ITEM 1. BUSINESS
GENERAL
The Company is a Delaware corporation and is a thrift holding company for First Federal Bank (the "Bank"), a federally chartered capital stock savings bank regulated by the Office of Thrift Supervision ("OTS"), Abstractors, Inc., which is a title insurance agency, NEP Trust Co. (the "Trust Co."), which offers trust, estate and asset management services and products and Higgins Insurance Associates, Inc. ("Higgins"), which provides insurance and investment products to individuals and businesses. The Company's executive offices are located at 12 East Broad Street, Hazleton, Pennsylvania 18201.
The Company's operations are primarily conducted through the Bank. These operations have been and continue to be attracting retail deposits from the general public in the areas surrounding its 16 full service community offices and investing those deposits, together with funds generated from operations and borrowings, primarily in one-to-four family mortgage loans, consumer loans, commercial loans and multi-family and commercial real estate loans. The Company has attempted to diversify and expand its loan products to better serve its customer base by placing a greater emphasis on its consumer lending and commercial lending, primarily to small businesses and municipalities.
The Company's revenues are derived from four principal business activities: banking, insurance, investments and trust services. First Federal Bank's revenues are derived principally from interest on its loans, and to a lesser extent, interest and dividends on its investment and mortgage-related securities and through other non-interest income. Investment income is generated through annuity sales and commissions on investment sales. Insurance premium income is generated through sales of commercial lines, property and casualty and employee benefits insurance policies to businesses and individuals. The Trust Co. continues to expand its customer base with assets under management of $167.1 million at September 30, 2004. The Company's primary sources of funds are deposits, principal and interest payments on loans and mortgage related securities, FHLB advances and other borrowings and proceeds from the sale of loans.
Effective January 1, 2004, the Bank sold the deposits and property of its branch office located in Danville, Pennsylvania to the First National Bank of Berwick, Berwick, Pennsylvania. For further information regarding this sale and transfer, please see Note 23 to the Consolidated Financial Statements included in Item 8 of this Form 10-K.
AGREEMENT AND PLAN OF MERGER
On December 8, 2004, KNBT Bancorp, Inc. ("KNBT"), the parent company of Keystone Nazareth Bank & Trust Company, entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which the Company will merge with and into KNBT. Concurrently with the merger, it is expected that the Bank will merge with and into Keystone Nazareth Bank & Trust Company.
Under the terms of the Agreement, the Company's stockholders may elect to receive either $23.00 of KNBT common stock or $23.00 in cash in exchange for their shares of Northeast Pennsylvania common stock, subject to an overall requirement that 50% of the total outstanding Company Common Stock be exchanged for KNBT Common Stock and 50% for cash. To the extent they receive shares of KNBT, the transaction is expected to be tax-free to Northeast Pennsylvania stockholders.
The number of shares of KNBT common stock into which each Northeast Pennsylvania share will be exchanged will be based on the price of KNBT common stock over a measurement period prior to the closing.
In addition, each director of Northeast Pennsylvania entered into a Shareholder Agreement with KNBT, pursuant to which each person agreed, among other things, to vote his or her shares of Company common stock in favor of the Merger Agreement at a meeting of shareholders of the Company to be called to consider and approve the Merger Agreement.
The transaction is expected to close in the second quarter of 2005. It is subject to certain conditions, including the approval of stockholders and the receipt of regulatory approval.
MARKET AREA AND COMPETITION
The Company is a community-oriented banking institution offering a variety of retail financial products and services to meet the needs of the communities it serves. The Company's lending and deposit gathering is concentrated in its market area consisting of a seven county region in Northeastern and Central Pennsylvania.
The Company maintains its headquarters in Hazleton. The Company's six banking offices in Luzerne County, including Hazleton, accounted for $299.9 million or 62% of the Company's total deposits at September 30, 2004. Hazleton is situated approximately 100 miles from Philadelphia and New York City and approximately 50 miles from Allentown and the Wilkes-Barre/Scranton area. The Company also maintains two banking offices in Bloomsburg (Columbia County), one each in Lehighton and Weatherly (both in Carbon County), one in Brodheadsville (Monroe County) and one each in Frackville, Pottsville, Shenandoah, and Schuylkill Haven (all in Schuylkill County).
The economy of the greater Hazleton area is characterized by diversified light manufacturing and is the site of production facilities for several major manufacturers including Union Camp, Hershey-Cadbury Chocolates, Quebecor and Hazleton Pumps, Inc. As a consequence, the manufacturing sector employs more than one third of the area's work force. The Hazleton area has excellent access to major highway transportation routes including Interstates 80 and 81 as well as rail transportation. The population of Luzerne County has remained relatively static and has one of the oldest average ages for all counties in the United States. The southern end of Schuylkill County is proving to be a growth area as individuals and companies which were previously based in the Allentown-Berks county areas are relocating to the southern end of Schuylkill County. Notwithstanding such growth, the overall population in the Company's market area is relatively small and, in recent years, has grown slowly, and the unemployment rate in the area is greater than the national average. Monroe County, the location of the Brodheadsville banking branch, is dominated by the Pocono Mountains, making the area one of the Mid-Atlantic's most popular resort areas.
The Company faces significant competition both in generating loans and in attracting deposits. Its most direct competition for deposits has historically come from savings banks and associations, commercial banks and credit unions. In addition, the Bank faces increasing competition for deposits from non-bank institutions such as brokerage firms and insurance companies in such investments as short-term money market funds, corporate and government securities funds, mutual funds and annuities. At June 30, 2004, which is the most recent date for which data is available from the Federal Deposit Insurance Corporation, the Bank held approximately 6.25% of the deposits in Luzerne County and, approximately 5.67% of the deposits in Schuylkill County, which was the fifth largest market share out of 19 financial institutions with offices in Luzerne county and the fifth largest market share out of 18 financial institutions with offices in Schuylkill county. In addition, the Bank's competition includes banks owned by large bank holding companies, such as PNC Financial Services Group, Inc., Wachovia Corporation, M&T Bank Corporation and Bank of America Corporation that are significantly larger and have significantly greater resources than the Bank that allows them to offer a wider variety of products and services.
The Company's competition for loans comes principally from commercial banks, savings banks, credit unions, mortgage brokers, mortgage banking companies and insurance companies. Its most direct competition for deposits has historically come from savings banks and associations, commercial banks and credit unions. In addition, the Bank faces increasing competition for deposits from non-bank institutions such as brokerage firms and insurance companies in such instruments as short-term money market funds, corporate and government securities funds, mutual funds and annuities.
Competition has also increased as a result of the lifting of restrictions on the interstate operations of financial institutions, as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. The Gramm-Leach-Bliley Act, which permits affiliation among banks, securities firms and insurance companies also changed the competitive environment in which the Bank conducts business.
In addition, the Company recognizes that its customer base increasingly focuses on convenience and access to services. The Company has addressed these customer needs through the implementation of electronic banking services and enhanced voice response capabilities, a computerized loan origination and document system and the issuance of debit cards. The Company continues to evaluate and enhance its service and delivery systems in order to better serve its retail and business customers.
LENDING ACTIVITIES
GENERAL. The information relating to the composition and maturity of the Bank's loan portfolio appears in "Loans" under Item 7 of this Form 10-K and is incorporated herein by reference.
ORIGINATION AND SALE OF LOANS. The Bank's lending activities are conducted primarily by its loan personnel operating at its branch and loan origination offices. All loans originated by the Bank are underwritten pursuant to the Bank's policies and procedures. The Bank originates both adjustable-rate and longer-term and shorter-term fixed-rate loans. The Bank's ability to originate fixed or adjustable-rate loans is dependent upon the relative customer demand for such loans, which is affected by the current and expected future level of interest rates. It is currently the policy of the Bank to sell newly originated fixed-rate one-to-four family mortgages with maturities greater than 15 years with retained servicing. Additionally, the Bank from time to time may sell certain loans to manage its interest-rate risk position in light of its overall asset/liability management strategy.
ONE-TO-FOUR FAMILY MORTGAGE LENDING. The Bank currently offers both fixed-rate and adjustable-rate mortgage ("ARM") one-to-four family mortgage loans with maturities up to 30 years. One-to-four family mortgage loan originations are generally obtained from the Bank's in-house loan representatives, from existing or past customers, and through referrals from members of the Bank's local communities.
The origination of ARM loans, as opposed to fixed-rate residential mortgage loans, helps reduce the Bank's exposure to increases in interest rates. However, adjustable-rate loans generally pose credit risks not inherent in fixed-rate loans, primarily because as interest rates rise, the underlying payments of the borrower rise, thereby increasing the potential for default. Periodic and lifetime caps on interest rate increases help to reduce the credit risks associated with adjustable-rate loans but also limit the interest rate sensitivity of such loans.
Most one-to-four family mortgage loans are underwritten according to Fannie Mae and Freddie Mac guidelines. In recent years, the Bank began offering one-to-four family mortgage loans which, when underwritten, did not fully meet established Fannie Mae or Freddie Mac standards, for example, the standard regarding income to debt ratios for the borrower and thus are not saleable in the secondary market. Mortgage loans originated by the Bank generally include due-on-sale clauses that provide the Bank with the contractual right to deem the loan immediately due and payable in the event the borrower transfers ownership of the property without the Bank's consent. Due-on-sale clauses are an important means of adjusting the yields on the Bank's fixed-rate mortgage loan portfolio and the Bank has generally exercised its rights under these clauses. The Bank requires fire, casualty, title and, in certain cases, flood insurance on all properties securing real estate loans made by the Bank.
MULTI-FAMILY AND COMMERCIAL REAL ESTATE LENDING. The Bank originates fixed-rate and adjustable-rate multi-family and commercial real estate loans that generally are secured by properties used for business purposes or a combination of residential and retail purposes.
Pursuant to the Bank's underwriting policies a multi-family mortgage or commercial real estate loan may be made in an amount up to 80% of the lower of the appraised value or sales price of the underlying property with terms generally ranging from 15 to 25 years.
The factors considered by the Bank in granting these loans include: the net operating income of the mortgaged premises before debt service and depreciation; the debt coverage ratio (the ratio of net earnings to debt service); and the ratio of loan amount to appraised value. The Bank has generally required that the properties securing commercial real estate loans have debt service coverage ratios of at least 125%.
The Bank's largest multi-family and commercial real estate loan at September 30, 2004 was a $593,000 loan secured by real estate and was performing according to its original terms. Loans secured by multi-family and commercial real estate generally have larger loan values and involve greater risks than one- to four-family residential mortgage loans. Payments on loans secured by such properties are often dependent on successful management and operation of the properties. Repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks in a variety of ways, including strict adherence to its underwriting standards, limiting the size of such loans and strictly scrutinizing the financial condition of the borrower, the quality of the collateral and the management of the property securing the loan. The Bank also obtains loan guarantees from financially capable parties. The Bank's lending personnel or an agent of the Bank inspect all of the properties securing the Bank's multi-family and commercial real estate loans before the loan is made. The Bank also obtains appraisals on each property in accordance with applicable regulations.
CONSTRUCTION LENDING. The Bank also offers residential construction loans. Such loans have been for presold one- to four-family residences for the construction phase and convert into permanent financing. The Bank generates residential construction loans primarily through direct contact with borrowers or home builders, and these loans involve properties located in the Bank's primary market area. Such loans require that the Bank review plans, specifications and cost estimates and that the home builder be approved by the Bank. The amount of construction advances, together with the sum of previous disbursements, may not exceed the percentage of completion of the construction. The maximum loan-to-value limit applicable to such loans is generally 80%.
The Bank's largest construction loan at September 30, 2004 was a $5.0 million loan secured by all of the improved and unimproved building lots and amenities of a resort community located in Hazleton, Pennsylvania. This loan was performing according to its original terms at September 30, 2004. Construction financing is generally considered to involve a higher degree of credit risk than long-term financing on owner-occupied real estate. The risk of loss on construction loans is dependent largely upon the accuracy of the value of the property at completion of the construction compared to the estimated cost of construction and other assumptions. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to protect the value of the property.
Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property's value at completion of construction and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the building. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or before the maturity of the loan, with a building having a value that is insufficient to assure full repayment. If the Bank is forced to foreclose on a building before or at completion due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.
CONSUMER LENDING. The Bank offers consumer loans, which include home equity loans, home equity lines of credit, direct and indirect automobile loans, education loans and other consumer loans. The Bank's home equity loans are generated primarily through the Bank's retail branch offices. The Bank generally offers home equity loans with a term of 180 months or less. The Bank also offers home equity lines of credit with terms up to 20 years, the last 10 years of which require full amortization of the principal balance. The maximum loan amount for both home equity loans and home equity lines of credit, is subject to a combined loans-to-value ratio of 80%.
The Bank also offers automobile loans, both on a direct and an indirect basis (through new and used car dealers). The indirect automobile loans are originated by dealers in accordance with underwriting standards pre-established by the Bank and are serviced by the Bank. The Bank also offers loans on recreational vehicles and boats and other consumer loans, deposit-secured loans, and other personal and unsecured loans.
Consumer loans tend to bear higher rates of interest and have shorter terms to maturity than first lien residential mortgage loans. Nationally, consumer loans have historically tended to have a higher rate of default. Additionally, consumer loans generally involve greater risk than residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.
COMMERCIAL LENDING. The Bank makes commercial business loans primarily in its market area to a variety of professionals, sole proprietorships and small businesses. The Bank offers a variety of commercial lending products, including term loans for fixed assets and working capital, revolving lines of credit, letters of credit, and Small Business Administration guaranteed loans. Interest rates charged generally are based on the prime rate as published in the Wall Street Journal. Prior to making commercial business loans, the borrower is required to provide the Bank with sufficient information to allow a prudent loan decision to be made. Such information generally includes financial statements and projected cash flows, and is reviewed to evaluate debt service capability. Commercial business loans are generally secured by a variety of collateral, including real estate, personal property and fixed assets and frequently are supported by personal guarantees. In addition, the Bank actively participates in industrial loans arranged through the Greater Wilkes-Barre Industrial Fund and CanDo, Inc. a Hazleton area industrial fund.
The Bank's largest commercial business loan at September 30, 2004 was a $7.3 million loan secured by the fixed assets at a manufacturing facility. This loan was performing in accordance with its original terms at September 30, 2004. Commercial business loans generally involve higher credit risks than loans secured by real estate. Unlike residential mortgage loans, which generally are made on the basis of the borrower's ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans are of higher risk and
typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
LOAN APPROVAL PROCEDURES AND AUTHORITY. The Board of Directors establishes the lending policies and the levels of loan approval authority for employees of the Bank and oversees the Bank's lending activities. The Board of Directors has established an Executive Committee and a Risk Committee which, among other things, oversee the lending activities of the Bank and manages a committee of loan officers that have initial oversight over certain loans. All loans exceeding certain prescribed limits are reported to the Risk Management and Executive Committee of the Board.
NONPERFORMING ASSETS AND ALLOWANCE FOR LOAN LOSSES. The information relating to the Bank's nonperforming assets and allowance for loan losses appears in Item 7 of this Form 10-K the "Nonperforming Assets" and "Allowance for Loan Losses" sections of Management's Discussion and Analysis of Financial Condition and Results of Operations and is incorporated herein by reference.
INVESTMENT ACTIVITIES
The above captioned information appears in the "Investment Activities" section of Management's Discussion and Analysis of Financial Condition and Results of Operations and is incorporated herein by reference.
SOURCE OF FUNDS
Information relating generally to the Bank's source of funds and a description of the Bank's deposits appears in Item 7 of this Form 10-K under "Sources of Funds" section of Management's Discussion and Analysis of Financial Condition and Results of Operations and is incorporated herein by reference.
BORROWINGS. The Bank utilizes advances from the Federal Home Loan Bank of Pittsburgh (the "FHLB") as well as other borrowings as a supplement to retail deposits to fund its operations. Such advances are collateralized primarily by the Bank's mortgage loans and mortgage-related securities and secondarily by the Bank's investment in the capital stock of the FHLB of Pittsburgh. FHLB advances are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The maximum amount that the FHLB of Pittsburgh will advance to member institutions, including the Bank, fluctuates from time to time in accordance with the policies of the FHLB of Pittsburgh. See "Regulation-Federal Home Loan Bank System." At September 30, 2004, the Bank had $243.9 million in outstanding FHLB advances, compared to $258.9 million at September 30, 2003. The Bank had $135.3 million of additional borrowing capacity from the FHLB at September 30, 2004. Other borrowings consist of overnight retail repurchase agreements, which for the periods presented were immaterial, and repurchase agreements. Repurchase agreements are treated as financings with the obligations to repurchase securities sold reflected as a liability in the balance sheet. The dollar amount of securities underlying the agreements remains recorded as an asset, although the securities underlying the agreements are delivered to the brokers who arranged the transactions. In certain instances, the broker may have sold, loaned, or disposed of the securities to other parties in the normal course of their operations, and have agreed to deliver to the Bank substantially similar securities at the maturity of the agreements. Securities underlying sales of securities under repurchase agreements consisted of investment securities that had an amortized cost of $21.9 million and a market value of $22.2 million at September 30, 2004. At September 30, 2004, the Bank had $20 million in outstanding repurchase agreements. The Bank had no such agreements outstanding as of September 30, 2003.
The following table sets forth certain information regarding the Bank's borrowed funds on the dates indicated:
SUBSIDIARY ACTIVITIES
The Company has six active wholly-owned subsidiaries: the Bank, incorporated under the laws of the United States; Abstractors, Inc., the Trust Co., and Higgins, each of which are incorporated under Pennsylvania law; and NEP Capital Trust I and NEP Capital Trust II, each of which is incorporated under Delaware law. Abstractors, Inc. is a title insurance agency with total assets of $451,000 at September 30, 2004. The Trust Co., offers trust estate and asset management services and products and had total assets of $1.1 million and $167.1 million of trust assets under management at September 30, 2004. Higgins provides insurance and investment products to individuals and businesses and had total assets of $1.4 million at September 30, 2004. NEP Capital Trust I and NEP Capital Trust II were established in connection with the issuance of trust preferred securities. The proceeds of the offerings were used to purchase debentures from the Company.
PERSONNEL
As of September 30, 2004, the Company had 246 full-time equivalent employees, none of whom were covered by a collective bargaining agreement. Management believes that the Company has good relations with its employees and there are no pending or threatened labor disputes.
REGULATION AND SUPERVISION
As a savings and loan holding company, the Company is required by federal law to file reports with and otherwise comply with, the rules and regulations of the OTS. The Bank is subject to extensive regulation, examination and supervision by the OTS, as its chartering agency, and the Federal Deposit Insurance Corporation (the "FDIC"), as the deposit insurer. The Bank is a member of the Federal Home Loan Bank ("FHLB") System. The Bank's deposit accounts are insured up to applicable limits by the Savings Association Insurance Fund ("SAIF") managed by the FDIC. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. There are periodic examinations by the OTS and the FDIC to test the Bank's safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the OTS, the FDIC or the Congress, could have a material adverse impact on the Company, the Bank and their operations.
Certain of the regulatory requirements applicable to the Bank and to the Company are referred to below or elsewhere herein. The description of statutory provisions and regulations applicable to savings associations and their holding companies set forth in this Form 10-K does not purport to be complete descriptions of such statutes and regulations and their effects on the Bank and the Company are qualified in its entirety by reference to such statutes and regulations.
FEDERAL SAVINGS INSTITUTION AND REGULATIONS
BUSINESS ACTIVITIES. The activities of federal savings institutions are governed by the federal laws and regulations. These laws and regulations delineate the nature and extent of the activities in which federal associations may engage. In particular, many types of lending authority for federal associations, e.g., commercial, non-residential real property loans and consumer loans, are limited to a specified percentage of the institution's capital or assets.
LOANS-TO-ONE-BORROWER. Federal law provides that, savings institutions are generally subject to the national bank limit on loans-to-one borrower. Generally, this limit is 15% of the Bank's unimpaired capital and surplus, plus an additional 10% of unimpaired capital and surplus, if such loan is secured by specified readily marketable collateral. At September 30, 2004, the largest aggregate amount of loans-to-one borrower was $7.3 million, which was less than the Bank's general limit on loans-to-one borrower which was $10.5 million.
QTL TEST. Federal law requires savings institutions to meet a qualified thrift lending ("QTL") test. Under the test, a savings association is required to either qualify as a "domestic building and loan association" under the Internal Revenue Code or maintain at least 65% of its "portfolio assets" (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least 9 months out of each 12-month period. A savings association that fails the QTL test is subject to certain operating restrictions and may be required to convert to a bank charter. As of September 30, 2004, the Bank maintained 92.1% of its portfolio assets in qualified thrift investments and, therefore, met the QTL test. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered as "qualified thrift investments."
LIMITATION ON CAPITAL DISTRIBUTIONS. OTS regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to stockholders of another institution in a cash-out merger. Under the regulations, an application to and the prior approval of the OTS is required before any capital distribution if the institution does not meet the criteria for "expedited treatment" of applications under OTS regulations (generally, examination ratings in one of two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with the OTS. If an application is not required, the institution must still give advance notice to the OTS of the capital distribution, if, like the Bank, it is a subsidiary of a holding company. If the Bank's capital fell below its regulatory requirements or if the OTS notified it that it was in need of more than normal supervision, the Bank's ability to make capital distributions could be restricted. In addition, the OTS could prohibit a proposed capital distribution, which would otherwise be permitted by regulation, if the OTS determines that the distribution would be unsafe or unsound practice.
ASSESSMENTS. Savings institutions are required to pay assessments to the OTS to fund the agency's operations. The general assessments, paid on a semi-annual basis, are based upon the savings institution's total assets, including consolidated subsidiaries, as reported in the Bank's latest quarterly Thrift Financial Report. The assessments paid by the Bank for the year ended September 30, 2004 totaled $245,000.
BRANCHING. OTS regulations permit federally-chartered savings associations to branch nationwide under certain conditions. Generally, federal savings associations may establish interstate networks and geographically diversify their loan portfolios and lines of business. The OTS authority preempts any state law purporting to regulate branching by the federal savings associations.
COMMUNITY REINVESTMENT. Under the Community Reinvestment Act ("CRA"), as implemented by OTS regulations, a savings institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OTS, in connection with its examination of a savings institution, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank received a "Satisfactory" CRA rating in its most recent examination.
TRANSACTIONS WITH RELATED PARTIES. The Bank's authority to engage in transactions with related parties or "affiliates" (i.e., any company that controls or is under common control with an institution, including the Company and its non-savings institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution's capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. The transactions with affiliates must be on terms and under circumstances, that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.
The recently enacted Sarbanes-Oxley Act generally prohibits loans by the Company to its executive officers and directors. However, the Act contains a specific exception from such prohibitions for loans by the Bank to its executive officers and directors in compliance with federal banking regulations restrictions on such loans. The Bank's authority to extend credit to executive officers, directors and 10% stockholders ("insiders"), as well as entities such persons control, is also governed by federal law. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. An exception exists for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. The law limits both the individual and aggregate amount of loans the Bank may make to insiders based, in part, on the Bank's capital position and requires certain board approval procedures to be followed.
ENFORCEMENT. The OTS has primary enforcement responsibility over savings institutions and has the authority to bring action against the institution and all "institution-affiliated parties," including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers or directors, receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or $1 million per day in especially egregious cases. The FDIC has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the
Director, the FDIC has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.
STANDARDS FOR SAFETY AND SOUNDNESS. The federal banking agencies have adopted Interagency Guidelines Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the OTS determines that a savings institution fails to meet any standard prescribed by the guidelines, the OTS may require the institution to submit an acceptable plan to achieve compliance with the standard.
CAPITAL REQUIREMENTS. The OTS capital regulations require savings institutions to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% leverage (core capital) ratio and an 8% risk-based capital ratio. Core capital is defined as common stockholder's equity (including retained earnings), certain non-cumulative perpetual preferred stock and related surplus, minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights ("MSRs") and credit card relationships. The OTS regulations require that, in meeting the leverage ratio, tangible and risk-based capital standards institutions generally must deduct investments in and loans to subsidiaries engaged in activities not permissible for a national bank. In addition, the OTS prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio, and, together with the risk-based capital standards itself, a 4% Tier 1 risk-based capital standard.
The risk-based capital standard for savings institutions requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off balance sheet assets, recourse obligations, direct credit substitutes and other residual interests are multiplied by a risk-weight factor of 0% to 100%, as assigned by the OTS capital regulation based on the risks OTS believes are inherent in the type of asset. The components of core capital are equivalent to those discussed earlier. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses, limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market value. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.
The OTS also has authority to establish minimum capital requirements in appropriate cases upon a determination that an institution's capital levels are or may become inadequate in light of the particular circumstances. At September 30, 2004, the Bank met each of its capital requirements. The following table presents the Bank's capital position at September 30, 2004. (Dollars in thousands)
PROMPT CORRECTIVE REGULATORY ACTION. The OTS is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution's degree of under capitalization. Generally, a savings institution that has a total risk-based capital of less than 8% or a leverage ratio or a Tier 1 capital ratio that is less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the higher examination rating) is considered to be undercapitalized. A savings institution that has a total risk-based capital less than 6%, a Tier 1 risk-based capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be "significantly undercapitalized" and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be "critically undercapitalized." Subject to a narrow exception, the OTS is required to appoint a receiver or conservator for an institution that is critically undercapitalized within specified time frames. The regulation also provides that a capital restoration plan must be filed with the OTS within 45 days of the date an association receives notice that it is "undercapitalized," significantly undercapitalized" or "critically undercapitalized." Compliance with the plan must be guaranteed by any parent holding company. In addition, numerous mandatory supervisory actions may become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators, restrictions on growth, capital distributions and expansion. The OTS could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.
INSURANCE OF DEPOSIT ACCOUNTS. The FDIC maintains a risk-based assessment system by which institutions are assigned to one of three categories based on the institution's capitalization and one of three subcategories based on examination ratings and other supervisory information. An institution's assessment rate depends on the categories to which it is assigned. Assessment rates for SAIF member institutions are determined semi-annually and currently range from 0 basis points, for the healthiest institutions to 27
basis points, for the riskiest institutions. The Bank's assessment rate for the fiscal year 2004 was 3 basis points (not including the FICO payment discussed below) and the premium paid for this period was $122,442. The FDIC has authority to increase insurance assessments. A significant increase in SAIF insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation ("FICO") to recapitalize the predecessor to the SAIF. During 2004, FICO payments for SAIF members approximated 1.5 basis points.
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the FHLB System, which consists of 12 regional FHLBs. The FHLB provides a central credit facility primarily for member institutions. The Bank, as a member of the FHLB, is required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLB, whichever is greater. The Bank was in compliance with this requirement with an investment in FHLB stock at September 30, 2004, of $13.0 million. FHLB advances must be secured by specified types of collateral and all long-term advances may only be obtained for the purpose of providing funds for residential housing finance. At September 30, 2004, the Bank had $243.9 million in FHLB advances.
The FHLBs are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members. For the years ended September 30, 2004, 2003 and 2002 dividends from the FHLB to the Bank amounted to approximately $179,000, $312,000, and $439,000, respectively. If dividends were reduced, the Bank's net interest income would likely also be reduced. Recent legislation has changed the structure of the Federal Home Loan Banks' funding obligations for insolvent thrifts, revised the capital structure of the Federal Home Loan Banks and implemented entirely voluntary membership for Federal Home Loan Banks. Management cannot predict the effect that these changes may have with respect to its Federal Home Loan Bank membership.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board regulations require savings institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for accounts aggregating $47.6 million or less (subject to adjustment by the Federal Reserve Board) the reserve requirement is 3%; and for accounts greater than $47.6 million, the reserve requirement is 10%. The first $7.0 million of otherwise reservable balances (subject to adjustment by the Federal Reserve Board) are exempted from the reserve requirements. The Bank is in compliance with these requirements.
HOLDING COMPANY REGULATION
The Company is a nondiversified unitary savings and loan holding company within the meaning of federal law. Under prior law, a unitary savings and loan holding company, such as the Company, was not generally restricted as to the types of business activities in which it may engage, provided that the Bank continues to be a qualified thrift lender, as previously described. The Gramm-Leach-Bliley Act of 1999 provides that no company may acquire control of a savings institution after May 4, 1999 unless it engages only in the financial activities permitted for financial holding companies or those permitted under the law for multiple savings and loan holding companies as described below. Further, the Gramm-Leach-Bliley Act specifies that existing savings and loan holding companies may only engage in such activities. The Gramm-Leach-Bliley Act, however, grandfathered the unrestricted authority of activities with respect to unitary savings and loan holding companies existing prior to May 4, 1999, so long as the holding company's savings institution subsidiary continues to comply with the qualified thrift lender test. The Company qualifies for the grandfathering. Upon any non-supervisory acquisition by the Company of another savings institution, or savings bank that meets the qualified thrift lender test and is deemed to be a savings institution by the Office of Thrift Supervision, the Company would become a multiple savings and loan holding company (if the acquired institution is held as a separate subsidiary) and would generally be limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain activities authorized by OTS regulation. However, the OTS has issued an interpretation concluding that multiple savings and loan holding companies may also engage in activities permitted for financial holding companies.
A savings and loan holding company is prohibited from, directly or indirectly, acquiring more than 5% of the voting stock of another savings institution, or holding company thereof, without prior written approval of the OTS and from acquiring or retaining control of a depository institution that is not insured by the FDIC. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
The OTS may not approve any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, except: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies, and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Although savings and loan holding companies are not currently subject to specific capital requirements or specific restriction on the payment of dividends or other capital distributions, federal regulations do prescribe such restrictions on subsidiary savings institutions as described below. The Bank must notify the OTS 30 days before declaring any dividend to the Company. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the OTS and the agency has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution.
ACQUISITION OF THE COMPANY. Under the Federal Change in Bank Control Act ("CIBCA"), a notice must be submitted to the OTS if any person (including a company), or group acting in concert, seeks to acquire "control" of a savings and loan holding company. Under certain circumstances, a change of control may occur, and prior notice is required, upon the acquisition of 10% or more of the Company's outstanding voting stock, unless the OTS has found that the acquisition will not result in a change of control of the Company. Under the CIBCA, the OTS has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that so acquires control would then be subject to regulation as a savings and loan holding company.
TRUST COMPANY REGULATION
The Trust Co. is chartered under the laws of Pennsylvania and the Pennsylvania Department of Banking is responsible for its regulation, supervision and examination. Pennsylvania law governs the activities and investments of the Trust Co. as well as its administration of trust accounts. The Trust Co. limits its activities to trust, fiduciary and related activities and is not insured by the FDIC. The Pennsylvania Department of Banking maintains authority to issue orders and suspend directors, officers or employees for violations of law or regulations or unsafe practices and to take possession as receiver or conservator of any institution for violations, unsafe practices or condition or insolvency. The Trust Co. pays assessments to the Pennsylvania Department of Banking, which in fiscal 2004 amounted to $2,500.
FEDERAL AND STATE TAXATION
FEDERAL TAXATION
GENERAL. The Company and the Bank report their income on a September 30 fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Bank or the Company. Neither the Company nor the Bank has been audited by the IRS in the past five years.
BAD DEBT RESERVE. Historically, savings institutions such as the Bank which met certain definitional tests primarily related to their assets and the nature of their business ("qualifying thrifts") were permitted to establish a reserve for bad debts and to make annual additions thereto, which may have been deducted in arriving at their taxable income. The Bank's deductions with respect to "qualifying real property loans," which are generally loans secured by certain interest in real property, were computed using an amount based on the Bank's actual loss experience, or a percentage equal to 8% of the Bank's taxable income, computed with certain modifications and reduced by the amount of any permitted addition to the non-qualifying reserve. Due to the Bank's loss experience, the Bank generally recognized a bad debt deduction equal to 8% of taxable income.
In August 1996, the provisions repealing the above thrift bad debt rules were passed by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminated the 8% of taxable income method for deducting additions to the tax bad debt reserves for all thrifts for tax years beginning after December 31, 1995. These rules also required that all thrift institutions recapture all or a portion of their bad debt reserves added since the base year (the last taxable year beginning before January 1, 1988). The Bank had previously recorded a deferred tax liability equal to the bad debt recapture and as such, the new rules had no
effect on net income or federal income tax expense. For taxable years that began after December 31, 1995, the Bank's bad debt deduction was equal to net charge-offs. The new rules allowed an institution to suspend the bad debt reserve recapture for the 1996 and 1997 tax years if the institution's lending activity for those years was equal to or greater than the institution's average mortgage lending activity for the six taxable years preceding 1996. For this purpose, only home purchase and home improvement loans were included and the institution could have elected to have the tax years with the highest and lowest lending activity removed from the average calculation. If an institution was permitted to postpone the reserve recapture, it had to begin its six year recapture no later than the 1998 tax year. The unrecaptured base year reserves were not subject to recapture as long as the institution continued to carry on the business of banking. In addition, the balance of the pre-1988 bad debt reserves continued to be subject to a provision of present law referred to below that required recapture in the case of certain excess distributions to stockholders.
DISTRIBUTIONS. To the extent that the Bank makes "non-dividend distributions" to the Company that are considered as made: (i) from the reserve for losses on qualifying real property loans, to the extent the reserve for such losses exceeds the amount that would have been allowed under the experience method, or (ii) from the supplemental reserve for losses on loans ("Excess Distributions"), then an amount based on the amount distributed will be included in the Bank's taxable income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial or complete liquidation. However, dividends paid out of the Bank's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Bank's bad debt reserve. Thus, any dividends to the Company that would reduce amounts appropriated to the Bank's bad debt reserve and deducted for federal income tax purposes would create a tax liability for the Bank. The amount of additional taxable income created from an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus if the Bank makes a "non-dividend distribution," then approximately one and one-half times the amount so used would be includable in gross income for federal income tax purposes, assuming a 34% corporate income tax rate (exclusive of state and local taxes). The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserve.
CORPORATE ALTERNATIVE MINIMUM TAX. The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset by net operating loss carryovers of which the Company currently has none. AMTI is increased by an amount equal to 75% of the amount by which the Company's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). In addition, for taxable years beginning after June 30, 1986 and before January 1, 1996, an environmental tax of 0.12% of the excess of AMTI (with certain modifications) over $2.0 million is imposed on corporations, including the Company, whether or not an Alternative Minimum Tax ("AMT") is paid. The Company does not expect to be subject to the AMT.
DIVIDENDS RECEIVED DEDUCTION AND OTHER MATTERS. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend then 80% of any dividends received may be deducted.
STATE AND LOCAL TAXATION
The Company and its non-thrift Pennsylvania subsidiaries are subject to the Pennsylvania Corporation Net Income Tax and Capital Stock and Franchise Tax. The state Corporate Net Income Tax rate for fiscal years ended 2004, 2003 and 2002 was 9.99% and was imposed on the Company's and its non-thrift subsidiaries' unconsolidated taxable income for federal purposes with certain adjustments. In general, the Capital Stock Tax is a property tax imposed at the rate of .699% of a corporation's capital stock value, which is determined in accordance with a fixed formula. The Company is also required to file an annual report with and pay an annual franchise tax to the State of Delaware.
The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax Act (the "MTIT"), as amended, to include thrift institutions having capital stock. Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the Bank from all other taxes imposed by the Commonwealth of Pennsylvania for state income tax purposes and from all local taxation imposed by political subdivisions, except taxes on real estate and real estate transfers. The MTIT is a tax upon net earnings, determined in accordance with generally accepted accounting principles prevailing in the United States ("GAAP") with certain adjustments. The MTIT, in computing GAAP income, allows for the exclusion of interest earned on Pennsylvania and federal securities, while disallowing a percentage of a thrift's interest expense deduction in the proportion of interest income on those securities to the overall interest income of the Bank. Net operating losses, if any, thereafter can be carried forward three years for MTIT purposes. Neither the Company nor the Bank have been audited by the Commonwealth of Pennsylvania in the last five years.
ADDITIONAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information regarding the executive officers of the Company and its subsidiaries as of September 30, 2004 who are not directors.
NAME AGE AS OF 9/30/04 POSITION - ----------------- ----------------- ----------------------------------------- Jerry D. Holbrook 48 Chief Financial Officer and Secretary of the Bank and Company since 2003. From 2000 to 2002, Chief Financial Officer of E-Duction, a financial services start-up company located in the metropolitan area of Philadelphia, Pennsylvania. Prior to 2000, 15 years of senior level banking experience at First USA Bank (JP Morgan Chase) and WSFS Financial Corporation, both located in Wilmington, Delaware.
Leo R. Loftus 49 Senior Vice President and Chief Lending Office at First Federal Bank since September 2003. Prior to that, Senior Vice President - Commerical Lender at First Federal Bank.
ITEM 2.
ITEM 2. PROPERTIES
The Company currently conducts its business through 16 full service community offices located in Luzerne, Carbon, Columbia, Monroe and Schuylkill counties in Northeast Pennsylvania. Abstractors, Inc. and Northeast Pennsylvania Trust Co. conduct their business in the downtown Hazleton area. The following table sets forth the Company's offices as of September 30, 2004. The Kingston, Pennsylvania branch office listed below was opened in December 2004 and, accordingly, has no book value or deposits at September 30, 2004.
(1) The Company is presently in negotiations to extend its lease for the Schuylkill Mall office by one year. (2) The Bank owns the building and provides intercompany leases to NEP Trust Company and Abstractors, Inc.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Such routine legal proceedings, in the aggregate, are believed by management to be immaterial to the Company's financial condition or results of operation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
MARKET FOR REGISTRANT'S COMMON EQUITY
The Company's common stock is traded on the Nasdaq Stock Market under the symbol NEPF. At September 30, 2004, the Company had 1,482 registered common stockholders of record. The following table sets forth the range of high and low bid information for each quarterly period within the two most recent fiscal years as well as the quarterly dividends paid.
The closing market price of the common stock at September 30, 2004 was $16.51.
STOCK PRICE RANGE ------------------ Low High Dividends -------- -------- --------- 1st quarter $ 17.50 $ 20.00 $ 0.06 2nd quarter 17.01 19.75 0.06 3rd quarter 16.80 18.39 0.06 4th quarter 16.25 17.74 0.06 --------- $ 0.24
1st quarter $ 13.96 $ 17.05 $ 0.12 2nd quarter 14.67 17.42 0.12 3rd quarter 15.00 16.75 0.12 4th quarter 14.77 18.47 0.12 --------- $ 0.48
The Company's dividend policy is impacted by, among other things, our views on potential future capital requirements relating to balance sheet growth, the expansion of the Bank's branch distribution channel, investments and acquisitions and legal risks. The Company is also subject to the requirements of Delaware law which limits dividends to an amount not to exceed the surplus or net profits of the Company. Additionally, the Company agreed to limit its quarterly dividends to $.06 per share in the Definitive Agreement and Plan of Merger dated December 8, 2004 with KNBT Bancorp, Inc.
RECENT SALES OF UNREGISTERED SECURITIES
Under the Agreement, dated December 7, 2000, by and among, Northeast Pennsylvania Financial Corp., James Clark, James McCann, Joseph P. Schlitzer, John W. Sink and Higgins Insurance Associates, Inc., in consideration for the purchase of Higgins Insurance Associates, Inc., Northeast Pennsylvania is required to issue on each of the December 31, 2001, 2002, 2003 and 2004, an amount of shares of common stock equal to $100,000 provided that certain performance measures have been met. This resulted in the Company issuing 6,568, 6,369, and 5,206 shares of common stock on December 2001, 2002 and 2003, respectively. These shares were not registered under the Securities Act of 1933, as amended.
PURCHASES OF EQUITY SECURITIES
The following table sets forth information regarding the Company's repurchases of its common stock during the quarter ended September 30, 2004.
- ----------
(1) On May 26, 2004, the Board of Directors authorized the repurchase of 5% of the Company's outstanding shares, or approximately 209,000 shares, from time to time, subject to market conditions. This plan will continue until it is completed or terminated by the Board of Directors. (2) The Company agreed to postpone any future repurchases of its common stock on December 8, 2004 when it executed the Agreement and Plan of Merger with KNBT Bancorp, Inc.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial and other data of the Company set forth below is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of the Company and Notes thereto presented elsewhere in this Annual Report on Form 10-K. Prior periods have been restated to reflect the correction of certain accounting errors which were discovered in July and September 2003. See Note 2 to the Consolidated Financial Statements for additional information regarding the restatement.
(See footnotes on next page)
(1) Loans, net, represent gross loans receivable net of the allowance for loan losses, loans in process and deferred loan origination fees and exclude loans held-for-sale. The allowance for loan losses at September 30, 2004, 2003, 2002, 2001, and 2000 was $8.4 million, $10.2 million, $5.4 million, $4.5 million, $4.2 million and $2.9 million, respectively.
(2) To the extent applicable, all ratios are based on average daily balances.
(3) Calculations of yield are presented on a taxable equivalent basis using the combined Federal and state income tax rate of 40%.
(4) The average interest rate spread represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of average interest-bearing liabilities.
(5) The net interest margin represents net interest income as a percent of average interest-earning assets.
(6) Calculated as non-interest expense divided by the sum of total income less interest expense.
(7) The dividend payout ratio equals dividends paid per share divided by net income per share. Since the Company reported a net loss for 2003, this ratio was not meaningful.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION AND BUSINESS
The Company's results of operations are dependent primarily on the results of operation of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of the interest paid on deposits and borrowings. However, non-interest income has become a significant contributor to the Company's results of operations mainly due to fees earned by non-bank subsidiaries. Results of operations are also affected by the Company's provision for loan losses, loan and security sales activities, service charges and other fee income, and noninterest expense. The Company's noninterest expense principally consists of compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.
The Company's results of operations have been restated for the years ended September 30, 2002 through 1998 to reflect the correction of accounting errors discovered in July and September 2003. These errors primarily related to the Company's indirect automobile loan portfolio, mortgage and consumer loan portfolios, employee health and welfare benefit plans and certain operating expenses, which are more fully described in Note 2 to the Consolidated Financial Statements. The net effect of such restatements was to reduce net interest income, increase operating expenses and decrease retained earnings for prior periods. The following discussion of the Company's business reflects these restatements.
The following discussion and analysis is presented on a consolidated basis and focuses on the major components of the Company's operations and significant changes in the results of operations for the periods presented. The discussion should be read in conjunction with the Company's Consolidated Financial Statements and accompanying notes thereto presented elsewhere in this Annual Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The Company has established various accounting policies that govern the application of principles generally accepted in the United States in the preparation of its financial statements. Significant accounting policies are described in the Footnotes to the Consolidated Financial Statements. The Company believes the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in the preparation of the Consolidated Financial Statements. For further discussion of the allowance for loan losses, see "Financial Condition - Allowance for Loan Losses." Although we believe we use the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors.
MANAGEMENT STRATEGY
The long-term strategy of the Company has been to become a high-performing financial service company focusing on its customer needs for high-quality financial products and services. The Bank provides residential and commercial real estate, commercial and consumer lending services, as well as retail deposit and cash management services. Lending activities are funded primarily with retail deposits and borrowings. To promote long-term financial strength and profitability, the Company's operating strategy has been focused on originating high-quality consumer and small-business commercial loans and deposit relationships. The Company also manages an investment portfolio of high-quality mortgage-related securities and investment securities, which are funded with long-term Federal Home Loan Bank advances and deposits. The Company currently sells newly originated fixed-rate residential mortgages in the secondary market.
In September 2003, the Board of Directors initiated several management and operational changes including appointing two seasoned bank executives to lead the Company. Thomas Petro was appointed as President and Chief Executive Officer after the resignation of the former President and Chief Executive Officer and Jerry Holbrook was appointed as Chief Financial Officer. The Company's new management team has repositioned the balance sheet and improved earnings by divesting certain fixed-rate residential mortgage loans and investment securities and reinvesting these proceeds in similar assets that are interest-rate sensitive. The Company also evaluated alternatives to restructure a portion of its long-term fixed-rate FHLB borrowings to improve net interest income and effectively manage the Bank's interest-rate risk position. This resulted in the Bank entering into interest-rate swap contracts whereby such long-term fixed-rate advances were swapped to variable rates. In addition, the Bank has developed loan and deposit pricing systems to support its long-term strategy of increasing core deposits in its local market areas while expanding the loan portfolio through new originations, commercial loan participations and strategic purchases of high-quality loan receivables.
MANAGEMENT OF INTEREST RATE RISK AND MARKET RISK ANALYSIS
The principal objective of the Bank's interest rate risk management is to evaluate the interest rate risk included in certain balance sheet accounts, determine the level of risk appropriate given the Bank's business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with approved guidelines. Through such management, the Bank seeks to reduce the vulnerability of its operations to changes in interest rates. The Bank's Asset Liability Committee (the "ALCO") is responsible for reviewing the Bank's asset/liability policies and interest rate risk position. The ALCO meets on a monthly basis and reports trends and the Bank's interest rate risk position to the Risk Management Committee of the Board of Directors. The extent of the movement of interest rates is an uncertainty that could have a negative impact on the earnings of the Bank.
Management believes that reducing its exposure to interest rate fluctuations within certain limits will enhance long-term profitability. However, the Bank's strategies may adversely impact net interest income due to lower initial yields on some of its adjustable rate loans and securities in comparison to longer-term fixed-rate investments and whole loans. To promote a higher yield on its investment securities, while at the same time addressing the Bank's interest rate risk management policies, the Bank has
invested a portion of its portfolio of investment securities in longer-term (more than five years) Federal agency obligations, which have call features. Given the rates of such securities in comparison to current market interest rates, the Bank anticipates the majority of such securities may be called prior to their contractual maturity. The Bank also uses the derivatives markets to manage interest-rate risk from time-to-time primarily by engaging in interest rate swaps to manage interest rate risk on its borrowings. Under the Agreement and Plan of Merger, the Bank must obtain KNBT's approval before entering into or modifying any interest rate caps on swap agreements or arrangements. At September 30, 2004, there were $40.0 million in notional amount of derivative contracts in effect.
NET PORTFOLIO VALUE. The Company's interest rate sensitivity is primarily monitored by management through the use of a model, which generates estimates of the change in the Company's net portfolio value ("NPV") over a range of interest rate scenarios. NPV is the present value of expected cash flows from assets, liabilities, and off-balance sheet contracts. The NPV ratio, under any interest rate scenario, is the NPV divided by the market value of assets in the same scenario. The model estimates loan prepayment rates, reinvestment rates, and deposit decay rates. The Office of Thrift Supervision ("OTS") also produces a similar analysis using its own model, based upon data submitted on the Bank's quarterly Thrift Financial Reports, the results of which vary from the Company's internal model primarily due to differences in assumptions utilized.
The following table sets forth the Company's NPV model as of September 30, 2004.
NPV AS % OF PORTFOLIO Change in NET PORTFOLIO VALUE VALUE OF ASSETS Interest Rates ----------------------------------------------------------- In Basis Points NPV (Rate Shock) Amount $ Change % Change Ratio Change(1) - --------------- --------- --------- -------- --------- --------- ($ in thousands) +300 $ 65,965 $ (18,984) (22.35)% 8.41% (171) +200 74,005 (10,944) (12.88) 9.21 (91) +100 80,862 (4,087) (4.81) 9.83 (29) 0 84,949 - - 10.12 - -100 83,649 (1,300) (1.53) 9.82 (30)
(1) Expressed in basis points.
The following table sets forth the Company's NPV model as of September 30, 2003.
NPV AS % OF PORTFOLIO Change in NET PORTFOLIO VALUE VALUE OF ASSETS Interest Rates ----------------------------------------------------------- In Basis Points NPV (Rate Shock) Amount $ Change % Change Ratio Change(1) - --------------- --------- --------- -------- --------- --------- ($ in thousands) +300 $ 63,654 $ (39,635) (38.37)% 7.58% (361) +200 75,326 (27,963) (27.07) 8.71 (248) +100 83,779 (19,510) (18.89) 9.44 (175) 0 103,289 - - 11.19 - -100 87,614 (15,675) (15.18) 9.48 (171)
(1) Expressed in basis points.
The change in the NPV model between 2004 and 2003 reflects changes in the balance sheet mix and the move to a more neutral repricing gap position as a result of shortening the duration of interest-earning assets and lengthening the duration of interest-bearing liabilities. This change resulted in the Bank becoming less sensitive to rising interest rates. Certain shortcomings are inherent in the methodology used in NPV interest rate risk measurements. Modeling changes in NPV require the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV presented assumes that the composition of the Company's interest sensitive assets and liabilities existing at the beginning of a period remain constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Accordingly, NPV measurements provide an indication of the Company's interest rate risk exposure at a particular point in time. Such measurements are not intended to, and do not, provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and will differ from actual results.
ANALYSIS OF NET INTEREST INCOME
Net interest income is the most significant component of operating income to the Company. Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them. The interest rate spread is influenced by regulatory, economic and competitive factors that affect interest rates, loan demand and deposit flows. Additionally, the level of nonperforming loans impacts the interest rate spread by reducing the overall yield on the loan portfolio.
AVERAGE BALANCE SHEET. The following table sets forth certain information relating to the Company for the fiscal years ended September 30, 2004, 2003 and 2002. The average yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The yields and costs include fees which are considered adjustments to yields.
(1) Balances are net of deferred loan origination costs, undisbursed proceeds of construction loans in process, but include non-performing loans and loans held-for-sale. (2) Interest and Yield/Rate are presented on a tax-equivalent basis using a tax rate of 40%. (3) Includes mortgage-related securities available-for-sale and held-to-maturity. (4) Includes investment securities available for sale and held to maturity, stock in the FHLB, Freddie Mac and Fannie Mae securities. (5) Net interest rate spread represents the difference between the weighted-average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities. (6) Net interest margin represents net interest income as a percentage of average interest-earning assets.
RATE/VOLUME ANALYSIS. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated on a proportional basis between changes in rate and volume.
(1) Balances are net of deferred loan origination costs, undisbursed proceeds of construction loans in process, but include nonperforming loans. (2) Presented on a taxable equivalent basis using the combined Federal and state income tax marginal rate of 40%. (3) Includes mortgage-related securities available-for-sale and held-to-maturity. (4) Includes investment securities available-for-sale and held-to-maturity, stock in FHLB, Freddie Mac and Fannie Mae.
RESULTS OF OPERATIONS
GENERAL. The Company reported net income of $5.1 million for fiscal 2004 compared to a net loss of $4.1 million and net income of $2.7 million for fiscal years 2003 and 2002, respectively. The increase between fiscal 2003 and fiscal 2004 was primarily attributable to a $5.4 million decrease in the provision for loan losses, a $1.0 million increase in net interest income, a $1.4 million increase in non-interest income and a $5.6 million decrease in non-interest expense.
The Company experienced a $6.8 million decrease in net income between fiscal 2002 and fiscal 2003, which was primarily attributable to a $4.1 million increase in the provision for loan losses, a $4.6 million increase in non-interest expense and a $3.5 million decrease in net interest income, offset by a $1.9 million increase in non-interest income.
NET INTEREST INCOME. Net interest income increased $1.0 million, or 5%, to $21.1 million in fiscal 2004 compared to $20.2 million in fiscal 2003. Total interest income decreased $4.4 million between fiscal 2003 and fiscal 2004, primarily due to a decrease in the yield on total loans of 60 basis points offset by an increase of 49 basis points in mortgage-related securities. Such declines in loan yields were responsible for a $4.4 million decrease in interest income during 2004. Average long-term market interest rates remained lower in 2004 than in 2003.
Interest expense on deposits decreased $3.9 million from 2003 to 2004, primarily due to a decrease in the average cost of deposits of 50 basis points from 2.19% to 1.69%. The decline in interest expense was significantly impacted by the relatively low market interest rates in 2004 as well as a shift in the deposit mix from certificates of deposit to shorter-term money market and NOW accounts. The rates paid on borrowings also decreased by 149 basis points between 2004 and 2003. The reduction in the rates paid on borrowings was due to the Bank entering into several derivative contracts, which swapped the fixed rate the Bank pays on $40.0 million of FHLB advances to variable rates. Additionally, certain long-term, fixed rate higher average rate advances matured during 2004 and were replaced with lower rate borrowings with similar terms.
Between 2002 and 2003, interest income decreased $7.3 million while interest expense decreased by $3.8 million. The decreases were largely due to overall lower market interest rates in 2003 compared to 2002. Interest expense on FHLB advances and trust-preferred debt increased between 2003 and 2002 as the Bank increased such borrowings.
PROVISION FOR LOAN LOSSES. The Company records a provision for loan losses in order to maintain the allowance for loan losses at a level which management considers its best estimate of known and probable inherent losses. Management's evaluation is based upon a continuing review of the portfolio and requires significant management judgment. For the year ended September 30, 2004, the Company recorded a provision for loan losses of $1.4 million compared to $6.9 million in 2003 and $2.8 million in 2002. The decrease in the provision for the twelve month period ended September 30, 2004 was due to a reduction in nonperforming loans, a decrease in loans charged-off, the sale of lower credit quality indirect automobile loans and decreases in total loans outstanding from $502.8 million at September 30, 2003 to $413.1 million at September 30, 2004. The decrease in the provision was due to a significant decrease in nonperforming loans over the levels previously recorded. As of September 30, 2004, nonperforming loans totaled $6.9 million, a decrease of $5.6 million, or 45%, from the $12.5 million of such loans at September 30, 2003. Total nonperforming commercial loans totaled $5.3 million at September 30, 2004 compared to $10.6 million at September 30, 2003. This $5.3 million decrease was primarily the result of several large commercial loans and commercial mortgage loans being reduced to cash collections. Additionally, foreclosed assets were reduced by $707,000 between fiscal 2004 and fiscal 2003 due to the sale of several one-to-four family properties.
The provision for loan losses was $6.9 million in fiscal year 2003 compared to a $2.8 million provision in fiscal 2002. The increase in fiscal 2003 was largely due to higher levels of nonperforming loans and charge-offs. See the Nonperforming Assets and the Allowance for Loan Loss sections of Management's Discussion and Analysis for a further discussion of asset quality.
NON-INTEREST INCOME. Non-interest income increased $1.3 million, or 14%, from $10.0 million in 2003 to $11.3 million in 2004. The increase was largely a result of a $798,000 gain on the sale of the Danville branch in January 2004 and the impact of a $1.5 million impairment loss on an equity investment in 2003. For further discussion of this loss, see Note 18 to the Consolidated Financial Statements. The 2004 increases were offset by reduced insurance premium income and lower levels of gains on the sale of residential mortgage loans as loan originations and sales decreased due to lower volumes.
The Company experienced a $1.9 million increase in non-interest income for fiscal 2003. The increase was largely due to increased service charges and other fee income of $663,000, increased insurance premium income of $801,000 and increased gains on the sale of securities of $1.0 million as part of a restructuring of the investment portfolio. These increases were offset by the recognition of a $1.5 million loss on an equity investment.
NON-INTEREST EXPENSE. Non-interest expense decreased $5.6 million, or 19%, from $29.2 million in 2003 to $23.6 million in 2004. This decrease was primarily due to reductions in salaries and benefits as the Company reduced staff in 2003 as part of a
restructuring effort to better align the Bank's operational processes with its product offerings. The 2003 period also included a $900,000 charge to earnings for one-time severance costs related to the resignation of the Company's former President and Chief Executive Officer. Occupancy costs and amortization of intangibles also decreased as a result of the branch closings and the sale of the Bank's Danville branch. Data processing costs increased between periods due to the Bank outsourcing its data processing to a third-party vendor in November 2003.
Total non-interest expense increased $4.6 million, or 19%, from $24.6 million in 2002 to $29.2 million in 2003. This increase was due primarily to an increase in salaries and employee benefits of $2.5 million. Approximately $900,000 of this increase related to one-time severance costs resulting from the resignations of the Company's former President and Chief Executive Officer, Chief Financial Officer and Senior Vice President. Additionally, $1.2 million related to increased salaries for new employees hired in the first half of the fiscal year to staff growth in the Company's businesses.
Additionally in September 2003, the Company incurred additional severance charges of approximately $200,000 in connection with the termination of 33 employees. These reductions represent a realignment of the banking operations in light of the management changes. Professional fees increased by $417,000 during 2003, or 30%, primarily due to the restatement of prior period earnings and increased consulting services during the transition between chief financial officers. Other expenses increased by $1.6 million due to costs for closing three bank offices as well as costs associated with increased levels of nonperforming assets combined with general increases in other operating expenses.
INCOME TAXES. The Company recorded a $2.3 million income tax provision for the fiscal year ended September 30, 2004, compared to an income tax benefit of $1.8 million and an income tax provision of $1.6 million for the years ended September 30, 2003 and 2002, respectively. The increase in 2004 was primarily due to $7.4 in million pre-tax net income the Company recorded. The Company's effective tax rate for 2004, 2003 and 2002 was 31%, (31)% and 38%, respectively. The decrease in 2003 was primarily due to the $5.9 million pre-tax net loss the Company recorded offset by an increase in the deferred tax valuation allowance related to the Company's inability to use a charitable contribution carryforward. Also during 2003, the Company recorded a $1.5 million impairment loss which is a capital loss for income tax purposes and did not result in a tax benefit.
FINANCIAL CONDITION
Total assets decreased $60.3 million to $836.0 million at September 30, 2004 compared to $896.3 million at September 30, 2003. The decrease was primarily due to a decrease in loans of $86.4 million offset by an increase in cash and cash equivalents of $6.8 million and an increase in investment securities available-for-sale of $30.6 million.
Net loans decreased $86.4 million from $490.0 million at September 30, 2003 to $403.6 million at September 30, 2004. Residential one-to-four family mortgage loans decreased by approximately $37.6 million, or 25%, due in part to the sale of $16.2 million in modified fixed-rate residential mortgage loans as well as a policy to sell all newly-originated fixed-rate loans. Construction loans decreased by $17.5 million to $4.9 million at September 30, 2004 compared to $22.4 million at September 30, 2003. The decrease was due to pricing changes made to reduce the interest-rate risk inherent with construction loan financing, which resulted in lower originations. Automobile loans decreased by $35.0 million to $101.1 million at September 30, 2004 as a result of the sale of approximately $19.2 million of lower credit quality indirect automobile loans, representing substantially all of the Company's lower credit quality indirect automobile loans. In addition, the Bank ceased originating non-prime indirect automobile loans in October 2003.
Total liabilities decreased $60.3 million from $837.9 million at September 30, 2003 to $777.6 million at September 30, 2004. During the year, deposits decreased by $63.9 million due to the continued lower interest rate environment and a decision to lower interest rates on certain deposit products offered by the Bank. This resulted in a decrease of $33.9 million in certificates of deposits less than $100,000 and a decrease of $20.8 million in money market accounts.
The reductions in deposits were offset by increased borrowings of $19.9 million, primarily repurchase agreements.
Total equity increased by $101,000 to $58.5 million at September 30, 2004 from $58.4 million at September 30, 2003. Earnings of $5.1 million increased equity and were offset by treasury stock repurchases of $3.5 million and net reductions in other comprehensive income of $1.8 million.
INVESTMENT ACTIVITIES
The investment policy of the Company, as approved by the Board of Directors, requires management to maintain adequate liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk and to complement the Company's lending activities. The Company primarily utilizes investments in securities for liquidity management and as a method of deploying excess funds not utilized for loan originations or purchases. Generally, the Company's investment policy is more restrictive than the OTS regulations allow and, accordingly, the Company has invested primarily in U.S. Government and agency securities, which qualify as liquid assets under the OTS regulations, Federal funds and U.S. Government-sponsored agency-issued mortgage-backed securities. As required by SFAS No. 115, the Company has established an investment portfolio of securities that are categorized as held-to-maturity or available-for-sale. The Company does not currently maintain a portfolio of trading securities. At September 30, 2004, the available-for-sale securities portfolio totaled $357.2 million, or 43% of assets, and the held-to-maturity portfolio totaled $1.0 million, or 0.1% of assets.
The following table sets forth certain information regarding the amortized cost and fair value of the Company's securities at the dates indicated.
The table below sets forth certain information regarding the carrying value, weighted-average yields and contractual maturities of the Company's debt securities as of September 30, 2004.
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. Weighted-average yields are based on amortized cost including municipal securities, which are not reported on a tax-equivalent basis.
LOANS
The following table sets forth the composition of the Company's loan portfolio in dollar amounts and as a percentage of the portfolio at the dates indicated.
LOAN MATURITY. The following table shows the remaining contractual maturity of the Company's total loans at September 30, 2004. The table does not include the effect of future principal prepayments.
(1) Construction loans, which consist of loans for the construction of one- to four-family residences, automatically convert to permanent financing upon completion of the construction phase.
The following table sets forth, at September 30, 2004, the dollar amount of loans contractually due after September 30, 2005, and whether such loans have fixed or adjustable interest rates.
DUE AFTER SEPTEMBER 30, 2005 ------------------------------------ (IN THOUSANDS) Fixed Adjustable Total ---------- ---------- ---------- Real estate loans: One-to-four family $ 68,835 $ 43,137 $ 111,972 Multi-family and commercial real estate 11,195 58,488 69,683 Construction 2,981 1,453 4,434 ---------- ---------- ---------- Total real estate loans 83,011 103,078 186,089 ---------- ---------- ---------- Consumer loans 144,904 37,667 182,571 Commercial loans 10,511 20,197 30,708 ---------- ---------- ---------- Total loans $ 238,426 $ 160,942 $ 399,368 ========== ========== ==========
NONPERFORMING ASSETS. Nonperforming assets, which include nonaccruing loans, real estate owned and repossessed assets can negatively affect the Company's results of operations. Nonaccruing loans are those on which the accrual of interest has ceased. Loans are placed on nonaccrual status immediately if, in the opinion of management, collection is doubtful, or when principal or interest is past due 90 days or more and the value of the collateral is insufficient to cover the repayment of principal and interest. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed and charged against interest income. In addition, the amortization of net deferred loan fees is suspended when a loan is placed on nonaccrual status. Subsequent cash receipts are applied either to the outstanding principal balance or recorded as interest income, depending on management's assessment of the ultimate collectibility of principal and interest. Past due loans are loans contractually past due 90 days or more as to principal or interest payments but which remain in accrual status because they are considered well secured and in the process of collection. For the years ended September 30, 2004, 2003 and 2002, the amount of additional interest income that would have been recognized on nonaccrual loans if such loans had continued to perform in accordance with their contractual terms was $535,000, $646,000 and $464,000, respectively. The amount of interest income on such loans included in net income in fiscal years 2004, 2003 and 2002 was $233,000, $290,000 and $131,000, respectively.
The following table sets forth information regarding nonperforming assets and past due loans at the dates indicated:
(1) Real estate owned balances and other repossessed assets are shown net of related loss allowances.
ALLOWANCE FOR LOAN LOSSES. The Company maintains allowances for loan losses and charges losses to these allowances when such losses are realized. The determination of the allowance for loan losses requires significant management judgment reflecting management's best estimate of probable loan losses related to specifically identified loans as well as probable loan losses in the remaining loan portfolio. Management's evaluation is based upon a continuing review of the loan portfolio, with consideration given to examinations performed by regulatory authorities.
Management establishes the loan loss allowance in accordance with accounting principles generally accepted in the United States of America and the guidance provided in the Securities and Exchange Commission's Staff Accounting Bulletin 102 (SAB 102). Its methodology for assessing the appropriateness of the allowance consists of several key elements which include: specific allowances for identified problem loans; formula allowances for commercial and commercial real estate loans; and allowances for pooled homogenous loans.
Specific reserves are established for certain loans in cases where management has identified significant conditions or circumstances related to a specific credit that management believes indicate the probability that a loss has been incurred.
The formula allowances for commercial and commercial real estate loans are calculated by applying loss factors to outstanding loans in each case based on the internal risk grade of loans. Changes in risk grades of both performing and nonperforming loans affect the amount of the formula allowance. Loss factors by risk grade have a basis in the Bank's historical loss experience for such loans and may be adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio as of the evaluation date.
Pooled loans are loans that are usually smaller, not individually graded and homogenous in nature, such as consumer installment loans, indirect automobile loans and residential mortgages. Pooled loan loss allowances are based on historical net charge-offs, delinquency trends, average credit scores and the average time frame between the occurrence of a default event and the resulting default and loss realization. Default events include job loss, divorce, medical crises and death. The average loss allowance per homogenous pool is based on the product of the average annual historical loss rate and the average estimated duration of the pool multiplied by the pool balances. These risk pools are then assigned a reserve for losses based upon this historical loss information, as adjusted for historical loss adjustment factors, as adjusted based on management's evaluation of various current conditions. The evaluation of the inherent loss with respect to these more current conditions is subject to a higher degree of uncertainty because they are not identified with specific credits. The more current conditions, analyzed in connection with the adjustment factors, include an evaluation of the following:
o General economic and business conditions affecting the Bank's key lending areas, o Credit quality trends (including trends in nonperforming loans expected to result from existing conditions), o Recent loss experience in particular segments of the portfolio, o Collateral values and loan-to-value ratios, o Loan volumes and concentration, including changes in the composition of the loan portfolio, o Age of the loan portfolio, o Specific industry conditions within portfolio segments, o Bank regulatory examination results, and o Other factors, including changes in quality of the loan origination, servicing and risk management processes.
As of September 30, 2004, the Company's allowance for loan losses was $8.4 million, or 2.04% of total loans compared to $10.2 million, or 2.03% of total loans as of September 30, 2003. The decrease in the allowance was due to a $1.6 million transfer in connection with the sale of $19.2 million of lower credit quality indirect automobile loans and $1.6 million in net charge-offs, offset by an additional provision of $1.4 million.
The Bank's loan officers and risk managers meet monthly to discuss and review the conditions and risks associated with individual problem loans and loan portfolios with higher risk concentrations. The Bank also has a third-party review its analysis of such loans and its respective risk gradings quarterly. By assessing the probable estimated losses inherent in the loan portfolio on a routine basis, management is able to adjust specific and inherent loss estimates based on more recent information. While the Company continues to monitor and modify its allowance for loan losses as conditions change, there can be no assurance that the loan loss allowance will be sufficient to absorb all such future credit losses.
The following table sets forth activity in the Company's allowance for loan losses for the periods indicated.
The following table sets forth the Company's allowance for loan losses in each of the categories listed at the dates indicated and the percentage of such amounts to the total allowance and to total loans. These allocations are estimates and are subject to revision as conditions change. The change in the allowance from 2002 to 2003 reflects increased levels of nonaccrual loans and consumer (indirect automobile loans) charge-offs. The change in the allowance from 2001 to 2002 reflects increased activity in commercial and consumer lending and increased levels of nonaccrual loans.
AT SEPTEMBER 30, 2004 (IN THOUSANDS) ------------------------------ % of % of Allowance Loans in each in each Category Category to Total to Total Amount Allowance Loans ------- --------- -------- Real Estate $ 511 6.05% 45.57% Consumer 2,875 34.04 44.63 Commercial 5,058 59.89 9.80 Unallocated 2 0.02 - ------- --------- -------- Total allowance for loan losses $ 8,446 100.00% 100.00% ======= ========= ========
SOURCES OF FUNDS
GENERAL. Deposits, loan repayments and prepayments, proceeds from sales of loans and securities, cash flows generated from operations, FHLB advances and other borrowings are the primary sources of the Company's funds for use in lending, investing and for other general purposes.
DEPOSITS. The Company offers a variety of deposit products with a range of interest rates and terms. The Company's deposits consist of checking, money market, savings, NOW, certificate accounts and Individual Retirement Accounts. More than 41% of the Company's deposits at September 30, 2004 are in certificate of deposit accounts. At September 30, 2004, core deposits (savings, NOW, money market accounts and non-interest bearing deposits) represented 59% of total deposits. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. The Company's deposits are obtained predominantly from the areas in which the Company's offices are located. The Company has historically relied primarily on customer service and long-standing relationships with customers to attract and retain these deposits; however, market interest rates and rates offered by competing financial institutions significantly affect the Company's ability to attract and retain deposits. The Company uses traditional means of advertising its deposit products, including radio and print media, and generally does not solicit retail deposits from outside its market area. At September 30, 2004, the Company had $10.0 million of brokered certificates of deposit.
At September 30, 2004, the Company had $26 million in certificate accounts in amounts of $100,000 or more maturing as follows:
MATURITY PERIOD AMOUNT ------------------------ -------------- (IN THOUSANDS) Three months or less $ 3,117 Over 3 through 6 months 1,228 Over 6 through 12 months 2,338 Over 12 months 19,363 --------------- Total $ 26,046 ==============
The above maturity schedule does not include $10 million of brokered CD's with an average maturity of 18 months.
BORROWINGS. The Bank utilizes advances from the FHLB of Pittsburgh as an alternative to deposits to fund its operations as part of its operating strategy. These borrowings are collateralized primarily by certain mortgage loans and mortgage-related securities of the Bank and secondarily by the Bank's investment in capital stock of the FHLB of Pittsburgh. FHLB advances are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The maximum amount that the FHLB of Pittsburgh will advance to member institutions, including the Bank, fluctuates from time to time in accordance with the policies of the FHLB of Pittsburgh. At September 30, 2004, the Bank had $243.9 million in outstanding FHLB advances, compared to $258.9 million at September 30, 2003. Other borrowings, which consist of overnight retail and wholesale repurchase agreements, increased $19.9 million from approximately $500,000 at September 30, 2003 to $20.4 million at September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds on a long-term and short-term basis are deposits, principal and interest payments on loans, mortgage-backed and investment securities and FHLB advances. The Company uses the funds generated to support its lending and investment activities as well as any other demands for liquidity such as deposit outflows. While maturities and scheduled amortization of loans are predictable sources of funds; deposit flows, loan prepayments and the exercise of call features are greatly influenced by general interest rates, economic conditions and competition.
The Bank's most liquid assets are cash and cash equivalents and its investment and mortgage-related securities available-for-sale. The levels of these assets are dependent on the Bank's operating, financing, lending and investing activities during any given period. At September 30, 2004, cash and cash equivalents and investment and mortgage-related securities available-for-sale totaled $353.9 million, or 42.3% of total assets.
The Bank has other sources of liquidity if a need for additional funds arises, including FHLB advances and other borrowings. At September 30, 2004, the Bank had $243.9 million in advances outstanding from the FHLB, and had an additional overall borrowing capacity from the FHLB of $135.3 million. Depending on market conditions, the pricing of deposit products and FHLB advances, the Bank may continue to rely on such borrowings to fund asset growth.
At September 30, 2004, the Company had commitments to originate and purchase loans, unused outstanding lines of credit and
undisbursed proceeds of construction mortgages totaling $60.9 million. The Company anticipates that it will have sufficient funds available to meet its current loan origination commitments. Certificate accounts, including Individual Retirement Accounts ("IRA") and KEOGH accounts, which are scheduled to mature in less than one year from September 30, 2003, totaled $62.9 million. Based on past experience, the Company expects that a substantial portion of maturing certificate accounts will be retained by the Company at maturity.
The primary sources of funding for the Company are dividend payments from the Bank, the offering of trust-preferred securities, sales and maturities of investment securities and, to a lesser extent, earnings on investments and deposits held by the Company. Dividend payments by the Bank have primarily been used to fund stock repurchase programs and to pay cash dividends. The Bank's ability to pay dividends and other capital distributions to the Company is generally limited by the regulations of the OTS. Additionally, the OTS may prohibit the payment of dividends which are otherwise permissible by regulation for safety and soundness reasons.
In June 2004, the Board of Directors authorized the repurchase of 209,000 shares (approximately 5%) of the Company's outstanding common stock. As of December 15, 2004, management has purchased 206,000 shares under the repurchase program at an average price of $17.22. This repurchase program has been suspended pending the merger of the Company into KNBT Bancorp, Inc.
At September 30, 2004, the Bank exceeded all of its regulatory capital requirements with a tangible capital level of $61.3 million, or 7.4% of total assets, which is above the required level of $12.4 million, or 1.5%; core capital of $61.3 million, or 7.4% of total assets, which is above the required level of $33.1 million, or 4.0%; and risk-based capital of $65.8 million, or 15.07% of risk-weighted assets, which is above the required level of $34.9 million, or 8.0%. An institution with a ratio of risk-based capital to risk-weighted assets of greater than or equal to 10.0%, a ratio of tier 1 capital to risk-weighted assets of greater than or equal to 6.0% and a ratio of core capital to total assets of greater than or equal to 5.0% is considered to be "well-capitalized" pursuant to OTS regulations.
OFF-BALANCE SHEET ARRANGEMENTS
For a discussion of the Company's off-balance sheet arrangements, see Footnote 13, "Commitments and Contingencies" and Footnote 15 "Derivative Financial Instruments" in the Consolidated Financial Statements.
CONTRACTUAL OBLIGATIONS
The following table sets forth information relating to the Company's payments due under contractual obligations at September 30, 2004.
(1) Includes obligations to the Company's third party data processing provider.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with generally accepted accounting principles ("GAAP"), which requires the measurement of financial position and operating results generally in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike industrial companies, nearly all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
IMPACT OF RECENT ACCOUNTING STANDARDS
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task
Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of this Statement did not have an impact on the Company's financial position or results of operations.
On October 1, 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions," effective for all business combinations initiated after October 1, 2002. This Statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This Statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions," and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17, "When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method." The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets. ." SFAS No. 142 was adopted on October 1, 2001. This Statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. Upon early adoption of this statement, as of October 1, 2001, the carrying amount of the previously recognized unidentifiable intangible asset related to the Schuylkill Savings branch acquisitions that was reclassified to goodwill was $200,000, while the related 2002 amortization expense that was reversed was $81,000, pre-tax. The Company will continue to review the remaining goodwill on an annual basis for impairment. However, $7.9 million in core deposit intangible will continue to be amortized and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123." This statement amends FASB Statement No.123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Statement also amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years ending after December 15, 2002, except for financial reports containing condensed financial statements for interim periods for which disclosure is effective for periods beginning after December 15, 2002. This Statement announces, "in the near future, the Board plans to consider whether it should propose changes to the U.S. standards on accounting for stock-based compensation." As permitted, the Company continues to account for stock options with the methodology prescribed by Accounting Principles Board No. 25.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The amendments set forth in SFAS No. 149 require that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. This statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. The provisions of this statement that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after June 30, 2003. The adoption of this statement did not have a material effect on the Company's financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes how an issuer classifies financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify these financial instruments as a liability (or, in certain circumstances, an asset). Previously these financial instruments would have been classified entirely as equity, or between the liabilities section and equity section of the statement of financial condition. This Statement also addresses questions about the classification of certain financial instruments that embody obligations to issue equity shares. The provisions of this Statement are effective for interim periods beginning after June 15, 2003. The adoption of this statement did not have a material impact on the Company's financial position or results of operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This interpretation elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor's obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of this interpretation did not have a material effect on the Company's financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," (FIN 46) in an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. The objective of this interpretation is not to restrict the use of variable interest entities but to improve financial reporting by companies involved with variable interest entities. Until now, one company generally has included another entity in its consolidated financial statements only if it controlled the entity through voting interests. This interpretation changes that by requiring a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirement of this interpretation apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. As a result of the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the second fiscal quarter of 2004. The result was an increase in the junior debt of $681,000.
In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." This statement provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for the other-than-temporary impairment evaluations made in the reporting periods beginning after June 15, 2004. The FASB staff has issued a proposed Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The proposed FSP would provide implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads and analyzed for other-than-temporary impairment under paragraph 16 of Issue 03-1. Based on comment letters received by constituents, the Board decided to further consider whether application guidance is necessary for all securities analyzed for impairment under paragraph 10-20 of Issue 03-1. The Company will delay the effective application until the implementation guidance is finalized.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The above-captioned information appears in Item 7 under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations"-"Management of Interest Rate Risk and Market Risk Analysis" and is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
KPMG LLP 1601 Market Street Philadelphia PA 19103-7212
The Board of Directors and Stockholders of Northeast Pennsylvania Financial Corp.:
We have audited the accompanying consolidated statements of financial condition of Northeast Pennsylvania Financial Corp. and subsidiaries (the "Company") as of September 30, 2004 and 2003 and the related consolidated statements of operations, comprehensive income (loss), changes in equity, and cash flows for each of the years in the three year period ended September 30, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Northeast Pennsylvania Financial Corp. and subsidiaries as of September 30, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three year period ended September 30, 2004, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company has restated their consolidated statements of operations, comprehensive income (loss), changes in equity, and cash flows for the year ended September 30, 2002.
/s/ KPMG LLP - ------------------
Philadelphia, PA October 26, 2004
[LOGO OF NORTHEAST PENNSYLVANIA FINANCIAL CORP.] NORTHEAST PENNSYLVANIA FINANCIAL CORP. 12 E. BROAD STREET HAZLETON, PA 18201-6591 PHONE (570) 459-3700 FAX (570) 450-6110
MANAGEMENT'S STATEMENT ON FINANCIAL REPORTING
To Our Stockholders:
The management of Northeast Pennsylvania Financial Corp. (the "Company") is responsible for establishing and maintaining effective internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America, including controls over safeguarding assets. This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.
There are inherent limitations in any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
In July 2003, while evaluating the Company's internal controls and procedures, the former president and chief executive officer and chief financial officer concluded that the Company's disclosures and internal controls were not effective. This review discovered that the Company's financial statements for fiscal years 1998 through 2002 and for the quarters ended December 31, 2002 and March 31, 2003 required restatement as described in Management's Discussion and Analysis and Note 2 to the audited Consolidated Financial Statements included in this report.
Subsequent to the discovery of the errors, management implemented staffing, system and procedural changes designed to improve the training of the individuals involved in implementing and reviewing the controls and procedures to strengthen the review and authorization process so that differences, if any, are detected and corrected on a timely basis. These changes resulted in the identification of additional accounting errors as described in Note 2 to the Consolidated Financial Statements included in this report.
Management assessed the Company's internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America as of September 30, 2004. This assessment was based on criteria for effective internal control over financial reporting established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of September 30, 2004, the Company maintained effective internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America.
The Company assessed its compliance with the designated laws and regulations relating to safety and soundness. Based on this assessment, management believes that the Company complied, in all material respects, with the designated laws and regulations related to safety and soundness for the year ended September 30, 2004.
/s/ Thomas M. Petro /s/ Jerry D. Holbrook - ----------------------- ------------------------
Thomas M. Petro Jerry D. Holbrook President and Chief Financial Officer Chief Executive Officer
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30, ----------------------- (IN THOUSANDS) (EXCEPT SHARE AND PER SHARE DATA) 2004 2003 ---------- ---------- ASSETS
Cash and cash equivalents $ 26,938 $ 20,142 Investment securities available-for-sale 357,223 326,626 Investment securities held-to-maturity (estimated market value of $1,015 at September 30, 2004 and $3,622 at September 30, 2003) 998 3,555 Loans held for sale - 1,073 Loans (less allowance for loan loss of $8,446 at September 30, 2004 and $10,196 at September 30, 2003) 403,584 489,986 Accrued interest receivable 2,731 3,892 Assets acquired through foreclosure 315 1,022 Property and equipment, net 10,820 12,152 Goodwill 3,255 3,255 Intangible assets 7,129 8,556 Bank-owned life insurance 11,362 10,875 Other assets 11,680 15,161 ---------- ---------- Total assets $ 836,035 $ 896,295 ========== ==========
LIABILITIES AND EQUITY
Deposits $ 483,441 $ 547,305 Federal Home Loan Bank advances 243,867 258,901 Trust preferred debt 22,681 22,000 Other borrowings 20,426 529 Advances from borrowers for taxes and insurance 1,178 1,239 Accrued interest payable 1,380 1,318 Other liabilities 4,604 6,646 ---------- ---------- Total liabilities 777,577 837,938 ---------- ----------
Preferred stock ($.01 par value; 2,000,000 authorized shares; none issued) - - Common stock ($.01 par value; 16,000,000 authorized shares; 6,427,350 shares issued) 64 64 Additional paid-in capital 62,307 61,879 Common stock acquired by stock benefit plans (2,668) (3,772) Retained earnings - substantially restricted 33,245 29,368 Accumulated other comprehensive income (loss), net (99) 1,730 Treasury stock, at cost (2,451,551 shares at September 30, 2004 and 2,250,756 shares at September 30, 2003) (34,391) (30,912) ---------- ---------- Total equity 58,458 58,357 ---------- ---------- Total liabilities and equity $ 836,035 $ 896,295 ========== ==========
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES.
BUSINESS. Northeast Pennsylvania Financial Corp. (the "Company") is a thrift holding company organized under the laws of the state of Delaware. The Company's principal subsidiary, First Federal Bank (the "Bank") is a federal savings bank organized under the laws of the United States. The Bank provides a wide range of financial products and services to individual and corporate customers through its community offices in Northeastern and Central Pennsylvania. Such products include checking accounts, savings accounts, certificates of deposit, commercial and consumer loans, real estate loans and home equity loans. The Bank is subject to competition from other financial institutions and other companies that provide financial services. The Company is subject to the regulations of certain federal bank regulatory agencies and undergoes periodic examinations by those regulatory authorities.
PRINCIPLES OF CONSOLIDATION AND PRESENTATION. The accompanying financial statements of the Company include the accounts of the Bank, Abstractors, Inc., NEP Trust Co. (the "Trust Co."), Higgins Insurance Associates, Inc. ("Higgins"), NEP Capital Trust I and NEP Capital Trust II. The Bank, Abstractors, Inc., the Trust Co. and Higgins are wholly-owned subsidiaries of Northeast Pennsylvania Financial Corp. Abstractors, Inc. is a title insurance agency. The Trust Co. offers trust, estate and asset management services and products. Higgins provides insurance and investment products to individuals and businesses. NEP Capital Trust I and NEP Capital Trust II are subsidiaries established in connection with trust preferred offerings. All material inter-company balances and transactions have been eliminated in consolidation. Prior period amounts are reclassified, when necessary, to conform with the current year's presentation. Such reclassifications had no effect on net income (loss) or stockholders' equity and do not relate to the restatement described in Footnote 2.
The Company follows accounting principles and reporting practices which are generally accepted in the United States of America ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to determination of the allowance for loan losses, the evaluation and realizability of deferred taxes and the evaluation of other than temporary impairment for investments.
RISKS AND UNCERTAINTIES. In the normal course of its business, the Company encounters two significant types of risk: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases from its interest-earning assets. The Company's primary credit risk is the risk of defaults in the Company's loan portfolio that result from borrowers inability or unwillingness to make contractually required payments. The Company's lending activities are concentrated in Pennsylvania. The largest concentration of the Company's loan portfolio is located in Northeastern Pennsylvania. The ability of the Company's borrowers to repay amounts owed is dependent on several factors, including the economic conditions in the borrowers' geographic regions and the borrowers' financial conditions. Market risk reflects changes in the value of the collateral underlying loans, the valuation of real estate held by the Company, and the valuation of loans held for sale, securities, mortgage servicing assets and other investments.
The Bank is subject to the regulations of various government agencies. These regulations can and do change significantly from period to period. The Bank also undergoes periodic examinations by the regulatory agencies which may subject it to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions resulting from the regulators' judgments based on information available to them at the time of their examination.
CASH AND CASH EQUIVALENTS. For the purpose of the consolidated statements of cash flows, cash and cash equivalents include cash and interest-bearing deposits with an original maturity of three months or less.
SECURITIES. The Company divides its securities portfolio into two segments: (a) held-to-maturity and (b) available-for-sale. Securities in the held-to -maturity category are accounted for at cost, adjusted for amortization of premiums and accretion of discounts, using the level yield method, based on the Company's intent and ability to hold the securities until maturity. All other securities are included in the available-for-sale category and are reported at fair value, with unrealized gains or losses excluded from earnings and reported, net of tax, as a component of stockholders' equity. At the time of purchase, the Company makes a determination as to whether or not it will hold the securities to maturity, based upon an evaluation of the probability of future events. Securities which the Company believes may be involved in interest rate risk, liquidity or other asset/liability management decisions, which might reasonably result in such securities not being held to maturity, are classified as available for sale. If securities are sold, a gain or loss is determined by specific identification and reflected in the operating results in the period the trade occurs.
OTHER INVESTMENT. The Company had a $1.5 million investment in the preferred stock of a start-up venture. Prior to June 2003, since the investment did not have a readily determinable market value, the Company was not accounting for the investment under SFAS No. 115. The accounting for this security was initially guided by EITF Topic No. D-68, EITF Topic No. 98-13 and EITF Topic No. 99-10, which, in essence, provide that investee losses should be absorbed by investments in other securities once an investee's common equity has been exceeded by net losses. However, during the Company's 2001 third fiscal quarter the investee issued additional equity and entered into certain other business relationships which reduced the Company's influence over the investee and resulted in the Company prospectively utilizing the cost method of accounting for its remaining investment. During 2003, the Company wrote off its remaining $1.5 million equity investment in this start-up venture since the venture was unable to obtain additional equity financing to support its operations and the impairment was deemed permanent.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is maintained at a level representing management's best estimate of known and inherent losses in the portfolio, based upon management's evaluation of the portfolio's collectibility. Management's evaluation is based upon an analysis of the portfolio, past loss experience, current economic conditions and other relevant factors. While management uses the best information available to make evaluations, such evaluations are highly subjective, and future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance, based on their judgments about information available to them at the time of their examination. The allowance is increased by the provision for loan losses, which is charged to operations. Loan losses are charged directly against the allowance, and recoveries on previously charged-off loans are added to the allowance.
Loans are deemed to be "impaired" if upon management's assessment of the relevant facts and circumstances, it is probable that the Company will be unable to collect all proceeds due according to the contractual terms of the loan agreement. For purposes of applying the measurement criteria for impaired loans, the Company excludes large groups of smaller balance homogeneous loans, primarily consisting of residential real estate and consumer loans, as well as commercial loans with balances of less than $100,000.
The Company's policy for the recognition of interest income on impaired loans is the same as for non-accrual loans discussed below. Impaired loans are charged off when the Company determines that foreclosure is probable, and the fair value of the collateral is less than the recorded investment of the impaired loan or in the case of unsecured loans, management determines the loan to be uncollectable.
LOANS, LOAN ORIGINATION FEES, AND UNCOLLECTED INTEREST. Loans are recorded at cost, net of unearned discounts, deferred fees and allowances. Discounts or premiums on purchased loans are amortized using the interest method over the remaining contractual life of the portfolio, adjusted for actual prepayments. Loan origination fees and certain direct origination costs are deferred and amortized using the level yield method over the contractual life of the related loans as an adjustment of the yield on the loans.
Uncollected interest receivable on loans is accrued to income as earned. Non-accrual loans are loans on which the accrual of interest has ceased because the collection of principal or interest payments is determined to be doubtful by management. It is the policy of the Bank to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more (unless the loan principal and interest are determined by management to be fully secured and in the process of collection), or earlier if the financial condition of the borrower raises significant concern with regard to the ability of the borrower to service the debt in accordance with the terms of the loan. Interest income on such loans is not accrued until the financial condition and payment record of the borrower demonstrates the ability to service the debt.
LOAN SECURITIZATION. In June 2002, the Bank sold automobile loan receivables through a securitization transaction. A transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a sale to the extent that consideration, other than beneficial interests in the transferred assets, is received in exchange. Liabilities and derivatives incurred or obtained by transferors as part of a transfer of financial assets are initially measured at fair value, if practicable. Servicing assets and other retained interests in the transferred assets are measured by allocating the previous carrying amount between the assets sold, if any, and retained interests, if any, based on their relative fair values at the date of the transfer.
The Company allocates the previous carrying amount of the securitized automobile loan receivables plus any other transferred assets between the assets sold and the retained interests (principally an interest-only strip net of a recourse obligation (the "Interest-Only Strip") and a cash reserve), based on their relative estimated fair values at the date of sale. A gain or loss is recognized at the time of sale equal to the excess of the fair value of the assets obtained (principally cash) over the allocated fair value of the assets sold.
Over the term of the securitized assets, securitization income includes the yield of the retained interests, which includes certain fees from the underlying assets as well as fees resulting from the Company's right to service the underlying assets.
Due to prepayment risk, the Interest-Only Strips are measured like available-for-sale securities. Accordingly, the Interest-Only Strips are reported at their fair value which approximates the net carrying amount of such assets. Unrealized holding gains or losses on the Interest-Only Strips, if any, are excluded from earnings and reported, net of taxes, as a separate component of shareholders' equity, except that, if a decline in fair value is judged to be other than temporary, such a decline is accounted for as a realized loss and is presented as a reduction of securitization income in the accompanying consolidated statement of operations.
The Company estimates the fair value of the Interest-Only Strip at the date of the transfer based on a discounted cash flow analysis. The cash flows of the Interest-Only Strip are estimated as the excess of the cash inflows of the loans sold over the sum of the pass-through interest rate plus the servicing fee, a trustee fee, credit enhancement costs and an estimate of future credit losses over the life of the loans. These cash flows are estimated over the life of the loans using prepayment, default and interest rate assumptions that market participants would use for financial instruments subject to similar levels of prepayment, credit and interest rate risk.
The cash reserve account is not subject to prepayment risk and is initially recorded at the allocated carrying amount based on its fair value as estimated by management at the date of transfer using the "cash-out" method.
Management discounts the net cash flows of the Interest-Only Strips and cash reserve accounts at interest rates that management believes a purchaser unrelated to the seller of such a financial instrument would demand. The discount on the cash reserve account is accreted and recorded in the results of operations.
LOANS HELD FOR SALE. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses are recognized by charges to operations.
MORTGAGE SERVICING RIGHTS. Upon the sale of a mortgage loan where the Company retains servicing rights, a mortgage servicing right is recorded which is included in other assets on the statement of financial condition. Mortgage servicing rights are amortized into income over the average life of the loans sold using the level yield method of amortization. Such assets are subject to disaggregated impairment tests.
ASSETS ACQUIRED THROUGH FORECLOSURE. Real estate and other repossessed collateral acquired through foreclosure or by deed in lieu of foreclosure are classified as assets acquired through foreclosure. Assets acquired through foreclosure are carried at the lower of cost or fair value less selling expenses. Costs relating to the development or improvement of the property are capitalized; holding costs are charged to expense.
PROPERTY AND EQUIPMENT. Property and equipment are stated at cost less accumulated depreciation. Depreciation for each class of depreciable asset is computed using the straight-line method over the estimated useful lives of the assets (generally 39 years for buildings and 3 to 7 years for furniture and equipment). When assets are retired, or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts. The cost of maintenance and repairs is charged to expense as incurred and renewals and betterments are capitalized. Leasehold improvements are depreciated using the straight line method over the shorter of the useful life of the improvement or the remaining life of the lease.
INTANGIBLE ASSETS. Intangible assets include core deposit intangibles and certain other deferrable acquisition costs. The core deposit intangibles are being amortized to expense over a 10- to 31-year life on an accelerated basis and other intangible assets are being amortized to expense on an accelerated basis over a period of 3.7 to 5 years. The recoverability of the carrying value of intangible assets is evaluated on an ongoing basis, and permanent declines in value, if any, are charged to expense.
GOODWILL. Goodwill is the excess of cost over the fair value of assets acquired in connection with business acquisitions and was being amortized on the straight-line method over 5, 6 and 20 years, prior to October 1, 2001. On October 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which changed the accounting for goodwill from an amortization method to an impairment-only approach. This statement eliminates the regularly scheduled amortization of goodwill and replaces this method with a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company's reported net income because impairment losses, if any, could occur irregularly and in varying amounts. The Company, upon adoption of this Statement, stopped amortizing existing goodwill of $3.0 million. During 2002, the Company performed its initial impairment analysis of goodwill and other intangible assets and determined that the estimated fair value exceeded the carrying amount. During 2004 and 2003, the Company performed its annual analysis of goodwill and other intangible assets and recognized a $25,000 and $39,000 impairment, respectively, related to its acquisition of an insurance book of business.
INCOME TAXES. The Company accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part be beyond the Company's control, it is at least reasonably possible that management's judgment about the need for a valuation allowance for deferred taxes could change in the near term.
Retained earnings at September 30, 2004 and 2003 include approximately $10.2 million, for which no provision for Federal income tax has been made. These amounts represent allocations of earnings to bad debt reserves for tax purposes and are a restriction upon retained earnings. If, in the future, this portion of retained earnings is reduced for any purpose other than tax bad debt losses, Federal income taxes may be imposed at the then-applicable rates.
EARNINGS (LOSS) PER SHARE.
Earnings (loss) per share (EPS), basic and diluted, were $1.32 and $1.26, respectively for the year ended September 30, 2004, $(1.08) and $(1.08), respectively for the year ended September 30, 2003 and $0.67 and $0.63, respectively, for the year ended September 30, 2002.
The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share is calculated utilizing net income (loss) as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options, warrants, and convertible securities are adjusted in the denominator.
The following table presents the reconciliation of the numerators and denominators of the basic and diluted EPS computations:
(1) Diluted earnings per share include the dilutive effect of the Company's weighted-average stock options/awards
outstanding using the Treasury Stock method. The Company had 76,500, 60,550 and 8,735 anti-dilutive common stock options outstanding as of September 30, 2004, 2003 and 2002, respectively. These options are not included in the calculation of diluted earnings per share for the periods presented.
COMPREHENSIVE INCOME. The Company is required to present comprehensive income in a full set of general purpose financial statements for all periods presented. Other comprehensive income is comprised of unrealized holding gains (losses) on the available-for-sale securities portfolio and on the retained interest on asset securitization.
STOCK OPTIONS. The Company maintains stock option plans for officers, employees, and directors. When the exercise price of the Company's stock options is greater than or equal to the market price of the underlying stock on the date of the grant, no compensation expense is recognized in the Company's financial statements.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation." This Statement encourages, but does not require, the adoption of fair-value accounting for stock-based compensation to employees. The Company, as permitted, has elected not to adopt the fair-value accounting provisions of SFAS No. 123, and has instead continued to apply APB Opinion No. 25 and related interpretations in accounting for the plans and to provide the required proforma disclosures of SFAS No. 123; accordingly, no expense is recognized in the Consolidated Statement of Operations. Pro forma net income and earnings per share are presented to reflect the impact of the stock option plan assuming compensation expense had been recognized based on the fair value of the stock options granted under the plan.
The following table represents the effect on net income and earnings per share had the Company applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation:
The effects on pro forma net income and diluted earnings per share of applying the disclosure requirement of SFAS No. 123 in past years may not be representative of the future pro forma effects on net income and EPS due to the vesting provisions of the options and future awards that are available to be granted.
2. EFFECTS OF RESTATEMENT
The Consolidated Financial Statements for the fiscal years ended September 30, 2002, 2001, 2000, 1999 and 1998 have been restated to reflect the correction of accounting errors for the Company's indirect automobile, mortgage and consumer loan portfolios. Such errors were discovered in July 2003 and were primarily the result of computer coding errors and did not impact any loan customers.
In September 2003, the Company completed a review of its accounting records and discovered additional accounting errors. As such, the Company has further restated its financial statements for the fiscal year ended September 30, 2002 to reflect the correction of additional accounting errors related to an adjustment to deferred loan fees, an underaccrual in the Company's health and welfare benefit plans, the write-off of improperly deferred advertising and professional fees and the improper recording of a receivable related to the sale of indirect automobile loans. Such errors resulted in a decrease in interest and fees on loans, an increase in salaries and employee benefits, advertising, professional fees and other expense.
These errors had no material effect on the Company's cash flows for operating, investing or financing activities.
The following table describes the cumulative effects of the restatements on net income and earnings per share for the year ended September 30, 2002.
EARNINGS PER SHARE (EPS)
The cumulative effect of these accounting errors on stockholders' equity is as follows for the period presented:
3. SECURITIES
The following table summarizes the estimated fair value of securities with gross unrealized losses at September 30, 2004, segregated between securities that have been in a continuous unrealized loss position for less than twelve months and those that have been in a continuous unrealized loss position for twelve months or longer.
Management does not believe any individual unrealized loss as of September 30, 2004 represents an other-than-temporary impairment. The temporary impairment is directly related to changes in market interest rates. In general, as interest rates rise, the fair value of fixed-rate securities will decrease and, as interest rates fall, the fair value of fixed-rate securities will increase. The severity of the impairment as a percent of the total investment position is nominal and the duration of the impairment to date is short. The impairments are deemed temporary based on the direct relationship of the decline in fair value to movements in interest rates, as well as the relatively short duration of the investments and their high credit quality.
Securities that have been impaired greater than twelve months include primarily mortgage-related securities. The decline in the market value of these securities was deemed temporary due to positive factors supporting the recoverability of these investments. Positive factors considered include timely principal and interest payments and the financial health of the issuer.
Securities are summarized as follows:
The amortized cost and estimated fair value of debt securities by contractual maturity are as follows:
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. Weighted average yields are based on amortized cost including municipal securities which are not reported on a tax-equivalent basis.
Proceeds from sales of securities available for sale during the year ended September 30, 2004 were $59.8 million resulting in gross realized gains of $2.0 million and gross realized losses of $712,000. Proceeds from sales of securities available for sale during the year ended September 30, 2003 were $122.9 million resulting in gross realized gains of $1.6 million and gross realized losses of $255,000. Proceeds from sales of securities available for sale during the year ended September 30, 2002 were $31.2 million resulting in gross realized gains of $513,000 and gross realized losses of $205,000.
Securities classified as agencies and mortgage-related securities, with an amortized cost of $171.8 million and a fair value of approximately $172.0 million at September 30, 2004, were pledged to secure public deposits as required by law.
4. LOANS
Loans are summarized as follows: AT SEPTEMBER 30, ------------------------ (IN THOUSANDS) 2004 2003 ---------- ---------- REAL ESTATE LOANS: One- to four-family $ 112,186 $ 149,741 Multi-family and commercial 71,138 64,343 Construction 4,899 22,384 ---------- ---------- Total real estate loans $ 188,223 $ 236,468 ---------- ----------
CONSUMER LOANS: Home equity loans and lines of credit $ 69,400 $ 73,036 Automobile 101,148 136,182 Unsecured lines of credit 4,424 3,455 Other 9,387 9,421 ---------- ---------- Total consumer loans $ 184,359 $ 222,094 ---------- ---------- COMMERCIAL LOANS $ 40,473 $ 43,203 ---------- ---------- Total loans $ 413,055 $ 501,765 ---------- ---------- LESS: Allowance for loan losses (8,446) (10,196) Deferred loan origination fees (1,025) (1,583) ---------- ---------- Total loans, net $ 403,584 $ 489,986 ========== ==========
At September 30, 2004, the Company had a $22.5 million recorded investment in impaired loans, which had specific loan loss allowances totaling $4.1 million. At September 30, 2003, there was $30.1 million of impaired loans, which had specific loan loss allowances totaling $6.3 million. The average net recorded investment in impaired loans for the years ended September 30, 2004, 2003 and 2002 was $24.0 million, $15.4 million and $5.6 million, respectively. The related amount of interest income recognized on impaired loans was $1.3 million, $969,000 and $375,000 for the years ended September 30, 2004, 2003 and 2002, respectively.
Non-accrual loans totaled $6.9 million, $12.5 million and $4.2 million at September 30, 2004, 2003 and 2002, respectively. There were $0, $0 and $55,000 in troubled debt restructuring loans at September 30, 2004, 2003 and 2002, respectively. The Bank has no commitments to lend additional funds to borrowers whose loans were classified as non-performing or as a troubled debt restructuring.
The activity in the allowance for loan losses is as follows:
SEPTEMBER 30, -------------------------------------- 2004 2003 2002 ---------- ---------- ---------- Balance, beginning $ 10,196 $ 5,449 $ 4,497
Transfer due to sale of indirect automobile loans (1,557) - - Provision charged to income 1,444 6,852 2,766 Charge-offs (2,106) (2,251) (1,993) Recoveries 469 146 179 ---------- ---------- ---------- Balance, ending $ 8,446 $ 10,196 $ 5,449 ========== ========== ==========
An analysis of the activity of loans to directors and executive officers is as follows:
SEPTEMBER 30, ------------------------ (IN THOUSANDS) 2004 2003 ---------- ---------- Balance, beginning of year $ 4,511 $ 2,152 New loans and line of credit advances 448 3,086 Repayments (2,891) (727) ---------- ---------- Balance end of year $ 2,068 $ 4,511 ========== ==========
5. MORTGAGE SERVICING ACTIVITY
Mortgage servicing rights are included in other assets on the Consolidated Statements of Financial Condition. A summary of mortgage servicing rights activity follows:
YEARS ENDED SEPTEMBER 30, -------------------------------------- (IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Balance, beginning of year $ 715 $ 465 $ 493 Originated servicing rights 345 562 143 Amortization (246) (312) (171) ---------- ---------- ---------- Balance, end of year $ 814 $ 715 $ 465 ========== ========== ==========
At September 30, 2004, 2003 and 2002, the Bank serviced loans for others of $117.2 million, $92.9 million and $67.2 million, respectively. Loans serviced by others for the Bank as of September 30, 2004, 2003 and 2002 were $8.5 million, $12.9 million and $31.5 million, respectively.
6. PROPERTIES AND EQUIPMENT
Properties and equipment by major classification are summarized as follows:
SEPTEMBER 30, ------------------------ (IN THOUSANDS) 2004 2003 ---------- ---------- Land $ 2,051 $ 2,287 Buildings and improvements 11,027 11,285 Furniture, fixtures and equipment 7,277 8,452 Leasehold improvements 636 844 ---------- ---------- Total $ 20,991 $ 22,868 ---------- ---------- Less: accumulated depreciation (10,171) (10,716) ---------- ---------- Net $ 10,820 $ 12,152 ========== ==========
The Company has entered into operating leases for several of its branch facilities and operating departments. The minimum annual rental payments under these leases at September 30, 2004 are as follows:
YEARS ENDING SEPTEMBER 30, -------------------------- 2005 $ 238,624 2006 80,790 2007 48,761 2008 48,432 2009 48,432 2010 and after 16,056 --------- Total $ 481,095 =========
Rent expense was $262,000, $272,000 and $312,000 for the years ended September 30, 2004, 2003 and 2002, respectively.
7. ASSET SECURITIZATION
In June 2002, the Bank sold $50.0 million in automobile loan receivables through a securitization transaction. In the transaction, automobile loan receivables were transferred to an independent trust (the "Trust") that issued certificates representing ownership interests in the Trust, primarily to institutional investors. Although the Bank continues to service the underlying accounts and maintain the customer relationships, this transaction is treated as a sale for financial reporting purposes to the extent of the investors' interest in the Trust. Accordingly, the receivables associated with the investors' interests are not reflected on the Consolidated Statement of Financial Condition. In connection with this transaction, the Bank enhanced the credit protection of the certificate holders by funding a cash reserve account.
In connection with this June 2002 transaction, the Bank originally recorded a pre-tax gain on the sale of auto loans of $854,000, which was included in gain on sale of loans in the Consolidated Statement of Operations. In July 2003, the Company discovered that computer coding errors related to the indirect automobile loan portfolio also impacted the original gains related to this securitization. As such, the Company has retroactively adjusted the original gain, as well as key assumptions, to collectively reflect a pre-tax gain of $407,000. At the time of the transaction, the Bank also recognized a retained interest related to the loan sale, which includes an Interest-Only Strip and cash reserve account. The cash reserve account is subject to liens by the providers of the credit enhancement facilities for the securitizations.
As of September 30, 2004, the balance of automobile loan receivables in the Trust was $10.8 million. Because the historical performance of the receivables met the established criteria as of September 30, 2003, the balance of the cash reserve account was reduced from 4.75% to 3.00% of the original balance at that time. The aggregate balance of the retained interest totaled approximately $1.4 million at September 30, 2004.
The key assumptions used in measuring the fair value of the retained interest and cash collateral account for the transaction is shown in the following table:
Retained interest
Average annual repayment rate 1.5% Average annual expected default rate 3.0% Discount rate 10.0% Weighted average life of underlying automobile loans 26 months
The key economic assumptions and the sensitivity of the fair value of the retained interest asset to an immediate adverse change of 10% and 20% to those assumptions are as follows for the period indicated:
SEPTEMBER 30, 2004 ------------------ (IN THOUSANDS) Fair value of retained interest $ 1,420
Weighted-average repayment rate assumption: Pre-tax decrease to earnings due to a 10% adverse change $ 9 Pre-tax decrease to earnings due to a 20% adverse change $ 8
Weighted-average expected default rate: Pre-tax decrease to earnings due to a 10% adverse change $ 17 Pre-tax decrease to earnings due to a 20% adverse change $ 34
Weighted-average discount rate: Pre-tax decrease to earnings due to a 10% adverse change $ 12 Pre-tax decrease to earnings due to a 20% adverse change $ 24
The terms of the transaction included provisions related to the performance of the underlying receivables and other specific conditions that could result in an early payout of invested amounts to the certificate holders.
Changes in fair value based on a 10% adverse variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, the effect of an adverse variation on a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. However, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.
8. DEPOSITS
Deposits consist of the following major classifications:
Certificates of deposit are frequently renewed at maturity rather than liquidated; a summary of certificates by contractual maturity at September 30, 2004 follows:
YEARS ENDING SEPTEMBER 30, ---------------------------------------- (IN THOUSANDS) Amount ----------- 2005 $ 67,929 2006 113,597 2007 5,050 2008 7,405 2009 3,844 2010 and after - ----------- Total $ 197,825 ===========
Interest expense on deposits is comprised of the following:
YEARS ENDED SEPTEMBER 30, ------------------------------------ (IN THOUSANDS) 2004 2003 2002 ---------- ---------- ---------- Savings accounts $ 94 $ 395 $ 1,141 Money market accounts 806 1,674 1,436 Certificates of deposit 6,720 8,956 13,324 NOW Accounts 593 1,133 1,021 ---------- ---------- ---------- Total $ 8,213 $ 12,158 $ 16,922 ========== ========== ==========
9. FEDERAL HOME LOAN BANK ADVANCES
Under terms of its collateral agreement with the Federal Home Loan Bank of Pittsburgh (the "FHLB"), the Bank maintains otherwise unencumbered qualifying assets (principally one-to-four family residential mortgage loans and U.S. Government and Agency notes and bonds) in the amount of at least as much as its advances from the FHLB. The Bank's FHLB stock is also pledged to secure these advances. At September 30, 2004, such advances mature as follows:
DUE BY SEPTEMBER 30, WEIGHTED-AVERAGE RATE SEPTEMBER 30, 2004 - --------------------- --------------------- ------------------ (IN THOUSANDS) 2005 6.34% $ 52,000 2006 3.50 102,000 2007 3.26 40,080 2008 4.89 10,000 2009 - - Thereafter 5.40 39,787 ---- ------------------ Total FHLB advances 4.43% $ 243,867 ==== ==================
The Bank has included in the preceding tables annually renewable lines of credit totaling $75.0 million. At September 30, 2004, there were no such borrowings outstanding at FHLB. The Bank, from time to time, has used lines of credit to meet liquidity needs. There were $27.5 million in borrowings outstanding at September 30, 2003 under such lines of credit with an interest rate at the overnight FHLB borrowing rate of 1.31%.
At September 30, 2004, the Bank had outstanding advances from the FHLB of $140.0 million which have callable features. Such advances have a fixed rate for a specified period of time after which the FHLB can, at its option, convert the advance to a variable rate. The Bank, at the same time, can repay the advance without a prepayment fee.
10. TRUST PREFERRED DEBT
On April 10, 2002, NEP Capital Trust I, a Delaware statutory business trust, issued $7.0 million of floating rate capital securities through a pooled trust preferred securities offering. The proceeds from this issuance, along with the Company's $217,000 payment for the Trust's common securities, were used to acquire $7.2 million aggregate principal amount of the Company's floating rate junior subordinated deferrable interest debentures due April 22, 2032 (the "Debentures"), which constitute the sole asset of the Trust. The interest rate on the Debentures and the distribution rate on the capital securities are variable and adjust semi-annually at 3.70% over the six-month LIBOR, with an initial rate of 6.02%. A rate cap of 11% is effective through April 11, 2007. The stated maturity of the Debentures is April 22, 2032. In addition, the Debentures are subject to redemption at par at the option of the Company, subject to prior regulatory approval, in whole or in part on any interest payment date after April 22, 2007. In 2002, the Company recognized an amortizable intangible asset with a value of $220,000 relating to the issuance costs of these trust preferred securities.
On October 29, 2002, NEP Capital Trust II, a Delaware statutory business trust, issued $15.0 million in the form of floating rate capital securities through a pooled trust preferred securities offering. The proceeds from this issuance, along with the Company's $464,000 payment for the Trust's common securities, were used to acquire $15.5 million aggregate principal amount of the Company's floating rate junior subordinated deferrable interest debentures due November 7, 2032 (the "Debentures"), which constitute the sole asset of the Trust. The interest rate on the Debentures and the distribution rate on the capital securities are variable and adjust quarterly at 3.45% over the three-month LIBOR, with an initial rate of 5.27%. A rate cap of 12.5% is effective
through November 7, 2007. The stated maturity of the Debentures is November 7, 2032. In addition, the Debentures are subject to redemption at par at the option of the Company, subject to prior regulatory approval, in whole or in part on any interest payment date after August 7, 2007. The Company recognized an amortizable intangible asset with a value of $450,000 relating to the issuance costs of these trust preferred securities.
In December 2003, the FASB revised Financial Interpretation No. ("FIN") 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (the Interpretation). The Interpretation requires the consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Previously, entities were generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity. Application of this Interpretation is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. As a result of the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the second fiscal quarter of 2004. The result was an increase in the junior debt of $681,000.
A summary of the trust securities issued and outstanding at September 30, 2004 is as follows:
11. INCOME TAXES
The Small Business Job Protection Act of 1996, enacted on August 20, 1996, repealed the tax bad debt deduction computed under the percentage of taxable income method. Upon repeal, the Bank was required to recapture into income, over a six-year period, the portion of its tax bad debt reserves that exceeded its base year reserves (i.e., tax reserves for tax years beginning before 1988). The base year tax reserves, which may be subject to recapture if the Bank ceases to qualify as a savings bank for Federal income tax purposes, are restricted with respect to certain distributions. The Bank's total tax bad debt reserves at September 30, 2004 were approximately $10.2 million, of which $10.2 million represents the base year amount and $0 is subject to recapture currently.
The provision (benefit) for income taxes is summarized as follows:
YEAR ENDED SEPTEMBER 30, -------------------------------------- (IN THOUSANDS) AS RESTATED 2004 2003 2002 ---------- ---------- ----------- Current: Federal $ 1,209 $ 216 $ 815 State 478 21 223 Deferred: Federal 311 (1,765) 582 State 301 (301) - ---------- ---------- ----------- Total $ 2,299 $ (1,829) $ 1,620 ========== ========== ===========
The provision (benefit) for income taxes differs from the statutory rate due to the following:
YEAR ENDED SEPTEMBER 30, --------------------------------------- (IN THOUSANDS) AS RESTATED 2004 2003 2002 ---------- ---------- ----------- Federal income tax at statutory rate $ 2,512 $ (2,006) $ 1,467 Tax exempt interest, net (371) (444) (419) State taxes, net of Federal benefit 616 (287) 147 Excess ESOP compensation expense 92 102 35 Bank-owned life insurance (171) (184) (99) Excess Officer Compensation - 159 - Adjustment for prior year taxes (250) - - Other, net (129) (3) 2 Increase in valuation allowance for deferred tax assets - 834 487 ---------- ---------- ----------- Total provision (benefit) $ 2,299 $ (1,829) $ 1,620 ========== ========== ===========
The components of the net deferred tax liability (asset) are as follows:
SEPTEMBER 30, ------------------------ (IN THOUSANDS) 2004 2003 ---------- ---------- Deferred tax assets: ESOP funding difference $ (132) $ (132) Recognition and retention plan - (130) Deferred compensation (384) (470) Accrued hospitalization (136) (261) Book bad debt reserves - loans (2,905) (3,505) Intangibles amortization (56) (226) Investment writedown (680) (680) AMT credit carryforward (601) (30) Net operating loss carryover - (356) Purchase accounting adjustment-loans (90) (160) Capital loss carryover (66) (28) Employee Retirement Reserves (3) (52) Unrealized loss on available for sale securities (62) - Accrued Expenses (116) (19) ---------- ---------- Total deferred tax assets (5,231) (6,049) Valuation allowance 680 680 ---------- ---------- Net deferred tax asset $ (4,551) $ (5,369) ---------- ---------- Deferred tax liabilities: Depreciation / Amortization $ 99 $ 133 Accretion 152 183 Recognition and retention plan 29 - Title plant 26 26 Loan fees and costs 19 51 Unrealized gain on available-for-sale securities - 988 Purchase accounting adjustment-deposits 2,176 2,377 ---------- ---------- Total deferred tax liabilities 2,501 3,758 ---------- ---------- Net deferred tax liability (asset) $ (2,050) $ (1,611) ========== ==========
Deferred income taxes reflect the net tax-effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Based on the Company's history of prior operating earnings and its expectation of the future, management believes that taxable income will more likely than not be insufficient to realize all of the Company's gross deferred tax assets at September 30, 2004 and 2003. Valuation allowance increases of $834,000 were established during the year ended September 30, 2003 to offset a portion of the charitable contribution carryforward that management believes may not be realized. The cumulative amount of the valuation allowance that has been established related to the unused charitable contribution carryforward is $1,175,000 through September 30, 2003. The charitable contribution carryover has expired as of September 30, 2003 and is no longer available for usage after this date. Accordingly, this valuation allowance, along with the tax benefit associated with the gross amount of the unused charitable contribution carryover, has been removed as of September 30, 2003. As of September 30, 2004 and September 30, 2003, $680,000 of the valuation allowance has been established to offset the entire amount of tax benefits associated with an impaired investment.
For federal income tax purposes, the Company has approximately $145,000 of net capital loss carryforwards resulting in a deferred tax asset of $66,000 as of September 30, 2004. The Company also has alternative minimum tax credits of $601,000 that have an indefinite life.
12. STOCK OPTION PLANS
The Company maintains a stock-based incentive plan ("the 1998 Plan") for officers, directors and certain employees of the Company and its subsidiaries. Pursuant to the terms of the 1998 Plan, the number of common shares reserved for the issuance of options was 642,735. All options were issued at not less than fair market value at the date of grant and expire 10 years from date of grant. The majority of stock options granted in the 1998 Plan vest over a five year period from the date of grant. In January 2000, the Company adopted the 2000 Stock Option Plan ("the 2000 Plan"). The 2000 Plan reserved an additional 173,624 shares for issuance under terms similar to the 1998 Plan. At September 30, 2004, 10,000 shares subject to option remain available for grant under the 2000 plan. In February 2004, the Company adopted the 2004 Stock Plan. The number of shares of restricted stock and stock options that may be awarded under the Plan to employees is 185,000 and the amount of shares of restricted stock and stock options that can be awarded to Directors under the Plan is 20,000. The maximum number of shares of restricted stock awards which can be granted is 100,000. No stock options can be granted under the Plan for less than fair market value on the date of grant. The maximum annual grant of options or restricted shares under the Plan to any one individual shall not exceed one and a half percent (1.5%) of the total outstanding shares of common stock of company, in the aggregate, per calendar year.
A summary of the status of the Company's outstanding stock option plans as of September 30, 2004, 2003 and 2002 and changes during the years then ended is presented below:
The following table summarizes all stock options outstanding for the plans as of September 30, 2004, segmented by range of exercise prices:
OUTSTANDING ----------------------------- WEIGHTED- WEIGHTED- AVERAGE AVERAGE EXERCISE REMAINING NUMBER PRICE CONTRACTUAL LIFE ------- ---------- ---------------- STOCK OPTIONS: $10.00-$10.50 17,419 $ 10.35 5.1 years $10.51-$11.00 2,209 $ 10.63 4.7 $11.01-$11.50 4,955 $ 11.38 4.7 $11.51-$12.00 491,610 $ 11.75 4.2 $12.01-$12.50 44,738 $ 12.25 6.3 $12.51-$13.00 2,000 $ 12.75 4.4 $14.00-$14.50 1,845 $ 14.20 7.0 $15.00-$15.50 14,100 $ 15.26 8.0 $15.51-$16.00 1,000 $ 15.95 8.8 $16.01-$16.50 435 $ 16.41 7.5 $16.51-$17.00 8,750 $ 16.93 7.3 $17.50-$18.00 117,050 $ 17.80 9.2 $18.50-$19.00 22,000 $ 18.75 9.1 $19.01-$19.50 1,000 $ 19.10 9.3 ------- ---------- ---------------- 729,111 $ 13.08 5.8 years
13. COMMITMENTS AND CONTINGENCIES
LENDING OPERATIONS The Company is party to financial instruments with off-balance-sheet risk in the normal course of business primarily to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Commitments to originate loans amounted to $5.6 million as of September 30, 2004, of which $3.3 million was for variable-rate loans. The balance of the commitments represent fixed-rate loans with interest rates ranging from 5.38% to 6.25%. In addition, at September 30, 2004, the Company had undisbursed loans in process of $12.0 million and $50.9 million in undisbursed lines of credit. These instruments involve, to varying degrees, elements of credit, interest rate or liquidity risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of these commitments reflect the extent of involvement the Company has in particular classes of financial instruments.
In addition, the Company also has an obligation of $743,000 in standby letters of credit.
The Company's exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments as it does for balance-sheet instruments.
Commitments to extend credit are legally-binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer's credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company on extensions of credit, is based on management's credit assessment of the counterparty. At September 30, 2004, the Company expects all commitments to be funded within 60 days.
DERIVATIVES
At September 30, 2004, there were $40.0 million in notional amount of derivative contracts in effect, see Footnote 15 for detail.
LEGAL PROCEEDINGS
The Company is commonly subject to various pending and threatened legal actions which involve claims for monetary relief. Based upon information presently available to the Company, it is the Company's opinion that any legal and financial responsibility arising from such claims will not have a material adverse effect on the Company's results of operations.
DATA PROCESSING OPERATIONS
In August 2003, the Company entered into a 5-year contract with Aurum Technology for data processing and other related services. The projected future minimum annual contractual payments for the remaining term of the Agreement are as follows:
2005 $ 582,000 2006 $ 586,000 2007 $ 586,000 2008 $ 538,000
14. FAIR VALUE OF FINANCIAL INSTRUMENTS.
The reported fair values of financial instruments are based on a variety of factors. Estimates of fair value are made at a specific point in time based upon, where available, relevant market prices and information about the financial instrument. Such estimates do not include any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. For a substantial portion of the Company's financial instruments, no quoted market exists. Therefore, estimates of fair value are necessarily based on a number of significant assumptions. Such assumptions include assessments of current economic conditions, perceived risks associated with these financial instruments and their counterparties, future expected loss experience and other factors. Given the uncertainties surrounding these assumptions, the reported fair values represent estimates only, and therefore cannot be compared to the historical accounting model. Use of different assumptions or methodologies is likely to result in significantly different fair value estimates.
The estimated fair values presented neither include nor give effect to the values associated with the Company's banking, or other businesses, existing customer relationships, extensive branch banking network, property, equipment, goodwill or certain tax implications related to the realization of unrealized gains or losses. Also, the fair value of non-interest-bearing demand deposits, savings, NOW accounts and money market deposit accounts is equal to the carrying amount because these deposits have no stated maturity. Obviously, this approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. As a consequence, the fair value of individual assets and liabilities may not be reflective of the fair value of a banking organization that is a going concern.
The following methods and assumptions were used to estimate the fair value of each major classification of financial instruments at September 30, 2004 and 2003.
CASH AND CASH EQUIVALENTS. Current carrying amounts approximate estimated fair value.
INVESTMENTS AND MORTGAGE-BACKED SECURITIES. Current quoted market prices were used to determine fair value.
LOANS. Fair values were estimated for portfolios of loans with similar financial characteristics. Loans were segregated by type and each loan category was further segmented by fixed-and adjustable-rate interest terms. The estimated fair value of the segregated portfolios was calculated by discounting cash flows through the estimated maturity using estimated prepayment speeds while using estimated market discount rates that reflect credit and interest rate risk inherent in the loans. The estimate of the maturities and prepayment speeds was based on the Company's historical experience. Cash flows were discounted using market rates adjusted for portfolio differences.
ACCRUED INTEREST RECEIVABLE. Current carrying amounts approximate estimated fair value.
BANK-OWNED LIFE INSURANCE. The fair value is equal to the cash surrender value of the life insurance policies.
DEPOSITS WITH NO STATED MATURITY. Current carrying amounts approximate estimated fair value.
CERTIFICATES OF DEPOSIT. Fair values were estimated by discounting the contractual cash flows using current market rates offered in the Company's market area for deposits with comparable terms and maturities.
FEDERAL HOME LOAN BANK ADVANCES. The fair value of borrowings was estimated using rates currently available to the Company for debt with similar terms and remaining maturities.
OTHER BORROWINGS. The fair value was estimated by discounting the contractual cash flows using rate currently available for similar debt with comparable terms and maturities.
ACCRUED INTEREST PAYABLE. Current carrying amounts approximate estimated fair value.
TRUST PREFERRED DEBT. The fair value was estimated by discounting the contractual cash flows using rates currently available for similar debt with comparable terms and maturities.
INTEREST RATE SWAPS. The fair value of the interest rate swaps are equal to the estimated market prices.
COMMITMENTS TO EXTEND CREDIT. The majority of the Company's commitments to extend credit carry current market interest rates if converted to loans. Because commitments to extend credit are generally unassignable by either the Company or the borrower, they only have value to the Company and the borrower. The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counter parties.
The carrying amounts and estimated fair values of the Company's financial instruments were as follows:
15. DERIVATIVE FINANCIAL INSTRUMENTS
The Bank uses interest rate swaps to hedge the impact of changing interest rates on market values of certain fixed-rate FHLB borrowings. Under the terms of the swaps, the Bank receives fixed rate payments and pays variable-rate payments based on 3-month LIBOR. The fixed-rate interest swap payments received by the Bank equal the amounts payable to the FHLB, effectively converting the FHLB borrowings to a variable rate. Changes in the fair value of the swaps are highly effective in offsetting changes in the fair value of the FHLB borrowings, since the structure of the critical terms of the swaps match the FHLB borrowings.
The following table summarizes the Bank's derivative financial instruments as of September 30, 2004:
NOTIONAL MARKET RECEIVE PAY AMOUNT VALUE MATURITY FIXED FLOATING - ---------- ---------- ---------- ---------- --------------------- (IN THOUSANDS) $ 5,000 $ (32) 2/23/2011 5.1800% 3 month LIBOR + 1.74% 5,000 (75) 2/23/2011 4.9900% 3 month LIBOR + 1.74% 10,000 (137) 4/23/2014 5.4050% 3 month LIBOR + 1.73% 20,000 (268) 5/21/2014 5.6000% 3 month LIBOR + 1.87% - ---------- ---------- $ 40,000 $ (512) - ---------- ----------
Since the terms of the interest rate swap mirror those of the hedged items, the Bank has adopted the short cut method of accounting for these transactions. Therefore, no hedge ineffectiveness was recognized in earnings related to these fair value hedges.
16. CAPITAL AND REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possible additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital and tangible capital (as defined) to total assets (as defined). Management believes, as of September 30, 2004, that the Bank met all capital adequacy requirements to which it was subject. As of September 30, 2004, the most recent notification from the Office of Thrift Supervision categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the institution's category.
The Bank's actual capital amounts and ratios at September 30, 2004 and 2003 are presented in the following table:
(1) For the periods presented the components of tangible capital were the same as those of core capital. Tangible and core capital are computed as a percentage of adjusted total assets and tangible assets of $828 million and $876 million at September 30, 2004 and 2003, respectively. Risk-based capital and Tier I capital are computed as a percentage of risk-weighted assets of $437 million and $565 million at September 30, 2004 and 2003, respectively. Tier I capital is reduced by the amount of low-level recourse and residual interests to compute Tier I capital.
The Bank established a liquidation account at the time of its conversion from a Federally-chartered mutual savings and loan association to a Federally-chartered stock savings bank (the "Conversion"). This liquidation account was initially established in an amount equal to the equity of the Bank as of September 30, 1997, the date of its latest balance sheet date contained in the final Prospectus used in connection with the Conversion. In the unlikely event of a complete liquidation of the Bank, (and only in such an event), eligible depositors who continue to maintain accounts at the Bank shall be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account, which decreases if the balances of eligible deposits decrease at the
annual determination dates, approximated $4.3 million at September 30, 2004.
The Company may not declare nor pay dividends on its stock if such declaration and payment would violate statutory or regulatory requirements.
In addition to the 16,000,000 authorized shares of common stock, the Company authorized 2,000,000 shares of preferred stock with a par value of $.01 per share. The Board of Directors is authorized, subject to any limitations by law, to provide for the issuance of the shares of preferred stock in series, to establish from time to time the number of shares to be included in each such series, and to fix the designation, powers, preferences and rights of the shares of each such series and any qualifications, limitations or restrictions thereof. As of September 30, 2004, there were no shares of preferred stock issued.
17. EMPLOYEE BENEFIT PLANS
DEFINED BENEFIT PLAN The Company participates in a multi-employer defined benefit pension plan covering all employees who are age 21 and have one year of service with the Company. Because of the multi-employer nature of the plan, information regarding the Company's portion of present values of vested and nonvested benefits is not available. The Company amended the plan and froze the benefits for current participants as of October 1, 2003. As such, the Company has limited its future obligations to the plan. For the year ended September 30, 2004 and 2003, the Company accrued $181,000 and $107,000, for its obligations under this plan. The plan was fully funded and no contributions were required during the year ended September 30, 2002.
401(K) PLAN The Bank maintains a Section 401(k) defined contribution plan which covers substantially all of its employees. The Company made contributions to this plan of approximately $187,000, $223,000, and $205,000 for the years ended September 30, 2004, 2003 and 2002, respectively.
EMPLOYEE STOCK OWNERSHIP PLAN The Bank maintains an Employee Stock Ownership Plan ("ESOP"). The Plan is designed to provide retirement benefits for eligible employees. Because the ESOP invests in the stock of the Company, it gives eligible employees an opportunity to acquire an ownership interest in the Company. Employees are eligible to participate in the Plan after reaching age 21 and completing six months of service. Benefits become 100% vested after four years, with a 25% vesting occurring each year.
The ESOP purchased 8.0% or 514,188 shares of the common stock issued in the Conversion. The ESOP borrowed 100% of the aggregate purchase price of the common stock, or $5.1 million, from the Company. The loan has a 10 year term, with an annual interest rate of prime (4.75% at September 30, 2004) and will be repaid principally from the Bank's contributions to the ESOP. The Company recognized $910,000, $710,000, and $758,000 in compensation and benefit expense related to the ESOP for the years ended September 30, 2004, 2003 and 2002, respectively, offset by dividends in the amount of $134,000, $232,000, and $214,000, respectively.
Shares purchased by the ESOP were pledged as collateral for the loan and are held in a suspense account until they are released annually in an amount proportional to the repayment of the ESOP loan for each plan year. The released shares are allocated among the accounts of participants on the basis of the participant's compensation for the year of allocation.
At September 30, 2004, the ESOP held 430,200 shares of the Company's stock of which 224,524 shares were allocated to participant accounts. The unallocated ESOP shares are presented as a reduction of stockholders' equity in the consolidated financial statements. At September 30, 2004, the unallocated ESOP shares had a fair market value of $3.4 million.
STOCK AWARDS The Company maintains a stock-based award plan (The 1998 Plan) for officers, directors and certain employees of the Company and its subsidiaries, under which 257,094 shares of common stock were available for grant. All awards granted vest over a five-year period from the date of grant and result in compensation expense during the vesting period. The Board of Directors of the Company has adopted the 2004 Stock Plan ("Plan"). The number of shares of restricted stock and stock options that may be awarded under the Plan to employees is 185,000 and the amount of shares of restricted stock and stock options that can be awarded to Directors under the Plan is 20,000. The maximum number of shares of restricted stock awards which can be granted is 100,000. The maximum annual grant of options or restricted shares under the Plan to any one individual shall not exceed one and a half percent (1.5%) of the total outstanding shares of common stock of company, in the aggregate, per calendar year.
The Company recognized $141,000, $714,000 and $496,000 in compensation and benefit expense related to the stock awards for the fiscal years ended September 30, 2004, 2003 and 2002, respectively. A total of 133,748 shares, 54,780 shares, and 42,178 shares vested in fiscal 2004, fiscal 2003 and fiscal 2002, respectively. At September 30, 2004, 9,470 shares of restricted stock remain unawarded in the 1998 Plan and 97,000 shares remain unawarded in the 2004 Plan.
OPTION PLANS For a full description of the Company's option plans, see Footnote 12.
18. GOODWILL AND INTANGIBLE ASSETS
A summary of goodwill is as follows:
AT SEPTEMBER 30, 2004 AND 2003 ----------------------------------- GROSS NET CARRYING ACCUMULATED CARRYING AMOUNT AMORTIZATION AMOUNT -------- ------------ -------- (in thousands) Acquisition of: Abstractors $ 248 $ (160) $ 88 Security Savings Association of Hazleton 571 (28) 543 Higgins Insurance Associates, Inc. 2,519 (95) 2,424 Schuylkill Savings and Loan Association 200 - 200 -------- ------------ -------- Total goodwill $ 3,538 $ (283) $ 3,255 ======== ============ ========
At September 30, 2004 and 2003, $75,000 of the Company's acquired intangible assets were considered to be indefinite lived and not subject to amortization. This intangible represents title plant related to the acquisition of Abstractors. The components for intangible assets were as follows:
Amortization expense of other amortizing intangible assets and impairment losses on goodwill for the year ended September 30, 2004, 2003 and 2002 are as follows:
2004 2003 2002 ---------- ---------- ---------- (IN THOUSANDS) Core deposit intangibles $ 670 $ 888 $ 954 Other amortizing intangibles 177 134 54 Impairment loss on goodwill 25 39 - ---------- ---------- ---------- Total amortizing intangibles $ 872 $ 1,061 $ 1,008 ========== ========== ==========
The estimated amortization expense of amortizing intangible assets for each of the five succeeding fiscal years is as follows:
There were no intangible assets acquired in the year ended September 30, 2004.
19. IMPAIRMENT LOSS ON EQUITY INVESTMENT
The Company had a $2.0 million equity investment in the convertible preferred stock of a private entity, which makes loans to and provides services to residential construction builders in the Eastern United States. The Company had previously been accounting for such investment on a cost method. During June 2003, the Company recognized an impairment loss of the entire remaining $1.5 million investment in this entity since efforts by it to raise additional equity capital have proven unsuccessful. While this entity and its lending programs continue to operate, the Bank is no longer a lender in such programs. Additionally, no tax benefit has been recognized for the current impairment loss since such loss is a capital loss and is deductible only against other capital gains.
20. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of this Statement did not have an impact on the Company's financial position or results of operations.
On October 1, 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions," effective for all business combinations initiated after October 1, 2002. This Statement addresses the financial accounting and reporting for the acquisition of all or part of a financial institution, except for a transaction between two or more mutual enterprises. This Statement removes acquisitions of financial institutions, other than transactions between two or more mutual enterprises, from the scope of SFAS No. 72, "Accounting for Certain Acquisitions of Banking or Thrift Institutions," and FASB Interpretation No. 9, "Applying APB Opinions No. 16 and 17, "When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method." The acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 was adopted on October 1, 2001. This Statement also provides guidance on the accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets (such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets), including those acquired in transactions between two or more mutual enterprises. Upon early adoption of this statement, as of October 1, 2001, the carrying amount of the previously recognized unidentifiable intangible asset related to the Schuylkill Savings branch acquisitions that was reclassified to goodwill was $200,000, while the related 2002 amortization expense that was reversed was $81,000, pre-tax. The Company will continue to review the remaining goodwill on an annual basis for impairment. However, $7.9 million in core deposit intangible will continue to be amortized and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123." This statement amends FASB Statement No.123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The Statement also amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is effective for fiscal years ending after December 15, 2002, except for financial reports containing condensed financial statements for interim periods for which disclosure is effective for periods beginning after December 15, 2002. This Statement announces, "in the near future, the Board plans to
consider whether it should propose changes to the U.S. standards on accounting for stock-based compensation." As permitted, the Company continues to account for stock options with the methodology prescribed by Accounting Principles Board No. 25. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The amendments set forth in SFAS No. 149 require that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting. This statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. The provisions of this statement that relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after June 30, 2003. The adoption of this statement did not have a material effect on the Company's financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This Statement establishes how an issuer classifies financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify these financial instruments as a liability (or, in certain circumstances, an asset). Previously these financial instruments would have been classified entirely as equity, or between the liabilities section and equity section of the statement of financial condition. This Statement also addresses questions about the classification of certain financial instruments that embody obligations to issue equity shares. The provisions of this Statement are effective for interim periods beginning after June 15, 2003. The adoption of this statement did not have a material impact on the Company's financial position or results of operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. This interpretation clarifies that a guarantor is required to disclose (a) the nature of the guarantee, including the approximate term of the guarantee, how the guarantee arose, and the events or circumstances that would require the guarantor to perform under the guarantee; (b) the maximum potential amount of future payments under the guarantee; (c) the carrying amount of the liability, if any, for the guarantor's obligations under the guarantee; and (d) the nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under the guarantee. This interpretation also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the obligations it has undertaken in issuing the guarantee, including its ongoing obligation to stand ready to perform over the term of the guarantee in the event that the specified triggering events or conditions occur. The objective of the initial measurement of that liability is the fair value of the guarantee at its inception. The initial recognition and initial measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor's fiscal year-end. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of this interpretation did not have a material effect on the Company's financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," (FIN 46) in an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. The objective of this interpretation is not to restrict the use of variable interest entities but to improve financial reporting by companies involved with variable interest entities. Until now, one company generally has included another entity in its consolidated financial statements only if it controlled the entity through voting interests. This interpretation changes that by requiring a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements of this interpretation apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. As a result of the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the second fiscal quarter of 2004. The result was an increase in the junior debt of $681,000.
In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." This statement provides guidance for evaluating whether an investment is other-than-temporarily impaired and was effective for the other-than-temporary impairment evaluations made in the reporting periods beginning after June 15, 2004. The FASB staff has issued a proposed Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The proposed FSP would provide implementation guidance with respect to debt securities that are impaired solely due to interest rates and/or sector spreads and
analyzed for other-than-temporary impairment under paragraph 16 of Issue 03-1. In September 2004, based on comment letters received by constituents, the Board decided to further consider whether application guidance is necessary for all securities analyzed for impairment under paragraph 10-20 of Issue 03-1. The delay did not include the disclosure provisions which will remain in effect until the full reconsideration of Issue 03-01 guidance is completed. The Company will delay the effective application until the implementation guidance is finalized.
21. RELATED PARTY TRANSACTIONS
In the ordinary course of business, executive officers and directors of the Company may have consumer and commercial loans issued by the Bank. Pursuant to the Company's policy, such loans are issued on the same terms as those prevailing at the time for comparable loans to unrelated persons and do not involve more than the normal risk of collectibility.
The Company's Chairman of the Board of Directors is also a partner in a law firm that provides general legal counsel to the Company. The Company paid professional fees to this law firm during the years ended September 30, 2004, 2003 and 2002 of $117,000, $124,000 and $74,000, respectively.
In prior years, the Company paid rent for its Pottsville insurance office to a partnership in which a director of the Company has a one-third ownership interest. Such rents totaled $14,000 and $21,000 for the years ended September 30, 2003 and 2002, respectively. The building was sold in May 2003 and therefore no rents were paid to the director in the year ending September 30, 2004.
22. ACQUISITIONS
During 2002, the Company purchased three banking offices from Schuylkill Savings and Loan Association and Higgins acquired the DeAndrea Agency which specializes in personal and commercial insurance. These acquisitions resulted in the Company recognizing an amortizable core deposit intangible of $255,000 and amortizable other intangible assets of $435,000.
23. DISPOSITIONS
In January 2004, the Bank sold $650,000 of real estate and transferred $10.3 million of deposits at its Danville, Pennsylvania branch to the First National Bank of Berwick, Pennsylvania. This sale resulted in a pre-tax gain of $798,000.
24. SUBSEQUENT EVENTS
On December 8, 2004, KNBT Bancorp, Inc. ("KNBT"), the parent company of Keystone Nazareth Bank & Trust Company, and Northeast Pennsylvania Financial Corp. ("Northeast Pennsylvania"), the parent company of First Federal Bank, entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which Northeast Pennsylvania will merge with and into KNBT. Concurrently with the merger, it is expected that First Federal Bank will merge with Keystone Nazareth Bank & Trust Company.
Under the terms of the Agreement, the Company's stockholders may elect to receive either $23.00 of KNBT common stock or $23.00 in cash in exchange for their shares of Northeast Pennsylvania common stock, subject to an overall requirement that 50% of the total outstanding Company Common Stock be exchanged for KNBT Common Stock and 50% for cash. To the extent they receive shares of KNBT, the transaction is expected to be tax-free to Northeast Pennsylvania stockholders.
The number of shares of KNBT common stock into which each Northeast Pennsylvania share will be exchanged will be based on the price of KNBT common stock over a measurement period prior to closing.
In addition, each director of Northeast Pennsylvania entered into a Shareholder Agreement with KNBT, pursuant to which each such person agreed, among other things, to vote his or her shares of NEPF common stock in favor of the Merger Agreement at a meeting of stockholders of NEPF to be called to consider and approve the Merger Agreement. The merger also requires appropriate regulatory approvals. Additionally, the Agreement contains certain operating restrictions on the Company from the date of the Merger Agreement until the closing.
25. PARENT COMPANY FINANCIAL INFORMATION
CONDENSED STATEMENT OF FINANCIAL CONDITION
SEPTEMBER 30, ----------------------- (IN THOUSANDS) 2004 2003 ---------- ---------- Assets: Cash $ 3,901 $ 4,826 Investment in subsidiaries 70,689 65,621 Securities available for sale 62 6,567 Accrued interest receivable - 140 Due from affiliates 601 (162) Other assets 6,374 3,811 ---------- ---------- Total Assets $ 81,627 $ 80,803 ========== ==========
Liabilities and stockholders' equity: Trust preferred debt $ 22,681 $ 22,000 Other liabilities 488 446 ---------- ---------- Total Liabilities 23,169 22,446 ---------- ---------- Total stockholders' equity 58,458 58,357 ---------- ---------- Total Liabilities and Stockholders' Equity $ 81,627 $ 80,803 ========== ==========
CONDENSED STATEMENT OF OPERATIONS
CONDENSED STATEMENTS OF CASH FLOWS
Quarterly Financial Data (unaudited) (in thousands, except per share amounts)
FIRST SECOND THIRD FOURTH 2004 QUARTER QUARTER QUARTER QUARTER - ------------------------- ---------- ---------- ---------- ---------- Net Interest Income $ 5,259 $ 5,476 $ 5,293 $ 5,078 Provision for Loan Losses 677 485 232 50 Non-Interest Income 2,685 3,910 2,528 2,212 Non-Interest Expense 5,998 5,986 5,824 5,803 ---------- ---------- ---------- ---------- Net Income $ 1,039 $ 2,090 $ 1,027 $ 931 ========== ========== ========== ========== Earnings Per Share Basic $ 0.27 $ 0.53 $ 0.26 $ 0.25 Diluted $ 0.25 $ 0.51 $ 0.25 $ 0.24
2003 (1) - ------------------------- Net Interest Income $ 5,282 $ 5,059 $ 4,962 $ 4,873 Provision for Loan Losses 370 610 850 5,022 Non-Interest Income 2,618 3,728 1,715 1,915 Non-Interest Expense 6,624 6,747 6,952 8,876 ---------- ---------- ---------- ---------- Net Income $ 669 $ 920 $ (1,193) $ (4,466) ========== ========== ========== ========== Earnings Per Share Basic $ 0.18 $ 0.24 $ (0.32) $ (1.19) Diluted $ 0.17 $ 0.23 $ (0.32) $ (1.19)
(1) Certain amounts have been restated to reflect the correction of accounting errors as more fully described in Note 2 to the Consolidated Financial Statements.
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
During the initial preparation and review of the Form 10-Q for the June 30, 2003 period, the Registrant discovered that its financial statements for its fiscal years 1998 through 2002 and for the December 2002 and March 2003 quarters required restatement. The Company believes that it maintained effective controls and procedures designed to ensure that information required to be disclosed in its reports filed under the Securities Exchange Act of 1934 with respect to those prior periods, except that the individuals responsible for implementing such controls and procedures, including reviewing the work performed and authorizing the final results, failed to detect material errors, including a computer coding error related to the Company's indirect automobile loan portfolio, which required the restatement. Consequently, the new management conducted an exhaustive analysis of the Company's accounting records. This review discovered additional accounting errors, which were included in the restatements. Subsequent to the discovery of these errors in June and September, management implemented staffing, system and procedural changes designed to improve the training of the individuals involved in implementing and reviewing the controls and procedures to strengthen the review and authorization process so that such errors do not occur in the future.
The Company's management, including the Company's principal executive officer and principal financial officer, have evaluated the effectiveness of the Company's "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the "Exchange Act"). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the "SEC) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and (2) is accumulated and communicated to the Company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS
Information regarding each of the directors is contained below. Unless otherwise stated, each individual has held his current occupation for the last five years. The age listed in each nominee's biography is as of September 30, 2004. There are no family relationships among the directors or executive officers. The indicated period for service as a director includes service as a director of the Bank.
Barbara M. Ecker. Ms. Ecker was a certified public accountant with the Greater Hazleton Health Alliance from 1993 until her retirement in April 2003. Ms. Ecker also holds an MBA in Finance and has taught banking and finance at local universities. Age 63. Director since 1987.
R. Peter Haentjens, Jr. Mr. Haentjens is President of Weir Hazleton, Inc., a manufacturing company located in Hazleton, Pennsylvania. Age 59. Director since 1981.
George J. Hayden. Mr. Hayden is President of George J. Hayden, Inc., an electrical contracting firm, and President of several fast food restaurants. Age 67. Mr. Hayden has been a director of the Bank since 2000.
Thomas L. Kennedy. Mr. Kennedy has been a practicing attorney for over 30 years. He is the President of the law firm of Kennedy & Lucadamo, P.C. Mr. Kennedy serves as Chairman of the Board and General Counsel of the Company and the Bank. Age 60. Director since 1985.
The Honorable John P. Lavelle. Judge Lavelle served as the President Judge for the Court of Common Pleas of Carbon County, Pennsylvania from 1978 until his retirement in February 2001. Age 73. Director since 1972.
Michael J. Leib. Mr. Leib is the President of Weatherly Casting & Machine Company, located in Weatherly, Pennsylvania. Mr. Leib served as the President of WCM, International Inc., a foreign sales corporation for exported cast products located in Weatherly, Pennsylvania from February 1992 until August 2002. Age 56. Director since 1989.
Thomas M. Petro. Mr. Petro served as Executive Vice President of the Company and the Bank from June 2003 before being named President and Chief Executive Officer of the Company and the Bank on September 13, 2003. Prior to joining the Company, Mr. Petro was a principal with S.R. Snodgrass, LLC, a public accounting and consulting firm, located in Wexford, Pennsylvania, from June 2002 to May 2003. Mr. Petro also served as Executive Vice President of The Bryn Mawr Trust Company and President of the Bryn Mawr Brokerage Company, both of which are located in Bryn Mawr, Pennsylvania, from 1990 to 2001. Age 46. Director since 2003.
Joseph P. Schlitzer. Mr. Schlitzer has been President of Higgins since 1976. He has also served as Treasurer of Pinebrook-Higgins Realty since 2001. Mr Schlitzer was also President of CBHA, Inc., a real estate company, from 1976 to 2001. Mr. Schlitzer also served on the Board of Directors of Heritage Bancorp, Inc. and its successor Main Street Bancorp, Inc. from 1995 to 2000. Mr. Schlitzer was appointed as a director of the Company on November 28, 2000 in connection with the Company's acquisition of Higgins. Age 52.
William J. Spear. Mr. Spear is the President of Hazle Drugs, Inc., a retail pharmacy located in Hazleton, Pennsylvania. Age 68. Director since 1981.
EXECUTIVE OFFICERS
The information relating to the officers of the Company is incorporated herein by reference to the section captioned "Executive Officers" in Part 1 of this Annual Report on Form 10-K.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors, and persons who own more than 10% of any registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Executive officers, directors and greater than 10% stockholders are required by regulation to furnish the Company with copies of all Section 16(a) reports they file.
Based solely on its review of the copies of the reports it has received and written representations provided to the Company from the individuals required to file the reports, the Company believes that each of its executive officers and directors has complied
with applicable reporting requirements for transactions in Company common stock during the fiscal year ended September 30, 2004, with the exception of one late report by Mr. Schlitzer with regard to shares issued to him in connection with the acquisition of Higgins.
CODE OF CONDUCT
The Company has adopted a Code of Conduct that is designed to promote the highest standards of ethical conduct by the Company's directors, executive officers and employees. The Code of Conduct requires that the Company's directors, executive officers and employees avoid conflicts of interest, comply with all laws and other legal requirements, conduct business in an honest and ethical manner and otherwise act with integrity and in the Company's best interest. Under the terms of the Code of Conduct, directors, executive officers and employees are required to report any conduct that they believe in good faith to be an actual or apparent violation of the Code of Conduct. In addition, the Company has adopted a Code of Ethics for Financial Professionals.
As a mechanism to encourage compliance with the Code of Conduct and Code of Ethics for Financial Professionals, the Company has established procedures to receive, retain and address complaints received regarding accounting, internal accounting controls or auditing matters. These procedures ensure that individuals may submit concerns regarding questionable accounting or auditing matters in a confidential and anonymous manner. The Code of Conduct also prohibits the Company from retaliating against any director, executive officer or employee who reports actual or apparent violations of the Code of Conduct.
A copy of the Code of Conduct and Code of Ethics for Financial Professionals is available, without charge, upon written request to Jerry D. Holbrook, Corporate Secretary, Northeast Pennsylvania Financial Corp., 12 E. Broad Street, Hazleton, Pennsylvania 18201.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following information is furnished for the chief executive officer and the other executive officers of the Company and its subsidiaries who received salary, commissions and bonus of $100,000 or more during the fiscal year ended September 30, 2004. The table does not include certain additional benefits, the aggregate amount of which do not exceed 10% of salary and bonus for the named executive officers.
- ---------- (1) Includes directors' fees for Messrs. Petro, Kennedy and Schlitzer.
(2) Reflects 13,000, 2,000, 0, 3,000 and 1,000 shares of restricted stock granted to Messrs. Petro, Kennedy, Schlitzer, Holbrook and Loftus, respectively. The dollar amount set forth in the table represents the market value of the shares on the date of grant. The restricted stock awards vest in three equal annual installments commencing on the first anniversary of the date of grant. When shares become vested and are distributed from the trust in which they are held, the recipient will also receive an amount equal to accumulated cash and stock dividends (if any) paid with respect thereto, plus earnings thereon. The number and value of all unvested shares of restricted stock held by each named executive officer as of September 30, 2004 is as follows:
NUMBER OF VALUE OF UNVESTED SHARES UNVESTED SHARES --------------- --------------- Mr. Petro 13,000 $ 214,630 Mr. Kennedy 2,000 33,020 Mr. Schlitzer -- -- Mr. Holbrook 3,000 9,530 Mr. Loftus 1,000 16,510
(3) Details of the amounts reported in the All Other Compensation column for 2004 is provided in the table below.
(4) Mr. Petro became affiliated with the Company when he was named Executive Vice President and Chief Operating Officer on June 16, 2003. He was appointed President and Chief Executive Officer on September 13, 2003. (5) Includes $85,720 in deferred compensation payments to Mr. Kennedy during 2004. (6) Includes $270,864, $235,426 and $263,900 in sales commissions for fiscal 2004, 2003 and 2002, respectively. Also includes $49,857 in deferred compensation payments during fiscal 2004. (7) Mr. Holbrook joined the Company on September 15, 2003.
EMPLOYMENT AGREEMENTS
The Company and the Bank maintain an employment agreement with each of Mr. Petro and Mr. Kennedy and Higgins maintains an employment agreement with Mr. Schlitzer. The employment agreements are intended to ensure that the Company, the Bank and Higgins will be able to maintain a stable and competent management base. The continued success of the Company, the Bank and Higgins depends to a significant degree on the skills and competence of Messrs. Petro, Kennedy and Schlitzer.
The Company and Bank employment agreements provide for twelve month terms for each executive, while the Higgins employment agreement provides for a four-year term. The terms of the employment agreements are renewable annually. The Company and Bank employment agreements provide for a base salary of $214,500 for Mr. Petro and $156,768 for Mr. Kennedy. In addition to the base salary, the Company and Bank employment agreements provide for, among other things, participation in stock benefit plans and other fringe benefits applicable to similarly-situated executive personnel. The Higgins employment agreement provides that Mr. Schlitzer will receive $50,000 in base salary plus sales commissions and other fringe benefits applicable to similarly-situated executive personnel.
The employment agreements provide for termination for cause, as defined in the employment agreements, at any time. If the executive's employment is terminated for reasons other than for cause, or if the executive resigns after specified circumstances that would constitute constructive termination, the executive, or if the executive dies, his or her beneficiary, would be entitled to receive a severance payment. Under Mr. Petro's employment agreement, the payment would be equal to six months of base salary if the termination occurs during the first year of the agreement, one year of base salary if such termination occurs during the second year of the agreement and two years of base salary thereafter. Under Mr. Kennedy's agreement, the payment would be equal to two years of base salary. Mr. Schlitzer will receive an amount equal to the remaining payments due to him and the contributions that would have been made on his behalf to any employee benefit plans during the remaining term of the employment agreement. The Company and Bank employment agreements restrict each executive's right to compete against the Bank or the Company for one year from the date of termination of the agreement (six months in the case of Mr. Petro if he is terminated within the first year of the employment agreement) if his employment is terminated without cause, except if termination follows a change in control. The Higgins employment agreement restricts Mr. Schlitzer's right to compete with Higgins for two years from the expiration of the agreement.
Under the Company and the Bank and Higgins employment agreements, if involuntary or, under certain circumstances, voluntary termination follows a change in control, the executive, or if the executive dies, his or her beneficiary, would be entitled to a severance payment equal to the greater of: (1) the payments due for the remaining term of the agreement; or (2) three times the average of the three (five in the case of Higgins) preceding taxable years' annual compensation. The executive's life, health, and disability coverage would also continue for sixty and thirty-six months under the Company and the Bank and Higgins employment agreements, respectively.
All reasonable costs and legal fees paid or incurred by the executive pursuant to any dispute or question of interpretation relating to the Company and Bank employment agreements will be paid by the Company or the Bank, respectively, if the executive is successful on the merits pursuant to a legal judgment, arbitration or settlement. The Company and Bank employment agreements also provide that the Company and the Bank shall indemnify the executive to the fullest extent allowable under Delaware and federal law, as applicable.
The Bank maintains an employment agreement with Mr. Holbrook. The agreement provides for a twelve month term, renewable annually. The employment agreement also provides for a base salary of $185,000 per year, as well as participation in stock benefit plans and other fringe benefits applicable to senior executives of the Bank.
The Bank may terminate Mr. Holbrook's employment for cause at any time. If Mr. Holbrook's employment is terminated for reasons other than cause, or if he resigns after special circumstances that would constitute constructive termination (as defined in the agreement), he would be entitled to a severance payment of six months of base salary during the first year of the employment agreement and one year of base salary thereafter. Mr. Holbrook will also receive continued life and disability coverage for the remaining term of his agreement.
If involuntary or, under certain circumstances, involuntary termination follows a change in control, Mr. Holbrook would receive the greater of payments due to him for the remaining term of the agreement or three (3) times his base salary (including incentive compensation) on the date of termination. However, the agreement limits payable upon a change in control to one dollar less than the maximum amount deductible by the Bank in accordance with Section 280G of the Internal Revenue Code.
The employment agreement restricts Mr. Holbrook's right to compete with the Bank for six months during the first year of the agreement or one year thereafter, unless termination follows a change in control. The agreement also provides for indemnification of the executive to the maximum extent permissible under applicable law.
CHANGE IN CONTROL AGREEMENT
First Federal maintains a change in control agreement with Leo R. Loftus, a Senior Vice President of First Federal. The change in control agreement will continue indefinitely until discontinued by the Board of Directors. If, following a change in control of the Company or First Federal, Mr. Loftus' employment is terminated for reasons other than for cause, or if Mr. Loftus voluntarily resigns upon the occurrence of circumstances specified in this agreement, Mr. Loftus will receive a severance payment under his agreement equal to one time his average annual compensation for the three most recent taxable years. First Federal will also continue Mr. Loftus' health and welfare benefit coverage for 24 months following his termination of employment.
RETIREMENT PLAN
The Bank participates in the Financial Institutions Retirement Fund (the "Retirement Plan") to provide retirement benefits for eligible employees. However, the accrual of benefits under the Retirement Plan was frozen as of October 1, 2003. Employees are generally eligible to participate in the Retirement Plan if they are 21 years old and have completed 12 consecutive months of employment with the Bank. Hourly paid employees are excluded from participating in the Retirement Plan. Benefits payable to a participant under the Retirement Plan are based on the participant's years of service and salary. The formula for normal retirement benefits payable annually under the Retirement Plan is 1% multiplied by years of benefit service multiplied by the participant's career average salary paid by the Bank. A participant may elect early retirement as early as age 45. However, such participant's normal retirement benefits will be reduced by an early retirement factor based on the participant's age at early retirement. Participants generally become 100% vested in the accrued benefits under the Retirement Plan following the completion of five years of service with the Bank, or when they turn 65, die or terminate employment due to a disability.
The following table sets forth the estimated annual benefits payable upon retirement at age 65 for the period ended September 30, 2004.
YEARS OF BENEFIT SERVICE CAREER AVERAGE -------------------------------------------------------------- COMPENSATION 15 20 25 30 35 - --------------- ---------- ---------- ---------- ---------- ---------- $ 75,000 $ 11,300 $ 15,000 $ 18,800 $ 22,500 $ 26,300 100,000 15,000 20,000 25,000 30,000 35,000 125,000 18,800 25,000 31,300 37,500 43,800 150,000 22,500 30,000 37,500 45,000 52,500 175,000 26,300 35,000 43,800 52,500 61,300 200,000 30,000 40,000 50,000 60,000 70,000 250,000 37,500 50,000 62,500 75,000 87,500 300,000 45,000 60,000 75,000 90,000 105,000 350,000 52,500 70,000 87,500 105,000 122,500
The benefits listed in the foregoing table for the Retirement Plan are not subject to a deduction for Social Security benefits or any other offset amount. As of September 30, 2004, Mr. Kennedy had 4 years, 10 months of credited service and Mr. Loftus had 4 years, 3 months of credited service. Messrs. Petro, Schlitzer and Holbrook do not participate in the Retirement Plan.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN
The Bank maintains a non-qualified supplemental executive retirement plan (the "SERP") to provide certain officers of the Bank and its affiliates, including the Company, with additional retirement benefits. The SERP is intended to make up benefits lost under the ESOP when a participant retires prior to the complete repayment of the ESOP loan. When a participant retires, the benefits under the SERP are determined by: (1) projecting the number of shares that would have been allocated to the participant under the ESOP if they had been employed throughout the period of the ESOP loan (measured from the participant's first date of ESOP participation) and reducing such number by the number of shares actually allocated to the participant's account under the ESOP; and (2) multiplying such number of shares by the average fair market value of the Company common stock over the preceding five years. Benefits under the SERP vest in five equal annual installments commencing as of the date of a participant's participation in the SERP. The vested portion of the SERP participant's benefits are payable to the participant upon retirement (as defined in the ESOP) or to the participant's beneficiary if the participant dies. As of September 30, 2004, only Mr. Kennedy participated in the SERP.
OPTION GRANTS IN LAST FISCAL YEAR
The following table lists all options granted to the executive officers named in the Summary Compensation Table (the "Named Executive Officers") during fiscal 2004 and contains certain information about the potential value of those options based upon certain assumptions as to the appreciation of the Company's common stock over the life of the option.
(1) The options granted will vest in three equal annual installments beginning on the first anniversary of the date of grant. The options granted will be immediately exercisable if the optionee terminates employment following a change in control of the Company, or due to death or disability. (2) The dollar gains under these columns result from calculations required by the Securities and Exchange Commission's rules and are not intended to forecast future price appreciation of the Company's common stock. It is important to note that options have value only if the price of the Company's common stock increases above the exercise price shown in the table during the effective option period. To realize the potential values set forth in the 5% and 10% columns in the table, the price per share of the Company's common stock would have to be approximately $30.54 and $48.63, respectively, as of the expiration date of the options granted in November 2003, and $29.09 and $46.32, respectively, as of the expiration date of the options granted in March 2004.
FISCAL YEAR-END OPTION VALUE
The named executive officers exercised no stock options during the fiscal year ended September 30, 2004. The following table provides certain information with respect to the number and value of shares of common stock represented by outstanding options held by the named executive officers as of September 30, 2004.
NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT FISCAL IN-THE-MONEY OPTIONS YEAR-END(#)(1) AT FISCAL YEAR-END($) --------------------------- --------------------------- NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE - ------------------- ----------- ------------- ----------- ------------- Thomas M. Petro 10,001 51,999 $ -- $ -- Thomas L. Kennedy 156,266 6,500 728,422 9,210 Joseph P. Schlitzer 39,360 -- 167,374 -- Jerry D. Holbrook 10,000 41,000 -- -- Leo R. Loftus 2,000 4,000 10,270 --
(1) Value of unexercised in-the-money stock options equals the market value of the shares covered by in-the-money options on September 30, 2004, less the option exercise price. Options are in-the-money if the market value of shares covered by the options is greater than the exercise price.
DIRECTORS' COMPENSATION
DIRECTORS' FEES. Under the 2004 stock plan each non-employee director was to receive stock options to purchase at least 500 shares of common stock and at least 500 shares of restricted stock in lieu of an annual retainer. However, due to execution of the merger agreement with KNBT, these payments will not be made in fiscal 2005.
OPTION GRANTS. On February 20, 2004, each non-employee director received stock options to acquire 500 shares of common stock at an exercise price of $17.781, the fair market value of the common stock on the date of grant. Additionally, on that date, each non-employee director received 500 shares of restricted stock. The options become exercisable and the shares of restricted stock vest on February 20, 2005.
ITEM 12.
ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
STOCK OWNERSHIP
The following table provides information as of December 20, 2004 with respect to persons believed by us to be the beneficial owners of more than 5% of our outstanding common stock based upon reports of beneficial ownership filed with the Securities and Exchange Commission. A person may be considered to beneficially own any shares of common stock over which he or she has, directly or indirectly, sole or shared voting or investing power.
(1) Includes 205,676 shares that have not been allocated to participants' accounts. Under the terms of the ESOP, the ESOP trustee will vote shares allocated to participants' accounts in the manner directed by participants. The ESOP trustee, subject to its fiduciary responsibilities, will vote unallocated shares and allocated shares for which no timely voting instructions are received in the same proportion as shares for which the trustee has received voting instructions from participant (2) The foundation's gift instrument requires that all shares of common stock held by the foundation be voted in the same ratio as all other shares of our common stock on all matters considered by stockholders. (3) Based on information in a Schedule 13D filed with the Securities and Exchange Commission on November 17, 2003. (4) See table on the following page for additional information regarding Messrs. Kennedy's and Schlitzer's beneficial ownership of common stock.
The following table provides information about the shares of our common stock that may be considered to be beneficially owned by each director or nominee for director of the Company, by the executive officers named in the Summary Compensation Table and by all directors and executive officers of the Company as a group as of December 20, 2004. A person may be considered to beneficially own any shares of common stock over which he or she has, directly or indirectly, sole or shared voting or investment power. Unless otherwise indicated, each of the named individuals has sole voting and investment power with respect to the shares shown.
- ---------- * Less than 1% of shares outstanding (1) Includes shares held under the ESOP, with respect to which the beneficial owner has voting but not investment power as follows: Mr. Kennedy--9,168 shares; Mr. Schlitzer--2,486 shares; and Mr. Loftus--2,957 shares. (2) Includes unvested shares of restricted stock held in trust, with respect to which the beneficial owner has voting but not investment power as follows: Ms. Ecker and Messrs. Haentjens, Hayden, Lavelle, Leib and Spear--500 shares; Mr. Holbrook--3,000 shares; Mr. Kennedy--2,000 shares; Mr. Petro--10,666 shares; and Mr. Loftus--1,000 shares. (3) Based on 3,975,799 common stock outstanding and entitled to vote as of December 20, 2004, plus for each person, the number of shares that such person may acquire within 60 days by exercising stock options. (4) Includes 14,329 shares owned by Ms. Ecker's spouse and 700 shares owned by Ms. Ecker's mother over which Ms. Ecker has power of attorney. (5) Includes 18,536 shares held by Mr. Leib's spouse. (6) Includes 2,245 shares held by Mr. Spear's spouse. (7) Includes 8,750 shares owned by Mr. Kennedy's spouse. (8) Includes 1,000 shares owned by Mr. Loftus' spouse.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information about Company common stock that may be issued upon exercise of options, warrants and rights under all of the Company's equity compensation plans as of September 30, 2004.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
TRANSACTIONS WITH MANAGEMENT
LOANS AND EXTENSIONS OF CREDIT. The recently enacted Sarbanes-Oxley Act generally prohibits loans by the Company to its executive officers and directors. However, the Act contains a specific exemption from such prohibition for loans by the Bank to its executive officers and directors in compliance with federal banking regulations restrictions on such loans. Federal regulations require that all loans or extensions of credit to executive officers and directors of insured institutions must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, except for loans made under programs generally available to all employees, and must not involve more than the normal risk of repayment or present other unfavorable features. The Bank is therefore prohibited from making any new loans or extensions of credit to executive officers and directors at different rates or terms than those offered to the general public, except for loans made pursuant to programs generally available to all employees. In addition, loans made to a director or executive officer in an amount that, when aggregated with all other loans to such person or his or her related interests, are in excess of the greater of $25,000 or 5% of the Bank's capital and surplus (up to a maximum of $500,000) must be approved in advance by a majority of the disinterested members of the Board of Directors.
OTHER TRANSACTIONS. Kennedy & Lucadamo, P.C., of which Thomas L. Kennedy is President, performs legal services for the Company and First Federal. In fiscal 2004, the Company and First Federal paid a total of $117,000 in legal fees to Kennedy & Lucadamo, P.C.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The following table sets forth the fees billed to the Company for the fiscal years ending September 30, 2004 and 2003 by KPMG LLP:
2004 2003 ---------- ---------- Audit fees $ 247,071 $ 325,173 Audit related fees (1) 36,875 157,687 Tax fees (2) 16,328 46,636 All other fees -- --
- ---------- (1) Audit related fees consists primarily of discussion and research of accounting issues, due diligence assistance, review of securities filings, issuance of consents and audits of financial statements of employee benefit plans. (2) Other non-audit related fees consisted of tax-related services.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
The following documents are filed as a part of this report
(1) Consolidated Financial Statements of the Company are included in Item 8 of this Form 10-K.
(2) All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or the notes thereto included in Item 8 of this Form 10-K.
(3) Exhibits
(a) The following exhibits are filed as part of this report.
2.1 Agreement and Plan of Merger dated December 8, 2004 by and between KNBT Bancorp, Inc. and Northeast Pennsylvania Financial Corp. (1) 3.1 Certificate of Incorporation of Northeast Pennsylvania Financial Corp. (2) 3.2 Bylaws of Northeast Pennsylvania Financial Corp. (3) 4.0 Form of Stock Certificate of Northeast Pennsylvania Financial Corp. (2) 10.1 Employment Agreement between Northeast Pennsylvania Financial Corp., First Federal Bank and Thomas M. Petro (4) 10.2 Employment Agreement between Northeast Pennsylvania Financial Corp., First Federal Bank and Thomas L. Kennedy (4) 10.3 Employment Agreement between Higgins Insurance Associates, Inc. and Joseph P. Schlitzer (5) 10.4 Amendment to Employment Agreement between Higgins Insurance Associates, Inc. and Joseph P. Schlitzer (4) 10.5 Employment Agreement between Northeast Pennsylvania Financial Corp., First Federal Bank and Jerry D. Holbrook (4) 10.6 Form of First Federal Bank Supplemental Executive Retirement Plan (4) 10.7 Form of Shareholder Agreement between KNBT and the directors of Northeast Pennsylvania Financial Corp. (1) 10.8 Northeast Pennsylvania Financial Corp. 1998 Stock-Based Incentive Plan (6) 10.9 Northeast Pennsylvania Financial Corp. 2000 Stock Option Plan (7) 10.10 Registration Rights Agreement, dated as of December 31, 2000, by and among Northeast Pennsylvania Financial Corp., James Clark, James McCann, Joseph Schlitzer and John W. Sink (8) 10.11 Termination and Release Agreement, dated December 8, 2004, by and among Northeast Pennsylvania Financial Corp., First Federal Bank, KNBT Bancorp, Inc. and Thomas L. Kennedy (1) 10.12 Termination and Release Agreement, dated December 8, 2004, by and among Northeast Pennsylvania Financial Corp., First Federal Bank, KNBT Bancorp, Inc. and Thomas M. Petro (1) 10.13 Termination and Release Agreement, dated December 8, 2004, by and among Northeast Pennsylvania Financial Corp., First Federal Bank, KNBT Bancorp, Inc. and Jerry D. Holbrook (1) 10.14 First Federal Bank Employee Severance Compensation Plan, as amended. 10.15 Northeast Pennsylvania Financial Corp. 2004 Stock Plan. (9) 10.16 Change in Control Agreement between First Federal Bank and Leo R. Loftus. 11.0 Statement regarding Computation of Per Share Earnings (See Notes to Consolidated Financial Statements) 21.0 Subsidiary information is incorporated by reference to "Part I - Subsidiaries" 23.0 Consent of KPMG LLP 31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certifications
- ---------- 1. Incorporated by reference into this document from the Exhibits to the Company's Form 8-K/A filed on December 16, 2004. 2. Incorporated herein by reference into this document from the Exhibits to the Form S- 1 Registration Statement, and any amendments thereto, Registration No. 333-43281 3. Incorporated herein by reference into this document from the Exhibits to the Company's Form 10-K/A for the year ended September 30, 2002. 4. Incorporated herein by reference into this document from the Exhibits to the Company's Form 10-K for the year ended September 30, 2003.
5. Incorporated herein by reference into this document from the Exhibits to the Company's Form 10-K for the year ended September 30, 2001. 6. Incorporated herein by reference into this document from the Proxy Statement for the 1998 Special Meeting of Stockholders dated September 9, 1998. 7. Incorporated herein by reference into this document from the proxy statement for the 2000 Annual Meeting of Stockholders dated December 20, 1999. 8. Incorporated herein by reference into this document from the Exhibits to the Company's Form 10-Q for the quarter ended March 31, 2002. 9. Incorporated herein by reference into this document from the Proxy Statement for the 2004 Annual Meeting of Stockholders dated January 15, 2004.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Northeast Pennsylvania Financial Corp.
By /s/ Thomas M. Petro December 29, 2004 ---------------------------------- Thomas M. Petro President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Thomas M. Petro December 29, 2004 - ------------------------------------- Thomas M. Petro President, Chief Executive Officer and Director (Principal Executive Officer)
/s/ Barbara Ecker December 29, 2004 - ------------------------------------- Barbara Ecker Director
/s/ R. Peter Haentjens, Jr. December 29, 2004 - ------------------------------------- R. Peter Haentjens, Jr. Director
/s/ George J. Hayden December 29, 2004 - ------------------------------------- George J. Hayden Director
/s/ Thomas L. Kennedy December 29, 2004 - ------------------------------------- Atty. Thomas L. Kennedy Chairman of the Board
/s/ John P. Lavelle December 29, 2004 - ------------------------------------- Honorable John P. Lavelle Director
/s/ Michael J. Leib December 29, 2004 - ------------------------------------- Michael J. Leib Director
/s/ William J. Spear December 29, 2004 - ------------------------------------- William J. Spear Director
/s/ Joseph Schlitzer December 29, 2004 - ------------------------------------- Joseph Schlitzer Director
/s/ Jerry D. Holbrook December 29, 2004 - ------------------------------------- Jerry D. Holbrook Chief Financial Officer and Secretary (Principal Accounting and Financial Officer)