the last 18 months resulting in average borrowings that were up $315.6 million for 2004 as compared to the previous year. The cost of funding was aided by the change in the make-up of both the deposit base and external borrowings. The fall of market interest rates over the last two years not only enabled a significant reduction of interest-bearing deposit rates, but also caused many customers to shift their funds from time deposits to less restrictive accounts such as savings and demand deposits due to the greatly diminished rate spread between the two groups of accounts. This is demonstrated by the percentage of average deposits that were in time deposit accounts dropping from 45% in 2002 to 41% in 2004, accounting for a portion of the reduced funding costs beyond the absolute drop in rates. The Company also changed the proportion of short-term funding in average external borrowings from 28% in 2002 to 54% in 2004 to take advantage of historically low short-term rates, providing further funding cost savings. Total interest expense increased by $2.5 million to $61.8 million in 2004. As shown in Table 4, higher levels of deposits and borrowings accounted for an $11.3 million increase in interest expense, offset by an $8.9 million decrease as a result of lower rates on deposits and external borrowings. Interest expense as a percentage of earning assets fell by 27 basis points to 1.66%. The rate on interest bearing deposits fell 34 basis points to 1.49%, due largely to declines in time deposit rates for the first three quarters of 2004. The rate on external borrowings declined 83 basis points to 3.30% because of substantially lower market rates and the previously mentioned shift in funding mix towards short-term borrowings. Total interest expense decreased by $17.9 million to $59.3 million in 2003 as compared to 2002. Lower rates on deposits and external borrowings accounted for the majority of the decrease. The rate on interest bearing deposits fell 73 basis points to 1.83% and the rate on external borrowings declined 47 basis points to 4.13%. 15 The following table sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the years ended December 31, 2004, 2003 and 2002. Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.7% in 2004, 38.9% in 2003, and 39.3% in 2002. Average balances are computed by summing the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include non-accrual loans. Table 3: Average Balance Sheet
(000's omitted except yields and rates) Year Ended December 31, 2004 Year Ended December 31, 2003 ------------------------------------- ------------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid - ------------------------------------------------------------------------------- ------------------------------------- Interest-earning assets: Time deposits in other banks $ 868 $ 22 2.53% $ 346 $ 4 1.16% Taxable investment securities (2) 940,744 54,205 5.76% 779,107 48,212 6.19% Non-taxable investment securities (2) 512,666 35,626 6.95% 406,034 29,149 7.18% Loans (net of unearned discount)(1) 2,264,857 137,450 6.07% 1,885,604 125,855 6.67% ----------------------- ----------------------- Total interest-earning assets 3,719,135 227,303 6.11% 3,071,091 203,220 6.62% Non-interest earning assets 477,686 400,598 ---------- ---------- Total assets $4,196,821 $3,471,689 ========== ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $1,128,071 6,368 0.56% $1,000,238 6,769 0.68% Time deposits 1,188,625 28,219 2.37% 1,090,511 31,519 2.89% Short-term borrowings 442,287 7,242 1.64% 212,512 2,685 1.26% Long-term borrowings 381,716 19,923 5.22% 295,880 18,328 6.19% ----------------------- ----------------------- Total interest-bearing liabilities 3,140,699 61,752 1.97% 2,599,141 59,301 2.28% Non-interest bearing liabilities: Demand deposits 558,552 473,568 Other liabilities 56,943 56,301 Shareholders' equity 440,627 342,679 ---------- ---------- Total liabilities and shareholders' equity $4,196,821 $3,471,689 ========== ========== Net interest earnings $ 165,551 $ 143,919 ========== ========== Net interest spread 4.14% 4.34% Net interest margin on interest- earnings assets 4.45% 4.69% Fully tax-equivalent adjustment $ 14,508 $ 12,091 (000's omitted except yields and rates) Year Ended December 31, 2002 ------------------------------------- Avg. Average Yield/Rate Balance Interest Paid - ------------------------------------------------------------------------------- Interest-earning assets: Time deposits in other banks $ 525 $ 6 1.14% Taxable investment securities (2) 906,902 58,458 6.45% Non-taxable investment securities (2) 358,643 26,899 7.50% Loans (net of unearned discount)(1) 1,759,564 131,801 7.49% ----------------------- Total interest-earning assets 3,025,634 217,164 7.18% Non-interest earning assets 367,530 ---------- Total assets $3,393,164 ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $ 969,664 11,416 1.18% Time deposits 1,131,296 42,462 3.75% Short-term borrowings 141,024 2,586 1.83% Long-term borrowings 366,869 20,779 5.66% ----------------------- Total interest-bearing liabilities 2,608,853 77,243 2.96% Non-interest bearing liabilities: Demand deposits 441,800 Other liabilities 47,655 Shareholders' equity 294,856 ---------- Total liabilities and shareholders' equity $3,393,164 ========== Net interest earnings $ 139,921 ========== Net interest spread 4.22% Net interest margin on interest- earnings assets 4.62% Fully tax-equivalent adjustment $ 12,071
(1) The impact of interest and fees not recognized on non-accrual loans was immaterial. (2) Averages for investment securities are based on historical cost and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes. 16 As discussed above, the change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category. Table 4: Rate/Volume
------------------------------ ------------------------------ 2004 Compared to 2003 2003 Compared to 2002 ------------------------------ ------------------------------ Increase (Decrease) Due to Increase (Decrease) Due to Change in (1) Change in (1) ------------------------------ ------------------------------ Net Net (000's omitted) Volume Rate Change Volume Rate Change ------------------------------ ------------------------------ Interest earned on: Time deposits in other banks $10 $8 $18 ($2) $0 ($2) Taxable investment securities 9,485 (3,492) 5,993 (7,981) (2,265) (10,246) Non-taxable investment securities 7,437 (960) 6,477 3,439 (1,189) 2,250 Loans (net of unearned discount) 23,730 (12,135) 11,595 9,033 (14,979) (5,946) Total interest-earning assets (2) $40,477 ($16,394) $24,083 $3,222 ($17,166) ($13,944) Interest paid on: Interest checking, savings and money market deposits $803 ($1,204) ($401) $349 ($4,996) ($4,647) Time deposits 2,666 (5,966) (3,300) (1,483) (9,460) (10,943) Short-term borrowings 3,578 979 4,557 1,058 (959) 99 Long-term borrowings 4,774 (3,179) 1,595 (4,274) 1,823 (2,451) Total interest-bearing liabilities (2) $11,329 ($8,878) $2,451 ($286) ($17,656) ($17,942) Net interest earnings (2) $29,139 ($7,507) $21,632 $2,117 $1,881 $3,998
(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of change in each. (2) Changes due to volume and rate are computed from the respective changes in average balances and rates of the totals; they are not a summation of the changes of the components. 17 Non-interest Income The Company's sources of non-interest income are of three primary types: general banking services related to loans, deposits and other core customer activities typically provided through the branch network; financial services, comprised of retirement plan administration and employee benefit trusts (Benefit Plans Administrative Services or BPA), employee benefit actuarial and consulting services (Harbridge Consulting Group or Harbridge), personal trust, investment and insurance products (Community Investment Services, Inc. or CISI) and investment management (Elias Asset Management or EAM); and periodic transactions, most often net gains (losses) from the sale of investments and prepayment of term debt. Table 5: Non-interest Income
Years Ended December 31, -------------------------------- (000's omitted) 2004 2003 2002 - ------------------------------------------------------------------------------------------ Banking services: Electronic banking $ 2,585 $ 2,604 $ 2,375 Mortgage banking 525 518 175 Deposit service charges 5,475 5,374 5,310 Overdraft fees 14,867 13,476 6,937 Credit life and disability insurance 1,206 856 1,082 Commissions and other 2,974 2,199 2,662 - ------------------------------------------------------------------------------------------ Total banking services 27,632 25,027 18,541 Financial services: Retirement plan administration and trustee fees 5,820 4,668 3,845 Actuarial and benefit plan consulting fees 3,478 1,552 0 Asset advisory and management fees 1,832 1,890 2,606 Investment and insurance product commissions 3,907 3,339 3,715 Personal trust 1,704 1,453 1,682 - ------------------------------------------------------------------------------------------ Total financial services 16,741 12,902 11,848 Gain (loss) on investment securities & debt prepayment 72 (2,698) 1,673 - ------------------------------------------------------------------------------------------ Total non-interest income $44,445 $35,231 $32,062 ========================================================================================== Non-interest income/operating income (FTE) 21.2% 19.7% 18.6%
As displayed in Table 5, total non-interest income in 2004 increased by 26.2% to $44 million, largely as a result of higher overdraft volume, the acquisition of Harbridge, growth at BPA and the absence of losses on the early retirement of long-term borrowings. Total non-interest income for 2003 was up $3.2 million or 9.9% from 2002's level, driven by significantly higher overdraft volume, the acquisition of Harbridge and the growth at BPA. These improvements were offset by substantially higher losses on the early retirement of long-term borrowings, the absence of gains on the sale of securities and decreases in the other financial services group businesses. Non-interest income as a percent of operating income (FTE basis) was 21.2% in 2004, up 1.5 percentage points from the prior year, an all-time high for the Company. This increase was primarily driven by the aforementioned strong growth in overdraft fees and BPA revenue, as well as the acquisition of Harbridge. This ratio is considered an important measure for determining the progress the Company is making on one of its primary long-term strategies, expansion of non-interest income in order to diversify its revenue sources and reduce reliance on net interest margins that may be strongly impacted by general interest rate and other market conditions. The largest portion of the Company's recurring non-interest income is the wide variety of fees earned from general banking services, which reached $27.6 million in 2004, up 10.4% from the prior year. Total banking services contributed 62% of 2004 non-interest income. A large portion of the income growth was attributable to overdraft fees, up $1.4 million (10.3%) over 2003's level, due in large part to the incremental transaction volume generated from the accounts added through the First Heritage, Grange and Peoples acquisitions. In addition, commissions and other increased $0.8 million, due to higher commissions and cash surrender values derived from life insurance policies acquired in the 2003 and 2004 acquisitions. Fees from the general banking services was $25.0 million in 2003, up $6.5 million or 35% from 2002 primarily driven by the success of the Company's Overdraft FreedomTM program implemented in December 2002. 18 As disclosed in Table 5, non-interest income from financial services rose $3.8 million or 30% in 2004 to $16.7 million. Financial services revenue now comprises 38% of total non-interest income, excluding net gains (losses) on the sale of investment securities and retirement of debt. This compares to 34% in 2003, with the increase primarily due to seven more months of revenue from Harbridge, which was acquired at the end of July 2003, resulting in $1.9 million of incremental revenue for the financial services group in the current year. Another impressive year of revenue growth at BPA (up $1.2 million or 25%) was driven by a significant number of new plans under administration and growth in the market value of client assets. These two businesses are part of the BPAS subsidiary, and operate collaboratively to offer clients a full array of employee benefits, recordkeeping and consulting services throughout much of the country. BPAS revenue of $9.3 million in 2004 was $3.1 million higher than prior year results. BPAS revenue for 2003 was $6.2 million, up $2.4 million from 2002 primarily due to the acquisition of Harbridge in July of 2003 as well as strong organic growth at BPA. CISI and personal trust had positive growth of $568,000 (17%) and $251,000 (17%), respectively, as improving market conditions have positively impacted both businesses. Increased volume of annuity sales in response to higher interest rates and additional client relationships developed in the new markets opened up by the Company's acquisitions has had a positive impact. Additionally, CISI has obtained a large number of higher net-worth investors caused by recent retirees rolling over their 401(k) plans and/or receiving inheritances. In 2003, CISI, Elias and personal trust were all negatively impacted by the challenging retail investment market conditions of the past few years. Non-interest income for 2003 was down $376 million (10%), $716 million (27%) and $229 million (14%) at CISI, Elias and personal trust, respectively as compared to 2002. Assets under management from the Company's financial services businesses rose considerably over the last two years reaching $2.102 billion at the end of 2004, compared to $1.807 billion at year-end 2003 and $1.364 billion at year-end 2002. Market-driven gains in equity-based assets were augmented by attraction of new client assets. BPA in particular was very successful at growing its asset base, as demonstrated by the $259 million or 34% increase in its assets under administration. The total financial services group contributed $2.1 million (excluding allocation of indirect corporate expense) or 3.1% of the Company's pre-tax income this year, reflecting nearly a 12% margin. In 2003, financial services' contribution was $1.6 million or 2.9% of total pre-tax income, with a margin of 12%. The higher earnings were the result of new client business at BPA, CISI and personal trust as well as a full year of Harbridge as compared to only five months in 2003. The increase in percentage contribution was primarily due to higher growth in the financial services businesses than the banking business's increase in net interest income and decline of the provision for loan losses. There was a total net gain on security and debt transactions of $72,000 this year compared to a net loss of $2.7 million in 2003. The loss in 2003 was primarily composed of $2.6 million of charges associated with the early retirement of $25 million of longer-term FHLB borrowings that were replaced with lower rate, short-term borrowings, which are expected to provide a long-term earnings benefit as well as reduce interest rate risk. The $1.7 million net gain in 2002 included $2.6 million of gains on $80 million of investment sales, and a $0.9 million prepayment penalty on the retirement of approximately $11 million of intermediate-term FHLB borrowings. The security and debt gains and losses taken over the last three years are illustrative of the Company's active management of its investment portfolio and external borrowings to achieve a desirable total return through the combination of net interest income, transaction gains/losses and changes in market value across financial market cycles. Operating Expenses As shown in Table 6, operating expenses rose $17.2 million or 17% in 2004 to $119.9 million. Excluding acquisition expenses, operating expenses were up $16.0 million or 15.6% in 2004, reflective mostly of incremental operating expenses associated with the acquisitions of First Heritage in 2004 and Harbridge, Grange and Peoples in 2003. This year's operating expenses as a percent of average assets were 2.86%, down from 2.96% in 2003 and higher than the 2.81% in 2002. The decrease in this ratio for 2004 was principally due to the acquisitions in late 2003 and the first half of 2004 (Grange and First Heritage), whereby average assets increased significantly (21%), while operating expenses only increased 17%. The increase in this ratio for 2003 was principally due to the acquisition of a financial services unit whose revenue is not driven by earning assets (Harbridge), and the charge-offs resulting from higher overdraft volume, another significant revenue generating tool with a limited underlying asset base. The efficiency ratio, a performance measurement tool widely used by banks, is defined by the Company as operating expenses (excluding acquisition expenses and intangible amortization) divided by operating income (fully tax-equivalent net interest income plus non-interest income, excluding net securities and debt gains and losses). Lower ratios correspond to higher efficiency. In 2004 the efficiency ratio decreased 0.6 percentage points to 52.8% due in part to the investment leverage strategy in effect during the first half of 2004. The efficiency ratio for 2003 was 1.4 percentage points higher than the 52.0% ratio for 2002. This was primarily a result of net interest income being tempered for much of the year due to the 19 investment de-leveraging strategy, rising pension and medical expenses and the impact from reduced pre-tax margins in the financial services businesses in 2003, as discussed earlier. Table 6: Operating Expenses Years Ended December 31, ---------------------------------- (000's omitted) 2004 2003 2002 ---------------------------------------------------------------------- Salaries and employee benefits $ 61,146 $ 53,164 $ 47,864 Occupancy 10,177 9,297 8,154 Equipment and furniture 8,636 7,828 7,538 Legal and professional fees 4,578 3,183 3,272 Data processing 7,737 6,800 6,574 Amortization of intangible assets 7,414 5,093 5,953 Office supplies 2,232 1,996 2,321 Foreclosed property 994 561 902 Acquisition expenses 1,704 498 700 Other 15,281 14,291 12,008 ---------------------------------------------------------------------- Total operating expenses $119,899 $102,711 $ 95,286 ====================================================================== Operating expenses/average assets 2.86% 2.96% 2.81% Efficiency ratio 52.8% 53.4% 52.0% Higher personnel expenses accounted for 46% of 2004's increase in operating costs, primarily the result of three acquisitions in 2003 and the First Heritage acquisition in 2004. The remainder of the increases in personnel expense reflect higher benefit costs, merit increases and new hiring activity. Total full-time equivalent staff at the end of 2004 was 1,301 compared to 1,259 at year-end 2003 and 1,120 at year-end 2002. Medical expenses were up in 2004 due to a general rise in the cost of medical care, administration and insurance, as well as a greater number of insured employees. Qualified and non-qualified pension expenses decreased slightly in 2004 principally due to a change in the Company's defined benefit pension plan from a standard annuity paid benefit, to a cash balance design, offset by a reduction of the discount rate applied to future payments to 5.9% from 6.1% (increases current expenses in present value terms) and additional obligations for employees added through acquisition and organic growth. The three assumptions that have the largest impact on the calculation of annual pension expense are the aforementioned discount rate, the rate applied to future compensation increases and the expected rate of return on plan assets. Table 7 contains the results of a sensitivity analysis conducted to determine what the impact of a 1.0 percentage point increase and decrease in these three assumptions would have on the annual pension expense for the two plans. Also, see Note K to the financial statements for further information concerning the pension plan. Table 7: Pension Plan Sensitivity Analysis One Percentage Point -------------------- (000's omitted) Increase Decrease ---------------------------------------------------- Discount rate ($611) $ 707 Rate of compensation increase $ 324 ($289) Expected return on plan assets ($402) $ 402 Total non-personnel expenses increased $9.2 million or 19% in 2004. Excluding acquisition-related expenses, non-personnel expenses were up $8.0 million or 16% from 2003's level. As displayed in Table 6, this was largely caused by higher occupancy expense (up $.9 million), equipment and furniture expense ($.8 million), legal and professional fees ($1.4 million), data processing expense ($.9 million), amortization of intangible assets ($2.3 million) and other expenses ($1.0 million). The increase in occupancy expense and equipment and furniture expense in 2004 was mainly due to incremental costs from recently acquired facilities, expenses arising from renovations and repairs, the effect of higher rates and severe weather on maintenance and utilities expenses and the general increase in property taxes in many of the locations we do business in. The increase in legal and professional fees over the prior year was caused, in most part, by the additional responsibilities associated with complying with new governance and regulatory requirements. Data processing and other expenses were up primarily due to incremental recurring operating expense associated with the five acquisitions completed during the last eighteen months. Intangible amortization in 2004 was up versus the prior year due to the amortization of core deposit and customer relationship intangibles arising from the 2003 and 2004 acquisitions. 20 Total non-personnel expenses increased $2.1 million or 4.5% in 2003 as compared to 2002, largely caused by higher occupancy expense (up $1.1 million), and other expenses (up $2.3 million) and partially offset by lower intangible amortization (down $0.9 million). The increase in occupancy expense in 2003 was mainly due to incremental costs from recently acquired facilities. Other expenses include two volume-driven expense items that were up considerably due to record levels of business activity. Intangible amortization in 2003 was down versus the prior year because the drop in accelerated amortization of core deposit intangibles from the FleetBoston branch acquisitions had a greater impact than the amortization of intangibles added as a result of the three acquisitions completed in 2003. Acquisition expenses totaled $1.7 million in 2004, up from $498,000 in 2003. These expenditures were primarily comprised of severance and employee benefits of $1.0 million, legal and consulting fees of $491,000, and system conversion costs of $130,000 and $39,000 of other general administrative expenses. Acquisition expenses totaled $498,000 in 2003, down from $700,000 in 2002. These expenditures were primarily comprised of legal and consulting fees of $213,000, $191,000 of system conversion costs and $94,000 of other general administrative expenses. The majority of these expenses were incurred in conjunction with the Company's largest acquisition of 2003, Grange National Banc Corp., in November 2003. Income Taxes The Company estimates its tax expense based on the amount it expects to owe the respective tax authorities, plus the impact of deferred tax items. Taxes are discussed in more detail in Note I of the Consolidated Financial Statements on page 55. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Company's tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required. The effective tax rate for 2004 increased by 0.9 percentage points to 24.9%. This increase was primarily due to a larger proportion of income from fully taxable sources in 2004, in comparison to 2003. The effective tax rate for 2003 of 24.0% was down from the 26.5% rate in 2002. This decline was primarily due to the benefits realized on a larger proportion of income from tax-exempt investment securities in 2003, versus 2002. Capital Shareholders' equity ended 2004 at $474.6 million, up $69.8 million or 17% from one year earlier. This increase reflects $54.7 million of common stock issued in conjunction with the acquisition of First Heritage, net income of $50.2 million and $8.9 million from the issuance of shares through employee stock plans. These increases were partially offset by common dividends declared of $20.5 million, treasury share purchases of $21.7 million and a $1.8 million decline in the market value adjustment ("MVA", represents the after-tax, unrealized change in value of available-for-sale securities in the Company's investment portfolio). Excluding accumulated other comprehensive income in both 2004 and 2003, capital rose by $71.6 million or 19%. Shares outstanding rose by 2,311,000 during the year, comprised of 2,592,000 issued to First Heritage shareholders and 703,000 added through employee stock plans, offset by the purchase of 984,000 treasury shares. The Company's ratio of tier I capital to assets (or tier I leverage ratio), the basic measure for which regulators have established a 5% minimum to be considered "well-capitalized," decreased 32 basis points in 2004 to 6.94%. This was due to the net issuance of common stock and the capital-building contribution from retained earnings (net income less dividends declared) offset by the proportionately higher organic and acquired growth of the investment and loan portfolios. The tangible equity/tangible assets ratio was 5.82% at the end of 2004 versus 5.70% one year earlier. The Company manages organic and acquired growth in a manner that enables it to continue to build upon its strong capital base, and maintain the Company's ability to take advantage of future strategic growth opportunities. Cash dividends declared on common stock in 2004 of $20.5 million represented an increase of 26% over the prior year. This growth was mostly a result of dividends per share of $0.68 for 2004 increasing from $0.61 in 2003 due to quarterly dividends per share being raised from $0.16 to $0.18 (+12.5%) in the third quarter of 2004 and from $0.145 to $0.16 (+10.3%) in the third quarter of 2003. The increase in dollar amount of dividends declared also reflects an increase in the number of shares outstanding at the end of this year, primarily a result of the 2.6 million shares issued in May 2004 to First Heritage shareholders. 21 The dividend payout ratio for this year was 40.9% compared to 40.2% in 2003, and 37.7% in 2002, and near the top of the Company's targeted payout range for dividends on common stock of 30 to 40%. Liquidity Liquidity risk is measured by the Company's ability to raise cash when needed at a reasonable cost and with a minimum of loss. The Company must be capable of meeting all obligations to its customers at any time and, therefore, the active management of its liquidity position is critical. Given the uncertain nature of our customers' demands as well as the Company's desire to take advantage of earnings enhancement opportunities, the Company must have available adequate sources of on and off balance sheet funds that can be acquired in time of need. Accordingly, in addition to the liquidity provided by balance sheet cashflows, liquidity must be supplemented with additional sources such as credit lines from correspondent banks, Federal Home Loan Bank, and Federal Reserve Bank. Other funding alternatives may also be appropriate from time to time, including wholesale and retail repurchase agreements, large certificates of deposit, and brokered CD relationships. The Company's primary approach to measuring liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities as a percentage of total assets); and second, a projection of subsequent cash availability over an additional 60 days. As of December 31, 2004, this ratio was 15.4% and 17.5% for the respective time periods, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank and other sources. There is currently $134 million in additional Federal Home Loan Bank borrowing capacity based on the Company's year-end collateral levels. Additionally, the Company has $11 million in unused capacity at the Federal Reserve Bank and $47 million in unused capacity from an unsecured line of credit with other correspondent banks. In addition to the 30 and 90-day basic surplus/deficit model, longer-term liquidity over a minimum of five years is measured and a liquidity worksheet projecting sources and uses of funds is prepared. To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how liquidity levels could change over time. This five-year measure reflects ample liquidity for loan growth over the next five years. Though remote, the possibility of a funding crisis exists at all financial institutions and therefore must be planned for. Management has addressed this issue by formulating a Liquidity Contingency Plan, which has been reviewed and approved by both the Board of Directors and the Company's Asset/Liability Management Committee. The plan addresses those actions the Company would take in response to both a short-term and long-term funding crisis. A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations. Such a crisis should be temporary in nature and would not involve a change in credit ratings. A long-term funding crisis would most likely be the result of drastic credit deterioration at the Company. Management believes that both circumstances have been fully addressed, backed up with detailed action plans and trigger points for monitoring such events. Intangible Assets Intangible assets at the end of 2004 of $232.5 million were up $36.4 million from the prior year-end due to $43.4 million of additional intangible assets arising from the acquisitions of First Heritage Bank and a branch located in Dansville, as well as $0.4 million of goodwill adjustments related primarily to fair value adjustments associated with the 2003 acquisitions, offset by $7.4 million of amortization during the year. Intangible assets consist of goodwill, core deposit value and customer relationships arising from acquisitions. Goodwill represents the excess cost of an acquisition over the fair value of the net assets acquired. Goodwill at December 31, 2004 equaled $195 million, comprised of $184 million related to banking acquisitions and $11 million arising from the acquisition of financial services businesses. Goodwill is subjected to an annual impairment analysis to determine whether the carrying value of the acquired net assets exceeds their fair value, which would necessitate a write-down of the goodwill. The Company completed its goodwill impairment analyses during 2004 and 2003 and no adjustments were necessary. The impairment analysis was based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators. Management believes that there is a low probability of future impairment with regard to the goodwill associated with whole-bank acquisitions. The performance of Elias Asset Management weakened subsequent to its acquisition in 2000 as a result of adverse market conditions, however, its performance stabilized in 2004 22 as market conditions improved. Additional declines in EAM's operating results may result in impairment to its recorded goodwill of $7.3 million. Core deposit intangibles represent the premium the Company has paid for deposits acquired in excess of the cost incurred had the funds been purchased in the capital markets. Core deposit intangibles are amortized on either an accelerated or straight-line basis over periods ranging from seven to twenty years. The recognition of a customer relationship intangible arose due to the acquisition of Harbridge. This asset was determined based on a methodology that calculates the present value of the projected future revenue derived from the acquired customer base. This asset is being amortized over eleven years on an accelerated basis. Loans The Company's loans outstanding, by type, as of December 31 are as follows: Table 8: Loans Outstanding
(000's omitted) 2004 2003 2002 2001 2000 - ------------------------------------------------------------------------------------------------------------- Consumer mortgage $ 801,412 $ 739,593 $ 510,309 $ 443,767 $ 416,160 Business lending 831,244 689,436 629,874 643,834 576,887 Consumer direct and indirect 725,885 699,562 666,838 645,487 523,832 - ------------------------------------------------------------------------------------------------------------- Gross loans 2,358,541 2,128,591 1,807,021 1,733,088 1,516,879 Less: unearned discount 48 82 116 218 1,002 - ------------------------------------------------------------------------------------------------------------- Net loans 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877 Allowance for loan loss 31,778 29,095 26,331 23,901 20,035 - ------------------------------------------------------------------------------------------------------------- Loans, net of allowance for loan losses $2,326,715 $2,099,414 $1,780,574 $1,708,969 $1,495,842 =============================================================================================================
As disclosed in Table 8 above, gross loans outstanding, reached a record level of $2.359 billion as of year-end 2004, up $230 million or 10.8% compared to twelve months earlier. The acquisitions of First Heritage and Dansville accounted for $212 million of that growth. Excluding the impact of these acquisitions (at time of completion), total loans rose $18 million or 1% from the prior year. All of the organic loan growth was produced in the consumer mortgage and installment lines of business, with declines experienced in business lending. The organic loan growth was attributable to the New York market, with the Pennsylvania market experiencing a net decline in loans outstanding. The compounded annual growth rate ("CAGR") for the Company's total loan portfolio between 2000 and 2003 was 8.3% with approximately 7% of the growth coming from whole bank and branch acquisitions and the balance from organic growth. The greatest overall expansion occurred in the consumer mortgage segment, which grew at a 14% CAGR (including the impact of acquisitions) over that time frame. The consumer mortgage growth was primarily driven by record mortgage refinancing volumes over the last three years, as well as the acquisition of consumer-oriented banks in the intervening period. The other loan categories grew at compounded annual growth rates of between 5% and 7% from 2000 to 2004. As a consequence, the consumer mortgages segment accounted for 34% of the total loan portfolio at year-end 2004 versus 27% at the end of 2000. The weighting of retail lending in the Company's loan portfolio enables it to be highly diversified. Approximately 65% of loans outstanding at the end of 2004 were made to consumers borrowing on an installment and residential mortgage loan basis. The commercial portfolio is also broadly diversified by industry type as demonstrated by the following distributions at year-end 2004: real estate development (16%), healthcare (11%), general services (11%), motor vehicle and parts dealers (9%), construction (7%), agriculture (6%), restaurant & lodging (6%), retail trade (6%), manufacturing (5%) and wholesale trade (5%). A variety of other industries with less than a 3% share of the total portfolio comprise the remaining 18%. Over the last year, the mix of loans has become more weighted towards business lending due to the high proportion of commercial loans in First Heritage's portfolio. The consumer mortgage segment of the Company's loan portfolio is comprised of fixed (94%) and adjustable rate (6%) residential lending. Approximately $21 million of the $62 million growth in consumer mortgages was attributable to the acquisition of First Heritage. Excluding the impact of this acquisition, this segment was up $41 million or 5.6% in 2004 due to continued strong mortgage volumes in the historically low interest rate environment. All of the organic growth was generated in the New York market, as Pennsylvania experienced a net decline in 2004 despite a significant volume of new originations. The combined total of general-purpose business lending, dealer floor plans, mortgages on commercial property, and farm loans is characterized as the Company's business lending activity. Approximately $170 million in business loans added 23 through the First Heritage acquisition offset the $28 million (4.1%) decrease from ongoing operations in 2004. The majority of this decrease was attributable to the Pennsylvania market, with the New York market experiencing a slight decrease. Lending efforts in First Liberty's traditional markets continue to be challenged by a modest economic recovery, diminished capital spending levels in the commercial sector, an extremely competitive pricing environment and the Company's dedication to maintaining strong credit quality standards. Management has worked aggressively to address the loan generation challenges in Pennsylvania by adding enhanced management, lending and credit administration resources, and strong business relationships via the acquisition of First Heritage in 2004 and Grange in 2003. The enhanced scale and coverage of the Pennsylvania business combined with the new management team's continued commitment to business development efforts, positions them to fully take advantage of growth opportunities in this key market as economic conditions continue to improve and increased capital spending leads to expanded borrowing activity in the commercial sector. Consumer installment loans, both those originated directly (such as personal loans and home equity loans and lines of credit), and indirectly (originated predominantly in automobile, marine and recreational vehicle dealerships), rose $26 million (3.8%) from one year ago. Excluding acquisitions, consumer installment loans increased $5 million year over year. Historically low interest rates, aggressive dealer and manufacturer incentives on new vehicles, and very competitive pricing on used vehicles have existed in these product types for more than a year. Consumer installment loans increased in the New York markets during the last 12 months, while the Pennsylvania markets decreased slightly. The following table shows the maturities and type of interest rates for business and construction loans as of December 31, 2004: Table 9: Maturity Distribution of Business and Construction Loans (1)
Maturing Maturing in After One Maturing One Year or but Within After Five (000's omitted) Less Five Years Years ------------------------------------------------------------------------------------ Commercial, financial and agricultural $328,497 $376,030 $120,629 Real estate - construction 11,304 ------------------------------------------------------------------------------------ Total $339,801 $376,030 $120,629 ==================================================================================== Fixed or predetermined interest rates $ 83,198 $189,120 $ 43,802 Floating or adjustable interest rates 256,603 186,910 76,827 ------------------------------------------------------------------------------------ Total $339,801 $376,030 $120,629 ====================================================================================
(1) Scheduled repayments are reported in the maturity category in which the payment is due. 24 Asset Quality The following table presents information concerning non-performing assets: Table 10: Non-performing Assets
As of December 31, ------------------------------------------------------- (000's omitted) 2004 2003 2002 2001 2000 - --------------------------------------------------------------------------------------------------------------------- Non-accrual loans $11,798 $11,940 $ 9,754 $ 7,186 $ 5,473 Accruing loans 90+ days delinquent 1,158 1,307 1,890 1,914 1,930 Restructured loans 0 28 43 75 116 - --------------------------------------------------------------------------------------------------------------------- Total non-performing loans 12,956 13,275 11,687 9,175 7,519 Other real estate 1,645 1,077 704 1,427 1,293 - --------------------------------------------------------------------------------------------------------------------- Total non-performing assets $14,601 $14,352 $12,391 $10,602 $ 8,812 ===================================================================================================================== Allowance for loan losses to total loans 1.35% 1.37% 1.46% 1.38% 1.32% Allowance for loan losses to non-performing loans 245% 219% 225% 261% 266% Non-performing loans to total loans 0.55% 0.62% 0.65% 0.53% 0.50% Non-performing assets to total loans and other real estate 0.62% 0.67% 0.69% 0.61% 0.58%
The Company places a loan on nonaccrual status when the loan becomes ninety days past due (or sooner, if management concludes collection of interest is doubtful), except when, in the opinion of management, it is well-collateralized and in the process of collection. As shown in Table 10 above, non-performing loans, defined as non-accruing loans plus accruing loans 90 days or more past due, ended 2004 at $13.0 million, down approximately $0.3 million or 2.4% from one year earlier despite a $230 million increase in loans outstanding. The ratio of non-performing loans to total loans declined seven basis points from twelve months earlier to 0.55%. The ratio of non-performing assets (which includes troubled debt restructuring and other real estate, or OREO, in addition to non-performing loans) to total loans plus OREO decreased to 0.62% at year-end 2004, down five basis points from one-year earlier. The improvement in both ratios was driven by improvements in the economy, enhanced collection and recovery efforts, and the charge-off and disposition of certain problematic loans over the last two years. Had nonaccrual loans as of December 31, 2004 been current in accordance with their original terms, additional interest income of approximately $1.0 million would have been recorded. At year end 2004, there were 30 OREO properties with a value of $1.6 million as compared to 25 OREO properties at a value of $1.1 million a year earlier. Total delinquencies, defined as loans 30 days or more past due or in nonaccrual status, finished the current year at 1.45% of total loans outstanding versus 1.77% at the end of 2003. As of year-end 2004, total delinquency ratios for commercial loans, consumer loans, and real estate mortgages were 1.57%, 2.08%, and 1.00%, respectively. These measures were 2.18%, 2.36% and 1.10%, respectively, as of December 31, 2003. Delinquency levels, particularly in the 30 to 89 days category, tend to be somewhat volatile due to their measurement at a point in time, and therefore management believes that it is useful to look at this ratio over a longer period. The total average delinquency ratio for 2004 was 1.52% versus 1.76% in 2003. 25 The changes in the allowance for loan losses for the last five years is as follows: Table 11: Allowance for Loan Loss Activity
Years Ended December 31, ---------------------------------------------------------------------- (000's omitted) 2004 2003 2002 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------------- Amount of loans outstanding at end of period $2,358,493 $2,128,509 $1,806,905 $1,732,870 $1,515,877 Daily average amount of loans (net of unearned discount) $2,264,857 $1,885,604 $1,759,564 $1,580,870 $1,484,945 Allowance for loan losses at beginning of period $ 29,095 $ 26,331 $ 23,901 $ 20,035 $ 18,528 Charge-offs: Business lending 3,621 5,521 5,071 2,310 3,423 Consumer mortgage 535 239 221 282 93 Consumer direct and indirect 7,624 7,351 6,723 6,070 3,964 - ---------------------------------------------------------------------------------------------------------------------------------- Total charge-offs 11,780 13,111 12,015 8,662 7,480 Recoveries: Business lending 871 417 281 313 181 Consumer mortgage 48 78 119 56 72 Consumer direct and indirect 2,437 2,353 1,823 1,709 1,012 - ---------------------------------------------------------------------------------------------------------------------------------- Total recoveries 3,356 2,848 2,223 2,078 1,265 - ---------------------------------------------------------------------------------------------------------------------------------- Net charge-offs 8,424 10,263 9,792 6,584 6,215 Provision for loan losses 8,750 11,195 12,222 7,097 7,722 Allowance on acquired loans (1) 2,357 1,832 0 3,353 0 - ---------------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $ 31,778 $ 29,095 $ 26,331 $ 23,901 $ 20,035 ================================================================================================================================== Net charge-offs to average loans outstanding 0.37% 0.54% 0.56% 0.42% 0.42%
(1) This reserve addition is attributable to loans purchased from First Heritage Bank in 2004, Peoples Bankcorp Inc. and Grange National Banc Corp in 2003 and Citizens National Bank of Malone and FleetBoston Financial Corporation in 2001. As displayed in Table 11 above, total net charge-offs in 2004 were $8.4 million, down $1.8 million from the prior year, principally due to significantly improved results in the business lending portfolio. Net charge-offs in 2003 were $0.5 million above 2002's level, and were impacted by the increased size of the average loan portfolio, resulting from both organic and acquired loan growth in 2003. In addition, a prolonged period of economic weakness from late 2000 through early 2003 impacted the net charge-off levels in both 2002 and 2003, with the greatest impact being realized in the business loan segment. Due to the significant increase in average loan balances in 2004 and 2003 as a result of the factors mentioned above, management believes that net charge-offs as a percent of average loans ("net charge-off ratio") offers a clearer representation of asset quality trends. The net charge-off ratio for 2004 was down 17 basis points from last year to 0.37%. This year's ratio benefited from improved recovery performance, as evidenced by the $0.5 million increase in recoveries to $3.4 million, representing 27% of average gross charge-offs for the latest two years, compared to 23% in 2003. Business loan net charge-offs decreased in 2004, totaling $2.8 million or 0.35% of average business loans outstanding versus $5.1 million and 0.80% in 2003. The primary reason for the decreased net charge-off ratio for business loans was generally improved economic conditions in the markets served by the Company, as well as the charge-off of a number of business loans in 2003 that had been identified as weak and had been specifically reserved for in previous periods. Consumer direct and indirect loan net charge-offs increased slightly to $5.2 million this year from $5.0 million in 2003, but the net charge-off ratio dropped slightly from 0.74% in 2003 to 0.73% in 2004 due to larger average balances. Consumer mortgage net charge-offs rose $0.3 million to $0.5 due to the much larger size of the portfolio. The net charge-off ratio of 0.06% was higher than the prior year, but remains low. All the primary asset quality metrics deteriorated in 2002 and continued into 2003, in comparison to the 1999 to 2001 period. This was principally due to the weakened economic conditions in the Company's markets, and was manifested most strongly in the business loan portfolio. Based on almost all measurements, the asset quality profile of the Company began to improve in 2003 in conjunction with gradually improving economic conditions and strengthened credit administration and loan review resources. Significant changes and enhancements were made to lending and credit administration functions in 2003 and through 2004, and these improvements had a significantly positive impact on credit management performance in 2004. 26 Management continually evaluates the credit quality of the Company's loan portfolio and conducts a formal review of the allowance for loan loss adequacy on a quarterly basis. The two primary components of the loan review process that are used to determine proper allowance levels are specific and general loan loss allocations. Measurement of specific loan loss allocations is typically based on expected future cash flows, collateral values and other factors that may impact the borrower's ability to pay. Impaired loans greater than $500,000 are evaluated for specific loan loss allocations, as defined in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended. Consumer mortgages and consumer direct and indirect loans are considered smaller balance homogeneous loans and are evaluated collectively. The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts according to the contractual terms of the loan agreement or the loan is delinquent 90 days or more. The second component of the allowance establishment process, general loan loss allocations, is composed of two calculations that are computed on the four main loan segments: commercial, consumer direct, consumer indirect and residential real estate. The first calculation determines an allowance level based on the latest three years of historical net charge-off data for each loan category (commercial loans exclude balances with special loan loss allocations). The second calculation is qualitative and takes into consideration five major factors affecting the level of loan loss risk: portfolio risk migration patterns (internal credit quality trends); the growth of the segments of the loan portfolio; economic and business environment trends in the Company's markets (includes review of bankruptcy, unemployment, population, consumer spending and regulatory trends); industry, geographical and product concentrations in the portfolio; and the perceived effectiveness of managerial resources and lending practices and policies. These two allowance calculations are added together to determine the general loan loss allocation. The allowance levels computed from the specific and general loan loss allocation methods are combined to derive the necessary allowance for loan loss to be reflected on the Consolidated Statement of Condition. The loan loss provision is calculated by subtracting the previous period allowance for loan loss, net of the interim period net charge-offs, from the current required allowance level. This provision is then recorded as an expense in the income statement for that period. Members of senior management and the loan committee of the Board of Directors review the adequacy of the allowance for loan loss quarterly. Management is committed to continually improving the credit assessment and risk management capabilities of the Company and will dedicate the resources necessary to ensure advancement in this critical area of operations. The allowance for loan loss was increased to $31.8 million at year-end 2004 from $29.1 million at the end of 2003. The $2.7 million increase was primarily due to $230 million more in loans outstanding, offset by an overall improvement in the Company's asset quality profile. The ratio of the allowance for loan loss to total loans decreased to 1.35% for year-end 2004 versus 1.37% at the end of last year. Management believes the year-end 2004 allowance for loan losses to be adequate in light of the probable losses inherent in the Company's loan portfolio. The loan loss provision decreased by $2.4 million or 22% in 2004 as a result of management's assessment of the probable losses in the loan portfolio, and the reduced level of charge-offs in 2004, as discussed above. The loan loss provision as a percentage of average loans decreased from 0.59% in 2003 to 0.39% this year in most part due to the provision last year being elevated to cover higher risk levels in the business loan segment of the portfolio. The loan loss provision covered net charge-offs by 104% this year versus 109% in 2003, reflective of the improvements in asset quality trends during the year. The net charge-off ratio in 2004 was more consistent with the ratios of the 1999 to 2001 period, as shown in Table 11 above. As previously noted, there was a strong correlation between the increased level of net charge-offs in 2002 and 2003 and the performance of the overall economy. The Company's net charge-off ratio was also above 50 basis points during the 1990 to 1992 period, when the ratio fluctuated between 51 and 59 basis points. Not surprisingly, similar to the period from mid-2001 through late 2003, that time frame included a recession and the first stage of an economic recovery. The net charge-off ratio dropped significantly in the years immediately following that period. In 2004, the Company realized the benefits of one of management's primary goals, which was to steadily bring the net charge-off ratio back to a range that was consistent with historical performance. 27 The following table shows management's allocation of the allowance for loan losses by loan type as of December 31: Table 12: Allowance for Loan Losses by Loan Type
2004 2003 2002 2001 2000 ----------------- ----------------- ----------------- ----------------- ----------------- Loan Loan Loan Loan Loan (000's omitted) Allowance Mix Allowance Mix Allowance Mix Allowance Mix Allowance Mix - -------------------- ----------------- ----------------- ----------------- ----------------- ----------------- Consumer mortgage $ 1,810 34.0% $ 1,724 34.7% $ 479 28.2% $ 406 25.6% $ 1,483 27.5% Business lending 16,439 35.2% 15,549 32.4% 16,765 34.9% 14,417 37.2% 7,386 38.0% Consumer direct and indirect 11,487 30.8% 11,112 32.9% 8,978 36.9% 8,970 37.2% 8,314 34.5% Unallocated 2,042 710 109 108 2,852 - -------------------- ---------------- ---------------- ---------------- ---------------- ---------------- Total $31,778 100.0% $29,095 100.0% $26,331 100.0% $23,901 100.0% $20,035 100.0% ==================== ================ ================ ================ ================ ================
As demonstrated in Table 12 above and discussed previously, the risk inherit in the consumer mortgage portfolio is much lower than that of the other segments of the loan portfolio. The risk differential is illustrated by the average net charge-off ratio of 0.04% over the last three years for consumer mortgages compared to the 0.68% average for the rest of the portfolio over the same time frame. This is manifested in the comparatively small $1.8 million allowance attributable to consumer mortgages, representing only 0.2% of the their ending balance versus 1.8% for the remaining portion of the loan portfolio. The increase in the unallocated portion of the allowance for loan losses over 2003 related principally to the portfolio and reserves acquired as part of the First Heritage acquisition. As that acquired portfolio is further subjected to the Company's established risk rating and review procedures, it is expected that some portion of the unallocated reserve will be allocated to the specific product categories. Funding Sources The Company utilizes a variety of funding sources to support the earning asset base as well as to achieve targeted growth objectives. Overall funding is comprised of three primary sources that possess a variety of maturity, stability, and price characteristics: deposits of individuals, partnerships and corporations (IPC deposits); collateralized municipal deposits (public funds); and external borrowings. The average daily amount of deposits and the average rate paid on each of the following deposit categories are summarized below for the years indicated: Table 13: Average Deposits
2004 2003 2002 --------------------------- ---------------------------- ---------------------------- Average Average Average Average Average Average (000's omitted, except rates) Balance Rate Paid Balance Rate Paid Balance Rate Paid - ----------------------------------- --------------------------- ---------------------------- ---------------------------- Noninterest-bearing demand deposits $ 558,552 0.00% $ 473,568 0.00% $ 441,800 0.00% Interest-bearing demand deposits 300,377 0.24% 274,688 0.24% 262,313 0.47% Regular savings deposits 521,582 0.66% 430,263 0.80% 402,728 1.32% Money market deposits 306,112 0.72% 295,287 0.89% 304,623 1.60% Time deposits 1,188,625 2.37% 1,090,511 2.89% 1,131,296 3.75% - ----------------------------------- ---------- ---------- ---------- Total deposits $2,875,248 1.20% $2,564,317 1.49% $2,542,760 2.12% =================================== ========== ========== ==========
As displayed in Table 13 above, total average deposits for 2004 equaled $2.875 billion, up $311 million or 12.1% from the prior year. This increase was principally the result of deposits obtained through the First Heritage acquisition in 2004 and the Grange and Peoples acquisitions in late 2003. The Dansville branch acquisition did not have a significant impact on full-year average deposit levels because it was completed late in the year. Average deposits in 2003 were up $22 million or 0.8% from 2002. The acquisitions of Peoples and Grange did not have a significant impact on full-year average deposit levels because they were completed relatively late in the year. The Company's funding composition continues to benefit from a high level of IPC deposits, which reached an all-time high in 2004 with an average balance of $2.692 billion, an increase of $295 million or 12.3% over the comparable 2003 period. This was largely due to the $210 million and $219 million in IPC deposits added in conjunction with the acquisition of First Heritage in May 2004 and Grange in late 2003, respectively. IPC deposits are frequently considered to be a bank's most attractive source of funding because they are generally stable, do not need to be collateralized, have a relatively low cost, and provide a strong customer base for which a variety of loan, deposit and other financial service-related products can be sold. Full-year average deposits of local municipalities increased $16 million or 9.5% during 2004, $7.3 million as a result of the Grange, First Heritage and Dansville acquisitions. The Company is required to collateralize all local government deposits 28 with marketable securities from its investment portfolio. Because of this stipulation, management considers this source of funding to be equivalent to external borrowings. As such, the Company generally prices these deposits consistent with alternative external borrowing rates. The mix of average deposits in 2004 changed slightly in comparison to 2003. The weightings of demand deposit and savings account balances all increased from their 2003 levels, while interest checking, money market and time deposit weightings decreased. This change in mix largely reflects less willingness by certain customers to being locked into lower CD rates and accounts with higher minimum balance requirements (interest checking and money market) given the market-driven contraction of interest rate spreads between these accounts and the ones with less restrictions on withdrawels, such as demand deposits and savings. This shift in the deposit mix resulted in a greater drop in the overall cost of funds on deposits than would have been achieved through the reduction of interest rates alone. As a result of market interest rates remaining at historically low levels for an extended period of time, spreads between these groups of accounts have stabilized and customers appear to be more willing to hold term deposits given the lack of viable alternatives with similar risk/return characteristics. This factor combined with the Company's ongoing commitment to continually expand its advantageous IPC deposit base to fund earning-asset growth, prompted the development of a new money market product in the fourth quarter of 2004 that has been an effective tool for attracting new customer funds. The remaining maturities of time deposits in amounts of $100,000 or more outstanding as of December 31 are as follows: Table 14: Time Deposit > $100,000 Maturities (000's omitted) 2004 2003 -------------------------------------------------------- Less than three months $ 69,239 $ 60,504 Three months to six months 32,163 24,351 Six months to one year 41,768 48,306 Over one year 36,364 35,080 -------------------------------------------------------- Total $179,534 $168,241 ======================================================== External borrowings are defined as funding sources available on a national market basis, generally requiring some form of collateralization. Borrowing sources for the Company include the Federal Home Loan Bank of New York and Federal Reserve Bank of New York, as well as access to the national repurchase agreement market through established relationships with primary market security dealers. The Company also had approximately $80 million in fixed and floating-rate subordinated debt outstanding at the end of 2004 that is held by unconsolidated subsidiary trusts. External borrowings averaged $824 million or 22% of total funding sources for all of 2004 as compared to $508 million or 17% of total funding sources for 2003. As shown in Table 15 below, at year-end 2004, $649 million or 71% of external borrowings had remaining terms of one year or less, up considerably from $397 million and 60% at the end of 2003. This change in external funding mix is due to an increase in short and medium term borrowings to take advantage of historically low short term rates, as well as, to reduce the Company's sensitivity to falling interest rates and to provide more flexibility with regard to altering future debt levels. During fourth quarter 2003, $25 million in longer-term Federal Home Loan Bank borrowings were retired early and replaced with significantly lower rate, short-term debt, resulting in an earnings charge of $2.6 million. This strategy was implemented because the projected cost of the replacement debt, including prepayment charges, was favorable on a long-term, economic basis in comparison to holding the existing borrowings. As displayed in Table 3 on page 16, the overall mix of funding has shifted in 2004. The percentage of funding derived from deposits decreased to 78% in 2004 from 83% in 2003 and 2002. Short and medium term FHLB borrowings increased during the year principally to fund security purchases. These borrowings carry relatively short maturities and help provide funding cost stability for a period of time that is complementary to our asset/liability profile. 29 The following table summarizes the outstanding balance of short-term borrowings of the Company as of December 31: Table 15: Short-term Borrowings
(000's omitted, except rates) 2004 2003 2002 --------------------------------------------------------------------------- Federal funds purchased $ 13,200 $ 36,300 $ 33,000 Term borrowings at banks 90 days or less 465,000 361,000 215,000 Over 90 days 171,000 0 0 Commercial loans sold with recourse 74 0 0 Capital lease obligations 0 96 241 --------------------------------------------------------------------------- Balance at end of period $649,274 $397,396 $248,241 =========================================================================== Daily average during the year $442,287 $212,512 $141,024 Maximum month-end balance $649,274 $397,396 $248,241 Weighted average rate during the year 1.64% 1.26% 1.83% Year-end average rate 2.51% 1.28% 1.50%
The following table shows the maturities of various contractual obligations as of December 31, 2004: Table 16: Maturities of Contractual Obligations
Maturing Maturing Maturing After One After Three Within Year but Years but Maturing One Year Within Within After (000's omitted) or Less Three Years Five Years Five Years Total - -------------------------------------------------------------------------------------------------------------------------------- Federal funds purchased $ 13,200 $ 0 $ 0 $ 0 $ 13,200 Federal Home Loan Bank advances 636,000 -- 15,000 175,000 826,000 Subordinated debt held by unconsolidated subsidiary trusts 80,446 80,446 Commercial loans sold with recourse 74 236 -- 555 865 Operating leases 2,204 3,810 2,282 4,374 12,670 - -------------------------------------------------------------------------------------------------------------------------------- Total $651,478 $ 4,046 $ 17,282 $260,375 $933,181 ================================================================================================================================
Financial Instruments with Off-Balance Sheet Risk The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The fair value of these commitments is immaterial for disclosure in accordance with FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". The contract amount of these off-balance sheet financial instruments as of December 31 is as follows: Table 17: Off-Balance Sheet Financial Instruments (000's omitted) 2004 2003 -------------------------------------------------------- Commitments to extend credit $429,751 $315,898 Standby letters of credit 22,948 19,163 -------------------------------------------------------- Total $452,699 $335,061 ======================================================== 30 Investments The objective of the Company's investment portfolio is to hold low-risk, high-quality earning assets that provide favorable returns and are another effective tool to actively manage its asset/liability position to maximize future net interest income operation. This must be accomplished within the following constraints: (a) implementing certain interest rate risk management strategies which achieve a relatively stable level of net interest income; (b) providing both the regulatory and operational liquidity necessary to conduct day-to-day business activities; (c) considering investment risk-weights as determined by the regulatory risk-based capital guidelines; and (d) generating a favorable return without undue compromise of the other requirements. As displayed in Table 18 below, the book value of the Company's investment portfolio increased $258 million or 20% during the year to $1.529 billion as a result of the First Heritage acquisition and the leveraging strategy that began in the third quarter of 2003 and ended during the second quarter of 2004. Average investment balances (book value basis) for 2004 were up $268 million or 23% versus the prior year. Investment interest income in 2004 was $10 million or 14.9% higher than the prior year as a result of the increased average balances in the portfolio, offset by the decrease in the average investment yield from 6.53% to 6.18%. The decline in the yield was primarily due to the maturity of securities from the portfolio that had been issued in the higher interest rate environments of previous periods and were replaced with investments that carry comparatively lower yields. This was expected given the fact that longer-term market interest rates, despite modest increases in the third quarter of 2003 and all of 2004, were still at historically low levels. However, the impact of lower investment yields was mostly offset by the funding of the purchases with very low rate medium and short-term borrowings, resulting in similar net spreads. In order to protect the Company against its exposure to falling interest rates, the vast majority of the investment purchases in 2003 and 2004 were in intermediate-term US Agency securities with average call protection in excess of six years. Investments sales, excluding Federal Home Loan Bank, in the current year totaled $18 million and were all related to securities inherited from acquired companies, and resulted in an immaterial amount of net gains. The sales were based on the Company's total return strategy (see below) or to remove securities that no longer adhere to investment policy guidelines. Those proceeds that were reinvested resulted in an improved interest rate risk position. As of December 31, 2004 the investment portfolio had a weighted average life of 5.9 years as compared to 6.6 as of December 31, 2003. The investment portfolio has limited credit risk due to the composition continuing to heavily favor U.S. Agency debentures, U.S. Agency mortgage-backed pass-throughs, U.S. Agency CMOs and municipal bonds insured by third parties. As of year-end 2004, these four AAA-rated (highest possible rating) security types accounted for 97% of the portfolio's total book value, excluding Federal Home Loan Bank stock and Federal Reserve Bank stock, or 52%, 3%, 5% and 37% respectively. These four security types comprised 98% of total investments as of December 31, 2003 at 48%, 6%, 7% and 37%, respectively. The change in the investment mix reflects management's strategy over the last several years of primarily purchasing medium-term, call-protected US Agency and municipal bonds that offer both attractive yields and are free from short-term reinvestment risk. MBS and CMO securities typically possess a high level of this latter risk, particularly in periods with high levels of mortgage refinancing such as have existed over the last few years in the extremely low interest rate environment. As a consequence, the Company has avoided investing in these types of securities during this period, and this fact combined with high run-off rates explains the significant drop in their weighting in the total investment portfolio. The Company has utilized total return as its primary methodology for managing investment portfolio assets. Under this analytical method, shareholder value is maximized through both interest income and market value appreciation. The commitment to this approach is reflected in the fact that no security sales were conducted in 2004 outside of minor transactions associated with the investments of acquired banks, despite the significant level of market gains in the portfolio (see MVA discussion in the following paragraph). Management chose not to take gains in the current year to increase short-term earnings at the expense of profitability in future periods. Ninety one percent of the investment portfolio was classified as available-for-sale at year-end 2004 versus eighty nine percent at the end of 2003. The net pre-tax market value gain over book value for the available-for-sale portfolio as of December 31, 2004 was $55.8 million, $3.1 million lower than it was one year earlier. 31 The following table sets forth the amortized cost and market value for the Company's investment securities portfolio: Table 18: Investment Securities
2004 2003 2002 ------------------------- ------------------------- ------------------------- Amortized Amortized Amortized Cost/Book Fair Cost/Book Fair Cost/Book Fair (000's omitted) Value Value Value Value Value Value - ----------------------------------------- ------------------------- ------------------------- ------------------------- Held-to-Maturity Portfolio: U.S. treasury and agency securities $ 127,490 $ 125,906 $ 127,635 $ 125,003 $ 0 $ 0 Obligations of state and political subdivisions 6,576 6,694 7,459 7,677 7,412 7,666 Other securities 3,578 3,578 3,558 3,558 3,018 3,018 - ----------------------------------------- ------------------------- ------------------------- ------------------------- Total held-to-maturity portfolio 137,644 136,178 138,652 136,238 10,430 10,684 - ----------------------------------------- ------------------------- ------------------------- ------------------------- Available-for-Sale Portfolio: U.S. treasury and agency securities 630,058 650,767 456,913 479,454 380,243 411,278 Obligations of state and political subdivisions 545,698 573,551 443,930 470,210 404,864 420,605 Corporate securities 40,443 43,898 27,712 30,251 27,972 30,225 Collateralized mortgage obligations 70,986 72,444 89,566 93,552 235,286 245,368 Mortgage-backed securities 50,347 52,664 76,628 80,177 131,755 137,211 - ----------------------------------------- ------------------------- ------------------------- ------------------------- Sub-total 1,337,532 1,393,324 1,094,749 1,153,644 1,180,120 1,244,687 Equity securities (1) 43,515 43,515 29,185 29,185 25,814 25,814 Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,652 5,652 - ----------------------------------------- ------------------------- ------------------------- ------------------------- Total available-for-sale portfolio 1,390,903 1,446,695 1,131,987 1,190,882 1,211,586 1,276,153 Net unrealized gain on available-for-sale portfolio 55,792 0 58,895 0 64,567 0 - ----------------------------------------- ------------------------- ------------------------- ------------------------- Total $1,584,339 $1,582,873 $1,329,534 $1,327,120 $1,286,583 $1,286,837 ========================================= ========================= ========================= =========================
(1) Includes $42,480, $28,365 and $24,575 of FHLB common stock at December 31, 2004, 2003, and 2002, respectively. 32 The following table sets forth as of December 31, 2004, the maturities of investment securities and the weighted-average yields of such securities, which have been calculated on the cost basis, weighted for scheduled maturity of each security, and adjusted to a fully tax-equivalent basis: Table 19: Maturities of Investment Securities
Maturing Maturing Maturing After One After Five Total Within Year but Years but Maturing Amortized One Year Within Within After Cost/Book (000's omitted, except rates) or Less Five Years Ten Years Ten Years Value - -------------------------------------------------------------------------------------------------------------------------------- Held-to-Maturity Portfolio: U.S. treasury and agency securities $ 0 $ 0 $ 99,344 $ 28,146 $ 127,490 Obligations of state and political subdivisions 4,387 1,959 230 0 6,576 Other securities 0 0 22 3,556 3,578 - -------------------------------------------------------------------------------------------------------------------------------- Total held-to-maturity portfolio $ 4,387 $ 1,959 $ 99,596 $ 31,702 $ 137,644 ================================================================================================================================ Weighted Average Yield for Year (1) 3.89% 6.30% 4.71% 5.46% 4.88% Available-for-Sale Portfolio: U.S. treasury and agency securities $ 0 $ 20,000 $ 458,221 $ 151,837 $ 630,058 Obligations of state and political subdivisions 5,263 35,927 228,903 275,605 545,698 Corporate securities 0 0 25,044 15,399 40,443 Collateralized mortgage obligations 0 1,090 17,297 52,599 70,986 Mortgage-backed securities 0 2,832 1,280 46,235 50,347 - -------------------------------------------------------------------------------------------------------------------------------- Total available-for-sale portfolio $ 5,263 $ 59,849 $ 730,745 $ 541,675 $1,337,532 ================================================================================================================================ Weighted Average Yield for Year (1) 8.06% 5.82% 5.58% 6.47% 5.96%
(1) Weighted average yields on the tax-exempt obligations have been computed on a fully tax equivalent basis assuming a marginal federal tax rate of 35.0%. These yields are an arithmetic computation of accrued income divided by average balance; they may differ from the yield to maturity, which considers the time value of money. Impact of Inflation and Changing Prices The Company's financial statements have been prepared in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effect of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Notwithstanding this, inflation can directly affect the value of loan collateral, in particular real estate. New Accounting Pronouncements See Accounting Pronouncement Section of Note A of the notes to the consolidated financial statements on page 48 for additional accounting pronouncements. Forward-Looking Statements This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Moreover, the Company's plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company's control). Factors that could cause actual results to differ from those discussed in the forward-looking statements include: (1) risks related to credit quality, interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business; (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (4) inflation, interest rate, market and monetary fluctuations; (5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing products and services; (6) changes in consumer spending, borrowing and savings habits; (7) technological changes; (8) any acquisitions or mergers that might be considered or consumated by the Company and the costs and factors associated therewith; (9) the ability to 33 maintain and increase market share and control expenses; (10) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and accounting principles generally accepted in the United States; (11) changes in the Company's organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets; (12) the costs and effects of litigation and of any adverse outcome in such litigation; (13) other risk factors outlined in the Company's filings with the Securities and Exchange Commission from time to time; and (14) the success of the Company at managing the risks of the foregoing. The foregoing list of important factors is not exclusive. Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made. If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. 34 Item 7A. Quantitative and Qualitative Disclosures about Market Risk Market Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk. Credit risk associated with the Company's loan portfolio has been previously discussed in the asset quality section of Management's Discussion and Analysis of Financial Condition and Results of Operations. Although more than a third of the securities portfolio at year-end 2004 was invested in municipal bonds, management believes that the tax risk of the Company's municipal investments associated with potential future changes in statutory, judicial and regulatory actions is minimal. The Company also believes that it has an insignificant amount of credit risk in its investment portfolio because essentially all of the fixed-income securities in the portfolio are AAA-rated (highest possible rating). The Company does not have any material foreign currency exchange rate risk exposure. Therefore, almost all the market risk in the investment portfolio is related to interest rates. The ongoing monitoring and management of both interest rate risk and liquidity, in the short and long term time horizons is an important component of the Company's asset/liability management process, which is governed by limits established in the policies reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out the policies to the Asset/Liability Committee (ALCO), which meets each month. The committee is made up of the Company's senior management as well as regional and line-of-business managers who oversee specific earning asset classes and various funding sources. Asset/Liability Management The primary objective of the Company's asset/liability management process is to maximize earnings and return on capital within acceptable levels of risk. As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools that enable it to identify and quantify sources of interest rate risk in varying rate environments. The primary tools used by the Company in managing interest rate risk are the income simulation model and economic value of equity modeling. Interest Rate Risk Interest rate risk (IRR) can result from the timing differences in the maturity/repricing of an institution's assets, liabilities, and off-balance sheet contracts; the effect of embedded options, such as loan prepayments, interest rate caps, and deposit withdrawals; and differences in the behavior of lending and funding rates, sometimes referred to as basis risk; an example of basis risk would occur if floating rate assets and liabilities, with otherwise identical repricing characteristics, were based on market indexes that were imperfectly correlated. Given the potential types and differing related characteristics of IRR, it is important that the Company maintain an appropriate process and set of measurement tools that enable it to identify and quantify its primary sources of IRR. The Company also recognizes that effective management of IRR includes an understanding of when potential adverse changes in interest rates will flow through the income statement. Accordingly, the Company will manage its position so that it monitors its exposure to net interest income over both a one year planning horizon and a longer-term strategic horizon. It is the Company's objective to manage its exposure to interest rate risk, bearing in mind that it will always be in the business of taking on rate risk and that rate risk immunization is not possible. Also, it is recognized that as exposure to interest rate risk is reduced, so too may net interest margin be reduced. Income Simulation Income simulation is tested on a wide variety of balance sheet and treasury yield curve scenarios. The simulation projects changes in net interest income caused by the effect of changes in interest rates. The model requires management to make assumptions about how the balance sheet is likely to evolve through time in different interest rate environments. Loan and deposit growth rate assumptions are derived from management's outlook, as are the assumptions used for new loan yields and deposit rates. Loan prepayment speeds are based on a combination of current industry averages and internal historical prepayments. Balance sheet and yield curve assumptions are analyzed and reviewed by the ALCO Committee regularly. 35 The following table reflects the Company's one-year net interest income sensitivity, using December 31, 2004 asset and liability levels as a starting point. The prime rate and federal funds rates are assumed to move up 300 basis points and down 100 basis points over a 12-month period while flattening the long end of the treasury curve to spreads over federal funds that are more consistent with historical norms. Deposit rates are assumed to move in a manner that reflects the historical relationship between deposit rate movement and changes in the federal funds rate, generally reflecting 10%-65% of the movement of the federal funds rate. Cash flows are based on contractual maturity, optionality and amortization schedules along with applicable prepayments derived from internal historical data and external sources. Net Interest Income Sensitivity Model Calculated increase (decrease) in Projected Net Interest Income at December 31 ------------------------------------------- Changes in Interest Rates 2004 2003 ----------------------------------------------------------------------- + 200 basis points ($4,300,000) ($3,900,000) -100 basis points ($1,200,000) ($2,100,000) In the 2004 model, both the rising and falling rate environments reflect a reduction in net interest income (NII) from a flat rate environment due to the assumed flattening of the yield curve. The modeled NII in a falling rate environment is initially more favorable than if rates were to rise due to a faster initial reaction from core deposit pricing and short-term capital market borrowing rates. Over a longer time period, however, the growth in NII improves significantly in a rising rate environment as a result of lower yielding earning assets running off and being replaced at increased rates. The analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions: the nature and timing of interest rate levels (including yield curve shape), prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and other factors. While the assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates. Management uses a "value of equity" model to supplement the modeling technique described above. Those supplemental analyses are based on discounted cash flows associated with on- and off-balance sheet financial instruments. Such analyses are modeled to reflect changes in interest rates and shifts in the maturity curve of interest rates and provide management with a long-term interest rate risk metric. 36 Item 8. Financial Statements and Supplementary Data The following consolidated financial statements and independent auditor's reports of Community Bank System, Inc. are contained on pages 38 through 66 of this item. o Consolidated Statements of Condition, December 31, 2004 and 2003 o Consolidated Statements of Income, Years ended December 31, 2004, 2003, and 2002 o Consolidated Statements of Changes in Shareholders' Equity, Years ended December 31, 2004, 2003, and 2002 o Consolidated Statements of Comprehensive Income, Years ended December 31, 2004, 2003, and 2002 o Consolidated Statements of Cash Flows, Years ended December 31, 2004, 2003, and 2002 o Notes to Consolidated Financial Statements, December 31, 2004 o Management's Report on Internal Control over Financial Reporting o Report of Independent Registered Public Accounting Firm Quarterly Selected Data (Unaudited) for 2004 and 2003 are contained on page 67. 37 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CONDITION (In Thousands, Except Share Data)
December 31, December 31, 2004 2003 - ---------------------------------------------------------------------------------------------------------------------- Cash and due from banks $ 118,345 $ 103,923 Available-for-sale investment securities 1,446,695 1,190,882 Held-to-maturity investment securities 137,644 138,652 - ---------------------------------------------------------------------------------------------------------------------- Total investment securities (fair value of $1,582,873 and $1,327,120, respectively) 1,584,339 1,329,534 Loans 2,358,493 2,128,509 Allowance for loan losses 31,778 29,095 - ---------------------------------------------------------------------------------------------------------------------- Net loans 2,326,715 2,099,414 Core deposit intangibles, net 35,351 33,998 Goodwill 195,163 159,596 Other intangibles, net 1,986 2,517 - ---------------------------------------------------------------------------------------------------------------------- Intangible assets, net 232,500 196,111 Premises and equipment, net 63,510 61,705 Accrued interest receivable 27,947 25,851 Other assets 40,475 38,859 - ---------------------------------------------------------------------------------------------------------------------- Total assets $ 4,393,831 $ 3,855,397 ====================================================================================================================== Liabilities: Non-interest bearing deposits $ 567,106 $ 498,195 Interest bearing deposits 2,361,872 2,227,293 - ---------------------------------------------------------------------------------------------------------------------- Total deposits 2,928,978 2,725,488 Federal funds purchased 13,200 36,300 Borrowings 826,865 551,096 Subordinated debt held by unconsolidated subsidiary trusts 80,446 80,390 Accrued interest and other liabilities 69,714 57,295 - ---------------------------------------------------------------------------------------------------------------------- Total liabilities 3,919,203 3,450,569 - ---------------------------------------------------------------------------------------------------------------------- Commitments and contingencies (See Note N) Shareholders' equity: Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued Common stock, $1.00 par value, 50,000,000 shares authorized; 32,041,591 and 28,746,612 shares issued in 2004 and 2003, respectively 32,042 28,747 Additional paid-in capital 190,769 130,066 Retained earnings 248,295 218,628 Accumulated other comprehensive income 34,200 35,958 Treasury stock, at cost (1,400,000 and 416,300 shares, respectively) (30,199) (8,490) Employee stock plan - unearned (479) (81) - ---------------------------------------------------------------------------------------------------------------------- Total shareholders' equity 474,628 404,828 - ---------------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 4,393,831 $ 3,855,397 ======================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 38 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands, Except Per-Share Data)
Years Ended December 31, ------------------------------------ 2004 2003 2002 - ---------------------------------------------------------------------------------------------------------------- Interest income: Interest and fees on loans $ 137,077 $ 125,256 $ 130,860 Interest and dividends on taxable investments 52,744 47,047 57,133 Interest and dividends on non-taxable investments 22,974 18,826 17,100 - ---------------------------------------------------------------------------------------------------------------- Total interest income 212,795 191,129 205,093 - ---------------------------------------------------------------------------------------------------------------- Interest expense: Interest on deposits 34,587 38,288 53,878 Interest on short-term borrowings 7,242 2,685 2,586 Interest on subordinated debt held by unconsolidated subsidiary trusts 5,750 5,632 5,985 Interest on long-term borrowings 14,173 12,696 14,794 - ---------------------------------------------------------------------------------------------------------------- Total interest expense 61,752 59,301 77,243 - ---------------------------------------------------------------------------------------------------------------- Net interest income 151,043 131,828 127,850 Less: provision for loan losses 8,750 11,195 12,222 - ---------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 142,293 120,633 115,628 - ---------------------------------------------------------------------------------------------------------------- Non-interest income: Deposit service fees 25,201 23,121 16,480 Other banking services 2,431 1,906 2,061 Trust, investment and asset management fees 7,443 6,682 8,003 Benefit plan administration, consulting and actuarial fees 9,298 6,220 3,845 Gain (loss) on investment securities & debt extinguishments 72 (2,698) 1,673 - ---------------------------------------------------------------------------------------------------------------- Total non-interest income 44,445 35,231 32,062 - ---------------------------------------------------------------------------------------------------------------- Operating expenses: Salaries and employee benefits 61,146 53,164 47,864 Occupancy 10,177 9,297 8,154 Equipment and furniture 8,636 7,828 7,538 Amortization of intangible assets 7,414 5,093 5,953 Legal and professional fees 4,578 3,183 3,272 Data processing 7,737 6,800 6,574 Office supplies 2,232 1,996 2,321 Acquisition expenses 1,704 498 700 Other 16,275 14,852 12,910 - ---------------------------------------------------------------------------------------------------------------- Total operating expenses 119,899 102,711 95,286 - ---------------------------------------------------------------------------------------------------------------- Income before income taxes 66,839 53,153 52,404 Income taxes 16,643 12,773 13,887 - ---------------------------------------------------------------------------------------------------------------- Net income $ 50,196 $ 40,380 $ 38,517 ================================================================================================================ Basic earnings per share $ 1.68 $ 1.54 $ 1.48 Diluted earnings per share $ 1.64 $ 1.49 $ 1.46 Dividends declared per share $ 0.68 $ 0.61 $ 0.56
The accompanying notes are an integral part of the consolidated financial statements. 39 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Years ended December 31, 2002, 2003 and 2004 (In Thousands, Except Share Data)
Common Stock Accumulated ---------------------- Additional Other Employee Shares Amount Paid-In Retained Comprehensive Treasury Stock Plan Outstanding Issued Capital Earnings Income Stock -Unearned Total --------------------------------------------------------------------------------------------------- Balance at December 31, 2001, as previously reported 12,902,812 $12,903 $77,710 $170,472 $7,281 $0 ($386) $267,980 Two-for-one stock split 12,902,812 12,904 (12,904) 0 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 25,805,624 25,807 64,806 170,472 7,281 0 (386) 267,980 2001, as restated Net income 38,517 38,517 Other comprehensive income, net of tax 31,270 31,270 Dividends declared: Common, $0.56 per share (14,506) (14,506) Common stock issued under employee stock plan, including tax benefits of $219 151,484 151 1,273 353 1,777 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2002 25,957,108 $25,958 $66,079 $194,483 $38,551 $0 ($33) $325,038 Net income 40,380 40,380 Other comprehensive loss, net of tax (2,593) (2,593) Dividends declared: Common, $0.61 per share (16,235) (16,235) Common stock issued under employee stock plan, including tax benefits of $1,410 495,322 495 5,913 (48) 6,360 Stock issued for acquisition 2,294,182 2,294 58,074 60,368 Treasury stock purchased (416,300) (8,490) (8,490) - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 28,330,312 $28,747 $130,066 $218,628 $35,958 ($8,490) ($81) $404,828 2003 Net income 50,196 50,196 Other comprehensive loss, net of tax (1,758) (1,758) Dividends declared: Common, $0.68 per share (20,529) (20,529) Common stock issued under employee stock plan, including tax benefits of $3,165 702,766 703 8,576 (398) 8,881 Stock and options issued for acquisition 2,592,213 2,592 52,127 54,719 Treasury stock purchased (983,700) (21,709) (21,709) - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2004 30,641,591 $32,042 $190,769 $248,295 $34,200 ($30,199) ($479) $474,628 ===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 40 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In Thousands)
Years Ended December 31, ---------------------------------- 2004 2003 2002 - ---------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, before tax: Change in minimum pension liability adjustment $ 0 $ 92 $ 4,919 Unrealized (losses) gains on securities: Unrealized holding (losses) gains arising during period (3,031) (5,727) 49,796 Reclassification adjustment for (gains) losses included in net income (72) 54 (2,598) - ---------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, before tax (3,103) (5,581) 52,117 Income tax benefit (expense) related to other comprehensive (loss) income 1,345 2,988 (20,847) - ---------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income, net of tax (1,758) (2,593) 31,270 Net income 50,196 40,380 38,517 - ---------------------------------------------------------------------------------------------------------------- Comprehensive income $ 48,438 $ 37,787 $ 69,787 ================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 41 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars, except Share Data)
Years Ended December 31, ----------------------------------- 2004 2003 2002 - ---------------------------------------------------------------------------------------------------------------------------------- Operating activities: Net income $ 50,196 $ 40,380 $ 38,517 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 8,025 7,139 6,596 Amortization of intangible assets 7,414 5,093 5,953 Net amortization of premiums and discounts on securities and loans 1,392 2,303 3,256 Amortization of unearned compensation and discount on subordinated debt 439 172 443 Provision for loan losses 8,750 11,195 12,222 Provision for deferred taxes 1,286 898 4,458 (Gain) loss on investment securities and debt extinguishments (72) 2,698 (1,673) Loss (gain) on loans and other assets 211 350 (28) Proceeds from the sale of loans held for sale 0 67,482 9,103 Origination of loans held for sale 0 (61,036) (14,858) Change in other operating assets and liabilities 7,823 (3,604) (11,815) - ---------------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 85,464 73,070 52,174 - ---------------------------------------------------------------------------------------------------------------------------------- Investing activities: Proceeds from sales of available-for-sale investment securities 51,889 41,227 96,294 Proceeds from maturities of held-to-maturity investment securities 4,852 5,229 4,521 Proceeds from maturities of available-for-sale investment securities 127,222 242,614 197,928 Purchases of held-to-maturity investment securities (3,991) (133,517) (4,577) Purchases of available-for-sale investment securities (395,252) (141,658) (383,598) Net increase in loans outstanding (26,278) (151,520) (77,906) Cash received (paid) for acquisition, net of cash (paid) acquired of ($7,023), $23,986, $0 21,939 (9,630) 0 Capital expenditures (7,377) (8,322) (8,831) - ---------------------------------------------------------------------------------------------------------------------------------- Net cash used by investing activities (226,996) (155,577) (176,169) - ---------------------------------------------------------------------------------------------------------------------------------- Financing activities: Net change in demand deposits, NOW accounts, and savings accounts 25,068 39,745 25,005 Net change in time deposits (66,203) (68,220) (65,619) Net change in federal funds purchased (23,100) 3,300 18,800 Net change in short-term borrowings 87,328 147,356 202,976 Change in long-term borrowings (net of payments of $177, $30,000 and $252,000) 168,865 (30,000) (37,000) Issuance of common stock 5,344 4,819 1,151 Purchase of treasury stock (21,709) (8,490) 0 Cash dividends paid (19,543) (15,466) (14,228) Other financing activities (96) (145) (113) - ---------------------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 155,954 72,899 130,972 - ---------------------------------------------------------------------------------------------------------------------------------- Change in cash and cash equivalents 14,422 (9,608) 6,977 Cash and cash equivalents at beginning of year 103,923 113,531 106,554 - ---------------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 118,345 $ 103,923 $ 113,531 ================================================================================================================================== Supplemental disclosures of cash flow information: Cash paid for interest $ 59,644 $ 60,062 $ 79,250 Cash paid for income taxes $ 9,422 $ 13,095 $ 6,429 Supplemental disclosures of non-cash financing and investing activities: Dividends declared and unpaid $ 5,515 $ 4,529 $ 3,760 Gross change in unrealized gains on available-for-sale investment securities ($3,103) ($5,673) $ 47,198 Acquisitions: Fair value of assets acquired, excluding acquired cash and intangibles $ 258,416 $ 260,902 $ 0 Fair value of liabilities assumed $ 268,611 $ 257,532 $ 0 Common stock and options issued $ 54,719 $ 60,368 $ 0
The accompanying notes are an integral part of the consolidated financial statements. 42 COMMUNITY BANK SYSTEM, INC. NOTE A: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations Community Bank System, Inc. is a single bank holding company which wholly-owns four consolidated subsidiaries: Community Bank, N.A. (the Bank), Benefit Plans Administrative Services, Inc. (BPAS), CFSI Closeout Corp. (CFSICC), and First of Jermyn Realty Co. (FJRC). BPAS owns two subsidiaries, Benefit Plans Administrative Services LLC and Harbridge Consulting Group LLC. BPAS provides administration, consulting and actuarial services to sponsors of employee benefit plans. CFSICC and FJRC are inactive companies. The Bank operates 125 customer facilities throughout 22 counties of Upstate New York and five counties of Northeastern Pennsylvania. The Bank owns the following subsidiaries: Community Investment Services, Inc. (CISI), CBNA Treasury Management Corporation (TMC), CBNA Preferred Funding Corporation (PFC), Elias Asset Management, Inc. (EAM) and First Liberty Service Corp. (FLSC). CISI provides broker-dealer and investment advisory services. TMC operates the cash management, investment, and treasury functions of the Bank. PFC primarily is an investor in residential real estate loans. EAM provides asset management services to individuals, corporate pension and profit sharing plans, and foundations. FLSC provides banking-related services to the Pennsylvania branches of the Bank. The Company wholly-owns three unconsolidated subsidiary business trusts formed for the purpose of issuing mandatorily redeemable preferred securities which are considered Tier I capital under regulatory capital adequacy guidelines (see Note H). Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform with the current period presentation. Critical Accounting Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting estimates include the allowance for loan losses, actuarial assumptions associated with the pension, post-retirement and other employee benefit plans, the provision for income taxes, and the carrying value of goodwill and other intangible assets. Risk and Uncertainties In the normal course of its business, the Company encounters economic and regulatory risks. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different basis, from its interest-earning assets. The Company's primary credit risk is the risk of default on the Company's loan portfolio that results from the borrowers' inability or unwillingness to make contractually required payments. Market risk reflects potential changes in the value of collateral underlying loans, the fair value of investment securities, and loans held for sale. The Company is subject to regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies which may subject it to further changes with respect to asset valuations, amounts of required loan loss allowances, and operating restrictions resulting from the regulators' judgements based on information available to them at the time of their examinations. Revenue Recognition The Company recognizes income on an accrual basis. CISI recognizes fee income when investment and insurance products are sold to customers. EAM provides asset management services to brokerage firms and clients and recognizes income ratably over the contract period during which service is performed. Revenue from BPA's administration and 43 recordkeeping services is recognized ratably over the service contract period. Revenue from consulting and actuarial services is recognized when services are rendered. All inter-company revenue and expense among related entities are eliminated in consolidation. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and highly liquid investments with original maturities of less than ninety days. The carrying amounts reported in the balance sheet for cash and cash equivalents approximate those assets' fair values. Investment Securities The Company has classified its investments in debt and equity securities as held-to-maturity or available-for-sale. Held-to-maturity securities are those for which the Company has the positive intent and ability to hold to maturity, and are reported at cost, which is adjusted for amortization of premiums and accretion of discounts. Securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair market value with net unrealized gains and losses reflected as a separate component of shareholders' equity, net of applicable income taxes. None of the Company's investment securities has been classified as trading securities. Equity securities are stated at cost and include restricted stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York. Investment securities are reviewed regularly for other than temporary impairment. Where there is other than temporary impairment, the carrying value of the investment security is reduced to the estimated fair value, with the impairment loss recognized in the consolidated statements of income as other expense. The average cost method is used in determining the realized gains and losses on sales of investment securities. Premiums and discounts on securities are amortized and accreted, respectively, on a systematic basis over the period to maturity, estimated life, or earliest call date of the related security. Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans Loans are stated at unpaid principal balances, net of unearned income. Mortgage loans held for sale are carried at the lower of cost or fair value and are included in loans as the balance of such loans was not significant. Fair values for variable rate loans that reprice frequently are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest approximates its fair value. Interest on loans is accrued and credited to operations based upon the principal amount outstanding. Unearned discount on installment loans is recognized as income over the term of the loan, principally by the interest method. Non-refundable loan fees and related direct costs are included in the loan balances and are deferred and amortized over the life of the loan as an adjustment to loan yield using the effective interest method. Premiums and discounts on purchased loans are amortized on an accelerated method over the life of the loans. Impaired and Other Nonaccrual Loans The Company places a loan on nonaccrual status when the loan becomes ninety days past due (or sooner, if management concludes collection is doubtful), except when, in the opinion of management, it is well-collateralized and in the process of collection. A loan may be placed on nonaccrual status earlier than ninety days past due if there is deterioration in the financial position of the borrower or if other conditions of the loan so warrant. When a loan is placed on nonaccrual status, uncollected accrued interest is reversed against interest income and the deferral and amortization of non-refundable loan fees and related direct costs is discontinued. Interest income during the period the loan is on nonaccrual status is recorded on a cash basis after recovery of principal is reasonably assured. Nonaccrual loans are returned to accrual status when management determines that the borrower's performance has improved and that both principal and interest are collectible. This generally requires a sustained period of timely principal and interest payments. Commercial loans greater than $500,000 are evaluated individually for impairment in accordance with FASB No. 114, "Accounting by Creditors for Impairment of a Loan." A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based upon the present value of expected future cash flows or the fair value of the collateral, if the loan is collateral-dependent. 44 The Company's charge-off policy by loan type is as follows: o Commercial loans are generally charged-off to the extent outstanding principal exceeds the fair value of estimated proceeds from collection efforts, including liquidation of collateral. The charge-off is recognized when the loss becomes reasonably quantifiable. o Consumer installment loans are generally charged-off to the extent outstanding principal balance exceeds the fair value of collateral, and are recognized by the end of the month in which the loan becomes 120 days past due. o Loans secured by 1-4 family residential real estate are generally charged-off to the extent outstanding principal exceeds the fair value of the property, and are recognized when the loan becomes 180 days past due. Allowance for Loan Losses Management continually evaluates the credit quality of the Company's loan portfolio, and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis. The allowance reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. The Company's allowance methodology consists of two broad components, general and specific loan loss allocations. The general loan loss allocation is composed of two calculations that are computed on four main loan segments: commercial, consumer direct, consumer indirect and residential real estate. The first calculation determines an allowance level based on the latest three years of historical net charge-off data for each loan category (commercial loans exclude balances with specific loan loss allocations). The second calculation is qualitative and takes into consideration five major factors affecting the level of loan loss risk: portfolio risk migration patterns (internal credit quality trends); the growth of the segments of the loan portfolio; economic and business environment trends in the Company's markets (includes review of bankruptcy, unemployment, population, consumer spending and regulatory trends); industry, geographical and product concentrations in the portfolio; and the perceived effectiveness of managerial resources and lending practices and policies. These two calculations are added together to determine the general loan loss allocation. The specific loan loss allocation relates to individual commercial loans that are both greater than $0.5 million and in a non-accruing status with respect to interest. Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan loss is charged to operations based on management's periodic evaluation of factors previously mentioned. Intangible Assets Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 7 to 20 years. Goodwill is evaluated at least annually for impairment. The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Computer software costs that are capitalized only include external direct costs of obtaining and installing the software. The annual provision for depreciation is computed using the straight-line method over the assets' estimated useful lives. Maintenance and repairs are charged to expense as incurred. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, the Company recognizes a loss for the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis. Impairment losses are recorded in other expenses on the income statement. 45 Other Real Estate Properties acquired through foreclosure, or by deed in lieu of foreclosure, are carried at the lower of the unpaid loan balance or fair value less estimated costs of disposal. Subsequent changes in value are reported as adjustments to the carrying amount, not to exceed the initial carrying value of the asset at the time of transfer. Changes in value subsequent to transfer are recorded in operating expenses on the income statement. Gains or losses not previously recognized resulting from the sale of other real estate are recognized as an expense on the date of sale. At December 31, 2004 and 2003, other real estate, included in other assets, amounted to $1,645,000 and $1,077,000, respectively. Mortgage Servicing Rights Originated mortgage servicing rights are recorded at their allocated fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the period of estimated net servicing income or loss. The Company uses a valuation model that calculates the present value of future cash flows to determine the fair value of servicing rights. In using this valuation method, the Company incorporates assumptions that market participants would use in estimating future net servicing income, which includes estimates of the servicing cost per loan, the discount rate, and prepayment speeds. The carrying value of the originated mortgage servicing rights is periodically evaluated for impairment using these same market assumptions. Deposits The fair value of deposit obligations are based on current market rates for alternative funding sources, principally the Federal Home Loan Bank of New York. The carrying value of accrued interest approximates fair value. Borrowings The carrying amounts of federal funds purchased and short-term borrowings approximate their fair values. Fair values for long-term borrowings are estimated using discounted cash flows and interest rates currently being offered on similar borrowings. Since the Company considers debt extinguishments to be a component of its interest rate risk management, any related gains or losses are not deemed extraordinary and are presented in the non-interest income section of the consolidated statements of income. Treasury Stock On June 9, 2003, the Company announced a twelve-month authorization to repurchase up to 1,400,000 of its outstanding shares in open market or privately negotiated transactions. As of December 31, 2004, the Company has repurchased all of the shares at an aggregate cost of $30,199,000 or $21.57 per share. The repurchases were for general corporate purposes, including those related to acquisition and stock plan activities. Income Taxes Provisions for income taxes are based on taxes currently payable or refundable, and deferred taxes which are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. Retirement Benefits The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including discount rate, rate of future compensation increases and expected return on plan assets. Assets Under Management or Administration Assets held in fiduciary or agency capacities for customers are not included in the accompanying consolidated statements of condition as they are not assets of the Company. Substantially all fees associated with providing asset management services are recorded on an accrual basis of accounting and are included in non-interest income. Assets 46 under management or administration at December 31, 2004 and 2003 were $2,102,000,000 and $1,807,000,000, respectively. Earnings Per Share Basic earnings per share are computed based on the weighted-average common shares outstanding for the period. Diluted earnings per share are based on the weighted-average shares outstanding adjusted for the dilutive effect of the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method of accounting. The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. At a special meeting of the shareholders held on March 26, 2004, the shareholders approved an amendment to the certificate of incorporation of the Company to increase the number of authorized shares of common stock to 50 million. This amendment was effected in connection with the previously announced two-for-one stock split of the Company's common stock. The stock split was effected in the form of a 100 percent stock dividend, and was paid on April 12, 2004 to shareholders of record on March 17, 2004. Accordingly, all share, option and per-share amounts have been adjusted in the consolidated financial statements to reflect the stock split. Stock-Based Compensation The Company accounts for stock-based awards issued to directors, officers and key employees using the intrinsic value method. This method requires that compensation expense be recognized to the extent that the fair value of the underlying stock exceeds the exercise price of the stock award at the grant date. The Company generally does not recognize compensation expense related to stock awards because the stock awards generally have fixed terms and exercise prices that are equal to or greater than the fair value of the Company's common stock at the grant date. SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use the "intrinsic value method" to account for stock compensation plans to provide pro forma disclosures of the net income and earnings per share effect of stock options using the "fair value method." Under this method, the fair value of the option on the date of grant is recognized ratably as compensation expense over the vesting period of the option. Management estimated the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not necessarily a precise indicator of the value of an option, but it is commonly used for this purpose. The Black-Scholes model requires several assumptions, which management developed based on historical trends and current market observations. These assumptions include:
2004 2003 2002 - ---------------------------------------------------------------------------------------- Weighted-average expected life (in years) 7.33-7.43 7.55-8.76 6.74 Future dividend yield 3.00% 3.00% 3.00% Share price volatility 26.88%-27.02% 25.59%-27.58% 27.82% Weighted average risk-free interest rate 4.02%-4.45% 3.82%-4.03% 3.81%-5.16% ========================================================================================
If these assumptions are not accurate, the estimated fair value used to derive the information presented in the following table also will be inaccurate. Moreover, the model assumes that the estimated fair value of an option is amortized over the option's vesting period and would be included in salaries and employee benefits on the income statement. 47 The pro forma impact of applying the fair value method of accounting for the periods shown below may not be indicative of the pro forma impact in future years.
(000's omitted except per share amounts) 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------------ Net income, as reported $50,196 $40,380 $38,517 Stock-based compensation expense included in net income, as reported 228 64 216 Stock-based compensation expense determined under fair value method, net of tax (886) (738) (555) - ------------------------------------------------------------------------------------------------------------------ Pro forma net income $49,538 $39,706 $38,178 ================================================================================================================== Earnings per share: As reported: Basic $ 1.68 $ 1.54 $ 1.48 Diluted $ 1.64 $ 1.49 $ 1.46 Pro forma: Basic $ 1.66 $ 1.51 $ 1.47 Diluted $ 1.61 $ 1.47 $ 1.45
Fair Values of Financial Instruments The Company determines fair values based on quoted market values where available or on estimates using present values or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS 107, "Disclosures about Fair Value of Financial Instruments," excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The fair values of investment securities, loans, deposits, and borrowings have been disclosed in footnotes C, D, G, and H, respectively. New Accounting Pronouncements In December 2004, the Financial Accounting Standards Board revised SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS 123R establishes accounting requirements for share-based compensation to employees and carries forward prior guidance on accounting for awards to non-employees. The provisions of this statement will become effective July 1, 2005 for all equity awards granted after the effective date. SFAS 123R requires an entity to recognize compensation expense based on an estimate of the number of awards expected to actually vest, exclusive of awards expected to be forfeited. Management does not expect the impact of the adoption of this pronouncement to be materially different from the pro forma impacts disclosed under SFAS No. 123. NOTE B: ACQUISITIONS Dansville Branch Acquisition On December 3, 2004, the Company completed the purchase of a branch office in Dansville, N.Y. from HSBC Bank USA, N.A with deposits of $32.6 million. First Heritage Bank On May 14, 2004, the Company acquired First Heritage Bank ("Heritage"), a closely held bank headquartered in Wilkes-Barre, PA with three branches in Luzerne County, Pennsylvania. First Heritage's three branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration included 2,592,213 shares of common stock with a fair value of $52 million, employee stock options with a fair value of $3.0 million, and $7.0 million of cash (including capitalized acquisition costs of $1.0 million). Grange National Banc Corp. On November 24, 2003, the Company acquired Grange National Banc Corp. ("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa. Grange's 12 branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. The Company issued 2,294,182 shares of its common stock to certain of the former shareholders at a cost of $23.97 per share. The remaining shareholders received $21.25 in cash or approximately $20.9 million. In addition, Grange stock options representing $5.4 million of fair value were exchanged for options of the Company. 48 Peoples Bankcorp Inc. On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a $29-million-asset savings and loan holding company based in Ogdensburg, New York. Peoples' single branch is being operated as a branch of the Bank's network of branches in Northern New York. Harbridge Consulting Group On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York Global Human Resource Solutions consulting group. This practice was renamed Harbridge Consulting Group ("Harbridge") and is a leading provider of retirement and employee benefits consulting services throughout Upstate New York, and is complementary to Benefit Plans Administrative Services, LLC., the Company's defined contribution plan administration subsidiary. Acquisition Expenses The Company incurred certain expenses in connection with the above acquisitions. The following table shows the components of acquisition expenses that are presented in the consolidated statements of income for the years ended December 31: (000's omitted) 2004 2003 2002 - -------------------------------------------------------------------------------- Severance and employee benefits $1,044 $ 0 $ 97 Legal and professional fees 491 213 455 Data processing 130 191 16 Other 39 94 132 - -------------------------------------------------------------------------------- Total $1,704 $498 $700 ================================================================================ NOTE C: INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities as of December 31 are as follows:
2004 2003 ---------------------------------------------- ---------------------------------------------- Gross Gross Estimated Gross Gross Estimated Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair (000's omitted) Cost Gains Losses Value Cost Gains Losses Value - --------------------------- ---------------------------------------------- ---------------------------------------------- Held-to-Maturity Portfolio: U.S. treasury and agency securities $ 127,490 $ 356 $1,940 $ 125,906 $ 127,635 $ 235 $2,867 $ 125,003 Obligations of state and political subdivisions 6,576 120 2 6,694 7,459 218 0 7,677 Other securities 3,578 0 0 3,578 3,558 0 0 3,558 - --------------------------- ---------------------------------------------- ---------------------------------------------- Total held-to-maturity portfolio 137,644 476 1,942 136,178 138,652 453 2,867 136,238 Available-for-Sale Portfolio: U.S. treasury and agency securities 630,058 20,917 208 650,767 456,913 22,638 97 479,454 Obligations of state and political subdivisions 545,698 27,899 46 573,551 443,930 26,291 11 470,210 Corporate securities 40,443 3,460 5 43,898 27,712 2,539 0 30,251 Collateralized mortgage obligations 70,986 1,680 222 72,444 89,566 3,987 1 93,552 Mortgage-backed securities 50,347 2,351 34 52,664 76,628 3,668 119 80,177 - --------------------------- ---------------------------------------------- ---------------------------------------------- Sub-total 1,337,532 56,307 515 1,393,324 1,094,749 59,123 228 1,153,644 Equity securities 53,371 0 0 53,371 37,238 0 0 37,238 - --------------------------- ---------------------------------------------- ---------------------------------------------- Total available-for-sale portfolio 1,390,903 $56,307 $ 515 $1,446,695 1,131,987 $59,123 $ 228 $1,190,882 Net unrealized gain on available-for-sale portfolio 55,792 0 58,895 0 - --------------------------- ---------- ---------- ---------- ---------- Total $1,584,339 $1,582,873 $1,329,534 $1,327,120 =========================== ========== ========== ========== ==========
49 A summary of investment securities as of December 31, 2004 that have been in a continuous unrealized loss position for less than or greater than twelve months is as follows:
Less than 12 Months 12 Months or Longer Total --------------------- -------------------- -------------------- Gross Gross Gross Fair Unrealized Fair Unrealized Fair Unrealized (000's omitted) Value Losses Value Losses Value Losses - ------------------------------------- --------------------- -------------------- -------------------- Held-to-Maturity Portfolio: U.S. treasury and agency securities $0 $0 $88,060 ($1,940) 88,060 (1,940) Obligations of state and political subdivisions 1,567 (2) 0 0 1,567 (2) - ------------------------------------- --------------------- -------------------- -------------------- Total held-to-maturity portfolio $1,567 ($2) $88,060 ($1,940) $89,627 ($1,942) ===================================== ===================== ==================== ==================== Available-for-Sale Portfolio: U.S. treasury and agency securities $22,633 ($208) $0 $0 $22,633 ($208) Obligations of state and political subdivisions 7,731 (46) 0 0 7,731 (46) Corporate securities 1,061 (5) 0 0 1,061 (5) Collateralized mortgage obligations 7,915 (222) 0 0 7,915 (222) Mortgage-backed securities 950 (17) 1,197 (17) 2,147 (34) - ------------------------------------- --------------------- -------------------- -------------------- Total available-for-sale portfolio $40,290 ($498) $1,197 ($17) $41,487 ($515) ===================================== ===================== ==================== ====================
Management does not believe any individual unrealized loss as of December 31, 2004 represents an other than temporary impairment. The unrealized losses reported for the agency and mortgage-backed securities relate primarily to securities issued by FHLB, FNMA and FHLMC and are currently rated AAA by Moody's Investor Services and Standards & Poor. The unrealized losses in the portfolios are primarily attributable to changes in interest rates. The Company has both the intent and ability to hold these securities for the time necessary to recover the amortized cost. The unrealized losses of $3,095,000 as of December 31, 2003 were less than 12 months old. The amortized cost and estimated fair value of debt securities at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Held-to-Maturity Available-for-Sale ------------------------ ------------------------ Carrying Fair Carrying Fair (000's omitted) Value Value Value Value - -------------------------------------- ------------------------ ------------------------ Due in one year or less $ 4,387 $ 4,395 $ 5,263 $ 5,414 Due after one through five years 1,959 2,044 55,927 57,916 Due after five years through ten years 99,596 98,533 712,168 736,972 Due after ten years 31,702 31,206 442,841 467,914 - -------------------------------------- ------------------------ ------------------------ Sub-total 137,644 136,178 1,216,199 1,268,216 Collateralized mortgage obligations 0 0 70,986 72,444 Mortgage-backed securities 0 0 50,347 52,664 - -------------------------------------- ------------------------ ------------------------ Total $ 137,644 $ 136,178 $1,337,532 $1,393,324 ====================================== ======================== ========================
Cash flow information on investment securities for the years ended December 31 is as follows:
(000's omitted) 2004 2003 2002 - -------------------------------------------------------------------------------------------------------- Proceeds from the sales of investment securities $ 51,889 $ 41,227 $ 96,294 Gross gains on sales of investment securities 187 11 2,593 Gross losses on sales of investment securities 115 65 0 Proceeds from the sales of mortgage-backed securities and CMO's 3,679 20,823 56,451 Proceeds from the maturities of mortgage-backed securities and CMO's 51,652 204,746 174,524 Purchases of mortgage-backed securities and CMO's $ 10,915 $ 27,092 $ 25,664
Investment securities with a carrying value of $699,806,000 and $563,341,000 at December 31, 2004 and 2003, respectively, were pledged to collateralize certain deposits and borrowings. 50 NOTE D: LOANS Major classifications of loans at December 31 are summarized as follows: (000's omitted) 2004 2003 - -------------------------------------------------------------------------------- Consumer mortgage $ 801,412 $ 739,593 Business lending 831,244 689,436 Consumer direct and indirect 725,885 699,562 - -------------------------------------------------------------------------------- Gross loans 2,358,541 2,128,591 Unearned discount 48 82 - -------------------------------------------------------------------------------- Net loans 2,358,493 2,128,509 Allowance for loan losses 31,778 29,095 - -------------------------------------------------------------------------------- Loans, net of allowance for loan losses $2,326,715 $2,099,414 ================================================================================ The estimated fair value of loans at December 31, 2004 and 2003 was $2.4 billion and $2.1 billion, respectively. Non-accrual loans of $11,798,000 and $11,940,000 and accruing loans ninety days past due of $1,158,000 and $1,307,000 at December 31, 2004 and 2003, respectively, are included in net loans. Changes in loans to directors and officers and other related parties for the years ended December 31 are summarized as follows: (000's omitted) 2004 2003 - ------------------------------------------------------------------------------- Balance at beginning of year $ 14,838 $ 15,735 New loans 9,796 3,313 Payments (1,481) (4,210) - ------------------------------------------------------------------------------- Balance at end of year $ 23,153 $ 14,838 =============================================================================== Mortgage loans serviced for others are not included in the accompanying consolidated statements of condition. The unpaid principal balances of mortgage loans serviced for others were $107,155,000, $126,324,000, and $103,663,000 at December 31, 2004, 2003, and 2002, respectively. Custodial escrow balances maintained in connection with the foregoing loan servicing, and included in demand deposits, were approximately and $813,000 and $773,000 at December 31, 2004 and 2003, respectively. At December 31, 2004 and 2003, mortgage servicing rights, included in other assets, amounted to $459,000 and $456,000 respectively. Changes in the allowance for loan losses for the years ended December 31 are summarized as follows: (000's omitted) 2004 2003 2002 - ------------------------------------------------------------------------------- Balance at beginning of year $ 29,095 $ 26,331 $ 23,901 Provision for loan losses 8,750 11,195 12,222 Reserve on acquired loans 2,357 1,832 0 Charge offs (11,780) (13,111) (12,015) Recoveries 3,356 2,848 2,223 - ------------------------------------------------------------------------------- Balance at end of year $ 31,778 $ 29,095 $ 26,331 =============================================================================== As of December 31, 2004 and 2003, the Company had impaired loans of $2,271,000 and $5,682,000, respectively. The specifically allocated allowance for loan loss recognized on these impaired loans was $900,000 and $1,825,000 at December 31, 2004 and 2003, respectively. For the years ended December 31, 2004 and 2003 the Company had average impaired loans of $2,399,000 and $7,100,000. There was no interest income recognized on these loans in 2004 or 2003. 51 NOTE E: PREMISES AND EQUIPMENT Premises and equipment consist of the following at December 31: (000's omitted) 2004 2003 - ------------------------------------------------------------------------------- Land and land improvements $ 9,340 $ 8,616 Bank premises owned 57,519 53,560 Equipment and construction in progress 46,010 42,146 - ------------------------------------------------------------------------------- Premises and equipment, gross 112,869 104,322 Less: Accumulated depreciation (49,359) (42,617) - ------------------------------------------------------------------------------- Premises and equipment, net $ 63,510 $ 61,705 =============================================================================== NOTE F: INTANGIBLE ASSETS The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:
As of December 31, 2004 As of December 31, 2003 --------------------------------------- --------------------------------------- Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying (000's omitted) Amount Amortization Amount Amount Amortization Amount - --------------------------------- --------------------------------------- --------------------------------------- Amortizing intangible assets: Core deposit intangibles $63,691 ($28,340) $35,351 $55,455 ($21,457) $33,998 Other intangibles 2,750 (764) 1,986 2,750 (233) 2,517 - --------------------------------- --------------------------------------- --------------------------------------- Total amortizing intangibles 66,441 (29,104) 37,337 58,205 (21,690) 36,515 Non-amortizing intangible assets: Goodwill 195,163 0 195,163 159,596 0 159,596 - --------------------------------- --------------------------------------- --------------------------------------- Total intangible assets, net $261,604 ($29,104) $232,500 $217,801 ($21,690) $196,111 ================================= ======================================= =======================================
The increases in the gross carrying amount of core deposit intangibles and goodwill relate to the 2004 acquisition of First Heritage Bank ($30,946,000 in goodwill), a branch acquisition in Dansville, NY ($4,191,000 in goodwill) and $430,000 of goodwill adjustments mainly related to adjusting certain real property from the 2003 acquisitions to fair value. No goodwill impairment adjustments were recognized in 2004 and 2003. The estimated aggregate amortization expense for each of the five succeeding fiscal years ended December 31 is as follows: 2005 $ 7,243 2006 6,047 2007 5,657 2008 5,335 2009 4,836 Thereafter 8,219 - -------------------------------------------------------------------------- Total $37,337 ========================================================================== NOTE G: DEPOSITS Deposits consist of the following at December 31: (000's omitted) 2004 2003 - -------------------------------------------------------------------------------- Demand $ 567,106 $ 498,195 Interest checking 313,639 294,563 Savings 536,460 470,166 Money market 321,461 288,212 Time 1,190,312 1,174,352 - -------------------------------------------------------------------------------- Total deposits $2,928,978 $2,725,488 ================================================================================ 52 The estimated fair value of deposits at December 31, 2004 and 2003 was approximately $2.7 billion and $2.5 billion, respectively. At December 31, 2004 and 2003, time certificates of deposit in denominations of $100,000 and greater totaled $179,534,000 and $168,241,000 respectively. The approximate maturities of time deposits at December 31, 2004 are as follows: (000's omitted) Amount - -------------------------------------------------------------------------------- 2005 $ 920,488 2006 132,051 2007 78,405 2008 30,727 2009 28,053 Thereafter 588 - -------------------------------------------------------------------------------- Total $1,190,312 ================================================================================ NOTE H: BORROWINGS Outstanding borrowings at December 31 are as follows:
(000's omitted) 2004 2003 - --------------------------------------------------------------------------------------- Short-term borrowings: Federal funds purchased $ 13,200 $ 36,300 Federal Home Loan Bank advances 636,000 361,000 Commercial loans sold with recourse 74 0 Capital lease obligations 0 96 - --------------------------------------------------------------------------------------- Total short-term borrowings 649,274 397,396 Long-term borrowings: Federal Home Loan Bank advances 190,000 190,000 Commercial loans sold with recourse 791 0 Subordinated debt held by unconsolidated subsidiary trusts, net of discount of $1,463 and $1,519 80,446 80,390 - --------------------------------------------------------------------------------------- Total long-term borrowings 271,237 270,390 - --------------------------------------------------------------------------------------- Total borrowings $920,511 $667,786 =======================================================================================
The weighted-average interest rates on short-term borrowings for the years ended December 31, 2004 and 2003 were 1.64% and 1.26%, respectively. Federal Home Loan Bank advances are collateralized by a blanket lien on the Company's residential real estate loan portfolio and various investment securities. 53 Long-term borrowings at December 31, 2004 have maturity dates as follows: Weighted (000's omitted, except rate) Amount Average Rate - -------------------------------------------------------------------------------- October 3, 2007 $ 236 3.00% January 23, 2008 (callable) 10,000 5.44% January 28, 2008 (callable) 5,000 5.48% April 14, 2010 (callable) 25,000 6.35% September 27, 2010 (callable) 50,000 5.88% October 12, 2010 (callable) 50,000 5.84% November 1, 2010 (callable) 50,000 5.77% October 30, 2012 258 3.00% October 16, 2013 193 3.00% November 23, 2014 56 2.75% November 29, 2014 48 3.00% February 3, 2027 (callable) 30,779 9.75% July 16, 2031 (callable) 25,110 5.38% July 31, 2031 (callable) 24,557 5.12% - -------------------------------------------------------------------------------- Total $271,237 6.19% ================================================================================ The estimated fair value of long-term borrowings at December 31, 2004 and 2003 was approximately $319.0 million and $314.0 million, respectively. In December 2003, the Company prepaid $25.0 million of Federal Home Loan Bank ("FHLB") advances with maturity dates ranging from January 30, 2008 to February 4, 2008 and a weighted-average rate of 5.31%. In December 2002, the Company prepaid $11.0 million of FHLB advances with maturity dates ranging from December 15, 2003 to December 31, 2004 and a weighted-average rate of 6.17%. As a result of these prepayments, the Company incurred penalties of $2.6 million in 2003 and $925,000 in 2002. These penalties have been reflected in the consolidated statements of income as gain (loss) on investment securities and debt extinguishments. The Company sponsors three business trusts, Community Capital Trust I, Community Capital Trust II, and Community Statutory Trust III, of which 100% of the common stock is owned by the Company. The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company. The debentures held by each trust are the sole assets of that trust. Distributions on the preferred securities issued by each trust are payable semi-annually at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees. The terms of the preferred securities of each trust are as follows:
Issuance Interest Maturity Call Call Date Amount Rate Date Provision Price - ------------------------------------------------------------------------------------------------------------------------------------ I 2/3/1997 30,000 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017 II 7/16/2001 25,000 6 month LIBOR plus 3.75% (5.74%) 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011 III 7/31/2001 24,450 3 month LIBOR plus 3.58% (5.74%) 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011 ====================================================================================================================================
In the fourth quarter 2003, as a result of applying the provisions of FIN 46, the Company de-consolidated these subsidiary trusts from its financial statements. The de-consolidation of the net assets and results of operations of the trusts had an immaterial impact on the Company's financial statements. The Company continues to be obligated to repay the debentures held by the trusts and guarantees repayment of the preferred securities issued by the trusts. The preferred securities held by the trusts qualify as Tier I capital for the Company under Federal Reserve Board guidelines. 54 NOTE I: INCOME TAXES The provision for income taxes for the years ended December 31 is as follows: (000's omitted) 2004 2003 2002 - -------------------------------------------------------------------------------- Current: Federal $14,677 $11,534 $ 9,268 State 680 341 161 Deferred: Federal 1,229 758 3,764 State 57 140 694 - -------------------------------------------------------------------------------- Total income taxes $16,643 $12,773 $13,887 ================================================================================ Components of the net deferred tax liability, included in other assets/liabilities, as of December 31 are as follows: (000's omitted) 2004 2003 - ------------------------------------------------------------------------------- Allowance for loan losses $ 10,644 $ 10,537 Employee and director benefits 2,599 2,118 Other 1,478 1,501 - ------------------------------------------------------------------------------- Deferred tax asset 14,721 14,156 - ------------------------------------------------------------------------------- Investment securities 23,273 24,216 Intangible assets 8,145 4,910 Loan origination costs 3,998 3,324 Depreciation 5,264 3,526 Pension 531 1,586 Mortgage servicing rights 177 178 - ------------------------------------------------------------------------------- Deferred tax liability 41,388 37,740 - ------------------------------------------------------------------------------- Net deferred tax liability ($26,667) ($23,584) =============================================================================== The Company has determined that no valuation allowance is necessary as it is more likely than not that deferred tax assets will be realized through carryback of future deductions to taxable income in prior years, future reversals of existing temporary differences, and through future taxable income. A reconciliation of the differences between the federal statutory income tax rate and the effective tax rate for the years ended December 31 is shown in the following table: 2004 2003 2002 - ------------------------------------------------------------------------------ Federal statutory income tax rate 35.0% 35.0% 35.0% Increase (reduction) in taxes resulting from: Tax-exempt interest (11.3%) (11.2%) (9.9%) State income taxes, net of federal benefit 0.6% 0.1% 0.6% Other 0.6% 0.1% 0.8% - ------------------------------------------------------------------------------ Effective income tax rate 24.9% 24.0% 26.5% ============================================================================== 55 NOTE J: LIMITS ON DIVIDENDS AND OTHER REVENUE SOURCES The Company's ability to pay dividends to its shareholders is largely dependent on the Bank's ability to pay dividends to the Company. In addition to state law requirements and the capital requirements discussed below, the circumstances under which the Bank may pay dividends are limited by federal statutes, regulations, and policies. For example, as a national bank, the Bank must obtain the approval of the Office of the Comptroller of the Currency (OCC) for payments of dividends if the total of all dividends declared in any calendar year would exceed the total of the Bank's net profits, as defined by applicable regulations, for that year, combined with its retained net profits for the preceding two years. Furthermore, the Bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts, as defined by applicable regulations. At December 31, 2004, the Bank had approximately $27,758,000 in undivided profits legally available for the payments of dividends. In addition, the Federal Reserve Board and the OCC are authorized to determine under certain circumstances that the payment of dividends would be an unsafe or unsound practice and to prohibit payment of such dividends. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings. There are also statutory limits on the transfer of funds to the Company by its banking subsidiary, whether in the form of loans or other extensions of credit, investments or assets purchases. Such transfer by the Bank to the Company generally is limited in amount to 10% of the Bank's capital and surplus, or 20% in the aggregate. Furthermore, such loans and extensions of credit are required to be collateralized in specific amounts. NOTE K: BENEFIT PLANS Pension and post-retirement plans The Company provides defined benefit pension and other post-retirement health and life insurance benefits to qualified employees and retirees. Using a measurement date of December 31, the following table shows the funded status of the Company's plans reconciled with amounts reported in the Company's consolidated statements of condition:
Pension Benefits Post-retirement Benefits ---------------------- ------------------------ (000's omitted) 2004 2003 2004 2003 - ------------------------------------------------ ---------------------- ---------------------- Change in benefit obligation: Benefit obligation at the beginning of year $ 42,739 $ 34,864 $ 5,083 $ 4,159 Service cost 2,557 1,831 311 275 Interest cost 2,433 2,157 325 260 Participant contributions 0 0 227 186 Plan amendment/acquisition (881) 493 95 220 Other loss 0 1,218 0 0 Deferred actuarial loss 2,209 3,521 902 391 Benefits paid (1,444) (1,345) (573) (408) - ------------------------------------------------ ---------------------- ---------------------- Benefit obligation at end of year 47,613 42,739 6,370 5,083 - ------------------------------------------------ ---------------------- ---------------------- Change in plan assets: Fair value of plan assets at beginning of year 36,784 29,133 0 0 Actual return of plan assets 3,907 6,815 0 0 Participant contributions 0 0 227 186 Employer contributions 2,500 2,181 346 222 Benefits paid (1,444) (1,345) (573) (408) - ------------------------------------------------ ---------------------- ---------------------- Fair value of plan assets at end of year 41,747 36,784 0 0 - ------------------------------------------------ ---------------------- ---------------------- Unfunded status (5,866) (5,955) (6,370) (5,083) Unrecognized actuarial loss 14,454 14,057 1,480 615 Unrecognized prior service (benefit) cost (783) 899 331 361 Unrecognized transition liability 0 0 328 369 - ------------------------------------------------ ---------------------- ---------------------- Prepaid (accrued) benefit cost $ 7,805 $ 9,001 ($ 4,231) ($ 3,738) ================================================ ====================== ======================
In 2004, the Company amended its defined benefit pension plan to allow for a cash balance option. Participants in the plan as of December 31, 2003 were given an option to continue to have their benefits calculated under the traditional 56 plan formula or have their benefits determined as an account balance under a cash balance formula. All new participants to the plan will automatically participate in the cash balance option. In addition, the plan was amended to provide for the payment of certain benefits formerly accrued and payable under the Deferred Compensation Plan for Certain Executive Employees. The Company has unfunded supplemental pension plans for certain key executives. The projected benefit obligation and accrued benefit cost included in the preceding table related to these plans was $3,128,000 and $2,798,000 for 2004 and $2,606,000 and $2,245,000 for 2003, respectively. The accumulated benefit obligation for the defined benefit pension was $40,659,000 and $35,025,000 as of December 31, 2004 and 2003, respectively. The weighted-average assumptions used to determine the benefit obligations as of December 31 are as follows: Pension Benefits Post-retirement Benefits ---------------- ------------------------ 2004 2003 2004 2003 - ------------------------------ ---------------- ------------------------ Discount rate 5.60% 5.90% 5.60% 5.90% Expected return on plan assets 8.75% 8.75% 0.00% 0.00% Rate of compensation increase 4.00% 4.00% 0.00% 0.00% ============================== ================ ======================== The net periodic benefit cost as of December 31 is as follows:
Pension Benefits Post-retirement Benefits ------------------------------- ----------------------------- (000's omitted) 2004 2003 2002 2004 2003 2002 - ---------------------------------- ------------------------------- ----------------------------- Service cost $ 2,557 $ 1,831 $ 1,415 $ 311 $ 275 $ 159 Interest cost 2,433 2,157 1,926 325 260 241 Expected return on plan assets (3,160) (2,567) (2,268) 0 0 0 Net amortization and deferral 1,066 1,142 403 37 8 0 Amortization of prior service cost 155 129 131 30 30 30 Amortization of transition (asset) obligation 0 (4) (19) 41 41 41 Other expense 0 1,218 0 0 0 0 - ---------------------------------- ------------------------------- ----------------------------- Net periodic benefit cost $ 3,051 $ 3,906 $ 1,588 $ 744 $ 614 $ 471 ================================== =============================== =============================
Other expense represents a $1.2 million adjustment recorded in the fourth quarter of 2003 to reflect the proper actuarial impact of indexing salary levels associated with certain benefits frozen in 1988. The weighted-average assumptions used to determine the net periodic pension cost for the years ended December 31 are as follows: Pension Benefits Post-retirement Benefits -------------------- ------------------------ 2004 2003 2002 2004 2003 2002 - ------------------------------ -------------------- -------------------- Discount rate 5.90% 6.10% 6.75% 5.90% 6.10% 6.75% Expected return on plan assets 8.75% 9.00% 9.00% 0.00% 0.00% 0.00% Rate of compensation increase 4.00% 4.00% 4.00% 0.00% 0.00% 0.00% ============================== ==================== ==================== The amount of benefit payments that are expected to be paid over the next ten years are as follows: Pension Post-retirement (000's omitted) Benefits Benefits - -------------------------------------------------------------------------------- 2005 $ 2,866 $ 289 2006 2,666 308 2007 3,278 332 2008 4,607 350 2009 3,302 383 2010-2014 $21,541 $ 2,577 ================================================================================ The payments reflect future service and are based on various assumptions including retirement age and form of payment (lump-sum versus annuity). Actual results may differ from these estimates. 57 The expected long-term rate of return was estimated by taking into consideration asset allocation, reviewing historical returns on type of assets held and current economic factors. The asset allocation for the defined benefit pension plan as of December 31, by asset category, is as follows: 2004 2003 - ------------------------------------------------------------------------------- Equity securities 69% 70% Debt securities 19% 20% Cash 12% 10% - ------------------------------------------------------------------------------- Total 100% 100% =============================================================================== Plan assets include $2,571,000 (6%) and $2,230,000 (6%) of Community Bank System, Inc. stock at December 31, 2004 and 2003, respectively. The investment objective for the defined benefit pension plan is to achieve an average annual total return over a five-year period equal to the assumed rate of return used in the actuarial calculations. At a minimum performance level, the portfolio should earn the return obtainable on high quality intermediate-term bonds. The Company's perspective regarding portfolio assets combines both preservation of capital and moderate risk-taking. Asset allocation favors equities, with a target allocation of approximately 75% equity securities, 20% fixed income securities and 5% cash. No more than 10% of the portfolio can be in stock of the Company. Due to the volatility in the market, the target allocation is not always desirable and asset allocations will fluctuate between acceptable ranges. Prohibited transactions include purchase of securities on margin, uncovered call options, short sale transactions, and use of real estate, unlisted limited partnerships, derivative products or venture capital loans as fixed income investment vehicles. The Company makes contributions to its funded qualified pension plan as required by government regulation or as deemed appropriate by management after considering the fair value of plan assets, expected return on such assets, and the value of the accumulated benefit obligation. Based upon current information, the Company does not expect to make contributions to the funded qualified pension plan in 2005. The Company funds the payment of benefit obligations for the supplemental pension and post-retirement plans because such plans do not hold assets for investment. The assumed health care cost trend rate used in the post-retirement health plan at December 31,2004 was 9.0% for medical costs and 13.0% for prescription drugs. The rate to which the cost trend rate is assumed to decline (the ultimate trend rate) and the year that the rate reaches the ultimate trend rate is 5.0% and 2013, respectively. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage-point increase in the trend rate would increase the service and interest cost components by $35,000 and increase the benefit obligation by $264,000. A one-percentage-point decrease in the trend rate would decrease the service and interest cost components by $8,000 and decrease the benefit obligation by $141,000. 401(k) Employee Stock Ownership Plan The Company has a 401(k) Employee Stock Ownership Plan in which employees can contribute from 1% to 90% of eligible compensation, with up to 6% being eligible for matching contributions in the form of Company common stock. The Plan also permits the Company to distribute a discretionary profit-sharing component in the form of Company common stock to all participants except certain executive employees. The expense recognized under this plan for the years ended December 31, 2004, 2003 and 2002 was $1,583,000, $1,309,000 and $1,026,000, respectively. Deferred Compensation Plan for Certain Executive Employees The Company has a Deferred Compensation Plan for Certain Executive Employees in which participants may contribute up to 15% of their eligible compensation less any amounts contributed to the 401(k) Employee Stock Ownership Plan. Any discretionary profit-sharing amounts that the executive receives from the Company must be contributed to the Deferred Compensation Plan in the form of Company common stock. The expense recognized under this plan for the years ended December 31, 2004, 2003 and 2002 was $159,000, $119,000 and $68,000, respectively. Other Deferred Compensation Arrangements In addition to the supplemental pension plans for certain executives, the Company has nonqualified deferred compensation for several former directors, officers, and key employees. All benefits provided under these plans are unfunded and payments to plan participants are made by the Company. At December 31, 2004 and 2003, the Company has recorded a liability of $5,373,000 and $3,775,000, respectively. The expense recognized under these plans for the years ended December 31, 2004, 2003, and 2002 was $1,727,000, $947,000 and $398,000, respectively. 58 Deferred Compensation Plan for Directors Directors may defer all or a portion of their director fees under the Deferred Compensation Plan for Directors. Under this plan, there is a separate account for each participating director which is credited with the amount of shares which could have been purchased with the director's fees as well as any dividends on such shares. On the distribution date, the director will receive common stock equal to the accumulated share balance in his account. As of December 31, 2004 and 2003, there were 65,090 and 56,901 shares credited to the participants' accounts, for which a liability of $1,097,000 and $894,000 was accrued, respectively. The expense recognized under the plan for the years ended December 31, 2004, 2003 and 2002, was $206,000, $113,000, and $106,000, respectively. Director Stock Balance Plan The Company has a Stock Balance Plan for non-employee directors who have completed six months of service. The Plan is a nonqualified, noncontributory defined benefit plan. The Plan provides benefits for service prior to January 1, 1996 based on a predetermined formula and benefits for service after January 1, 1996 based on the performance of the Company's common stock. Participants become fully vested after six years of service. The directors can elect to receive offset stock options that may reduce the Company's liability under the Plan. These options vest immediately and expire one year after the date the director retires or two years in the event of death. Benefits are payable in the form of cash and/or Company stock (as elected by the director) on January 1st of the year after the director retires from the Board. As of December 31, 2004 and 2003, the accrued pension liability was $287,000 and $251,000, respectively. The expense recognized under this plan for the years ended December 31, 2004, 2003 and 2002, was $36,000, $38,000 and $69,000, respectively. The expense and related liability were calculated using a dividend rate of 3.00%, stock price appreciation of 6.00%, and a discount rate of 5.6% for 2004, 5.9% for 2003, and 6.10% for 2002. NOTE L: STOCK-BASED COMPENSATION PLANS The Company has a long-term incentive program for directors, officers, and key employees. Under this program the Company authorized 4,024,000 shares of Company common stock for the grant of incentive stock options, restricted stock awards, nonqualified stock options, retroactive stock appreciation rights, and offset options to its Stock Balance Plan (see Note K). The offset options vest and become exercisable immediately and expire one year after the date the director retires or two years in the event of death. The remaining options have a ten-year term. They vest and become exercisable on a grant-by-grant basis, ranging from immediate vesting to ratably over a five-year period. Option activity in this plan is as follows: Weighted Average Exercise Price Options of Shares Shares Outstanding Outstanding Exercisable - -------------------------------------------------------------------------------- December 31, 2001 1,901,488 $ 12.67 1,300,700 Granted 413,404 13.20 Exercised (173,286) 8.94 Forfeited (4,278) 12.62 - -------------------------------------------------------------------------------- December 31, 2002 2,137,328 $ 13.07 1,411,006 - -------------------------------------------------------------------------------- Granted 843,138 10.89 Exercised (545,158) 10.99 Forfeited (7,826) 14.22 - -------------------------------------------------------------------------------- December 31, 2003 2,427,482 $ 12.78 1,519,893 ================================================================================ Granted 669,139 18.37 Exercised (685,143) 8.35 Forfeited (10,546) 16.13 - -------------------------------------------------------------------------------- December 31, 2004 2,400,932 $ 15.59 1,383,369 ================================================================================ Approximately 222,000 and 390,000 options were exchanged in 2004 and 2003 in connection with the Heritage and Grange acquisitions, respectively. 59 At December 31, 2004 the range of exercise prices and other information relating to the Company's stock options is as follows:
Options Outstanding Options Exercisable ------------------------------------------ ----------------------- Weighted Weighted Weighted Average Average Average Range of Exercise Remaining Exercise Exercise Price Shares Price Life (years) Shares Price - --------------- ------------------------------------------ ----------------------- $3.65 - $5.15 76,044 $ 4.12 1.7 76,044 $ 4.12 $5.15 - $7.72 40,716 6.77 0.8 40,716 6.77 $7.72 - $10.30 69,516 9.13 3.3 69,516 9.13 $10.30 - $12.87 520,454 12.12 5.6 374,419 12.09 $12.87 - $15.44 452,121 13.57 6.1 275,261 13.86 $15.44 - $18.02 782,979 16.32 7.2 489,283 16.71 $18.02 - $20.59 15,000 18.96 8.4 3,000 18.96 $20.59 - $23.17 19,008 22.62 9.4 4,008 22.95 $23.17 - $24.15 425,094 24.15 9.1 51,122 24.15 - -------------------------------------------------------------------------------------- Total / Average 2,400,932 $ 15.59 6.6 1,383,369 $ 13.83 ======================================================================================
Information concerning the grants of stock options and restricted stock is as follows: Weighted Weighted Average Awards Average Grant Date Granted Exercise Price Fair Value - ------------------------------------------------------------------------------ 2004: Option price = fair market value 446,860 $ 24.09 $ 6.05 Option price < fair market value 222,279 $ 6.87 $ 13.28 Restricted stock 32,418 $ 23.76 $ 23.76 2003: Option price = fair market value 449,476 $ 15.78 $ 4.12 Option price < fair market value 393,662 $ 5.31 $ 13.73 Restricted stock 8,000 $ 19.12 $ 19.12 2002: Option price = fair market value 373,404 $ 13.20 $ 3.59 Option price < fair market value 40,000 $ 13.18 $ 4.33 ============================================================================== The Company used the Black-Scholes option-pricing model to estimate the weighted average grant date fair value. The assumptions used in the model are disclosed in Note A - Stock Based Compensation. Compensation expense related to restricted stock recognized in the income statement for the years ended December 31, 2004, 2003, and 2002 was $372,000, $105,000 and $353,000, respectively. On February 21, 1995, the Company adopted a Stockholder Protection Rights Agreement. Under the Plan, each stockholder received one right, representing the right to purchase one share of common stock for $42.50 for each share of stock owned. All of the rights expire on February 21, 2005, but the Company may redeem the rights earlier for $.005 per right, subject to certain limitations. Rights will become exercisable if a person or group acquires 15% or more of the Company's outstanding shares. Until that time, the rights will trade with the common stock; any transfer of common stock will also constitute a transfer of the associated right. If the rights become exercisable, they will begin to trade apart from the common stock. If one of a number of "flip-in events" occurs, each right will entitle the holder to purchase common stock having a market value equivalent of two times the exercise price. In January 2005, the Board of Directors voted to permit the agreement to expire in February 2005. 60 NOTE M: EARNINGS PER SHARE The following is a reconciliation of basic to diluted earnings per share for the years ended December 31: Per Share (000's omitted, except per share data) Income Shares Amount - ------------------------------------------------------------------------------- Year Ended December 31, 2004 Basic EPS $50,196 29,916 $ 1.68 Stock options 754 - --------------------------------------------------------------------- Diluted EPS $50,196 30,670 $ 1.64 ===================================================================== Year Ended December 31, 2003 Basic EPS $40,380 26,299 $ 1.54 Stock options 736 - --------------------------------------------------------------------- Diluted EPS $40,380 27,035 $ 1.49 ===================================================================== Year Ended December 31, 2002 Basic EPS $38,517 25,946 $ 1.48 Stock options 388 - --------------------------------------------------------------------- Diluted EPS $38,517 26,334 $ 1.46 ===================================================================== There were 424,594, 0 and 469,744 anti-dilutive stock options outstanding for the years ended December 31, 2004, 2003 and 2002, respectively. NOTE N: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The fair value of these commitments is immaterial for disclosure in accordance with FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". The contract amount of commitment and contingencies is as follows: (000's omitted) 2004 2003 - -------------------------------------------------------------------------------- Commitments to extend credit $429,751 $315,898 Standby letters of credit 22,948 19,163 - -------------------------------------------------------------------------------- Total $452,699 $335,061 ================================================================================ The fair value of these financial instruments approximates carrying value. The Company has unused lines of credit of $47,000,000 at December 31, 2004. The Company has unused borrowing capacity of approximately $134,492,000 through collateralized transactions with the Federal Home Loan Bank and $11,325,000 through collateralized transactions with the Federal Reserve Bank. The Company is required to maintain a reserve balance, as established by the Federal Reserve Bank of New York. The required average total reserve for the 14-day maintenance period of December 23, 2004 through January 5, 2005 was $58,779,000 of which $2,000,000 was required to be on deposit with the Federal Reserve Bank of New York. The remaining $56,779,000 was represented by cash on hand. 61 NOTE O: LEASES The Company leases buildings and office space under agreements that expire in various years. Rental expense included in operating expenses amounted to $2,486,000, $1,940,000 and $1,896,000 in 2004, 2003 and 2002, respectively. The future minimum rental commitments as of December 31, 2004 for all non-cancelable operating leases are as follows: 2005 $ 2,204 2006 2,022 2007 1,788 2008 1,280 2009 1,002 Thereafter 4,374 - -------------------------------------------------------------------------------- Total $12,670 ================================================================================ NOTE P: REGULATORY MATTERS The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum total core capital to risk weighted assets of 8%, and tier I capital to risk weighted assets and tier I capital to average assets of 4%. Management believes, as of December 31, 2004, that the Company and Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2004 and 2003, the most recent notification from the Office of the Comptroller of the Currency categorized the Company and Bank as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized," the Company and Bank must maintain minimum total core capital to risk weighted assets of 10%, tier I capital to risk weighted assets of 6% and tier I capital to average assets of 5%. There are no conditions or events since that notification that management believes have changed the institution's category. In addition, there were no significant capital requirements imposed or agreed to during the regulatory approval process of any of our acquisitions. The capital ratios and amounts of the Company and the Bank as of December 31 are presented below:
2004 2003 -------------------- -------------------- (000's omitted) Company Bank Company Bank - -------------------------------------- -------------------- -------------------- Tier 1 capital to average assets Amount $284,928 $276,654 $249,641 $245,809 Ratio 6.94% 6.74% 7.26% 7.28% Minimum required amount $164,229 $164,069 $137,607 $134,977 Tier 1 capital to risk weighted assets Amount $284,928 $276,654 $249,641 $245,809 Ratio 11.93% 11.61% 11.76% 11.63% Minimum required amount $ 95,536 $ 95,337 $ 84,916 $ 84,576 Total core capital to risk weighted assets Amount $314,783 $306,447 $276,177 $272,339 Ratio 13.18% 12.86% 13.01% 12.88% Minimum required amount $191,072 $190,675 $169,831 $169,151
62 NOTE Q: PARENT COMPANY STATEMENTS The condensed balance sheets of the parent company at December 31 is as follows: (000's omitted) 2004 2003 - -------------------------------------------------------------------------------- Assets: Cash $ 11,772 $ 24,429 Investment securities 2,885 2,885 Investment in and advances to subsidiaries 548,781 482,407 Other assets 3,562 3,023 - -------------------------------------------------------------------------------- Total assets $567,000 $512,744 ================================================================================ Liabilities and shareholders' equity: Accrued interest and other liabilities $ 8,926 $ 7,526 Borrowings 83,446 100,390 Shareholders' equity 474,628 404,828 - -------------------------------------------------------------------------------- Total liabilities and shareholders' equity $567,000 $512,744 ================================================================================ The condensed statements of income of the parent company for the years ended December 31 is as follows:
(000's omitted) 2004 2003 2002 - -------------------------------------------------------------------------------------- Revenues: Dividends from subsidiaries $41,500 $42,771 $29,587 Interest on investments 179 6 10 Other income 28 0 0 - -------------------------------------------------------------------------------------- Total revenues 41,707 42,777 29,597 - -------------------------------------------------------------------------------------- Expenses: Interest on long term notes and debentures 6,061 5,765 6,112 Other expenses 13 84 9 - -------------------------------------------------------------------------------------- Total expenses 6,074 5,849 6,121 - -------------------------------------------------------------------------------------- Income before tax benefit and equity in undistributed net income of subsidiaries 35,633 36,928 23,476 Income tax benefit 1,461 1,364 1,572 - -------------------------------------------------------------------------------------- Income before equity in undistributed net income of subsidiaries 37,094 38,292 25,048 Equity in undistributed net income of subsidiaries 13,102 2,088 13,469 - -------------------------------------------------------------------------------------- Net income $50,196 $40,380 $38,517 ======================================================================================
63 The statements of cash flows of the parent company for the years ended December 31 is as follows:
(000's omitted) 2004 2003 2002 - ------------------------------------------------------------------------------------------------------------- Operating activities: Net income $ 50,196 $ 40,380 $ 38,517 Adjustments to reconcile net income to net cash provided by operating activities Equity in undistributed net income of subsidiaries (13,102) (2,088) (13,469) Net change in other assets and other liabilities 3,157 1,633 (886) - ------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 40,251 39,925 24,162 - ------------------------------------------------------------------------------------------------------------- Investing activities: Purchase of investment securities 0 (227) (76) Capital contributions to subsidiaries 0 (33,131) (831) - ------------------------------------------------------------------------------------------------------------- Net cash used in investing activities 0 (33,358) (907) - ------------------------------------------------------------------------------------------------------------- Financing activities: Net change in borrowings (17,000) 20,000 (6,100) Issuance of common stock 5,344 4,819 1,151 Purchase of treasury stock (21,709) (8,490) 0 Cash dividends paid (19,543) (15,466) (14,228) - ------------------------------------------------------------------------------------------------------------- Net cash (used) provided by financing activities (52,908) 863 (19,177) - ------------------------------------------------------------------------------------------------------------- Change in cash and cash equivalents (12,657) 7,430 4,078 Cash and cash equivalents at beginning of year 24,429 16,999 12,921 - ------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 11,772 $ 24,429 $ 16,999 ============================================================================================================= Supplemental disclosures of cash flow information: Cash paid for interest $ 5,943 $ 5,841 $ 6,412 Supplemental disclosures of non-cash financing activities Dividends declared and unpaid $ 5,515 $ 4,529 $ 3,760
64 Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a - 15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004. Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein. Community Bank System, Inc. Date: March 14, 2005 /s/ Sanford A. Belden - --------------------------- Sanford A. Belden, President, Chief Executive Officer and Director /s/ Scott A. Kingsley - --------------------------- Scott A. Kingsley, Treasurer and Chief Financial Officer 65 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Community Bank System, Inc. We have completed an integrated audit of Community Bank System, Inc.'s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated financial statements In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Community Bank System, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Internal control over financial reporting Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 8, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP - ------------------------------ PricewaterhouseCoopers LLP Syracuse, New York March 11, 2005 66 TWO YEAR SELECTED QUARTERLY DATA (Unaudited)
2004 Results 4th 3rd 2nd 1st (000's omitted, except per share data) Quarter Quarter Quarter Quarter Total - ----------------------------------------------------------------------------------------------------------------- Net interest income $ 38,575 $ 39,057 $ 37,457 $ 35,954 $151,043 Provision for loan losses 2,100 2,300 2,300 2,050 8,750 - ----------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 36,475 36,757 35,157 33,904 142,293 Non-interest income 10,832 12,164 10,919 10,530 44,445 Operating expenses 30,442 29,926 29,775 29,756 119,899 - ----------------------------------------------------------------------------------------------------------------- Income before income taxes 16,865 18,995 16,301 14,678 66,839 Income taxes 4,199 4,761 4,160 3,523 16,643 - ----------------------------------------------------------------------------------------------------------------- Net income $ 12,666 $ 14,234 $ 12,141 $ 11,155 $ 50,196 ================================================================================================================= Basic earnings per share $ 0.41 $ 0.47 $ 0.41 $ 0.39 $ 1.68 Diluted earnings per share $ 0.40 $ 0.45 $ 0.40 $ 0.38 $ 1.64 ================================================================================================================= 2003 Results 4th 3rd 2nd 1st (000's omitted, except per share data) Quarter Quarter Quarter Quarter Total - ----------------------------------------------------------------------------------------------------------------- Net interest income $ 34,703 $ 32,539 $ 32,102 $ 32,484 $131,828 Provision for loan losses 3,093 2,029 2,673 3,400 11,195 - ----------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 31,610 30,510 29,429 29,084 120,633 Non-interest income 7,698 9,779 8,947 8,807 35,231 Operating expenses 27,879 25,206 25,179 24,447 102,711 - ----------------------------------------------------------------------------------------------------------------- Income before income taxes 11,429 15,083 13,197 13,444 53,153 Income taxes 2,759 3,354 3,165 3,495 12,773 - ----------------------------------------------------------------------------------------------------------------- Net income $ 8,670 $ 11,729 $ 10,032 $ 9,949 $ 40,380 ================================================================================================================= Basic earnings per share $ 0.32 $ 0.45 $ 0.38 $ 0.38 $ 1.54 Diluted earnings per share $ 0.31 $ 0.44 $ 0.38 $ 0.38 $ 1.49 =================================================================================================================
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9A. Controls and Procedures Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a - 15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report. Management's annual report on internal control over financial reporting is included under the heading "Report on Internal Control Over Financial Reporting" at Item 8 of this Annual Report on Form 10-K. The attestation report of the registered public accounting firm is included under the heading "Report of the Independent Registered Public Accounting Firm" at Item 8 of this Annual Report on Form 10-K. The Company continually assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments, and internal and external audit and regulatory recommendations. No change in internal control over financial reporting during the quarter ended December 31, 2004 or through the date of this Annual Report on Form 10-K have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Item 9B. Other Information None 67 Part III Item 10. Directors and Executive Officers of the Registrant The information concerning Directors of the Company required by this Item 10 is incorporated herein by reference to the sections entitled "Nominees for Director and Directors Continuing in Office" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement. The information concerning executive officers of the Company required by this Item 10 is incorporated by reference to Item 4A of this Annual Report on Form 10-K. The Company has adopted a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The text of the code of ethics is posted on the Company's web-site at www.communitybankna.com. The Company intends to satisfy the requirements under Item 5.05 of Form 8-K regarding an amendment to, or a waiver from, the code of ethics that relates to certain elements thereof, by posting such information on its web-site referenced above. In addition, information concerning Audit Committee and Audit Committee Financial Expert is included in the Proxy Statement under the caption "Audit Committee Report" and is incorporated herein by reference. Item 11. Executive Compensation The information required by this Item 11 is incorporated herein by reference to the section entitled "Compensation of Executive Officers" in the Company's Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item 12 is incorporated herein by reference to the section entitled "Nominees for Director and Directors Continuing in Office" in the Company's Proxy Statement. Item 13. Certain Relationships and Related Transactions The information required by this Item 13 is incorporated herein by reference to the section entitled "Transactions with Management" in the Company's Proxy Statement. Item 14. Principal Accounting Fees and Services The information required by this Item 14 is incorporated herein by reference to the section entitled "Audit Fees" in the Company's Proxy Statement. 68 Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K A. Documents Filed 1. The following consolidated financial statements of Community Bank System, Inc. and subsidiaries are included in Item 8: - Consolidated Statements of Condition, December 31, 2004 and 2003 - Consolidated Statements of Income, Years ended December 31, 2004, 2003, and 2002 - Consolidated Statements of Changes in Shareholders' Equity, Years ended December 31, 2004, 2003, and 2002 - Consolidated Statements of Comprehensive Income, Years ended December 31, 2004, 2003, and 2002 - Consolidated Statement of Cash Flows, Years ended December 31, 2004, 2003, and 2002 - Notes to Consolidated Financial Statements, December 31, 2004 - Report of Independent Registered Public Accounting Firm - Quarterly selected data, Years ended December 31, 2004 and 2003 (unaudited) 2. Schedules are omitted since the required information is either not applicable or shown elsewhere in the financial statements. 3. The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed below: 2.1 Agreement and Plan of Merger, dated January 6, 2004 and amended March 11, 2004, by and among Community Bank System, Inc., Community Bank, N.A., and First Heritage Bank. Incorporated by reference to Annex A to the proxy statement/prospectus included in Registration Statement on Form S-4 filed on March 12, 2004, as amended (Registration No. 333-113581). 2.2 Amended and Restated Agreement and Plan of Merger, dated June 7, 2003, by and between Community Bank System, Inc. and Grange National Banc Corp. Incorporated by reference to Annex A to the proxy statement/prospectus included in the Registration Statement on Form S-4 filed on August 20, 2003, as amended (Registration No. 333-107949). 2.3 Agreement and Plan of Merger, dated May 6, 2003, by and among the Registrant, PB Acquisition Corp. and Peoples Bankcorp, Inc. Incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K of the Registrant filed on May 8, 2003 (Registration No. 001-13695). 2.4 Agreement and Plan of Merger, dated November 29, 2000, by and between Community Bank System, Inc. and First Liberty Bank Corp. Incorporated by reference to Exhibit No. 2.1 to the Current Report on Form 8-K filed on December 20, 2000 (Registration No. 001-13695). 2.5 Agreement regarding the Agreement and Plan of Merger, dated September 26, 2000, by and between Community Bank, N.A. and The Citizens National Bank of Malone. Incorporated by reference to Exhibit No. 10.1 to the Registration Statement on Form S-4 filed on October 20, 2000 (Registration No. 333-48374). 69 2.6 Purchase and Assumption Agreement, dated December 6, 1994, by and between Community Bank System, Inc. and The Chase Manhattan Bank, N.A. Incorporated by reference to Exhibit No. 10.01 to the Registration Statement on Form S-2 filed on April 11, 1995 (Registration No. 033-58539). 3.1 Certificate of Amendment of Certificate of Incorporation of Community Bank System, Inc. Incorporated by reference to Exhibit No. 3.1 to the Quarterly Report on Form 10-Q filed on May 5, 2004 (Registration No. 001-13695). 3.2 Bylaws of Community Bank System, Inc., as amended. Incorporated by reference to Exhibit No. 3.2 to the Registration Statement on Form S-4 filed on October 20, 2000 (Registration No. 333-48374). 4.1 Junior Subordinated Deferrable Interest Debentures, dated as February 3, 1997, by and between Community Bank System, Inc. and The Chase Manhattan Bank. Incorporated by reference to Exhibit No. 4.1 to the Registration Statement on Form S-4 filed on June 25, 1997 (Registration No. 333-30045). 4.2 Amended and Restated Declaration of Trust of Community Capital Trust I, dated as February 3, 1997, by and between Community Bank System, Inc. and The Chase Manhattan Bank. Incorporated by reference to Exhibit No. 4.5 to the Registration Statement on Form S-4 filed on June 25, 1997 (Registration No. 333-30045). 4.3 Form of Common Stock Certificate. Incorporated by reference to Exhibit No. 4.1 to the Amendment No. 1 to the Registration Statement on Form S-3 filed on October 24, 2001 (Registration No. 333-68866). 10.1 Employment Agreement, effective March 1, 2004, by and between Community Bank System, Inc. and Sanford A. Belden. Incorporated by reference to Exhibit No. 10.1 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.2 Post-2004 Supplemental Retirement Agreement, effective January 1, 2005, by and between Community Bank System, Inc., Community Bank N.A. and Sanford Belden. * ** 10.3 Pre-2005 Supplemental Retirement Agreement, effective December 31, 2004, by and between Community Bank System, Inc., Community Bank N.A. and Sanford Belden. * ** 10.4 Employment Agreement, effective March 8, 2004, by and between Community Bank System, Inc. and Mark E. Tryniski. Incorporated by reference to Exhibit No. 10.4 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.5 Supplemental Retirement Plan Agreement, effective July 1, 2003, by and between Community Bank System Inc. and Mark E. Tryniski. Incorporated by reference to Exhibit No. 10.5 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.6 Employment Agreement, effective August 2, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and Scott A. Kingsley. Incorporated by reference to Exhibit No. 10.3 to the Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration No. 001-13695). ** 10.7 Supplemental Retirement Plan Agreement, effective August 2, 2004, by and between Community Bank System Inc. and Scott A. Kingsley. Incorporated by reference to Exhibit No. 10.4 to the Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration No. 001-13695). ** 10.8 Agreement dated December 23, 2002, by and between Community Bank System, Inc., Community Bank N.A. and David G. Wallace. Incorporated by reference to Exhibit 10.2 to the Annual Report on Form 10-K filed on March 23, 2003 (Registration No. 001-13695). ** 10.9 Employment Agreement, effective August 1, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and Brian D. Donahue. Incorporated by reference to Exhibit No. 10.1 to the Quarterly Report on Form 10-Q filed on November 8, 2004 (Registration No. 001-13695). ** 10.10 Employment Agreement, effective March 20, 2003, by and between Community Bank System, Inc. and Michael A. Patton. Incorporated by reference to Exhibit No. 10.8 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 70 10.11 Supplemental Retirement Plan Agreement, effective February 1, 2004, by and between Community Bank System Inc. and Michael A. Patton. Incorporated by reference to Exhibit No. 10.9 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.12 Employment Agreement, effective March 20, 2003, by and between Community Bank System, Inc. and James A. Wears. Incorporated by reference to Exhibit No. 10.6 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.13 Supplemental Retirement Plan Agreement, effective February 1, 2004, by and between Community Bank System Inc. and James A. Wears. Incorporated by reference to Exhibit No. 10.7 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.14 Employment Agreement, effective November 21, 2003, by and between Community Bank System, Inc. and Thomas A. McCullough. Incorporated by reference to Exhibit No. 10.10 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.15 Supplemental Retirement Plan Agreement, effective March 26, 2003, by and between Community Bank System Inc. and Thomas McCullough. Incorporated by reference to Exhibit No. 10.11 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.16 Employment Agreement, effective May 1, 2004, by and between Community Bank System, Inc., Community Bank N.A. and Steven R. Tokach. Incorporated by reference to Exhibit No. 10.2 to the Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration No. 001-13695). ** 10.17 Employment Agreement, effective September 1, 2002, by and between Community Bank System, Inc., Community Bank N.A. and Timothy J. Baker. Incorporated by reference to Exhibit No. 10.2 to the Quarterly Report on Form 10-Q filed on November 8, 2004 (Registration No. 001-13695). ** 10.18 Change of Control Agreement, effective November 30, 2001 by and between Community Bank System, Inc., Community Bank N.A. and W. Valen McDaniel. * ** 10.19 Employment Agreement, effective September 1, 2002, by and between Community Bank System, Inc., Community Bank N.A. and Joseph J. Lemchak. Incorporated by reference to Exhibit No. 10.4 to the Quarterly Report on Form 10-Q filed on November 8, 2004 (Registration No. 001-13695). ** 10.20 Employment Agreement, effective October 1, 2004, by and between Community Bank System, Inc., Community Bank N.A. and J. David Clark. Incorporated by reference to Exhibit No. 10.3 to the Quarterly Report on Form 10-Q filed on November 8, 2004 (Registration No. 001-13695). ** 10.21 Employment Agreement, effective May 15, 2004, by and between Community Bank System, Inc., Community Bank N.A. and Robert P. Matley. * ** 10.22 Change of Control Agreement, effective August 20, 2002 by and between Community Bank System, Inc., Community Bank N.A. and J. Michael Wilson. * ** 10.23 Employment Agreement, effective April 3, 2000, by and between Community Bank System, Inc. and David J. Elias. Incorporated by reference to Exhibit No. 10.12 to the Annual Report on Form 10-K filed on March 12, 2004 (Registration No. 001-13695). ** 10.24 2004 Long-Term Incentive Compensation Program. Incorporated by reference to Appendix A to the Definitive Proxy Statement on Schedule 14A filed on April 15, 2004 (Registration No. 001-13695). ** 10.25 Stock Balance Plan for Directors, as amended. Incorporated by reference to Annex I to the Definitive Proxy Statement on Schedule 14A filed on March 31, 1998 (Registration No. 001-13695).** 10.26 Deferred Compensation Plan for Directors, as amended. Incorporated by reference to Annex I to the Definitive Proxy Statement on Schedule 14A filed on March 31, 1998 (Registration No. 001-13695).** 10.27 Community Bank System, Inc. Pension Plan Amended and Restated as of January 1, 2004. ** 21.1 Subsidiaries of Community Bank System, Inc. 71 Jurisdiction of Name Incorporation ---- --------------- Community Bank, N.A New York Community Capital Trust I Delaware Community Capital Trust II Delaware Community Statutory Trust III Connecticut Community Financial Services, Inc. New York Benefit Plans Administrative Services, Inc. New York Benefit Plans Administrative Services LLC New York Harbridge Consulting Group LLC New York CBNA Treasury Management Corporation New York Community Investment Services, Inc. New York CBNA Preferred Funding Corp. Delaware CFSI Close-Out Corp. New York Elias Asset Management, Inc. Delaware First Liberty Service Corporation Delaware First of Jermyn Realty Co. Delaware 23.1 Consent of PricewaterhouseCoopers LLP. * 31.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. * 31.2 Certification of Scott A. Kingsley, Treasurer and Chief Financial Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. * 32.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * 32.2 Certification of Scott A. Kingsley, Treasurer and Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * * Filed herewith ** Denotes management contract or compensatory plan or arrangement B. Reports on Form 8-K o Form 8-K related to quarterly earnings press release was filed on January 25, 2005. o Form 8-K related to quarterly earnings press release was filed on October 25, 2004. C. Not applicable 72 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden ----------------------- Sanford A. Belden President, Chief Executive Officer and Director March 14, 2005 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 14th day of March 2005. /s/ James A. Gabriel - -------------------------- James A. Gabriel, Director and Chairman of the Board of Directors /s/ Scott A. Kingsley - -------------------------- Scott A. Kingsley Treasurer and Chief Financial Officer Directors: /s/ Brian R. Ace - -------------------------- Brian R. Ace, Director /s/ John M. Burgess - -------------------------- John M. Burgess, Director /s/ Paul M. Cantwell, Jr. - -------------------------- Paul M. Cantwell, Jr., Director /s/ William M. Dempsey - -------------------------- William M. Dempsey, Director /s/ Nicholas A. DiCerbo - -------------------------- Nicholas A. DiCerbo, Director /s/ Lee T. Hirschey - -------------------------- Lee T. Hirschey, Director /s/ Harold S. Kaplan - -------------------------- Harold S. Kaplan, Director /s/ Saul Kaplan - -------------------------- Saul Kaplan, Director /s/ Charles E. Parente - -------------------------- Charles E. Parente, Director /s/ David C. Patterson - -------------------------- David C. Patterson, Director /s/ Peter A. Sabia - -------------------------- Peter A. Sabia, Director /s/ Sally A. Steele - -------------------------- Sally A. Steele, Director 73 NEW YORK STOCK EXCHANGE The undersigned Chief Executive Officer of Community Bank System, Inc. certifies to the New York Stock Exchange that, as of the date of this certification, he is unaware of any violation by Community Bank System, Inc. of the New York Stock Exchange's corporate governance listing standards in effect as of the date of this certification. Date: March 14, 2005 /s/ Sanford A. Belden - -------------------------- Sanford A. Belden, President, Chief Executive Officer and Director 74 EX-10.2 2 d62959_ex10-2.txt POST-2004 SUPPLEMENTAL RETIREMENT AGREEMENT Exhibit 10.2 POST-2004 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth the Post-2004 Supplemental Retirement Plan Agreement made effective as of January 1, 2005 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) SANFORD A. BELDEN, an individual currently residing at 9 Lynacres Boulevard, Fayetteville, New York ("Employee"). This Agreement is entered into pursuant to paragraph 4(d) of the Employment Agreement between the parties, effective as of March 1, 2004 and as amended ("Employment Agreement"). WITNESSETH IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the product of (i) 5% times Employee's number of years of service, considering only the Employee's first 10 years of service, plus 2% times Employee's number of years of service in excess of ten years, times (ii) Employee's final average compensation, with the product of (i) times (ii) reduced by Employee's other retirement benefits. Notwithstanding the foregoing, except in the event of Employee's voluntary termination of employment prior to July 1, 2006, the product of (i) times (ii) above shall not be less than the product that would be derived if Employee remained employed pursuant to the Employment Agreement through December 31, 2007 and received the Base Salary (including increases) and Management Incentive Plan payments (assuming a minimum 50 percent incentive payment under Employer's Management Incentive Plan) described in the Employment Agreement. Subject to the adjustments described in paragraph 1(h), the benefit described in this paragraph 1(a) initially shall be expressed as a single life annuity (payable for Employee's life) commencing as of the date determined pursuant to paragraph 1(g). (b) For purposes of this paragraph 1, and subject to paragraph 2, "years of service" shall be credited to Employee in the same manner as years of service are credited to Employee under the Community Bank System, Inc. Pension Plan, as amended through December 31, 2004 ("Pension Plan"); and no more than 15 years of service will be taken into account under paragraphs 1 and 2. (c) For purposes of this paragraph 1, and except as provided in the second sentence of paragraph 1(a) and in paragraph 2(a)(iii), Employee's "final average compensation" shall be the annual average of Employee's Base Salary (as defined in the Employment Agreement) and cash incentive payment awarded during the five consecutive calendar years preceding Employee's termination. (d) For purposes of this paragraph 1, Employee's "other retirement benefits" shall mean the sum of (i) the annual benefit earned by Employee pursuant to the Pension Plan, plus -2- (ii) 50 percent of the estimated annual benefit payable to Employee pursuant to the Federal Social Security Act, plus (iii) the annual benefit that could be provided by Employer contributions (other than elective deferrals) made on Employee's behalf under (A) the Community Bank System, Inc. 401(k) Employee Stock Ownership Plan, and (B) the Deferred Compensation Plan for Certain Executive Employees of Community Bank System, Inc., adjusted to reflect actual earnings, losses and expenses credited to and charged against such Employer contributions, if such contributions (as adjusted) were converted to a single life annuity benefit payable at the same time as the benefit paid under this paragraph 1, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin under this paragraph 1; plus (iv) the annual benefit payable to or on behalf of Employee pursuant to the separate Pre-2005 Supplemental Retirement Plan Agreement between Employee and Employer, when such benefit is expressed as an actuarially equivalent single life annuity payable for Employee's life commencing as of the date determined pursuant to paragraph 1(g) (using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin). (e) For purposes of paragraph 1(d)(ii), Employee's Social Security Benefit ("Benefit") will be valued by the actual Benefit Employee receives or is qualified to receive at the time Employee elects to receive the supplemental retirement benefit, or if Employee has not yet qualified for the Benefit, the Benefit will be valued by the maximum benefit available to an individual equal in age to Employee. -3- (f) For the purposes of paragraph 1(d)(i), Employee's Pension Plan benefit will be Employee's accrued benefit under the Pension Plan, determined as of the earlier of (i) the date Employee begins to receive such Pension Plan benefit, or (ii) the date Employee begins to receive the supplemental retirement plan benefit, expressed (in either case) in the form of a single life annuity (payable for Employee's life) commencing as of the date determined pursuant to paragraph 1(g). In the event payments of supplemental retirement benefits commence before payments of Employee's Pension Plan benefit commence, the supplemental retirement benefit shall be adjusted (if necessary) to reflect any difference between the Pension Plan benefit calculated pursuant to the preceding sentence and the actual benefit paid to Employee pursuant to the Pension Plan. (g) The supplemental retirement benefit described in paragraph 1 shall be payable commencing on the first day of the seventh month that follows the month during which Employee separates from service (or, if earlier, the month during which Employee dies). (h) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced Joint and 100% Survivor benefit (using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin), with Employee's spouse as survivor annuitant. Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 100% survivor benefit determined as if Employee retired on the day prior to his death and immediately commenced receipt of payments under both this paragraph 1 (including any adjustment required by the second sentence of paragraph 1(a)) and the Pension Plan in the form -4- of an actuarially reduced Joint and 100% Survivor benefit with his spouse as survivor annuitant. If Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (i) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's retirement (including Employee's voluntary early retirement), disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the Employment Agreement), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date of Employee's termination of employment or the effective date of the Change of Control, as applicable. (j) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, -5- assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. (k) Notwithstanding the foregoing of this paragraph 1 or any other provision of this Agreement, supplemental retirement benefits earned pursuant to this Agreement shall be limited to those benefits earned by Employee after December 31, 2004. Supplemental retirement benefits earned by Employee through December 31, 2004 are determined pursuant to the separate Pre-2005 Supplemental Retirement Plan Agreement between Employee and Employer, as such benefits are valued in accordance with Internal Revenue Service Notice 2005-1 (Q&A 17). In no event will retirement benefits of any type payable to Employee be duplicated. 2. Change of Control (a) If Employee's employment with Employer shall cease for any reason, including Employee's voluntary termination for "good reason," but not including Employee's termination for "cause" or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control", (as those quoted terms are defined in the Employment Agreement), Employer shall: (i) Credit Employee under this Agreement with the greater of 3 years of service or the years of service Employee is retained as a consultant under the terms of paragraph 6 of the Employment Agreement for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and -6- (ii) Credit Employee under this Agreement with two additional years of service for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and (iii) Determine Employee's "final average compensation" under paragraph 1(c) by considering the years of service Employee is retained as a consultant under the terms of the Employment Agreement as service that precedes Employee's termination and considering amounts paid to Employee during that period as Base Salary and cash incentive payments to Employee. (b) Subject to paragraph 2(c) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then, to the extent permitted by Internal Revenue Code Section 409A, the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. The amount of any payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such payment. -7- 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. 4. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements regarding the calculation and payment of supplemental retirement benefits earned after December 31, 2004. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent -8- jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. -9- The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By: /s/ James A. Gabriel ----------------------------- Its: Chairman Date: February 15, 2005 COMMUNITY BANK, N.A. By: /s/ James A. Gabriel ----------------------------- Its: Chairman Date: February 15, 2005 /s/ Sanford A. Belden --------------------------------- SANFORD A. BELDEN Date: February 15, 2005 -10- EX-10.3 3 d62959_ex10-3.txt PRE-2005 SUPPLEMENTAL RETIREMENT AGREEMENT Exhibit 10.3 PRE-2005 SUPPLEMENTAL RETIREMENT PLAN AGREEMENT This sets forth an amendment and restatement of the Supplemental Retirement Plan Agreement made effective as of March 1, 2004 between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) SANFORD A. BELDEN, an individual currently residing at 9 Lynacres Boulevard, Fayetteville, New York ("Employee"). This amended and restated Agreement supersedes the March 1, 2004 version of this Agreement, and is entered into pursuant to paragraph 4(d) of the Employment Agreement between the parties, effective as of March 1, 2004 and as amended ("Employment Agreement"). This amended and restated Agreement is effective as of December 31, 2004. This amended and restated Agreement is entered into by the parties in accordance with guidance provided by the Internal Revenue Service in Internal Revenue Service Notice 2005-1. The intent of this amended and restated Agreement is to preserve supplemental retirement benefits earned and vested under this Agreement (and prior versions of this Agreement) through December 31, 2004 and to stop future accruals under this Agreement as of December 31, 2004. Supplemental retirement benefits earned and vested through December 31, 2004 will be treated as not subject to the requirements of Internal Revenue Code Section 409A. Supplemental retirement benefits earned after December 31, 2004, which benefits will be subject to Internal Revenue Code Section 409A, shall be determined and governed by the separate Post-2004 Supplemental Retirement Plan Agreement between the parties. WITNESSETH IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Supplemental Retirement Benefit. (a) Employer shall pay Employee an annual supplemental retirement benefit equal to the product of (i) 5% times Employee's number of years of service, considering only the Employee's first 10 years of service, plus 2% times Employee's number of years of service in excess of ten years, times (ii) Employee's final average compensation, with the product of (i) times (ii) reduced by Employee's other retirement benefits. Notwithstanding the foregoing, except in the event of Employee's voluntary termination of employment prior to July 1, 2006, the product of (i) times (ii) above shall not be less than the product that would be derived if Employee remained employed pursuant to the Employment Agreement through December 31, 2007 and received the Base Salary (including increases) and Management Incentive Plan payments (assuming a minimum 50 percent incentive payment under Employer's Management Incentive Plan) described in the Employment Agreement. Subject to the adjustments described in paragraph 1(h), the benefit described in this paragraph 1(a) initially shall be expressed as a single life annuity (payable for Employee's life) commencing as of the date determined pursuant to paragraph 1(g). (b) For purposes of this paragraph 1, and subject to paragraph 2, "years of service" shall be credited to Employee in the same manner as years of service are credited to Employee under the Community Bank System, Inc. Pension Plan, as amended through -2- December 31, 2004 ("Pension Plan"); and no more than 15 years of service will be taken into account under paragraphs 1 and 2. (c) For purposes of this paragraph 1, and except as provided in the second sentence of paragraph 1(a) and in paragraph 2(a)(iii), Employee's "final average compensation" shall be the annual average of Employee's Base Salary (as defined in the Employment Agreement) and cash incentive payment awarded during the five consecutive calendar years preceding Employee's termination. (d) For purposes of this paragraph 1, Employee's "other retirement benefits" shall mean the sum of (i) the annual benefit earned by Employee pursuant to the Pension Plan, plus (ii) 50 percent of the estimated annual benefit payable to Employee pursuant to the Federal Social Security Act, plus (iii) the annual benefit that could be provided by Employer contributions (other than elective deferrals) made on Employee's behalf under (A) the Community Bank System, Inc. 401(k) Employee Stock Ownership Plan, and (B) the Deferred Compensation Plan for Certain Executive Employees of Community Bank System, Inc., plus earnings on such Employer contributions under (A) and (B) at an assumed rate of 8% per year, if such contributions (as adjusted) were converted to a single life annuity benefit payable at the same time as the benefit paid under this paragraph 1, using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin under this paragraph 1. -3- (e) For purposes of paragraph 1(d)(ii), Employee's Social Security Benefit ("Benefit") will be valued by the actual Benefit Employee receives or is qualified to receive at the time Employee elects to receive the supplemental retirement benefit, or if Employee has not yet qualified for the Benefit, the Benefit will be valued by the maximum benefit available to a then 62 year old individual. (f) For the purposes of paragraph 1(d)(i), Employee's Pension Plan benefit will be Employee's accrued benefit under the Pension Plan, determined as of the earlier of (i) the date Employee begins to receive such Pension Plan benefit, or (ii) the date Employee begins to receive the supplemental retirement plan benefit, expressed (in either case) in the form of a single life annuity (payable for Employee's life) commencing as of the date determined pursuant to paragraph 1(g). In the event payments of supplemental retirement benefits commence before payments of Employee's Pension Plan benefit commence, the supplemental retirement benefit shall be adjusted (if necessary) to reflect any difference between the Pension Plan benefit calculated pursuant to the preceding sentence and the actual benefit paid to Employee pursuant to the Pension Plan. (g) The supplemental retirement benefit described in paragraph 1 shall be payable commencing on the first day of the month following the later of (i) Employee's receipt of all payments due under the terms of his Employment Agreement, or (ii) termination of employment as an employee of Employer. (h) The supplemental retirement benefit described in this paragraph 1 shall be paid in the form of an actuarially reduced Joint and 100% Survivor benefit (using the factors applied to determine actuarial equivalents under the Pension Plan at the time payments begin), -4- with Employee's spouse as survivor annuitant; provided, however, that, if Employee or his beneficiaries shall receive payment of Employee's benefit under the Pension Plan prior to Employee's attainment of age 62, then the supplement retirement benefit under this paragraph 1 shall be subject to the same early retirement reduction, using the factors applied to determine early retirement benefits under the Pension Plan at the time payments begin. Notwithstanding the foregoing, if Employee dies prior to commencing receipt of payments under this paragraph 1, Employee's surviving spouse shall receive an actuarially reduced 100% survivor benefit determined as if Employee retired on the day prior to his death and immediately commenced receipt of payments under both this paragraph 1 (including any adjustment required by the second sentence of paragraph 1(a)) and the Pension Plan in the form of an actuarially reduced Joint and 100% Survivor benefit with his spouse as survivor annuitant. If Employee has no spouse at the time of Employee's death, no survivor benefits shall be paid pursuant to this paragraph 1. (i) Employer shall establish a "grantor trust" (as that term is defined in Internal Revenue Code Section 671) to aid it in the accumulation and payment of the supplemental retirement benefit described in this paragraph 1; provided that the trust shall be established with the intention that the creation and funding of the trust shall not result in the recognition of gross income by Employee of any amount credited under the trust prior to the date the amount is paid or made available. Assets of the trust, and any other assets set aside by Employer to satisfy its obligations under this Agreement, shall remain at all times subject to the claims of Employer's general creditors. Employee and his beneficiaries shall not have any rights under this paragraph 1 that are senior to the claims of general unsecured creditors of Employer. -5- Notwithstanding any other term or provision of this Agreement or the trust, within ten business days following Employee's termination of employment with Employer due to Employee's retirement (including Employee's voluntary early retirement), disability or death, or, if earlier, immediately prior to the effective date of a "Change of Control" (as defined in the Employment Agreement), Employer shall fully fund the trust (using the same actuarial assumptions used to establish funding in the Pension Plan) for all benefits earned pursuant to this Agreement through the date of Employee's termination of employment or the effective date of the Change of Control, as applicable. (j) The right to receive the supplemental retirement benefit described in this paragraph 1 shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge or encumbrance, nor subject to attachment, garnishment, levy, execution or other legal or equitable process for the debts, contracts or liabilities of Employee or his beneficiaries. (k) Notwithstanding the foregoing of this paragraph 1 or any other provision of this Agreement, Employee's supplemental retirement benefit determined pursuant to this Agreement shall not be greater than the benefit determined as of December 31, 2004 in accordance with Internal Revenue Service Notice 2005-1 (Q&A 17). Employee shall not earn supplement retirement benefits pursuant to this Agreement after December 31, 2004. Supplemental retirement benefits earned by Employee after December 31, 2004 shall be determined and governed by the separate Post-2004 Supplemental Retirement Plan Agreement between the parties. In no event will retirement benefits of any type payable to Employee be duplicated. -6- 2. Change of Control (a) If Employee's employment with Employer shall cease for any reason, including Employee's voluntary termination for "good reason," but not including Employee's termination for "cause" or Employee's voluntary termination without "good reason," within 2 years following a "Change of Control", (as those quoted terms are defined in the Employment Agreement), Employer shall: (i) Credit Employee under this Agreement with the greater of 3 years of service or the years of service Employee is retained as a consultant under the terms of paragraph 6 of the Employment Agreement for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and (ii) Credit Employee under this Agreement with two additional years of service for purposes of determining Employee's supplemental retirement benefit described in paragraph 1; and (iii) Determine Employee's "final average compensation" under paragraph 1(c) by considering the years of service Employee is retained as a consultant under the terms of the Employment Agreement as service that precedes Employee's termination and considering amounts paid to Employee during that period as Base Salary and cash incentive payments to Employee. (b) Subject to paragraph 2(c) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then the parties shall negotiate a restructuring of payment dates and/or methods (but not payment amounts) to -7- minimize or eliminate the application of Internal Revenue Code Section 280G. If an agreement to restructure payments cannot be reached within 60 days of the date the first payment is due under this Agreement, then payments shall be made without restructuring. The amount of any payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such payment. (c) Notwithstanding the foregoing of this paragraph 2, if the Board of Directors of Employer elects to make a single lump sum payment to Employee pursuant to paragraph 6(a)(vi) of the Employment Agreement, Employer shall pay all benefits due Employee pursuant to this Agreement in an actuarial equivalent single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. In the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from all income and excise tax liability attributable to such single lump sum payment. 3. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, this instrument shall be construed as if such invalid provisions had not been inserted. This Agreement shall be interpreted and applied in all circumstances in a manner that is consistent with the intent of the parties that the amount earned and vested pursuant to this Agreement -8- through December 31, 2004 shall not be subject to the requirements of Internal Revenue Code Section 409A. 4. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 5. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. 6. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements regarding supplemental retirement benefits earned through December 31, 2004, including the March 1, 2004 version of this Agreement. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. 7. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 8. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is a party in a proceeding to collect payments due pursuant to this Agreement and prevails in collecting payments due in the proceeding or settlement of the proceeding, Employer shall reimburse -9- Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By: /s/ James A. Gabriel ----------------------------- Its: Chairman Date: February 15, 2005 COMMUNITY BANK, N.A. By: /s/ James A. Gabriel ----------------------------- Its: Chairman Date: February 15, 2005 /s/ Sanford A. Belden --------------------------------- SANFORD A. BELDEN Date: February 15, 2005 -10- EX-10.18 4 d62959_ex10-18.txt CHANGE OF CONTROL Exhibit 10.18 CHANGE OF CONTROL AGREEMENT This CHANGE OF CONTROL AGREEMENT is dated as of November 30, 2001 between COMMUNITY BANK SYSTEM, INC., a Delaware Corporation and registered bank holding company ("CBSI"), and COMMUNITY BANK, N.A., a wholly-owned subsidiary of CBSI, having an office in DeWitt, New York ("CBNA") (CBSI and CBNA are referred to collectively in this Agreement as the "Employer"), and W. Valen McDaniel ("Employee"). Recitals A. Employee is currently employed by CBNA in a senior management capacity. B. Employer desires to retain the services of Employee and to induce Employee to remain with CBNA. C. In consideration of the agreements of the parties contained in this Agreement, and intending to be legally bound by the terms of this Agreement, the parties agree as follows: Terms 1. Term of Agreement. The term of this Agreement shall be for the period from the date of the Agreement to December 31, 2005 and shall automatically expire effective December 31, 2005. 2. Change of Control. (a) Subject to the limitations described in paragraphs 2(d), (e), (f) and (g), if Employee's employment by CBNA shall cease for any reason, including Employee's voluntary termination, but not including Employee's termination for "cause" (as defined in paragraph 3), within 1 year following a "Change of Control" that occurs during the term of this Agreement, Employer shall: (i) Pay to Employee an aggregate severance benefit equal to (A) the greater of 150 percent of Employee's then current Base Salary or the severance benefit otherwise due Employee, plus (B) an amount equal to the Management Incentive paid to Employee in the year previous to the year during which the "Change of Control" occurs; and (ii) Treat as immediately exercisable all options granted by CBSI to Employee to acquire CBSI common stock that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI stock not yet purchased until the end of the exercise period provided in the original grant of the option right; and (iii) Treat as immediately vested all restricted CBSI stock held by Employee; and (iv) Provide Employee with continuation of life and health insurance benefits, under the same terms and conditions (including cost) that Employer provides such insurance to its active employees, until payments under paragraph 2(a)(i) above have been paid in full. (b) The severance benefit payable under paragraph 2(a)(i) above shall be payable in substantially equal installments over a period of eighteen months or longer if provided for under Employer's established severance policy. (c) The provision of health insurance to Employee during the period described in paragraph 2(a)(iv) shall not be credited towards Employer's obligation to provide continuation of health insurance coverage under the Consolidated Omnibus Reconciliation Act of 1985 ("COBRA"). Accordingly, upon expiration of the period described in paragraph 2(a)(iv), Employee (and Employee's qualified beneficiaries) shall be eligible to commence continuation coverage under the COBRA provisions of Employer's group health plan(s). (d) In no event shall the aggregate of all amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 2 or otherwise) exceed the maximum aggregate amount or value that could be paid to, or received by, Employee without such aggregate amount being treated as a "parachute payment" within the meaning of Internal Revenue Code Section 280G. (e) Employer shall not be obligated to provide or continue the payments specified in paragraph 2(a)(i) above, if Employer, within the one-year period following such Change of Control, provides Employee, and Employee accepts, a position within Employer's organization of comparable responsibility and compensation. Employer shall allow Employee to maintain such alternative position for a period of not less than one year from the date of acceptance. (f) As provided in paragraph 2(a) above, Employee may voluntarily terminate his employment with CBNA within 1 year following a Change of Control, and receive all of the payments and benefits specified in 2(a) above. In the event of such a voluntary termination, the payments specified in paragraph 2(a)(i) shall be reduced by any non-Employer related wages or self-employment income derived by Employee during the period payments are made under paragraph 2(a)(i). (g) Payments made and benefits provided pursuant to this paragraph 2 shall be subject to withholding for income, employment and other similar taxes Employer may be required to withhold. (h) For purposes of paragraph 2(a), a "Change of Control," shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of CBSI or CBNA representing 30% or more of the combined voting power of CBSI's or CBNA's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of CBSI or CBNA before the Transaction shall cease to constitute a majority of the Board of Directors of CBSI or CBNA or any successor to either; (iii) CBSI or CBNA is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of CBSI or CBNA, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of CBSI or CBNA representing 30% or more of the combined voting power of CBSI's or CBNA's then outstanding voting securities; or (v) CBSI or CBNA transfers substantially all of its assets to another corporation which is not controlled by CBSI or CBNA. 3. Termination "For Cause" (a) Notwithstanding any contrary provision contained in paragraph 2, CBSI or CBNA may terminate this Agreement "for cause" (defined below) at any time, effective upon receipt by Employee of written notice of termination. Upon termination of employment "for cause," Employee shall be entitled only to the salary due Employee from Employer to the date of receipt by Employee of written notice of termination and Employee shall forfeit any and all stock options granted by CBSI or CBNA that remain unexercised as of the date of the written termination notice and any and all shares of restricted CBSI stock that are not vested as of the date of the written termination notice. (b) Termination "for cause" for purposes of this Agreement shall include, but not be limited to, any of the following: (i) any act of dishonesty or fraud, acts of moral turpitude, or the commission of a felony; or (ii) breach of duty or obligation to CBSI or CBNA or receipt of financial or other economic profit or gain as a result of or in any way arising out of Employee's position with CBNA and failure to account to CBSI or CBNA for such profits or other gains; or (iii) disclosure of confidential or private Employer information or aiding a competitor of Employer (or any affiliate of Employer) to the detriment of Employer (or any affiliate of Employer). 4. Miscellaneous. (a) Notices. Any and all notices with respect to this Agreement shall be sufficient if furnished personally in writing or sent by certified mail, return receipt requested, to the last known address or other address designated by the parties to this Agreement. (b) Entire Agreement: Release From Prior Agreements. This Agreement represents the entire agreement between the parties and specifically supersedes any and all oral or written agreements previously entered into by the parties, and each party releases the other party of all obligations and liabilities with respect to any prior employment agreements between the parties. (c) Governing Law. This Agreement, having been made and duly executed within the State of New York, shall be construed and governed in accordance with and pursuant to New York law. (d) Waiver. In the event that any breach of this Agreement by Employee or Employer is waived by act or failure to act, such waiver shall not constitute a waiver of any subsequent breach by either party. (e) Severability. If any provision of this Agreement shall be held invalid or unenforceable, such invalidity or unenforceability shall affect only that particular provision and shall not affect or render invalid or unenforceable any other provision of this Agreement, and this Agreement shall be carried out as if any such invalid or unenforceable provision were not a part of the Agreement. (f) Binding Effect. This Agreement shall be binding upon and shall inure to the benefit of the successors, assigns, legal representatives and heirs of the parties. (g) Arbitration and Fees. Any dispute between the parties relating to the terms of this Agreement, or any interpretation, construction or enforcement hereof, shall first be submitted to non-binding arbitration in Syracuse, New York in accordance with the rules and regulations of the American Arbitration Association then in effect. Each party shall be responsible for its own costs and expenses in pursuing non-binding arbitration, and any arbitration fees or costs shall be shared equally between the parties. However, if Employee is a party in an arbitration to collect payments due pursuant to this Agreement and prevails in collecting payments due in the arbitration or settlement of the arbitration. Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such arbitration. (h) Personal Qualifications. It is hereby agreed that this Agreement and the employment of Employee pursuant hereto is personal in nature, and that Employee possesses highly specialized skills and abilities. For such reason and in accordance with applicable provisions of New York State law, this agreement may not be assigned by Employee, and as to the obligations to be performed by Employee, other than the rendering or personal service as an employee ofCBNA, this Agreement shall be binding upon Employee's heirs and/or administrators and executors. IN WITNESS WHEREOF, the parties have signed this Agreement after full opportunity to read and discuss the provisions of the Agreement, and both parties voluntarily assent to this Agreement with full understanding of its provisions. EMPLOYEE /s/ W. Valen McDaniel . --------------------------------------- W. Valen McDaniel COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden . --------------------------------------- Sanford A. Belden COMMUNITY BANK, N.A. By: /s/ Sanford A. Belden . --------------------------------------- Sanford A. Belden EX-10.21 5 d62959_ex10-21.txt EMPLOYMENT AGREEMENT Exhibit 10.21 EMPLOYMENT AGREEMENT This Employment Agreement is between (i) COMMUNITY BANK SYSTEM, INC., a Delaware corporation and registered bank holding company, and COMMUNITY BANK, N.A., a national banking association, both having offices located in Dewitt, New York (collectively, the "Employer"), and (ii) ROBERT P. MATLEY, an individual currently residing in Dallas, Pennsylvania ("Employee"). This Agreement shall become effective upon the closing of the merger of Community Bank, N.A. and First Heritage Bank ("Merger"). W I T N E S S E T H IN CONSIDERATION of the promises and mutual agreements and covenants contained herein, and other good and valuable consideration, the parties agree as follows: 1. Employment. (a) Term. Employer shall employ Employee, and Employee shall serve, as Executive Vice President and Senior Lending Officer, Pennsylvania Banking, for Community Bank System, Inc. and Community Bank, N.A. for the period that begins on the date of the closing of the Merger and that ends on December 31, 2007 ("Period of Employment"), subject to termination as provided in paragraph 3 hereof. (b) Salary. From the effective date of this Agreement through December 31, 2004, Employer shall pay Employee a base salary at the annual rate of not less than $140,000 ("Base Salary"). Employee's Base Salary for calendar years after 2004 shall be reviewed and may be increased (but not decreased) annually in accordance with Employer's regular payroll practices for executive employees. (c) Incentive Compensation. During the Period of Employment, Employee shall be entitled to annual incentive compensation pursuant to the terms of the Management Incentive Plan which has been approved by the Board of Directors of Employer to cover Employee and other key personnel of Employer. Upon termination of Employee's employment pursuant to subparagraph 3(a), 3(b), 3(c) or 6, Employee shall be entitled to a pro rata portion (based on Employee's complete months of employment in the applicable year) of the annual incentive award that is payable with respect to the year during which the termination occurs or, if the annual award for such year is not determinable at the termination date, then the immediately prior year's award shall be used to determine such pro rata portion. (d) Signing Bonus. Employer shall pay Employee $125,000 (less applicable withholding), as a one-time signing bonus on the closing date of the Merger and the commencement of Employee's employment with Employer. Employee acknowledges that the payment made pursuant to this paragraph 1(d) is in satisfaction of and replaces all bonuses to which Employee may have become entitled, pursuant to employment and/or stock option agreements between Employee and First Heritage Bank, upon the exercise of certain options to acquire common stock of First Heritage Bank. Upon receipt of the payment described in this paragraph 1(d), Employee agrees that he will not make any claim for any bonus related to the exercise of any stock option of any type. 2. Duties during the Period of Employment. Employee shall be designated as Employer's second-in-command in Pennsylvania and shall have full responsibility, subject to the control of Employer's President, Pennsylvania Banking, and/or the authorized designee of 2 Employer's Board of Directors, for the supervision of substantially all aspects of Employer's credit operations in the Commonwealth of Pennsylvania, and the discharge of such other duties and responsibilities to Employer, not inconsistent with such position, as may from time to time be reasonably assigned to Employee by Employer's President, Pennsylvania Banking, and/or the authorized designee of Employer's Board of Directors. Employee shall report to Employer's President, Pennsylvania Banking, and to Employer's Chief Credit Officer. Employee shall devote Employee's best efforts to the affairs of Employer, serve faithfully and to the best of Employee's ability and devote all of Employee's working time and attention, knowledge, experience and skill to the business of Employer, except that Employee may provide services to or affiliate with professional associations, and business, civic and charitable organizations, provided that such services and affiliations do not unreasonably interfere with the performance of Employee's duties under this Agreement. 3. Termination. Employee's employment by Employer shall be subject to termination as follows: (a) Expiration of the Term. This Agreement shall terminate automatically at the expiration of the Period of Employment unless the parties enter into a written agreement extending Employee's employment, except for the continuing obligations of the parties as specified hereunder. (b) Termination Upon Death. This Agreement shall terminate upon Employee's death. In the event this Agreement is terminated as a result of Employee's death, Employer shall continue payments of Employee's Base Salary for a period of 90 days following Employee's death to the beneficiary designated by Employee on the "Beneficiary Designation Form" attached to this Agreement as Appendix A. Employee's beneficiary shall be free to 3 dispose of any restricted stock previously granted to Employee by Employer. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Beneficiary to purchase the balance of Community Bank System, Inc. ("CBSI") Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's death or termination of employment. (c) Termination Upon Disability. Employer may terminate this Agreement upon Employee's disability. For the purpose of this Agreement, Employee's inability to perform substantially all of Employee's duties under this Agreement by reason of physical or mental illness or injury for a period of 26 successive weeks (the "Disability Period") shall constitute disability. The determination of disability shall be made by a physician selected by Employer and a physician selected by Employee; provided, however, that if the two physicians so selected shall disagree, the determination of disability shall be submitted to arbitration in accordance with the rules of the American Arbitration Association and the decision of the arbitrator shall be binding and conclusive on Employee and Employer. During the Disability Period, Employee shall be entitled to 100% of Employee's Base Salary otherwise payable during that period, reduced by any other income replacement benefits to which Employee may be entitled for the Disability Period on account of such disability (including, but not limited to, benefits provided under any disability insurance policy or program, worker's compensation law, or any other benefit program or arrangement). Upon termination pursuant to this disability provision, Employee shall be free to dispose of any restricted stock granted to Employee. Additionally, Employer shall treat as immediately exercisable all unexpired stock options issued 4 by Employer and held by Employee that are not exercisable or that have not been exercised, so as to permit the Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's disability or termination of employment. (d) Termination for Cause. Employer may terminate Employee's employment immediately for "Cause" by written notice to Employee. For purposes of this Agreement, a termination shall be for "Cause" if the termination results from any of the following events: (i) Material breach of this Agreement which is not cured within 60 days after Employer gives Employee written notice of such breach; (ii) Documented misconduct of Employee engaging in any act of dishonesty or criminal conduct; (iii) Continued neglect or refusal to perform the duties assigned to Employee under or pursuant to this Agreement, unless cured within 60 days after Employer gives Employee written of such neglect or refusal; (iv) Conviction of a felony; (v) Adjudication as a bankrupt, which adjudication has not been contested in good faith, unless bankruptcy is caused directly by Employer's unexcused failure to perform its obligations under this Agreement; (vi) Intentional refusal to follow the reasonable, written instructions of Employer's President, Pennsylvania Banking, the Employer's Chief Credit Officer and/or the Board of Directors of Employer, provided that the instructions do not require Employee to engage in unlawful conduct; or 5 (vii) Any documented intentional violation by Employee of the rules or regulations of the Office of the Comptroller of the Currency or of any other regulatory agency. Notwithstanding any other term or provision of this Agreement to the contrary, if Employee's employment is terminated for Cause, Employee shall forfeit all rights to payments and benefits otherwise provided pursuant to this Agreement; provided, however, that Base Salary shall be paid through the date of termination. (e) Termination For Reasons Other Than Cause. If Employer terminates Employee's employment for reasons other than Cause, or if Employee voluntarily terminates his employment for "Good Reason" (as defined in paragraph 6(c) below), in either case on or after the first anniversary of the closing of the Merger and prior to December 31, 2007, then Employee shall be entitled to a severance benefit equal to the greater of (i) the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal biweekly installments over the 12-month period following Employee's termination, or (ii) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in biweekly installments through the balance of the unexpired term of this Agreement. In addition, Employer shall: (iii) permit Employee to dispose of any restricted stock granted to Employee; and (iv) treat as immediately exercisable all unexpired stock options held by Employee that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI Stock not yet purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right determined without regard to Employee's termination of employment. 6 Notwithstanding the foregoing, if Employer terminates Employee for reasons other than Cause, or if Employee voluntarily terminates his employment for Good Reason, in either case on or after the first anniversary of the closing of the Merger and prior to December 31, 2007, then amounts payable under clauses (i) or (ii) of this paragraph 3(e) shall be reduced by any payments made to Employee under paragraphs 6(a)(i) and (ii). If Employee's employment terminates prior to the first anniversary of the closing of the Merger, Employee's sole and exclusive right to payments (if any) shall be governed by paragraph 3(f). (f) First Heritage Employment Agreement. Employer acknowledges that Employee could have become entitled to certain severance payments pursuant to Section 9 of the Employment Agreement between Employee and First Heritage Bank effective July 1, 1999 ("First Heritage Employment Agreement") as a result of the Merger, which payments Employee has agreed to waive in connection with the Merger and the execution of this Agreement. In consideration of such waiver, (i) in the event that Employee elects to terminate his employment with Employer prior to this first anniversary of the closing of the Merger, Employer shall pay to Employee, in equal biweekly installments over a period of one year, an amount equal to the annual base salary rate in effect on November 1, 2003 and payable to Employee by First Heritage Bank, and (ii) in the event Employer elects to terminate Employee's employment with Employer for reasons other than Cause prior to the first anniversary of the closing of the Merger, Employer shall pay to Employee, in a single sum at the time of termination, an amount equal to twice the annual base salary rate in effect on November 1, 2003 and payable to Employee by First Heritage Bank. Employee shall be required to mitigate the amount of any payment required under paragraph 3(f)(i) by seeking other employment. 7 Notwithstanding any other term or provision in this Agreement, Employer and Employee intend that this paragraph 3(f) shall provide the sole and exclusive basis for payments to be made by Employer to Employee if Employee's employment under this Agreement is terminated voluntarily by Employee, or involuntarily by Employer for reasons other than Cause, prior to the first anniversary of the closing of the Merger. By way of example, and not limitation, Employee shall not be entitled to payments under the other subparagraphs of paragraph 3, or under the provisions of paragraph 6, if benefits are payable pursuant to this subparagraph 3(f). (g) Expiration of Term Without Renewal. In the event that Employee's employment ends on December 31, 2007 solely because Employer chooses not to renew or extend this Agreement beyond December 31, 2007 for reasons other than Cause, then Employee shall be entitled to a severance benefit equal to the sum of (i) 175 percent of the annual Base Salary in effect at the time of termination, and (ii) the most recent payment to Employee under the Management Incentive Plan, such sum to be payable in equal biweekly installments over the six-month period following Employee's termination of employment. Amounts payable under this paragraph 3(g) shall be reduced by any payments made to Employee under paragraphs 6(a)(i) and (ii). 4. Fringe Benefits. (a) Benefit Plans. During the Period of Employment, Employee shall be eligible to participate in any employee pension benefit plans (as that term is defined under Section 3(2) of the Employee Retirement Income Security Act of 1974, as amended), Employer-paid group life insurance plans, medical plans, dental plans, long-term disability plans, business travel insurance programs and other fringe benefit programs maintained by Employer for the benefit of or which are applicable to its executive employees. Participation in any of Employer's 8 benefit plans and programs shall be based on, and subject to satisfaction of, the eligibility requirements and other conditions of such plans and programs. Employer may require Employee to submit to an annual physical, to be performed by a physician of his own choosing. Employee shall be reimbursed for related expenses not covered by Employer's health insurance plan, or any other plan in which Employee is enrolled. Employee shall not be eligible to participate in Employer's Severance Pay Plan maintained for employees not covered by employment agreements. (b) Expenses. Upon submission to Employer of vouchers or other required documentation, Employee shall be reimbursed for (or Employer shall pay directly) Employee's actual out-of-pocket travel and other expenses reasonably incurred and paid by Employee in connection with Employee's duties hereunder. Reimbursable expenses must be submitted to the President and Chief Executive Officer of Employer, or the President and Chief Executive Officer's designee, for review on no less than a quarterly basis. (c) Other Benefits. During the Period of Employment, Employee also shall be entitled to receive the following benefits: (i) Paid vacation of four weeks during each calendar year (with no carry over of unused vacation to a subsequent year) and any holidays that may be provided to all employees of Employer in accordance with Employer's holiday policy; (ii) Reasonable sick leave; (iii) Employer-paid memberships for Employee at one country club and one social (eating) club in the Dallas or Scranton/Wilkes-Barre, Pennsylvania area, subject to the approval of the President and Chief Executive Officer of Employer. Although it is contemplated that the memberships shall be utilized for marketing and promotion of Employer's 9 business interests, in the event that any part of any membership shall be treated as taxable compensation to Employee, Employer shall reimburse Employee for any federal, state or local income tax owed by Employee, including any such taxes owed as a result of any reimbursement under this subparagraph, in connection with such membership; and (iv) The use of an Employer-owned or Employer-leased late model automobile, the selection and replacement of which shall be subject to the approval of the President and Chief Executive Officer of Employer. 5. Restricted Stock and Stock Options. (a) Employer shall cause the Compensation Committee of the Board of Directors of Employer to grant to Employee 2,000 shares of restricted common stock of CBSI effective as of the closing date of the Merger, the restrictions on which shares shall expire in increments of 500 shares on each January 1 beginning January 1, 2005, provided that Employee remains employed by Employer on such January 1. The foregoing grant of restricted stock shall be issued pursuant to, and subject to all the terms and conditions of, the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program or a comparable successor program. (b) In addition, Employer shall cause the Compensation Committee of the Board of Directors of Employer to review whether Employee should be granted additional shares of restricted stock and/or options to purchase shares of common stock of CBSI. Such review may be conducted pursuant to the terms of the Community Bank System, Inc. 1994 Long-Term Incentive Compensation Program, a successor plan, or independently, as the Compensation Committee shall determine. Reviews shall be conducted no less frequently than annually. 10 6. Change of Control. (a) Except as provided in paragraph 3(f), if Employee's employment with Employer shall cease for any reason, including Employee's voluntary termination for Good Reason, but not including Employee's termination for Cause or Employee's voluntary termination without Good Reason, on or after the first anniversary of the closing of the Merger and within 2 years following a "Change of Control" that occurs during the Period of Employment, Employer shall: (i) Pay to the Employee the greater of (A) 200 percent of the sum of the annual Base Salary in effect at the time of termination and the most recent payment to Employee under the Management Incentive Plan, payable in equal biweekly installments over the 24-month period following Employee's termination, or (B) amounts of Base Salary and expected Management Incentive Plan payments that otherwise would have been payable through the balance of the unexpired term of this Agreement, payable in biweekly installments through the balance of the unexpired term of this Agreement; (ii) Provide Employee with fringe benefits, or the cash equivalent of such benefits (equal to Employer's cost for such benefits), identical to those described in paragraph 4(a) for the period during which Base Salary is payable to Employee pursuant to (i) above. To the extent the benefits provided to Employee in this paragraph 6(a)(ii) are deemed taxable benefits, Employer shall reimburse Employee for taxes owed by Employee on the benefits and tax reimbursement; (iii) Treat as immediately exercisable all unexpired stock options issued by Employer and held by Employee that are not otherwise exercisable or that have not been exercised (so as to permit Employee to purchase the balance of CBSI Stock not yet 11 purchased pursuant to said options until the end of the full exercise period provided in the original grant of the option right, determined without regard to Employee's termination of employment) and permit Employee to dispose of any restricted stock previously granted to Employee; and (iv) Permit Employee to dispose of any shares of restricted stock granted to Employee. (v) Subject to Employer's right to make the single lump sum payment described in paragraph 6(a)(vi) below, if any portion of the amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 6 or otherwise) constitutes an "excess parachute payment" within the meaning of Internal Revenue Code Section 280G, then payments to Employee pursuant to this Agreement shall be limited or modified to the minimum extent necessary to eliminate the application of Internal Revenue Code Sections 280G and 4999. The determination of any reduction in payments to Employee pursuant to this paragraph 6(a)(v) shall be made by the independent certified public accountant of Employer in consultation with Employee. (vi) Notwithstanding the foregoing of this paragraph 6(a), the Board of Directors of Employer may elect, in its sole discretion, to pay all benefits due Employee pursuant to this paragraph 6 in a single lump sum payment within 90 days following a Change of Control and Employee's termination of employment with Employer. Subject to the limitation in paragraph 6(a)(v), in the event a single lump sum payment is made pursuant to the foregoing sentence, the amount of the payment shall be increased to the extent necessary to hold Employee harmless from any marginal income and employment tax liability created by the single lump sum payment (i.e., the income and employment tax liability that exceeds the income 12 and employment tax liability that would have been incurred by Employee if payments were made in the manner and during the periods otherwise described in this paragraph 6). (b) For purposes of this paragraph 6, a "Change of Control" shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of Employer before the Transaction shall cease to constitute a majority of the Board of Directors of Employer or any successor to Employer; (iii) Employer is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of Employer, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of Employer representing 30% or more of the combined voting power of Employer's then outstanding voting securities; or (v) Employer transfers substantially all of its assets to another corporation which is not controlled by Employer. 13 (c) For purposes of this Agreement, "Good Reason" shall mean action taken by Employer that results in: (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; (ii) An involuntary relocation of the office from which Employee is expected to perform his duties to a location that is not within 50 miles of Wilkes-Barre, Pennsylvania; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements and clerical support) applicable to Employee. 7. Withholding. Employer shall deduct and withhold from compensation and benefits provided under this Agreement all required income and employment taxes and any other similar sums required by law to be withheld. 8. Covenants. (a) Confidentiality. Employee shall not, without the prior written consent of Employer, disclose or use in any way, either during his employment by Employer or thereafter, except to perform his services as an employee Employer, any confidential business or technical information or trade secret that is not in the public domain acquired in the course of Employee's employment by Employer. Employee acknowledges and agrees that it would be difficult to fully compensate Employer for damages resulting from the breach or threatened breach of the foregoing provision and, accordingly, that Employer shall be entitled to temporary preliminary injunctions and permanent injunctions to enforce such provision. This provision with respect to injunctive relief shall not, however, diminish Employer's right to claim and recover damages. Employee covenants to use his best efforts to prevent the publication or 14 disclosure of any trade secret or any confidential information that is not in the public domain concerning the business or finances of Employer or Employer's affiliates, or any of its or their dealings, transactions or affairs which may come to Employee's knowledge in the pursuance of his duties or employment. (b) No Competition. Employee's employment is subject to the condition that during the term of his employment hereunder and for the period specified in paragraph 8(c) below, Employee shall not, within a 50 mile radius of Wilkes-Barre, Pennsylvania, directly or indirectly, own, manage, operate, control or participate in the ownership, management, operation or control of, or be connected as an officer, employee, partner, director, individual proprietor, lender, consultant or otherwise with, or have any financial interest in, or aid or assist anyone else in the conduct of, any entity or business (a "Competitive Operation") which competes in the banking industry or with any other business conducted by Employer or by any group, affiliate, division or subsidiary of Employer. Employee shall keep Employer fully advised as to any activity, interest, or investment Employee may have in any way related to the banking industry. It is understood and agreed that, for the purposes of the foregoing provisions of this paragraph, (i) no business shall be deemed to be a business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless 5% or more of Employer's consolidated gross sales or operating revenues is derived from, or 5% or more of Employer's consolidated assets are devoted to, such business; (ii) no business conducted by any entity by which Employee is employed or in which he is interested or with which he is connected or associated shall be deemed competitive with any business conducted by Employer or any group, division, affiliate or subsidiary of Employer unless it is one from which 2% or more of its consolidated gross sales or operating revenues is derived, or to which 2% or 15 more of its consolidated assets are devoted; and (iii) no business which is conducted by Employer at the Date of Termination and which subsequently is sold by Employer shall, after such sale, be deemed to be a Competitive Operation within the meaning of this paragraph. Ownership of not more than 5% of the voting stock of any publicly held corporation shall not constitute a violation of this paragraph. (c) Non-Competition Period. If Employee's employment with Employer shall cease for any reason during the Period of Employment as defined in paragraph 1(a) of this Agreement, the "non-competition period" shall begin on the date the first payment is made pursuant to the terms of this Agreement and shall end on the earlier of (i) the date that is 12 months after the date the final payment is made pursuant to the terms of this Agreement, or (ii) December 31, 2007; provided, however, that the date determined pursuant to (i) above shall be the date the final payment is made pursuant to the terms of this Agreement, if Employer terminates Employee during the Period of Employment for reasons other than Cause or if Employee voluntarily terminates his employment during the Period of Employment for Good Reason. (d) Termination of Payments. Upon the breach by Employee of any covenant under this paragraph 8, Employer shall cease all payments to Employee and may offset immediately any and all amounts payable to Employee under this Agreement against any damages to which Employer is legally entitled in addition to any and all other remedies available to Employer under the law or in equity. 9. Notices. Any notice which may be given hereunder shall be sufficient if in writing and mailed by overnight mail, or by certified mail, return receipt requested, to Employee at his residence and to Employer at 5790 Widewaters Parkway, Dewitt, New York 16 13214, or at such other addresses as either Employee or Employer may, by similar notice, designate. 10. Rules, Regulations and Policies. Employee shall abide by and comply in all material respects with all of the rules, regulations, and policies of Employer, including without limitation Employer's policy of strict adherence to, and compliance with, any and all requirements of the banking, securities, and antitrust laws and regulations. 11. No Prior Restrictions. Employee represents and warrants that Employee is under no obligations to any former employer or other third party which is in any way inconsistent with, or which imposes any restriction upon, the employment of Employee by Employer, or Employee's undertakings under this Agreement. 12. Return of Employer's Property. After Employee has received notice of termination or at the end of the Period of Employment, whichever first occurs, Employee shall promptly return to Employer all documents and other property in his possession belonging to Employer. 13. Construction and Severability. The invalidity of any one or more provisions of this Agreement or any part thereof, all of which are inserted conditionally upon their being valid in law, shall not affect the validity of any other provisions to this Agreement; and in the event that one or more provisions contained herein shall be invalid, as determined by a court of competent jurisdiction, the court shall have authority to modify such provision in a manner that most closely reflects the intent of the parties and is valid. 14. Governing Law. This Agreement was executed and delivered in New York and shall be construed and governed in accordance with the laws of the State of New York. 17 15. Assignability and Successors. This Agreement may not be assigned by Employee or Employer, except that this Agreement shall be binding upon and shall inure to the benefit of the successor of Employer through merger or corporate reorganization. Any attempted assignment in violation of this paragraph 15 shall be null and void and of no effect, 16. Miscellaneous. This Agreement constitutes the entire understanding and agreement between the parties with respect to the subject matter hereof and shall supersede all prior understandings and agreements, including the First Heritage Employment Agreement. Employee hereby waives all claims Employee may have under the First Heritage Employment Agreement and any related agreement, plan or program of First Heritage Bank. This Agreement cannot be amended, modified, or supplemented in any respect, except by a subsequent written agreement entered into by the parties hereto. The services to be performed by Employee are special and unique; it is agreed that any breach of this Agreement by Employee shall entitle Employer (or any successor or assigns of Employer), in addition to any other legal remedies available to it, to apply to any court of competent jurisdiction to enjoin such breach. The provisions of paragraphs 6 and 8 hereof shall survive the termination of this Agreement. 17. Counterparts. This Agreement may be executed in counterparts (each of which need not be executed by each of the parties), which together shall constitute one and the same instrument. 18. Jurisdiction, Venue and Fees. The jurisdiction of any proceeding between the parties arising out of, or with respect to, this Agreement shall be in a court of competent jurisdiction in New York State, and venue shall be in Onondaga County. Each party shall be subject to the personal jurisdiction of the courts of New York State. If Employee is the prevailing party in a proceeding to collect payments due pursuant to this Agreement, Employer 18 shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such proceeding. The foregoing is established by the following signatures of the parties. COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden -------------------------------------- Sanford A. Belden President and Chief Executive Officer COMMUNITY BANK, N.A. By: /s/ Sanford A. Belden -------------------------------------- Sanford A. Belden President and Chief Executive Officer /s/ Robert P. Matley ----------------------------------------- ROBERT P. MATLEY 19 APPENDIX A BENEFICIARY DESIGNATION FORM Pursuant to the Employment Agreement between (i) Community Bank System, Inc. and Community Bank, N.A., and (ii) Robert P. Matley ("Agreement"), I, Robert P. Matley, hereby designate Gertrude Matley, my wife, as the beneficiary of amounts payable upon my death in accordance with paragraph 3(b) of the Agreement. My beneficiary's current address is 18 Pheasant Run Dr. Dallas, PA 18612. Dated: May 14, 2004 /s/ Robert P. Matley -------------------------- Robert P. Matley _______________________________ Witness 20 EX-10.22 6 d62959_ex10-22.txt CHANGE OF CONTROL AGREEMENT Exhibit 10.22 CHANGE OF CONTROL AGREEMENT This CHANGE OF CONTROL AGREEMENT is dated as of August 20, 2002 between COMMUNITY BANK SYSTEM, INC., a Delaware Corporation and registered bank holding company ("CBSI"), and COMMUNITY BANK, N.A., a wholly-owned subsidiary of CBSI, having an office in DeWitt, New York ("CBNA") (CBSI and CBNA are referred to collectively in this Agreement as the "Employer"), and James Michael Wilson ("Employee"). Recitals A. Employee is currently employed by CBNA in a senior management capacity. B. Employer desires to retain the services of Employee and to induce Employee to remain with CBNA. C. In consideration of the agreements of the parties contained in this Agreement, and intending to be legally bound by the terms of this Agreement, the parties agree as follows: Terms 1. Term of Agreement. The term of this Agreement shall be for the period from the date of the Agreement to December 31, 2005 and shall automatically expire effective December 31, 2005. 2. Change of Control. (a) Subject to the limitations described in paragraphs 2(d), (e), (f) and (g), if Employee's employment by CBNA shall cease for any reason, including Employee's voluntary termination for "good reason" (as defined in paragraph 2(h) below), but not including Employee's voluntary termination without "good reason" or Employee's termination for "cause" (as defined in paragraph 3), within 1 year following a "Change of Control" that occurs during the term of this Agreement, Employer shall: (i) Pay to Employee an aggregate severance benefit equal to (A) the greater of 100 percent of Employee's then current Base Salary or the severance benefit otherwise due Employee, plus (B) an amount equal to the Management Incentive paid to Employee in the year previous to the year during which the "Change of Control" occurs; and (ii) Treat as immediately exercisable all options granted by CBSI to Employee to acquire CBSI common stock that are not exercisable or that have not been exercised, so as to permit Employee to purchase the balance of CBSI stock not yet purchased until the end of the exercise period provided in the original grant of the option right; and (iii) Treat as immediately vested all restricted CBSI stock held by Employee; and (iv) Provide Employee with continuation of life and health insurance benefits, under the same terms and conditions (including cost) that Employer provides such insurance to its active employees, until payments under paragraph 2(a)(i) above have been paid in full. (b) The severance benefit payable under paragraph 2(a)(i) above shall be payable in substantially equal installments over a period of twelve months or longer if provided for under Employer's established severance policy. (c) The provision of health insurance to Employee during the period described in paragraph 2(a)(iv) shall not be credited towards Employer's obligation to provide continuation of health insurance coverage under the Consolidated Omnibus Reconciliation Act of 1985 ("COBRA"). Accordingly, upon expiration of the period described in paragraph 2(a)(iv), Employee (and Employee's qualified beneficiaries) shall be eligible to commence continuation coverage under the COBRA provisions of Employer's group health plan(s). (d) In no event shall the aggregate of all amounts paid to, or value received by, Employee following a "Change of Control" (whether paid or received pursuant to this paragraph 2 or otherwise) exceed the maximum aggregate amount or value that could be paid to, or received by. Employee without such aggregate amount being treated as a "parachute payment" within the meaning of Internal Revenue Code Section 280G. (e) Employer shall not be obligated to provide or continue the payments specified in paragraph 2(a)(i) above, if Employer, within the one-year period following such Change of Control, offers Employee a position within Employer's organization of comparable responsibility and compensation. Employer shall allow Employee to maintain such alternative position for a period of not less than one year from the date of acceptance. (f) Payments made and benefits provided pursuant to this paragraph 2 shall be subject to withholding for income, employment and other similar taxes Employer may be required to withhold. (g) For purposes of paragraph 2(a), a "Change of Control," shall be deemed to have occurred if: (i) any "person," including a "group" as determined in accordance with the Section 13(d)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), is or becomes the beneficial owner, directly or indirectly, of securities of CBSI or CBNA representing 30% or more of the combined voting power of CBSI's or CBNA's then outstanding securities; (ii) as a result of, or in connection with, any tender offer or exchange offer, merger or other business combination (a "Transaction"), the persons who were directors of CBSI or CBNA before the Transaction shall cease to constitute a majority of the Board of Directors of CBSI or CBNA or any successor to either; (iii) CBSI or CBNA is merged or consolidated with another corporation and as a result of the merger or consolidation less than 70% of the outstanding voting securities of the surviving or resulting corporation shall then be owned in the aggregate by the former stockholders of CBSI or CBNA, other than (A) affiliates within the meaning of the Exchange Act, or (B) any party to the merger or consolidation; (iv) a tender offer or exchange offer is made and consummated for the ownership of securities of CBSI or CBNA representing 30% or more of the combined voting power of CBSI's or CBNA's then outstanding voting securities; or (v) CBSI or CBNA transfers substantially all of its assets to another corporation which is not controlled by CBSI or CBNA. (h) For purposes of this paragraph 2, "good reason" shall mean action taken by Employer that results in: (i) An involuntary and material adverse change in Employee's title, duties, responsibilities, or total remuneration; (ii) An involuntary and material relocation of the office from which Employee is expected to perform Employee's duties; or (iii) An involuntary and material adverse change in the general working conditions (including travel requirements) applicable to Employee. 3. Termination "For Cause" (a) Notwithstanding any contrary provision contained in paragraph 2, CBSI or CBNA may terminate this Agreement and Employee's employment "for cause" (defined below) at any time, effective upon receipt by Employee of written notice of termination. Upon termination of employment "for cause," Employee shall be entitled only to the salary due Employee from Employer to the date of receipt by Employee of written notice of termination and Employee shall forfeit any and all stock options granted by CBSI or CBNA that remain unexercised as of the date of the written termination notice and any and all shares of restricted CBSI stock that are not vested as of the date of the written termination notice. (b) Termination "for cause" for purposes of this Agreement shall include, but not be limited to, any of the following: (i) any act of dishonesty or fraud, acts of moral turpitude, or the commission of a felony; or (ii) breach of duty or obligation to CBSI or CBNA or receipt of financial or other economic profit or gain as a result of or in any way arising out of Employee's position with CBNA and failure to account to CBSI or CBNA for such profits or other gains; or (iii) disclosure of confidential or private Employer information or aiding a competitor of Employer (or any affiliate of Employer) to the detriment of Employer (or any affiliate of Employer). 4. Miscellaneous. (a) Notices. Any and all notices with respect to this Agreement shall be sufficient if furnished personally in writing or sent by certified mail, return receipt requested, to the last known address or other address designated by the parties to this Agreement. (b) Entire Agreement; Release From Prior Agreements. This Agreement represents the entire agreement between the parties and specifically supersedes any and all oral or written agreements previously entered into by the parties, and each party releases the other party of all obligations and liabilities with respect to any prior employment agreements between the parties. (c) Governing Law. This Agreement, having been made and duly executed within the State of New York, shall be construed and governed in accordance with and pursuant to New York law. (d) Waiver. In the event that any breach of this Agreement by Employee or Employer is waived by act or failure to act, such waiver shall not constitute a waiver of any subsequent breach by either party. (e) Severability. If any provision of this Agreement shall be held invalid or unenforceable, such invalidity or unenforceability shall affect only that particular provision and shall not affect or render invalid or unenforceable any other provision of this Agreement, and this Agreement shall be carried out as if any such invalid or unenforceable provision were not a part of the Agreement. (f) Binding Effect. This Agreement shall be binding upon and shall inure to the benefit of the successors, permitted assigns, legal representatives and heirs of the parties. (g) Arbitration and Fees. Any dispute between the parties relating to the terms of this Agreement, or any interpretation, construction or enforcement hereof, shall first be submitted to non-binding arbitration in Syracuse, New York in accordance with the rules and regulations of the American Arbitration Association then in effect. Each party shall be responsible for its own costs and expenses in pursuing non-binding arbitration, and any arbitration fees or costs shall be shared equally between the parties. However, if Employee is a party in an arbitration to collect payments due pursuant to this Agreement and prevails in collecting payments due in the arbitration or settlement of the arbitration. Employer shall reimburse Employee for reasonable attorneys' fees incurred by Employee in connection with such arbitration. (h) Personal Qualifications. It is hereby agreed that this Agreement and the employment of Employee pursuant hereto is personal in nature, and that Employee possesses highly specialized skills and abilities. For such reason and in accordance with applicable provisions of New York State law, this Agreement may not be assigned by Employee, and as to the obligations to be performed by Employee, other than the rendering or personal service as an employee of CBNA, this Agreement shall be binding upon Employee's heirs and/or administrators and executors. IN WITNESS WHEREOF, the parties have signed this Agreement after full opportunity to read and discuss the provisions of the Agreement, and both parties voluntarily assent to this Agreement with full understanding of its provisions. EMPLOYEE /s/ James Michael Wilson . --------------------------------------- James Michael Wilson COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden . --------------------------------------- Sanford A. Belden President, CEO COMMUNITY BANK, N.A. By: /s/ Sanford A. Belden . --------------------------------------- Sanford A. Belden President, CEO EX-10.27 7 d62959_ex10-27.txt CBS INC. PENSION PLAN Exhibit 10.27 COMMUNITY BANK SYSTEM, INC. PENSION PLAN Amended and Restated as of January 1, 2004 Article I HISTORY AND PURPOSE OF PLAN 1.1 History. Community Bank System, Inc. established the Community Bank System, Inc. Pension Plan ("Plan"), effective as of July 1, 1976, for the benefit of covered employees and their beneficiaries. The Plan has been amended and restated a number of times since 1976, the most recent amendment and restatement being effective as of January 1, 2001. This document amends and restates the Plan in its entirety, effective as of January 1, 2004, except to the extent a different effective date is specified for certain provisions. This amended and restated Plan document incorporates a "cash balance" design. The Plan shall at all times be considered a defined benefit pension plan for purposes of Code ss.ss.401(a), 411, 412 and 417. 1.2 Purpose. The purpose of the Plan is to provide retirement and certain survivor benefits for the Participants and their Beneficiaries. To provide such benefits, the Employer shall make contributions to the Plan as provided herein. 1.3 Application of Restated Plan. Unless expressly stated otherwise herein, the amount of Accrued Benefit and the rate of accrual of benefits for Participants (or their Beneficiaries) who have terminated employment, or whose benefits are in pay status, as of the Restatement Effective Date shall be determined under the terms of the predecessor(s) to this Plan in effect during his employment or at his termination date and not under the Plan as restated by this document. Article II DEFINITIONS As used in this Plan, the following terms shall have the following meanings, unless a different meaning is stated and clearly indicated by the context: 2.1 "Account" means the account established and maintained for a Participant who is entitled to benefits pursuant to Paragraph 5.3. The Administrator may establish one or more sub-Accounts as may be necessary to administer the Plan. A Participant's Account shall include all such sub-Accounts. 2.2 "Accrual Computation Period" shall mean a Plan Year. 2.3 "Accrued Benefit" means the amount of retirement benefit earned by a Participant hereunder, and payable during the life of the Participant, expressed in the form of an annual benefit commencing at the Participant's Normal Retirement Date. A Participant's Accrued Benefit under the Traditional Formula (if applicable) as of any Valuation Date shall be determined in accordance with Paragraph 5.2, based on his credited Years of Creditable Service and his Average Annual Compensation, both determined as of such Valuation Date. A Participant's Accrued Benefit under the Cash Balance Formula (if applicable) as of any Valuation Date shall be the Actuarial Equivalent of the Participant's Account balance determined in accordance with Paragraph 5.3; provided that, for Valuation Dates that occur prior to the Participant's Normal Retirement Date, such Actuarial Equivalent shall be determined by projecting the value of the Participant's Account balance to the Participant's Normal Retirement Age, using the Interest Rate described in subparagraph 2.4(c)(1), and then converting such projected Account balance to a single life annuity payable to the Participant commencing at the Participant's Normal Retirement Date; provided further that such Actuarial Equivalent (when expressed as a single lump sum) shall not be less than the Participant's Account balance as of the applicable Valuation Date. 2.4 "Actuarial Equivalent". (a) An Actuarial Equivalent benefit shall mean a form of benefit differing in time, period or manner of payment from a specific benefit under the Plan, but having the same present value as such specific benefit. (b) Except as otherwise provided in subparagraphs (c) and (d) below, an Actuarial Equivalent benefit shall be determined by using the following assumptions: Interest Rate - 6% pre-retirement 6% post-retirement Mortality - pre-retirement: 1984 Unisex Table post-retirement: 1984 Unisex Table 2 (c) Effective for Plan Years beginning on or after January 1, 1995, the following assumptions shall be used to compute a lump-sum Actuarial Equivalent benefit: (1) Interest Rate - an interest rate that is the annual interest rate announced by the Commissioner of Internal Revenue on 30-year U.S. Treasury securities (A) for the first full calendar month immediately preceding the Plan Year of distribution, with respect to distributions prior to January 1, 2005, and (B) the second full calendar month immediately preceding the Plan Year of distribution, with respect to distributions after December 31, 2004 (provided that distributions during 2005 will be based on the interest rate in (A) or (B) that produces the greatest benefit), which rate shall be constant during that entire Plan Year; and (2) Mortality - mortality assumptions under the prevailing commissioners' standard table as described in Code ss.807(d)(5)(A) used to determine reserves for group annuity contracts issued on the date as of which the determination of present value is being made. Notwithstanding the foregoing provisions of this subparagraph (c), a Participant's lump sum Actuarial Equivalent benefit shall in no event be less than the present value of the Participant's Vested Accrued Benefit earned as of December 31, 1994, computed by taking into account the Participant's age at the Annuity Starting Date and by using the actuarial assumptions set out in subparagraph (b) above. (d) In the event this paragraph is amended so as to affect benefits protected under Code ss.411(d)(6), the Actuarial Equivalent benefit on or after the date of change shall be the greater of: (1) the Actuarial Equivalent benefit as of the date of change computed under the Plan provisions in effect immediately prior to such change; or (2) the Actuarial Equivalent benefit computed under the Plan provisions in effect immediately after such change. 2.5 "Administrator" or "Plan Administrator" shall mean the person or entity that administers the Plan, as further described in Article XIII. 2.6 "Affiliated Company" shall mean any corporation which is a member of a controlled group of corporations (as defined in Code ss. 1563(a), determined without regard to ss.ss.1563(a)(4) and (e)(3)(C), except that, with respect to the limitations on Annual Additions in Article VIII, "50%" shall be substituted for "80%" wherever such percentage appears in Code ss.1563(a)(1)) which includes the Employer; any trade or business (whether or not incorporated) which is under common control (as defined in Code ss.414(c)) with the Employer; any affiliated service group (as defined in Code ss.414(m)) which includes the Employer; and any other entity required to be aggregated with the Employer pursuant to regulations under Code ss.414(o). 2.7 "Age" shall mean age as of the nearest birthday. 3 2.8 "Anniversary Date" means the first day of the Plan Year. 2.9 "Annuity Starting Date" shall mean (i) the first day of the first period for which an amount is paid as an annuity (whether by reason of retirement or disability) or (ii) in the case of a benefit not payable in the form of an annuity, the first day on which all events have occurred which entitle the recipient to such benefit. 2.10 "Average Annual Compensation" shall mean the average of a Participant's annual Compensation for the 5 consecutive Years of Participation which produce the highest average. If he has less than 5 Years of Participation as of his termination date, the average shall be determined by averaging the annual Compensation received during the Participant's entire Service with the Employer. 2.11 "Beneficiary" shall mean the person(s) or entity(s) designated by a Participant, or otherwise designated as such under the provisions of this Plan, to receive benefits hereunder following the Participant's death. 2.12 "Break in Service" shall mean, for purposes of eligibility, the failure of an Employee to complete more than 500 Hours of Service during any Eligibility Computation Period, and for purposes of benefit accrual and vesting, the failure of a Participant to complete more than 500 Hours of Service during any Plan Year. The term "One-Year Break in Service" shall mean any such Break in Service. An Employee shall not incur a Break in Service for the Plan Year in which he becomes a Participant, dies or retires. 2.13 "Cash Balance Formula" means the cash balance formula, including minimum and supplemental amounts, used to determine a Participant's Accrued Benefit pursuant to Paragraph 5.3. 2.14 "Code" means the Internal Revenue Code of 1986, as amended from time to time, any regulations thereunder, and any rulings issued by the Internal Revenue Service. Reference to any Code Section shall include any successor provision thereto. 2.15 "Compensation". (a) "Compensation" shall mean the amount reportable by the Employer on IRS Form W-2 for wages as defined in Code ss.3401(a) and other amounts pursuant to Code ss.ss.6041(d) and 6051(a)(3), for the calendar year ending in the Plan Year. Compensation shall include all of the Participant's elective deferrals as defined in Code ss.402(g), amounts withheld from the Participant's pay which are not includable in the Participant's gross income under Code ss.ss.125, 402(e)(3), 402(h)(1)(B), 403(b), or 132(f)(4), amounts deferred under a Code ss.457 plan, and amounts treated as employer contributions under Code ss.414(h)(2). Compensation, however, shall not include income attributable to the grant or exercise of stock options, the vesting of restricted stock, the sale of stock, or any other income attributable to the acquisition or disposition of stock or rights related to stock. 4 (b) For purposes of Article VIII, Compensation shall be measured in relation to the Limitation Year and adjusted in accordance with Treasury Regs. ss.ss.1.415-2(d)(2) and (3), if required thereunder. In the case of an employee of two or more Affiliated Companies, his Compensation from all such Affiliated Companies while so affiliated shall be aggregated. (c) In addition to other applicable limitations set forth in the Plan, and notwithstanding any other provision of the Plan to the contrary, the annual Compensation of each Employee shall not exceed $150,000, as adjusted by the Commissioner for increases in the cost of living in accordance with Code ss.401(a)(17)(B). The cost-of-living adjustment in effect for a calendar year applies to any period not exceeding 12 months over which compensation is determined ("Determination Period") beginning in such calendar year. If a Determination Period consists of fewer than 12 months, the compensation limit will be multiplied by a fraction, the numerator of which is the number of months in the Determination Period, and the denominator of which is 12. If Compensation for any prior Determination Period is taken into account in determining an Employee's benefits accruing in the current Plan Year, the Compensation for that prior Determination Period is subject to the OBRA `93 Annual Compensation Limit in effect for that prior Determination Period. For this purpose, for Determination Periods beginning before the first day of the first Plan Year beginning on or after January 1, 1994, the OBRA `93 Annual Compensation Limit is $150,000. Effective for Plan Years beginning after December 31, 1996, and notwithstanding anything in this Plan to the contrary, an Employee who is a Family Member of a Highly Compensated Employee shall be considered a separate Employee and shall not be aggregated with the Highly Compensated Employee for purposes of determining the Compensation of the Employee or the Compensation of the Highly Compensated Employee for any purposes under this Plan. (d) Increase in Compensation Limit. The annual compensation of each participant taken into account in determining benefit accruals in any Plan Year beginning after December 31, 2001 shall not exceed $200,000, as adjusted for cost-of-living increases in accordance with Code ss.401(a)(17)(B). Annual compensation means compensation during the Plan Year or such other consecutive 12-month period over which compensation is otherwise determined under the Plan (the Determination Period). For purposes of determining benefit accruals in a Plan Year beginning after December 31, 2001, compensation for any prior Determination Period shall not exceed the limit in effect pursuant to Code ss.401(a)(17) for such prior Determination Period. The cost-of-living adjustment in effect for a calendar year applies to annual compensation for the Determination Period that begins with or within such calendar year. 2.16 "Cost of Living Factor" shall mean the cost of living adjustment prescribed by the Secretary of the Treasury under Code ss.415(d). 2.17 "Defined Benefit Plan" shall mean a Retirement Plan other than a Defined Contribution Plan. 5 2.18 "Defined Benefit Plan Fraction" shall mean a fraction, the numerator of which is the sum of the Participant's projected annual benefit (calculated in accordance with Treasury regulations) under all the Defined Benefit Plans (whether or not terminated) maintained by the Employer, and the denominator of which is the lesser of (i) 125% of the dollar limitation in effect for the Limitation Year under Code ss.415(b)(1) and (d) or (ii) 140% of the Participant's average compensation for the 3 consecutive Years of Service that produces the highest average, including any adjustments under Code ss.415(b). Notwithstanding the preceding, if the Participant participated as of the first day of the first Limitation Year beginning after December 31, 1986, in one or more Defined Benefit Plans maintained by the Employer which were in existence on May 6, 1986, the denominator of this fraction will not be less than 125% of the sum of the annual benefits under such plans which the Participant had accrued as of the close of the Limitation Year beginning before January 1, 1987, disregarding any changes in the terms and conditions of the Plan after May 5, 1986. The preceding sentence applies only if the Defined Benefit Plans individually and in the aggregate satisfied Code ss.415 limits at the end of the 1986 Limitation Year. For purposes of the preceding calculation, a Participant's "projected annual benefit" shall mean the annual retirement benefit (adjusted to an actuarially equivalent straight life annuity if such benefit is expressed in a form other than a straight life annuity or qualified joint and survivor annuity) to which the Participant would be entitled under the terms of the plan assuming: (a) the Participant will continue employment until normal retirement age under the plan (or current age, if later), and (b) the Participant's compensation for the current Limitation Year and all other relevant factors used to determine benefits under the Plan will remain constant for all future Limitation Years. For limitation years beginning on or after December 31, 1986 the denominator of the defined benefit fraction shall be determined using the dollar limitation under Code ss.415 as amended by the Tax Reform Act of 1986, even if the Plan terminated in a prior limitation year. 2.19 "Defined Contribution Plan" shall mean a Retirement Plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account. 2.20 "Defined Contribution Plan Fraction" shall mean a fraction, the numerator of which is the Annual Additions to the Participant's Account under the Employer's Defined Contribution Plans currently or formerly maintained by the Employer for the current and all prior Limitation Years, including Annual Additions attributable to the Participant's nondeductible contributions to the Employer's Defined Benefit Plans and Annual Additions attributable to all welfare benefit funds (defined in Code ss.419(e)) and individual medical accounts (defined in Code ss.415(1)(2)), and the denominator of which is the sum of the lesser of the following 6 amounts determined for such year and each prior year of the Participant's Service with the Employer: (i) 125% times the dollar limitation in effect under Code ss.415(c)(1)(A) for the pertinent year, or (ii) 140% times the amount that could be contributed under the percentage limitation of Code ss.415(c)(1)(B) for the Participant. If the Employee was a participant in one or more Defined Contribution Plans maintained by the Employer which were in existence on May 6, 1986, the numerator of this fraction shall be adjusted in accordance with Code ss.4l5 if the sum of this fraction and the Defined Benefit Plan Fraction would otherwise exceed 1.0 under the terms of this Plan. Under the adjustment, an amount equal to the product of (1) the excess of the sum of the fractions over 1.0 times (2) the denominator of this fraction, will be permanently subtracted from the numerator of this fraction. The adjustment is calculated using the fractions as they would be computed as of the end of the last Limitation Year beginning before January 1, 1987, and disregarding any changes in the terms and conditions of the Plan made after May 5,1986, but using the Code ss.415 limitation applicable to the first Limitation Year beginning on or after January 1, 1987. 2.21 "Determination Date" shall mean with respect to the first Plan Year of the Plan, the last day of that Plan Year, and with respect to any subsequent Plan Year, the last day of the preceding Plan Year. 2.22 "Disabled" Participant shall mean one whose physical and/or mental incapacity, disability or illness qualifies him for benefits under the Employer's long-term disability insurance program or, in the absence of such program, which qualifies the Participant for disability benefits under Title II of the Social Security Act. The Administrator may require a Participant to submit to a physician examination to make such determination. 2.23 "Early Retirement Age" of a Participant shall mean (i) the date the Participant attains age 55 and completes 10 Years of Vesting Service, as defined in Paragraph 7.2 below, or (ii) the date he attains the earliest age when Social Security benefits may be paid and completes 5 Years of Vesting Service. 2.24 "Early Retirement Date" shall mean the first day of the month following the date the Participant attains his Early Retirement Age. 2.25 "Effective Date of the Restatement" or "Restatement Effective Date" shall mean January 1, 2004. The "Effective Date" of the Plan shall mean July 1, 1976. 2.26 "Eligibility Computation Period" for each Employee shall mean a 12-consecutive month period beginning on the date the Employee first performs an Hour of Service with the Employer and any succeeding Eligibility Computation Period shall mean a Plan Year beginning with the Plan Year immediately following the Plan Year within which the Employee first performed an Hour of Service. In the case of an Employee who has a Break in Service where Service prior to such Break in Service is disregarded pursuant to Paragraph 3.4, the Eligibility Computation Period shall be determined pursuant to this paragraph beginning on the date the Employee first completes an Hour of Service with the Employer immediately following such Break in Service. 7 2.27 "Employee" shall mean any person who is employed by the Employer and treated by the Employer for payroll and employment tax purposes as a common law employee. For all purposes under this Plan, no independent contractor or any other individual treated by the Employer for payroll and employment tax purposes as a non-employee shall be considered an Employee, even if reclassified by a court or regulatory agency as an employee of the Employer. 2.28 "Employer" shall mean Community Bank System, Inc. and any Participating Employer. 2.29 "Entry Date" shall mean January 1, April 1, July 1, and October 1. 2.30 "ERISA" shall mean the Employee Retirement Income Security Act of 1974, as amended from time to time, and the regulations thereunder. References to any ERISA section shall include any successor provision thereto. 2.31 "Fiscal Year" means the 12-month period beginning January 1 and ending December 31. 2.32 "Forfeiture" shall mean that portion of a Participant's Accrued Benefit that is not Vested and which is forfeited pursuant to Article VII. 2.33 "Highly Compensated Employee" includes Highly Compensated Active Employees and Highly Compensated Former Employees. (a) A Highly Compensated Active Employee means any Employee who (i) was a 5% owner (as defined in Code ss.416(i)(1)) of the Employer at any time during the current or the preceding Plan Year, or (ii) for the preceding Plan Year had compensation from the Employer in excess of $80,000 (as adjusted by the Secretary pursuant to Code ss.415(d)). (b) A former Employee shall be treated as a Highly Compensated Employee if: (i) the Employee was a Highly Compensated Employee when he separated from Service, or (ii) the Employee was a Highly Compensated Employee at any time after attaining age 55. (c) The determination of who is a Highly Compensated Employee will be made in accordance with Code ss.414(q). (d) For purposes of this paragraph, the term "compensation" means compensation within the meaning of Code ss.415(c)(3). For Plan Years beginning on or after January 1, 2001, amounts excluded from gross income by reason of Code ss.132(f)(4) shall be added to compensation. This definition of a Highly Compensated Employee is effective for Plan Years beginning after December 31, 1996, except that, in determining whether an Employee is a Highly Compensated Employee in 1997, this definition is treated as having been in effect in 8 1996, and the family aggregation rules under Code ss.414(q)(6) shall be treated as inapplicable beginning in 1996. 2.34 "Hour of Service" shall mean: (a) each hour for which an Employee is paid or entitled to payment for the performance of duties for the Employer; (b) each hour (up to 501 hours for any single continuous period, whether or not occurring in a single computation period) for which an Employee is paid, or entitled to payment, by the Employer during which no duties are performed (regardless of whether the employment relationship has terminated) due to vacation, holiday, illness, incapacity (including disability), layoff, jury or military duty, or leave of absence. Hours under this paragraph shall be calculated and credited pursuant to 29 C.F.R. 2530.200b-2(b) and (c) which are incorporated herein by this reference; (c) for purposes other than benefit accrual, each hour (up to the number required to avoid a Break in Service) for which an Employee would otherwise be credited but for an unpaid parental leave beginning after December 31, 1984, or family medical leave in effect on or beginning after February 6, 1995. In any case in which such hours cannot be determined, the Employee shall be credited with 8 Hours of Service per day of such absence. Parental leave shall mean an authorized absence by reason of (i) the Employee's pregnancy, (ii) birth of the Employee's child, (iii) placement of a child with the Employee through adoption, or (iv) caring for the Employee's child immediately following its birth or adoption. Family medical leave shall mean leave authorized under the Family Medical Leave Act of 1993 ("FMLA"). No Hours of Service shall be credited under this subparagraph (c) unless the Employee furnishes to the Administrator such timely information as the Administrator shall require to determine whether an Employee's absence constitutes a parental or family medical leave, and the length of such absence. Hours of Service shall be credited under this subparagraph (c) in the computation period in which the absence begins only if such credited hours would prevent a Break in Service in such period, otherwise in the next succeeding computation period; (d) if not credited under the preceding paragraphs, each hour for which back pay, irrespective of mitigation of damages, is either awarded or agreed to by the Employer. These hours shall be credited for the computation period or periods to which the award or agreement pertains rather than the computation period in which the award, agreement or payment is made; (e) for purposes other than benefit accrual, each hour (up to 501 hours in any Plan Year) during which an Employee performs no duties for the Employer while on an unpaid Leave of Absence. Such hours shall be credited to the Employee only if the additional hours awarded would prevent the Employee from incurring a One-Year Break in Service. Hours under this subparagraph shall be credited on the basis of 40 hours per work week or 8 hours per work day. "Leave of Absence" shall mean any absence authorized by the Employer under the Employer's standard personnel practices, provided that the Employee retires or returns within the 9 period of authorized absence. The Employer shall treat all Employees under similar circumstances in a consistent, non-discriminatory manner; (f) each hour for which a leased employee who is considered an Employee under this Plan would be credited under the foregoing provisions. Unless the Employer maintains records of actual Hours of Service, a salaried Employee who completes at least one Hour of Service during a monthly period shall be credited with 190 Hours for each such period. Notwithstanding the foregoing, no credit shall be given for any period during which no duties are performed but for which an Employee receives payment or is entitled to payment under a plan maintained solely for the purpose of complying with applicable worker's compensation, unemployment compensation or disability insurance laws or where payment solely reimburses an Employee for medical or medically related expenses incurred by the Employee. Service rendered at overtime or other premium rates shall be credited at the rate of one Hour of Service for each hour worked, regardless of the rate of compensation in effect with respect to such hour. For purposes of eligibility and vesting, Hours of Service will be credited to an Employee for employment with any Affiliated Company while that company was an Affiliated Company with the Employer. 2.35 "Interest Credit" means, with respect to any Plan Year, an addition to an eligible Participant's Account determined pursuant to subparagraph 5.3(f). 2.36 "Investment Manager" shall mean any person or entity who: (a) is registered as an investment adviser under the Investment Advisers Act of 1940, a bank (as defined in the Investment Advisers Act of 1940), or an insurance company qualified to manage, acquire and dispose of Plan assets under the laws of more than one state; (b) acknowledges in writing that it is a fiduciary with respect to the Plan; and (c) is granted the power to manage, acquire or dispose of any asset of the Plan pursuant to its provisions. 2.37 "Key Employee" shall mean any Employee or former Employee (or such Employee's Beneficiary) who at any time during the Plan Year including the Determination Date or during any of the 4 preceding Plan Years is or was: (a) an officer of the Employer who has Top Heavy Compensation greater than 50% of the amount in effect under Code ss.415(b)(1)(A) for the Plan Year; 10 (b) an owner (or one who is considered an owner under the provisions of Code ss.318) of one of the 10 largest interests in the Employer if such individual's Top Heavy Compensation exceeds the amount in effect under Code ss.415(c)(1)(A); (c) a more than 5% owner of the Employer; or (d) a 1% owner of the Employer earning more than $150,000 in Top Heavy Compensation from the Employer. For purposes of subparagraph (a), not more than 50 (or, if there are less than 500 Employees, not more than the greater of three or 10% of the Employees) shall be considered a Key Employee by virtue of being an officer. For purposes of subparagraph (b), if 2 Employees have the same ownership percentage, the Employee having greater Compensation shall be considered as having a larger interest. "Key Employee" shall mean any Employee or former Employee (including any deceased Employee) who at any time during the Plan Year that includes the Determination Date was an officer of the Employer having annual compensation greater than $130,000 (as adjusted under Code ss.416(i)(1) for Plan Years beginning after December 31, 2002), a 5-percent owner of the Employer, or a 1-percent owner of the Employer having annual compensation of more than $150,000. For purpose, annual compensation means compensation within the meaning of Code ss.415(c)(3). The determination of who is a Key Employee will be made in accordance with Code ss.416(i)(1) and the applicable regulations and other guidance of general applicability issued thereunder. 2.38 "Late Retirement Date" shall mean the first day of the month coinciding with or next following a Participant's delayed termination from Service after having reached his Normal Retirement Age. 2.39 "Non-Highly Compensated Employee" shall mean an Employee or former Employee who is not a Highly Compensated Employee. 2.40 "Non-Key Employee" shall mean any Employee or former Employee who is not a Key Employee, and any Beneficiary of a Non-Key Employee. 2.41 "Normal Retirement Age" of a Participant shall mean the later of the Participant's 65th birthday or the 5th anniversary of the date the Participant commenced participation in the Plan. 2.42 "Normal Retirement Benefit" shall mean a Participant's benefit earned for Service up to his Normal Retirement Age, and expressed in the form of an annual benefit commencing at his Normal Retirement Date. 2.43 "Normal Retirement Date" shall mean the first day of the month coincident with or next following the date a Participant attains his Normal Retirement Age, presuming he retires from Service upon attaining Normal Retirement Age. 11 2.44 "Participant" shall mean (i) an Employee who has met the eligibility requirements for participation in the Plan and who continues to participate ("Active Participant"), and (ii) a former Employee whose Accrued Benefit hereunder has not yet been fully distributed to him or forfeited under the terms of the Plan ("Inactive Participant"). 2.45 "Participating Employer" shall mean any entity that adopts the Plan in accordance with the provisions of Article XXI. 2.46 "Permissive Aggregation Group" shall mean the Required Aggregation Group of plans plus any other planes) of the Employer which, when considered as a group with the Required Aggregation Group, would continue to satisfy the requirements of Code ss.ss.401(a)(4) and 410. 2.47 "Plan" shall mean the defined benefit plan and trust as set forth in this document. 2.48 "Plan Year" shall mean the 12-month period beginning January 1 and ending December 31. 2.49 "Predecessor Plan" means the Employer's tax-qualified pension plan which has been restated in its entirety by this document. 2.50 "Pre-Retirement Survivor Annuity" shall mean an annuity payable for the life of the Participant's Spouse following the Participant's death prior to the Participant's Annuity Starting Date, in an amount determined as follows: (a) For a Participant dying after his Earliest Retirement Age (as defined in Article VI), the Pre-Retirement Survivor Annuity shall equal the survivor annuity portion of the Qualified Joint and Survivor Annuity payable if the Participant had begun to receive the Qualified Joint and Survivor Annuity the day before his death. (b) For a Participant dying on or before his Earliest Retirement Age (as defined in Article VI), the Pre-Retirement Survivor Annuity shall equal the survivor annuity portion of the Qualified Joint and Survivor Annuity payable under the Plan if the Participant had separated from service on the date of his death (or date of separation from Service, if earlier), had survived to his Earliest Retirement Age, had begun to receive the Qualified Joint and Survivor Annuity at such Earliest Retirement Age, and had died the day after attaining his Earliest Retirement Age. 2.51 "Qualified Joint and Survivor Annuity" means an annuity for the life of a Participant with a survivor annuity for the life of his Spouse which is 50% of the amount of the annuity payable during the joint lives of the Participant and his Spouse, and which is the Actuarial Equivalent of his Accrued Benefit payable in the form of a life annuity. 2.52 "Required Aggregation Group" shall mean each qualified plan of the Employer or any Affiliated Company, whether or not the plan is terminated, in which at least one Key 12 Employee participates (in the Plan Year containing the Determination Date or any of the four preceding Plan Years) and any other qualified plan of the Employer which enables any plan in which a Key Employee participates to meet the requirements of Code ss.ss.401(a)(4) or 410. 2.53 "Retirement Age" shall mean the date the Participant attains his Early or Normal Retirement Age as defined herein. 2.54 "Retirement Date" shall mean the Participant's effective date of retirement after attaining his Retirement Age. 2.55 "Retirement Plan" shall mean (i) any profit sharing, pension or stock bonus plan described in Code ss.ss.401(a) and 501(a), (ii) any annuity plan or annuity contract described in Code ss.ss.403(a) or 403(b), (iii) any qualified bond purchase plan described in Code ss.405(a), and (iv) any individual retirement account, individual retirement annuity or retirement bond described in Code ss.ss.408(a), 408(b) or 409. 2.56 "Rollover Contribution" shall mean: (a) an amount distributed to a Participant or directly to this Plan on his behalf in a distribution that qualifies under Code ss.402(c)(4) as an eligible rollover distribution; or (b) an amount which the Participant receives from an individual retirement account or individual retirement annuity in a distribution described in Code ss.408(d)(3)(A)(ii). An amount shall not qualify as a Rollover Contribution if it includes any after-tax contribution by the Participant or anyone else. 2.57 "Service" means any period of time the Employee is in the employ of the Employer, including any period the Employee is on a Leave of Absence (as defined in the Hour of Service definition herein). 2.58 "Service Credit" means an addition to a Participant's Account determined pursuant to subparagraph 5.3(b) or subparagraph 5.3(c), as applicable. 2.59 "Social Security Taxable Wage Base" means the contribution and benefit base in effect under Section 230 of the Social Security Act as of the first day of each Plan Year for which Service Credits are added to Accounts pursuant to Paragraph 5.3. 2.60 "Spouse" shall mean the spouse or surviving spouse of the Participant, except that a former spouse will be treated as the Spouse to the extent specifically provided under a Qualified Domestic Relations Order as defined in Paragraph 15.5 or to the extent required by law. 2.61 "Super Top Heavy" shall mean that for any Plan Year, the Plan is determined to be Top Heavy under any of the circumstances described in the definition of "Top Heavy" herein, except that the applicable Top Heavy Ratio exceeds 90%. 13 2.62 "Termination of Employment" shall mean termination of employment with the Employer other than by reason of a Participant's death, his becoming Disabled, or retirement after attaining Retirement Age. 2.63 "Top Heavy" shall mean that for any Plan Year: (a) this Plan is not a part of any Required Aggregation Group or Permissive Aggregation Group of plans, and the Top Heavy Ratio for this Plan exceeds 60%; (b) this Plan is a part of a Required Aggregation Group of plans but not a part of a Permissive Aggregation Group, and the Top Heavy Ratio for the Required Aggregation Group exceeds 60%; or (c) this Plan is a part of a Permissive Aggregation Group of plans and the Top Heavy Ratio for the Plan exceeds 60% and the Top Heavy Ratio for the Permissive Aggregation Group exceeds 60%. 2.64 "Top Heavy Compensation" means compensation as defined in Code ss.415(c)(3), including any amount that is excludable from the Employee's gross income under ss.ss.125, 402(e)(3), 402(b), 403(b), or, for Plan Years beginning on or after January 1, 2001, ss.132(f)(4). 2.65 "Top Heavy Ratio" shall mean the ratio determined as follows: (a) If the Employer maintains one or more defined benefit plans and the Employer has never maintained any defined contribution plan which has covered or could cover a Participant in this Plan, the Top Heavy Ratio is a fraction, the numerator of which is the sum of the present values of the accrued benefits of all Key Employees under such planes) as of the Determination Date (including any part of any accrued benefit distributed in the five year period ending on the Determination Date), and the denominator of which is the sum of the present values of the accrued benefits (including any part of any accrued benefit distributed in the five year period ending on the Determination Date) of all participants in such planes) as of the Determination Date. Both the numerator and denominator of the Top Heavy Ratio shall be adjusted to reflect any benefit which is accrued but unpaid as of the Determination Date. (b) If the Employer maintains one or more defined benefit plans and maintains or has maintained one or more defined contribution plans (including any Simplified Employee Pension Plan) which have covered or could cover a Participant in this Plan, the Top Heavy Ratio is a fraction, the numerator of which is the sum of the present values of the accrued benefits under the defined benefit planes) for all Key Employees and the sum of the account balances under the defined contribution planes) for all Key Employees as of the Determination Date, and the denominator of which is the sum of the present values of the accrued benefits under the defined benefit planes) for all Participants and the sum of the account balances under the defined contribution planes) for all Participants as of the Determination Date(s). Both the numerator and denominator of the Top Heavy Ratio are adjusted for any distribution of an 14 account balance or distribution of an accrued benefit made in the five year period ending on the Determination Date and any contribution due but unpaid as of the Determination Date. (c) For purposes of (a) and (b) above, the present value of a Participant's Accrued Benefit in this Plan and all other defined benefit plans included in the Required or Permissive Aggregation Group shall be determined (i) by taking into account all benefits derived from Employer and Employee contributions other than deductible employee contributions and (ii) by using the actuarial assumptions set forth in Paragraph 2.3. (d) For purposes of (a) and (b) above, the value of account balances and the Present Value of accrued benefits will be determined as of the most recent Valuation Date that falls within or ends with the twelve month period ending on the Determination Date. The account balances and accrued benefits of a Participant who is not a Key Employee but who was a Key Employee in a prior year will be disregarded. The account balances and accrued benefits of a participant who has not performed any service for the Employer at any time during the five year period ending on the Determination Date will be disregarded; however, if the participant returns to Service, his account balances and accrued benefits will again be considered. The calculation of the Top Heavy Ratio, and the extent to which distributions, rollovers, and transfers are taken into account will be made in accordance with Code ss.416. When aggregating plans the value of account balances and accrued benefits will be calculated with reference to the Determination Dates that fall within the same calendar year. Effective January 1, 1987, the accrued benefit of a Non-Key Employee shall be determined under the method that uniformly applies for accruing benefits under all defined benefit plans maintained by the Employer or any Affiliated Employer, and if none, as if such benefit accrued not more rapidly than the slowest accrual rate allowed under Code ss.411(b)(1)(C). (e) Determination of present values and amounts. This subparagraph (e) shall apply for purposes of determining the present values of Accrued Benefits and the amounts of account balances of employees as of the Determination Date. (1) Distributions during year ending on the Determination Date. The present values of Accrued Benefits and the amounts of account balances of an Employee as of the Determination Date shall be increased by the distributions made with respect to the Employee under the Plan and any plan aggregated with the Plan under Code ss.416(g)(2) during the 1-year period ending on the Determination Date. The preceding sentence shall also apply to distributions under a terminated plan which, had it not been terminated, would have been aggregated with the plan under Code ss.416(g)(2)(A)(i). In the case of a distribution made for a reason other than separation from Service, death, or disability, this provision shall be applied by substituting "5-year period" for 1-year period." (2) Employees not performing services during year ending on the Determination Date. The Accrued Benefits and accounts of any individual who has not performed services for the Employer during the 1-year period ending on the Determination Date shall not be taken into account. 15 2.66 "Top Heavy Year" shall mean a particular Plan Year for which the Plan has been determined to be Top Heavy and for which the benefit accrual and vesting requirements described in Code ss.416 and in this Plan must be met. 2.67 "Traditional Formula" means the formula, including minimum and supplemental amounts, used to determine a Participant's Accrued Benefit pursuant to Paragraph 5.2. 2.68 "Trust" shall mean the trust created by the Employer by establishing this Plan and thereby declaring the trust upon which the Trustee will receive, manage and administer contributions hereunder, which Trust is upon all the terms and conditions set out in this instrument. 2.69 "Trust Fund" shall mean all property of every kind held or acquired by the Trustee under the Plan. 2.70 "Trustee" or "Trustees" shall mean the person or persons named to act as trustees, and each duly appointed additional or successor Trustee or Trustees acting hereunder. 2.71 "Valuation Date" shall mean the first day of the Plan Year or any other day agreed upon by the Employer, Plan Administrator and Trustee. 2.72 "Vested" shall mean that portion of a Participant's Accrued Benefit which is nonforfeitable. 2.73 "Vesting Computation Period" shall mean the Plan Year or, for periods of Service prior to the Effective Date of the Plan, the same 12-month period as the Plan Year. 2.74 "Year of Creditable Service" shall mean an Accrual Computation Period during which the Employee completes 1000 Hours of Service. 2.75 "Year of Participation" shall mean an Accrual Computation Period commencing on or after the Effective Date of the Plan during which an Employee is a Participant and completes 1000 Hours of Service. 16 Article III ELIGIBILITY REQUIREMENTS 3.1 Eligibility Requirements and Participation. (a) Except as otherwise provided in this paragraph: (1) any Employee employed on the Restatement Effective Date who participated in the Predecessor Plan on the day before the Restatement Effective Date shall continue as a Participant in the Plan; (2) any other Employee employed on the Restatement Effective Date who has completed a Year of Service shall become a Participant as of the Restatement Effective Date, unless participation is specifically waived by the Employee; and (3) after the Restatement Effective Date, an Employee shall become a Participant (unless he specifically waives participation) as of the Entry Date coincident with or next following the date (prior to January 1, 2005, the Entry Date closest to the date) on which he satisfies the requirements described previously in this subparagraph (a), unless he is no longer employed on such date. (b) (1) Notwithstanding anything herein to the contrary, leased employees shall not be eligible to participate in this Plan. (2) Effective for Plan Years beginning after December 31, 1996, for purposes of this subparagraph (b), the term "leased employee" means any person (other than an Employee of the Employer) who pursuant to an agreement between the Employer and any other person ("leasing organization") has performed services for the Employer (or for the Employer and related persons determined in accordance with Code ss.414(n)(6)) on a substantially full-time basis for a period of at least 1 year, and such services are performed under the Employer's primary direction or control. (c) Notwithstanding the foregoing, no person who is included in a unit of employees covered by a collective bargaining agreement (as so determined by the Secretary of Labor) between employee representatives and the Employer shall be eligible to participate in the Plan if retirement benefits were the subject of good faith bargaining unless such collective bargaining agreement expressly provides for the inclusion of such persons as Participants. Any Participant who joins such unit as a member shall immediately cease to accrue benefits hereunder; however, his Service credited thereafter shall be counted for vesting purposes. (d) Notwithstanding any other provision of this Plan, individuals who are not contemporaneously classified as Employees of the Employer for purposes of the Employer's payroll system (including, without limitation, individuals employed by temporary help firms, technical help firms, staffing firms, professional employer organizations or other staffing firms whether or not deemed to be "common law" employees within the meaning of Code ss.414(n)) are 17 not considered to be eligible Employees of the Employer and shall not be eligible to participate in the Plan. In the event any such individuals are reclassified as Employees for any purpose, including, without limitation, common law or statutory employees, by any action of any third party, including, without limitation, any government agency, or as a result of any private lawsuit, action, or administrative proceeding, such individuals shall, notwithstanding such reclassification, remain ineligible for participation hereunder. In addition to and not in derogation of the foregoing, the exclusive means for individuals who are not contemporaneously classified as an Employee of the Employer on the Employer's payroll system to become eligible to participate in this Plan is through an amendment to this Plan, duly executed by the Employer, which specifically renders such individuals eligible for participation hereunder. 3.2 Year of Service. For purposes of determining an Employee's eligibility to participate, a "Year of Service" shall mean the Eligibility Computation Period during which the Employee completes at least 1000 Hours of Service. Except as may be provided in ensuing paragraphs of this Article, credit shall be given for Years of Service completed beginning with the first year the Employee was employed by the Employer. 3.3 Waiver. An Employee may, subject to the approval of the Employer, make an irrevocable election in writing not to participate in the Plan. 3.4 Participation and Service Upon Reemployment. (a) A reemployed Employee who previously separated from Service with a Vested benefit shall be eligible to resume participation effective as of his reemployment date. (b) A reemployed Employee who previously separated from Service prior to satisfying the eligibility requirements for participation shall commence participation on the Entry Date coinciding with or next following the date on which he meets such eligibility requirements, provided he is so employed on such Entry Date. For this subparagraph (b), all Years of Service shall be taken into account except those disregarded under subparagraph (e). (c) A reemployed Employee who had completed the eligibility requirements for participation but who previously separated from Service prior to becoming a Participant shall commence participation immediately upon his reemployment, unless his prior Service is disregarded under subparagraph (e). (d) A reemployed Employee who had participated in the Plan but separated from Service with no Vested benefit derived from Employer contributions shall be eligible to resume participation effective as of his reemployment date, unless his prior Service is disregarded under subparagraph (e). (e) For purposes of subparagraphs (b)-(d), an Employee's Years of Service before a period of at least 5 consecutive Breaks in Service shall be disregarded if the consecutive Breaks in Service exceed the aggregate number of the Participant's credited Years of Service before such Break period, and the Employee shall be considered a new Employee as of his 18 reemployment date. For purposes of this subparagraph (e), Years of Service not required to be taken into account by reason of any prior Break in Service shall be disregarded. 3.5 Forms Upon Eligibility. Each Employee who becomes eligible to participate in the Plan shall be notified of his eligibility and shall be provided with such information as is required by ERISA within the time prescribed for providing such information and forms for designating one or more Beneficiaries to receive benefits following the Employee's death. 3.6 Change in Status. (a) In the event a person who has been employed in a category of employment not eligible for participation in this Plan changes to covered employment, he shall become a Participant immediately upon his change in status, provided he has completed the eligibility requirements for participation. If he has not completed the eligibility requirements, he will become a Participant on the Entry Date coinciding with or next following the date he completes the eligibility requirements. (b) In the event a Participant who has been employed in covered employment changes to a category of employment not eligible for participation in the Plan, he shall continue to participate in the Plan and shall receive credit for benefit accrual purposes based upon such Participant's Compensation from the Employer and Hours of Service from the first day of the Plan Year up to the date of change from covered employment, provided such Participant completed the eligibility requirements under Paragraph 3.1, treating service with an Affiliated Company as Service with the Employer. In any subsequent Plan Year, such Participant shall not be eligible for further benefit accruals under the Plan, unless he returns to covered employment with the Employer. 3.7 Improper Omission or Inclusion of Participant. (a) If, for any Plan Year, an Employee who should be included as a Participant in the Plan is erroneously omitted and discovery of such error is not made until a later year, the Employee's status as a Participant shall be corrected and his Accrued Benefit and Vesting credited to him as if he had not been omitted. (b) If an Employee who is ineligible to participate in the Plan is erroneously included as a Participant, his Accrued Benefit for the period he is ineligible shall be treated as a Forfeiture in the year the error is discovered. 3.8 Service With Predecessor Employer. If the Employer maintains the plan of a predecessor employer, whether a corporation, partnership, sole proprietorship or other business entity, any period of service with such employer shall be treated as Service with the Employer for eligibility purposes. If the Plan is not the plan of a predecessor employer, service with such predecessor employer shall not be considered Service with the Employer, except to the extent required pursuant to Treasury regulations. 19 3.9 Special Credit for Certain Employees. (a) With respect to any Employee who was formerly employed on June 13, 1997 by Key Bank, N.A. ("Key") and who on that date became employed by the Employer, all of the Employee's Service with Key shall be treated as service with the Employer for purposes of determining his eligibility to participate in the Plan. Any such Employee who meets the service requirement specified in Paragraph 3.1 after taking into account such service shall commence participation on January 1, 1998. (b) With respect to any Employee who was formerly employed on July 18, 1997 by Fleet Bank ("Fleet") and who on that date became employed by the Employer, all of the Employee's Service with Fleet shall be treated as service with the Employer for purposes of determining his eligibility to participate in the Plan. Any such Employee who meets the service requirement specified in Paragraph 3.1 after taking into account such service shall commence participation on January 1, 1998. (c) With respect to Joseph Butler who was formerly employed on June 20, 1997 by Fleet and who on that date became employed by the Employer, all of the Employee's Service with Fleet shall be treated as service with the Employer for purposes of determining his eligibility to participate in the Plan. Provided that he meets the service requirement specified in Paragraph 3.1 after taking into account such service Joseph Butler shall commence participation on January 1, 1998. (d) With respect to Douglas Frank who was formerly employed on January 27, 1997 by Key and who on that date became employed by the Employer, all of the Employee's Service with Key shall be treated as service with the Employer for purposes of determining his eligibility to participate in the Plan. Provided that he meets the service requirement specified in Paragraph 3.1 after taking into account such service Douglas Frank shall commence participation on January 1, 1998. (e) With respect to Brian Aldrich who was formerly employed on June 26, 1997 by Key and who on that date became employed by the Employer, all of the Employee's Service with Key shall be treated as service with the Employer for purposes of determining his eligibility to participate in the Plan. Provided that he meets the service requirement specified in Paragraph 3.1 after taking into account such service Brian Aldrich shall commence participation on January 1, 1998. (f) With respect to any Employee who was formerly employed on July 8, 1996 by Benefit Plans Administrators ("BPA") and who on that date became employed by the Employer, all of the Employee's services with BPA shall be treated as Service with the Employer for purposes of determining his eligibility to participate in the Plan. (g) With respect to any Employee who was formerly employed on October 29, 1994 by Chase Bank at the branch located in Cato, New York ("Chase") and who on that date became employed by the Employer, all of the Employee's services with Chase shall be 20 treated as Service with the Employer for purposes of determining his eligibility to participate in the Plan. (h) With respect to any Employee who was formerly employed on July 15, 1995 by Chase Bank ("Chase") and who on that date became employed by the Employer, all of the Employee's services with Chase shall be treated as Service with the Employer for purposes of determining his eligibility to participate in the Plan. (i) With respect to any Employee who was formerly employed on January 26, 2001 by Citizens National Bank of Malone ("Citizens Bank") and who on that date became employed by the Employer, all of the Employee's services with Citizens Bank shall be treated as Service with the Employer for purposes of determining his eligibility to participate in the Plan. (j) With respect to any Employee who was formerly employed on November 16, 2001 by FleetBoston Financial Corporation Fleet National Bank ("FleetBoston") and who on that date became employed by the Employer, all of the Employee's services with FleetBoston shall be treated as Service with the Employer for purposes of determining his eligibility to participate in the Plan. (k) With respect to any Employee who was formerly employed on August 1, 2003 by PricewaterhouseCoopers, LLP ("PricewaterhouseCoopers") and who on that date became employed by the Employer, all of the Employee's service with PricewaterhouseCoopers shall be treated as service with the Employer for purposes of determining his eligibility to participate in this Plan. Any such Employee who meets the service requirement specified in Paragraph 3.1 after taking into account such service shall commence participation on August 1, 2003. (l) With respect to any Employee who was formerly employed on September 5, 2003 by Peoples Bankcorp, Inc. ("Peoples") and who on that date became employed by the Employer, all of the Employee's service with Peoples shall be treated as service with the Employer for purposes of determining his eligibility to participate in this Plan. Any such Employee who meets the service requirements specified in Paragraph 3.1 after taking into account such service shall commence participation on September 5, 2003. (m) With respect to any Employee who was formerly employed on November 22, 2003 by Grange National Banc Corp. ("Grange") and who on that date became employed by the Employer, all of the Employee's service with Grange shall be treated as service with the Employer for purposes of determining his eligibility to participate in this Plan. Any such Employee who meets the service requirement specified in Paragraph 3.1 after taking into account such service shall commence participation on November 22, 2003. (n) With respect to any Employee who was employed by First Heritage Bank ("First Heritage") on May 14, 2004, and who on that date became employed by the Employer, all of the Employee's service with First Heritage shall be treated as service with the Employer for purposes of determining the Employee's eligibility to participate in this Plan. An Employee who 21 meets the eligibility requirements specified in Paragraph 3.1 after taking into account such service shall commence participation in the Plan on May 14, 2004. (o) With respect to any Employee who was employed by HSBC Bank at its branch located in Dansville, New York ("HSBC") on December 3, 2004, and who on that date became employed by the Employer, all of the Employee's service with HSBC shall be treated as service with the Employer for purposes of determining the Employee's eligibility to participate in this Plan. An Employee who meets the eligibility requirements specified in Paragraph 3.1 after taking into account such service shall commence participation in the Plan on December 3, 2004. 3.10 Special Credit for Elias Employees. With respect to any Employee who was employed on April 3, 2000 by Elias Asset Management Incorporated ("Elias"), all of the Employee's Service with Elias shall be treated as service with the Employer for purposes of determining his eligibility to participate in this Plan. Any such Employee who meets the service requirement specified in Paragraph 3.1 after taking into account such Service shall commence participation on April 3, 2000. 22 Article IV CREDITED SERVICE FOR BENEFIT ACCRUAL 4.1 Benefit Accrual. (a) A Participant shall be credited with Service for benefit accrual purposes for each Year of Creditable Service he completes. (b) Except as otherwise specifically provided in the Plan, no employee of an Affiliated Company shall be credited with Service with the Employer with respect to any time period prior to the date the Affiliated Company became so affiliated with the Employer by reason of purchase, merger or otherwise. Without limiting the generality of the prior sentence, with respect to any Employee described in Paragraph 3.9, none of the Employee's service with any company prior to his employment by the Employer shall be taken into account for purposes of this Article. Notwithstanding the foregoing, for purposes of calculating a Participant's Years of Creditable Service and Accrued Benefit, both as of December 31, 1988, a Participant employed or formerly employed by Nichols Bank shall be credited with Service as if he were employed by the Employer from his hire date with Nichols Bank. 4.2 Service Limitations. (a) No more than one Year of Creditable Service shall be credited to a Participant with respect to any Accrual Computation Period. (b) No more than 35 Years of Creditable Service shall be credited to any Participant. 4.3 Loss of Service - Non-Vested Participants. In the case of a Participant who incurs a period of five or more consecutive One-Year Breaks in Service who did not have any Vested right to his Accrued Benefit derived from Employer contributions at his severance date and who subsequently resumes participation in the Plan, no Years of Creditable Service with the Employer before the Break in Service shall be taken into account in computing his Accrued Benefit if the number of consecutive One-Year Breaks in Service equals or exceeds the aggregate number of Years of Creditable Service before the Break. 4.4 Reinstatement of Creditable Service - Vested Participant. A Participant who, at the time he incurred one or more consecutive Breaks in Service, had a Vested right to his Accrued Benefit derived from Employer contributions, who is reemployed by the Employer and who resumes participation in the Plan, shall have his pre-Break Years of Creditable Service restored in determining his Accrued Benefit unless, after his employment termination, the Participant received a lump-sum distribution of his Vested Accrued Benefit and upon reemployment, failed to repay the distribution within the time period allowed and in accordance with Paragraph 7.7. 23 4.5 Retention of Service. The Accrued Benefit of a Participant who separates from Service after the Effective Date will not be reduced by termination of employment, absences from employment, or other Breaks in Service, except as provided under the terms of this Plan. 24 Article V RETIREMENT BENEFITS 5.1 Choice of Traditional Formula or Cash Balance Formula. (a) Each Participant who is classified by the Employer as an active Employee on October 1, 2004, may elect prior to November 1, 2004 either (1) to have the Participant's total Accrued Benefit determined under the Traditional Formula described in Paragraph 5.2 below, or (2) to have the Participant's Accrued Benefit determined under the Cash Balance Formula described in Paragraph 5.3 below. An eligible Participant who fails to make an affirmative election of either (1) or (2) above shall be deemed to have elected (2) above. An election or deemed election shall apply to all of the Participant's recognized service with the Employer, including recognized service rendered after a future break in service. (b) A Participant who was not classified by the Employer as an active Employee on October 1, 2004, but who thereafter returns to active employment shall have an Accrued Benefit equal to the sum of (1) the Participant's Accrued Benefit earned prior to October 1, 2004 under the Traditional Formula, plus (2) the Participant's Accrued Benefit earned after September 30, 2004 under the Cash Balance Formula. (c) An Employee who becomes a Participant after October 1, 2004 shall have an Accrued Benefit determined only under the Cash Balance Formula. (d) Except to the extent provided in subparagraph 5.3(e) (regarding certain supplemental cash balance benefits), in no event shall a Participant be entitled to benefits under both the Traditional Formula and the Cash Balance Formula for the same period of service. 5.2 Traditional Formula. (a) Normal Retirement Benefit. Subject to the provisions of Article XIV and the limitations under this Paragraph and Article VIII, a Participant who retires upon attaining his Normal Retirement Age and whose benefit is determined in whole or in part under the Traditional Formula (see Paragraph 5.1) shall be entitled to receive a Normal Retirement Benefit under the Traditional Formula equal to the greater of the amount described in (1) below or the amount described in (2) below: (1) (A) an amount equal to the Participant's Accrued Benefit earned as of December 31, 1988 under the terms of the Predecessor Plan as modified by the terms of subparagraph 5.2(b), disregarding all Service after December 31, 1988, but adjusted for anyone who completed one or more Hours of Service after December 31, 1988 for changes in Compensation after December 31, 1988 by multiplying such Accrued Benefit by a fraction (not less than 1.0), the numerator of which is his Average Annual Compensation as of the date the computation is performed, and the denominator of which is his Average Annual Compensation as of the Plan Year ending December 31, 1988; however, the Accrued Benefit, as so adjusted, of any Participant or Former Participant employed by Exchange National Bank or its predecessor 25 shall be reduced by his unadjusted accrued benefit earned prior to July 1, 1984 under the defined benefit pension plan sponsored by the Bank of New York; plus (B) an amount equal to .9% of his Average Annual Compensation, plus .65% of his Average Annual Compensation in excess of his Covered Compensation, multiplied by the Participant's Years of Creditable Service earned after December 31, 1988, not to exceed 35 years reduced by his total Years of Creditable Service earned prior to January 1, 1989. (2) An amount equal to .9% of his Average Annual Compensation, plus .65% of his Average Annual Compensation in excess of his Covered Compensation, multiplied by the Participant's total Years of Creditable Service, not to exceed 35 years. (3) Notwithstanding the foregoing, a Participant employed or formerly employed by Nichols Bank shall receive under the Traditional Formula the greater of the sum of the benefits under subparagraphs (a)(1) and (a)(2) above, or the Actuarial Equivalent of the Participant's Accrued Benefit to which his account balance in the former profit sharing plan sponsored by Nichols Bank was converted as of January 1, 1988. (4) Notwithstanding the foregoing, to the extent the Normal Retirement Benefit of a Participant employed or formerly employed by First Liberty Bank & Trust is determined under the Traditional Formula (see Paragraph 5.1) such benefit shall equal the sum of (A) the Participant's accrued benefit determined under the First Liberty Bank & Trust Retirement Plan as of December 31, 2001, plus (B) the benefit earned by the Participant after December 31, 2001 under subparagraph (a)(2) above (taking into account only Compensation and Years of Creditable Service earned by the Participant after December 31, 2001). (5) In applying the Traditional Formula, neither the Maximum Excess Allowance (as hereinafter defined) nor the Overall Permitted Disparity Limits (as hereinafter defined) may be exceeded in any Plan Year with respect to any Participant. Accordingly, at such time that a Participant's cumulative permitted disparity reaches the Participant's applicable limit calculated in accordance with Treas. Regs. ss.1.401(1)-5, then for each Year of Creditable Service thereafter, the formula under subparagraph (a)(2) shall be modified such that the Participant shall accrue a benefit at the rate of the Base Benefit Percentage times his Average Annual Compensation. (6) For all purposes under this Plan: (A) "Base Benefit Percentage" means the rate, expressed as a percentage, at which Employer-derived benefits are accrued with respect to that amount of a Participant's Average Annual Compensation that is at or below the Participant's Covered Compensation for the Plan Year. (B) "Covered Compensation" for each Participant for a Plan Year shall be the average of the taxable wage bases in effect under the Social Security Act for each calendar year during the 35-year period ending with the calendar year in which the 26 Participant attains or will attain his Social Security retirement age (as defined in Code ss.415(b)(8)), rounded to the nearest multiple of $600. For this purpose, the taxable wage base for all years after the year in which the determination is being made is assumed to be the same as the taxable wage base in effect for the year of determination. Covered Compensation for a participant after the 35-year period is the same as his Covered Compensation as of his Social Security retirement age. A Participant's Covered Compensation shall be automatically adjusted each Plan Year. (C) "Excess Benefit Percentage" means the rate, expressed as a percentage, at which Employer-derived benefits are accrued with respect to that amount of a Participant's Average Annual Compensation that is above the Participant's Covered Compensation for the Plan Year, which rate (except as otherwise provided herein) shall be 0.65%. (D) "Maximum Excess Allowance" means the maximum differential allowed under ss.404(1) and the regulations thereunder between the Base Benefit Percentage and the Excess Benefit Percentage. (E) "Overall Permitted Disparity Limits" means the cumulative permitted disparity applicable to a Participant's benefit accrued hereunder as of any Plan Year, which amount is based on the Participant's total Years of Creditable Service and calculated in accordance with ss.401(1) and the regulations thereunder. (7) Except as provided in subparagraph 5.2(b), the Employer intends that ss.401(l) and the regulations thereunder shall apply only to benefits that accrue in Plan Years beginning after December 31, 1988 and not to benefits that accrued under the Predecessor Plan as of December 31,1988, and the Plan shall be construed accordingly. (8) A Participant's Normal Retirement Benefit under the Traditional Formula shall not be less than his Accrued Benefit earned under that formula (as applicable) as of the date he attained Early Retirement Age. (9) For Plan Years that begin on or after January 1, 2004, a Participant's annual Normal Retirement Benefit under the Traditional Formula shall equal the greater of the Normal Retirement Benefit determined under subparagraph 5.2(a) or the following amount: Participant (by Employee ID No.) Amount -------------------- ------- 98744 $ 32,232 68051 $109,812 93083 $115,944 Any Active Participant $ 0 described in subparagraphs 3.9(k), (l), (m), (n), or (o) All other Active Participants $ 660 27 Notwithstanding the dollar amounts set forth above, no Normal Retirement Benefit shall exceed the limits set forth in Paragraph 8.1. (10) For Plan Years beginning on or after January 1, 2004, and subject to the limits set forth in Paragraph 8.1, the following Participants shall have their annual Normal Retirement Benefit under the Traditional Formula determined above under this subparagraph 5.2(a) increased by the following amounts: Participant (by Employee ID No.) Amount -------------------- ------- 4091 $ 6,302 3954 $15,045 (11) With respect to any Employee described in Section 3.9(k), (l), (m), (n) or (o), none of the Employee's service while employed by PricewaterhouseCoopers, LLP, Peoples Bankcorp, Inc., Grange National Banc Corp., First Heritage Bank or HSBC, as the case may be, shall be taken into account for any purpose of this Article. (b) For purposes of determining a Participant's Accrued Benefit earned as of December 31, 1988 ("Pre-1989 Accrued Benefit"), the terms of the Predecessor Plan shall be followed, except as modified by the following: (1) The Pre-1989 Accrued Benefit for each Employee or former employee of Exchange National Bank shall be determined by (A) combining the benefits earned by the Employee prior to July 1, 1984 under the defined benefit pension plan sponsored by the Bank of New York, with the benefits accrued by the Employee under the Predecessor Plan from July 1, 1984 through December 31, 1988, and (B) adjusting such benefit (if necessary) such that the Base Benefit Percentage is not less than 50% of the Excess Benefit Percentage under the Prior Plan. (2) The Pre-1989 Accrued Benefit for each Employee or former employee of Nichols Bank shall be determined as if the employee participated in the Predecessor Plan from his hire date at Nichols Bank. (c) Nonforfeitability of Normal Retirement Benefits. The Accrued Benefit of a Participant who while in Service attains his Normal Retirement Age prior to completing a period of 5 consecutive One-Year Breaks in Service shall become 100% nonforfeitable. 28 (d) Payment of Benefit. Unless the Participant selects a different form, the Participant's Normal Retirement Benefit shall be payable in the manner set forth in Paragraph 9.1. Payment shall commence on the Participant's Normal Retirement Date or as soon thereafter as administratively feasible. (e) Re-Employment. If a former Participant who is entitled to receive a Normal Retirement Benefit shall be reemployed, his Normal Retirement Benefit payments shall continue. 5.3 Cash Balance Formula. (a) The Accrued Benefit of a Participant to whom the Cash Balance Formula applies (see Paragraph 5.1) shall be based upon the Participant's Account balance, which Account balance shall be determined pursuant to this Paragraph 5.3. (b) A Participant who elected (pursuant to Paragraph 5.1) to have the Cash Balance Formula apply and who had an Accrued Benefit as of December 31, 2003 shall have an opening Account balance as of January 1, 2004 equal to the present value of the Participant's Accrued Benefit determined as of December 31, 2003 under the Traditional Formula as in effect on January 1, 2004 (determined without regard to the minimum benefit provisions of subparagraph 5.2(a)(9)), where present value for this purpose is determined by using an interest rate of 5.5% and the 1994 Group Annuity Reserve table (projected to 2002 and weighted equally for males and females). The Account of a Participant who elected (pursuant to Paragraph 5.1) to have the Cash Balance Formula apply and who completes at least 1000 Hours of Service during each Plan Year after December 31, 2003 shall be credited with a Service Credit as of the end of each subsequent Plan Year (beginning December 31, 2004) in accordance with the following table: ---------------------------------------------------------------------- Attained Age On December 31* Service Credit** --------------- ---------------- ---------------------------------------------------------------------- Under 22 5.00% ---------------------------------------------------------------------- 22 and 23 5.05% ---------------------------------------------------------------------- 24 and 25 5.10% ---------------------------------------------------------------------- 26 and 27 5.15% ---------------------------------------------------------------------- 28 and 29 5.20% ---------------------------------------------------------------------- 30 and 31 5.25% ---------------------------------------------------------------------- 32 and 33 5.30% ---------------------------------------------------------------------- 34 and 35 5.35% ---------------------------------------------------------------------- 36 and 37 5.40% ---------------------------------------------------------------------- 38 and 39 5.45% ---------------------------------------------------------------------- 40 and 41 5.50% ---------------------------------------------------------------------- 42 and 43 5.55% ---------------------------------------------------------------------- 44 and 45 5.60% ---------------------------------------------------------------------- 46 and 47 5.65% ---------------------------------------------------------------------- 48 and 49 5.70% ---------------------------------------------------------------------- 50 and 51 5.75% ---------------------------------------------------------------------- 29 ---------------------------------------------------------------------- Attained Age On December 31* Service Credit** --------------- ---------------- 52 and 53 5.80% ---------------------------------------------------------------------- 54 and 55 5.85% ---------------------------------------------------------------------- 56 and 57 5.90% ---------------------------------------------------------------------- 58 and 59 5.95% ---------------------------------------------------------------------- 60 and 61 6.00% ---------------------------------------------------------------------- 62 and 63 6.05% ---------------------------------------------------------------------- 64 and 65 6.10% ---------------------------------------------------------------------- Over 65 6.10% ---------------------------------------------------------------------- *or the last day of the Participant's employment, if the Participant's termination occurs prior to December 31. ---------------------------------------------------------------------- **Service Credits shall be applied to the sum of the Participant's total Compensation for the Plan Year, plus the portion of the Participant's total Compensation for the Plan Year that is in excess of the Social Security Taxable Wage in effect for the Plan Year. ---------------------------------------------------------------------- (c) The Account of a Participant to whom the Cash Balance Formula applies (see Paragraph 5.1) but who is not entitled to Service Credits pursuant to subparagraph (b) above shall be credited with a Service Credit as of the end of each Plan Year during which the Participant completes at least 1000 Hours of Service. The Service Credit, which will be added to the Participant's Account as of December 31 of each applicable Plan Year, shall equal five percent (5%) of the sum of the Participant's total Compensation for the Plan Year, plus the portion of the Participant's total Compensation for the Plan Year that is in excess of the Social Security Taxable Wage Base for the Plan Year. (d) (1) Notwithstanding the other provisions of this Paragraph 5.3, for Plan Years beginning on or after January 1, 2004, the annual Normal Retirement Benefit payable to the following Participants shall not be less than the following amounts, except as may be limited under Article VIII: Participant (by Employee ID No.) Minimum Benefit -------------------- --------------- 98840 $283,041 3952 $100,000 (2) Notwithstanding the other provisions of this Paragraph 5.3, the opening Account balance on January 1, 2004 for the Plan Participant with Employee ID No. 1026 shall be $153,548. (3) Notwithstanding the other provisions of this Paragraph 5.3, the Account balance on December 31, 2004 for the Plan Participant with Employee ID No. 3398 shall be $37,781. 30 (e) In addition to the Accrued Benefit determined pursuant to Paragraph 5.2 or the other provisions of Paragraph 5.3, each Participant identified below shall have a supplemental Account balance, as of October 1, 2004, determined as follows: Supplemental Account Participant Balance (by Employee ID No.) As of October 1, 2004 -------------------- --------------------- 4577 $ 23,943 98890 $ 20,095 98744 $ 22,315 1438 $ 23,613 908 $ 19,988 45999 $ 47,577 49575 $ 14,514 68051 $234,655 2996 $ 16,241 3398 $ 9,636 93083 $212,272 The supplemental Account balance provisions in this subparagraph (e) shall apply to each listed Participant regardless of the election (or deemed election) made by the Participant pursuant to Paragraph 5.1. The supplemental Account balance described in this subparagraph (e) shall not be increased by any Service Credits described in subparagraphs 5.3(b) or (c) or by the Interest Credit described in subparagraph 5.3(f). (f) Beginning December 31, 2004 and continuing on each December 31 thereafter until the Participant's employment ends, the Account of each Participant to whom the Cash Balance Formula applies shall be credited with an Interest Credit. The Interest Credit for Plan Years during employment shall equal six percent (6%) of the total balance credited to the Participant's Account as of January 1 of the same Plan Year. For the Plan Year during which the Participant's employment ends, the Interest Credit shall be six percent (6%), prorated based on months of employment, plus the lesser of six percent (6%) or the Interest Rate described in subparagraph 2.4(c)(1), prorated based on months between the date employment ends and December 31 of the Plan Year during which employment ends. The Interest Credit described in the preceding sentence shall be added to the Participant's Account as of December 31 of the Plan Year during which the Participant's employment ends. As of December 31 of each Plan Year that follows the Plan Year during which the Participant's employment ends, the Participant's Account will be credited with an Interest Credit equal to the lesser of six percent (6%) or the Interest Rate described in subparagraph 2.4(c)(1), times the amount credited to the Participant's Account as of January 1 of the same Plan Year. For the Plan Year during which the Participant's Account balance is withdrawn as a lump sum or converted to annuity payments, the Interest Credit described in the preceding sentence shall be prorated through the date of withdrawal or conversion. 31 (g) In no event will a Participant's benefit determined under the Cash Balance Formula (if applicable) be less than the benefit the Participant would have accrued under the Traditional Formula as of December 31, 2004. (h) Notwithstanding the above, the annual rate at which a Participant accrues future Normal Retirement Benefits under the Cash Balance Formula shall be limited to the extent necessary to ensure compliance with the applicable accrual rate rules described in Section 411 of the Code. 5.4 Accrued Benefits Attributable to Prior Mandatory Employee Contributions. (a) If under the terms of the Predecessor Plan a Participant made mandatory employee contributions, such Participant's Accrued Benefit as of any Valuation Date shall equal the greater of: (1) his Accrued Benefit; or (2) the benefit derived from the sum of his mandatory employee contributions accumulated with interest at the rate of 120% of the federal mid-term rate in effect in the month preceding payment under Code ss.1274. Upon distribution of a Participant's mandatory employee contributions plus interest, the Accrued Benefit of such Participant shall be reduced by that portion of the Accrued Benefit derived from that distributed amount. (b) Notwithstanding anything in this Plan to the contrary, a Participant shall at all times be 100% Vested in that portion of his Accrued Benefit derived from his or her mandatory employee contributions. 5.5 Early Retirement. (a) A Participant who retires after attaining his Early Retirement Age but prior to his Normal Retirement Age shall be entitled to receive an annual retirement benefit determined as follows: (1) If payment of such benefit commences at his Normal Retirement Date, the amount of the benefit shall be the Participant's Accrued Benefit, determined in accordance with the applicable provisions of Paragraph 5.2 and/or Paragraph 5.3 as of his Early Retirement Date. (2) If the Participant elects to receive payment of such benefit prior to his Normal Retirement Date, the amount of the benefit shall be his Accrued Benefit, reduced by 3.5% for each of the first 3 years by which his Annuity Starting Date precedes Age 65 and reduced by 5.5% for each of the next 7 years by which his Annuity Starting Date precedes Age 65. 32 (3) If a Participant who has satisfied the service requirement for Early Retirement under this paragraph separates from Service before satisfying the age requirement for Early Retirement, the Participant may elect, upon satisfying such age requirement, to receive an early retirement benefit equal to his Accrued Benefit in which he was Vested at the time of his Termination of Employment, subject to the same reduction as provided in subparagraph (a)(2). (b) Unless the Participant selects an optional form under Paragraph 9.3, a Participant's early retirement benefit shall be payable in the manner set forth in Paragraph 9.1(a). Payment shall commence as of the date elected by the Participant, or as soon thereafter as administratively feasible. (c) If a Participant who is receiving his early retirement benefit returns to Service prior to January 1, 2005, his benefit payments shall be suspended until he terminates Service or attains his Required Beginning Date, whichever occurs earlier. At such date, and at each subsequent Valuation Date if the Participant remains in Service after his Required Beginning Date, he shall be entitled to receive an annual benefit equal to his Accrued Benefit determined pursuant to the applicable provisions of Paragraph 5.2 and/or Paragraph 5.3 as of the date for which the calculation is being made, reduced actuarially by the value of benefit payments already made to the Participant; provided, however that to the extent the Participant repays the earlier distribution(s) in accordance with Paragraph Article XXI there shall be no actuarial reduction. After December 31, 2004, no benefit will be suspended upon reemployment, but any additional benefits earned during reemployment shall be reduced actuarially by the value of benefit payments made to the Participant. (d) Prohibition Against Reduction in Benefit. Notwithstanding any contrary provision contained in this Plan, no amendment to this Plan shall reduce or eliminate a Participant's early retirement benefit accrued prior to such restatement or amendment, determined as the day before its effective date. 5.6 Late Retirement. A Participant who remains in Service with the Employer after attaining his Normal Retirement Age shall have payment of benefits suspended until the earlier of his Late Retirement Date or his Required Beginning Date. At such date and each subsequent Valuation Date, the Participant shall be entitled to receive an annual benefit equal to the greater of (a) the Actuarial Equivalent of his Normal Retirement Benefit earned as of the date he attained his Normal Retirement Age, or (b) his Accrued Benefit earned through his Late Retirement Date using the applicable formula or formulas set out in Paragraph 5.2 and/or Paragraph 5.3 and any limitations described therein. The Participant's benefit determined under the foregoing shall be reduced actuarially to reflect the value of benefit payments previously made to the Participant hereunder. 5.7 Disability. (a) Disability Retirement Benefits. A Participant who terminates from Service because of his becoming Disabled prior to attaining his Normal Retirement Age shall be entitled to receive a retirement benefit ("Disability Retirement Benefit") determined as follows: 33 (1) If payment commences at his Normal Retirement Date, the amount of the benefit shall be the Participant's Vested Accrued Benefit determined under the applicable provisions of Paragraph 5.2 and/or Paragraph 5.3 by applying the relevant factors as of his Disability Retirement Date. (2) If the Participant elects to begin payment prior to his Normal Retirement Date, the amount of the benefit shall be the Actuarial Equivalent of the Participant's Vested Accrued Benefit determined under the applicable provisions of Paragraph 5.2 and/or Paragraph 5.3 based on the relevant factors as of his Disability Retirement Date. (b) Unless the Participant elects an optional form under Paragraph 9.3, or defers payment under Paragraph 9.1, his Disability Retirement Benefit shall be payable in the normal form in accordance with Paragraph 9.1(a). Payment shall commence on his Retirement Date or (if he so elects) on his Disability Retirement Date, or as soon thereafter as practicable. (c) If a Participant who is receiving or has received disability benefits under this Plan resumes Service, he shall resume participation in this Plan, and payments of his disability benefits shall cease. In addition, his Years of Creditable Service and Years of Vesting Service for the period prior to his becoming Disabled shall be reinstated, and he shall be treated in the same manner as any other rehired Employee, except that the Participant's Accrued Benefit shall be reduced actuarially by the value of the Participant's disability retirement benefits previously paid to him hereunder; provided, however, that no such reduction shall be applied to the extent the Participant repays the earlier distribution(s) received in accordance with the provisions of Paragraph 7.7. 5.8 Relation to Social Security Benefits. Increases in Social Security benefits or the Social Security Wage Base under Title II of the Social Security Act subsequent to a Participant's termination of employment or retirement shall not cause a reduction in benefits under this Plan. 5.9 Supplemental Retirement Benefit. Notwithstanding any other provision in this Plan, John A. Lanahan shall be entitled to receive a supplemental retirement benefit equal to $250.00 per month payable as a life annuity beginning at his Annuity Starting Date. Such benefit shall be in addition to any other benefits he may be entitled to under the terms of this Plan. Payment of such benefit shall be made in accordance with the terms of Article IX. 34 Article VI DEATH BENEFITS 6.1 Benefits Upon Death. (a) If a Participant (including any Inactive Participant) dies prior to his Annuity Starting Date at a time when he is not married on the date of his death, no death benefit shall be payable under this Plan with respect to such Participant, except to the extent provided in subparagraph (f) below. (b) If a married Participant (including any married Inactive Participant) who is Vested in any portion of his Accrued Benefit dies prior to his Earliest Retirement Age (as defined in subparagraph (c) below), a Pre-Retirement Survivor Annuity shall be payable to the Participant's Spouse. The Pre-Retirement Survivor Annuity cannot be waived, and no optional form of benefit shall be provided in lieu of the Pre-Retirement Survivor Annuity, except as provided in subparagraphs (e) and (f) below. (c) For purposes of this Article, "Earliest Retirement Age" means the earliest date on which the Participant can elect to receive retirement benefits under the Plan (disregarding disability retirement benefits), and administered (for purposes of this paragraph) as follows: (1) If a Participant dies or separates from Service before completing the service requirement for an Early Retirement Benefit hereunder, the Earliest Retirement Age is the date the Participant would have attained his Normal Retirement Age had he survived. (2) If a Participant dies or separates from Service after completing the service requirement for an Early Retirement Benefit hereunder, the Earliest Retirement Age is the earliest date the Participant could have retired and begun receiving his Early Retirement Benefit. (d) If retirement benefits have begun to be paid to the Participant and the Participant dies before his entire interest has been distributed to him, distribution shall continue to the Participant's Beneficiary in accordance with the terms of this Plan and the Participant's executed beneficiary designation (if in effect) and consistent with the method of payment selected by the Participant. Notwithstanding anything to the contrary in the Plan or any payment election made by a Participant, if distribution of the Participant's benefit has begun as of the time of the Participant's death as determined under Code ss.401(a)(9), the remaining benefit shall be distributed to his Beneficiary at least as rapidly as under the method of distribution in effect as of the date of the Participant's death. (e) Regardless of the normal form of benefit or any optional form chosen by the Participation or his Beneficiary, the Actuarial Equivalent of the Pre-Retirement Survivor Annuity shall be paid in a lump sum, without the consent of the Participant's Spouse, under the following circumstances: 35 (1) for Plan Years beginning before August 6, 1997, the single sum Actuarial Equivalent of such death benefit does not exceed $3,500 at the time of distribution; (2) for Plan Years beginning on or after August 6, 1997, the single sum Actuarial Equivalent of such death benefit does not exceed $5,000 at the time of distribution. Notwithstanding the foregoing, no distribution to the surviving Spouse may be made after the Annuity Starting Date unless the Spouse consents in writing to such distribution within the 90-day period preceding the date of distribution. (f) Notwithstanding the provisions of subparagraphs (a) and (b) above, to the extent the Cash Balance Formula and/or the provisions of subparagraph 5.2(a)(9) or (10) apply to a Participant at the time of his death, the provisions of this subparagraph (f) shall apply. (1) If a Participant dies prior to the Participant's Retirement Date, such Participant's Beneficiary shall receive a death benefit equal to the Actuarial Equivalent of the Accrued Benefit determined as of the date of death. (2) Death benefits payable by reason of the death of a Participant or a Retired Participant shall be paid to such Participant's Beneficiary in accordance with the following provisions: (A) Upon the death of a Participant subsequent to the Participant's Retirement Date, but prior to the Annuity Starting Date, the Participant's Beneficiary shall be entitled to a death benefit in an amount equal to the Actuarial Equivalent of the benefit the Participant would have received at the Participant's Retirement Date. (B) Upon the death of a Participant subsequent to the Annuity Starting Date, the Participant's Beneficiary shall be entitled to whatever death benefit may be available under the settlement arrangements pursuant to which the Participant's benefit is made payable. (C) In the event of a Terminated Participant's death subsequent to the Participant's termination of employment, the Participant's Beneficiary shall receive the Present Value of such Participant's Vested Accrued Benefit as of the date of the Participant's death. (3) The Administrator may require such proper proof of death and such evidence of the right of any person to receive the death benefit payable as a result of the death of a Participant as the Administrator may deem desirable. The Administrator's determination of death and the right of any person to receive payment shall be conclusive. (4) Unless otherwise elected in the manner prescribed in Paragraph 6.4, the Beneficiary of that portion of the death benefit necessary to fund the "minimum spouse's death benefit" shall be the Participant's surviving spouse, who shall receive such benefit in the 36 form of a Pre-Retirement Survivor Annuity. Except, however, the Participant may designate a Beneficiary other than the surviving spouse to receive the Actuarial Equivalent of the "minimum spouse's death benefit" if: (A) the Participant and the Participant's spouse have validly waived the Pre-Retirement Survivor Annuity in the manner prescribed in Paragraph 6.4, and the spouse has waived the right to be the Participant's Beneficiary, or (B) the Participant is legally separated or has been abandoned (within the meaning of local law) and the Participant has a court order to such effect (and there is no qualified domestic relations order which provides otherwise), or (C) the Participant has no spouse, or (D) the spouse cannot be located. In such event, the designation of a Beneficiary shall be made on a form satisfactory to the Administrator. A Participant may at any time revoke a designation of a Beneficiary or change a Beneficiary by filing written (or in such other form as permitted by the Internal Revenue Service) notice of such revocation or change with the Administrator. However, the Participant's spouse must again consent in writing (or in such other form as permitted by the Internal Revenue Service) to any change in Beneficiary of that portion of the death benefit that would otherwise be paid as a Pre-Retirement Survivor Annuity unless the original consent acknowledged that the spouse had the right to limit consent only to a specific Beneficiary and that the spouse voluntarily elected to relinquish such right. That portion of the death benefit remaining after the "minimum spouse's death benefit" shall be paid to the Participant's designated Beneficiary. In the event no valid designation of Beneficiary exists, or if the Beneficiary is not alive, at the time of the Participant's death, the death benefit shall be payable in accordance with Paragraph 6.6. Additionally, if the Beneficiary does not predecease the Participant, but dies prior to the distribution of the death benefit, the death benefit will be paid to the Beneficiary's estate. (5) The benefit payable under this subparagraph (f) shall be paid pursuant to the provisions of Article IX. (6) In no event shall the death benefit payable to a surviving spouse be less than the Actuarial Equivalent of the "minimum spouse's death benefit." (7) For the purposes of this Section, the "minimum spouse's death benefit" means a death benefit for a Vested married Participant payable in the form of a Pre-Retirement Survivor Annuity. Such annuity payments shall be equal to the amount which would be payable as a survivor annuity under the joint and survivor annuity provisions of the Plan if: (A) in the case of a Participant who dies after the Earliest Retirement Age, such Participant had retired with an immediate joint and survivor annuity on the day before the Participant's date of death, or 37 (B) in the case of a Participant who dies on or before the Earliest Retirement Age, such Participant had: (i) separated from service on the earlier of the actual time of separation or the date of death, (ii) survived to the Earliest Retirement Age, (iii) retired with an immediate joint and survivor annuity at the Earliest Retirement Age based on the Participant's Vested Accrued Benefit on date of death, and (iv) died on the day after the day on which said Participant would have attained the Earliest Retirement Age. (g) Inactive Participants who are not credited with an Hour of Service after August 22, 1984 shall be provided with rights to a pre-retirement survivor annuity in accordance with Section 303(e)(2) of the Retirement Equity Act of 1984 and not under the preceding terms of this paragraph. 6.2 Commencement of Payment. To the extent the Traditional Formula applies, unless a later date is elected by the Participant's Spouse, payment to the Spouse of the Pre-Retirement Survivor Annuity or the Actuarial Equivalent lump sum shall be made as soon as administratively feasible following the Participant's Earliest Retirement Age (as defined in Paragraph 6.1). To the extent the Cash Balance Formula applies, the Actuarial Equivalent of the Pre-Retirement Survivor Annuity or the balance credited to the Participant's Account shall be payable as soon as administratively feasible following the Administrator's receipt of the Spouse's and/or Beneficiary's election(s). Notwithstanding anything to the contrary herein, distribution of the Pre-Retirement Survivor Annuity to a surviving Spouse must commence on or before the later of: (1) December 31st of the calendar year immediately following the calendar year in which the Participant died; or (2) December 31st of the calendar year in which the Participant would have attained age 70 1/2 ("Required Beginning Date"). Distribution to a designated Beneficiary (who is not the Spouse) must be made by December 31st of the calendar year immediately following the calendar year during which the Participant died. 6.3 Notice of Right to Waive Pre-Retirement Survivor Annuity. The Administrator shall provide each Participant with a written explanation of the terms and conditions of the Pre-Retirement Survivor Annuity in a manner consistent with Treasury regulations within that of the following periods ending last: (a) the period beginning on the first day of the Plan Year in which the Participant attains age 32 and ending on the last day of the Plan Year in which the Participant attains age 34; (b) a reasonable period after he became a Participant; 38 (c) a reasonable period ending after Code ss.401(a)(11) first applies to the Participant; (d) a reasonable period after the Participant's termination of employment if the Participant's termination occurs prior to age 35. 6.4 Effective Waiver of Pre-Retirement Survivor Annuity. (a) Election Period. A waiver of a Pre-Retirement Survivor Annuity may be elected only during the period that begins on the first day of the Plan Year in which the Participant attains age 35 (or, if he separates from Service with the Employer prior to then, the date of separation) and ends on the date of his death. (b) Form of Election. The Participant's election shall be made in writing on a form prescribed by the Administrator. (c) Spousal Consent. The Participant's spouse must consent in writing to a Participant's election under this paragraph. Such consent shall acknowledge the effect of the election and shall be either notarized or witnessed by a Plan representative. (d) Revocation of Election; Subsequent Election(s). A Participant may revoke his election at any time during the election period and make one (1) or more subsequent elections at any time during the election period. A Spouse who consents to a Participant's election may not revoke his or her consent to the Participant's election. A subsequent election by the Participant resulting in a change of form of benefit must be consented to by the Spouse at the time the subsequent election is made. (e) Valid Election Without Consent. Notwithstanding anything herein to the contrary, a Participant's election under this paragraph shall be valid without the Spouse's consent if the Participant establishes to the satisfaction of the Plan Administrator that (1) the Participant is not married at the time of the election; (2) after all reasonable efforts by the Participant, the Spouse cannot be located; or (3) there exists other circumstances not requiring spousal consent, as provided under Treasury regulations. 6.5 Beneficiary Designation. Except as provided in subparagraph 6.1(f), no beneficiary other than the Participant's Spouse shall be entitled to receive death benefits payable by reason of a married Participant's death prior to his Annuity Starting Date. To the extent the Cash Balance Formula applies to a Participant who is not married at the time of his death prior to his Annuity Starting Date, death benefits shall be paid to the Beneficiary designated by the Participant. 39 6.6 No Beneficiary Designation. If a Participant fails to name a Beneficiary in accordance with Paragraph 6.5, or if all designated Beneficiaries predecease him or die before complete distribution of benefits, the Trustees shall pay the Participant's remaining benefits in one of the methods specified under Article IX in the following order of priority to: (a) the surviving Spouse; (b) surviving children, including adopted children, in equal shares; or (c) the legal representatives of the estate of the last to die of the Participant and his Beneficiary. 40 Article VII EMPLOYMENT TERMINATION BENEFITS 7.1 Termination of Employment. Any Participant who terminates from Service prior to attaining Retirement Age shall be entitled to receive the Vested portion of his Accrued Benefit in accordance with the terms of this Article. Vesting shall be determined under the following schedule, based on his Years of Vesting Service as of his termination date: (a) For those Participants hired on or after January 1, 1989: Years of Vesting Service Vested Percentage ------------------------ ----------------- Less than 5 0% 5 or more 100% (b) For those Participants hired before January 1, 1989 credited with at least 1 Hour of Service on or after January 1, 1989: Years of Vesting Service Vested Percentage ------------------------ ----------------- Less than 4 0% 4 40% 5 or more 100% If this Plan becomes Top Heavy, this vesting schedule shall be superceded by the vesting schedule set forth in Article XIV. 7.2 Vesting Service. (a) Except as otherwise provided in this paragraph, for purposes of Paragraph 7.1, a "Year of Vesting Service" shall mean any Vesting Computation Period during which the Participant completes at least 1000 Hours of Service with the Employer. Should an Employee's Eligibility Computation Period overlap two Vesting Computation Periods, and if such Employee completes 1000 Hours of Service in the Eligibility Computation Period but fails to complete 1000 Hours of Service in either of the overlapping Vesting Computation Periods, the Year of Service completed for eligibility purposes shall also be considered a Year of Vesting Service at the time the Employee becomes a Participant. (b) With respect to any Employee described in Paragraph 3.9, all of the Employee's service with Key Bank, N.A., Fleet Bank, Benefit Plans Administrators, Chase Bank, Citizens Bank, FleetBoston, Pricewaterhouse Coopers, LLP, Peoples Bankcorp, Inc., 41 Grange National Banc Corp., First Heritage Bank or HSBC, as the case may be, prior to such Employee's employment by the Employer shall be treated as Service with the Employer for purposes of determining his Vested interest in his Accrued Benefit under this Plan. (c) With respect to any Employee described in Paragraph 3.10, all of the Employee's service with Elias prior to April 3, 2000 shall be treated as Service with the Employer for purposes of determining his Vested interest in his Accrued Benefit under this Plan. 7.3 Break in Service. For purposes of this Article, a Participant shall incur a Break in Vesting Service if during any Vesting Computation Period he does not complete more than 500 Hours of Service with the Employer. 7.4 Determination of Years of Service for Vesting. All of the Participant's credited Years of Vesting Service with the Employer shall be taken into account in determining a Participant's Vested interest in the Plan, except as follows: (a) In the case of a Participant who has any One-Year Break in Service, Years of Vesting Service before such Break shall be disregarded until such Participant completes a Year of Vesting Service after his return to employment. (b) In the case of any Participant who incurs 5 or more consecutive One-Year Breaks in Service and who at the time of his Termination of Employment did not have a Vested right to any portion of his Accrued Benefit derived from Employer Contributions, Years of Vesting Service before such break shall be disregarded for purposes of vesting his Accrued Benefit that is earned after such break if the number of consecutive One-Year Breaks in Service equals or exceeds the number of Years of Vesting Service before such break. Such aggregate number of Years of Vesting Service before such break shall not include any Years of Vesting Service not required to be taken into account under this paragraph by reason of any prior Break in Service. (c) Years of Vesting Service after a period of 5 or more consecutive One-Year Breaks in Service shall be disregarded for purposes of determining the Participant's Vested interest in his Accrued Benefit that is earned before such break. (d) Notwithstanding (c) above, for the purpose of determining a reemployed Participant's Vested interest in his Accrued Benefit earned after such Participant's date of reemployment, if the Participant had a Vested interest in his then Accrued Benefit when his prior period of employment terminated, any Years of Vesting Service attributable to his prior period of employment shall not be disregarded and shall be reinstated as of the date of such Participant's reparticipation. 7.5 Forfeitures. (a) Forfeiture of any portion of a Participant's Accrued Benefit shall occur as of the date the Participant receives a lump sum distribution of his Vested Accrued Benefit following his Termination of Employment. A Participant who at his Termination of Employment 42 had no Vested right to his Accrued Benefit will be considered to have received a lump sum distribution of his entire Vested Accrued Benefit on the last day on which he performed an Hour of Service. (b) Forfeitures for any Plan Year shall be applied to reduce the Employer's contribution to the Trust for such Plan Year and succeeding Plan Years and shall not revert to the Employer except as otherwise permitted herein. 7.6 Payment of Vested Benefit. (a) To the extent the Traditional Formula applies, the Vested Accrued Benefit of a Participant who terminates employment prior to attaining Retirement Age shall become payable to the Participant, if living, in an Actuarial Equivalent amount as soon as administratively feasible following the date the Participant attains Retirement Age. Payment shall be made to the Participant in the normal form in accordance with Paragraph 9.1 or an optional form in accordance with Paragraph 9.3. (b) To the extent the Cash Balance Formula applies, the Vested Account balance of a Participant who terminates employment shall be payable to the Participant as soon as administratively feasible following the Administrator's receipt of appropriate election and consent forms. Payment shall be made in accordance with Article IX. (c) Notwithstanding subparagraphs (a) and (b), the single sum Actuarial Equivalent of the Participant's Vested Accrued Benefit shall be paid in a single sum as soon as practicable following his Termination of Employment without his consent or the consent of his Spouse under any of the following circumstances: (1) for distribution occurring in Plan Years beginning before August 6, 1997, the amount of such single sum did not exceed $3,500 at the time of distribution; (2) for distributions occurring in Plan Years beginning on or after August 6, 1997, the amount of such single sum does not exceed $5,000 at the time of distribution, regardless of the value of the Participant's Vested Accrued Benefit at the time of any earlier distribution; however, this subparagraph (2) shall not apply if a Participant has begun to receive distribution of his Vested Accrued Benefit and there is still payable at least one scheduled periodic distribution and the single sum present value of his Vested Accrued Benefit exceeded $5,000 at the time the earlier distribution began or was made. 7.7 Reemployment of Participant. If a former Participant who received a distribution returns to Service and repays the entire amount previously received, plus interest from the date of distribution at 120% of the Federal mid-term rate (in effect under Code ss.1274 for the first month of the Plan Year of payment) compounded annually, before the earlier of (i) the fifth anniversary of the Participant's Reemployment Date or (ii) the close of a period of 5 consecutive One-Year Breaks in Service commencing after distribution, his Accrued Benefit, Years of Creditable Service and Years of Vesting Service shall be restored to the levels at the time of his termination of employment. If the former Participant fails to repay the amount(s) plus 43 interest, his Accrued Benefit, Years of Creditable Service and Years of Vesting Service attributable to his pre-Break Service shall be fully restored, but his benefit payable upon his later termination from Service shall be reduced actuarially by the value of amounts previously paid. 44 Article VIII LIMITATION OF BENEFITS 8.1 Maximum Permissible Benefit. (a) Except as otherwise provided in this Article, a Participant's annual retirement benefit payable hereunder and expressed as a straight life annuity with no ancillary benefits (hereinafter referred to in this Article as the "Annual Benefit") shall not exceed the lesser of: (1) $160,000 ($90,000 for Limitation Years ending before January 1, 2002) multiplied by the Cost of Living Factor, and further multiplied by a fraction (not to exceed 1), the numerator of which is the Participant's Years of Participation, and the denominator of which is 10; or (2) 100% of the Participant's Compensation for his high three consecutive Years of Service, multiplied by a fraction (not to exceed 1), the numerator of which is all of his Years of Service, and the denominator of which is 10. For purposes of this paragraph, a Year of Service shall mean any Eligibility Computation Period, beginning on the Participant's first hire date or thereafter, during which the Participant completed 1000 Hours of Service. The limitation described in this subparagraph (a) shall be referred to in this Article as the Participant's "Maximum Permissible Benefit". (b) An Accrued Benefit payable in any form other than a straight life annuity shall be adjusted to an equivalent straight life annuity. For purposes of adjusting a benefit to an equivalent "annual benefit", the equivalent "annual benefit" shall be the greater of the Actuarial Equivalent of such "annual benefit" computed using the Plan interest rate and mortality table (as determined under Paragraph 2.3) and the equivalent "annual benefit" computed using 5% interest and the blended 1983 GAM table specified in Revenue Ruling 95-6, or such successor table as may be prescribed by the Secretary of the Treasury. If the benefit is paid in a form other than a nondecreasing life annuity payable for a period of not less than the life of the Participant or, in the case of a Pre-Retirement Survivor Annuity, the life of the surviving spouse, the annual interest rate on 30-year Treasury securities as published for the second full calendar month (the "Lookback Month") preceding the first day of the Plan Year (the "Stability Period") shall be substituted for 5% in the preceding sentence. As the Effective Date of the Plan is after the first day of the first Limitation Year beginning in 1995 (the "Retirement Protection Act of 1994 section 415 effective date"), all changes to Code ss.415(b)(2)(E) enacted in the Retirement Protection Act of 1994 shall apply to all benefit calculations hereunder. 8.2 Aggregation of Defined Benefit Plans. For purposes of this Article, all defined benefit plans maintained by the Employer shall be considered as a single plan. 45 8.3 Adjustments to Benefit Limitations. (a) Retirement Prior to Social Security Retirement Age. If a Participant's retirement benefit begins before the Participant's Social Security Retirement Age under the Social Security Act, the dollar limitation under Paragraph 8.1(a)(l) shall be reduced as follows: (1) If payment commences prior to age 62, reduction of the dollar limit under Paragraph 8.1(a)(1) shall be to the Actuarial Equivalent of such dollar limit beginning at age 62, reduced for each month by which benefits commence before the month the Participant attains age 62. The interest rate assumption used to determine the Actuarial Equivalent shall be the greater of 5% or the post-retirement interest rate described in Paragraph 2.3(b). (2) If payment commences on or after age 62 and the Participant's Social Security Retirement Age is 65, reduction of the dollar limit under Paragraph 8.1(a)(l) shall be 5/9 of 1 % for each month by which benefits commence before the month in which the Participant attains age 65. (3) If payment commences on or after age 62 and the Participant's Social Security Retirement Age is 66 or older, reduction of the dollar limit under Paragraph 8.1(a)(l) shall be 5/9 of 1% for each of the first 36 months and 5/12 of 1 % for each additional month (up to 24 months) by which benefits commence before the month of the Participant's Social Security Retirement Age. For Limitation Years ending after December 31, 2001, if a Participant's retirement benefit begins before the Participant attains age 62, the dollar limitation under Paragraph 8.1(a)(1) shall be reduced to the Actuarial Equivalent of such dollar limit beginning at age 62, reduced for each month by which benefits commence before the month the Participant attains age 62. The interest rate assumption used to determine the Actuarial Equivalent shall be the greater of 5% or the post-retirement interest rate described in Paragraph 2.3(b). (b) Retirement After Social Security Retirement Age. If the retirement benefit begins after the Participant's Social Security Retirement Age, the dollar limitation under Paragraph 8.1(a)(l) shall be increased so that it is the Actuarial Equivalent of the amount in such Paragraph 8.1 (a)(l) beginning at the Participant's Social Security Retirement Age, multiplied by the Cost of Living Factor. The interest rate assumption used to determine the Actuarial Equivalent shall not exceed 5%. For Limitation Years ending after December 31, 2001, if the retirement benefit begins on or after the Participant 66th birthday, the dollar limitation under Paragraph 8.1(a)(1) shall be increased so that it is the Actuarial Equivalent of the amount in such Paragraph 8.1(a)(1) beginning at age 66, multiplied by the Cost of Living Factor. The interest rate assumption used to determine the Actuarial Equivalent shall not exceed 5%. (c) No Anticipatory Adjustments. For purposes of adjusting the Annual Benefit under this paragraph, no adjustments shall be taken into account before the year for which such adjustment first takes effect. 46 8.4 Exception for Minimum Benefit. Notwithstanding the preceding provisions of this Article, the Participant's retirement benefit shall be deemed not to exceed the Maximum Permissible Benefit if (a) his Annual Benefit payable under this Plan and under all other Defined Benefit Plans sponsored by the Employer does not exceed $10,000, multiplied by a fraction (not to exceed 1) the numerator of which is all of his Years of Service (as defined in Paragraph 8.1(a)) and the denominator of which is 10; and (b) the Participant never participated in a Defined Contribution Plan maintained by the Employer. 8.5 Limitations for Defined Contribution Plans. Effective for Plan Years beginning on or after December 31, 1994, the Annual Additions for any Limitation Year for a Participant participating only in a Defined Contribution Plan maintained by the Employer shall not exceed the lesser of: (i) $30,000 multiplied by the applicable Cost of Living Factor, or (ii) 25% of the Participant's compensation as defined in Code ss.415(c)(3). 8.6 Limitation if Employer Maintains Defined Contribution Plan(s) in Addition to this Plan. For Plan Years beginning prior to January 1, 2000, if an Employee is or has ever been a Participant in one or more Defined Benefit Plans and one or more Defined Contribution Plans maintained by the Employer or any Affiliated Company, then for any Limitation Year the sum of the Participant's Defined Benefit Plan Fraction and Defined Contribution Plan Fraction may not exceed 1.0. If for any Limitation Year such sum would exceed 1.0, to the extent necessary to avoid such excess (a) the Participant's voluntary contributions which constitute Annual Additions to the Defined Contribution Plans of the Employer and any Affiliated Company and Participant voluntary contributions to this Plan shall be returned to him, and (b) the annual benefit which the Participant would accrue for such Limitation Year under this Plan shall be limited such that the sum of both fractions shall not exceed 1.0. 8.7 Definitions. For purposes of this Article, the following terms shall have the following meanings: (a) "Annual Additions" with respect to any Participant shall mean the sum of the following amounts allocated to the Participant's Account in a Defined Contribution Plan for a Limitation Year: (1) all Employer contributions; (2) all Employee contributions (excluding any Rollover Amount); (3) all forfeitures; plus (4) amounts described in Code ss.415(i)(1) and amounts described in Code ss.419(A)(d)(2), which are paid or accrued to a Key Employee, but only for determining whether the dollar limit in Paragraph 8.5 is exceeded. (b) "Limitation Year" shall mean the Employer's fiscal year or any other 12 consecutive month period the Employer, by written resolution, adopts for all plans of which it is the Employer. 47 (c) "Accounting Date" shall mean the date with respect to which the plan administrator allocates all or any portion of Employer contributions, Employee contributions, and Forfeitures (if any) to the Participants' Accounts. (d) "Highest average compensation" shall mean the average Compensation for the 3 consecutive years of service with the Employer that produces the highest average. (e) "Participant's Account" shall mean the account established and maintained for each Participant with respect to his total interest in the Defined Contribution Plan maintained by the Employer. (f) (1) "Compensation" for purposes of the limitations contained in this Article shall be the Participant's Compensation measured in relation to the Limitation Year, adjusted in accordance with Treas. Regs. ss.1.415-2(d)(2) and (3). (2) For Limitation Years beginning on and after January 1, 2001, for purposes of applying the limitations described in Paragraphs 8.1 and 8.5, Compensation paid or made available during such limitation years shall include elective amounts that are not includible in the gross income of the Employee by reason of Code ss.132(f)(4). (g) Social Security Retirement Age means: (1) age 65 for a Participant attaining age 62 before January 1, 2000; (2) age 66 for a Participant attaining age 62 after December 31, 1999 and before January 1, 2017; (3) age 67 for a Participant attaining age 62 after December 31, 2016. 48 Article IX PAYMENT OF BENEFITS 9.1 Form and Payment of Benefit. The retirement benefit payable to a Participant hereunder shall be paid in accordance with the following: (a) The normal form of benefit is, for a non-married Participant, a life annuity, and for a married Participant, a Qualified Joint and Survivor Annuity which is the Actuarial Equivalent of his Accrued Benefit payable in the form of a life annuity. Prior to distribution, the Administrator shall obtain the consent of the Participant and, if he is married, the Participant's Spouse, if required pursuant to Paragraph 9.9. (b) Subject to the terms of Paragraph 9.4, unless the Participant elects a later beginning date in writing, the Trustee shall commence distribution of a Participant's benefit not later than 60 days after the close of the Plan Year in which the latest of the following occurs: (1) The earlier of the Participant's Normal Retirement Date, or the date he attains age 65; (2) The tenth anniversary of the year in which the Participant commenced participation in the Plan; or (3) The date on which the Participant terminates Service with the Employer. (c) Notwithstanding the terms of subparagraph (a), a Participant may elect at any time during the 90-day period ending on his Annuity Starting Date to receive an optional form of benefit under Paragraph 9.3 or to select a non-Spouse Beneficiary, however, a married Participant must obtain the consent of his Spouse to either such election unless otherwise provided in this Article. 9.2 Notice of Right to Waive Normal Form and Select Optional Form. (a) Subject to the provisions of subparagraph (b) below, no less than 30 days nor more than 90 days before the Participant's Annuity Starting Date, the Administrator shall provide the Participant a written explanation of the terms and conditions of the normal form of benefit, including the Participant's right to make and the effect of an election to waive the normal form of benefit, the material features and relative values of the available optional forms of benefit, the rights of the Participant's Spouse regarding the waiver election, and the Participant's right to make and the effect of a revocation of a waiver election. (b) Effective for Plan Years beginning after December 31, 1996, the Participant may elect to begin receiving his benefits less than 30 days after the Participant receives the written explanation described in subparagraph (a) above, provided that: 49 (1) the Administrator clearly informs the Participant of the Participant's right to a period of at least 30 days after receipt of the explanation to consider the decision to receive his benefit and to elect an optional form; (2) the distribution does not begin before the end of the 7-day period that begins the day after the Participant's receipt of the written explanation; (3) the Participant affirmatively elects distribution after receipt of the notice; (4) the Participant is notified of his right to revoke his election prior to the end of the 7-day period described in subparagraph (b)(2) above and does not revoke his election within that time period; and (5) in accordance with Paragraph 9.5 his Spouse consents to the optional form chosen (if any) and to the waiver of the 30-day notice period. 9.3 Optional Forms of Benefit. (a) Participant's Waiver and Election of Optional Form. A Participant may elect, under the procedure described in Paragraph 9.5, to waive his normal form of benefit and select an Actuarial Equivalent form under one of the following options: (1) a life annuity, payable no less frequently than annually, with payments ending on the Participant's death; (2) a life annuity with 60 monthly payments guaranteed; (3) a joint life and last survivor annuity, with payments ending on the death of the survivor of the Participant and the contingent annuitant (Payments to the contingent annuitant shall be equal to 50%, 75% or 100% of the monthly amount paid to the Participants.); (4) a joint life and last survivor annuity, payable no less frequently than annually, with 60 monthly payments guaranteed; (5) to the extent the Cash Balance Formula applies, or subparagraph 5.2(a)(9), 5.2(a)(10), 5.3(d) or 5.3(e) applies, a single lump sum payment; and (6) with respect to any vested Participant who terminated employment for any reason after December 31, 2003 and before October 1, 2004, a single lump sum payment; provided that such a Participant must make the lump sum election by June 30, 2005. Eligible Participants who make the foregoing election and who previously commenced receipt of Plan benefits shall be considered to have a new Annuity Starting Date and shall have the elected lump sum payment reduced by the value of Plan benefits previously paid. 50 (b) Cash-Out. Notwithstanding the normal form of benefit or any optional form selected by the Participant, the Actuarial Equivalent of the Participant's Vested Accrued Benefit shall be paid in a single sum under any of the following circumstances: (1) for distribution occurring in Plan Years beginning before August 6, 1997, the amount of such single sum does not exceed $3,500 at the time of distribution; or (2) for distributions occurring in Plan Years beginning on or after August 6, 1997, the amount of such single sum does not exceed $5,000 at the time of distribution, regardless of the value of the Participant's Vested Accrued Benefit at the time of any earlier distribution; however, this subparagraph shall not apply if a Participant has begun to receive distribution of his Vested Accrued Benefit and there is still payable at least one scheduled periodic distribution and the single sum present value of his Vested Accrued Benefit exceeded $5,000 at the time the earlier distribution began or was made. Such distributions may be made without the consent of either the Participant or his Spouse; however, if distribution is to be made after the Annuity Starting Date, the Participant and his Spouse (or if the Participant has died, the surviving Spouse) must consent in writing to such distribution in accordance with Paragraph 9.9. (c) Selection of Form by Beneficiary. Following a Participant's death the Beneficiary may elect to receive his or her benefit under any of the options listed in subparagraph (a), unless the Participant irrevocably elects an optional form of benefit to be paid to his Beneficiary. (d) Alternate Form to Comply With Minimum Distribution Rules. No alternate form of benefit described in subparagraph (a) shall result in an annual payment to a Participant or his Beneficiary which fails to comply with the minimum distribution rules under Code ss.401(a)(9), as generally described in Paragraph 9.4. The Administrator shall, after consultation with the Participant (or his Beneficiary, as the case may be), modify such non-complying form to the extent necessary to conform the selected mode of payment to such rules. (e) Validity of ss.242(b)(2) Elections. Notwithstanding the foregoing provisions of this Article, the Administrator shall pay the Participant's retirement benefit in accordance with his timely written election which meets the requirements of ss.242(b)(2) of the Tax Equity and Fiscal Responsibility Act of 1982, provided that a married Participant's Spouse consents in writing to such election, which consent is either notarized or witnessed by a Plan representative. (f) Validity of Waiver. A Participant's waiver of the normal form of retirement benefit or pre-retirement death benefit and election of an optional form under this paragraph shall be valid only if executed in accordance with Paragraph 9.5. (g) Participant Consent to Early Distributions. No distribution of an optional form of benefit to the Participant (except a cash-out under subparagraph (b)) may be made without the Participant's prior consent, if required under the provisions of Paragraph 9.9. 51 9.4 Minimum Distribution Rules. (a) Benefits under this Plan shall be paid in a form that, as of the Required Beginning Date, satisfies the minimum distribution rules and minimum distribution incidental benefit rules under this paragraph, Code ss.401(a)(9) and Treas. Reg. ss. 1.401(a)(9)-2. If any provision of this Plan is inconsistent with Code ss.401(a)(9), the provisions of Code ss.401(a)(9) shall control. (b) The Administrator shall, after consultation with the Participant (or his Beneficiary, as the case may be), modify any noncomplying form of payment to the extent necessary to conform the selected mode of payment to such rules. (c) Without limiting the generality of the foregoing provisions of this paragraph, a Participant's Accrued Benefit payable to the Participant must be distributed: (1) in its entirety to the Participant on or before his Required Beginning Date, or (2) in two or more payments, beginning on or before his Required Beginning Date, over a period of time not extending beyond the Participant's life, the lives of the Participant and his Designated Beneficiary, the Participant's life expectancy, or the joint life and last survivor expectancy of the Participant and his Designated Beneficiary. (d) If the Participant dies prior to the date benefit payments have begun (determined in accordance with Code ss.401(a)(9)), the following rules apply: (1) With respect to benefits payable other than to a Designated Beneficiary, the benefits shall be distributed in their entirety by no later than December 31 of the calendar year in which occurs the fifth anniversary of the Participant's death; (2) The portion of the Participant's benefit payable to a Designated Beneficiary shall commence by December 31 of the calendar year immediately following the calendar year of the Participant's death, and shall be distributed in minimum amounts in accordance with Code ss.401(a)(9), over the life of the Designated Beneficiary or over a period not longer than the Designated Beneficiary's life expectancy as selected by the Designated Beneficiary. Alternatively, the Designated Beneficiary may irrevocably elect to receive all benefits by no later than December 31 of the calendar year containing the fifth anniversary of the Participant's death. Such election must be made by the earlier of: (A) December 31 of the calendar year in which distributions would, absent such election, be required to begin to the Designated Beneficiary; or (B) December 31 of the calendar year containing the fifth anniversary of the Participant's death. 52 Absent such election, payments shall be made over the life expectancy of the Designated Beneficiary, commencing by December 31 of the calendar year following the Participant's death. With respect to benefits payable to the surviving Spouse, payment need not commence until the later of (i) December 31 of the calendar year immediately following the calendar year of the Participant's death, or (ii) December 31 of the calendar year in which the Participant would have attained age 70 1/2. (e) Death of Participant After Payments Begin. If the Participant dies after the date benefit payments have begun (determined in accordance with Code ss.401(a)(9)), the balance of the Participant's benefit shall be distributed at least as rapidly as under the method of distribution in effect as of the date of his death. (f) Definitions. For purposes of this Article: (1) "Required Beginning Date" shall mean: (A) for a Participant who is a 5% owner (as determined under Code ss.401(a)(9)), the April 1 following the calendar year in which he attains age 70 1/2; and (B) effective for Plan Years beginning after December 31, 1996, for all other Participants, the April 1 following the later of (i) the calendar year in which he attains age 70 1/2 or (ii) the calendar year in which he retires. If the Participant becomes a 5% owner after attaining age 70 1/2, his Required Beginning Date shall be the April 1 immediately following the calendar year with or within which ends the Plan Year in which the Participant became a 5% owner. (2) "Designated Beneficiary" shall mean such person or entity named by the Participant or named pursuant to Paragraph 6.6 to receive benefits following the Participant's death, who (or which) qualifies as a "designated beneficiary" under Code ss.401(a)(9). (g) Effect of Disclaimer. Any Designated Beneficiary may disclaim all or any portion of the benefit to which the Designated Beneficiary is entitled at any time within 9 months following the Participant's death. Such disclaimed portion shall then be payable to such alternate Beneficiary designated by the Participant to receive the disclaimed portion, or in the absence of such contingent designation, to such individual(s), in the order of priority, designated in Paragraph 6.6. 9.5 Election Procedure-Qualified Waivers. (a) Election Period. A married Participant's waiver of a Qualified Joint and Survivor Annuity or an unmarried Participant's waiver of a straight life annuity may be elected only during the 90-day period ending on the Annuity Starting Date. (b) Form of Election. The Participant's election shall be made in writing on a form prescribed by the Administrator. 53 (c) Spousal Consent. No election of an optional form of benefit by a married Participant shall be effective without the written consent of the Participant's Spouse. Such consent shall acknowledge the effect of the election and shall be either notarized or witnessed by a Plan representative. (d) Revocation of Election; Subsequent Election(s). A Participant may revoke his election at any time during the applicable election period, and he or she may make one or more subsequent elections at any time during the applicable election period. A Spouse who consents to a Participant's election may not revoke his or her consent to that election. A subsequent election by the Participant resulting in a change of Beneficiary or form of benefit must be consented to by the Participant's Spouse at the time the subsequent election is made, unless the Spouse executed a general consent. Such consent must, in addition, acknowledge the specific non-spouse Beneficiary including any class of beneficiaries or any contingent Beneficiaries. (e) Valid Election Without Consent. Notwithstanding anything herein to the contrary, a Participant's election under this paragraph shall be valid without the Spouse's consent if the Participant establishes to the satisfaction of the Administrator that: (1) the Participant is not married at the time of the election; (2) after all reasonable efforts by the Participant, the Participant's Spouse cannot be located; or (3) there exists other circumstances not requiring spousal consent, as provided under Treasury regulations. 9.6 Qualified Domestic Relations Orders. For purposes of this Article and Article XV, to the extent provided in a Qualified Domestic Relations Order (as defined in Article XV), a Participant's Spouse or former Spouse who is entitled to any portion of the Participant's Accrued Benefit shall be treated as the Participant's Spouse or surviving Spouse, as the case may be, with respect to the portion of the Accrued Benefit to which he or she may be entitled under such Qualified Domestic Relations Order. With respect to the remaining portion (if any) of the Participant's Accrued Benefit, the Participant's former Spouse shall be treated as not married to the Participant. 9.7 Post-Distribution Credits. If after payment has commenced there shall be additional benefits accrued by a Participant, the Administrator shall direct adjustment of the remaining payments so as to include all such credited sums, as nearly evenly as possible, in the remaining payments. 9.8 Incompetency of Recipient. In the event of the incompetency of a Participant or Beneficiary at any time while he or she is entitled to receive benefits under the Plan, the Trustees, in their sole discretion, may pay such benefits to the legal representative of such incompetent or to such other person as the Trustees shall deem appropriate. 54 9.9 Required Consents. (a) (1) If the Participant's Vested Accrued Benefit cannot be distributed under Paragraphs 7.6(b) or 9.3(b), the Participant and the Participant's Spouse (or where either the Participant or the Spouse has died, the survivor) must consent to any distribution of the Vested Accrued Benefit. Such consent shall be obtained in writing within the 90-day period ending on the Annuity Starting Date. The Administrator shall notify the Participant and the Participant's Spouse of the right to defer any distribution until the Participant's Accrued Benefit is no longer immediately distributable. Such notification shall describe the material features and explain the relative values of the optional forms of benefit available under the Plan in a manner that would satisfy the notice requirements of Paragraph 9.2. The notice shall be provided no less than 30 days but no more than 90 days prior to the Annuity Starting Date, except as provided in subparagraph (a)(2) below. (2) The written explanation described in subparagraph (a)(1) may be provided after the Annuity Starting Date, in which case the 90-day election period shall not end before the 30th day after the date on which such explanation is provided. The Secretary may by regulations limit the period of time by which the Annuity Starting Date precedes the provision of the written explanation. A Participant may elect (with spousal consent if the Participant is married) to waive any requirement that the written explanation be provided at least 30 days before the Annuity Starting Date, and may waive the 30-day requirement under the foregoing provisions of this subparagraph, if the distribution commences more than 7 days after the explanation is provided. (b) Notwithstanding the foregoing, only the Participant need consent to the commencement of a distribution in the form of a Qualified Joint and Survivor Annuity while the benefit is immediately distributable. Neither the consent of the Participant or the Participant's Spouse shall be required to the extent that a distribution is required to satisfy Code ss.ss.401(a)(9) or 415. (c) A benefit is immediately distributable if any part of the benefit could be distributed to the Participant (or surviving Spouse) before the Participant attains (or would have attained had he not died) the later of his Normal Retirement Age or age 62. 9.10 Annuity Contracts. Any annuity form of distribution may be distributed to the annuitant in the form of an annuity contract, provided that such contract is by its terms non-transferable (except for surrender to the obligor under such contract). The terms of any such contract shall comply with the requirements of this Plan and, in the event of any conflict, the terms of this Plan shall control. 9.11 Loans to Participants. Loans to Participants or Beneficiaries shall not be allowed from this Plan. 55 9.12 Direct Rollover. (a) Rollover to Eligible Plan. Notwithstanding any contrary provision in this Plan, a Distributee may elect, at the time and in the manner prescribed by the Plan Administrator, to have any portion of an Eligible Rollover Distribution paid directly to an Eligible Retirement Plan specified by the Distributee in a Direct Rollover. (b) Definitions. For purposes of this paragraph: (1) "Eligible Rollover Distribution" means any distribution of all or any portion of the balance to the credit of the Distributee, except that an Eligible Rollover Distribution does not include: any distribution that is one of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the Distributee or the joint lives (or joint life expectancies) of the Distributee and the Distributee's designated beneficiary, or for a specified period of 10 years or more; any distribution to the extent such distribution is required under Code ss.401(a)(9); nor the portion of any distribution that is not includable in gross income (determined without regard to the exclusion for net unrealized appreciation with respect to employer securities). For distributions made after December 31, 2001, any amount that is distributed on account of hardship shall not be an eligible rollover distribution and the distribute may not elect to have any portion of such a distribution paid directly to an eligible retirement plan. (2) "Eligible Retirement Plan" means an individual retirement account described in Code ss.408(a), an individual retirement annuity described in Code ss.408(b), an annuity plan described in Code ss.403(a), or a qualified trust described in Code ss.401(a), that accepts the Distributee's Eligible Rollover Distribution. However, in the case of an Eligible Rollover Distribution to the surviving Spouse, an Eligible Retirement Plan is limited to an individual retirement account or individual retirement annuity. For distributions made after December 31, 2001, an eligible retirement plan shall also mean an annuity contract described in Code ss.403(b) and an eligible plan under Code ss.457(b) which is maintained by a state, political subdivision of a state, or any agency or instrumentality of a state or political subdivision of a state, and which agrees to separately account for amounts transferred into such plan from this Plan. The definition of eligible retirement plan shall also apply in the case of a distribution to a surviving spouse, or to a spouse or former spouse who is the alternative payee under a qualified domestic relation order, as defined in Code ss.414(p). (3) "Distributee" means an Employee or former Employee, his or her surviving Spouse, or his or her Spouse or former Spouse who is the Alternate Payee under a Qualified Domestic Relations Order (as defined in Paragraph 15.5) with regard to the interest of the Spouse or former Spouse. (4) "Direct Rollover" means a payment by the Plan to the Eligible Retirement Plan specified by the Distributee. 56 (c) Automatic Rollover. Effective as of March 28, 2005, absent an affirmative election by the Distributee, an Eligible Rollover Distribution of an amount in excess of $1,000 but not exceeding $5,000 which is required to be distributed to the Distributee without the consent of the Distributee (in accordance with the applicable terms of the Plan) shall be rolled over into an individual retirement plan, as defined in Code Section 7701(a)(37), established for the benefit of the Distributee. The establishment of the individual retirement plan shall comply with the requirements of 29 C.F.R. 2550.404a-2. Automatic rollovers from the Plan shall be administered in accordance with, and shall be subject to, the requirements of Code Sections 401(a)(31) and 402. 57 Article X CONTRIBUTIONS 10.1 Fund. The funding of the Plan and payment of the benefits hereunder will be provided through, and only through, the medium of a Trust Fund to which contributions shall be made by the Employer as provided herein, and which shall be held by the Trustee under the provisions of this Plan and Trust. This Plan confers no right to any Participant, Beneficiary or any other person claiming through such Participant or Beneficiary to any asset of the Employer to provide the benefits provided hereunder. 10.2 Employer Contributions. The Employer intends to make from time to time such contributions to the Trust Fund as determined necessary or appropriate by the Plan Administrator to fund the Plan in accordance with the minimum funding standards of the Code, and to make such contributions in periodic installments as may be required under ERISA or the Code. Administration expenses of the Plan, unless paid by the Employer, will be paid out of the assets of the Trust Fund. 10.3 Employee Contributions. No Participant shall be required or allowed to make contributions to the Trust. 10.4 Rollover Contribution. Rollover Contributions will not be accepted by the Plan. 58 Article XI EMPLOYER ADMINISTRATIVE PROVISIONS 11.1 Information to Administrator. The Employer shall supply current information to the Administrator as to the name, date of birth, date of employment, annual compensation, leaves of absences, Service and date of termination of employment of each Employee who is, or who will be eligible to become, a Participant under the Plan, together with any other information which the Administrator considers necessary. The Employer's records as to the current information the Employer furnishes to the Administrator shall be conclusive as to all persons. 11.2 No Liability. Except as specifically provided herein, the Employer assumes no obligation or responsibility to any of its Employees, Participants or Beneficiaries for any act or failure to act on the part of the Trustees or the Administrator. 11.3 Indemnity of Administrator. To the maximum extent not prohibited by law, the Employer shall indemnify and hold harmless the Administrator from and against any and all loss, liability or expense incurred by the Administrator by reason of any act or conduct (except that amounting to the Administrator's willful misconduct or gross negligence) in the administration of the Trust or Plan or both, including all expenses reasonably incurred in the Administrator's defense in case the Employer fails to provide such defense. 59 Article XII PARTICIPANT ADMINISTRATIVE PROVISIONS 12.1 Personal Data to Plan Administrator. Each person entitled to benefits hereunder must furnish to the Administrator such evidence, data or information as the Administrator considers necessary or desirable for the purpose of administering the Plan. The provisions of this Plan are effective for the benefit of each Participant upon the condition precedent that each Participant furnish promptly full, true and complete evidence, data and information when requested by the Administrator. 12.2 Address for Notification. Each Participant and each Beneficiary of a deceased Participant shall file with the Administrator from time to time, in writing, his post office address and any change of post office address. Any communication, statement or notice addressed to a Participant or Beneficiary at his last post office address filed with the Administrator, or as shown on the records of the Employer, shall bind the Participant, or Beneficiary, for all purposes of this Plan. 12.3 Assignment or Alienation. Except as permitted under the Code and/or ERISA, neither a Participant nor a Beneficiary shall transfer, assign or alienate any benefit provided under the Plan, nor shall such benefit be subject to attachment, execution, garnishment or other legal or equitable process, and the Trustee shall not recognize any such transfer, assignment, alienation, attachment, execution or legal or equitable process. 12.4 Litigation Against the Trust. If any legal action filed against the Trustee or the Administrator, or against any individual Administrator, by or on behalf of any Participant or Beneficiary, results adversely to the Participant or to the Beneficiary, the Trustee shall reimburse itself or the Administrator all costs and fees expended by it or him by surcharging, to the extent such surcharging is not prohibited by ERISA, all costs and fees against the sums payable under the Plan to the Participant or to the Beneficiary. 12.5 Denial of Claim. (a) If the Plan Administrator denies a claim in whole or in part, it shall send the claimant a written notice of the denial. (b) The Plan Administrator shall send the denial notice within 90 days after the date if receives a claim, unless it needs additional time to make its decision. In that case, the Plan Administrator may authorize an extension of up to an additional 90 days, if it notifies the claimant of the extension within the initial 90-day period. The extension notice shall state the reasons for the extension and the expected decision date. (c) The denial notice shall be written in a manner calculated to be understood by the claimant and shall contain: (1) The specific reason or reasons for the denial of the claim; 60 (2) Specific reference to pertinent Plan provisions on which the denial is based; (3) A description of any additional material or information necessary to perfect the claim, with an explanation of why the material or information is necessary; (4) An explanation of the review procedures provided by Section 12.6 and 12.7; and (5) A statement regarding the claimant's right to commence a civil action. 12.6 Request for Review of Denial. (a) Within 60 days after the claimant receives a denial notice, the claimant may file a request for review with the Plan Administrator. Any such request must be made in writing. (b) A claimant who timely requests review shall have the right to review documents affecting the claim, to submit additional information or written comments, and to be represented. 12.7 Review Decision. (a) The Plan Administrator shall send the claimant a written decision on any request for review that it receives. (b) The Plan Administrator shall send the review decision within 60 days after the date it receives a request for review, unless an extension of time is needed, due to special circumstances. In that case, the Plan Administrator may authorize an extension of up to an additional 60 days, provided it notifies the claimant of the extension within the initial 60-day period. (c) The review decision shall be written in a manner calculated to be understood by the claimant and shall contain: (1) The specific reason or reasons for the decision; (2) Specific reference to the pertinent Plan provisions on which the decision is based; and (3) A statement regarding the claimant's right to commence a civil action. (d) If the Plan Administrator does not send the claimant a review decision within the applicable time period, the claim shall be deemed denied on review. 61 (e) The review decision (including a deemed decision) shall be the final decision of the Plan. 62 Article XIII ADMINISTRATION 13.1 Appointment; Compensation. (a) The Employer shall appoint one or more persons (whether or not Participants) to act as Administrator. In the absence of such appointment, the Employer shall act as Administrator. (b) The Administrator shall serve without compensation, but the Employer shall pay all expenses of the Administrator including the expense for any bond required under ERISA. 13.2 Term. The Administrator shall serve until its successor is appointed. Any Administrator may resign upon 10 days' prior written notice. The Employer may remove any individual acting as Administrator at any time and, in its discretion, appoint a successor whenever a vacancy occurs. 13.3 Action During Vacancy. In case of a vacancy in the position of Administrator, the persons remaining to act as Administrator may exercise any and all of the powers, authority, duties and discretion conferred upon the Administrator pending the filling of the vacancy. 13.4 General Powers and Duties. The Administrator shall have the authority and responsibility to administer the Plan. The Administrator shall have all powers necessary or appropriate to administer the Plan, including, but not limited to the following: (a) to select a secretary, who need not be an individual; (b) to direct the Trustee as respects the crediting and distribution of the Trust fund; (c) to furnish the Employer with information required by the Employer for tax or other purposes; (d) to engage the service of actuaries, agents, accountants, attorneys, physicians or such other personnel, whom it may deem advisable to assist it with the performance of its duties; (e) to engage the services of an Investment Manager who shall have full power and authority to manage, acquire or dispose (or direct the Trustees with respect to acquisition or disposition) of any Plan asset under its control; (f) to be the sole and exclusive arbiter of all questions arising with respect to issues under the Plan as to coverage and eligibility, both as to participation and as to benefits and the amount thereof, including, without limitation, the determination of those individuals who are 63 deemed employees of the Employer (or any controlled group member). This Plan is to be construed to exclude all individuals who are not classified by the Employer as employees for purposes of the Employer's payroll system, and the Administrator is authorized to do so, despite the fact that its decision may result in the loss of the Plan's tax qualification; (g) to adopt rules of procedure and regulations as the Administrator deems desirable for the conduct of the administration of the Plan; (h) to interpret the terms of the Plan and the Administrator's rules and regulations, and to determine all questions arising in the administration, interpretation and application of the Plan; (i) to render and review decisions respecting claims for benefits and rights under the Plan; (j) to make factual determinations relating to the value of a Participant's Accrued Benefit and the right to receive such Accrued Benefit; (k) to determine whether a domestic relations order constitutes a Qualified Domestic Relations Order and whether a putative Alternate Payee otherwise qualifies for benefits hereunder; and (1) to correct any defect, supply any omission or reconcile any inconsistency, including but not limited to mathematical or arithmetical errors, in such manner and to such an extent as it shall deem necessary to carry out the purposes of this Plan. Any final decision by the Administrator shall be binding and conclusive on all parties concerned. The Administrator shall have absolute, exclusive, total and complete discretion in carrying out the Administrator's duties and responsibilities, and no decision by the Administrator shall be modified or overturned upon judicial review unless it was arbitrary and capricious or made in bad faith. 13.5 Funding Policy. The Administrator shall establish a funding policy and method consistent with the objectives of the Plan and the requirements of Title I of ERISA. The Administrator shall review, not less often than annually, all pertinent Employee information and Plan data in order to review the funding policy of the Plan and to determine the appropriate methods of carrying out the Plan's objectives. The Administrator shall communicate annually to the Trustee and to any Investment Manager the Plan's short-term and long-term financial needs so that investment policy can be coordinated with Plan financial requirements. 13.6 Manner of Action. The decision of a majority of persons acting as Administrator shall control. 13.7 Authorized Representative. The Administrator may authorize anyone of its members to sign on its behalf any notices, directions, applications, certificates, consents, 64 approvals, waivers, letters or other documents. The Administrator must evidence this authority by an instrument signed by all members and filed with the Trustees. 13.8 Interested Member. No Administrator may decide or determine any matter concerning the distribution, nature or method of settlement of his own benefits under the Plan, unless he is acting alone in the capacity of the Administrator. 13.9 Annual Statement. As soon as practicable after the Valuation Date of each Plan Year but within the time prescribed by ERISA and the regulations under the Act, the Plan Administrator shall deliver to each Participant (and to each Beneficiary) a statement reflecting his Accrued Benefit in the Plan as of such Valuation Date and such other information the Act required by ERISA to be furnished to the Participant or Beneficiary. 13.10 Unclaimed Benefit Procedure. (a) Neither the Trustees nor the Administrator shall be obliged to search for, or ascertain the whereabouts of, any Participant or Beneficiary. The Administrator, by certified or registered mail addressed to his last known address of record with the Administrator or the Employer, shall notify any Participant, or Beneficiary, that he is entitled to a distribution under this Plan, and the notice shall quote the provisions of this paragraph. (b) If the Participant or Beneficiary fails to claim his benefit or make his whereabouts known in writing to the Administrator within 6 months from the date of mailing of the notice or before this Plan is terminated or discontinued, whichever should first occur, the Administrator shall request a third party of the Administrator's choice to locate such Participant or Beneficiary. If after a 2-year period commencing from the date the Administrator notifies the Trustees that a Participant's Accrued Benefit is to be distributed, a Participant or his Beneficiary fails to claim his benefit, the Administrator may either treat as a Forfeiture, or permanently segregate such benefit for the Participant or Beneficiary in any manner acceptable under ERISA. (c) The forfeiture of a Participant's unclaimed benefit shall be subject to the right of the Participant (or, following the Participant's death, the Participant's Beneficiary) at any time to make a claim for such benefit. In the event a Participant or the Participant's Beneficiary claims such forfeited amount, the Employer shall contribute such additional amount to the Plan as is required to make complete distribution to the claimant, but if the Trust is not in existence, the Employer shall pay such amount directly to the claimant. 65 Article XIV TOP HEAVY REQUIREMENTS 14.1 General. If this Plan becomes Top Heavy with respect to any Plan Year, the requirements of this Article must be met, notwithstanding any other Plan provision to the contrary. The requirements of this Article will not apply, however, to Participants who have ceased employment with the Employer before the Plan becomes Top Heavy and who have not returned to employment with the Employer in a Top Heavy Year. 14.2 Minimum Benefits for Top Heavy Plan. (a) If the Employer does not maintain any qualified defined contribution plan, and if this Plan becomes Top Heavy, then a minimum Normal Retirement Benefit shall accrue for each Non-Key Employee Participant equal to 2% of his "average annual compensation", multiplied by the number of Years of Participation (not to exceed 10) earned as a Non-Key Employee Participant in Top Heavy Years ("Top Heavy Minimum Benefit"). For purposes of this Paragraph, "average annual compensation" shall be the average of the Participant's "415 Compensation" for such five consecutive Top Heavy Years that produce the highest average. "415 Compensation" shall mean compensation as defined in Treas. Regs. ss.1.415-2(d). The Plan meets this requirement if the Non-Key Employee's Accrued Benefit at the end of the Top Heavy Year is at least equal to the Top Heavy Minimum Benefit. For purposes of this paragraph, a Non-Key Employee Participant includes any Employee eligible to participate in the Plan and entitled to benefit accrual for the Plan Year but who does not participate solely because his Compensation does not exceed a specified level. For purposes of this paragraph, the Participant's Accrued Benefit and Top Heavy Minimum Benefit is expressed as a straight life annuity payable annually beginning at Normal Retirement Age. If, at the end of any Top Heavy Year, a Non-Key Employee Participant's Accrued Benefit is not at least equal to the Top Heavy Minimum Benefit, the Participant shall earn the additional accrual necessary to increase his Accrued Benefit to such Top Heavy Minimum Benefit. The Participant's Accrued Benefit shall never be less than the Top Heavy Minimum Benefit, regardless of whether the Plan is Top Heavy in Plan Years subsequent to a Top Heavy Year. The Employer shall not impute Social Security benefits to determine whether it has satisfied its obligation to provide the Top Heavy Minimum Benefit, nor shall the Plan offset a Participant's Social Security Benefit against his Top Heavy Minimum Benefit. The provisions of this subparagraph (a) shall not apply to any Participant to the extent the Participant is covered under any other defined benefit plan of the Employer and the Employer has provided in such other plan the Top Heavy Minimum Benefit. 66 For Plan Years beginning after December 31, 2001, if this Plan is frozen, for purposes of satisfying the minimum benefit requirements of Code ss.416(c)(1) and the Plan, in determining Years of Service with the Employer, any service with the Employer shall be disregarded to the extent that such service occurs during a Plan Year when the Plan benefits (within the meaning of Code ss.410(b)) no Key Employee or former Key Employee. (b) If the Employer maintains, in addition to this Plan, any qualified defined contribution plan which is part of a Required or Permissive Aggregation Group, and a Non-Key Employee participates in both plans, the Non-Key Employee shall be entitled to the top heavy minimum benefit under this Plan. (c) The minimum benefit provided for a Participant under this paragraph (to the extent such benefit is Vested) shall not be treated as forfeitable solely because the Plan provides (i) that the payment of benefits is suspended for such period as the Employee is employed, subsequent to the commencement of payment of such benefits, or (ii) that, in the case of a Participant who does not have a Vested right to at least 50% of his Accrued Benefit derived from Employer contributions, such Accrued Benefit may be forfeited on account of the withdrawal by the Participant of any amount attributable to the benefit derived from mandatory contributions made by such Participant. 14.3 Combined Plan Limits in Top Heavy Years. (a) If for any Plan Year the Plan is Super Top Heavy, then for purposes of the limitations on contributions and benefits under Code ss.415 as described in Article V, the dollar limitations in the denominators of the Defined Benefit Plan Fraction and the Defined Contribution Plan Fraction shall be multiplied by 100% rather than 125% (as otherwise stated in the definitions of such Fractions in Article II). The foregoing shall not apply in Plan Years beginning after December 31, 1999. (b) If reduction of the multiplier in the Defined Benefit and Defined Contribution Plan Fractions from 125% to 100% would cause a Participant to exceed the combined Code ss.415 limitations on contributions and benefits, then the application of the provisions of Paragraph 14.2 shall be suspended as to such Participant until such time as he no longer exceeds the combined Code ss.415 limits. During the period of such suspension, there shall be no Employer contributions allocated to such Participant under this Plan. The foregoing shall not apply in Plan Years beginning after December 31, 1999. 14.4 Top Heavy Vesting. Notwithstanding anything to the contrary in Article VII, the following vesting schedule shall apply in any Top Heavy Year for any Participant who is credited with an Hour of Service after the Plan becomes Top Heavy: 67 Years of Vesting Service Vested Percentage --------------- ----------------- Less than 3 0% 3 or more 100% If following a Top Heavy Year this Plan ceases to be Top Heavy, a Participant's Vested percentage of his Accrued Benefit shall be determined under the schedule in Paragraph 7.1, subject to the Participant's right of election under Paragraph 19.3. No change in the Plan's Top Heavy status which alters the Plan's vesting schedule shall reduce a Participant's Vested percentage of his Accrued Benefit as determined immediately prior to the effective date of such change. 68 Article XV QUALIFIED DOMESTIC RELATIONS ORDERS 15.1 Payment of Benefits to Alternate Payee. Notwithstanding the prohibitions contained in Paragraph 12.3, all or a portion of a Participant's Accrued Benefit shall be paid to one or more Alternate Payees in accordance with the terms of a Qualified Domestic Relations Order entered into on or after January 1, 1985. 15.2 Determination of Qualified Status. (a) Initial Notice. Within 30 days following receipt of any domestic relations order, or within such other time period as may be prescribed by Treasury regulations, the Administrator shall notify the Participant and each Alternate Payee in writing of its receipt and shall provide a copy of the Administrator's procedures as outlined below for determining if such order qualifies as a Qualified Domestic Relations Order. (b) Notice of Determination. Within 90 days following the Administrator's initial notice described in subparagraph (a) above, the Administrator shall notify the Participant and each Alternate Payee in writing of its determination whether the proposed order is qualified. If the order is denied qualified status, the Administrator shall list the specific reasons therefor. Whether or not the order is determined to be qualified, the Administrator shall notify the Participant and each Alternate Payee of their right to appeal such determination within 60 days after receipt of the determination, and that failure to appeal such determination in writing within the 60-day period will render such determination final, binding and conclusive. The Administrator's notice shall identify the name of the Administrator and the address to which appeal is to be forwarded. (c) Appeal. If a Participant or Alternate Payee should appeal the Administrator's decision, he may submit in writing all pertinent issues and comments and may review pertinent Plan documents. The Administrator shall re-examine all facts related to the appeal and make a final determination as to whether the initial determination is justified under the circumstances. The Administrator shall notify the appellant of the Administrator's decision within such time period as provided in rules adopted by the Administrator. 15.3 Authorized Representative. An Alternate Payee may designate an authorized representative to receive copies of all notices with respect to the payment of benefits or claim for such payment under a domestic relations order. The Alternate Payee shall notify the Administrator of such designation in writing, which shall be effective upon its receipt by the Administrator. 15.4 Transition Rule. In the case of a domestic relations order entered into before January 1, 1985, the Administrator shall treat such order as a Qualified Domestic Relations Order if benefits pursuant to such order are in pay status on January 1, 1985. In addition, the Administrator, in its sole discretion, may treat any other order entered into before January 1, 69 1985 as a Qualified Domestic Relations Order notwithstanding its failure to meet all the requirements for qualification under Code ss.4l4(p). 15.5 Definitions. (a) "Qualified Domestic Relations Order" shall mean a domestic relations order that meets the requirements of Code ss.4l4(p). (b) "Domestic relations order" shall mean any judgment, decree or order, including approval of a property settlement agreement, which relates to the provision of child support, alimony payments, or marital property rights of a Spouse, former Spouse, child or other dependent of a Participant, and which is made pursuant to a state domestic relations law (including community property law). (c) "Alternate Payee" shall mean a Spouse, former Spouse, child or other dependent of a Participant who is recognized by a domestic relations order as entitled to receive all or a portion of the benefits payable under a qualified plan with respect to the Participant. 15.6 Method and Timing of Distribution. (a) Distribution of benefits to an Alternate Payee specified in a Qualified Domestic Relations Order shall be in any optional form of distribution allowable under this Plan. (b) A domestic relations order which requires payment to an Alternate Payee prior to the Participant's "earliest retirement age" as defined in Code ss.4l4(p)(4)(B) shall be allowable under this Plan. 70 Article XVI TRUSTEE POWERS AND DUTIES 16.1 Acceptance. The Trustees accept the Trust created under the Plan and agree to perform the obligations imposed upon them hereunder. The Trustees shall provide bond for the faithful performance of their duties under the Trust to the extent required by ERISA. 16.2 Receipt of Contributions. The Trustees shall be accountable to the Employer for the funds contributed to the Trust by the Employer, but shall have no duty to see that the contributions received comply with the provisions of the Plan. The Trustees shall not be obligated to collect any contributions from the Employer, nor be obligated to see that funds deposited in the Trust are deposited according to the provisions of the Plan. 16.3 Full Investment Powers. The Trustees shall have full discretion and authority with regard to the investment of the Trust Fund, except with respect to a Plan asset under the control or direction of a properly appointed Investment Manager. The Trustees shall coordinate their investment policy with the financial needs of the Plan as communicated to the Trustees by the Administrator. The Trustees are authorized and empowered, but not by way of limitation, with the following powers, rights and duties with respect to the Trust Fund: (a) to invest any or all of the Trust Fund in any common or preferred stocks, bonds (including United States retirement plan bonds), insurance contracts, mortgages, notes or other property of any kind, real or personal, as a prudent man would do under like circumstances with due regard for the purposes of this Plan; (b) to retain in cash so much as the Trustees may deem advisable to satisfy liquidity needs of the Plan and to deposit any cash in a bank account without liability for the highest rate of interest available; (c) to manage, sell, contract to sell, grant options to purchase, convey, exchange, transfer, abandon, improve, repair, insure, lease for any term even though commencing in the future or extending beyond the term of the Trust, and otherwise deal with all property, real or personal, in such manner, for such consideration and on such terms and conditions as the Trustees shall decide; (d) to credit and distribute the Trust as directed by the Administrator. The Trustees shall not be obliged to inquire as to whether the distribution is proper or within the terms of the Plan, or as to the manner of making any payment or distribution. The Trustees shall be accountable only to the Administrator for any payment or distribution made by it in good faith on the order or direction of the Administrator; (e) to borrow money, to assume indebtedness, extend mortgages and encumber by mortgage or pledge; 71 (f) to compromise, contest, arbitrate or abandon claims and demands, in their discretion; (g) to have all of the rights of an individual owner, including the power to give proxies, to participate in any voting trusts, mergers, consolidations or liquidations, and to exercise or sell stock subscriptions or conversion rights; (h) to hold any securities or other property in the name of the Trustees or their nominee, or in another form as they may deem best, with or without disclosing the trust relationship; (i) to perform any and all other acts in their judgment necessary or appropriate for the proper and advantageous management, investment and distribution of the Trust; (j) to retain any funds or property subject to any dispute without liability for the payment of interest, and to decline to make payment or delivery of the funds or property until final adjudication is made by a court of competent jurisdiction; (k) to apply for one or more insurance contracts and to pay to the insurer in accordance with such insurance contract(s) and otherwise to act as contractholder under such insurance contract(s). (1) to file all required tax returns; and (m) to begin, maintain or defend any litigation necessary in connection with the administration of the Plan. 16.4 Accounting. Upon request by the Administrator within 60 days after the later of the Anniversary Date or receipt of the Employer's contribution for the Fiscal Year, the Trustees shall furnish to the Employer and Administrator a written statement of account with respect to the Fiscal Year for which such contribution was made, and any prior period for which the Trustees have not provided an accounting, setting forth: (a) the net income or loss of the Trust Fund; (b) the gains or losses realized by the Trust Fund upon sales or other disposition of the assets; (c) the increase or decrease in the value of the Trust Fund; (d) all payments and distributions made from the Trust Fund; and (e) such further information as the Trustees and/or Administrator deems appropriate. The Employer, forthwith upon its receipt of each such statement of account, shall acknowledge receipt thereof in writing and advise the Trustees and/or Administrator of its 72 approval or disapproval thereof. Failure by the Employer to disapprove any such statement of account within a reasonable period after its receipt thereof shall be deemed an approval thereof. The approval by the Employer of any statement of accounting shall be binding as to all matters embraced therein as between the Employer and the Trustees to the same extent as if the account of the Trustee has been settled by judgment or decree in an action for a judicial settlement of its account in a court of competent jurisdiction in which the Trustees, the Employer and all persons having or claiming an interest in the Plan were parties; provided, however, that nothing herein contained shall deprive the Trustees of their right to have the accounts judicially settled if the Trustees so desire. 16.5 Records and Statements. The Trustees' records shall be open to the inspection of the Administrator and the Employer at all reasonable times and may be audited from time to time by any person(s) as the Administrator may specify in writing. The Trustees shall furnish the Administrator with whatever information relating to the Trust Fund the Administrator considers necessary. 16.6 Fees and Expenses From Fund. The Trustees shall receive annual compensation as may be agreed upon from time to time between the Employer and the Trustees; however, no person who is receiving full pay from the Employer shall receive compensation for services as Trustee. The Trustees shall pay all expenses reasonably incurred by them in their administration of the Plan from the Trust Fund unless the Employer pays the expenses. 16.7 Parties to Litigation. Except as otherwise provided by ERISA, only the Employer, the Administrator, and the Trustees shall be necessary parties to any court proceeding involving the Trust or the Trust Fund. No Participant or Beneficiary shall be entitled to any notice of process unless required by ERISA. Any final judgment entered in any proceeding shall be conclusive upon the Employer, the Administrator, the Trustees, Participants and Beneficiaries. 16.8 Professional Agents. The Trustees may employ and reasonably compensate from the Trust Fund such agents, attorneys, accountants and other persons to advise the Trustees as in their opinion may be necessary and may act or refrain from acting on such advice. The Trustees may delegate to any person any such power or duty vested in them by the Plan to the extent not prohibited by ERISA. 16.9 Third Party. No person dealing with the Trustees shall be obligated to see to the proper application of any money paid or property delivered to the Trustees, or to inquire whether the Trustees have acted pursuant to any of the terms of the Plan. Each person dealing with the Trustees may act upon any notice, request or representation in writing by the Trustees, or by the Trustees' duly authorized agent, and shall not be liable to any person whomsoever in so doing. The certificate of the Trustees that they are acting in accordance with the Plan shall be conclusive in favor of any third person relying on the certificate. 73 16.10 Resignation, Removal and Appointment of Trustee. (a) A Trustee may resign at any time by giving 30 days' written notice in advance to the Employer and to the Administrator. (b) The Employer may remove any Trustee upon written notice to such Trustee. (c) The Employer may appoint additional or successor Trustees at any time by giving written notice to such persons. Each additional or successor Trustee shall succeed to the title to the Trust by accepting in writing his appointment as Trustee and filing such acceptance with the former Trustee (if any) and the Administrator. (d) The Employer may designate one or more successors prior to the death, resignation, incapacity, or removal of a Trustee. In the event a successor is so designated by the Employer and accepts such designation, the successor shall, without further act, become vested with all the estate, rights, powers, discretions, and duties of his predecessor with the like effect as if he were originally named as Trustee herein immediately upon the death, resignation, incapacity, or removal of his predecessor. (e) A resigning or removed Trustee, upon receipt of acceptance in writing of the Trust by a successor Trustee, shall execute all documents and do all acts necessary to vest title of record in any successor Trustee. Each successor Trustee shall have and enjoy all of the powers, both discretionary and ministerial, conferred under this Agreement upon his predecessor. No successor Trustee shall be personally liable for any act or failure to act of any predecessor Trustee. With the approval of the Employer and the Administrator, a successor Trustee may accept the account rendered and the property delivered to it by a predecessor Trustee without incurring any liability or responsibility for so doing. 16.11 Limitation of Liability Upon Appointment of Investment Manager. The Trustees shall not be liable for the acts or omissions of any Investment Manager(s) appointed by the Administrator, nor shall the Trustees be under any obligation to invest or otherwise manage any asset of the Plan which is subject to the management of a properly appointed Investment Manager. 16.12 Investment in Pooled Fund. Notwithstanding the provisions of Paragraph 16.3, the Employer specifically authorizes the Trustees to invest all or any portion of the assets comprising the Trust Fund in any common trust fund which at the time of the investment provides for the pooling of the assets of plans qualified under Code ss.401(a). 16.13 Protection of Trustee. To the maximum extent not prohibited by law, the Employer shall indemnify and hold harmless the Trustees from any loss, liability or expense (including reasonable attorneys fees) suffered or incurred by the Trustees as a result of any act or omission on the Trustees' part in the performance of their duties hereunder, unless the same results from the Trustees' gross negligence or willful misconduct. 74 16.14 Duties Limited. The duties and responsibilities of the Trustees are limited to those specifically stated in this instrument and no other or further duties or responsibilities shall be implied. 16.15 Notices. (a) All notices to the Trustees hereunder shall be mailed or delivered to the Trustees at their last known address. (b) The Trustees shall be fully protected in presenting any notice hereunder to an Employer or Administrator by mailing such notice to the Employer, or in care of the Employer, at the last known address provided by such Employer, and in presenting any notice or distributing any benefit hereunder to a Participant by mailing it to such Participant at the latest address, if any, which may have been furnished to the Trustees or by mailing it in care of the Employer, as above provided. 16.16 Audit. If an audit of the Plan's records shall be required for any Plan Year, the Administrator shall direct the Trustees to engage an independent qualified public accountant for that purpose. Such accountant shall, after an audit of the books and records of the Plan in accordance with generally accepted auditing standards, within a reasonable period after the close of the Plan Year, furnish to the Administrator and the Trustees a report of his audit setting forth his opinion as to whether each of the following statements, schedules or lists, or any others that are required by ERISA ss.103 or the Secretary of Labor to be filed with the Plan's annual report, are presented fairly in conformity with generally accepted accounting principles applied consistently: (a) statement of the assets and liabilities of the Plan; (b) statement of changes in net assets available to the Plan; (c) statement of receipts and disbursements, a schedule of all assets held for investment purposes, a schedule of all loans or fixed income obligations in default at the close of the Plan Year; (d) a list of all leases in default or uncollectible during the Plan Year; (e) the most recent annual statement of assets and liabilities of any bank common or collective trust fund in which Plan assets are invested. 75 Article XVII VALUATION OF TRUST FUND 17.1 Valuation of Trust Fund. Each Plan Year, the Trustees shall value the Trust Fund at fair market value as of the close of business on each Valuation Date for the Plan Year. In making such valuation, the Trustees shall deduct all charges, expenses and other liabilities (if any), contingent or otherwise, then chargeable against the Trust Fund, in order to give effect to income realized and expenses paid or incurred, losses sustained and unrealized gains or losses constituting appreciation or depreciation in the value of Trust investments since the last previous valuation. As soon as practicable after such valuation, the Trustees shall deliver in writing to the Administrator and to the Employer a certified valuation of the Trust Fund together with a statement of the amount of net income or loss (including appreciation or depreciation in the value of Trust investments) since the last previous valuation. 17.2 Method of Valuation. In determining the fair market value of securities held in the Trust Fund which are listed on a registered stock exchange, the Administrator shall direct the Trustee to value them at the prices they were last traded on such exchange preceding the close of business on the Valuation Date. If such securities were not traded on the Valuation Date, or if the exchange on which they are traded was not open for business on the Valuation Date, then the securities shall be valued at the prices at which they were last traded prior to the Valuation Date. Any unlisted security held in the Trust Fund shall be valued at its bid price next preceding the close of business on the Valuation Date, which bid price shall be obtained from a registered broker or an investment banker. In determining the fair market value of assets other than securities for which trading or bid prices can be obtained, the Trustee may appraise such assets itself, or in its discretion, employ one or more appraisers for that purpose and rely on the values established by such appraiser or appraisers. 76 Article XVIII LIFE INSURANCE CONTRACTS AND COMPANIES 18.1 Purchase of Life Insurance Contracts for the Benefit of Individual Participants. (a) If life insurance coverage is made available on a uniform, non-discriminatory basis to all Participants, then upon written request received from any Participant, the Trustees shall purchase and pay premiums on one or more life insurance policies on the life of a Participant, provided that the face amounts of such Contract(s) covering anyone Participant shall be limited to the greater of: (1) 100 times the Participant's anticipated monthly retirement benefit; or (2) an amount of Ordinary Life Insurance that may be purchased by less than 66% of such Participant's Theoretical Contribution (as hereinafter defined); or (3) an amount of Universal Life Insurance or other Contract(s) that may be purchased by less than 33% of such Participant's Theoretical Contribution; or (4) an amount of insurance which is a combination of Ordinary Life, Universal Life or other life insurance Contracts where the sum of one-half of the Ordinary Life premiums plus all other premiums does not exceed 33% of such Participant's Theoretical Contribution. Notwithstanding the above, the Trustee may purchase Contracts as described in Code ss.412(i) for each Participant in units of $1,000 face amount for each $10 of anticipated monthly retirement benefit to which the Participant is entitled. (b) The Trustees shall, at or before such Participant's retirement, either (1) convert the entire value of such insurance policies into cash or into an annuity contract, which will provide periodic income so that no portion of such value may be used to continue life insurance protection beyond the date of retirement of such Participant, or (2) distribute such insurance policies to such Participant at the time such Participant is entitled to receive benefits under the Plan. (c) If the Trustees deem it prudent to purchase a Participant's existing insurance policy either from the Participant directly or from another qualified employee benefit plan, they may do so provided that such purchase be made in compliance with all relevant state and federal requirements. 77 (d) All dividends paid on such policies, if any, shall be used to reduce the Employer's contribution for the year in which the dividends are paid. In no event shall any dividends revert to the Employer. (e) If a Participant or his designated Beneficiary wishes to purchase an insurance policy from the Trust, the Trustees may transfer such policy in accordance with all relevant state and federal regulations. 18.2 Purchase of Life Insurance for the Benefit of the Trust. The Trustees may, in their discretion, purchase and pay premiums on one or more life insurance policies on the life of a Participant for the benefit of the Trust rather than the insured Participant, in which event all premiums paid shall be treated as a general expense of the Trust Fund and all proceeds from such insurance shall constitute a general asset of the Trust Fund. The Trustees may purchase a Participant's existing insurance contract subject to compliance with all relevant state and federal requirements. 18.3 Annuity Purchase Riders. Any insurance policy purchased hereunder may be subject to the terms of an annuity purchase rider, applied for by the Trustees and issued as a part of such policy, pursuant to which the proceeds of such policy may be applied for the purchase of an annuity to provide benefits under the Plan. The annuity referred to in this paragraph shall be paid according to the terms of such policy regardless of the survival of the Participant. 18.4 Designation of Trust as Owner and Beneficiary. Each application for an insurance policy and the policy itself shall nominate and designate the Trust or the Trustees as sole owner, with the right reserved to said Trustees to exercise any right or option contained therein. All such policies shall be held by the Trustees. The Trust or the Trustees shall be designated in the policies to receive the proceeds maturing by reason of the death of the Participant; however the Trustees shall be required to pay over the proceeds of any contract purchased pursuant to Paragraph 18.1 to the Participant's Beneficiary in accordance with the distribution provisions of this Plan, and under no circumstances shall the Trust retain any part of the proceeds of such contract. 18.5 Insurance Company Reliance on Trustee's Signature. For the purpose of applying to an insurance company and in the exercise of any right or option contained in any contract, the insurance company may rely upon the signature of anyone Trustee and shall be held harmless and completely discharged in acting at the direction and authorization of such Trustees. 18.6 Duties of Insurance Company. Each insurance company shall keep such records, make such identification of contracts, funds and accounts within funds, and supply such information as may be necessary for the proper administration of the Plan under which it is carrying insurance benefits. 18.7 Plan Provisions Control. In the event of any conflict between the terms of the Plan and the provisions of any insurance policy or annuity contract purchased hereunder, the terms of the Plan shall control. 78 18.8 Protection of Employer, Plan Administrator and Trustee. Neither the Employer, Administrator nor the Trustees shall be responsible for the validity of any insurance policy nor for the failure on the part of an insurance company to make payments under such insurance policies, nor for the action of any other person which may render a policy null and void or unenforceable in whole or in part. 18.9 Definitions. For purposes of this Article: (a) "Contract" shall mean an ordinary or term life insurance contract, or annuity contract, issued by an insurer. (b) "Issuing Company" is any life insurance company which has issued a policy upon application by the Trustee under the terms of this Plan. (c) "Ordinary Life Insurance" contracts shall mean contracts with nondecreasing death benefits and non-increasing premiums. (d) "Theoretical Contribution" shall mean the contribution that would be made on behalf of the Participant, using the actuarial assumptions stated in Paragraph 2.3(b) and the individual level premium funding method from the age at which participation commenced to Normal Retirement Age, to fund the Participant's entire retirement benefit without regard to preretirement ancillary benefits. (e) "Theoretical Individual Level Premium Reserve" shall mean the reserve that would be available at time of death if for each year of plan participation a contribution had been made on behalf of the Participant in an amount equal to the Theoretical Contribution. (f) "Universal Life" contracts are contracts where the premium or death benefit amounts can be adjusted. 79 Article XIX EXCLUSIVE BENEFIT, AMENDMENT, TERMINATION 19.1 Exclusive Benefit. (a) Except as specifically set forth in this Plan, the Employer shall have no beneficial interest in any asset of the Trust and no part of any asset in the Trust shall ever revert to or be repaid to the Employer, either directly or indirectly; nor shall any part of the corpus or income of the Trust Fund, or any asset of the Trust, be at any time used for, or diverted to, purposes other than for the exclusive benefit of the Participants or their Beneficiaries. (b) Any contribution made by the Employer because of a mistake of fact may be returned to the Employer within one year after the contribution was made. (c) All Employer contributions are conditioned upon the Plan's initial qualification under the Code. If the Employer receives a final determination that the Plan does not initially qualify, the Plan shall terminate and all Employer contributions shall be returned to the Employer within one year after the date such initial qualification is denied, but only if the application for qualification is made by the time prescribed by law for filing the Employer's tax return for the taxable year in which the Plan is adopted, or such later date as the Secretary of the Treasury may prescribe. (d) All Employer contributions are conditioned upon their deductibility under Code ss.404 for the Employer's fiscal year for which a deduction is claimed, and to the extent the deduction is disallowed, the contributions may be returned to the Employer within one year after the disallowance. (e) For purposes of this Article, "contribution" has the same meaning as in ERISA ss.403(c). 19.2 Amendment. The Employer shall have the right at any time to amend the Plan, subject to the limitations of this paragraph and such prohibitions as may be provided by law or by other terms of this Plan. Any such amendment shall be adopted by formal action of the Employer's Board of Directors and executed by an officer authorized to act on behalf of the Employer, except as otherwise provided herein. However, any amendment which affects the rights, duties or responsibilities of the Trustee and Administrator may only be made with the Trustee's and Administrator's written consent. In addition, subject to the foregoing limitation with respect to the rights, duties and responsibilities of the Trustee or the Administrator, the pension committee of the Employer's Board of Directors shall also have the authority to amend the Plan pursuant to written Plan amendments. (a) to comply with changes required by law, or 80 (b) to make any other change to the Plan, including any change required as a result of a corporate purchase or sale of stock or assets which involves the transfer of employees and their eligibility, participation or benefits under the Plan; provided that any such change does not have or create any material financial impact on the Employer and does not have any adverse impact on the rights of Participants. Any such amendment shall become effective as provided therein upon its execution. The Trustee shall not be required to execute any such amendment unless the Trust provisions contained herein are part of the Plan and the amendment affects the duties of the Trustee hereunder. 19.3 Amendment to Vesting Schedule. No amendment shall directly or indirectly reduce a Participant's Vested interest in his Accrued Benefit to the date of the amendment, as computed under the terms of the Plan in effect immediately prior to the date of the amendment. If the vesting schedule of the Plan is amended, each Participant with at least three Years of Service for vesting purposes may elect within the time period described below after the adoption of the amendment to have his Vested percentage computed under the Plan without regard to such amendment. The period during which the election may be made shall commence with the date the amendment is adopted and shall end on the later of: (a) 60 days after the amendment is adopted; (b) 60 days after the amendment becomes effective; or (c) 60 days after the Participant is issued written notice of the amendment by the Employer or Administrator. 19.4 Termination. The Employer shall have the right at any time to terminate the Plan by delivering to the Trustees and Administrator written notice of such termination. Upon full or partial termination of this Plan, the Accrued Benefit of each affected Participant, to the extent funded as of the date of such termination, shall become fully Vested. Upon complete termination of the Plan, the Employer, by written notice to the Trustee, and subject to the ensuing Paragraphs of this Article, shall distribute the assets in the Trust Fund in the form of deferred annuities payable at Normal Retirement Date. The Trustee may also distribute benefits in the form of a lump sum, in cash or in kind, as soon as practicable following termination. 19.5 Allocation of Assets. Upon complete termination of the Plan, the Administrator shall allocate the assets of the Plan among Participants and Beneficiaries in the following order of priority and subject in any event to the provisions of ERISA: (a) First, to that portion of each Participant's Accrued Benefit which is derived from his voluntary contributions. (b) Equally among individuals in the following two categories: (1) Benefits to retired Participants and their Beneficiaries to whom payment commenced at least 3 years prior to the termination date, based on Plan provisions in 81 effect during the 5-year period ending on such date. The lowest benefit in any pay status during the most recent 3-year period shall be considered the benefit in pay status for such period. (2) Benefits as respects a Participant wherein payment would have commenced at least 3 years prior to the termination date if the Participant had actually retired, based on the lowest benefit determined under the Plan provisions in effect during the 5-year period ending on such date. (c) All other benefits guaranteed (insured) under ERISA determined without regard to ss.4022(b)(5) thereof; and additional benefits, if any, under this subparagraph if ERISA Section 4022(b)(6) did not apply. (d) All other (uninsured) Vested benefits. (e) All other benefits under the Plan. Any funds remaining after satisfaction of the foregoing shall be returned to the Employer. 19.6 Limitation of Benefits on Early Termination. (a) Upon termination of this Plan, the benefits under the Plan for any Highly Compensated Employee (or any Highly Compensated Employee formerly employed by the Employer) shall be limited to benefits that are nondiscriminatory under Code ss.401(a)(4). (b) The following distribution restrictions shall apply only to the 25 highest paid Highly Compensated Employees or formerly employed Highly Compensated Employees taking into account the Employee's highest Compensation in any Plan Year ("Restricted Participants"). (1) The payments made to any Restricted Participant from this Plan shall be restricted to an amount equal to the payments that would be made under a single life annuity that is the Actuarial Equivalent of the sum of (A) the Employee's Accrued Benefit and the other benefits he is entitled to under the Plan (other than a social security supplement), plus (B) the amount of the payments that he is actually entitled to receive under a social security supplement (such sum to be hereinafter referred to as the "Restricted Amount"). (2) The restriction set forth in (1) above shall not apply if: (A) After payment to a Restricted Participant of his total benefit under the Plan, the value of the remaining Plan's assets is at least 110% of the value of the Plan's current liabilities (as defined in Code ss.412(l)(7)); or (B) The value of all benefits payable to a Restricted Participant is less than 1% of the value of the Plan's current liabilities (as defined in Code ss.412(l)(7)) before distribution; or 82 (C) The lump sum Actuarial Equivalent of all benefits payable to the Restricted Participant is less than $5,000; or (D) The Participant agrees in writing with the Plan Administrator to return to the Plan all amounts necessary for the distribution of assets upon Plan termination to meet the requirements of Code ss.401(a)(4) and to secure such obligation by agreeing either (A) to promptly deposit in escrow with an acceptable depository property having a fair market value of at least 125% of the Restricted Amount, or (B) to post a bond or arrange a bank letter of credit, in either case acceptable to the Plan Administrator, in an amount equal to at least 100% of the Restricted Amount. The escrow account shall at no time have a value less than 125% of the Restricted Amount. (c) If an escrow is arranged by the Participant, the following shall apply: (1) The Participant may withdraw amounts in the escrow account in excess of 125% of the Restricted Amount at any time; (2) If the value of the escrow account falls below 110% of the Restricted Amount, the Participant shall deposit additional property into the escrow account to increase the value to 125% of the Restricted Amount; (3) The depository may release all property from the escrow account only if the Plan Administrator certifies to the depository that the Participant (or his estate) is no longer obligated to repay the Restricted Amount, which certification shall be made only if at any time after distribution the conditions set forth in either subparagraphs (b)(2)(A) or (b)(2)(B) are met. 19.7 Merger or Consolidation. This Plan and Trust may be merged or consolidated with, or its assets and/or liabilities may be transferred to, any other plan and trust only if the benefits which would be received by a Participant of this Plan, in the event of a termination of the plan immediately after such transfer, merger or consolidation, are at least equal to the benefits the Participant would have received if this Plan had terminated immediately before the transfer, merger or consolidation. 19.8 Transfer to Qualified Plan. The Administrator may direct the Trustee to transfer all or any part of a Participant's Accrued Benefit to the trustee of any other plan that purportedly meets the qualification requirements of Code ss.401(a), provided, however, that such transfer would not disqualify this Plan under Code ss.401(a). The Trustee may require a certification from the trustee of such other plan as to the qualified status of such plan under Code ss.401(a) prior to making such transfer. 83 Article XX VETERANS' REEMPLOYMENT RIGHTS 20.1 Veterans' Reemployment Rights. Notwithstanding any other provision of this Plan and in accordance with the Uniformed Services Employment and Reemployment Rights Act of 1994 ("USERRA"), this Article shall apply to Participants reemployed on or after December 12, 1994, after a Qualified Leave. 20.2 Service Credit. (a) Participant's Qualified Leave shall not be considered as a Break in Service, but shall be deemed to constitute continuous Service with the Employer for purposes of determining such Participant's Accrued Benefit under this Plan and his Vested interest therein. (b) All rights to additional Service credit under this Article shall accrue only upon a Participant's timely reemployment in accordance with this Article; however, a Participant's Vested interest in his Accrued Benefit earned prior to entering a Uniformed Service shall not be reduced regardless of the date such Participant actually returns to Service with the Employer. 20.3 Compensation. For purposes of determining the benefits to which a Participant may be entitled under this Article, a Participant shall be deemed to have received Compensation from the Employer during his Qualified Leave, of an amount based on the rate of pay such Participant would have received from the Employer but for the Qualified Leave. If such Participant's pre-Qualified Leave Compensation was not based on a fixed rate, the calculation will be based on such Participant's average rate of pay during the 12-month period immediately preceding the Qualified Leave or, if shorter, the Participant's period of employment immediately preceding the Qualified Leave. 20.4 Qualified Leave. A Participant's absence from employment with the Employer shall be a "Qualified Leave" for the purposes of this Article if all of the following conditions are met: (a) Notice. The Participant (or an appropriate officer of the Uniformed Service in which services are to be performed) gives written or verbal notice to the Employer of such Participant's service in one of the Uniformed Services in advance of the Participant's departure for such service. (b) Cumulative Length of Absence. The cumulative length of the Participant's absence from employment with the Employer by reason of such Participant's service in one of the Uniformed Services, when combined with all previous absences from service with the Employer by reason of service in the Uniformed Services, does not exceed 5 years. 84 (c) Uniformed Service. The Participant's absence from employment with the Employer is due to the Participant's service in one of the following "Uniformed Services" of the United States: the Army, Navy, Marine Corps, Air Force, Coast Guard, Army Reserve, Naval Reserve, Marines Corps Reserve, Air Force Reserve, Coast Guard Reserve, Army National Guard, Air National Guard, commissioned corps of the Public Health Service, or any other category designated as a uniformed service by the President of the United States during a time of war or national emergency. (d) Reemployment. The Participant, upon completion of a period of service in one of the Uniformed Services, notifies the Employer of the Participant's intention to return to employment with the Employer by reporting to or submitting an application for reemployment to the Employer within the following time periods: (1) if the period of service in the Uniformed Services is less than 31 days, or a period of any length for the purposes of an examination to determine the Participant's fitness to perform service in the Uniformed Services, the Participant reports to the Employer not later than the beginning of the first full regularly scheduled work period in the first full calendar day following the completion of the period of service and the expiration of 8 hours after a period allowing for the safe transportation of the Participant from the place of that service to the Participant's residence; or if reporting within the period referred to above is impossible or unreasonable through no fault of the Participant, as soon as possible after the expiration of the 8-hour period referred to above; (2) if the period of service in the Uniformed Services is more than 30 days but less than 181 days the Participant submits an application for reemployment not later than 14 days after the completion of the period of such service, or if submitting such application within such time period is impossible or unreasonable through no fault of the Participant, the next first full calendar day when submission of such application becomes possible; (3) if the period of service in the Uniformed Services is more than 180 days the Participant submits an application for reemployment not later than 90 days after the completion of the period of such service; (4) a Participant who is hospitalized for, or convalescing from, an illness or injury incurred in, or aggravated during, the performance of service in the Uniformed Services shall, at the end of the period that is necessary for the person to recover from such illness or injury, report to (in the case of a Participant described in subparagraph (1) above) or submit an application for reemployment (in the case of a Participant described in subparagraph (2) or (3) above) with the Employer. Such period of recovery may not exceed 2 years, although such period shall be extended by the minimum time required to accommodate the circumstances beyond such Participant's control which make reporting within the period specified in subparagraph (1) impossible or unreasonable. (e) Less Than Honorable Discharge. Notwithstanding the above, a Participant shall not be entitled to the benefits of this Article if such Participant's service in the Uniformed Services terminates upon any of the following events: 85 (1) a separation of the Participant from such Uniformed Service with a dishonorable or bad conduct discharge; (2) a separation of such Participant from such Uniformed Service under other than honorable conditions; or (3) a dismissal or dropping from the rolls of any Uniformed Service of such Participant, in accordance with 10 U.S.C. 1161(a) or (b). 86 Article XXI PARTICIPATING EMPLOYERS 21.1 Adoption by Other Entities. Anything contained herein to the contrary notwithstanding, with the consent of the Employer, any corporation, partnership or sole proprietorship, whether an Affiliated Company or not, may adopt this Plan and all of the provisions hereof, and participate herein and be known as a Participating Employer, by a properly executed document evidencing said intent and will of such other entity. 21.2 Requirements of Participating Employers. (a) Each Participating Employer shall be required to use the same Trustee as provided in this Plan. (b) The Trustee shall commingle, hold and invest as one Trust Fund all contributions made by Participating Employers, as well as all increments thereof. (c) The transfer of any Participant from or to a company participating in this Plan, whether he be an Employee of the Employer or a Participating Employer, shall not affect such Participant's rights under the Plan, and the Participant's interest in his Accrued Benefit as well as his accumulated service time with the transferor or predecessor and his length of participation in the Plan, shall continue to his credit. 21.3 Designation of Agent. Each Participating Employer shall be deemed to be a part of this Plan; provided, however, that with respect to all of its relations with the Trustee and Administrator for the purpose of this Plan, each Participating Employer shall be deemed to have designated irrevocably the signatory Employer to this Plan document as its agent. Unless the context of the Plan clearly indicates the contrary, the word "Employer" shall be deemed to include each Participating Employer as related to its adoption of the Plan. 21.4 Employee Transfers. It is anticipated that an Employee may be transferred between Participating Employers, and in the event of any such transfer, the Employee involved shall carry with him his accumulated service and eligibility. No such transfer shall effect a termination of employment hereunder, and the Participating Employer to which the Employee is transferred shall thereupon become obligated hereunder with respect to such Employee in the same manner as was the Participating Employer from whom the Employee was transferred. 21.5 Amendment and Termination. Amendment or termination of this Plan by the Employer at any time when there shall be a Participating Employer hereunder shall only be by the written action of each and every Participating Employer and with the consent of the Trustee where such consent is necessary in accordance with the terms of this Plan. 21.6 Discontinuance of Participation. Any Participating Employer shall be permitted to discontinue or revoke its participation in the Plan. At the time of any such discontinuance or revocation, satisfactory evidence thereof and of any applicable conditions imposed shall be 87 delivered to the Trustee. The Trustee shall thereafter transfer, deliver and assign Contracts and other Trust Fund assets allocable to the Participants of such Participating Employer to such new Trustee as shall have been designated by such Participating Employer, in the event that it has established a separate pension plan for its Employees. If no successor is designated, the Trustee shall retain such assets for the Employees of said Participating Employer. In no such event shall any part of the corpus or income of the Trust as it relates to such Participating Employer be used for or diverted for purposes other than for the exclusive benefit of the Employees of such Participating Employer. 21.7 Administrator's Authority. The Administrator shall have authority to make any and all necessary rules or regulations, binding upon all Participating Employers and all Participants, to effectuate the purpose of this Article. 88 Article XXII MISCELLANEOUS 22.1 Evidence. Anyone required to give evidence under the terms of the Plan may do so by certificate, affidavit, document or other information which the person to act in reliance thereof may consider pertinent, reliable and genuine, and to have been signed, made or presented by the proper party or parties. The Administrator and the Trustees shall be fully protected in acting and relying upon any evidence described under this paragraph. 22.2 Named Fiduciaries and Allocation of Responsibility. The "named fiduciaries" of this Plan are the Employer, the Administrator, the Trustees and any Investment Manager appointed hereunder. The named fiduciaries shall have only those specific powers, duties, responsibilities, and obligations as are specifically given them under this Plan. Each named fiduciary warrants that any directions given, information furnished, or action taken by it shall be in accordance with the provisions of this Plan, authorizing or providing for such direction, information or action. Further, each named fiduciary may rely upon such direction, information or action of another named fiduciary as being proper under this Plan, and is not required under this Plan to inquire into the propriety of any such direction, information or action. It is intended that each named fiduciary shall be responsible only for the proper exercise of its own powers, duties, responsibilities and obligations under this Plan. Any person or group may serve in more than one fiduciary capacity. 22.3 Limited Responsibilities. The Trustees and the Administrator shall not have any obligation nor responsibility with respect to any action required by the Plan to be taken by the Employer, any Participant or eligible Employee, nor for the failure of the Employer to act or make any payment or contribution, or to otherwise provide any benefit contemplated under this Plan, nor shall the Trustee or the Plan Administrator be required to collect any contribution required under the Plan, or determine the correctness of the amount of any Employer contribution. The Trustees and the Administrator shall not have any obligation to inquire into or be responsible for any action or failure to act on the part of the others. 22.4 Fiduciaries Not Insurers. The Trustees, the Administrator and the Employer do not guarantee the Trust Fund from loss or depreciation. The Employer does not guarantee the payment of any money which may become due to any person from the Trust Fund. The liability of the Administrator and the Trustees to make any payment from the Trust Fund at any time and all times is limited to the then available assets of the Trust. 22.5 Waiver of Notice. Any person entitled to notice under the Plan may waive the notice. 22.6 Successors. The Plan shall be binding upon all persons entitled to benefits under the Plan, their respective heirs and legal representatives, upon the Employer, its successors and assigns, and upon the Trustees, the Administrator and their successors. 89 22.7 Word Usage. Words used in the masculine shall apply to the feminine where applicable, and wherever the context of the Plan dictates, the plural shall be read as the singular and the singular as the plural. 22.8 Status of Employment Relations. The adoption and maintenance of the Plan and Trust shall not be deemed to constitute a contract between the Employer and its Employees or to be consideration for, or an inducement or condition of, the employment of any person. Nothing herein contained shall be deemed (a) to give to any Employee the right to be retained in the employ of the Employer; (b) to affect the right of the Employer to discipline or discharge any Employee at any time; (c) to give the Employer the right to require any Employee to remain in its employ; or (d) to affect any Employee's right to terminate his employment at any time. 22.9 Interpretation of the Plan and Trust. It is the intention of the Employer that this Plan and Trust shall comply with the provisions of Code ss.ss.401 and 501, the requirements of ERISA, and the corresponding provisions of any subsequent laws. The provisions of this Plan and Trust shall be construed to effectuate such intention. 22.10 Governing Law. All questions arising with respect to the provisions of this Agreement shall be determined by application of the laws of the State of New York, except to the extent superseded by federal law. IN WITNESS WHEREOF, the Employer and the Trustees named herein have executed this Plan and Trust Agreement this 30th day of December, 2004. The Employer: COMMUNITY BANK SYSTEM, INC. By: /s/ Sanford A. Belden ---------------------------------- President and CEO The Trustee: By: /s/ Mark E. Tryniski ---------------------------------- Executive Vice President and COO 90 COMMUNITY BANK SYSTEM, INC. PENSION PLAN TABLE OF CONTENTS Article I HISTORY AND PURPOSE OF PLAN ............................... 1 Article II DEFINITIONS ............................................... 2 Article III ELIGIBILITY REQUIREMENTS .................................. 17 Article IV CREDITED SERVICE FOR BENEFIT ACCRUAL ...................... 23 Article V RETIREMENT BENEFITS ....................................... 25 Article VI DEATH BENEFITS ............................................ 35 Article VII EMPLOYMENT TERMINATION BENEFITS ........................... 41 Article VIII LIMITATION OF BENEFITS .................................... 45 Article IX PAYMENT OF BENEFITS ....................................... 49 Article X CONTRIBUTIONS ............................................. 58 Article XI EMPLOYER ADMINISTRATIVE PROVISIONS ........................ 59 Article XII PARTICIPANT ADMINISTRATIVE PROVISIONS ..................... 60 Article XIII ADMINISTRATION ............................................ 63 Article XIV TOP HEAVY REQUIREMENTS .................................... 66 Article XV QUALIFIED DOMESTIC RELATIONS ORDERS ....................... 69 Article XVI TRUSTEE POWERS AND DUTIES ................................. 71 Article XVII VALUATION OF TRUST FUND ................................... 76 Article XVIII LIFE INSURANCE CONTRACTS AND COMPANIES .................... 77 Article XIX EXCLUSIVE BENEFIT, AMENDMENT, TERMINATION ................. 80 Article XX VETERANS' REEMPLOYMENT RIGHTS ............................. 84 i Article XXI PARTICIPATING EMPLOYERS ................................... 87 Article XXII MISCELLANEOUS ............................................. 89 ii EX-23.1 8 d62959_ex23-1.txt CONSENT OF PRICEWATERHOUSECOOPERS LLP Exhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statement on and Form S-8 (Nos. 333-61916, 333-61672, 333-17011, 333-16635, 033-60607, 333-119887, 333-119590) of Community Bank System, Inc. of our report dated March 11, 2005 relating to the financial statements, management's assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, which appears in the Annual Report to Shareholders, which is incorporated in this Form 10-K. /s/ PricewaterhouseCoopers LLP Syracuse, New York March 14, 2005 EX-31.1 9 d62959_ex31-1.txt CEO CERTIFICATION Exhibit 31.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Sanford A. Belden, certify that: 1. I have reviewed this annual report on Form 10-K of Community Bank System, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 14, 2005 /s/ Sanford A. Belden - --------------------------- Sanford A. Belden, President, Chief Executive Officer and Director EX-31.2 10 d62959_ex31-2.txt CFO CERTIFICATION Exhibit 31.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Scott A. Kingsley, certify that: 1. I have reviewed this annual report on Form 10-K of Community Bank System, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have: d) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; e) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; f) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): c) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and d) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Dated: March 14, 2005 /s/ Scott A. Kingsley - --------------------------- Scott A. Kingsley, Treasurer and Chief Financial Officer EX-32.1 11 d62959_ex32-1.txt CEO CERTIFICATION Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Community Bank System, Inc. (the "Company") on Form 10-K for the year ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Sanford A. Belden, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Sanford A. Belden - --------------------- Sanford A. Belden President, Chief Executive Officer and Director March 14, 2005 EX-32.2 12 d62959_ex32-2.txt CFO CERTIFICATION Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Community Bank System, Inc. (the "Company") on Form 10-K for the year ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Scott A. Kingsley, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Scott A. Kingsley - --------------------- Scott A. Kingsley, Treasurer and Chief Financial Officer March 14, 2005 -----END PRIVACY-ENHANCED MESSAGE-----