10-K 1 form10k2006.txt FIRST CHESTER COUNTY CORPORATION UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON,D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2006, OR ----------------- [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to _____________ Commission File No. 0-12870 FIRST CHESTER COUNTY CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2288763 ------------ ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.1) 9 North High Street, West Chester, Pennsylvania 19380 ----------------------------------------------------- (Address of principal executive offices) Registrant's telephone number, including area code (484) 881-4000 ------------- Securities registered pursuant to Section 12(b) of the Act: Name of Each Exchange Title of Each Class on Which Registered ------------------- ------------------- None None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $1.00 per share --------------------------------------- (Title of Class) Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ___ No X Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ___ No X 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 to this Form 10-K. ( __ ) Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ___ Accelerated filer X Non-accelerated filer ___ 1 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No X The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant's most recently completed second fiscal quarter: $101,843,104. The number of shares outstanding of Common Stock of the Registrant as of February 28, 2007, was 5,135,167. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's definitive Proxy Statement for its 2007 Annual Meeting of Shareholders, which definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the Registrant's year end at December 31, 2006, are incorporated by reference into Part III of this form 10-K. 2 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS PAGE PART I: Item 1 - Business 4 Item 1A - Risk Factors 10 Item 1B - Unresolved Staff Comments 12 Item 2 - Properties 13 - 14 Item 3 - Legal Proceedings 14 Item 4 - Submission of Matters to a Vote of Security Holders 14 PART II: Item 5 - Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 15 - 16 Item 6 - Selected Financial Data 17 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation 18 - 36 Item 7A - Quantitative and Qualitative Disclosures about Market Risk 36 - 38 Item 8 - Financial Statements and Supplementary Data 39 - 70 Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure 71 Item 9A - Controls and Procedures 71 Item 9B - Other Information 71 PART III: Item 10 - Directors, Executive Officers and Corporate Governance 72 Item 11 - Executive Compensation 72 Item 12 - Security Ownership of Certain Beneficial Owners 72 and Management and Related Stockholder Matters Item 13 - Certain Relationships and Related Transactions and Director Independence 73 Item 14 - Principal Accountant Fees and Services 73 PART IV: Item 15 - Exhibits, Financial Statements and Schedules 73 - 75 SIGNATURES 76 - 77 3 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
PART I Item 1. Business. ------- --------- First Chester County Corporation (the "Corporation") may, from time to time, make written or oral "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including statements contained in the Corporation's filings with the Securities and Exchange Commission (including this Report on Form 10-K), its reports to shareholders and in other communications by the Corporation. These statements can often be identified by the use of forward-looking terminology such as "believes", "expects", "intends", "may", "will", "should" or "anticipates" or similar terminology. These statements involve risks and uncertainties and are based on various assumptions. Although the Corporation believes that its expectations are based on reasonable assumptions, investors and prospective investors are cautioned that such statements are only projections. Also, future results may differ materially from the Corporation's historic results. The risks and uncertainties described in this Report, among others, could cause the Corporation's actual future results to differ materially from those described in forward-looking statements made in this Report, or presented elsewhere by Management from time to time, or from the Corporation's historic results. The most significant of these risks and uncertainties are discussed in Item 1A, "Risk Factors." Additional discussion may be included in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Report. We are not obligated to update our forward-looking statements, even though our situation may change in the future. GENERAL The Corporation is a Pennsylvania corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "BHC Act"). As a bank holding company, the Corporation's operations are confined to the ownership and operation of banks and activities deemed by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") to be so closely related to banking to be a proper incident thereto. The Corporation was incorporated on March 9, 1984, for the purpose of becoming a registered bank holding company pursuant to the BHC Act and acquiring First National Bank of Chester County, formerly known as The First National Bank of West Chester (the "Bank"), thereby enabling the Bank to operate within a bank holding company structure. On September 13, 1984, the Corporation acquired all of the issued and outstanding shares of common stock of the Bank. The principal activities of the Corporation are the owning and supervising of the Bank, which engages in a general banking business based in Chester County, Pennsylvania. The Corporation directs the policies and coordinates the financial resources of the Bank. In addition, the Corporation is the sole shareholder of Turks Head Properties, Inc., a Pennsylvania corporation, which was formed in 1994, and Turks Head II LLC, which was formed in 2003, each of which serves the purpose of holding the Bank's interests in and operating foreclosed real property until liquidation of such properties. First Chester County Capital Trust I, which was formed on July 11, 2002, and First Chester County Capital Trust II, which was formed on November 13, 2003, are special purpose statutory trusts created expressly for the issuance of preferred capital securities and investing the proceeds therefrom in junior subordinated debentures of the Corporation. The Bank has two other wholly-owned subsidiaries, FNB Insurance Services, LLC, doing business as First National Financial Advisory Services (formerly, First National Wealth Advisory Services), and FNB Properties, LLC. First National Wealth Advisory Services offers insurance, full-service brokerage, financial planning and mutual fund services. FNB Properties, LLC acts as property manager for the properties where the Bank's Lionville and New Garden branches are located. On August 5, 2001, the Corporation became a financial holding company pursuant to the Gramm-Leach-Bliley Act of 1999. The Corporation's filings with the SEC including its annual report on Form 10-K, quarterly reports on Form 10-Q, periodic reports on Form 8-K, and amendments to these reports, are accessible free of charge at our website at http://www.fnbchestercounty.com as soon as reasonably practicable after filing with the SEC. By making this reference to our website, we do not intend to incorporate into this report any information contained in the website. The website should not be considered part of this Report. The SEC maintains a website at http:///www.sec.gov that contains reports, proxy and information statements, and other information free of charge regarding issuers, including the Corporation, that file electronically with the SEC. 4 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES BUSINESS OF THE BANK The Bank is engaged in the business of commercial and retail banking and was organized under the banking laws of the United States in December 1863. The Bank currently conducts its business through twenty one banking offices located in Chester and Delaware Counties, Pennsylvania, including its main office. In addition, the Bank operates 27 ATM facilities. The Bank is a member of the Federal Reserve System. At December 31, 2006, the Bank had total assets of approximately $872.1 million, total loans of approximately $694.3 million, total deposits of approximately $724.7 million and employed 287 persons, of which 258 were full-time and 29 were part-time. The Bank is a full service commercial bank offering a broad range of retail banking, commercial banking, Internet banking, trust and investment management and insurance services to individuals, businesses, governmental entities, nonprofit organizations, and community service groups. Retail services include checking accounts, savings programs, money-market accounts, certificates of deposit, safe deposit facilities, consumer loan programs, residential mortgages, overdraft checking, automated tellers and extended banking hours. Commercial services include revolving lines of credit, commercial mortgages, equipment leasing and letter of credit services. These retail and commercial banking activities are provided primarily to consumers and small to mid-sized companies within the Bank's market area. Lending services are focused on commercial, consumer, and real estate lending to local borrowers. The Bank attempts to establish a total borrowing relationship with its customers that may typically include commercial loans, a mortgage loan for the borrower's residence, a consumer loan or a revolving personal credit line. The Bank's Wealth Management Division provides a broad range of trust and investment management services. It administers and provides services for estates, trusts, agency accounts, and individual and employer sponsored retirement plans. At December 31, 2006, the Bank's Wealth Management Division administered or provided investment management services to accounts that held assets with an aggregate market value of approximately $563.0 million. For the year ended December 31, 2006, gross income from the Bank's Wealth Management Division and related activities amounted to approximately $3.4 million. In addition to retail and commercial banking and wealth management services, the Bank offers an array of investment opportunities including mutual funds, annuities, retirement planning, education planning and insurance through the Wealth Advisory Services Division. COMPETITION The Bank's service area consists primarily of greater Chester County, as well as the fringe of Delaware County, Pennsylvania. The core of the Bank's service area is located within a fifteen-mile radius of the Bank's main office in West Chester, Pennsylvania. The Bank encounters vigorous competition for market share in the communities it serves from bank holding companies, other community banks, thrift institutions, credit unions, Internet banks and other non-bank financial organizations such as mutual fund companies, brokerage firms, and the financing arms of corporate conglomerates. The Bank also competes with banking and financial institutions, some from out-of-state that have opened branches in the Bank's market, which are substantially larger and have greater financial resources than the Bank. The Bank's Wealth Management Division competes with a variety of companies including private trust companies, banks with trust departments, private money managers, brokerage firms, mutual fund companies, attorneys, accountants and insurance companies. Management believes that the Bank is able to effectively compete with its competitors because of its ability to provide responsive personalized services and competitive rates. This ability is a direct result of Management's knowledge of the Bank's market area and customer base. Management believes the needs of the small to mid-sized commercial business and retail customers are not adequately met by larger financial institutions, therefore creating a marketing opportunity for the Bank. 5 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES SUPERVISION AND REGULATION General The Corporation is a bank holding company and financial holding company subject to supervision and regulation by the Federal Reserve Board. In addition, the Bank is subject to supervision, regulation and examination by the Office of the Comptroller of the Currency (the "OCC") and secondary regulation by the Federal Deposit Insurance Corporation (the "FDIC"). The OCC must approve bank mergers, if the surviving bank would be a national bank, as well as the establishment of new branches. Federal and state laws impose a number of requirements and restrictions on the operations of the Bank, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be made and the types of services which may be offered, and restrictions on the ability to acquire deposits under certain circumstances. The Bank must also comply with various consumer laws and regulations. Certain aspects of the Bank's operation are also subject to state laws. The following sections discuss more fully some of the principal elements of the regulatory framework applicable to the Corporation and the Bank. This discussion is not intended to be an exhaustive description of the statutes and regulations applicable to the Corporation and the Bank and is subject to and qualified by reference to the statutory and regulatory provisions. A change in these statutes, regulations or regulatory policies, or the adoption of new statutes, regulations or regulatory policies, may have a material effect on the Corporation's business. Bank Holding Company Act The Corporation is required to file with the Federal Reserve Board an annual report, other periodic reports, and such additional information as the Federal Reserve Board may require pursuant to the BHC Act. The Federal Reserve Board also makes examinations of bank holding companies and their subsidiaries. The BHC Act requires each bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or if it would acquire or control more than 5% of the voting shares of such a bank. The Federal Reserve Board considers numerous factors, including its capital adequacy guidelines, before approving such acquisitions. For a description of certain applicable guidelines, see this Item "Capital," Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Adequacy," and Part II, Item 8, "Note K -- Regulatory Matters" in the consolidated financial statements. The Community Reinvestment Act The Community Reinvestment Act of 1977, as amended (the "CRA"), and the regulations promulgated to implement the CRA are designed to create a system for bank regulatory agencies to evaluate a depository institution's record in meeting the credit needs of its community. The CRA regulations were completely revised in 1995 to establish performance-based standards for use in examining a depository institution's compliance with the CRA (the "revised CRA regulations"). The revised CRA regulations establish new tests for evaluating both small and large depository institutions' investment in the community. For the purposes of the revised CRA regulations, the Bank is deemed to be a large retail institution, based upon financial information as of December 31, 2006. In connection with its assessment of CRA performance, the FDIC assigns a rating of "outstanding," "satisfactory," "needs to improve," or "substantial compliance." The Bank has opted to be examined under a three-part test evaluating the Bank's lending service and investment performance. The Bank received an outstanding rating at its last regulatory examination in May, 2005. Dividend Restrictions The Corporation is a legal entity separate and distinct from the Bank. Virtually all of the revenue of the Corporation available for payment of dividends on its Common Stock will result from amounts paid to the Corporation from dividends received from the Bank. All such dividends are subject to limitations imposed by federal and state laws and by regulations and policies adopted by federal and state regulatory agencies. The Bank, as a national bank, is required by federal law to obtain the approval of the OCC for the payment of dividends if the total of all dividends declared by the Board of Directors of the Bank in any calendar year will exceed the total of the Bank's net income for that year and the retained net income for the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. Under this formula, in 2006, the Bank, without affirmative governmental approvals, could declare aggregate dividends of approximately $7.0 million, plus an amount approximately equal to the net income, if any, earned by the Bank for the period from January 1, 2006, through the date of declaration of such dividend less dividends previously paid, subject to the further limitations that a national bank can pay dividends only to the extent that retained net profits (including the portion transferred to surplus) 6 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES exceed bad debts and provided that the Bank would not become "undercapitalized" (as these terms are defined under federal law). Dividends declared and paid in 2006 were $4.6 million. If, in the opinion of the applicable regulatory authority, a bank or bank holding company under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank or bank holding company, could include the payment of dividends), such regulatory authority may require such bank or bank holding company to cease and desist from such practice, or to limit dividends in the future. Finally, the several regulatory authorities described herein may, from time to time, establish guidelines, issue policy statements and adopt regulations with respect to the maintenance of appropriate levels of capital by a bank or bank holding company under their jurisdiction. Compliance with the standards set forth in such policy statements, guidelines and regulations could limit the amount of dividends which the Corporation and the Bank may pay. Capital The Corporation and the Bank are both subject to minimum capital requirements and guidelines. The Federal Reserve Board measures capital adequacy for bank holding companies on the basis of a risk-based capital framework and a leverage ratio. The Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines currently provide for a minimum leverage ratio of Tier I Capital to average total assets of 3% for bank holding companies that meet certain criteria, including that they maintain the highest regulatory rating. All other bank holding companies are required to maintain a leverage ratio of 3% plus an additional cushion of at least 100 to 200 basis points. The Federal Reserve Board has not advised the Corporation of any specific minimum leverage ratio under these guidelines which would be applicable to the Corporation. Failure to satisfy regulators that a bank holding company will comply fully with capital adequacy guidelines upon consummation of an acquisition may impede the ability of a bank holding company to consummate such acquisition, particularly if the acquisition involves payment of consideration other than common stock. In many cases, the regulatory agencies will not approve acquisitions by bank holding companies and banks unless their capital ratios are well above regulatory minimums. The Bank is subject to capital requirements which generally are similar to those affecting the Corporation. The minimum ratio of total Risk-Based Capital to Risk-Weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%. Capital may consist of equity and qualifying perpetual preferred stock, less goodwill ("Tier I Capital"), and certain convertible debt securities, qualifying subordinated debt, other preferred stock and a portion of the reserve for possible credit losses ("Tier II Capital"). Trust preferred securities may be included in Tier I Capital, subject to certain quantitative limits. The aggregate amount of trust preferred securities and certain other capital elements is limited to 25% of Tier I Capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier II Capital, subject to certain other restrictions. As described elsewhere in this report, the Corporation has $15.5 million in outstanding trust preferred securities which is includable in Tier I Capital. A depository institution's capital classification depends upon its capital levels in relation to various relevant capital measures, which include a Risk-Based Capital measure and a leverage ratio capital measure. A depository institution is considered well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure and critically undercapitalized if it fails to meet any critical capital level set forth in the regulations. An institution may be placed in a lower capitalization category if it receives an unsatisfactory examination rating, is deemed to be in an unsafe or unsound condition, or engages in unsafe or unsound practices. Under applicable regulations, for an institution to be well capitalized it must have a Total Risk-Based Capital ratio of at least 10%, a Tier I Capital ratio of at least 6% and a Leverage ratio of at least 5% and not be subject to any specific capital order or directive. As of December 31, 2006 and 2005, the Corporation and the Bank had capital in excess of all regulatory minimums and the Bank was "well capitalized." Deposit Insurance Assessments Prior to March 31, 2006, the Bank was subject to deposit insurance assessments by the FDIC's Bank Insurance Fund ("BIF"). On February 8, 2006, the President signed The Federal Deposit Insurance Reform Act of 2005, and, on February 15, 2006, the President signed into law The Federal Deposit Insurance Reform Conforming Amendments Act of 2005 (collectively, the Reform Act). The Reform Act provides for various changes to the FDIC's insurance program, including the merger of the BIF and the Savings Association Insurance Fund ("SAIF") into a new fund, the Deposit Insurance Fund ("DIF"), effective March 31, 2006. 7 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The Reform Act implements a complex risk-based assessment system, under which the assessment rate for an insured depository institution varies according to its level of risk. An institution's risk category is based upon whether the institution is well capitalized, adequately capitalized or undercapitalized and the institution's "supervisory subgroups": Subgroup A, B or C. Subgroup A institutions are financially sound institutions with a few minor weaknesses; Subgroup B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Subgroup C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. Based on its capital and supervisory subgroups, each DIF member institution is assigned an annual FDIC assessment rate per $100 of insured deposits varying between 5 basis points per annum (for well capitalized Subgroup A institutions) and 43 basis points per annum (for undercapitalized Subgroup C institutions). The Bank's Subgroup for 2006 was A. Prior to enactment of the Reform Act, the Bank was not required to pay any FDIC assessments. To help offset the new DIF assessment, the Bank expects to receive a one-time assessment credit. The assessment credit is presently expected to offset the cost of the deposit insurance premiums for 2007 and may partially offset the cost of such premiums for 2008. Such increases in FDIC assessments will be an additional expense to the Corporation and, thus, will affect the Corporation's net income in future years. In accordance with the Deposit Insurance Act of 1997 an additional assessment by the Financing Corporation ("FICO") became applicable to all insured institutions as of January 1, 1998. This assessment is not tied to the FDIC risk classification. The FICO assessment rates effective for the fourth quarter 2006 and the first quarter of 2007 were 1.24 basis points per $100 of DIF assessable deposits and 1.22 basis points, respectively. FICO deposit insurance expense was $88 thousand, $91 thousand and $86 thousand for the years 2006, 2005 and 2004. Financial Services Modernization Act of 1999 On November 12, 1999, the President signed into law the Gramm-Leach-Bliley Act (the "Act") which became effective in 2000. Among the Act's various provisions are some changes governing the operations of companies doing business in the financial services industry. The Act eliminates many of the restrictions previously placed on the activities of banks and bank holding companies, and through the creation of two new designations, financial holding companies and financial subsidiaries, bank holding companies and national banks may participate in a wider array of financial services and products (referred to as "financial activities" in the Act), including services and products that had been reserved only for insurance companies and securities firms. In addition, a bank holding company can now affiliate with an insurance company and a securities firm. A "financial activity" is an activity that does not pose a safety and soundness risk and is financial in nature, incidental to an activity that is financial in nature, or complementary to a financial activity. Some examples of "financial activities" which are permitted under the Act are: o Lending, investing or safeguarding money or securities; o Underwriting insurance or annuities, or acting as an insurance or annuity principal, agent or broker; o Providing financial or investment advice; o Underwriting, dealing in or making markets in securities; and o Insurance company portfolio investments. The Corporation elected to become a financial holding company on August 5, 2001, and currently meets the qualifications set forth under the Act to be a financial holding company. The Bank, as a national bank, is authorized by the Act to use "financial subsidiaries" to engage in financial activities, subject to the limitations imposed by the Act. During 2000, First National Financial Advisory Services was formed as a wholly-owned subsidiary of the Bank for the purpose of offering insurance, full service brokerage, financial planning and mutual fund services. First National Financial Advisory Services has elected to become a financial subsidiary under the Act. Control Acquisitions The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of ten percent or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Corporation, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. 8 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES In addition, as described above, under the BHC Act, the Federal Reserve Board must give its prior approval of any transaction pursuant to which any person or persons may acquire 25 percent (5 percent in the case of an acquirer that is a bank holding company) or more of any class of outstanding common stock of a bank holding company, such as the Corporation, or otherwise obtaining control or a "controlling influence" over that bank holding company. See this Item, "Bank Holding Company Act". The USA Patriot Act The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism of 2002 (the "USA Patriot Act") gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. Through amendments to the Bank Secrecy Act, the USA Patriot Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement agencies. Among other requirements, the USA Patriot Act requires banks to establish anti-money laundering policies, to adopt procedures and controls to detect and report money laundering, and to comply with certain enhanced recordkeeping obligations and due diligence standards with respect to correspondent accounts of foreign banks. Congress is currently considering some changes to the USA Patriot Act; however, these changes will generally not affect the provisions pertaining to commercial banking activities. Compliance with these new requirements has not had a material effect on the Corporation's operations. Other Matters Federal and state law also contains a variety of other provisions that affect the operations of the Corporation and the Bank including certain reporting requirements, regulatory standards and guidelines for real estate lending, "truth in savings" provisions, the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch, certain restrictions on investments and activities of nationally-chartered insured banks and their subsidiaries, limitations on credit exposure between banks, restrictions on loans to a bank's insiders, guidelines governing regulatory examinations, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. EFFECT OF GOVERNMENTAL POLICIES The earnings of the Bank and, therefore, of the Corporation are affected not only by domestic and foreign economic conditions, but also by the monetary and fiscal policies of the United States and its agencies (particularly the Federal Reserve Board), foreign governments and other official agencies. The Federal Reserve Board can and does implement national monetary policy, such as the curbing of inflation and combating of recession, by its open market operations in United States government securities, control of the discount rate applicable to borrowings from the Federal Reserve and the establishment of reserve requirements against deposits and certain liabilities of depository institutions. The actions of the Federal Reserve Board influence the level of loans, investments and deposits and also affect interest rates charged on loans or paid on deposits. The nature and impact of future changes in monetary and fiscal policies are not predictable. From time to time, various proposals are made in the United States Congress and the Pennsylvania legislature and before various regulatory authorities, who would alter the powers of different types of banking organizations, remove restrictions on such organizations and change the existing regulatory framework for banks, bank holding companies and other financial institutions. It is impossible to predict whether any of such proposals will be adopted and the impact, if any, of such adoption on the business of the Corporation. 9 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 1A. RISK FACTORS -------- ------------ The following are some of the factors that could materially and adversely affect our future performance or could cause actual results to differ materially from those expressed or implied in our forward-looking statements. The risks and uncertainties described below are not the only ones facing us and we cannot predict every event and circumstance that may adversely affect our business. However, these risks and uncertainties are the most significant factors that we have identified at this time. If one or more of these risks actually occurs, our business, results of operations, and financial condition could likely suffer, and the price of our stock would be negatively affected. Unless the context requires otherwise, references to "we," "us," or "our" in this "Risk Factors" section are intended to mean First Chester County Corporation, First National Bank of Chester County and its other wholly-owned subsidiaries, collectively. Adverse changes in the economic conditions in our market area could materially and negatively affect our business. Substantially all of our business is with consumers and small to mid-sized companies located within Chester and Delaware Counties, Pennsylvania. Our business is directly impacted by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of which are beyond our control. A deterioration in economic conditions, whether caused by national, regional or local concerns, including an economic slowdown in southeastern Pennsylvania, could result in the following consequences, any of which could materially harm our business and operating results: o customer's credit quality may deteriorate; o loan delinquencies and losses may increase; o problem assets and foreclosures may increase; o need to increase our allowance for loan and lease losses, thus reducing net income; o more non-accrual loans may reduce net income; o demand for our products and services may decrease; o competition for low cost or non-interest bearing deposits may increase; and o collateral securing loans may decline invalue. Competitive pressures from banks, financial services companies and other companies offering banking services could negatively impact our business. We conduct banking operations primarily in southeastern Pennsylvania. Increased competition in our market area may result in reduced loans and deposits, a decline in loan growth and/or loan margins, high customer turnover, and lower interest rate margins. We may not be able to compete successfully against current and future competitors. Many competitors in our market area, including national banks, regional banks and other community banks, offer the same banking services as we offer. We also face competition from many other types of financial institutions, including without limitation, savings and loan institutions, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. These competitors often have greater resources than we do, affording them competitive advantages, including the ability to maintain numerous banking locations and ATMs and conduct extensive promotional and advertising campaigns. Changes in interest rates could reduce our net interest margin and net interest income. Our income and cash flows and the value of our assets and liabilities depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These interest rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, in particular, the Federal Reserve and the Office of Comptroller of Currency. Changes in monetary policy, including changes in interest rates, will influence the origination and market value of loans and investment securities and the amounts paid on deposits. If we are unable to timely adjust our interest rates on our loans and deposits in response to any such changes in monetary policy, our earnings could be adversely affected. If the rate of interest we pay on our deposits, borrowings, and other interest-bearing liabilities increases faster than the rate of interest we earn on our loans, investments and other interest-earning assets, our net interest income, and therefore our earnings will decrease. Conversely, our earnings could also be adversely affected if the interest rates on our loans or other investments decline more quickly than those on our deposits and other borrowings. 10 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Significant increases in interest rates may affect customer loan demand and payment habits. Significant increases in market interest rates, or the perception that an increase may occur, could adversely impact our ability to generate new variable interest rate loans. An increase in market interest rates may also adversely affect the ability of adjustable rate borrowers to meet repayment obligations, thereby causing non-performing loans and loan charge-offs to increase. We may experience lower net interest income if our loan growth exceeds that of deposit growth requiring us to obtain other sources of funds at higher costs. Our growth strategy depends upon generating an increasing level of loans while maintaining a low level of loan losses. As our loans grow, it is necessary for the deposits to grow at a comparable pace in order to avoid the need for us to obtain other sources of loan funds at higher costs. If our loan growth exceeds the deposit growth, we may have to obtain other sources of funds at higher costs, thus reducing our net interest income. If our allowance for loan and lease losses is not adequate to cover actual or estimated future loan and lease losses, our earnings may decline. We maintain an allowance for loan and lease losses to provide for loan defaults and non-performance by borrowers of their obligations. Our allowance for loan and lease losses may not be adequate to cover actual or estimated future loan and lease losses and future provisions for loan and lease losses could materially and adversely affect our operating results. Our allowance for loan and lease losses is based on prior experience, as well as an evaluation of risks in the current portfolio. However, losses may exceed our current estimates. The amount of future losses is susceptible to changes in economic, operating and other conditions that may be beyond our control, including changes in interest rates, changes in borrowers' creditworthiness and the value of collateral securing loans and leases. Additionally, as our loan and lease portfolios grow, we may need to take additional provision expense to ensure that the allowance remains at levels deemed appropriate by Management for the size and quality of portfolio. Federal regulatory agencies review our loans and allowance for loan and lease losses and may require us to increase our allowance. While we believe that our allowance for loan and lease losses is adequate to cover our anticipated losses, we cannot assure that we will not further increase the allowance for loan and lease losses or that regulators will not require us to increase the allowance. Either of these occurrences could materially affect our earnings. Adverse changes in the market value of securities and investments that we manage for others may negatively impact the growth level of our non-interest income. We provide a broad range of trust and investment management services for estates, trusts, agency accounts, and individual and employer sponsored retirement plans. Fees for such services are typically based upon a percentage of the market value of such funds under management. The market value of such securities and investments may decline for a variety of factors, many of which are outside our control. Any such adverse changes in the market value of the securities and investments could negatively impact our non-interest income generated from providing these services. Expansion of our branch network may increase our expenses without proportionate increases in income. We continue to look for appropriate locations to open new branches. Such opportunities are attractive as a means to obtain additional core deposits and increase our customer base for new loans and services. However, the costs of opening a new branch may reduce our earnings before the benefits of the new branch are realized. Our decisions to open new branches are based upon demographic information and assumptions regarding the suitability of a particular location. There can be no assurance that such assumptions will be accurate and fully achievable. Our branch locations may be negatively affected by changes in regional and local demographics. We have strategically selected locations for our branches based upon regional and local demographics. Any unanticipated changes in such demographics may impact our ability to reach or maintain profitability at our branch locations. Changes in regional and local demographics may also affect the relative benefits of certain branch locations and Management may be required to reduce the number and/or locations of our branches, which may result in unanticipated expenses. 11 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Changes in the regulatory environment may adversely affect our business or the ability of the Bank to pay dividends to the Corporation. The banking industry is highly regulated and we are subject to extensive state and federal regulation, supervision, and legislation. We are subject to regulation and supervision by the Board of Governors of the Federal Reserve System, the Offices of the Comptroller of the Currency, and the Securities and Exchange Commission and the FDIC. Laws restricting our activities include, but are not limited to, the Gramm-Leach-Blilely Act, the Bank Secrecy Act, the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Bank Holding Company Act, the Community Reinvestment Act, the USA Patriot Act and the Real Estate Settlement Procedures Act. These laws may change from time to time, and new laws may be enacted, any of which may limit our ability to offer new products and services, obtain financing, attract deposits, and originate loans. Any changes to these laws may adversely affect loan demand, credit quality, consumer spending and saving habits, interest rate margins, FDIC assessments, and operating expenses, thus negatively affecting our results of operations and financial condition. In addition, if the Bank is restricted in its ability to pay dividends to the Corporation, the Corporation's ability to pay dividends to its shareholders or to meet its financial obligations may be impaired. Technology costs, new product development, and marketing costs may exceed our expectations and negatively impact our profitability. The financial services industry is constantly undergoing technological changes in the types of products and services provided to customers to enhance customer convenience. Our future success will depend upon our ability to address the changing technological needs of our customers. We have invested a substantial amount of resources to update our technology. Our investment in such technology seeks to increase overall efficiency and improve accessibility to customers. We are also investing in the expansion of bank branches, improvement of operating systems, and the development of new marketing initiatives. The benefits of such investments may not be achieved as quickly as anticipated, or at all. The costs of implementing technological changes, new product development, and marketing costs may exceed our expectations and negatively impact our results of operations and profitability. Changes to financial accounting standards may affect our reported results of operations. We prepare our financial statements in accordance with Generally Accepted Accounting Principles ("GAAP"). GAAP is subject to the rules and interpretations of the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may even affect our reporting of transactions completed before a change is announced. Accounting rules affecting many aspects of our business, including rules relating to accounting for business combinations, asset impairment, revenue recognition, restructuring or disposal of long-lived assets and stock option grants have recently been revised or are currently under review. Changes to those rules or current interpretation of those rules may have a material adverse effect on our reported financial results or on the way we conduct our business. If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. If we fail to maintain an effective system of internal controls, fail to correct any issues in the design or operating effectiveness of internal controls over financial reporting, or fail to prevent fraud, our shareholders could lose confidence in our financial reporting, which could harm our business and the trading price of our Common Stock. Item 1B. Unresolved Staff Comments. -------- -------------------------- None. 12 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 2. Properties. ------- ----------- The Bank owns nine properties which are not subject to any mortgages. In addition, the Corporation leases the Westtown-Thornbury, Exton, Frazer, Kendal at Longwood, Crosslands, Lima Estates, Granite Farms Estates, Hershey's Mill, Coatesville, Bradford Plaza, Freedom Village, Oxford, Wellington, Phoenixville and Royersford properties. Management of the Corporation believes the Corporation's and the Bank's facilities are suitable and adequate for their respective present needs. Set forth below is a listing of each banking office presently operated by the Bank, and other properties owned or leased by the Bank and the Corporation which may serve as future sites for branch offices. Management routinely evaluates all of its properties for ongoing use.
Current Banking Date Acquired Offices / Use Address or Opened ------------- ------- --------- Main Office / Branch 9 North High Street December 1863 and Corporate Headquarters * West Chester, Pennsylvania Goshen / Branch * 311 North Five Points Road September 1956 West Goshen, Pennsylvania Kennett Square / Branch * 126 West Cypress Street February 1987 Kennett Square, Pennsylvania Westtown-Thornbury / Route 202 and Route 926 May 1994 Branch Westtown, Pennsylvania Swope Building / Office Space * High & Market Streets July 1995 West Chester, Pennsylvania Exton / Branch Route 100 and Boot Road August 1995 West Chester, Pennsylvania Frazer / Branch 309 Lancaster Avenue August 1999 Frazer, Pennsylvania Kendal at Longwood / Branch 1109 E. Baltimore Pike December 1999 Kennett Square, Pennsylvania Crosslands / Branch 1660 E. Street Road December 1999 Kennett Square, Pennsylvania Lima Estates / Branch 411 North Middletown Road December 1999 Media, Pennsylvania Granite Farms Estates / Branch 1343 West Baltimore Pike December 1999 Wawa, Pennsylvania Lionville / Branch * Route 113 & Sheree Boulevard December 2000 Uwchlan Township, Pennsylvania New Garden / Branch * 741 West Cypress Street August 2001 Kennett Square, Pennsylvania Hershey's Mill / Branch 1371 Boot Road December 2001 West Chester, Pennsylvania Coatesville / Branch 258A East Lincoln Highway June 2003 Coatesville, Pennsylvania
13 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
Current Banking Date Acquired Offices / Use Address or Opened ------------- ------- --------- Bradford Plaza / Branch 700 Downingtown Pike September 2003 West Chester, Pennsylvania Freedom Village / Branch 15 Freedom Village Blvd. July 2004 West Brandywine, Pennsylvania Oxford / Branch 275 Limestone Road December 2004 Oxford, Pennsylvania Wellington / Branch 1361 Boot Road November 2005 West Chester, Pennsylvania Phoenixville / Loan Processing Office 347 Bridge St April 2006 Phoenixville, Pennsylvania Phoenixville / Branch 700 Nutt Rd November 2006 Phoenixville, Pennsylvania Royersford / Branch 967 Township Line Rd December 2006 Royersford, Pennsylvania Other Date Acquired Properties / Use Address or Opened ---------------- ------- --------- Market Street / Office Space 17 East Market Street February 1978 and parking * West Chester, Pennsylvania Operations 202 Carter Drive July 1988 Center / Operations * West Chester, Pennsylvania Matlack Street / 887 South Matlack Street September 1999 Operations * West Chester, Pennsylvania
* Indicates properties owned by the Bank Item 3. Legal Proceedings. ------- ------------------ There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation, or any of its subsidiaries, is a party or of which any of their respective property is the subject. The Corporation and the Bank are not parties to any legal proceedings under federal and state environmental laws. Item 4. Submission of Matters to a Vote of Security Holders. ------- ---------------------------------------------------- None. 14 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES PART II ------- Item 5. Market for the Corporation's Common Equity, Related Stockholder Matters, ------- ------------------------------------------------------------------------ and Issuer Purchases of Equity Securities. ------------------------------------------ The Corporation's Common Stock is publicly traded over the counter under the symbol "FCEC". As of January 31, 2007, there were approximately 976 shareholders of record of the Corporation's Common Stock. The closing stock price as of January 31, 2007 was $20.95. The authorized capital stock of the Corporation consists of 10,000,000 shares of Common Stock, par value $1.00 per share, of which 5,151,740 and 5,126,651 shares were outstanding (net of shares held in Treasury) at the end of 2006 and 2005, respectively. The following table shows the range of high and low bid prices for the Common Stock based upon transactions reported for each quarter respectively. Bid Prices ---------- 2006 2005 ---- ---- Quarter Ended High Low High Low ------------- ---- --- ---- --- First $22.00 $18.75 $26.82 $24.05 Second $23.00 $21.12 $25.45 $21.00 Third $22.75 $20.10 $21.46 $18.25 Fourth $22.75 $20.80 $19.75 $17.55 The Corporation has prepared a graph comparing the cumulative shareholder return on the Corporation's Common Stock as compared to the NASDAQ Composite Index and the SNL $500 Million to $1 Billion Bank Index for the years ended December 31, 2002, 2003, 2004, 2005 and 2006. This graph is included in the Corporation's 2006 Annual Report to Shareholders and can be found immediately following the signature pages of the Form 10-K included in that Annual Report. The Corporation declared cash dividends per share on its Common Stock during each quarter of the fiscal years ended December 31, 2006 and 2005, as set forth in the following table: Dividends --------- Amount Per Share ---------------- 2006 2005 ---- ---- First Quarter.............................................$ 0.135 $ 0.130 Second Quarter............................................ 0.135 0.130 Third Quarter............................................. 0.135 0.130 Fourth Quarter............................................ 0.135 0.135 Total...................................................$ 0.540 $ 0.525 The holders of the Corporation's Common Stock are entitled to receive such dividends as may be legally declared by the Corporation's Board of Directors. See Item 1 of this Report, "Supervision and Regulation" for further discussion of the applicable laws regarding the payment of dividends. The amount, time, and payment of future dividends, however, will depend on the earnings and financial condition of the Corporation, government policies and other factors. 15 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The following chart shows the purchases of the Corporation's Common Stock during 2006:
(a) (b) (c) (d) Total Number Average Total Number of Maximum Number (or of Shares Price Paid Shares (or Units) Approximate Dollar Value) (or Units) per Share Purchased as Part of Shares (or Units) that May Purchased (or Unit) of Publicly Announced Yet Be Purchased Under the Plans or Programs Plans or Programs October 1 to October 31, 2006 - - - $10,000,000 November 1 to November 30, 2006 - - - $10,000,000 December 1 to December 31,2006 50,057 $20.93 50,057 $ 8,951,583
Note: The Corporation announced on November 15, 2005 a program to repurchase up to $10.0 million of the Corporation's Common Stock. This program replaced a previous program that expired in October 2005. 16 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 6. Selected Financial Data ------- -----------------------
(Dollars in thousands, except per share data) STATEMENTS OF CONDITION ----------------------- December 31 ----------- 2006 2005 2004 2003 2002 ---- ---- ---- ---- ---- Assets $ 872,094 $ 845,534 $ 805,872 $ 689,533 $ 640,353 Gross loans and leases 694,343 664,276 618,005 511,249 447,682 Investment securities 88,714 97,088 140,029 130,729 128,375 Deposits 724,668 696,097 663,018 577,314 558,738 Borrowings 77,061 84,365 81,929 55,543 27,678 Stockholders' equity 63,262 58,677 55,402 51,750 48,612 Allowance for possible loan and lease losses 8,186 8,123 6,816 5,541 5,887 Wealth Management assets under management and custody (1) 562,952 561,030 555,644 550,217 531,756
STATEMENTS OF INCOME -------------------- Year Ended December 31 ----------------------- 2006 2005 2004 2003 2002 ---- ---- ---- ---- ---- Interest income $ 52,202 $ 44,604 $ 37,518 $ 33,533 $ 37,101 Interest expense 20,037 13,579 7,863 7,154 10,673 ------ ------ ----- ----- ------ Net interest income 32,165 31,025 29,655 26,379 26,428 Provision for possible loan and lease losses 3 1,382 1,164 2,519 2,231 - ----- ----- ----- ----- Net interest income after provision for possible loan and lease losses 32,162 29,643 28,491 23,860 24,197 Non-interest income 9,212 9,325 9,313 11,506 9,154 Non-interest expense 31,153 30,557 29,213 27,400 25,205 ------ ------ ------ ------ ------ Income before income taxes 10,221 8,411 8,591 7,966 8,146 Income taxes 2,886 1,900 2,430 2,161 2,444 ----- ----- ----- ----- ----- Net income $ 7,335 $ 6,511 $ 6,161 $ 5,805 $ 5,702 ========= ========= ========= ========= ========= PER SHARE DATA (2) ------------------ Net income per share (Basic) $ 1.42 $ 1.28 $ 1.24 $ 1.18 $ 1.17 Net income per share (Diluted) $ 1.40 $ 1.24 $ 1.19 $ 1.14 $ 1.16 Cash dividends declared $ 0.540 $ 0.525 $ 0.505 $ 0.493 $ 0.477 Book value $ 12.28 $ 11.45 $ 11.04 $ 10.42 $ 9.98 Basic weighted average shares outstanding 5,160,340 5,104,745 4,980,584 4,924,819 4,865,424 ========= ========= ========= ========= ========= Diluted weighted average shares outstanding 5,249,200 5,240,497 5,174,926 5,082,166 4,901,767 ========= ========= ========= ========= =========
Notes: (1) These assets are managed by the Wealth Management Division of the Bank and are not assets of the Bank or the Corporation. (2) All per share data has been retroactively adjusted for stock dividends. 17 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 7. Management's Discussion and Analysis of Financial Condition and Results ------- ------------------------------------------------------------------------ of Operations. -------------- DISCLOSURE ABOUT FORWARD LOOKING STATEMENTS The Corporation may, from time to time, make written or oral "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, including statements contained in the Corporation's filings with the Securities and Exchange Commission (including this Report on Form 10-K), its reports to shareholders and in other communications by the Corporation. These statements can often be identified by the use of forward-looking terminology such as "believes", "expects", "intends", "may", "will", "should" or "anticipates" or similar terminology. These statements involve risks and uncertainties and are based on various assumptions. Although the Corporation believes that its expectations are based on reasonable assumptions, investors and prospective investors are cautioned that such statements are only projections. Also, future results may differ materially from the Corporation's historic results. These risks and uncertainties are discussed in Item 1A, "Risk Factors", in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Report. These risks, among others, could cause our actual future results to differ materially from those described in our forward-looking statements or from our prior results. We are not obligated to update our forward-looking statements, even though our situation may change in the future. OVERVIEW Net income for the year ended December 31, 2006 was $7.3 million, an increase of $824 thousand or 12.7% from $6.5 million in 2005. Basic earnings per share in 2006 was $1.42, an increase of 10.9% from 2005 earnings per share of $1.28. Return on average equity in 2006 increased to 11.85%, compared with 11.48% in 2005. Return on average assets increased to 0.86% in 2006 from 0.79% in 2005. During 2006, total assets increased 3.1% to $872.1 million; loans and leases grew 4.5% to $694.3 million; and deposits grew 4.1% to $724.7 million. Deposit growth during 2006 is attributed to an expanded branch network and an aggressive marketing campaign designed to generate additional deposit relationships. Loan growth in 2006 reflects the Bank's focus on growing quality loan relationships. Earnings in 2006 were driven primarily by increases in net interest income, which increased $1.1 million or 3.7% from 2005 to 2006, and a decrease in the provision for possible loan and lease losses. The provision decreased $1.4 million from 2005 to 2006. These improvements were partially offset by a $1.0 million increase in income tax expense from 2005 to 2006. The increase in net interest income was primarily driven by an increase in interest income, partially offset by an increase in interest expense. During the year ended December 31, 2006, interest income benefited from a 4.5% growth in the loan portfolio and from increases in interest rates. The increase in interest expense was primarily attributable to a 5.3% growth in average interest-bearing deposits combined with an overall rise in the cost of funds. The reduced provision is a direct reflection of improved asset quality. Non-accrual loans decreased by $1.1 million from December 31, 2005 to December 31, 2006. Non-accrual loans as a percentage of gross loans and leases was 1.05% at December 31, 2006, compared to 1.26% at December 31, 2005. The allowance for loan and lease losses as a percentage of gross loans and leases at December 31, 2006 was 1.18% compared to 1.22% at December 31, 2005. There can be no assurance that our asset quality will remain at these levels or that additional provision for possible loan and lease losses will not be necessary in the future. Additional performance measures are included in the following table PERFORMANCE RATIOS 2006 2005 2004 ------------------ ---- ---- ---- Return on Average Assets 0.86% 0.79% 0.81% Return on Average Equity 11.85% 11.48% 11.59% Dividend Payout Ratio 37.98% 40.93% 41.05% 18 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NET INTEREST INCOME Net interest income is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities. Net interest income, on a tax equivalent basis, increased 3.4% or $1.1 million from $31.5 million in 2005 to $32.6 million in 2006, compared to a 4.4% increase or $1.3 million from 2004 to 2005. The increase in tax equivalent net interest income for 2006 was largely the result of an increase in interest-earning assets that was higher than the increase in interest-bearing liabilities. The average interest-earning asset growth during 2006 was approximately $33.4 million while average interest-bearing liabilities increased by $23.9 million. Partially offsetting the increase in interest income generated from this growth in 2006 was a larger increase in the average rate paid on interest-bearing liabilities, which increased 90 basis points, than the average yield earned on interest-earning assets, which increased by 69 basis points. Basis points, with regards to interest rate, are defined as one one-hundredth of a percentage point. The increase in tax equivalent net interest income for 2005 was largely the result of an increase in interest-earning assets that was higher than the increase in interest-bearing liabilities. Average interest-earning assets growth was $64.8 million while average interest-bearing liabilities increased by $59.0 million. Partially offsetting the increase in net interest income generated from this growth in 2005 was a larger increase in the average rate paid on interest-bearing liabilities, which increased 76 basis points, than the average yield earned on interest-earning assets, which increased by 46 basis points. Net yields on interest-earning assets, on a tax equivalent basis, were 3.99% and 4.03% for 2006 and 2005, respectively. Average interest-earning assets for 2006 was $816.9 million, an increase of $33.4 million or 4.3% when compared to 2005. In 2005, average interest-earning assets were $783.4 million, an increase of $64.8 million or 9.0% compared to 2004. The increase in average interest-earning assets for 2006 was primarily due to a $29.5 million or 4.5% increase in average loans outstanding combined with a $19.2 million or 91.2% increase in federal funds sold and other overnight investments. These increases were partially offset by a $15.0 million or 13.5% decrease in investment securities. The increase in average interest-earning assets for 2005 was the primarily due to a $83.2 million or 14.7% increase in average loans outstanding combined with a $5.2 million or 32.7% increase in federal funds sold and other overnight investments. These increases were partially offset by a $23.4 million or 17.4% decrease in investment securities. In 2006, average interest-bearing liabilities increased $23.9 million or 3.7% to $663.0 million when compared to $639.1 million in 2005. In 2005, average interest-bearing liabilities increased $59.0 million or 10.2% from $580.1 million in 2004. The increase in 2006 was due to a 5.3% or $29.3 million increase in average interest-bearing deposits partially offset by a 7.7% or $5.4 million decrease in Federal Home Loan Bank ("FHLB") advances and other borrowings. The increase in 2005 was due to a 10.1% or $51.0 million increase in the average interest-bearing deposits combined with a 13.0% or $8.0 million increase in FHLB advances and other borrowings. 19 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED AVERAGE BALANCE SHEET AND TAX EQUIVALENT INCOME/EXPENSES AND RATES FOR THE YEAR ENDED DECEMBER 31,
2006 2005 2004 ---- ---- ---- (Dollars in thousands) Daily Daily Daily Average Average Average Balance Interest Rate% Balance Interest Rate% Balance Interest Rate% ------- -------- ----- ------- -------- ----- ------- -------- ----- ASSETS Federal funds sold and interest $ 40,535 $ 2,061 5.08 $ 21,645 $ 761 3.57 $ 16,561 $ 249 1.53 bearing deposits in banks Investment securities Taxable 81,608 3,955 4.85 92,772 3,923 4.23 110,056 4,504 4.09 Tax-exempt (1) 14,256 576 4.04 18,079 754 4.17 24,209 1,086 4.49 ------ --- ---- ------ --- ---- ------ ----- ---- Total investment securities 95,864 4,531 4.73 110,851 4,677 4.22 134,265 5,590 4.16 ------ ----- ---- ------- ----- ---- ------- ----- ---- Loans and leases (2) Taxable 666,239 45,169 6.78 636,592 38,807 6.10 557,808 31,656 5.68 Tax-exempt (1) 14,235 895 6.29 14,346 877 6.11 9,947 590 5.93 ------ --- ---- ------ --- ---- ----- --- ---- Total loans 680,474 46,064 6.77 650,938 39,684 6.10 567,755 32,246 5.68 ------- ------ ---- ------- ------ ---- ------- ------ ---- Total interest-earning assets 816,873 52,656 6.45 783,434 45,122 5.76 718,581 38,085 5.30 Non-interest-earning assets Allowance for possible loan and lease losses (8,388) (7,930) (6,526) Cash and due from banks 24,791 27,187 24,029 Other assets 23,937 23,262 23,284 Total assets $857,213 $825,953 $759,368 ======== ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Savings, NOW, and money market deposits $368,754 $ 7,389 2.00 $386,668 $ 4,712 1.22 $391,057 $ 2,604 0.67 Certificates of deposit and other time 214,425 8,848 4.13 167,195 5,297 3.17 111,838 2,700 2.41 ------- ----- ---- ------- ----- ---- ------- ----- ---- Total interest-bearing deposits 583,179 16,237 2.78 553,863 10,009 1.81 502,895 5,304 1.05 Subordinated debt 15,465 1,304 8.43 15,465 1,015 6.56 15,465 728 4.71 Federal Home Loan Bank advances and other borrowings 64,347 2,496 3.88 69,736 2,555 3.66 61,707 1,831 2.97 ------ ----- ---- ------ ----- ---- ------ ----- ---- Total interest-bearing liabilities 662,991 20,037 3.02 639,064 13,579 2.12 580,067 7,863 1.36 Non-interest-bearing liabilities Non-interest-bearing demand deposits 126,461 124,684 121,664 Other liabilities 5,857 5,514 4,468 Total liabilities 795,309 769,262 706,199 ------- ------- ------- Stockholders' equity 61,904 56,691 53,169 Total liabilities and stockholders' Equity $857,213 $825,953 $759,368 ======== ======== ======== Net interest income $32,619 $31,543 $30,222 ======= ======= ======= Net yield on interest-earning assets 3.99 4.03 4.21 ==== ==== ====
(1) The indicated income and annual rate are presented on a tax equivalent basis using the federal marginal rate of 34%, adjusted for the TEFRA 20% penalty for 2006, 2005, and 2004. (2) Non accruing loans are included in the average balance. 20 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES RATE VOLUME ANALYSIS
Increase (decrease) in net interest income due to: -------------------------------------------------- Volume(1) Rate(1) Total Volume(1) Rate(1) Total --------- ------- ----- --------- ------- ----- (Dollars in thousands) 2006 Compared to 2005 2005 Compared to 2004 --------------------- --------------------- INTEREST INCOME --------------- Federal funds sold and interest $ 681 $ 619 $1,300 $ 78 $ 434 $ 512 bearing deposits in banks Investment securities Taxable (472) 504 32 (707) 126 (581) Tax-exempt(2) (159) (19) (178) (302) (30) (332) ---- --- ---- ---- --- ---- Total investment securities (631) 485 (146) (1,009) 96 (913) Loans Taxable 1,808 4,554 6,362 4,475 2,676 7,151 Tax-exempt(2) (7) 25 18 240 47 287 -- -- -- --- -- --- Total loans(3) 1,801 4,579 6,380 4,715 2,723 7,438 ----- ----- ----- ----- ----- ----- Total interest income 1,851 5,683 7,534 3,784 3,253 7,037 ----- ----- ----- ----- ----- ----- INTEREST EXPENSE ---------------- Savings, NOW and money market deposits (218) 2,895 2,677 (29) 2,137 2,108 Certificates of deposits and other time 1,497 2,054 3,551 1,334 1,263 2,597 ----- ----- ----- ----- ----- ----- Total interest bearing deposits 1,279 4,949 6,228 1,305 3,400 4,705 Subordinated debt 0 289 289 0 287 287 Federal Home Loan Bank advances and other borrowings (197) 138 (59) 238 485 723 ---- --- --- --- --- --- Total Interest expense 1,082 5,376 6,458 1,543 4,172 $5,715 ----- ----- ----- ----- ----- ------ Net Interest income $ 769 $ 307 $1,076 $2,241 $ (919) $1,322 ====== ====== ====== ====== ====== ======
NOTES: ------ (1) The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. (2) The indicated changes are presented on a tax equivalent basis. (3) Non-accruing loans have been used in the daily average balances to determine changes in interest due to volume. Loan fees included in the interest income computation are not material. 21 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST INCOME ON FEDERAL FUNDS SOLD AND DEPOSITS IN BANKS Interest income on federal funds sold and deposits in banks increased 170.8% to $2.1 million from $761 thousand in 2005. This follows an increase of 205.6% or $512 thousand from 2004 to 2005. The increase in interest income on these balances in 2006 and 2005 were partially due to increases in the average federal fund balances and overnight investments, and interest-bearing deposits at other banks. In 2006, these balances increased $18.9 million or 87.3% from $21.6 million to $40.5 million. In 2005, these balances increased $5.0 million or 30.5% from $16.6 million to $21.6 million. The increases in interest on federal funds sold and deposits in banks for 2006 and 2005 are also the result of market increases in the rates earned on these funds. The yield earned on federal funds sold and deposits in banks in 2006 was 5.08%, compared to 3.57% and 1.53% in 2005 and 2004, respectively. Our strategy to increase federal funds sold was intended to improve liquidity while at the same time remain in short-term funds during the rising rate environment. Also, the yield on overnight federal funds, given the flat yield curve, was very competitive with alternative short term investment securities. INTEREST INCOME ON INVESTMENT SECURITIES On a tax equivalent basis, interest income on investment securities decreased $146 thousand or 3.1% from $4.7 million in 2005 to $4.5 million in 2006, compared to a $913 thousand or 16.3% decrease from 2004 to 2005. The decrease in investment interest income in 2006 was the direct result of a 13.5% or $15.0 million decrease in average investment securities, which was partially offset by an increase in the yield on these assets of 51 basis points from 4.22% in 2005 to 4.73% in 2006. From 2004 to 2005, the decrease in interest income on investment securities was the direct result of a 17.4% or $23.4 million decrease in average investment securities, which was partially offset by an increase in the yield on these assets of 6 basis points from 4.16% in 2004 to 4.22% in 2005. The decrease in average investment securities for the years ended, December 31, 2006 and 2005 resulted from an increase in the amount of liquidity needed to provide for loan growth combined with management's decision to invest in fed funds sold and deposits in banks, given the rising interest rate environment and the relatively flat yield curve. 22 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES
INVESTMENT SECURITIES AT DECEMBER 31, 2006 2005 2004 ---- ---- ---- (Dollars in thousands) Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value ---- ----- ---- ----- ---- ----- Held-to-Maturity ---------------- State and municipal $ 5 $ 5 $ 10 $ 10 $ 10 $ 11 Available-for-Sale ------------------ U.S. Treasury $ 1,000 $ 998 $ 2,504 $ 2,476 $ 27,503 $ 27,514 U.S. Government agency 3,371 3,354 1,040 1,018 1,058 1,049 Mortgage-backed securities 56,439 55,052 57,456 56,020 65,830 65,685 State and municipal 9,906 9,602 15,672 15,160 24,797 24,713 Corporate securities 11,461 10,874 13,655 13,086 13,756 13,863 Asset-backed securities - - 117 116 377 376 Mutual Funds - - 796 788 863 797 Other equity securities 8,764 8,829 8,758 8,414 5,951 6,022 ----- ----- ----- ----- ----- ----- 90,941 88,709 99,998 97,078 140,135 140,019 ------ ------ ------ ------ ------- ------- $90,946 $88,714 $100,008 $97,088 $140,145 $140,030 ======= ======= ======== ======= ======== ========
INVESTMENT SECURITIES YIELD BY MATURITY AT DECEMBER 31, 2006 Due over Due over Due 1 year 5 years Due Within Through Through Over (Dollars in thousands) 1 year 5 years 10 years 10 years Total ------ ------- -------- -------- ----- Held-to-Maturity ---------------- State and municipal (2) $ -- $ 5 $ -- $ -- $ 5 Available-for-Sale ------------------ U.S. Treasury 1,000 -- -- -- 1,000 U.S. Government agency -- -- -- 3,371 3,371 Mortgage-backed securities(1) 5,000 8,856 3,174 39,409 56,439 State and municipal(2) 590 8,937 380 -- 9,906 Corporate securities -- 6,268 4,045 1,147 11,461 Asset-backed securities(1) -- -- -- -- -- Mutual Funds -- -- -- -- -- Other equity securities (3) -- -- -- 8,764 8,764 ----- ------ ----- ----- ----- 6,590 24,061 7,599 52,691 90,941 ----- ------ ----- ------ ------ Total Investment securities $6,590 $24,066 $7,599 $52,691 $90,946 ====== ======= ====== ======= ======= Weighted average yield 4.19% 4.17% 4.70% 9.69% 7.42% ==== ==== ==== ==== ====
NOTES: ------ (1) Mortgage-backed and Asset-backed securities are included in the above table based on their contractual maturity. (2) The yield on tax-exempt obligations has been computed on a tax equivalent basis using the Federal marginal rate of 34% adjusted for the 20% interest expense disallowance. (3) Other equity securities having no stated maturity have been included in "Due over 10 years". 23 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST INCOME ON LOANS AND LEASES During 2006, interest income on loans and leases, on a tax equivalent basis, increased by $6.4 million or 16.1% from 2005. This increase was partially due to an increase in average loan balances of $29.5 million or 4.5% from $650.9 million in 2005 to $680.5 million in 2006. The increase in interest income on loans and leases was also due to market rate increases in 2006 as compared to 2005. The average tax adjusted yield earned on loans and leases during 2006 was 6.77% and increase of 67 basis points or 11.0% from 6.10% in 2005. During 2005, interest income on loans and leases, on a tax equivalent basis, increased by $7.4 million or 23.1% from 2004. This increase resulted from an increase in average loan balances of $83.2 million or 14.7% from $567.8 million in 2004 to $650.9 million in 2005. The yields on interest-earning assets also contributed to the 2005 increase in the tax adjusted interest income on loans and leases. The yield increased to 6.10% in 2005, up from 5.68% in 2004. The yield increases for 2006 and 2005 are a direct result of market rate increases and increases in the Federal Reserve Rates over the course of 2006 and 2005. LOAN PORTFOLIO BY TYPE AT DECEMBER
(Dollars in thousands) 2006 2005 2004 2003 2002 ---- ---- ---- ---- ---- Commercial loans $243,651 $218,365 $187,903 $142,144 $122,005 Real estate - construction 41,287 49,095 59,093 56,340 47,601 Real estate other 287,998 266,067 243,490 202,898 175,846 Consumer loans (1) 108,700 112,993 101,157 77,113 62,646 Lease financing receivables 12,707 17,756 26,362 32,754 39,584 ------ ------ ------ ------ ------ Total gross loans and leases $694,343 $664,276 $618,005 $511,249 $447,682 Allowance for possible loan and lease losses $ (8,186) $ (8,123) $ (6,816) $ (5,541) $ (5,887) -------- -------- -------- -------- -------- Total net loans (2) $686,157 $656,153 $611,189 $505,708 $441,795 ======== ======== ======== ======== ========
NOTES: ------ (1) Consumer loans include open-end home equity lines of credit and credit card receivables. (As of February 21, 2003, the $2.7 million credit card portfolio was sold). (2) At December 31, 2006 there were no concentrations of loans exceeding 10% of total loans which is not otherwise disclosed as a category of loans in the above table. 24 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES MATURITIES AND RATE SENSITIVITY OF LOANS DUE TO CHANGES IN INTEREST RATES AT DECEMBER 31, 2006 (1)
Maturing Maturing After 1 Year Maturing Within And Within After (Dollars in thousands) 1 Year(2) 5 Years 5 Years Total --------- ------- ------- ----- Commercial loans $ 26,981 $ 60,286 $ 156,384 $ 243,651 Real Estate - construction 23,495 14,000 3,792 41,287 ------ ------ ----- ------ Total $ 50,476 $ 74,286 $ 160,176 $ 284,938 ========== ======== ========= ========= Loans maturing after 1 year with: Fixed interest rates Commercial Loans $ 35,785 $ 7,820 Commercial real estate - construction 840 782 Variable interest rates Commercial Loans 24,501 148,564 Commercial Real Estate - construction 13,160 3,010 ------ ----- Total $ 74,286 $ 160,176 ======== =========
NOTES: ------ (1) Determination of maturities included in the loan maturity table are based upon contract terms. In situations where a "rollover" is appropriate, the Corporation's policy in this regard is to evaluate the credit for collectability consistent with the normal loan evaluation process. This policy is used primarily in evaluating ongoing customer's use of their lines of credit with the Bank that are at floating interest rates. (2) Demand loans and overdrafts are reported maturing "Within 1 Year". Most construction real estate loans are reported maturing "Within 1 Year" because of their short term maturity or index to the Bank's prime rate. An immaterial amount of loans has no stated schedule of repayments. 25 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INTEREST EXPENSE ON DEPOSIT ACCOUNTS Interest expense on deposit accounts increased 62.2% or $6.2 million from $10.0 million in 2005 to $16.2 million in 2006. Increases in both the interest-bearing balances and the overall cost of these deposits contributed to this change. Average interest-bearing balances increased from $553.9 million in 2005 to $583.2 million in 2006, an increase of $29.3 million or 5.3%. The cost of these deposits increased from 1.81% in 2005 to 2.78% in 2006. Interest expense on deposit accounts increased 88.7% from $5.3 million in 2004 to $10.0 million in 2005. The increase in interest-bearing balances and an increase in the cost of these deposits contributed to this change. Average interest-bearing balances increased from $502.9 million in 2004 to $553.9 million in 2005, an increase of $51.0 million or 10.1%. The cost of these deposits increased from 1.05% in 2004 to 1.81% in 2005. Throughout 2005 and during the first half of 2006 the Bank increased rates paid on its interest bearing deposits in response to the increases in Federal Reserve rates and the increase in competitive pressures in the Bank's marketplace. These pressures are expected to continue in 2007 and the Bank will continue to respond with necessary rate increases to support the Bank's asset growth throughout 2007. DEPOSIT ANALYSIS
(Dollars in thousands) 2006 2005 2004 ---- ---- ---- Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate ------- ---- ------- ---- ------- ---- NOW $134,076 1.76% $145,201 1.04% $129,569 0.51% Money Market 80,009 3.84% 34,967 1.81% 26,255 0.51% Statement Savings 49,699 0.80% 60,570 0.75% 65,682 0.56% Other Savings 636 0.56% 1,230 0.57% 1,371 0.51% Tiered Savings 104,334 1.49% 144,700 1.46% 168,180 0.86% ------- ---- ------- ---- ------- ---- Total NOW, Savings, and money market 368,754 2.00% 386,668 1.22% 391,057 0.67% CD's Less than $100,000 169,630 4.16% 110,407 3.08% 85,872 2.46% CD's Greater than $100,000 44,795 3.99% 56,788 3.34% 25,966 2.28% ------ ---- ------ ---- ------ ---- Total CDs 214,425 4.13% 167,195 3.17% 111,838 2.41% Total interest-bearing deposits 583,179 553,863 502,895 Non-Interest-Bearing Demand Deposits 126,461 -- 124,684 -- 121,664 -- ------- ------- ------- Total Deposits $709,640 $678,547 $624,559 ======== ======== ========
MATURITIES OF CERTIFICATES OF DEPOSIT AND OTHER TIME DEPOSITS, $100,000 OR MORE, AT DECEMBER 31, 2006
Due Within Over 3 Months Over 6 Months Due Over (Dollars in thousands) 3 Months Through 6 Months Through 12 Months 12 Months Total -------- ---------------- ----------------- --------- ----- Certificates of Deposit $100,000 or more $ 6,083 $ 33,603 $ 1,776 $ 2,363 $ 43,825
26 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES ASSET QUALITY AND ALLOWANCE FOR LOAN AND LEASE LOSSES During 2006, the Corporation recorded a $3 thousand provision for loan and lease losses, compared to $1.4 million in 2005 and $1.2 million in 2004. Net recoveries in 2006 were $186 thousand, compared to $46 thousand of net charge-offs in 2005 and $185 thousand of net recoveries in 2004. The reduced provision in 2006 as compared to 2005 is a direct result of improved asset quality as reflected by a $1.1 million reduction in non-accrual loans from December 31, 2005. In addition, non-accrual loans as a percentage of gross loans and leases was 1.05% at December 31, 2006, compared to 1.26% at December 31, 2005 and the allowance for loan and lease losses as a percentage of gross loans and leases at December 31, 2006 was 1.18% compared to 1.22% at December 31, 2005. The increased provision in 2005 as compared to 2004 was due to an increase in the allowance to provide for potential loan write-downs and charge-offs. Management believes that the allowance for loan and lease losses is adequate based on its current assessment of probable and estimated losses. There can be no assurance that our asset quality will remain at these levels or that additional provision for possible loan and lease losses will not be necessary in the future. The allowance for loan and lease losses is an amount that Management believes will be adequate to absorb loan and lease losses on existing loans and leases that may become uncollectible based on Management's evaluations of the collectability of loans and leases. These evaluations take into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, adequacy of collateral, review of specific problem loans and leases, and current economic conditions that may affect the borrower's ability to pay. Management evaluates the adequacy of the allowance on a quarterly basis to ensure the provision for loan and lease losses has been charged against earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management's assessment of probable estimated losses. The Bank's methodology for assessing the appropriateness of the allowance for loan and lease losses consists of several key elements. These elements include a specific allowance for loan and lease classified list loans and an allowance based on historical trends. The Corporation consistently applies the following comprehensive methodology. The allowance for loan and lease losses addresses those loans and leases maintained on the Bank's loan and lease classified list, which are assigned a rating of substandard, doubtful, or loss. Substandard loans and leases are those with a well-defined weakness, which jeopardizes the repayment of the debt. A loan or lease may be classified as substandard as a result of impairment of the borrower's financial condition and repayment capacity. Loans and leases for which repayment plans have not been met or collateral equity margins do not protect the Bank may also be classified as substandard. Doubtful loans and leases have the characteristics of substandard loans and leases with the added characteristic that collection or liquidation in full, on the basis of presently existing facts and conditions, is highly improbable. Although the possibility of loss is extremely high for doubtful loans and leases, the classification of loss is deferred until pending factors, which might improve the loan or lease, have been determined. Loans and leases rated as doubtful in whole or in part are placed on non-accrual status. Loans and leases, which are classified as loss, are considered uncollectible and are charged to the allowance for loan and lease losses. Loans and leases on the loan and lease classified list may also be impaired loans, which are defined as non-accrual loans and leases or troubled debt restructurings, which are not in compliance with the restructured terms. Each of the classified loans and leases on the watch list is individually analyzed to determine the level of the potential loss under the current circumstances. The specific reserve established for these criticized by management and impaired loans and leases is based on careful analysis of the loan's and lease's performance, the related collateral value, cash flow considerations and the financial capability of any guarantor. The allowance for classified list loans and leases is equal to the total amount of potential unconfirmed losses for the individual classified loans and leases on the classified list. Classified loans and leases are managed and monitored by management. The allowance is based on historical trends and uses charge-off experience of the Bank to estimate potential unconfirmed losses in the balances of the loan and lease portfolios. The historical loss experience percentage is based on the charge-off history. Historical loss experience percentages are applied to all non-classified loans and leases to obtain the portion of the allowance for loan and lease losses which is based on historical trends. Before applying the historical loss experience percentages, loan and lease balances are reduced by amounts of government agency guarantees. Installment loan balances are also adjusted for unearned discounts. 27 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The Bank also maintains an unallocated allowance. The unallocated allowance is used to cover any factors or conditions, which may cause a potential loan and lease loss but are not specifically identifiable. Management believes that it is prudent to maintain an unallocated portion of the allowance because no matter how detailed an analysis of potential loan and lease losses may be, the analysis produces only estimates which, by definition, lack precision. Since all identified losses are immediately charged off, no portion of the allowance for loan and lease losses is restricted to any individual loan or groups of loans, or lease or groups of leases, and the entire allowance is available to absorb any and all loan and lease losses. The following tables present information regarding the Bank's total allowance for loan and lease losses as well as the allocation of such amounts to the various categories of loans at the dates indicated: December 31, 2006 ----------------- Allowance Percentage of loans for Loan in each Catagory (Dollars in thousands) Losses to total loans ------ ------------------- Commercial loans and leases $ 6,505 37% Residential real estate 355 47% Consumer loans 1,148 16% Unallocated 178 --- ----- Total allowance for loan and lease losses $ 8,186 100% ======== ===== December 31, 2005 ----------------- Allowance Percentage of loans for Loan in each Catagory (Dollars in thousands) Losses to total loans ------ ------------------- Commercial loans and leases $ 5,992 36% Residential real estate 361 47% Consumer loans 1,758 17% Unallocated 12 -- ----- Total allowance for loan and lease losses $ 8,123 100% ======== ===== December 31, 2004 ----------------- Allowance Percentage of loans for Loan in each Catagory (Dollars in thousands) Losses to total loans ------ ------------------- Commercial loans and leases $ 4,320 34% Residential real estate 276 50% Consumer loans 1,502 16% Unallocated 718 --- ----- Total allowance for loan and lease losses $ 6,816 100% ======== ===== December 31, 2003 ----------------- Allowance Percentage of loans for Loan in each Catagory (Dollars in thousands) Losses to total loans ------ ------------------- Commercial loans and leases $ 3,552 34% Residential real estate 199 51% Consumer loans 1,187 15% Unallocated 603 --- ----- Total allowance for loan and lease losses $ 5,541 100% ======== ===== 28 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES December 31, 2002 ----------------- Allowance Percentage of loans for Loan in each Catagory (Dollars in thousands) Losses to total loans ------ ------------------- Commercial loans and leases $ 4,296 36% Residential real estate 105 50% Consumer loans 1,403 14% Unallocated 83 -- ----- Total allowance for loan and lease losses $ 5,887 100% ======== ===== ANALYSIS OF CHANGES IN THE ALLOWANCE FOR LOAN AND LEASE LOSSES
December 31 ----------- (Dollars in thousands) 2006 2005 2004 2003 2002 ---- ---- ---- ---- ---- Balance at beginning of year $ 8,123 $ 6,816 $ 5,541 $ 5,887 $ 5,995 -------- -------- -------- -------- -------- Provision charged to operating expense 3 1,382 1,164 2,519 2,231 Recoveries of loans previously charged off Commercial loans 291 178 955 175 274 Real estate mortgages 6 196 31 9 - Consumer loans 13 12 28 28 51 Lease financing receivables 49 51 81 2 - -- -- -- - Total recoveries 359 437 1,095 214 325 --- --- ----- --- --- Loan charge-offs Commercial loans (32) (59) (261) (1,045) (841) Real estate mortgages (51) (245) (294) (545) (1,265) Consumer loans (72) (82) (121) (261) (216) Lease financing receivables (18) (97) (234) (1,248) (348) --- --- ---- ------ ---- Total charge-offs (173) (483) (910) (3,099) (2,670) ==== ==== ==== ====== ====== Net loan (charge-offs) recoveries 186 (46) 185 (2,885) (2,345) Allowance other adjustment (1) (126) (29) (74) 20 6 ---- --- --- -- - Balance at end of year $ 8,186 $ 8,123 $ 6,816 $ 5,541 $ 5,887 ======== ======== ======== ======== ======== Year-end loans outstanding $694,343 $664,276 $618,005 $511,249 $447,682 Average loans outstanding $680,474 $650,938 $567,755 $470,413 $442,613 Allowance for possible loan losses as a percentage of year-end loans outstanding 1.18% 1.22% 1.10% 1.08% 1.31% Ratio of net (charge-offs) recoveries to average loans outstanding (0.03)% 0.01% (0.03)% 0.61% 0.53%
(1)The Allowance other adjustment represents the reclassification of an allowance for possible losses on unfunded loans and unused lines of credit. These loans and lines of credit, although unfunded, have been committed to by the Bank. 29 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Non-performing loans and leases include those on non-accrual status and loans past due 90 days or more and still accruing. The Corporation's policy is to write down all non-performing loans to net realizable value based on updated appraisals. Non-performing loans are generally collateralized and are in the process of collection. Non-performing loans reduce the Corporation's earnings because interest income is not earned on such assets. There are seventeen non-accrual loans making up the $7.3 million total non-accrual loans and leases balance at December 31, 2006 of which, there is one commercial loan of $5.9 million. Management is actively working to collect this loan and does not anticipate a loss of principal. Management continues to take steps to reduce non-accrual loan and lease levels and correct and control current and future credit quality issues. The Credit Administration Department assists Management in improving the components of the allowance of loans and lease losses including the provision for loan and lease losses, recoveries, and charged-off loans. Please see the "Non-Interest Income" section for information regarding gains on the sale of OREO. The following chart represents detailed information regarding non-performing loans: NON-PERFORMING LOANS AND ASSETS
December 31 ----------- (Dollars in thousands) 2006 2005 2004 2003 2002 ---- ---- ---- ---- ---- Past due over 90 days and still accruing $ 793 $ -- $ -- $ 597 $ 321 Non-accrual loans and leases (1) 7,289 8,358 7,877 3,093 5,216 ----- ----- ----- ----- ----- Total non-performing loans and leases 8,082 8,358 7,877 3,690 5,537 Other real estate owned ("OREO") -- -- 757 965 368 Total non-performing assets $ 8,082 $ 8,358 $8,634 $ 4,655 $ 5,905 ======= ======= ====== ======= ======= Interest income which would have been recorded $ 682 $ 638 $ 209 $ 348 $ 448 Interest income that was received from customer -- -- (27) (46) (234) --- --- ---- Total contractual interest for non-accruing loans and leases not collected $ 682 $ 638 $ 182 $ 302 $ 214 ======= ====== ====== ======= ======= Non-performing loans as a percentage of total loans and leases 1.16% 1.26% 1.27% 0.72% 1.24% Allowance for loan and lease losses as a percentage of non-performing loans and leases 101.29% 97.19% 86.53% 150.16% 106.32% Non-performing assets as a percentage of total loans and leases and other real estate owned 1.16% 1.26% 1.40% 0.91% 1.32% Allowance for loan and lease losses as a percentage of non-performing assets 101.29% 97.19% 78.94% 119.03% 99.70%
(1) Generally the Bank places a loan in non-accrual status when principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection. Management believes that the allowance for loan and lease losses is adequate based on its current assessment of probable estimated losses. OREO represents residential and commercial real estate owned by the Corporation following default by borrowers that has been written down to estimated realizable value (net of estimated disposal costs) based on professional appraisals. 30 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Management is not aware of any loans or leases other than those included in these tables and mentioned in this section as well as the "Asset Quality and Allowance for Loan and Lease Losses" section that would be considered potential problem loans and cause Management to have doubts as to the borrower;s ability to comply with loan repayment terms. At December 31, 2006 and 2005, there were no properties held by the Corporation as OREO. NON-INTEREST INCOME Total non-interest income decreased $113 thousand or 1.2%, to $9.2 million in 2006, compared to an increase of $12 thousand or 0.1% from 2004 to 2005. The various components of non-interest income are discussed below. The largest component of non-interest income is Wealth Management revenue which increased $30 thousand or 0.9% to $3.4 million in 2006. This compares to a decrease of $93 thousand or 2.7% from $3.5 million in 2004. The market value of Wealth Management assets under management and custody increased 0.3% from $561.0 million at December 31, 2005 to $563.0 million at December 31, 2006. Wealth Management assets under management and custody grew 1.0% or $5.4 million in 2005. Service charges on deposit accounts increased $53 thousand or 2.7% to $2.0 million in 2006 compared to a decrease of $161 thousand or 7.6% in 2005 from 2004. To remain competitive and increase the core deposit base, the Corporation introduced a "Free Checking" product during the first quarter of 2005 which contributed to the decrease in service charges in 2005 from 2004. During 2006, checking account fees continued to decrease. This decrease was offset by an increase in overdraft protection fees. The effect of introducing a "Free Checking" product will continue to impact this component of non-interest income in the future as certain existing accounts, on which service charges are currently collected, may move to this new product. Gains and losses on the sale of investment securities was a loss of $79 thousand in 2006 as compared to a $58 thousand gain in 2005 and a $70 thousand gain in 2004. The gains realized on the sales of investment securities throughout 2006, 2005 and 2004 are the results of normal portfolio management. During 2005 and 2006 Corporation had operating lease agreements with several customers. The income on these agreements is classified as "Rental Income". Rental Income on operating lease agreements increased $155 thousand or 15.5% from $998 thousand in 2005 to $1.2 million in 2006. Rental income on operating lease agreements increased $170 thousand or 20.5% in 2005. The increases in 2006 and 2005 are due to an increased volume in operating leases with one customer. See the discussion of related depreciation expense in the "Non-Interest Expense" section. Gains and losses on the sale of fixed assets and OREO in 2006 was a $19 thousand gain as compared to a $6 thousand loss in 2005 and a $145 thousand gain in 2004. The gain in 2004 of was related to foreclosed property that was sold at a higher value than the Corporation had anticipated. Gains and fee income generated in the sales of residential mortgage loans during 2006 decreased by $115 thousand or 24.3% from $474 thousand in 2005 to $359 thousand in 2006. This compares with an increase of $97 thousand from $377 thousand in 2004. During 2006, the volume of refinancing and originations of saleable loans had substantially decreased from 2005, resulting in a lower amount of gains and fees being collected when compared to 2005. During 2005 this activity was strong and resulted in a substantial amount of gains and fee income when compared to 2004. When a mortgage is sold, all unamortized fees collected are recognized as income for that period and any gain or loss based on the current market value is recorded at the time of the sale. The Corporation retains the servicing on a portion of the loans sold and earns a servicing fee. Other non-interest income decreased $124 thousand or 5.1% from $2.5 million in 2005 to $2.3 million in 2006. This compares with an increase of $162 thousand or 7.1% from 2004. The primary components of other non-interest income over the past three years are as follows: 2006 2005 2004 ---- ---- ---- Electronic Banking $ 994 $ 873 $ 823 Wealth Advisory Services 373 367 268 Other 963 1,214 1,201 --- ----- ----- $2,330 $2,454 $2,292 ====== ====== ====== Other includes rental income, safe deposit box fees, merchant services income, and other commission and fee income. The decrease in this component of Other Non-Interest Income in 2006 as compared to 2005 was primarily due to a gain recorded in 2005 related to a forfeited deposit. 31 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NON-INTEREST EXPENSE Total non-interest expense increased $596 thousand or 2.0% from $30.6 million in 2005 to $31.2 million in 2006, compared to an increase of $1.3 million or 4.6% from 2004 to 2005. The various components of non-interest expense changes are discussed below. Employee salaries and benefits increased $1.6 million or 9.8% from $15.9 million in 2005 to $17.4 million in 2006, compared to an increase of $66 thousand or 0.4% from $15.8 million in 2004. The increase during 2006 as compared to 2005 was primarily caused by higher salary expense related to the adoption of a new performance-based incentive program in 2006 combined with higher base salaries and benefits due to a higher employee head count during the year. Net occupancy, equipment and data processing expense decreased $246 thousand or 4.4% from $5.6 million in 2005 to $5.4 million in 2006, compared to an increase of $244 thousand or 4.6% from $5.4 million in 2004. The lower expense in 2006 as compared to 2005 is primarily due to lower depreciation on core systems and equipment that became fully depreciated in 2006. The increase in net occupancy, equipment and data processing expense in 2005 as compared to 2004 was primarily due to higher depreciation and related costs on core system equipment that was purchased in the first quarter of 2005. Depreciation on operating leases increased $118 thousand or 13.6% from $869 thousand in 2005 to $987 thousand in 2006. This compares to an increase of $129 thousand or 17.4% from $740 thousand in 2004. This depreciation expense is associated with the operating lease agreements the Bank had with several customers. The income associated with this operating lease is classified as Rental Income. Professional services expense decreased $753 thousand or 28.9% from $2.6 million in 2005 to $1.8 million in 2006 compared to an increase of $853 thousand or 48.8% from $1.7 million in 2004. The higher professional services expense in 2005 as compared to 2006 and 2004 are primarily due to the cost of complying with Sarbanes-Oxley legislation recorded in 2005 combined with certain consulting fees for demographic and branch site analysis, real estate management, benefit plans and management planning also recorded in 2005. Bank Shares Tax was $726 thousand, $549 thousand, and $517 thousand for the years 2006, 2005, and 2004, respectively. Bank Shares Tax represented 1.02%, 1.00%, and 1.00% of average stockholders' equity for 2006, 2005, and 2004, respectively. The Pennsylvania Bank Shares Tax is based primarily on Bank stockholders' equity, and is paid on an annual basis. Total other non-interest expense decreased $251 thousand or 5.0% from $5.1 million to $4.8 million in 2006 compared with an increase of $20 thousand or .4% from $5.0 million in 2004. The primary components of other non-interest expense over the past three years are as follows: 2006 2005 2004 ---- ---- ---- Telephone, Postage, and Supplies $1,190 $1,004 $1,084 Marketing and Corporate Communications 1,000 1,094 1,168 Loan and Deposit Supplies 504 569 629 Other 2,107 2,385 2,151 ----- ----- ----- $4,801 $5,052 $5,032 ====== ====== ====== Other includes director fees, travel and mileage, Wealth Management processing fees, dues and subscriptions, FDIC Deposit Insurance premiums and assessments, and other general expenses. Prior to March 31, 2006, the Bank was subject to deposit insurance assessments by the FDIC's Bank Insurance Fund ("BIF"). On February 8, 2006, the President signed The Federal Deposit Insurance Reform Act of 2005, and, on February 15, 2006, the President signed into law The Federal Deposit Insurance Reform Conforming Amendments Act of 2005 (collectively, the Reform Act). The Reform Act provides for various changes to the FDIC's insurance program, including the merger of the BIF and the Savings Association Insurance Fund ("SAIF") into a new fund, the Deposit Insurance Fund ("DIF"), effective dateYear2006Day31Month3March 31, 2006. Prior to enactment of the Reform Act, the Bank was not required to pay any FDIC assessments. To help offset the new DIF assessment, the Bank expects to receive a one-time assessment credit. The assessment credit is presently expected to offset the cost of the deposit insurance premiums for 2007 and may partially offset the cost of such premiums for 2008. Such increases in FDIC assessments will be an additional expense to the Corporation and, thus, will affect the Corporation's net income in future years. 32 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES In accordance with the Deposit Insurance Act of 1997 an additional assessment by the Financing Corporation ("FICO") became applicable to all insured institutions as of dateYear1998Day1Month1January 1, 1998. This assessment is not tied to the FDIC risk classification. The FICO assessment rates effective for the fourth quarter 2006 and the first quarter of 2007 were 1.24 basis points per $100 of DIF assessable deposits and 1.22 basis points, respectively. FICO deposit insurance expense was $88 thousand, $91 thousand and $86 thousand for the years 2006, 2005 and 2004. In the fourth quarter of 2004, the Corporation opened a temporary modular facility in the Oxford area. This facility was equipped to meet all of our customers' needs and was replaced by a newly designed full-service branch in the fourth quarter of 2005. The Corporation also opened a mini-branch in the Wellington Retirement Community in late November 2005. In April, 2006, the Corporation opened a new loan processing office in Phoenixville, Pennsylvania. In the fourth quarter of 2006, the Corporation opened two new grocery store branches in Phoenixville and Royersford, Pennsylvania. These branches have a direct impact on all the components of non-interest expense. It is anticipated that the increases in costs will be offset over time by increases in net interest and fee income generated by business in the new marketing areas. We are continuously looking for new branch opportunities and may open new branches in the future as circumstances permit. The Corporation intends to open a new full service branch in 2007 in the Kennett Square, Pennsylvania area. INCOME TAXES Income tax expense was $2.9 million in 2006 compared with $1.9 million in 2005 and $2.4 million in 2004, representing an effective tax rate of 28.2%, 22.6%, and 28.3%, respectively. The decrease in the effective tax rate in 2005 as compared to 2006 and 2004 is primarily due to an increase in permanent differences as a relative percentage of pretax income. CAPITAL ADEQUACY The Corporation is subject to Risk-Based Capital Guidelines adopted by the Federal Reserve Board for bank holding companies. The Bank is also subject to similar capital requirements adopted by the OCC. Under these requirements, the regulatory agencies have set minimum thresholds for Tier I Capital, Total Capital, and Leverage ratios. At December 31, 2006, both the Corporation's and the Bank's capital exceeded all minimum regulatory requirements and the bank was considered "well capitalized", as defined in the regulations issued pursuant to the FDIC Improvement Act of 1994. The Corporation's and Bank's Risk-Based Capital Ratios, shown below, have been computed in accordance with regulatory accounting policies. RISK-BASED December 31 "Well Capitalized" ----------- ------------------ CAPITAL RATIOS 2006 2005 2004 Requirements -------------- ---- ---- ---- ------------ Corporation ----------- Leverage Ratio 9.34% 8.80% 8.62% N/A Tier I Capital Ratio 11.26% 10.94% 10.80% N/A Total Risk-Based Capital Ratio 12.49% 12.19% 11.91% N/A Bank ---- Leverage Ratio 8.58% 8.14% 8.11% 5.00% Tier I Capital Ratio 10.31% 10.08% 10.16% 6.00% Total Risk-Based Capital Ratio 11.53% 11.32% 11.26% 10.00% The Bank is not under any agreement with the regulatory authorities nor is it aware of any current recommendations by the regulatory authorities that, if they were to be implemented, would have a material effect on liquidity, capital resources or operations of the Corporation. 33 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The following table sets forth contractual obligations and other commitments representing required and potential cash outflows as of December 31, 2006:
(Dollars in thousands) Less than More Than 5 Total 1 year 1-3 years 3-5 years Years ----- ------ --------- --------- ----- Minimum Annual Rentals on non-cancelable operating leases $ 4,414 $ 498 $ 1,024 $ 1,096 $ 1,796 Remaining contractual maturities of time deposits 228,928 199,294 15,976 3,998 9,660 Loan commitments 253,870 253,870 Federal Home Loan Bank Advances and other borrowings 61,596 11,211 37,886 10,150 2,349 Subordinated debt 15,465 - - - 15,465 Standby letter of credit 12,628 12,628 - - - Total $576,901 $477,501 $54,886 $15,244 $29,270
BRANCHING PROJECTS The Corporation intends to open a series of new branch locations throughout Chester County, Pennsylvania over the next five years. A new, customer-focused branch design was introduced with the construction of the branch office in Oxford, Pennsylvania. This new "signature look" will be rolled out to new and certain current locations over the next five years. CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES The accounting and reporting policies of the Corporation conform with accounting principles generally accepted in the United States of America and general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the placecountry-regionUnited States of America requires Management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The Corporation considers that the determination of the allowance for loan and lease losses involves a higher degree of judgment and complexity than its other significant accounting policies. The balance in the allowance for loan and lease losses is determined based on Management's review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including Management's assumptions as to future delinquencies, recoveries and losses. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from Management's estimates, additional provisions for loan and lease losses may be required that would adversely impact earnings in future periods. Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities. Deferred tax assets are subject to Management's judgment based upon available evidence that future realization is more likely than not. If Management determines that the Corporation may be unable to realize all or part of the net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount. 34 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123 (revised 2004), "Share-Based Payments" (Statement 123(R)). Statement 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based compensation issued to employees in the income statement. Statement 123(R) generally requires that an entity account for those transactions using the fair-value-based method; and eliminates an entity's ability to account for share-based compensation transactions using the intrinsic value method of accounting in APB Opinion No. 25, "Accounting for Stock Issued to Employees," which was permitted under Statement 123, as originally issued. Statement 123(R) requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements. Statement 123(R) was effective for the Corporation beginning January 1, 2006. The Corporation must use either the modified prospective or the modified retrospective transition method. The adoption of Statement 123(R) is expected to reduce reported net income and earnings per share, resulting from the vesting of any equity-based compensation. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107"), which provides guidance on the interaction between Statement 123(R) and certain SEC rules and regulations. SAB 107 was issued to assist issuers in their initial implementation of Statement 123(R) and to enhance the information received by investors and other users of the financial statements. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when the pronouncement does not include specific transition provisions. SFAS No. 154 requires retrospective application of changes in accounting principle to prior periods' financial statements unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with early adoption permitted. The Corporation's adoption of SFAS No. 154 did not have an impact on our financial condition or results of operations. In September 2006, FASB issued Statement No. 157 ("SFAS 157"), "Fair Value Measurements," which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This Statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. The Corporation is currently evaluating the impact the adoption of SFAS No. 157 will have on our consolidated financial statements. In September 2006, FASB issued Statement No. 158 ("SFAS 158"), "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106, and 132(R)". SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Corporation adopted SFAS 158 as of December 31, 2006, but because the Corporation does not have a defined benefit plan, the adoption of SAB 158 did not have a material effect on our consolidated financial statements. In September 2006, the SEC staff issued Staff Accounting Bulletin No.108 ("SAB 108") "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements." SAB 108 established an approach that requires quantification of financial statement misstatements based on the effects of the misstatement on each of the company's financial statements and the related disclosures. SAB 108 allows registrants to initially apply the approach either by (1) retroactively adjusting prior financial statements as if the approach had always been used or (2) recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with the related offset recorded to the opening balance of retained earnings. The Corporation elected to record a cumulative effect adjustment as of January 1, 2006, as discussed in Footnote A to the Corporation's consolidated financial statements. In June 2006, FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of 35 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will apply to fiscal years beginning after December 15, 2006. The Corporation does not believe that the adoption of FIN 48 will have a material effect on the financial statements. In March 2006, FASB issued SFAS No. 156, "Amending Accounting for Separately Recognized Servicing Assets and Servicing Liabilities" ("SFAS 156"). This statement amends SFAS No. 140 and requires an entity to 1) separately recognize financial assets as servicing assets or servicing liabilities, each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts, 2) initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable and 3) separately present servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. The Corporation adopted SFAS 156 effective January 1, 2006. The adoption of this statement did not have a material impact on the Corporation's financial position or the results of operations. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140" ("SFAS 155"), to simplify and make more consistent the accounting for certain financial instruments. SFAS 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") and permits fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. SFAS 155 amends SFAS 140 to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 applies to all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after eptember 15, 2006, with earlier application allowed. SFAS 155 is not expected to have a material impact on the Corporation's financial condition or results of operations. Item 7A. Quantitative and Qualitative Disclosures About Market Risk LIQUIDITY MANAGEMENT AND INTEREST RATE SENSITIVITY The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for business expansion. Liquidity management addresses the Corporation's ability to meet deposit withdrawals either on demand or at contractual maturity, to repay borrowings as they mature and to make new loans and investments as opportunities arise. Liquidity is managed on a daily basis enabling Senior Management to monitor changes in liquidity and to react accordingly to fluctuations in market conditions. The primary sources of liquidity for the Corporation are funding available from growth of our existing deposit base, new deposits, FHLB, and cash flow from the investment and loan portfolios. The Corporation considers funds from such sources to comprise its "core" deposit base because of the historical stability of such sources of funds. Additional liquidity comes from the Corporation's non-interest bearing demand deposit accounts and credit facilities. Other deposit sources include a tiered savings product and certificates of deposit in excess of $100,000. Details of core deposits, non-interest-bearing demand deposit accounts and other deposit sources are highlighted in the "Deposit Analysis" table in the "Interest Expense on Deposit Accounts" section. The Corporation utilizes borrowings from the FHLB and collateralized repurchase agreements in managing its interest rate risk and as a tool to augment deposits and in funding asset growth. The Corporation may utilize these funding sources to better match its assets that are subject to longer term repricing (i.e., between one and five years). The Bank, as a member of the FHLB, maintains several credit facilities (overnight lines of credit, amortizing and non-amortizing fixed rate term and variable rate term advances with FHLB). As of December 31, 2006, the amount outstanding under the Bank's line of credit with the FHLB was $0. FHLB borrowings totaled $61.6 million compared to $68.9 million at December 31, 2006 and 2005, respectively. These advances consist of short and long term borrowings representing a combination of maturities. The average interest rate for 2006 and 2005 on these advances was approximately 3.9% and 3.7%, respectively. The Bank currently has a maximum borrowing capacity with the FHLB of approximately $208.4 million. 36 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The goal of interest rate sensitivity management is to avoid fluctuating net interest margins, and to enhance consistent growth of net interest income through periods of changing interest rates. Such sensitivity is measured as the difference in the volume of assets and liabilities in the existing portfolio that are subject to repricing in a future time period. The Corporation's net interest rate sensitivity of its "gap position" within one year is a negative $241.1 million or -27.6% of total assets at December 31, 2006, compared with a negative $122.6 million or -14.5% of total assets at the end of 2005. The Corporation's gap position is just one tool used to evaluate interest rate risk and the stability of net interest margins. The data in the following chart represents the gap position at a specific point in time and may not be indicative of future gap positions. Another tool that Management uses to evaluate interest rate risk is a computer simulation model that assesses the impact of changes in interest rates on net interest income, net-income under various interest rate forecasts and scenarios. Management has set acceptable limits of risk within its Asset Liability Committee policy and monitors the results of the simulations against these limits quarterly. Management monitors interest rate risk as a regular part of corporate operations with the intention of maintaining a stable net interest margin. INTEREST RATE SENSITIVITY GAP AS OF DECEMBER 31, 2006
(Dollars in thousands) Within Through Five Non-Rate One Year Five Years Years Sensitive Total -------- ---------- ----- --------- ----- ASSETS Federal funds sold $ 44,500 $ - $ - $ - $ 44,500 Investment securities 17,131 44,156 27,427 - 88,714 Interest bearing deposits in banks 285 - - - 285 Loans and leases 237,499 335,043 121,801 (8,186) 686,157 Cash and due from banks - - - 27,556 27,556 Premises & equipment - - - 13,988 13,988 Other assets - - - 10,894 10,894 --------- -------- -------- ------ ------ Total assets $ 299,415 $379,199 $149,228 $ 44,252 $872,094 ========= ======== ======== ========= ======== LIABILITIES AND CAPITAL Non-interest-bearing deposits$ - $ - $ - $ 129,911 $129,911 Interest bearing deposits 513,854 19,973 60,930 - 594,757 FHLB advances and other Borrowings 11,210 47,974 2,412 - 61,596 Subordinated debt 15,465 - - - 15,465 Other liabilities - - 7,103 - 7,103 Capital - - - 63,262 63,262 --------- -------- -------- ------ ------ Total liabilities and capital $ 540,529 $ 67,947 $ 70,445 $ 193,173 $872,094 ========= ======== ======== ========= ======== Net interest rate sensitivity gap $(241,114) $311,252 $ 78,783 $(148,921) $ - ========= ======== ======== ========= ======== Cumulative interest rate sensitivity gap $(241,114) $ 70,138 $148,921 $ - $ - ========= ======== ======== ======== ======= Cumulative interest rate sensitivity gap divided by total assets (27.6%) 8.0% 17.1% ===== === ====
37 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES The Corporation's gap position is one factor used to evaluate interest rate risk and the stability of net interest margins. Other factors include computer simulations of what might happen to net interest income under various interest rate forecasts and scenarios. The Corporation's Asset Liability Management Policy requires quarterly calculation of the effects of changes in interest rates on net interest income. The table below summarizes estimated changes in net interest income over the twelve-month period ending December 31, 2006 under alternative interest rate scenarios. The change in interest rates was modeled to simulate the effect of a proportional shift in asset and liability ratios (rate ramp). The prime rate as reported in the Wall Street Journal as of December 31, 2006 of 8.25% is used as the "driver rate" in these simulations. (Dollars in thousands) Change in Net Dollar Percent Interest Rates Interest Income Change Change -------------- --------------- ------ ------ +200 Basis Points $ 32,195 $ 845 2.70% +100 Basis Points 31,804 454 1.45% Flat Rate 31,350 - - -100 Basis Points 30,766 (584) (1.86)% -200 Basis Points 30,056 (1,294) (4.13)% Management believes that the assumptions utilized in evaluating the vulnerability of the Corporation's net interest income to changes in interest rates approximate actual experience; however, the interest rate sensitivity of the Corporation's assets and liabilities, as well as the estimated effect of changes in interest rates on net interest income, could vary substantially if different assumptions are used or actual experience differs from the experience on which the assumptions were based. In the event the Corporation should experience a mismatch in its desired gap position or an excessive decline in its net interest income subsequent to an immediate and sustained change in interest rates, it has a number of options which it could utilize to remedy such a mismatch. The Corporation could restructure its investment portfolio through sale or purchase of securities with more favorable repricing attributes. It could also promote loan products with appropriate maturities or repricing attributes. The Corporation could also solicit deposits or search for borrowings with more desirable maturities. However, market circumstances might make execution of these strategies cost prohibitive or unattainable. The nature of the Corporation's current operation is such that it is not subject to foreign currency exchange or commodity price risk. Additionally, neither the Corporation nor the Bank owns trading assets. At December 31, 2006, the Corporation did not have any hedging transactions in place such as interest rate swaps, caps or floors. 38 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 8. Financial Statements and Supplementary Data. Report of Independent Registered Public Accounting Firm Board of Directors First Chester County Corporation We have audited the accompanying consolidated balance sheets of First Chester County Corporation and its subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006. 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 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Chester County Corporation and its subsidiaries as of December 31, 2006 and 2005, and the consolidated results of their operations and their consolidated cash flows for each of the three years ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Effective January 1, 2006, the Corporation adopted Statement of Financial Accounting Standards No. 123(R), "Share-Based Payments" and Securities and Exchange Commission Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Mistatements When Quantifying Mistatements in the Current Year Financial Statements." We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of First Chester County Corporation's internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 9, 2007 expressed an unqualified opinion on management's assessment of the effectiveness of internal controls over financial reporting and an unqualified opinion on the effectiveness of internal controls over financial reporting. Grant Thornton LLP Philadelphia, Pennsylvania March 9, 2007 39 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(Dollars in thousands) December 31 ----------- 2006 2005 ---- ---- ASSETS Cash and due from banks $ 27,556 $ 37,401 Federal funds sold and other overnight investments 44,500 31,000 Interest bearing deposits 285 542 --- --- Total cash and cash equivalents 72,341 68,943 ------ ------ Investment securities held-to-maturity (fair value of $5 and $10 at December 31, 2006 and 2005, respectively) 5 10 Investment securities available-for-sale, at fair value 88,709 97,078 Loans and leases 694,343 664,276 Less allowance for loan and lease losses (8,186) (8,123) ------ ------ Net loans 686,157 656,153 Premises and equipment, net 13,988 13,786 Other assets 10,894 9,564 ------ ----- Total assets $872,094 $845,534 ======== ======== LIABILITIES Deposits Non-interest-bearing $129,911 $136,082 Interest-bearing (including certificates of deposit over $100 of $43,825 and $61,281 at December 31, 2006 and 2005, respectively) 594,757 560,015 ------- ------- Total deposits 724,668 696,097 Federal Home Loan Bank advances and other borrowings 61,596 68,900 Subordinated debt 15,465 15,465 Other liabilities 7,103 6,395 ----- ----- Total liabilities 808,832 786,857 ------- ------- STOCKHOLDERS' EQUITY Common stock, par value $1.00; authorized, 10,000,000 shares; Outstanding 5,279,815 at December 31, 2006 and 2005. 5,280 5,280 Additional paid-in capital 11,939 12,441 Retained earnings 50,486 46,503 Accumulated other comprehensive loss (1,473) (1,929) Treasury stock, at cost; 128,075 and 153,164 at December 31, 2006 and 2005, respectively. (2,970) ( 3,618) ------ ------- Total stockholders' equity 63,262 58,677 ------ ------ Total liabilities and stockholders' equity $872,094 $845,534 ======== ========
The accompanying notes are an integral part of these statements. 40 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share) Years ended December 31 ----------------------- 2006 2005 2004 ---- ---- ---- INTEREST INCOME Loans and leases, including fees $45,783 $39,402 $32,046 Investment securities 4,358 4,441 5,223 Federal funds sold and deposits in banks 2,061 761 249 ----- --- --- Total interest income 52,202 44,604 37,518 ====== ====== ====== INTEREST EXPENSE Deposits 16,237 10,009 5,304 Subordinated debt 1,304 1,015 728 Federal Home Loan Bank advances and other borrowings 2,496 2,555 1,831 ----- ----- ----- Total interest expense 20,037 13,579 7,863 ====== ====== ===== Net interest income 32,165 31,025 29,655 PROVISION FOR LOAN AND LEASE LOSSES 3 1,382 1,164 - ----- ----- Net interest income after provision for loan and lease losses 32,162 29,643 28,491 ------ ------ ------ NON-INTEREST INCOME Wealth Management 3,423 3,393 3,486 Service charges on deposit accounts 2,007 1,954 2,115 Investment securities gains (losses), net (79) 58 70 Operating lease rental income 1,153 998 828 Gains (losses) on the sales of fixed assets and OREO 19 (6) 145 Gains and fees on the sales of residential mortgages 359 474 377 Other 2,330 2,454 2,292 ----- ----- ----- Total non-interest income 9,212 9,325 9,313 ----- ----- ----- NON-INTEREST EXPENSE Salaries and employee benefits 17,432 15,881 15,815 Occupancy, equipment, and data processing 5,359 5,605 5,361 Depreciation expense on operating leases 987 869 740 Bank shares tax 726 549 517 Professional services 1,848 2,601 1,748 Other 4,801 5,052 5,032 ----- ----- ----- Total non-interest expense 31,153 30,557 29,213 ------ ------ ------ Income before income taxes 10,221 8,411 8,591 INCOME TAXES 2,886 1,900 2,430 ----- ----- ----- NET INCOME $ 7,335 $ 6,511 $ 6,161 ======= ======= ======= PER SHARE Basic earnings per common share $ 1.42 $ 1.28 $ 1.24 ======= ======= ======= Diluted earnings per common share $ 1.40 $ 1.24 $ 1.19 ======= ======= ======= Dividends declared $ 0.540 $ 0.525 $ 0.505 ======= ======= =======
The accompanying notes are an integral part of these statements. 41 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Dollars in thousands Accumulated Additional Other Total Common Stock Paid-in Retained Comprehensive Treasury Stockholders' Comprehensive Shares Par Value Capital Earnings Income/(loss) Stock Equity Income ------ --------- ------- -------- ------------- ----- ------ ------ Balance at January 1, 2004 4,799,666 $4,800 $ 1,877 $50,117 $ 306 $(5,350) $51,750 $ - Net Income 6,161 6,161 6,161 Cash dividends declared (2,529) (2,529) Other Comprehensive Income Net unrealized gains on investment securities available-for-sale (384) (384) (384) Treasury stock transactions (328) 229 (99) Share based compensation tax benefit 503 503 ------------------------------------------------------------------------------------------------------ Comprehensive Income $5,777 ====== Balance December 31, 2004 4,799,666 $4,800 $ 2,052 $53,749 $ (78) $(5,121) $55,402 Net Income 6,511 6,511 6,511 Cash dividends declared (2,665) (2,665) Stock dividends declared 480,149 480 10,612 (11,092) Other Comprehensive Income Net unrealized gains on investment securities available-for-sale (1,851) (1,851) (1,851) Treasury stock transactions (223) 1,503 1,280 ------------------------------------------------------------------------------------------------------ Comprehensive Income $4,660 ====== Balance December 31, 2005 5,279,815 $5,280 $12,441 $46,503 $(1,929) $(3,618) $58,677 Cumulative effect under SAB No. 108 adjustments (565) (565) ------------------------------------------------------------------------------------------------------ Balance at January 1, 2006, as adjusted 5,279,815 $5,280 $12,441 $45,938 $(1,929) $(3,618) $58,112 Net Income 7,335 7,335 7,335 Cash dividends declared (2,787) (2,787) Other Comprehensive Income Net unrealized gains on investment securities available-for-sale 456 456 456 Treasury stock transactions (733) 648 (85) Share based compensation tax 1 1 benefit 23 23 ------------------------------------------------------------------------------------------------------ Comprehensive Income $7,791 ====== Balance December 31, 2006 5,279,815 $5,280 $11,939 $50,486 $(1,473) $(2,970) $63,262 ======================================================================================================
The accompanying notes are an integral part of these statements 42 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands) Years ended December 31 ----------------------- 2006 2005 2004 ---- ---- ---- OPERATING ACTIVITIES Net income $ 7,335 $ 6,511 $ 6,161 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 2,777 2,615 1,558 Provision for loan and lease losses 3 1,382 1,164 Amortization of investment security premiums and accretion of discounts, net 232 194 563 Amortization of deferred loan fees 459 (111) (54) Investment securities (gains) losses, net 79 (58) (70) (Increase) in other assets (1,331) (2,509) (361) Increase in other liabilities 143 872 598 --- --- --- Net cash provided by operating activities 9,697 8,896 9,559 ----- ----- ----- INVESTING ACTIVITIES Net increase in loans (30,468) (46,234) (106,591) Proceeds from sales of investment securities available-for-sale 13,631 85,784 32,066 Proceeds from maturities of investment securities 9,216 56,985 101,351 Purchase of investment securities available-for-sale (14,094) (99,964) (143,131) Purchase of premises and equipment (2,979) (2,264) (2,527) ------ ------ ------ Net cash used in investing activities (24,694) ( 5,693) (118,832) ------- - ----- -------- FINANCING ACTIVITIES Increase (decrease) in Federal Home Loan Bank Advances (5,000) 750 (850) Increase in Federal Home Loan Bank Borrowings (2,304) - - Decrease in Federal Home Loan Bank Borrowings - 1,686 26,771 Net increase in deposits 28,571 33,079 85,704 Cash dividends paid (2,787) (2,665) (2,529) Net increase (decrease) in treasury stock transactions (85) 1,280 404 --- ----- --- Net cash provided by financing activities 18,395 34,130 109,500 ------ ------ ------- NET INCREASE IN CASH AND CASH EQUIVALENTS 3,398 37,333 227 Cash and cash equivalents at beginning of year 68,943 31,610 31,383 ------ ------ ------ Cash and cash equivalents at end of year $ 72,341 $ 68,943 $ 31,610 ========= ========= =========
The accompanying notes are an integral part of these statements. 43 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES First Chester County Corporation (the "Corporation"), through its wholly-owned subsidiary, First National Bank of Chester County (the "Bank"), has been serving the residents and businesses of Chester County, Pennsylvania, since 1863. The Bank is a locally managed community bank providing loan, deposit, cash management and trust and investment services from its twenty one locations. The Bank encounters vigorous competition for market share in the communities it serves from bank holding companies, other community banks, Internet banks, thrift institutions, credit unions and other non-bank financial organizations such as mutual fund insurance and brokerage companies. The Corporation and the Bank, and their wholly-owned subsidiaries FNB Properties, LLC, FNB Insurance Services, LLC, Turks Head Properties, Inc, Turks Head II, LLC, First Chester County Capital Trust I ("Trust I"), and First Chester County Capital Trust II ("Trust II") are subject to regulations of certain state and federal agencies. These regulatory agencies periodically examine the Corporation and the Bank for adherence to laws and regulations. 1. Basis of Financial Statement Presentation ----------------------------------------- The accounting policies followed by the Corporation and its wholly-owned subsidiaries conform to generally accepted accounting principles ("GAAP") and predominant practices within the banking industry. The accompanying consolidated financial statements include the accounts of the Corporation, the Bank, Turks Head Properties, Turks Head II, First National Bank Insurance Services, and FNB Properties. All significant intercompany transactions have been eliminated. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the balance sheets, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The principal estimate that is susceptible to significant change in the near term relates to the allowance for loan and lease losses. The evaluation of the adequacy of the allowance for loan and lease losses includes an analysis of the individual loans and leases and overall risk characteristics and size of the different loan and lease portfolios, and takes into consideration current economic and market conditions, the capability of specific borrowers to pay specific loan and lease obligations, as well as current loan collateral values. However, actual losses on specific loans and leases, which also are encompassed in the analysis, may vary from estimated losses. Statement of Financial Accounting Standards ("SFAS") No. 131 establishes standards for public business enterprises reporting information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also establishes standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess resources and performance. The Corporation has applied the aggregation criteria set forth in SFAS No. 131 for its operating segments to create one reporting segment, "community banking." The Corporation's community banking segment consists of construction, commercial, retail, and mortgage banking. The community banking segment is managed as a single strategic unit, which generates revenue from a variety of products and services provided by the Corporation. For example, construction and commercial lending is dependent upon the ability of the Corporation to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk. This situation is also similar for consumer and residential mortgage lending. Accordingly, all significant operating decisions are based upon analysis of the Corporation as one operating segment or unit. 44 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued Management has determined that Trust I and Trust II (Trust I and Trust II, collectively, the "Trusts") each qualify as variable interest entities under FASB Interpretation 46 ("FIN 46"). Each of the Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to the Corporation. Trust I and Trust II holds, as its sole asset, subordinated debentures issued by the Corporation. Subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, FIN 46(R), the provisions of which must be applied to certain variable interest entities. The Corporation adopted the provisions under the revised interpretation in the first quarter of 2004. FIN 46(R) required the Corporation to deconsolidate the Trusts. Accordingly, the Corporation deconsolidated the Trusts at the end of the first quarter of 2004. In March 2005, the Federal Reserve Board adopted a final rule that would continue to allow the inclusion of trust preferred securities in Tier I Capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier I Capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier II Capital, subject to restriction. Based on the final rule, the Corporation expects to include all of its $15.5 million in trust preferred securities in Tier I Capital. 2. Financial Instruments --------------------- The Corporation follows SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," which requires all entities to disclose the estimated fair value of their assets and liabilities considered to be financial instruments. Financial instruments requiring disclosure consist primarily of investment securities, loans, and deposits and borrowings. 3. Investment Securities --------------------- The Corporation follows SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires investments in securities to be classified in one of three categories: held-to-maturity, trading, or available-for-sale. Debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity and are reported at amortized cost. As the Corporation does not engage in security trading, the balance of its debt securities and any equity securities are classified as available-for-sale. Net unrealized gains and losses for such securities, net of tax effect, are required to be recognized as a separate component of stockholders' equity and excluded from the determination of net income. In November 2005, the FASB issued FASB Staff Position ("FSP") SFAS 115-1 and 124-1, "The meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." This FSP nullifies certain requirements of EITF-03-01 on this topic and provides additional guidance on when an investment in a debt or equity security should be considered impaired and when that impairment should be considered other-than-temporary and recognized as a loss in earnings. Specifically, the guidance clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. The FSP also required certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP SFAS 115-1 and 124-1 was effective for reporting periods beginning after December 15, 2005. Adoption of the FSP did not have a material impact on the Company's consolidated financial statements. The Corporation follows the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activity," as amended by SFAS No. 138. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments imbedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives either as assets or liabilities in the statement of financial position and measure those instruments at fair value. The Corporation did not have any derivative instruments at December 31, 2006, 2005, and 2004. 45 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued 4. Loans and Leases and Allowance for Loan and Lease Losses -------------------------------------------------------- Loans and leases that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, reduced by unearned discount and an allowance for loan and lease losses. The allowance for loan and lease losses is established through a provision for loan and lease losses charged to expense. Loan and lease principal considered to be uncollectible by Management is charged against the allowance for loan and lease losses. The allowance is an amount that Management believes will be adequate to absorb possible losses on existing loans and leases that may become uncollectible based upon an evaluation of known and inherent risks in the loan and lease portfolio. The evaluation takes into consideration such factors as changes in the nature and size of the loan and lease portfolio, overall portfolio quality, specific problem loans, loss experience, and current and future economic conditions which may affect the borrowers' ability to pay. The evaluation also details historical losses by loan category, the resulting loss rates for which are projected at current loan and lease total amounts. Loss estimates for specified problem loans and leases are also detailed. Interest on loans and leases is accrued and credited to operations based upon the principal amount outstanding. Certain origination and commitment fees and related direct loan or lease origination costs are deferred and amortized over the contractual life of the related loans and leases, resulting in an adjustment of the related loan's yield. Accrual of interest is discontinued on a loan when Management believes that the borrower's financial condition is such that collection of interest and principal is doubtful. Upon such discontinuance, all unpaid accrued interest is reversed. The Corporation accounts for impairment in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures." SFAS No. 114 requires loan impairment to be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, its observable market price or the fair value of the collateral if the loan is collateral dependent. If it is probable that a creditor will foreclose on a property, the creditor must measure impairment based on the fair value of the collateral. Residential mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value. Gains and losses and unamortized fees on sales of residential mortgage loans are included in non-interest income. The Corporation accounts for its transfers and servicing of financial assets in accordance with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". SFAS No. 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral. The Corporation follows FASB Interpretation 45 ("FIN 45") "Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others." FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of FIN 45, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. The Corporation has issued financial and performance letters of credit. Financial letters of credit require the Corporation to make payment if the customer's financial condition deteriorates, as defined in underlying agreements. Performance letters of credit require the Corporation to make payments if the customer fails to perform certain non-financial contractual obligations. 5. Premises and Equipment ---------------------- Premises and equipment are stated at cost less accumulated depreciation. Assets are depreciated over their estimated useful lives, principally by the straight-line method. The Corporation accounts for impairment of long-term assets in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." The standard requires recognition and measurement of long-lived assets to be held and used or to be disposed of by sale. The Corporation had no impaired long-lived assets at December 31, 2005, 2004, or 2003. 46 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - continued 6. Contributions ------------- The Corporation accounts for contributions in accordance with SFAS No. 116, "Accounting for Contributions Received and Contributions Made." SFAS No. 116 specifies that contributions made by the Corporation be recognized as expenses in the period made and as decreases of assets or increases of liabilities depending on the form of the benefits given. In accordance with SFAS No. 116, the Corporation incurred contribution expenses relating to long-term commitments to local not-for-profit organizations of $78 thousand, $192 thousand and $52 thousand during 2006, 2005 and 2004, respectively. 7. Income Taxes ------------ The Corporation accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." Under the liability method specified by SFAS No. 109, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense and benefits are the result of changes in deferred tax assets and liabilities. 8. Employee Benefit Plans ---------------------- The Corporation has certain employee benefit plans covering eligible employees. The Bank accrues such costs as earned by the employee. 9. Share Based Compensation Plan ----------------------------- Effective January 1, 2006, the Corporation has adopted FASB Statement No. 123 (R), "Share-Based Payment". Statement 123 (R) requires that compensation cost relating to share-based payment transactions be recognized in financial statements. The cost is measured based on the fair value of the equity or liability instruments issued. Statement 123 (R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123 (R) replaces FASB Statement No. 123, "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". Statement 123 established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Because the Corporation adopted Statement 123 (R) using the modified prospective transition method, prior periods have not been restated. Under this method, the Corporation is required to record compensation expense for all awards granted after the date of adoption for the unvested portion of previously granted awards that remain outstanding as of the beginning of the period of adoption. As of January 1, 2006, there were no unvested options. The Corporation measured share-based compensation cost using the Black-Scholes option pricing model for stock option grants prior toJanuary 1, 2006 and anticipates using this pricing mode for future grants. Forfeitures did not affect the calculated expense based upon historical activities of option grantees. The Corporation granted no stock option during 2006 and all grants prior to January 1, 2006 were fully vested. At December 31, 2006, the Company has one stock-based employee compensation plan. Reported net income, adjusting for share-based compensation that would have been recognized in the adoption of Statement 123 (R) did not change the way that the company has accounted for stock awards in prior periods and therefore no such change 47 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued is reflected in the pro forma table below. The Company expenses the fair value of stock awards determined at the grant date on a straight-line basis over the vesting period of the award. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation prior to January 1, 2006. 2005 2004 ---- ---- Net income (in thousands) As reported $ 6,511 $ 6,161 Stock-based compensation costs determined under fair value method for all awards 114 39 --- -- Pro forma $ 6,397 $ 6,122 ======= ======= Earnings per share (Basic) As reported $ 1.28 $ 1.24 Pro forma $ 1.23 $ 1.23 Earnings per share (Diluted) As reported $ 1.24 $ 1.19 Pro forma $ 1.22 $ 1.18 The fair value of an option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2005: dividend yield of 2.74%; expected volatility of 0.66; risk-free interest rate of 4.34%; and an expected life of 2.14 years. 10. Wealth Management Division Assets and Income -------------------------------------------- Assets held by the Corporation in fiduciary or agency capacities for its customers are not included in the accompanying consolidated balance sheets since such items are not assets of the Bank or Corporation. Operating income and expenses of the Wealth Management Division are included under their respective captions in the accompanying consolidated statements of income and are recorded on the accrual basis. 11. Earnings per Share and Stockholders' Equity ------------------------------------------- The Corporation follows the provisions of SFAS No. 128, "Earnings Per Share" requires presentations of basic and diluted earnings per share ("EPS") in conjunction with the disclosure of the methodology used in computing such EPS. Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period. All per share data has been retroactively adjusted for stock dividends. 48 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued 12. Cash Flow Information --------------------- For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold and overnight investments. Generally, federal funds are purchased and sold for one-day periods. Cash paid for interest for the years ended dateYear2006Day31Month12December 31, 2006, 2005, and 2004 was $19.7 million, $12.9 million and $7.9 million, respectively. Cash paid for income taxes for the years ended December 31, 2006, 2005, and 2004 was $3.7 million, $2.3 million, and $1.7 million, respectively. 13. Reporting Comprehensive Income ------------------------------ The Corporation follows the provisions of SFAS No. 130, "Reporting of Comprehensive Income," which requires the reporting of comprehensive income which includes net income as well as certain other items which result in a change to equity during the period.
December 31, 2006 ----------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ ------- ------ Unrealized holding gains (losses) arising during the period $ 770 $ (262) $ 508 Reclassification adjustment for gains realized in net income (79) 27 (52) --- -- --- Other comprehensive loss $ 691 $ (235) $ 456 ======== ====== =======
December 31, 2005 ----------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ ------- ------ Unrealized holding gains (losses) arising during the period $(2,983) $1,095 $(1,888) Reclassification adjustment for gains realized in net income 58 (21) 37 -- --- -- Other comprehensive loss $(2,925) $1,074 $(1,851) ======= ====== =======
December 31, 2004 ----------------- (Dollars in thousands) Before Tax Net of Tax (Expense) Tax Amount Benefit Amount ------ ------- ------ Unrealized holding losses arising during the period $ (651) $ 221 $ (430) Reclassification adjustment for gains realized in net income 70 (24) 46 -- --- -- Other comprehensive income $ (581) $ 197 $ (384) ======= ====== ======= Advertising Costs The Bank expenses advertising costs as incurred.
49 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued 14. Reclassifications ----------------- Certain numbers have been reclassified to conform with the 2006 presentation. These reclassifications have no impact on net income or earnings per share. 15. New Accounting Pronouncements ----------------------------- On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123 (revised 2004), "Share-Based Payments" (Statement 123(R)). Statement 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based compensation issued to employees in the income statement. Statement 123(R) generally requires that an entity account for those transactions using the fair-value-based method; and eliminates an entity's ability to account for share-based compensation transactions using the intrinsic value method of accounting in APB Opinion No. 25, "Accounting for Stock Issued to Employees," which was permitted under Statement 123, as originally issued. Statement 123 (R) requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements. Statement 123(R) is effective for the Corporation beginning January 1, 2006. The Corporation must use either the modified prospective or the modified retrospective transition method. Early adoption of Statement 123(R) for interim or annual periods for which financial statements or interim reports have not been issued is permitted. The adoption of Statement 123(R) is expected to reduce reported net income and earnings per share, resulting from the vesting of any equity-based compensation. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107"), which provides guidance on the interaction between Statement 123(R) and certain SEC rules and regulations. SAB 107 was issued to assist issuers in their initial implementation of Statement 123(R) and to enhance the information received by investors and other users of the financial statements. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement when the pronouncement does not include specific transition provisions. SFAS No. 154 requires retrospective application of changes in accounting principle to prior periods' financial statements unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, with early adoption permitted. The Corporation's adoption of SFAS No. 154 did not have an impact on our financial condition or results of operations. In September 2006, FASB issued Statement No. 157 ("SFAS 157"), "Fair Value Measurements," which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This Statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. The Corporation is currently evaluating the impact the adoption of SFAS No. 157 will have on our consolidated financial statements. In September 2006, FASB issued Statement No. 158 ("SFAS 158"), "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106, and 132(R)". SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Corporation adopted SFAS 158 as of December 31, 2006, but because the Corporation does not have a defined benefit plan, it does not believe that the adoption of SAB 158 had a material effect on our consolidated financial statements. 50 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES continued In September 2006, the SEC staff issued Staff Accounting Bulletin No.108 ("SAB 108") "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements." SAB 108 established an approach that requires quantification of financial statement misstatements based on the effects of the misstatement on each of the company's financial statements and the related disclosures. SAB 108 allows registrants to initially apply the approach either by (1) retroactively adjusting prior financial statements as if the approach had always been used or (2) recording the cumulative effect of initially applying the approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with the related offset recorded to the opening balance of retained earnings. The Corporation decreased Stockholders' Equity by $565 thousand on January 1, 2006 as a result of adopting SAB 108. The transition provisions of SAB 108 permit the Corporation to adjust for the cumulative effect on Stockholders' Equity of immaterial errors relating to prior years. This decrease in Stockholders' Equity consists of $327 thousand of salary and employee benefits expense that had not been accrued in 2005 and 2004, $144 thousand of occupancy, equipment and data processing expense related to the understatement of rent expense, and $94 thousand of other non-interest expense that had not been accrued in 2005 and 2004. In June 2006, FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes." FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will apply to fiscal years ending after December 15, 2006. The Corporation adopted FIN 48 as of December 31, 2006. The Corporation does not believe that the adoption of FIN 48 had a material effect on the financial statements. In March 2006, FASB issued SFAS No. 156, "Amending Accounting for Separately Recognized Servicing Assets and Servicing Liabilities" ("SFAS 156"). This statement amends SFAS No. 140 and requires an entity to 1) separately recognize financial assets as servicing assets or servicing liabilities, each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts, 2) initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable and 3) separately present servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. The Corporation adopted SFAS 156 effective January 1, 2006. The adoption of this statement did not have a material impact on the Corporation's financial position or the results of operations. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140" ("SFAS 155"), to simplify and make more consistent the accounting for certain financial instruments. SFAS 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") and permits fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. SFAS 155 amends SFAS 140 to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 applies to all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006, with earlier application allowed. SFAS 155 is not expected to have a material impact on the Corporation's financial condition or results of operations. 51 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - INVESTMENT SECURITIES The amortized cost, gross unrealized gains and losses, and fair market value of the Corporation's available-for-sale and held-to-maturity securities at December 31, 2006 and 2005 are summarized as follows:
Held-to-Maturity Available-for-Sale ---------------- ------------------ (Dollars in thousands) Gross Gross Gross Gross 2006 Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair ---- Cost Gains Losses Value Cost Gains Losses Value ---- ----- ------ ----- ---- ----- ------ ----- U.S. Treasury $ - $ - $ - $ - $ 1,000 $ - $ (2) $ 998 U.S. Government agency - - - - 3,371 8 (25) 3,354 Mortgage-backed securities - - - - 56,439 14 (1,401) 55,052 State and municipal 5 - - 5 9,906 - (304) 9,602 Corporate securities - - - - 11,461 - (587) 10,874 Other equity securities - - - - 8,764 187 (122) 8,829 --- --- --- --- ----- --- ---- ----- $ 5 $ - $ - $ 5 $90,941 $209 $(2,441) $88,709 === == == === ======= ==== ======= =======
Held-to-Maturity Available-for-Sale ---------------- ------------------ (Dollars in thousands) Gross Gross Gross Gross 2006 Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair ---- Cost Gains Losses Value Cost Gains Losses Value ---- ----- ------ ----- ---- ----- ------ ----- U.S. Treasury $ - $ - $ - $ - $ 2,504 $ - $ (28) $ 2,476 U.S. Government agency - - - - 1,040 1 (23) 1,018 Mortgage-backed securities - - - - 57,456 3 (1,439) 56,020 State and municipal 10 - - 10 15,672 3 (515) 15,160 Corporate securities - - - - 13,655 36 (605) 13,086 Asset-backed securities - - - - 117 - (1) 116 Mutual funds - - - - 796 - (8) 788 Other equity securities - - - - 8,758 53 (397) 8,414 --- --- --- --- ----- -- ---- ----- $10 $ - $ - $10 $99,998 $ 96 $(3,016) $97,078 === == == === ======= ==== ======= =======
The amortized cost and estimated fair value of debt securities classified as available-for-sale and held-to-maturity at December 31, 2006, by contractual maturity, are shown in the following table. 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. 52 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - INVESTMENT SECURITIES continued
Held-to-Maturity Available-for-Sale ---------------- ------------------ (Dollars in thousands) Amortized Fair Amortized Fair Cost Value Cost Value ---- ----- ---- ----- Due in one year or less $ - $ - $ 1,590 $ 1,579 Due after one year through five years 5 5 15,205 14,627 Due after five years through ten years - - 4,425 4,155 Due after ten years - - 4,518 4,467 ----- ----- 5 5 25,738 24,828 Mortgage-backed securities - - 56,439 55,052 Other equity securities - - 8,764 8,829 ----- ----- $ 5 $ 5 $90,941 $88,709 === === ======= =======
Proceeds from the sale of investment securities available for sale were $13.6 million, $85.8 million and $32.1 million during 2006, 2005, and 2004, respectively. Gains of $76 thousand, $112 thousand and $371 thousand and losses of $155 thousand, $54 thousand and $301 thousand were realized on sales of securities in 2006, 2005, and 2004, respectively. The Corporation uses the specific identification method to determine the cost of the securities sold. The principal amount of investment securities pledged to secure public deposits and for other purposes required or permitted by law was $78.1 million and $73.3 million at December 31, 2006 and 2005, respectively. There were no securities held from a single issuer that represented more than 10% of stockholders' equity. The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2006 (Dollars in thousands).
Description of Number of Securities Securities Less than 12 months 12 months or longer Total ---------- ---------- ------------------- ------------------- ----- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ----- ------ ----- ------ ----- ------ U.S. Treasury 1 $ - $ - $ 998 $ (2) $ 998 $ (2) U.S. Government agency 3 1,828 (2) 990 (23) 2,818 (25) Mortgage-backed securities 30 3,086 (5) 47,765 (1,396) 50,851 (1,401) State and municipal 28 - - 9,602 (304) 9,602 (304) Corporate securities 13 - - 10,873 (587) 10,873 (587) Other equity securities 3 - - 8,764 (122) 8,764 (122) - ----- ---- ----- ---- Total temporarily impaired investment securities 78 $4,914 $ (7) $78,992 $(2,434) $83,906 $(2,441) == ====== ==== ======= ======= ======= =======
Management has considered factors regarding other than temporarily impaired securities and believes that there are no securities that were impaired as of December 31, 2006. 53 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE B - INVESTMENT SECURITIES continued The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2005 (Dollars in thousands).
Description of Number of Securities Securities Less than 12 months 12 months or longer Total ---------- ---------- ------------------- ------------------- ----- Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ----- ------ ----- ------ ----- ------ U.S. Treasury 1 $ 2,476 $ (28) $ - $ - $ 2,476 $ ( 28) U.S. Government agency 1 - - 990 (23) 990 (23) Mortgage-backed securities 28 14,472 (192) 40,164 (1,247) 54,636 (1,439) State and municipal 34 4,734 (163) 10,423 (352) 15,157 (515) Corporate securities 13 7,507 (285) 3,549 (320) 11,056 (605) Asset-backed securities 2 - - 115 (1) 115 (1) Mutual funds 1 788 (8) 788 (8) Other equity securities 6 - - 3,462 (397) 3,462 (397) - ----- ---- ----- ---- Total temporarily impaired investment securities 86 $29,189 $(668) $59,491 $(2,348) $88,680 $(3,016) == ======= ===== ======= ======= ======= =======
Management has considered factors regarding other than temporarily impaired securities and believes that there are no securities that were impaired as of December 31, 2005. NOTE C LOANS AND LEASES Major classifications of loans are as follows: (Dollars in thousands) 2006 2005 ---- ---- Commercial loans $243,651 $218,365 Real estate construction 41,287 49,095 Real estate other 287,998 266,067 Consumer loans 108,700 112,993 Lease financing receivables 12,707 17,756 ------ ------ 694,343 664,276 Less: Allowance for loan and lease losses (8,186) (8,123) ------ ------ $686,157 $656,153 ======== ======== Loan and lease balances on which the accrual of interest has been discontinued amounted to approximately $7.3 million and $8.4 million at December 31, 2006 and 2005, respectively. Interest on these non-accrual loans and leases would have been approximately $682 thousand, $638 thousand and $211 thousand in 2006, 2005 and 2004, respectively. Loan and lease balances past due 90 days or more, which are not on a non-accrual status, but which Management expects will eventually be paid in full, amounted to $793 thousand, $0 and $0 at December 31, 2006, 2005 and 2004, respectively. 54 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE C LOANS AND LEASES - Continued At June 30, 2006, the Corporation reclassified $523 thousand of the allowance for loan and lease losses as other liabilities on the consolidated balance sheet. This amount represents an allowance for possible losses on unfunded loans and unused lines of credit. These loans and lines of credit, although unfunded, have been committed to by the Bank. At December 31, 2006 and 2005, the total amount recorded in other liabilities on the consolidated balance sheet as an allowance for possible losses on unfunded loans and lines of credit is $552 thousand and $426 thousand, respectively. Changes in the allowance for loan and lease losses are summarized as follows: (Dollars in thousands) 2006 2005 2004 ---- ---- ---- Balance at beginning of year $8,123 $6,816 $5,541 Provision charged to operating expenses 3 1,382 1,164 Recoveries 359 437 1,095 Loans charged-off (173) (483) (910) Allowance adjustment Other (126) (29) (74) ---- --- --- Balance at end of year $8,186 $8,123 $6,816 ====== ====== ====== The Bank identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The accrual of interest is discontinued on impaired loans and no income is recognized until all recorded amounts of interest and principal are recovered in full. The balance of impaired loans was $7.3 million, $8.4 million, and $7.9 million at December 31, 2006, 2005, and 2004, respectively. The associated allowance for loan and lease losses for impaired loans was $840 thousand, $897 thousand and $882 thousand at December 31, 2006, 2005, and 2004, respectively. During 2006, activity in the allowance for impaired loan and lease losses included a provision of $0, write offs of $11 thousand, recoveries of $0, and loans paid off or returned to performing status of $0. Interest income of $0 was recorded in 2006, while contractual interest in the same period amounted to $682 thousand. Cash collected on impaired loans in 2006 was $3.2 million, of which $3.2 million was applied to principal and $0 was applied to past due interest. During 2005, activity in the allowance for impaired loan and lease losses included a provision of $365 thousand, write offs of $122 thousand, recoveries of $0, and loans paid off or returned to performing status of $0. Interest income of $0 was recorded in 2005, while contractual interest in the same period amounted to $638 thousand. Cash collected on impaired loans in 2005 was $1.9 million, of which $1.9 million was applied to principal and $0 was applied to past due interest. During 2004, activity in the allowance for impaired loan and lease losses included a provision of $808 thousand, write offs of $61 thousand, recoveries of $1 thousand and loans paid off or returned to performing status of $1 thousand. Interest income of $0 was recorded in 2004, while contractual interest in the same period amounted to $211 thousand. Cash collected on impaired loans in 2004 was $1.2 million, of which $1.2 million was applied to principal and $27 thousand was applied to past due interest. In the normal course of business, the Bank makes loans to certain officers, directors, and their related interests. All loan transactions entered into between the Bank and such related parties were made on substantially the same terms and conditions as comparable transactions with all other parties. In Management's opinion, such loans are consistent with sound banking practices and are within applicable regulatory lending limitations. The balance of these loans at December 31, 2006 and 2005, was approximately $28.4 million and $19.2 million, respectively. In 2006 and 2005, principal payments on these loans were $26.8 million and $12.7 million, respectively. In 2006 and 2005, new loans to these individuals were $5.6 million and $13.4 million, respectively. 55 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE D - PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows: (Dollars in thousands) Useful Lives 2006 2005 2004 ---------------------- ------------ ---- ---- ---- Premises 5 40 Years $ 17,154 $ 16,356 $ 15,532 Equipment 1 - 5 Years 22,090 20,282 18,842 ------ ------ ------ 39,244 36,638 34,374 Less Accumulated depreciation (25,256) (22,852) (20,237) ------- ------- ------- $ 13,988 $ 13,786 $ 14,137 ======== ======== ========
Included in the equipment category above is $6.1 million and $5.0 million of operating lease assets as of December 31, 2006 and 2005, respectively. Included in the accumulated depreciation line above is $2.2 million and $1.6 million of accumulated depreciation on these operating lease assets as of December 31, 2006 and 2005, respectively. NOTE E - DEPOSITS At December 31, 2006, the scheduled maturities of certificates of deposit are as follows: (Dollars in thousands) 2007 $ 199,294 2008 12,132 2009 3,844 2010 2,146 2011 1,852 Thereafter 9,660 ----- $ 228,928 ========= NOTE F - BORROWINGS The Bank, as a member of the FHLB, maintains several credit facilities secured by the Bank's mortgage-related assets. FHLB borrowings provide additional funds to meet the Bank's liquidity needs. The Bank currently has a maximum borrowing capacity with the FHLB of approximately $208.4 million of which 73.0%, or $152.1 million, is currently available. FHLB advances are collateralized by a pledge on the Bank's entire portfolio of unencumbered investment securities, certain mortgage loans and a lien on the Bank's FHLB stock. 1. Short Term Borrowings --------------------- Short term FHLB advances generally have maturities of less than one year. The details of these short term advances are as follows:
(Dollars in thousands) 2006 2005 2004 ---------------------- ---- ---- ---- Average balance outstanding $ 4,000 $ 5,000 $ 3,407 Maximum amount outstanding at any month-end during the period $ 5,000 $ 5,000 $ 4,778 Balance outstanding at period end - $ 5,000 $ 4,250 Weighted-average interest rate during the period .94% 3.19% 2.14% Weighted-average interest rate at period end - 3.74% 1.55%
*Short term advances above do not include a Federal Funds purchased amount of $5.3 million and $3.0 million for the periods ending 2006 and 2005 respectively. 56 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE F - BORROWINGS - Continued 2. Long Term Borrowings -------------------- At December 31, 2006 and 2005, long term advances from the FHLB totaled $56,331 and $60,897. Long term advances consist of fixed-rate amortizing and non-amortizing advances that will mature within one to ten years. The amortizing advances had a weighted average interest rate of 5.43%, 5.53%, and 5.56% and the non-amortizing advances had a weighted average interest rate of 3.48%, 3.39%, and 2.73% for 2006, 2005 and 2004, respectively. As of December 31, 2006, Long term FHLB advances mature as follows: (Dollars in thousands) 2007 $ 5,946 2008 23,816 2009 14,070 2010 5,073 2011 5,077 Thereafter 2,349 ----- $ 56,331 ======== NOTE G - OTHER NON-INTEREST EXPENSE The components of other non-interest expense are detailed as follows: (Dollars in thousands) 2006 2005 2004 ---- ---- ---- Telephone, postage, and supplies $ 1,190 $ 1,004 $ 1,084 Marketing and corporate communications 1,000 1,094 1,168 Loan and deposit supplies 504 569 629 Director costs 290 285 259 Travel and mileage 291 289 367 Dues and subscription 151 110 106 Wealth Management processing 317 300 271 General expenses 585 834 589 Other 473 567 559 --- --- --- $ 4,801 $ 5,052 $ 5,032 ======= ======= ======= 57 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE H - INCOME TAXES
The components of income tax expense are detailed as follows: (Dollars in thousands) 2006 2005 2004 ---- ---- ---- Current expense $ 2,938 $ 2,401 $ 2,161 Deferred expense (benefit) (52) (501) 269 --- ---- --- Total tax expense $ 2,886 $ 1,900 $ 2,430 ======== ======= ======= The income tax provision reconciled to the statutory federal rate follows: 2006 2005 2004 ---- ---- ---- Statutory rate 34.0% 34.0% 34.0% Increase (decrease) in tax rate from Tax-exempt loan and investment income (3.7) (4.9) (4.6) Tax credits (2.6) (3.2) (2.9) Other, net 0.5 (3.3) 1.8 --- ---- --- Applicable income tax rate 28.2% 22.6% 28.3% ===== ===== =====
The net deferred tax asset consists of the following: (Dollars in thousands) 2006 2005 ---- ---- Allowance for possible loan losses $ 2,783 $ 2,889 Unrealized losses on investment securities available-for-sale 759 992 Prepaid expenses (177) (178) Accrued pension and deferred compensation 199 231 Depreciation 775 669 Bond accretion (69) 3 Allowance for unfunded loans and unused lines of credit 188 - Other (11) 22 --- -- Total net deferred tax asset $ 4,447 $ 4,628 ======== =======
58 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE I - ACCOUNTING FOR STOCK-BASED COMPENSATION PLANS At December 31, 2006, the Corporation had one restricted stock based compensation plan, pursuant to which, shares of the Corporation's common stock could be issued. The plan, adopted in 2005, allows the Corporation to grant up to 150 thousand shares of restricted stock to employees. During the year ended, December 31, 2006, the Corporation granted 1 thousand shares valued at $21.85 per share. This award was fully vested as of December 31, 2006. The Corporation's ability to issue stock options under the 1995 Stock Option Plan has expired. Outstanding stock options, however, remain in effect according to their terms. Aggregated information regarding the Corporation's Stock Option Plan as of December 31, 2006 is presented below. (dollars in thousands, except per share data): Weighted- Weighted-Average Average Remaining Aggregate Exercise Contractual Intrinsic Options Shares Price Term (years) Value ------- ------ ----- ------------ ----- Outstanding at January 1, 2006 382,649 $14.57 - $1,752,532 Substitute options issued - - - - Granted - - - - Exercised 80,260) 13.38 - - Forfeited (7,534) 17.99 - - Expired - - - - Outstanding at December 31, 2006 294,855 $14.80 3.42 $1,828,101 Exercisable at December 31, 2006 294,855 $14.80 3.42 $1,828,101 There were no options granted during the year ended December 31, 2006. The total intrinsic value (market value on date of exercise less grant price) of options exercised during the years ended December 31, 2006 was $1.8 million. As of January 1, 2006 there were no unvested options under the one Corporation's Stock Option Plan. Cash received from option exercise under the Stock Option Plan for the twelve months ended December 31, 2006 was $1.1 million. The actual tax benefit realized for the tax deductions from option exercise under the Plan for the twelve months ended December 31, 2006 was $69 thousand. The impact of these cash receipts is included in financing activities in the accompanying consolidated statements of cash flows. The impact of the tax benefit realized is included in other liabilities in operating activities on the Corporation's consolidated statements of cash flows. 59 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE J - EARNINGS PER SHARE The following table illustrates the reconciliation of the numerators and denominators of the basic and diluted EPS computations:
For the Year Ended December 31, 2006 ------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------- ------ Basic EPS: Net income available to common stockholders $7,334,945 5,160,340 $ 1.42 Effect of Dilutive Securities Add options to purchase common stock - 88,860 (0.02) ---------- ------ ----- Diluted EPS: $7,334,945 5,249,200 $ 1.40 ========== ========= ======
No anti-dilutive shares have been excluded in the computation of 2006 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average market price on December 31, 2006 was $20.96
For the Year Ended December 31, 2005 ------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------- ------ Basic EPS: $6,510,718 5,104,745 $ 1.28 Net income available to common stockholders Effect of Dilutive Securities Add options to purchase common stock - 135,752 (0.04) ---------- ------- ----- Diluted EPS: $6,510,718 5,240,497 $ 1.24 ========== ========= ======
No anti-dilutive shares have been excluded in the computation of 2005 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average market price on December 31, 2005 was $19.15
For the Year Ended December 31, 2004 ------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------- ------ Basic EPS: Net income available to common stockholders $ 6,160,648 4,980,584 $ 1.24 Effect of Dilutive Securities Add options to purchase common stock - 194,342 (0.05) ----------- ------- ----- Diluted EPS: $ 6,160,648 5,174,926 $ 1.19 =========== ========= ======
No anti-dilutive shares have been excluded in the computation of 2004 diluted EPS because the options' exercise price was greater than the average market price of the common shares. The average market price on December 31, 2004 was $24.75 60 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE K - REGULATORY MATTERS The Bank is required to maintain average reserve balances with the Federal Reserve Bank based upon deposit levels and other factors. The average amount of those reserve balances was $1.5 million for the years ended December 31, 2006 and 2005. Dividends are paid by the Corporation from its assets which are mainly provided by dividends from the Bank. However, certain restrictions exist regarding the ability of the Bank to transfer funds to the Corporation in the form of cash dividends, loans or advances. The Bank, without the prior approval of regulators, can declare dividends to the Corporation totaling approximately $7.0 million plus additional amounts equal to the net earnings of the Bank for the period from January 1, 2007, through the date of declaration of such a dividend, less dividends previously paid subject to the further limitations that dividends may be paid only to the extent the retained net profits (including the portion transferred to surplus) exceed bad debts and provided that the Bank would not become "undercapitalized" (as defined by Federal law). The Corporation and the Bank are subject to various regulatory capital requirements administered by 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 Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Corporation'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 Corporation to maintain minimum amounts and ratios of Total and Tier I Capital to risk-weighted assets, and Tier I Capital to average quarterly assets (Total Risk Based Capital ratio, Tier I Capital ratio, and Leverage ratio, respectively). Management believes that the Corporation and the Bank meet all capital adequacy requirements to which it is subject, as of December 31, 2006. Federal banking agencies categorized the Corporation and the Bank as well capitalized under the regulatory framework for corrective action. To be categorized as adequately capitalized the Corporation and the Bank must maintain minimum Total Risk-Based, Tier I Risk-Based, and Tier I leverage ratios as set forth in the table. The Corporation's and Bank's actual capital amounts and ratios are presented below:
To Be Well Capitalized Under For Capital Prompt Corrective (Dollars in thousands) Actual Adequacy Purposes Action Provisions ------ ----------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of December 31, 2006: Leverage Ratio Corporation $ 80,266 9.34% $ 34,380 >4.00% N/A N/A Bank $ 73,356 8.58% $ 34,204 >4.00% $ 42,755 >5.00% Tier I Capital Ratio Corporation $ 80,266 11.26% $ 28,504 >4.00% N/A N/A Bank $ 73,356 10.31% $ 28,469 >4.00% $ 42,704 >6.00% Total Risk Based Capital Ratio Corporation $ 89,004 12.49% $ 57,010 >8.00% N/A N/A Bank $ 82,094 11.53% $ 56,939 >8.00% $ 71,173 >10.00%
61 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE K - REGULATORY MATTERS continued
To Be Well Capitalized Under For Capital Prompt Corrective (Dollars in thousands) Actual Adequacy Purposes Action Provisions ------ ----------------- ----------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- As of December 31, 2005: Leverage Ratio Corporation $ 75,373 8.80% $ 34,248 >4.00% $ 42,810 N/A Bank $ 69,325 8.14% $ 34,086 >4.00% $ 42,607 >5.00% Tier I Capital Ratio Corporation $ 75,373 10.94% $ 27,546 >4.00% $ 41,319 N/A Bank $ 69,325 10.08% $ 27,512 >4.00% $ 41,269 >6.00% Total Risk Based Capital Ratio Corporation $ 83,922 12.19% $ 55,092 >8.00% $ 68,865 N/A Bank $ 77,891 11.32% $ 55,025 >8.00% $ 68,781 >10.00%
NOTE L - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the estimated fair value of an entity's assets and liabilities considered to be financial instruments. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in SFAS No. 107. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Corporation's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities. Therefore, the Corporation had to use significant estimations and present value calculations to prepare this disclosure. Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, Management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values. Fair values have been estimated using data which Management considered the best available and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimated fair value of cash and cash equivalents, deposits with no stated maturities, repurchase agreements and the fair value of commitments to extend credit, is estimated based upon the amount of unamortized deferred loan commitment fees. The fair value of letters of credit is based on the amount of unearned fees plus the estimated cost to terminate the letter of credit.. Quoted market prices were used to determine the estimated fair value of investment securities held-to-maturity and available-for-sale. Fair values of net loans and deposits with stated maturities were calculated using estimated discounted cash flows based on the year-end offering rate for instruments with similar characteristics and maturities. 62 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE L - FAIR VALUE OF FINANCIAL INSTRUMENTS - continued The estimated fair values and carrying amounts are summarized as follows:
2006 2005 ---- ---- (Dollars in thousands) Estimated Carrying Estimated Carrying Fair Value Amount Fair Value Amount ---------- ------ ---------- ------ Financial Assets Cash and cash equivalents $ 72,341 $ 72,341 $ 68,943 $ 68,943 Investment securities held-to-maturity 5 5 10 10 Investment securities available-for-sale 88,709 88,709 97,078 97,078 Net loans 672,557 694,343 630,292 664,276 Financial Liabilities Deposits with no stated maturities 426,891 495,740 508,963 508,963 Deposits with stated maturities 228,929 222,139 174,791 187,134 FHLB advances and other borrowings 55,254 61,596 53,528 68,900 Subordinated debt 15,465 15,465 15,465 15,465 Off-Balance-Sheet Investments Commitments for extended credit and outstanding letters of credit $ 266,498 $ 266,498 $ 262,425 $ 262,425
NOTE M SUBORDINATED DEBT AND GUARANTEED PREFERRED BENEFICIAL INTEREST IN THE CORPORATION'S SUBORDINATED DEBENTURES In 2003, Trust II issued $10.0 million (net proceeds of $9.79 million) of preferred capital securities in a pooled institutional placement transaction. These securities were issued through First Chester County Capital Trust II, a special purpose statutory trust created expressly for the issuance of these securities and investing the proceeds in subordinated debentures of the Corporation. These subordinated debentures will be redeemed in the year 2033. The debentures and securities will each be callable by the Corporation or Trust II, as applicable, at their option after five years of the date of issuance. At December 31, 2006, the rate paid on these subordinated debentures, based on three-month London Inter-bank offering rate ("LIBOR") plus 295 basis points, was 8.32%. In 2002, Trust I issued $5.0 million (net proceeds of $4.82 million) of preferred capital securities in a pooled institutional placement transaction. These securities were issued through Trust I, a special purpose statutory trust created expressly for the issuance of these securities and investing the proceeds in junior subordinated debentures of the Corporation. These subordinated debentures will be redeemed in the year 2032. The debentures and securities will each be callable by the Corporation or Trust I, as applicable, at their option after five years of the date of issuance. At December 31, 2006, the rate paid on these subordinated debentures, based on three-month LIBOR plus 365 basis points, was 9.02%. For 2006, 2005, and 2004, interest expense for Trust I & II was $1.3 million $1.0 million, and $728 thousand, respectively, with an average interest rate of 8.43%, 6.56%, and 4.71%, respectively. Management has determined that Trust I and Trust II (Trust I and Trust II, collectively, the "Trusts") each qualify as variable interest entities under FASB Interpretation 46 ("FIN 46"). Each of the Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to the Corporation. Trust I and Trust II holds, as its sole asset, subordinated debentures issued by the Corporation. Subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, FIN 46(R), the provisions of which must be applied to certain variable interest entities. The Corporation adopted the provisions under the revised interpretation in the first quarter of 2004. FIN 46(R) required the Corporation to deconsolidate the Trusts. Accordingly, the Corporation deconsolidated the Trusts at the end of the first quarter of 2004. In March 2005, the Federal Reserve Board adopted a final rule that would continue to allow the inclusion of trust preferred securities in Tier I Capital, but with stricter quantitative limits. Under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier I Capital 63 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE M SUBORDINATED DEBT AND GUARANTEED PREFERRED BENEFICIAL INTEREST IN THE CORPORATION'S SUBORDINATED DEBENTURES continued elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier II Capital, subject to restriction. Based on the final rule, the Corporation expects to include all of its $15.5 million in trust preferred securities in Tier I Capital. NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK The Corporation is a party to financial instruments with off-balance-sheet risk to meet the financing needs of its customers and reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risks in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless noted otherwise, the Corporation does not require collateral or other security to support financial instruments with credit risk. The contract amounts are as follows: (Dollars in thousands) 2006 2005 ---- ---- Financial instruments whose contract amounts represent credit risk Commitments to extend credit $ 253,870 $ 250,152 Standby letters of credit and financial guarantees written 12,628 12,273 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on Management's credit evaluation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Corporation holds residential or commercial real estate, accounts receivable, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments at December 31, 2006 and 2005, varies up to 100%. Standby letters of credit are collateralized within Management policies. Commercial and standby letters of credit were granted primarily to commercial borrowers. Substantially all of the Corporation's loans, commitments, and commercial and standby letters of credit have been granted to customers in the Corporation's primary market area, Chester County, Pennsylvania. Investments in state and municipal securities also involve governmental entities within the Corporation's market area. The concentrations of credit by type of loan are set forth in Note C - Loans. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon Chester County's economy. The distribution of commitments to extend credit approximates the distribution of loans outstanding. 64 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE O - EMPLOYEE BENEFIT PLANS 1. Qualified --------- The Corporation has a qualified deferred salary savings 401(k) plan (the "401(k) Plan") under which the Corporation contributes $0.75 for each $1.00 that an employee contributes, up to the first 5% of the employee's salary. The Corporation's contribution expense was $340 thousand, $324 thousand and $390 thousand in 2006, 2005, and 2004, respectively. The Corporation also has a qualified defined contribution pension plan (the "QDCP Plan"). Under the QDCP Plan, the Corporation makes annual contributions into the 401(k) Plan on behalf of each eligible participant in an amount equal to 3% of salary up to $30,000 in salary plus 6% of salary in excess of $30 thousand up to $200 thousand. Contribution expense in 2006, 2005 and 2004 under the QDCP Plan was $343 thousand, $406 thousand and $391 thousand, respectively. The Corporation may make additional discretionary employer contributions subject to approval of the Board of Directors. 2. Non-Qualified ------------- The Corporation makes annual contributions to a non-qualified defined contribution Plan (the "NQDCP Plan") equal to 3% of the participant's salary. Contribution expense for 2006, 2005 and 2004 under the NQDCP Plan was $72 thousand, $70 thousand and $58 thousand, respectively. The Corporation may make additional discretionary employer contributions subject to the approval of the Board of Directors. NOTE P COMMITMENTS AND CONTINGENCIES Future minimum rental payments are as follow: (Dollars in thousands) 2007 $ 498 2008 510 2009 515 2010 541 2011 554 Thereafter 1,796 ----- $4,414 The corporation leases one of its banking facilities from a director for which it paid $182 thousand during the year ended December 31, 2006. The Corporation has agreements with several of the Corporation's officers that provide for severance payments upon termination of employment under certain circumstances or a change of control as defined. The Corporation is involved in certain litigation arising in the ordinary course of business. In the opinion of Management, the outcome of this litigation will not have a significant effect on the accompanying financial statements. 65 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY Condensed financial information for First Chester County Corporation (Parent Company only) follows: CONDENSED BALANCE SHEETS
(Dollars in thousands) December 31 ----------- 2006 2005 ---- ---- ASSETS Cash and cash equivalents $ 1,001 $ 487 Investment securities available for sale, at market value 3,730 3,313 Investment in subsidiaries, at equity 72,516 68,851 Intercompany loan 1,250 1,322 Other assets 726 681 --- --- Total assets $ 79,223 $ 74,654 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Subordinated debt $ 15,465 $ 15,465 Other liabilities 496 512 Stockholders' equity 63,262 58,677 ------ ------ Total liabilities and stockholders' equity $ 79,223 $ 74,654 ======== ========
CONDENSED STATEMENTS OF INCOME
(Dollars in thousands) Year ended December 31 ---------------------- 2006 2005 2004 ---- ---- ---- INCOME Dividends from investment securities $ 166 $ 158 $ 42 Other income 195 276 270 --- --- --- Total income 361 434 312 --- --- --- EXPENSES Other expenses 1,636 1,385 1,026 ----- ----- ----- Total expenses 1,636 1,385 1,026 ----- ----- ----- Income before income taxes (1,275) (951) (714) ------ ---- ---- INCOME TAX (BENEFIT) (434) (323) (243) ---- ---- ---- Income before equity in undistributed income of subsidiaries (841) (628) (471) ---- ---- ---- EQUITY IN UNDISTRIBUTED INCOME OF SUBSIDIARIES 8,176 7,139 6,632 ----- ----- ----- NET INCOME $ 7,335 $ 6,511 $ 6,161 ======== ======== ========
66 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY - continued CONDENSED STATEMENTS OF CASH FLOWS
Year ended December 31 ---------------------- (Dollars in thousands) 2006 2005 2004 ---- ---- ---- OPERATING ACTIVITIES Net income $ 7,335 $ 6,511 $ 6,161 Adjustments to reconcile net income to net cash provided by (used in) operating activities Equity in undistributed income of subsidiary (4,058) (3,062) (6,857) (Increase) decrease in other assets 135 (14) 639 Increase (decrease) in other liabilities (250) 258 (592) ---- --- ---- Net cash provided by (used in) operating activities 3,162 3,693 (649) ----- ----- ---- INVESTING ACTIVITIES Proceeds from sales and maturities of investment securities - - (100) Purchases of investment securities available for sale (8) (3,230) - -- ------ ---- Net cash used in investing activities (8) (3,230) (100) -- ------ ---- FINANCING ACTIVITIES Dividends paid (2,786) (2,665) (2,529) ------ ------ ------ Treasury stock Transactions 146 1,280 404 --- ----- --- Net cash used in financing activities (2,640) (1,385) (2,125) ------ ------ ------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 514 (922) (2,874) Cash and cash equivalents at beginning of year 487 1,409 4,283 --- ----- ----- Cash and cash equivalents at end of year $ 1,001 $ 487 $ 1,409 ======= ======= ========
67 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED NOTE R - QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of the unaudited quarterly results of operations is as follows: 2006 ----
(Dollars in thousands, except per share) December 31 September 30 June 30 March 31 ----------- ------------ ------- -------- Interest income 13,405 13,473 13,064 12,259 Interest expense 5,589 5,422 4,891 4,135 ----- ----- ----- ----- Net interest income 7,816 8,051 8,173 8,124 Provision for loan losses - - - 3 Investment securities gains (loss), net 1 - - (80) Income before income taxes 2,066 2,678 2,914 2,563 Net income 1,552 1,856 2,081 1,846 Per share Net income (Basic) 0.30 0.36 0.40 0.36 Net Income (Diluted) 0.29 0.35 0.40 0.35 Dividends declared 0.135 0.135 0.135 0.135 2005 (Dollars in thousands, except per share) Interest income 12,102 11,592 10,726 10,184 Interest expense 4,157 3,756 3,099 2,567 ----- ----- ----- ----- Net interest income 7,945 7,836 7,627 7,617 Provision for loan losses 60 311 504 507 Investment securities gains (loss), net -- (2) (8) 67 Income before income taxes 3,085 2,397 1,501 1,428 Net income 2,578 1,843 1,072 1,018 Per share Net income (Basic) 0.50 0.36 0.21 0.20 Net Income (Diluted) 0.49 0.35 0.21 0.19 Dividends declared 0.135 0.130 0.130 0.128
68 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders First Chester County Corporation We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that First Chester County Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). First Chester County Corporation'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 an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit 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. Our audit included 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 considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. 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 (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) 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 (3) 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. In our opinion, management's assessment that First Chester County Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, First Chester County Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of First Chester County Corporation and its subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 9, 2007 expressed an unqualified opinion on those financial statements. /s/ Grant Thornton LLP Philadelphia, Pennsylvania March 9, 2007 69 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the Corporation's principal executive and principal financial officers and implemented by management and other personnel, subject to the oversight of the Corporation's Board of Directors, 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 and includes those policies and procedures that: o Pertain to the maintenance of records, that in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Corporation; o 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 Corporation are being made only in accordance with authorizations of management and directors of the Corporation; and o Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Corporation'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. 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. Management's Assessment Management assessed the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based upon this assessment, management believes that, as of December 31, 2006, the Corporation's internal control over financial reporting was effective at a reasonable assurance level based on these criteria. The Corporation's independent auditors have issued an attestation report on our assessment of the Corporation's internal control over financial reporting. This report appears on page 69 of this annual report. March 9, 2007 70 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 9. Changes in and Disagreements with Accountants on Accounting and -------- ---------------------------------------------------------------------- Financial Disclosure. --------------------- None. Item 9A. Controls and Procedures -------- ----------------------- Appearing as Exhibits 31.1, 31.2, and 31.3 (the "302 Certifications") to this Annual Report are three certifications, one by each of the Corporation's Chairman and Chief Executive Officer ("CEO"), President, and Treasurer and Chief Financial Officer ("CFO") (the Corporation's principal executive, operating, and accounting and financial officer, and, collectively, the "Principal Officers"). This Item 9A contains information concerning the evaluation of the Corporation's disclosure controls and procedures and matters regarding its internal control over financial reporting that are referred to in the Section 302 Certifications. This information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented in the 302 Certifications. Discussion of Disclosure Controls and Procedures The SEC requires that as of the end of the period covered by this Annual Report on Form 10-K, the Corporation's CEO and CFO/Treasurer evaluate the effectiveness of the design and operation of the Corporation's "disclosure controls and procedures" and report their conclusions on the effectiveness of the design and operation of the Corporation's disclosure controls and procedures in this Annual Report. "Disclosure controls and procedures" mean the controls and other procedures that are designed with the objective of ensuring that information required to be disclosed in the Corporation's reports filed under the Securities Exchange Act of 1934 (the "Exchange Act"), such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the rules and forms promulgated by the SEC. The Corporation's disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to Management, including the Principal Officers, as appropriate to allow timely decisions regarding required disclosure. Management, including the Principal Officers, conducted an evaluation, as of the end of the period covered by this Report, of the effectiveness of the Corporation's disclosure controls and procedures. Based upon their evaluation of the disclosure controls and procedures, the Principal Officers have concluded that the Corporation's disclosure controls and procedures were effective as of December 31, 2006 at the reasonable assurance level, to ensure that the information relating to the Corporation and its consolidated subsidiaries that is required to be disclosed in the reports filed by the Corporation with the SEC under the Exchange Act is made known to Management, including the Principal Officers, on a timely basis. Discussion of Internal Control Over Financial Reporting During the quarter ended December 31, 2006, there were no changes to the Corporation's internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting Management's report on internal control over financial reporting set forth on page 70 of this Report is incorporated in this Item by reference. Item 9B. Other Information -------- ----------------- None. 71 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES PART III -------- Item 10. Directors, Executive Officers and Corporate Governance. -------- ------------------------------------------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2007 Annual Meeting of Shareholders. Item 11. Executive Compensation. -------- ----------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2007 Annual Meeting of Shareholders. Item 12. Security Ownership of Certain Beneficial Owners and Management and -------- ---------------------------------------------------------------------- Related Stockholder Matters. ---------------------------- The information called for in Item 201(d) of Regulation S-K is set forth below. The other information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2007 Annual Meeting of Shareholders. Equity Compensation Plan Information Form
Number of securities remaining Number of securities Weighted-average available for to be issued upon exercise price future exercise of of outstanding issuance unde outstanding options, options, equity warrants and warrants and compensation rights* rights* plans** --------------------- ---------------- ---------------- Equity compensation plans approved by security holders 294,855*** $14.80 149,000 Equity compensation plans not approved by security holders -- -- -- Total 294,855*** $14.80 149,000
* The securities referred to in these columns are shares of the Corporation's Common Stock issuable upon exercise of options issued pursuant to the Corporation's 1995 Stock Option Plan. ** The securities referred to in this column are shares of the Corporation's Common Stock which may be awarded pursuant to the Company's 2005 Restricted Stock Plan. *** Number of options issued and outstanding that were exercisable as December 31, 2006. 72 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES Item 13. Certain Relationships and Related Transactions, and Director --------- --------------------------------------------------------------------- Independence. ------------- The information called for by this item is incorporated herein by reference to the Corporation's Proxy Statement for its 2007 Annual Meeting of Shareholders. Item 14. Principal Accountant Fees and Services -------- -------------------------------------- The information called for by this Item is incorporated herein by reference to the Corporation's Proxy Statement for its 2007 Annual Meeting of Shareholders. PART IV ------- Item 15. Exhibits, Financial Statements and Schedules. -------- --------------------------------------------- 1. Financial Statements -------------------- The Consolidated Financial Statements, for the years ending December 31, 2006 and 2005, together with the report thereon of Grant Thornton LLP dated March 9, 2007, are filed as part of this Report under Item 8. 2. Financial Statement Schedules ----------------------------- Financial Statement Schedules are not required under the related instructions of the Securities and Exchange Commission, are inapplicable or are included in the Consolidated Financial Statements or notes thereto. 3. Exhibits -------- The following is a list of the exhibits filed with, or incorporated by reference into, this Report (those exhibits marked with an asterisk are filed herewith and those exhibits marked "(CP)" are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates): 3(i). Certificate of Incorporation. Copy of the Corporation's Articles of Incorporation, as amended, is incorporated herein by reference to Exhibit 3(i) to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. 3(ii). By-Laws of the Corporation, as amended. Copy of the Corporation's ByLaws, as amended, is incorporated herein by reference to Exhibit 3(ii) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2000. 10. Material contracts. (a) Employment Agreement among the Corporation, the Bank and John A. Featherman, III, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (b) Employment Agreement among the Corporation, the Bank and Kevin C. Quinn, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) * (c) Compensatory Arrangements of Executive Officers and Directors for 2007. (CP) (d) The Corporation's Dividend Reinvestment and Stock Purchase Plan, filed as an exhibit to the Corporation's registration statement on Form S-3 filed August 7, 2003 (SEC File No. 333-107739) is incorporated herein by reference. (e) The Corporation's Amended and Restated Stock Bonus Plan, filed as an exhibit to the Corporation's registration statement on Form S-8 filed August 12, 1997 (SEC File No. 333-33411) is incorporated herein by reference. (CP) 73 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES * (f) The Bank's Amended and Restated Supplemental Benefit Retirement Plan, effective date January 1, 2005. (CP) (g) The Corporation's Amended and Restated 1995 Stock Option Plan, filed as an appendix to the Corporation's Proxy statement for the 2003 Annual Meeting of Shareholders as filed with the SEC via EDGAR is incorporated herein by reference. (CP) (h) Form of Stock Option Agreement (Directors) is incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (i) Form of Stock Option Agreement (Executive Officers) is incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (j) 2005 Restricted Stock Plan, is incorporated herein by reference to Appendix A to the Corporation's 2005 Proxy Statement filed March 17, 2005. (CP) * (k) Form of Restricted Stock Award Agreement used for grants of restricted stock on March 8, 2007, pursuant to the Incentive Plan filed herewith as Exhibit 10(w). (l) Letter of Employment to Deborah Pierce, is incorporated herein by reference to Exhibit 10.2 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2005. (CP) (m) Change of Control Agreement between the Bank and Deborah Pierce dated February 18, 2005, is incorporated herein by reference to Exhibit 10.3 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2005. (CP) (n) Letter of Employment to Susan Bergen-Painter, is incorporated herein by reference to Exhibit 10.1 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (o) Change of Control Agreement between the Bank and Susan Bergen-Painter dated April 25, 2005, is incorporated herein by reference to Exhibit 10.2 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (p) Letter of Employment to Karen Walter, is incorporated herein by reference to Exhibit 10.3 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (q) Change of Control Agreement between the Bank and Karen Walter dated May 6, 2005, is incorporated herein by reference to Exhibit 10.4 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (r) Letter of Employment to John Balzarini, is incorporated herein by reference to Exhibit 10.5 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (s) Change of Control Agreement between the Bank and John Balzarini dated June 3, 2005, is incorporated herein by reference to Exhibit 10.6 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (t) Change of Control Agreement between the Bank and Linda Hicks dated May 23, 2005, is incorporated herein by reference to Exhibit 10.7 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (u) Change of Control Agreement between the Bank and Michelle Venema dated June 10, 2005, is incorporated herein by reference to Exhibit 10.8 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) 74 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES (v) Change of Control Agreement between the Bank and Anthony Poluch dated May 25, 2005, is incorporated herein by reference to Exhibit 10.9 to the Corporation's Quarterly Report to Form 10-Q for the quarter ended June 30, 2005. (CP) * (w) Executive Annual Incentive Plan, effective January 1, 2006, as amended December 18, 2006 (the "Incentive Plan") with 2006 Exhibits. (CP) Portions of the 2006 Exhibits have been redacted and are subject to a confidential treatment request filed with the Secretary of the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended. * (x) Incentive Plan with 2007 Exhibits. (CP) Portions of the 2007 Exhibits have been redacted and are subject to a confidential treatment request filed with the Secretary of the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended. (y) Agreement for the Sale of Real Estate dated as of May 10, 2006 between First National Bank of Chester County and TD Banknorth, N.A., is incorporated herein by reference to Exhibit 10.1 to the Corporation's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 2006. * (z) Letter of Employment to Clay T. Henry, dated September 6, 2006. (CP) * (aa) Supplemental Letter of Employment to Clay T. Henry, dated September 5, 2006. (CP) * (bb) Separation Benefits Agreement, dated as of October 2, 2006, by and between the Bank and Clay T. Henry. (CP) * (cc) Restricted Stock Award Agreement for Clay T. Henry, dated as of October 2, 2006. (CP) * (dd) Employment Transition Agreement and General Release by and between the Bank and Linda Hicks, dated October 18, 2006. (CP) * (ee) Separation Benefits Agreement, dated as October 18, 2006, by and between the Bank and Linda Hicks. (CP) * 14. Code of Conduct (Ethics). * 21. Subsidiaries of the Corporation. First National Bank of Chester County, formerly known as The First National Bank of West Chester, is a banking institution organized under the banking laws of the United States in December 1863. Turks Head Properties, Inc., formerly known as 323 East Gay Street Corporation, was incorporated in 1996 in the State of Pennsylvania. Turks Head II, LLC was incorporated in 2003 in the State of Pennsylvania. FNB Insurance Services, LLC, doing business as First National Financial Advisory Services (formerly, First National Wealth Advisory Services), a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. FNB Properties, LLC, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. First Chester County Capital Trust I was formed on July 11, 2002. First Chester County Capital Trust II was formed on November 13, 2003. * 23. Consent of Grant Thornton LLP, dated March 9, 2007. * 31.1 Certification of Chief Executive Officer. * 31.2 Certification of President. * 31.3 Certification of Treasurer and Chief Financial Officer. * 32.1 Certification of Chief Executive Officer. * 32.2 Certification of President. * 32.3 Certification of Treasurer and Chief Financial Officer. 75 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST CHESTER COUNTY CORPORATION By: /s/ John A. Featherman, III --------------------------- John A. Featherman, III, Chief Executive Officer and Chairman of the Board Date: March 15, 2007 Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the Corporation and in the capacities indicated as of March 15, 2007. Signature Title --------- ----- /s/ John A. Featherman, III Chief Executive Officer and -------------------------------- Chairman of the Board John A. Featherman, III /s/ John Balzarini Treasurer and Chief Financial Officer -------------------------------- (Principal Accounting and Financial Officer) John Balzarini (Signatures continued on following page) 76 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES (Signatures continued from previous page) Signature Title /s/ John A. Featherman, III Director ---------------------------------- John A. Featherman, III /s/ John J. Ciccarone Director ---------------------------------- John J. Ciccarone /s/ M. Robert Clarke Director ---------------------------------- M. Robert Clarke /s/ Clifford E. DeBaptiste Director ---------------------------------- Clifford E. DeBaptiste /s/ John S. Halsted Director ---------------------------------- John S. Halsted /s/ J. Carol Hanson Director ---------------------------------- J. Carol Hanson /s/ Lynn Johnson-Porter Director ---------------------------------- Lynn Johnson-Porter /s/ Edward A. Leo Director ---------------------------------- Edward A. Leo /s/ David L. Peirce Director ---------------------------------- David L. Peirce /s/ John B. Waldron Director ---------------------------------- John B. Waldron /s/ Kevin C. Quinn Director ---------------------------------- Kevin C. Quinn /s/ Brian K. Campbell Director ---------------------------------- Brian K. Campbell /s/ Matthew S. Naylor Director ---------------------------------- Matthew S. Naylor 77 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES INDEX TO EXHIBITS The following is a list of the exhibits filed with, or incorporated by reference into, this Report (those exhibits marked with an asterisk are filed herewith and those exhibits marked "(CP)" are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates): 3(i). Certificate of Incorporation. Copy of the Corporation's Articles of Incorporation, as amended, is incorporated herein by reference to Exhibit 3(i) to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2004. 3(ii). By-Laws of the Corporation, as amended. Copy of the Corporation's ByLaws, as amended, is incorporated herein by reference to Exhibit 3(ii) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2000. 10. Material contracts. (a) Employment Agreement among the Corporation, the Bank and John A. Featherman, III, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(a) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (b) Employment Agreement among the Corporation, the Bank and Kevin C. Quinn, dated as of November 13, 2003 is incorporated herein by reference to Exhibit 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) * (c) Compensatory Arrangements of Executive Officers and Directors for 2007. (CP) (d) The Corporation's Dividend Reinvestment and Stock Purchase Plan, filed as an exhibit to the Corporation's registration statement on Form S-3 filed August 7, 2003 (SEC File No. 333-107739) is incorporated herein by reference. (e) The Corporation's Amended and Restated Stock Bonus Plan, filed as an exhibit to the Corporation's registration statement on Form S-8 filed August 12, 1997 (SEC File No. 333-33411) is incorporated herein by reference. (CP) * (f) The Bank's Amended and Restated Supplemental Benefit Retirement Plan, effective January 1, 2005. (CP) (g) The Corporation's Amended and Restated 1995 Stock Option Plan, filed as an appendix to the Corporation's Proxy statement for the 2003 Annual Meeting of Shareholders as filed with the SEC via EDGAR is incorporated herein by reference. (CP) (h) Form of Stock Option Agreement (Directors) is incorporated herein by reference to Exhibit 10(j) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (i) Form of Stock Option Agreement (Executive Officers) is incorporated herein by reference to Exhibit 10(k) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2004. (SEC File No. 00012870)(CP) (j) 2005 Restricted Stock Plan, is incorporated herein by reference to Appendix A to the Corporation's 2005 Proxy Statement filed March 17, 2005. (CP) * (k) Form of Restricted Stock Award Agreement used for grants of restricted stock on March 8, 2007, pursuant to the Incentive Plan filed herewith as Exhibit 10(w). (l) Letter of Employment to Deborah Pierce, is incorporated herein by reference to Exhibit 10.2 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2005. (CP) (m) Change of Control Agreement between the Bank and Deborah Pierce dated February 18, 2005, is incorporated herein by reference to Exhibit 10.3 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 2005. (CP) (n) Letter of Employment to Susan Bergen-Painter, is incorporated herein by reference to Exhibit 10.1 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) 78 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES (o) Change of Control Agreement between the Bank and Susan Bergen-Painter dated April 25, 2005, is incorporated herein by reference to Exhibit 10.2 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (p) Letter of Employment to Karen Walter, is incorporated herein by reference to Exhibit 10.3 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (q) Change of Control Agreement between the Bank and Karen Walter dated May 6, 2005, is incorporated herein by reference to Exhibit 10.4 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (r) Letter of Employment to John Balzarini, is incorporated herein by reference to Exhibit 10.5 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (s) Change of Control Agreement between the Bank and John Balzarini dated June 3, 2005, is incorporated herein by reference to Exhibit 10.6 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (t) Change of Control Agreement between the Bank and Linda Hicks dated May 23, 2005, is incorporated herein by reference to Exhibit 10.7 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (u) Change of Control Agreement between the Bank and Michelle Venema dated June 10, 2005, is incorporated herein by reference to Exhibit 10.8 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. (CP) (v) Change of Control Agreement between the Bank and Anthony Poluch dated May 25, 2005, is incorporated herein by reference to Exhibit 10.9 to the Corporation's Quarterly Report to Form 10-Q for the quarter ended June 30, 2005. (CP) * (w) Executive Annual Incentive Plan, effective January 1, 2006, as amended December 18, 2006 (the "Incentive Plan") with 2006 Exhibits. (CP) Portions of the 2006 Exhibits have been redacted and are subject to a confidential treatment request filed with the Secretary of the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended. * (x) Incentive Plan with 2007 Exhibits. (CP) Portions of the 2007 Exhibits have been redacted and are subject to a confidential treatment request filed with the Secretary of the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended. (y) Agreement for the Sale of Real Estate dated as of May 10, 2006 between First National Bank of Chester County and TD Banknorth, N.A., is incorporated herein by reference to Exhibit 10.1 to the Corporation's Quarterly Report on Form 10-Q/A for the quarter ended June 30, 2006. * (z) Letter of Employment to Clay T. Henry, dated September 6, 2006. (CP) * (aa) Supplemental Letter of Employment to Clay T. Henry, dated September 5, 2006. (CP) 79 FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES * (bb) Separation Benefits Agreement, dated as of October 2, 2006, by and between the Bank and Clay T. Henry. (CP) * (cc) Restricted Stock Award Agreement for Clay T. Henry, dated as of October 2, 2006. (CP) * (dd) Employment Transition Agreement and General Release by and between the Bank and Linda Hicks, dated October 18, 2006. (CP) * (ee) Separation Benefits Agreement, dated as of October 18, 2006, by and between the Bank and Linda Hicks. (CP) * 14. Code of Conduct (Ethics). * 21. Subsidiaries of the Corporation. First National Bank of Chester County, formerly known as The First National Bank of West Chester, is a banking institution organized under the banking laws of the United States in December 1863. Turks Head Properties, Inc., formerly known as 323 East Gay Street Corporation, was incorporated in 1996 in the State of Pennsylvania. Turks Head II, LLC was incorporated in 2003 in the State of Pennsylvania. FNB Insurance Services, LLC, doing business as First National Financial Advisory Services (formerly, First National Wealth Advisory Services), a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. FNB Properties, LLC, a wholly-owned subsidiary of the Bank, is a limited liability company formed in 2000 under the laws of Pennsylvania. First Chester County Capital Trust I was formed on July 11, 2002. First Chester County Capital Trust II was formed on November 13, 2003. * 23. Consent of Grant Thornton LLP, dated March 9, 2007. * 31.1 Certification of Chief Executive Officer. * 31.2 Certification of President. * 31.3 Certification of Treasurer and Chief Financial Officer. * 32.1 Certification of Chief Executive Officer. * 32.2 Certification of President. * 32.3 Certification of Treasurer and Chief Financial Officer. 80