Item 1. Business
Sky Financial Group, Inc. (Sky Financial) is a $17.7 billion financial holding company headquartered in Bowling Green, Ohio that owns one commercial bank primarily engaged in commercial and consumer banking business at over 330 financial centers and over 400 ATMs located in Ohio, western Pennsylvania, central Indiana, southern Michigan, and northern West Virginia. Sky Financial also operates businesses relating to insurance, trust and other related financial services.
On December 20, 2006, Sky Financial Group and Huntington Bancshares Incorporated (Huntington) announced the signing of a definitive agreement to merge the two companies in a stock (90%) and cash (10%) transaction valued at approximately $3.6 billion. Under the terms of the agreement, Sky Financial Group shareholders will receive 1.098 shares of Huntington common stock, on a tax-free basis, and a taxable cash payment of $3.023 for each share of Sky Financial Group. The merger was unanimously approved by both companies’ boards of directors and is expected to close early in the 2007 third quarter, pending customary regulatory approvals, as well as the approval of Huntington’s and Sky Financial Group’s shareholders.
Since 2005, Sky Financial has completed the following acquisitions:
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On November 15, 2006, Sky Financial acquired Wells River Bancorp, Inc. and its wholly-owned subsidiary Perpetual Savings Bank, a $71 million bank that operated three full-service branches in Columbiana County, Ohio.
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On October 17, 2006, Sky Financial acquired Union Federal Bank of Indianapolis and its parent company, Waterfield Mortgage Company, Inc., Ft. Wayne, Indiana. Sky Financial purchased Waterfield’s retail and commercial banking business conducted primarily through Union Federal Bank, which added approximately $2.3 billion in assets. Sky Financial also acquired Waterfield Insurance as a part of the transaction.
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On September 30, 2006, Sky Financial acquired Lindig Benefits Consultants located in Worthington, Ohio.
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On January 3, 2006, Sky Financial acquired the Peter B. Burke Agency, Inc. located in Pittsburgh, Pennsylvania.
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On November 29, 2005, Sky Financial acquired Falls Bank, an $80 million bank that operated two full-service branches in the Akron, Ohio market.
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On October 4, 2005, Sky Financial acquired Becker-McDowell Agency, Inc. and Steiner Insurance Agency, Inc., both located in Wooster, Ohio.
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On August 1, 2005, Sky Financial acquired B.K.M.’s Benefit Design Agency of Ohio, Inc., located in Findlay, Ohio.
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On June 1, 2005, Sky Financial acquired Belmont Bancorp, a $297 million bank holding company headquartered in St. Clairsville, Ohio, and its wholly-owned subsidiary, Belmont National Bank.
The Holding Company
Sky Financial’s corporate philosophy is to operate as a locally-oriented, community-based financial service organization, augmented by centralized support in select critical areas. This local market orientation is reflected in its financial centers and regional advisory boards comprised of local business persons, professionals and other community representatives that assist the bank in responding to local banking needs. Sky Financial’s bank subsidiary concentrates on client service and business development, while relying upon the support of Sky Financial for operational functions that are not readily visible to clients and those that are critical to risk management. Asset quality review, mortgage banking activities, financial reporting, investment activities, internal audit, compliance and funds management are among the functions that are overseen at the holding company level.
Sky Financial’s market area is economically diverse, with a base of manufacturing, service, transportation and agriculture industries, and thus Sky Financial is not dependent upon any single industry or employer. Similarly, Sky Financial’s client base is diverse. The company and its subsidiaries are not dependent upon any single industry or upon any single client.
Sky Financial’s strategic plan includes organically growing loans and deposits from a focused sales and service culture, increasing fee-based income, strengthening organizational synergies to manage operating costs, maintaining strong asset quality and acquiring financial institutions, branches and financial service businesses. Sky Financial has sought acquisition partners, which have experienced management, and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services.
There is significant competition among commercial banks in Sky Financial’s market area. As a result of the deregulation of the financial services industry, Sky Financial also competes with other providers of financial services such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, insurance agencies, commercial finance and leasing companies, the mutual funds industry, full-service brokerage firms and discount brokerage firms. Some of the company’s competitors, including certain regional bank holding companies, which have made acquisitions in Sky Financial’s market area, have greater resources than those of Sky Financial, and as such, may have higher lending limits and may offer other services not available through the company’s bank and non-bank subsidiaries. The bank and non-bank subsidiaries compete on the basis of rates of interest charged on loans, the rates of interest paid for funds, the availability of services and the responsiveness to the needs of its clients.
Sky Financial’s executive offices are located at 221 South Church Street, P.O. Box 428, Bowling Green, Ohio, and its telephone number is 419-327-6300.
The Bank Subsidiary
Sky Bank, headquartered in Salineville, Ohio, had total assets of $17.5 billion at December 31, 2006, and operates financial centers in Ohio, western Pennsylvania, southern Michigan, central Indiana and northern West Virginia. Sky Bank engages in commercial and consumer banking, including the acceptance of a variety of demand, savings and time deposits and the extension of commercial and consumer loans. Perpetual Savings Bank merged with Sky Bank on December 8, 2006, and Union Federal Bank of Indianapolis was merged into Sky Bank on November 3, 2006.
The Financial Services Subsidiaries
Sky Trust, National Association (Sky Trust), a wholly-owned subsidiary of Sky Financial, is headquartered in Pepper Pike, Ohio, and provides a full range of trust and employee benefit services to its commercial and consumer clients.
Sky Insurance, Inc. (Sky Insurance), Maumee, Ohio, is Sky Financial’s full service insurance agency offering a variety of insurance products and services to its clients.
Sky Financial has various other subsidiaries that are not significant to the consolidated entity.
Competition
The financial services industry is highly competitive. Sky Financial and its subsidiaries compete with other local, regional and national financial service providers, such as other financial holding companies, commercial banks, savings associations, credit unions, finance companies, leasing companies, and brokerage and insurance firms. The financial services industry is likely to become more competitive as further technological advances enable more companies to provide financial services on a more efficient and convenient basis.
Supervision and Regulation
Introduction
Sky Financial, its banking subsidiary and many of its non-banking subsidiaries, are subject to extensive regulation by federal and state agencies. The regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders. Although Sky Financial is recognized as a financial holding company, most regulations pertaining to bank holding companies also apply to it. As discussed in more detail below, this regulatory environment, among other things, may restrict Sky Financial’s ability to diversify into certain areas of financial services, acquire depository institutions in certain states and pay dividends on its capital stock. It may also require Sky Financial to provide financial support to its banking subsidiary, maintain capital balances in excess of those desired by management and pay higher deposit insurance premiums as a result of the deterioration in the financial condition of depository institutions in general.
Regulatory Agencies
Holding Company. Sky Financial is a financial holding company subject to regulation under the Bank Holding Company Act of 1956 (BHCA), as amended, and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System under the BHCA.
Subsidiary Bank. Sky Financial’s banking subsidiary is subject to regulation and examination primarily by the Ohio Division of Financial Institutions and the Federal Reserve Board and secondarily by the Federal Deposit Insurance Corporation (FDIC).
Financial Services Subsidiaries. Many of Sky Financial’s financial services subsidiaries also are subject to regulation by the Federal Reserve Board and other applicable federal and state agencies. Sky Financial’s insurance subsidiaries are subject to regulation by applicable state insurance regulatory agencies. Other non-bank subsidiaries of Sky Financial are subject to the laws and regulations of both the federal government and the various states in which they conduct business. Sky Trust, Sky Financial’s trust services affiliate, is regulated by the Office of the Comptroller of the Currency (OCC).
Securities and Exchange Commission (SEC) and NASDAQ. Sky Financial is also under the jurisdiction of the SEC and certain state securities commissions for matters relating to the offering and sale of its securities. Sky Financial is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. Sky Financial is listed on the NASDAQ Stock Market under the trading symbol “SKYF,” and is subject to the rules of NASDAQ for listed companies.
Bank Holding Company Activities
Interstate Banking. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal Act”), as amended, a bank holding company may acquire banks in states other than its home state, subject to certain limitations. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states.
Regulatory Approval. Under the BHCA, prior approval of the Federal Reserve Board is required for the acquisition of more than 5% of the voting stock of any bank. In determining whether to approve a proposed bank acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institution’s record of addressing the credit needs of the communities it serves, including the needs of low and moderate income neighborhoods, consistent with the safe and sound operation of the bank, under the Community Reinvestment Act of 1977.
Dividend Restrictions
Sky Financial is a legal entity separate and distinct from its subsidiary bank and other subsidiaries. Its principal source of funds to pay dividends on its common stock and service its debt is from dividends from its subsidiaries, primarily Sky Bank. Various federal and state statutory provisions and regulations limit the amount of dividends that Sky Bank may pay without regulatory approval. Dividends payable by a state chartered bank are limited to the lesser of the bank’s undivided profits and the bank’s retained net income for the current year plus its retained net income for the preceding two years (less any required transfers to capital surplus) up to the date of any dividend declaration in the current calendar year. As of December 31, 2006, $179,388 was available for distribution to Sky Financial as dividends without prior regulatory approval.
Federal bank regulatory agencies have the authority to prohibit Sky Bank from engaging in unsafe or unsound practices in conducting its business. The payment of dividends, depending on the financial condition of the bank, could be deemed an unsafe or unsound practice. The ability of Sky Bank to pay dividends in the future is currently influenced, and could be further influenced, by bank regulatory policies and capital guidelines.
Holding Company Structure
Transfer of Funds from Banking Subsidiary. Sky Financial’s banking subsidiary is subject to restrictions under federal law that limit the transfer of funds or other items of value from this subsidiary to Sky Financial and its non-banking subsidiaries, including affiliates, whether in the form of loans and other extensions of credit, investments and asset purchases or as other transactions involving the transfer of value from a subsidiary to an affiliate or for the benefit of an affiliate. Unless an exemption applies, these transactions by a banking subsidiary with a single affiliate are limited to 10% of the subsidiary bank’s capital and surplus and, with respect to all covered transactions with affiliates in the aggregate, to 20% of the subsidiary bank’s capital and surplus. Moreover, loans and extensions of credit to affiliates generally are required to be secured in specified amounts. A bank’s transactions with its non-bank affiliates are also generally required to be on arm’s-length terms.
Source of Strength Doctrine. Under current Federal Reserve Board policy, Sky Financial is expected to act as a source of financial and managerial strength to its subsidiary bank and, under appropriate circumstances, to commit resources to support such subsidiary bank. This support could be required at times when Sky Financial might not have the resources to provide it.
Capital loans from Sky Financial to its subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of Sky Financial’s bankruptcy, any commitment by Sky Financial to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Depositor Preference. The Federal Deposit Insurance Act provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including Sky Financial, with respect to any extensions of credit they have made to such insured depository institution.
Liability of Commonly Controlled Institutions. The deposits of Sky Bank are insured by the FDIC. FDIC-insured depository institutions can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC due to the default of an FDIC-insured depository institution controlled by the same bank holding company, or for any assistance provided by the FDIC to an FDIC-insured depository institution controlled by the same bank holding company that is in danger of default. “Default” means generally the appointment of a conservator or receiver. “In danger of default” means generally the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance.
Core (“Tier 1”) Capital
Supplementary (“Tier 2”) Capital
Market Risk (“Tier 3”) Capital
- Common equity
- Perpetual preferred stock not meeting the Tier 1 definition
- Qualifying mandatory convertible securities
- Qualifying subordinated debt
- Allowances for loan and lease losses, subject to limitations
- Recourse obligation on sold loan portfolios
- Qualifying unsecured subordinated debt
- Retained earnings
- Qualifying non-cumulative perpetual
preferred stock
- A limited amount of qualifying
cumulative perpetual stock at the
holding company level
- Minority interests in equity accounts of
consolidated subsidiaries
- Less goodwill, most intangible assets and certain other assets
Sky Financial, like other bank holding companies, currently is required to maintain Tier 1 capital and “total capital” (the sum of Tier 1, Tier 2 and Tier 3 capital) equal to at least 4% and 8%, respectively, of its total risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit). For a holding company to be considered “well capitalized” for regulatory purposes it’s Tier 1 and total capital ratios must be 6% and 10% on a risk-adjusted basis, respectively. At December 31, 2006, Sky Financial met both requirements, with Tier 1 and total capital equal to 10.0% and 12.0% of its respective total risk-weighted assets.
Federal Reserve Board, FDIC and state rules require Sky Financial to incorporate market and interest rate risk components into its risk-based capital standards. Under these market risk requirements, capital is allocated to support the amount of market risk related to a financial institution’s ongoing trading activities.
The Federal Reserve Board also requires bank holding companies to maintain a minimum “leverage ratio” (Tier 1 capital to adjusted total assets) of 3% if the holding company has the highest regulatory rating and meets other requirements, or of 3% plus an additional “cushion” of at least 100 to 200 basis points (one to two percentage points) if the holding company does not meet these requirements. Sky Financial’s leverage ratio at December 31, 2006 was 8.5%.
The Federal Reserve Board may set capital requirements higher than the minimums described above for holding companies whose circumstances warrant it. For example, holding companies experiencing or anticipating significant growth may be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. The Federal Reserve Board has also indicated that it will consider a “tangible Tier 1 capital leverage ratio” (deducting all intangibles) and other indications of capital strength in evaluating proposals for expansion or new activities.
Sky Bank is subject to similar risk-based and leverage capital requirements adopted by the Federal Reserve Board. Sky Financial’s management believes that Sky Bank meets all capital requirements to which it is subject.
Failure to meet capital requirements could subject a bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC, and to restrictions on its business, which are described under the next paragraph.
Federal Deposit Insurance Corporation Improvement Act of 1991. The Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), among other things, identifies five capital categories for insured depository institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. It requires U.S. federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements based on these categories. The FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Unless a bank is well capitalized, it is subject to restrictions on its ability to
offer brokered deposits and on other aspects of its operations. The FDICIA generally prohibits a bank from paying any dividend or making any capital distribution or paying any management fee to its holding company if the bank would thereafter be undercapitalized. An under-capitalized bank must develop a capital restoration plan, and its parent holding company must guarantee the bank’s compliance with the plan up to the lesser of 5% of the bank’s assets at the time it became undercapitalized and the amount needed to comply with the plan.
As of December 31, 2006, Sky Financial believes that its bank subsidiary was well capitalized, based on the prompt corrective action ratios and guidelines described above. A bank’s capital category is determined solely for the purpose of applying the prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
Deposit Insurance Assessments
The FDIC insures the deposits of Sky Financial’s depository institution subsidiary up to prescribed limits for each depositor. The amount of FDIC assessments paid by each Bank Insurance Fund (BIF) member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category. An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.
The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis. An increase in the assessment rate could have a material adverse effect on Sky Financial’s earnings, depending on the amount of the increase. The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for Sky Bank could have a material adverse effect on Sky Financial’s earnings.
Fiscal and Monetary Policies
Sky Financial’s business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. Sky Financial is particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the Federal Reserve are: (a) conducting open market operations in United States government securities; (b) changing the discount rates of borrowings of depository institutions; (c) imposing or changing reserve requirements against depository institutions’ deposits: and (d) imposing or changing reserve requirements against certain borrowing by banks and their affiliates. These methods are used in varying degrees and combinations to affect directly the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the Federal Reserve Board have a material effect on the earnings of Sky Financial.
Privacy Provisions of Gramm-Leach-Bliley Act
Under Gramm-Leach-Bliley Act (GLB Act), federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to non-affiliated third parties. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 contains important requirements for public companies in the area of financial disclosure and corporate governance. In accordance with section 302(a) of the Sarbanes-Oxley Act, written certifications by Sky Financial’s chief executive officer and chief financial officer are required. These certifications attest that Sky Financial’s quarterly and annual reports filed with the SEC do not contain any untrue statement of a material fact. Sky Financial has also implemented a program designed to comply with Section 404 of the Sarbanes-Oxley Act, which includes the identification of significant processes and accounts, documentation of the design of control effectiveness over process and entity level controls, and testing of the operating effectiveness of key controls. Also, in response to the Sarbanes-Oxley Act, Sky Financial adopted a series of procedures to improve its corporate governance practices. One of these actions included the formation of a Financial Disclosure Committee whose members include the chief executive officer, the chief financial officer and other Sky Financial officers. Sky Financial also requires signed certifications from managers who are responsible for internal controls throughout Sky Financial as to the integrity of the information they prepare. These procedures supplement Sky Financial’s Code of Ethics policies and procedures that have previously been in place. See Item 9A “Controls and Procedures” for Sky Financial’s evaluation of its disclosure controls and procedures.
Future Legislation
Various legislation, including proposals to change substantially the financial institution regulatory system and to expand or contract the powers of banking institutions and bank holding companies, is from time to time introduced in Congress. This legislation may change banking statutes and the operating environment of Sky Financial and its subsidiaries in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions and other financial institutions. Sky Financial cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it, or any implemented regulations, would have on the financial condition or results of operations of Sky Financial or any of its subsidiaries.
To the extent that the previous information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the full text of those provisions. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Sky Financial could have a material effect on the business of Sky Financial.
In addition, see the information contained in Note 21 “Regulatory Matters” in this Form 10-K.
Employees
As of December 31, 2006, Sky Financial and its subsidiaries had approximately 4,369 full-time equivalent employees. Sky Financial and its subsidiaries consider their employee relations to be good. None of the employees are covered by a collective bargaining agreement.
Available Information
Sky Financials’ Internet address is www.skyfi.com. We have made available free of charge on or through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such material was electronically filed with, or furnished to the SEC. Materials that Sky Financial files with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. This information may also be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. Sky Financial will provide a copy of any of the foregoing documents to stockholders upon request.
Certain Statistical Information Regarding Sky Financial
Certain financial and statistical information relative to Sky Financial as required under the SEC’s Industry Guide 3, “Statistical Disclosure By Bank Holding Companies,” and related discussion is incorporated by specific references from the indicated pages of this Form 10-K.
Item 1A.
Item 1A. Risk Factors
Interest Rate Risk
Changes in interest rates could adversely affect our earnings and financial condition.
Our earnings and financial condition are dependent to a large degree upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. The narrowing of interest-rate spreads, meaning the difference between the interest rates earned on loans and investments and the interest rates paid on deposits and borrowings, could adversely affect our earnings and financial condition.
Interest rates are highly sensitive to many factors, including:
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The rate of inflation;
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The rate of economic growth;
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Employment levels;
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Monetary policies; and
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Instability in domestic and foreign financial markets.
Changes in market interest rates will also affect the level of voluntary prepayments on our loans and the receipt of payments on our mortgage-backed securities resulting in the receipt of proceeds that may be reinvested at a lower rate than the loan or mortgage-backed security being prepaid.
We originate residential loans for sale and for our portfolio. The origination of loans for sale is designed to meet client financing needs and earn fee income. The origination of loans for sale is highly dependent upon the local real estate market and the level and trend of interest rates. Increasing interest rates may reduce the origination of loans for sale and consequently the fee income we earn. While our commercial banking, construction and income property business lines are an increasing portion of our activities, high interest rates may reduce our mortgage-banking activities and thereby our income. In contrast, decreasing interest rates have the effect of causing clients to refinance mortgage loans faster than anticipated. This causes the value of assets related to the servicing rights on loans sold to be lower than originally anticipated. If this happens, we may need to write down our servicing assets faster, which would accelerate our expense and lower our earnings.
Government Policies
Our business may be adversely affected by changes in government policies.
The earnings of banks and bank holding companies such as Sky Financial are affected by the policies of regulatory authorities, including the Federal Reserve Board, which regulates the money supply. Among the methods employed by the Federal Reserve Board are open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These methods are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve Board have had a significant affect on the operating results of commercial and savings banks in the past and are expected to continue to do so in the future.
The banking industry is highly regulated and changes in federal and state banking regulations as well as policies and administration guidelines may affect Sky Financial’s practices and growth prospects.
Credit Risk
Our earnings and reputation may be adversely affected if we fail to effectively manage our credit risk.
Originating and underwriting loans are integral to the success of our business. This business requires us to take “credit risk,” which is the risk of losing principal and interest income because borrowers fail to repay loans.
Collateral values and the ability of borrowers to repay their loans may be affected at any time by factors such as:
n A downturn in the local economies in which we operate or the national economy;
n A downturn in one or more of the business sectors in which our customers operate; or
n A rapid increase in interest rates.
Competition
Strong competition within our market area may reduce our ability to attract and retain deposits and originate loans.
We face competition both in originating loans and in attracting deposits. Competition in the financial services industry is intense. We compete for clients by offering excellent service and competitive rates on our loans and deposit products. The type of institutions we compete with include commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, mutual funds, insurance companies and brokerage and investment banking firms. As a result of their size and ability to achieve economies of scale, certain of our competitors offer a broader range of products and services than we offer. In addition, to stay competitive in our markets, we may need to adjust the interest rates on our products to match the rates offered by our competitors, which could adversely affect our net interest margin. As a result, our profitability depends upon our continued ability to successfully compete in our market areas while achieving our investment objectives.
Economy
Our business may be adversely affected by downturns in the local economies on which we depend.
Our loan portfolio is concentrated primarily in the northern and central Ohio regions, the southeast Michigan region, the central Indiana region, the western Pennsylvania region and the northern West Virginia region. Our profits depend on providing products and services to clients in these local regions. An increase in unemployment, a decrease in real estate values or continued increases in interest rates could weaken the local economies in which we operate. Weakness in our market area could depress our earnings and consequently our financial condition because:
n Clients may not want or need our products and services;
n Borrowers may not be able to repay their loans;
n The value of the collateral securing our loans to borrowers may decline; and
n The quality of our loan portfolio may decline.
Integration Risk
We may not be able to achieve the expected integration and cost savings from our ongoing bank acquisition activities.
We have a long history of acquiring financial institutions and we expect this acquisition activity to continue in the future. Difficulties may arise in the integration of the business and operations of the financial institutions that agree to merge with and into Sky Financial and its affiliates and, as a result, we may not be able to achieve the cost savings and synergies that we expect will result from the merger activities. Achieving cost savings is dependent on consolidating certain operational and functional areas, eliminating duplicative positions and terminating certain agreements for outside services. Additional operational savings are dependent upon the integration of the banking businesses of the acquired financial institution with that of Sky Financial, including the conversion of the acquired entity’s core operating systems, data systems and products to those of Sky Financial and the standardization of business practices. Complications or difficulties in the conversion of the core operating systems, data systems and products of these other banks to those of Sky Financial may result in the loss of clients, damage to our reputation within the financial services industry, operational problems, one-time costs currently not anticipated by us and/or reduced cost savings resulting from the merger activities.
Acquisition Risk
We may have difficulty in the future to continue to grow through acquisitions.
Any future acquisitions or mergers by Sky Financial or its banking subsidiaries are subject to approval by the appropriate federal and state banking regulators. The banking regulators evaluate a number of criteria in making their approval decisions, such as:
n Safety and soundness guidelines;
n Compliance with all laws including the USA Patriot Act of 2001, the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, the Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated under such Act or the Exchange Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Community Reinvestment Act, the Home Mortgage Disclosure Act and all other applicable fair lending laws and other laws relating to discriminatory business practices; and
n Anti-competitive concerns with the proposed transaction.
If the banking regulators or a commenter on our regulatory application raise concerns about any of these criteria at the time a regulatory application is filed, the banking regulators may deny, delay or condition their approval of a proposed transaction.
We have grown, and intend to continue to grow, through acquisitions of banks and other financial institutions. After these acquisitions, we may experience adverse changes in results of operations of acquired entities, unforeseen liabilities, asset quality problems of acquired entities, loss of key personnel, loss of clients because of change of identity, difficulties in integrating data processing and operational procedures and deterioration in local economic conditions. These various acquisition risks can be heightened in larger transactions.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Sky Financial’s executive offices are located in Bowling Green, Ohio. Sky Bank operates over 330 financial centers, of which substantially all are owned. Also, the information contained in Note 5 “Premises and Equipment” on page 48 of this Form 10-K is incorporated herein by reference in response to this item.
Item 3.
Item 3. Legal Proceedings
In re Commercial Money Center, Inc. Equipment Lease Litigation in the U. S. District Court for the Northern District of Ohio, Eastern Division, MDL Case No. 1:02-CV-16000
Between August 2000 and December 2001, Sky Bank and two of its predecessor banks provided financing to a commercial borrower and its affiliated entities for the purchase of six separate portfolios of commercial lease pools, and a warehouse line of credit to finance lease pools. These loans are secured by assignments of the payment streams from the underlying leases, surety bonds or insurance policies, and a limited guarantee from the sole member of the commercial borrower.
Upon default of these commercial loans, Sky Bank (and its predecessors) made demand for payment from Illinois Union Insurance Company (“IU”), RLI Insurance Company (“RLI”), and Royal Indemnity Company (“Royal”) under the relevant surety bonds and insurance policies. IU, RLI, and Royal (collectively, the “Sureties”) have failed to make the payments required under the surety bonds and insurance policies. As a result, in the spring of 2002, Sky and its predecessors filed suit against each of the Sureties seeking to enforce Sky Bank’s rights under the surety bonds and insurance policies issued by the Sureties in connection with the commercial lease pools. Sky’s complaints claim breach of contract, bad faith and allege that the Sureties are liable for the payments due to Sky under the terms of the bonds and are estopped from asserting fraud as a defense to paying any claims under the bonds. In October 2002, the suits were consolidated for pretrial purposes with more than 35 other lawsuits involving similar claims in the United States District Court for the Northern District of Ohio, Eastern Division, under the Federal Multi-district Litigation (“MDL”) Rules.
The key defense of the Sureties in denying Sky Bank’s claims under the surety bonds is that they were fraudulently induced by the originator of the commercial leases to issue the surety bonds in the first instance. The Sureties have also asserted related defenses that the underlying equipment leases are invalid, usurious, or otherwise unenforceable. Sky Bank believes that none of these defenses can defeat Sky Bank’s claims under the surety bonds, which, in the view of Sky Bank, provide for absolute and unconditional guarantees of payment. Moreover, Sky Bank believes that the Sureties are responsible to Sky Bank, as the Obligee or Named Insured under the bonds, for the underwriting of the lessees and leases, including all issues of fraud, and that the Sureties waived any defense of fraud to claims under the bonds.
On December 21, 2005, Sky Financial sold and assigned to a third party, without recourse, all of its rights and interests in three loans secured by commercial lease pools and surety bonds issued by Royal. On March 31, 2006, Sky Financial and IU settled in full its litigation pertaining to two loans secured by pools of leases and insurance policies issued by IU. The aggregate principal balance of the three loans sold to a third party and the two loans which were settled was $14.2 million, and the aggregate proceeds received by Sky Financial in the sale and the settlement was $14.9 million.
With respect to the remaining pool and the warehouse line of credit secured by surety bonds issued by RLI, which has a remaining principal balance of $15.4 million, Sky Financial has amended its complaint and is proceeding with pretrial discovery and motion practice in the MDL court in anticipation of trial.
Sky Financial has reviewed the relevant matters of fact and law with its special counsel and believes that it has substantial and meritorious claims against the remaining Surety. Sky Financial has and will continue to vigorously assert all the rights and remedies available to it to obtain payment under the bonds. While the ultimate outcome of this matter cannot be determined at this time, Sky Financial management does not believe that the outcome of these pending legal proceedings will materially effect the consolidated financial position or results of operations of Sky Financial.
American Home Mortgage Corp. v. Union Federal Bank of Indianapolis, Case No. 06-CV-7864 (JGK) (RLE), U.S. District Court for the Southern District of New York
Prior to its acquisition by Sky Financial, Waterfield Mortgage Company, Incorporated (“Waterfield”) sold its mortgage banking business to American Home Mortgage Corp. (“American Home”). As part of the sale agreement, an escrow in the amount of $55 million was established and any purchase price adjustment associated with the sale of the mortgage banking business was to be deducted from the escrow. Waterfield and American Home were unable to reach agreement as to the purchase price adjustment, and American Home filed the captioned lawsuit against Waterfield’s subsidiary, Union Federal Bank of Indianapolis, for breach of contract, negligent misrepresentation and declaratory and injunctive relief, and has made a claim for relief in excess of $29 million.
Sky Financial completed its acquisition of Waterfield on October 17, 2006, and as a result, has become a party in interest in the litigation. Sky Financial, in conjunction with the former shareholders of Waterfield to the extent of their respective interests in the escrow, have filed, inter alia, a motion to dismiss the action as well a motion to substitute the entity representing Waterfield shareholders in place of Union Federal Bank as the party in interest in the litigation.
After consultation with special counsel, Sky Financial believes that it has substantial and meritorious defenses and that exposure, if any, should be absorbed by the escrow, and as such is not expected to have a material effect on the consolidated financial position or results of operations of Sky Financial.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None
Executive Officers of the Registrant
The following table sets forth the names and ages and business experience of each of the executive officers of Sky Financial. Each executive officer of Sky Financial is appointed by the Board of Directors on an annual basis and serves at the pleasure of the Board.
Executive Officer
Age
Position With Company or Subsidiary and Experience
Officer Since*
Marty E. Adams
Chairman, President and Chief Executive Officer of Sky Financial; formerly President and Chief Operating Officer of Sky Financial and President and Chief Executive Officer of Sky Bank.
Frank J. Koch
Executive Vice President and Senior Credit Officer of Sky Financial, and Senior Credit Officer of Sky Bank.
W. Granger Souder, Jr.
Executive Vice President, General Counsel and Secretary of Sky Financial and Secretary of Sky Bank.
Gary M. Small
Corporate Executive Vice President for Community Banking; formerly Executive Vice President and Business Unit Coordinator for National City Bank.
Les V. Starr
Executive Vice President/Operations and Information Technology; formerly Senior Vice President and Director/Information Technology for Michigan National Bank.
Kevin T. Thompson
Executive Vice President and Chief Financial Officer of Sky Financial and Treasurer of Sky Bank.
Caren L. Cantrell
Division Executive Vice President and Chief Operations Officer; formerly Senior Vice President of Operations and Information Technology at Commercial Federal Bank; formerly Division EVP/Financial Services Operations of Sky Bank.
Zahid Afzal
Division Executive Vice President and Chief Technology Officer; formerly Senior Vice President and Chief Information Officer for Bank of America’s Consumer Banking Division.
Perry C. Atwood
Senior Vice President, Director of Sales of Sky Financial; formerly Director of Sales of Sky Bank.
Phillip C. Clinard
Senior Vice President/Change Management Officer of Sky Financial; formerly Senior Vice President of Mid Am Bank.
Thomas A. Sciorilli
Chief Human Resources Officer of Sky Financial; formerly Senior Vice President/Human Resources and Administration of Penn National Insurance.
Curtis E. Shepherd
Senior Vice President/Marketing and Product Development of Sky Financial; formerly Executive Vice President, Retail and Marketing of Sky Bank-Ohio Bank Region; formerly Senior Vice President of Marketing of Ohio Bank.
Richard R. Hollington III
Regional President, Greater Cleveland Region; formerly Executive Vice President, Chief Executive Officer of Sky Trust and Corporate Director of Financial Services; formerly Senior Vice President/Integration Manager of Sky Financial.
John S. Gulas
President and Chief Executive Officer of Sky Trust; formerly Executive Vice President with UMB Financial Corporation; formerly Regional Managing Director of First Union Corporation.
* Includes period in which executive officer was an officer of a subsidiary or acquired company.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
The information contained in Note 2 on page 43 and Note 18 “Stock Options” on page 59 of this Form 10-K is incorporated herein by reference in response to this item. There were no repurchases of shares of Sky Financial stock during the fourth quarter of 2006.
Quarterly Common Stock Prices, Dividends and Yields
* Calculated on average traded price for the quarter.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
Dividend Restrictions
Sky Financial is a legal entity separate and distinct from its subsidiary bank and other subsidiaries. Its principal source of funds to pay dividends on its common stock and service its debt is from dividends from its subsidiaries, primarily Sky Bank. Various federal and state statutory provisions and regulations limit the amount of dividends that Sky Bank may pay without regulatory approval. Dividends payable by a state chartered bank are limited to the lesser of the bank’s undivided profits and the bank’s retained net income for the current year plus its retained net income for the preceding two years (less any required transfers to capital surplus) up to the date of any dividend declaration in the current calendar year. As of December 31, 2006, $179,388 was available for distribution to Sky Financial as dividends without prior regulatory approval.
Item 6.
Item 6. Selected Financial Data
(Dollars and shares in thousands, except per share data)
(1) The results of operations and financial condition have been affected by the completed acquisitions discussed further in Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.
Item 7. Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
The following discussion and analysis represents a review of Sky Financial Group, Inc.’s (Sky Financial) consolidated financial condition and results of operations. This review should be read in conjunction with the consolidated financial statements presented elsewhere in this report.
Business Summary
Sky Financial is a diversified financial holding company with its headquarters located in Bowling Green, Ohio. Sky Financial operates over 330 financial centers and over 400 ATMs serving communities in Ohio, Pennsylvania, Michigan, Indiana and West Virginia. Sky Financial’s financial service affiliates include: Sky Bank, commercial and retail banking; Sky Trust, asset management services; and Sky Insurance, retail and commercial insurance agency services.
Sky Financial has a specific strategic plan for delivering profitable growth. Sky Financial’s success is the result of five strategic priorities that guide decisions and focus corporate resources. These are: 1) Organic Growth; 2) Fee Income; 3) Organizational Synergies; 4) Asset Quality; and 5) Acquisitions.
The primary source of Sky Financial’s revenue is net interest income from loans and deposits, and fee income. Full year average balance sheet growth was again strong in 2006. This growth was a direct result of Sky Financial’s acquisitions and organic growth strategy. The net interest margin for 2006 reflected a difficult interest rate environment, primarily in the second half of the year. In addition, the early fourth quarter acquisition of Union Federal, which had a lower net interest margin, also reduced the net interest margin in 2006. These declines were partially offset by disciplined spread management and interest rate risk management practices as well as the mid-fourth quarter balance sheet restructuring activities. While higher interest rates continued to limit Sky’s mortgage banking business, fee income rose overall due particularly to increases in service charges, brokerage and insurance commissions and trust services income.
Huntington Merger
On December 20, 2006, Sky Financial and Huntington Bancshares Incorporated (Huntington) announced the signing of a definitive agreement to merge the two companies in a stock (90%) and cash (10%) transaction valued at approximately $3.5 billion. Under the terms of the agreement, Sky Financial shareholders will receive 1.098 shares of Huntington common stock, on a tax-free basis, and a taxable cash payment of $3.023 for each share of Sky Financial.
The merger was unanimously approved by both companies’ boards of directors and is expected to close early in the 2007 third quarter, pending customary regulatory approvals, as well as the approval of Huntington’s and Sky Financial’s shareholders.
Completed Acquisitions
On November 15, 2006, Sky Financial completed its acquisition of Wells River Bancorp, Inc. (Wells River) and its wholly-owned subsidiary, Perpetual Savings Bank, a $71.3 million bank that operates three full-service branches in Columbiana County. The aggregate purchase price was $10,992, including direct acquisition costs of $24. The acquisition of Wells River expands Sky Financial’s community banking business further in the eastern Ohio market. Wells River shareholders received approximately 178 shares of Sky Financial common stock and cash of $6,600.
On October 17, 2006, Sky Financial completed its acquisition of Union Federal Bank of Indianapolis (Union Federal) and its parent company, Waterfield Mortgage Company, Inc., Ft. Wayne, Indiana. Sky Financial purchased Waterfield’s retail and commercial banking business conducted primarily through Union Federal Bank, which added $2.3 billion in assets. Sky Financial also acquired Waterfield Insurance as part of the acquisition.
The aggregate purchase price was $332,195 including direct acquisition costs of $2,369. The acquisition of Union Federal expands Sky Financial’s Indiana presence into the growing Indianapolis market with the addition of 42 branches in this area. Waterfield Mortgage shareholders received approximately 7,467 shares of Sky Financial common stock and cash of $136,505.
After the close of business on September 30, 2006, Sky Financial acquired Lindig Benefits Consultants located in Worthington, Ohio for 44 shares of Sky Financial common stock and $104 in cash.
On January 3, 2006, Sky Financial acquired the Peter B. Burke Insurance Agency in Pittsburgh, Pennsylvania for 64 shares of Sky Financial common stock and $206 in cash.
On November 29, 2005, Sky Financial completed its acquisition of Falls Bank, an $80 million bank that operated two full-service branches in the Akron, Ohio market. The aggregate purchase price was $12,273, including direct acquisition costs of $36. The acquisition of Falls Bank expanded Sky Financial’s community banking business further into the Akron market. Falls Bank shareholders received 350 shares of Sky Financial common stock and cash of $2,348.
On October 4, 2005, Sky Financial acquired Becker-
McDowell Agency, Inc. and Steiner Insurance Agency, Inc., both located in Wooster, Ohio. Becker-McDowell was acquired for 222 shares of Sky Financial common stock and $580 in cash. Steiner Insurance Agency was acquired for 111 shares of Sky Financial common stock and $288 in cash.
On August 1, 2005, Sky acquired B.K.M.’s Benefit Design Agency of Ohio, Inc., located in Findlay, Ohio for 137 shares of Sky Financial common stock and $661 in cash.
On June 1, 2005, Sky Financial completed its acquisition of Belmont Bancorp, a $297 million bank holding company headquartered in St. Clairsville, Ohio, and its wholly-owned subsidiary, Belmont National Bank. The aggregate purchase price was $68,431, including direct acquisition costs of $37. Belmont had offices located in Belmont, Harrison and Tuscarawas counties in Ohio, and Ohio County in West Virginia. Belmont Bancorp shareholders received 1,765 shares of Sky Financial common stock and cash of $18,705.
On November 30, 2004, Sky Financial acquired Prospect Bancshares, Inc. and its wholly-owned subsidiary Prospect Bank, a $202 million savings bank headquartered in Worthington, Ohio, for 1,139 shares of Sky Financial common stock and $17,600 in cash.
On July 1, 2004, Sky Financial acquired Second Bancorp Incorporated, a $2.0 billion bank holding company, and its wholly-owned subsidiaries including The Second National Bank of Warren and the Stouffer-Herzog Insurance Agency, Inc., for 11,953 shares of Sky Financial common stock. Second National Bank was a commercial bank headquartered in Warren, Ohio and Stouffer-Herzog, a full-service insurance agency, was headquartered in Ashtabula, Ohio.
On April 1, 2004, Sky Financial acquired EOB, Inc. for 177 shares of Sky Financial common stock and $516 in cash. Headquartered in Canton, Ohio, this insurance company specialized in the sales and service of group benefits.
On January 5, 2004, Sky Financial acquired Spencer-Patterson Insurance Agency, Inc. a professional liability, personal and commercial insurance agency headquartered in Findlay, Ohio, for 297 shares of Sky Financial common stock and $793 in cash.
All of these acquisitions were accounted for under the purchase method of accounting and their results of operation have been included in Sky Financial’s results of operation from the dates of the acquisition.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Discontinued Operations
On March 31, 2004, Sky Financial completed the sale of its dental financing affiliate, Sky Financial Solutions. Sky Financial Solutions is reported as a discontinued operation. For the year ended December 31, 2005, Sky Financial recorded additional pre-tax gain of $572 for the adjustment of certain contingencies related to the sale. This gain was recorded as after-tax income from discontinued operations.
The consolidated financial statements for the period ended December 31, 2004 reflects the presentation of Sky Financial Solutions as a discontinued operation. Sky Financial Solutions results of operations included revenues of $39,356 and pre-tax net income of $29,503 for 2004.
Overview
Sky Financial’s 2006 results from continuing operations continued to show improvement as a result of lower credit losses compared to the previous year, strong performance from fee-based businesses, a gain on the sale of a business and higher net interest income as a result of acquisitions. These increases were partially offset by net losses on derivative instruments, lower net interest margin compared to the previous year and balance sheet restructuring in the fourth quarter of 2006. Despite disciplined net interest margin management, a difficult interest rate environment in the second half of 2006 compressed net interest spreads and reduced the net interest margin for the year compared to the prior year. In addition, the early fourth quarter acquisition of Union Federal, which had a lower net interest margin, also reduced the margin in 2006. These declines were partially offset by the mid-fourth quarter balance sheet restructuring activities, which should improve the net interest margin going forward. Earnings per diluted share from continuing operations for 2006 were slightly higher than 2005 due to higher net income, partially offset by higher average shares outstanding as a result of recent acquisitions. Expenses increased associated with acquisition growth, higher merger and integration expenses associated with two acquisitions late in 2006, and additional employee expenses incurred in the fourth quarter of 2006.
Growth in loans and deposits, the continued development of fee-based revenues, and discipline in expense controls all contributed to the earnings improvement. Also during 2006, Sky Financial sold a portion of its insurance business and realized an after-tax gain of $4,328. Partially offsetting these increases in 2006, Sky Financial restructured its balance sheet in the fourth quarter in order to strengthen capital ratios, maintain a sound interest rate risk position and enhance the net interest margin. This restructuring resulted in an after-tax charge of $9,617 recorded in the fourth quarter of 2006. In addition, Sky Financial recorded additional employee expenses during 2006 related to additional incentive compensation for completed acquisitions and the sale of a portion of the insurance business that resulted in after-tax charges of $2,650.
The results for the years 2005 and 2004 reflected significant expansion from the combination of acquisitions and organic growth, despite the challenges from a competitive industry. The 2005 results reflected growth in loans and deposits, the development of fee-based revenues and discipline in expense control, despite higher provision for credit losses. In 2004, earnings growth overcame a significant reduction in mortgage banking revenues from previous levels as a result of rising market interest rates.
In 2006, net income for Sky Financial was $190,338, or $1.72 per diluted share, up from $182,563 or $1.69 per diluted share in 2005, which was down from $194,355, or $1.93 per diluted share in 2004. Net income for 2005 included $372 of after-tax income from discontinued operations. Net income for 2004 was increased by after-tax income from discontinued operations of
$19,155, or $.19 per diluted share. In 2004, Sky Financial completed the sale of its dental finance business for an after-tax gain of $20,306, or $.20 per diluted share, which strengthened its liquidity and capital positions and provided greater focus on its core regional financial services businesses.
Income from continuing operations for 2006 was $190,338 or $1.72 per diluted share, compared with $182,191 or $1.69 per diluted share in 2005, and $175,200 or $1.74 per diluted share in 2004. Income for the years 2006 and 2005 include expenses for stock options, which reduced earnings by $.03 per diluted share for both years. Income from continuing operations for 2004 does not include expense related to stock options. In addition, Sky Financial’s results include the impacts of mergers and acquisitions, which added assets of $2.6 billion in 2006, $0.4 billion in 2005 and $2.2 billion in 2004 as detailed in Note 2 of the financial statements. Completing the acquisitions and divestitures as well as other organizational changes resulted in pre-tax merger, integration and restructuring charges of $6,575 in 2006, $1,771 in 2005 and $4,542 in 2004, as detailed in Note 16 of the financial statements.
Net interest income increased $26,894 in 2006, mostly due to the growth in assets from acquisitions and organic growth. The growth in assets was partially offset by a decrease in the net interest margin from 3.73% in 2005 to 3.69% in 2006 as a result of a difficult interest rate environment, primarily in the second half of 2006 and the fourth quarter acquisition of Union Federal, which had a lower net interest margin. The declines were partially offset by disciplined spread management and interest rate risk management practices. Non-interest income increased $7,488 or 3.5% in 2006. The growth in 2006 was driven by increases in service charges and fees on deposit accounts, trust service income, brokerage and insurance commissions, and a gain on the sale of an insurance business, which more than offset net securities losses of $21,184, primarily as a result of the balance sheet restructuring and an impairment on a security in the fourth quarter and net losses on derivative instruments. Provision for credit losses decreased $15,395 primarily due to a decrease in net credit losses as a percent of average loans to .34% in 2006 from .57% in 2005. The higher net charge-offs in 2005 were primarily from two large commercial credits and the sale of a group of non-performing consumer loans. Non-interest expenses increased in 2006 by $38,508 due to the acquisitions in 2006, higher stock-based compensation expense for retirement eligible employees, additional compensation expenses incurred related to acquisitions and higher merger and integration expenses in 2006.
In 2005, net interest income increased $63,341 over 2004 in part due to the growth in assets as well as an increase in the net interest margin from 3.69% to 3.73% as the benefits from rising short-term rates were partially offset by the flattening of the yield curve. Non-interest income increased $7,965 or 3.9% in 2005 over 2004. The growth in 2005 was driven by increases in service charges and fees on deposit accounts, trust service income, brokerage and insurance commission and transaction fees partially offset by a decline of $10,907 in net securities gains. Provision for credit losses increased $14,589 primarily due to an increase in net credit losses as a percent of average loans to .57% in 2005 from .37% in 2004. Non-interest expenses increased in 2005 by $43,523 in part due the adoption of FAS 123(R) and to the acquisitions of Belmont and Falls Banks in 2005 as well as the full year impact of the 2004 merger transactions partially offset by lower merger, integration and restructuring expenses.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Net Interest Income
Net interest income, the difference between interest income earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, is the most significant component of Sky Financial’s earnings.
Net interest income is affected by changes in the volumes, rates and composition of interest-earning assets and interest-bearing liabilities.
Table 2 summarizes net interest income and net interest margin for each of the three years ended December 31, 2006,
Sky Financial’s net interest income, on a fully tax-equivalent basis, of $544,699 in 2006 increased from $517,915 in 2005, which was up from $454,683 in 2004. The growth in net interest income was mainly due to the increase in average earning assets up 6.4% in 2006 after growing 12.6% in 2005. The 2005 increase was also due to the higher net interest margin in 2005 over 2004.
Table 3 reflects the components of Sky Financial’s net interest income for each of the three years ended December 31, 2006, setting forth: (i) average assets, liabilities and shareholders’ equity (ii) interest income earned on interest-earning assets and interest expense incurred on interest-bearing liabilities; (iii) average yields earned on interest-earning assets and average rates incurred on interest-bearing liabilities; (iv) the net interest rate spread (e.g., the average yield earned on interest-earning assets less the average rate incurred on interest-bearing liabilities); and (v) the net interest margin (e.g., net interest income divided by average interest-earning assets). Rates are computed on a tax-equivalent basis. Non-accrual loans have been included in the average loan balances. Certain amounts related to brokered deposits from prior year have been reclassified to conform to current year presentation.
The increase in average earning assets in both 2006 and 2005 was mostly in loans and reflected solid organic growth in addition to the earning assets acquired through mergers. In 2006, loans, which are Sky Financial’s highest yielding assets, comprised 78% of average earning assets in 2006 and 2005 and 77% in 2004. In funding asset growth, Sky Financial emphasizes growth in non-interest-bearing sources. As a percent of earning assets, interest-bearing liabilities were to 85.6% in 2006, 85.5% in 2005 and 86.0% in 2004. Sky Financial intends to continue to emphasize non-interest bearing liability growth in order to fund asset growth.
The net interest margin, on a fully tax-equivalent basis, was 3.69% in 2006, down 4 basis points compared to 3.73% in 2005, which was up from 3.69% in 2004. The lower net interest margin in 2006 from 2005 reflected a difficult interest rate environment in the second half of 2006, which compressed net interest spreads and reduced the net interest margin for the year compared to the prior year, despite disciplined net interest margin management. In addition, the early fourth quarter acquisition of Union Federal, which had a lower net interest margin, also reduced the margin in 2006. These declines were partially offset by the mid-fourth quarter balance sheet restructuring activities, which should improve the net interest margin going forward. The higher net interest margin performance in 2005 over 2004 reflected the benefits from rising short-term interest rates and prudent spread and interest rate risk management practices, despite the effects of the flattened yield curve and increasingly competitive markets.
During the fourth quarter of 2006, Sky Financial restructured its balance sheet to strengthen capital ratios, maintain a sound interest rate risk position and enhance the net interest margin following the completion of its recent acquisitions of Union Federal and Wells River. The restructuring actions resulted in a reduction in total assets, which included the sale of $506 million of available-for-sale, fixed-rate investment securities with an average yield of 3.74% and the elimination of federal funds sold coming from the Union Federal acquisition. With the sale proceeds, Sky Financial paid off $255 million of FHLB advances and $72 million of borrowings, with a combined average cost of 5.92% and reduced federal funds purchased. In addition to de-leveraging the balance sheet, these actions should improve the net interest margin and increase net interest income.
- Loan fees are included in interest income.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Net interest income may also be analyzed by segregating the volume and rate components of interest income and interest expense. Table 4 presents an analysis of increases and decreases in interest income and expense in terms of changes in volume
and interest rates during the three years ended December 31, 2006. The table is presented on a tax-equivalent basis. Certain amounts related to brokered deposits from prior year have been reclassified to conform to current year presentation.
Non-Interest Income
Total non-interest income in 2006 increased $7,488 from 2005, which was $7,965 higher than in 2004. The 2006 growth was driven by increases in service charges and deposit fee income, trust income, transaction fees and brokerage commissions. The continued growth reflects Sky Financial’s focus on growing its fee-based businesses, in addition to contributions from acquisitions. These increases were partially offset by the net effect of the following: (1) charges of $19,435 recorded as net securities gains (losses) related to the balance sheet restructuring; (2) a gain of $6,658 related to the sale of an insurance business; (3) net charges of $5,895 related to derivative losses on swaps; (4) net gains of $4,183 recorded as other income related to the balance sheet restructuring; (5) charges of $1,681 related to securities impairment; and (6) charges of $845 related to additional amortization expense from mortgage servicing rights.
During the second quarter 2006, Sky Financial identified and corrected immaterial accounting errors related to certain derivative hedging relationships. The misstatements related to Sky Financial’s interpretation and application of the “shortcut” method of hedge accounting under Statement No. 133. Sky Financial determined that these hedges did not qualify for hedge accounting using the “shortcut” method. As a result, changes in the market value of the derivatives should have been recorded through non-interest income with no corresponding offset to the hedged item. Sky Financial evaluated the impact of these errors and concluded that the impact was not material to prior
quarterly and annual periods. Accordingly, an adjustment was recorded in the second quarter of 2006 to correct the cumulative impact of these errors. The cumulative impact of these out-of-period adjustments resulted in a charge to non-interest income in the second quarter of 2006 of $9,930 ($6,603 after-tax), which is included in derivative gains (losses) on swaps in the Consolidated Statements of Income. During the third and fourth quarters of 2006, Sky Financial terminated the affected swaps and recorded gains of $4,158 recorded as a component of derivative (losses) gains on swaps and other income.
One of Sky Financial’s five strategic priorities is to increase its fee-based revenue. A component of this is to increase total non-interest income as a percentage of total revenue (net interest income, fully-tax equivalent plus non-interest income). In 2006, Sky Financial acheived solid increases in many fee-based revenues, but was unable to completely offset the balance sheet restructuring charges and derivative losses as the contribution of non-interest income remained steady at 29% in both 2006 and 2005. This ratio was 31% for 2004.
Mortgage banking income decreased $1,850 in 2006 after increasing $147 in 2005. On a component basis, in 2006 origination and sales revenue decreased $3,715, mortgage loan servicing income increased $290 and amortization and impairment charges decreased $2,614. The decline in mortgage banking income in 2006 versus 2005 related to a decrease in volume that was mostly offset by a shift from origination and sales revenue to increased servicing income and a decrease in amortization expense. In addition, a net decline of $1,039 relating to impairment recapture (charges) from 2005 also contributed to the overall decline. The overall stable mortgage banking income in 2005 versus 2004 related to a slight decrease in volume but a shift from origination and sales revenue to increased servicing income and a decrease in amortization expense along with an net improvement of $1,862 in impairment recapture (charges) over 2004. The overall increase in mortgage interest rates in 2006 led to an anticipated slow down in prepayment rates on mortgages, which added to the value of the servicing rights and lowered the amortization expense. During 2006, Sky Financial recorded impairment charges of $20 as compared to impairment recapture of $1,019 in 2005.
Brokerage and insurance commissions increased $8,222 or 14% in 2006 and $3,352 or 6% in 2005. Commissions on insurance products were up over 15% in 2006 and 5% in 2005 from organic growth of the core business and acquisitions. Property and casualty revenue was up over 22% year-over-year and revenue for employee benefits and life insurance products increased over 28% for the same period. Sky Financial acquired Waterfield Insurance, Peter B. Burke Insurance Agency and Lindig Benefits Consultants in 2006. In 2005, Sky Financial acquired Becker-McDowell Agency, Inc., Steiner Insurance Agency, Inc. and B.K.M.’s Benefit Design Agency of Ohio, Inc.
Service charges and fees on deposit accounts increased $12,137 in 2006 and $7,606 in 2005. The increase in both years reflected the benefits from growth in deposit accounts, both organic and through acquisition, and fee structure modifications. The organic growth in deposit accounts was largely driven by Sky Financial’s sales and service process, successful sales campaigns targeted to grow retail and commercial deposits and continued emphasis on cross-selling to broaden client relationships. Trust income, which continued to be impacted by changes in the equity markets as well as growth from acquisitions and new business, increased $2,361 or 11% in 2006 after increasing $3,637 or 20% in 2005. Trust assets under management rose to $5.7 billion at year-end 2006, up from $4.8 billion at year-end 2005 and $4.3 billion at the end of 2004. The 2006 growth was from both organic growth and acquisitions with approximately $306 million coming with the Union Federal acquisition.
For the year 2006, Sky Financial realized net losses on the sales and impairment of securities of $21,184 compared with net gains of $3,662 in 2005 and $14,569 in 2004. The 2006 net losses included $19,435 related to the balance sheet restructuring and a loss of $1,681 related to the impairment of a security. In 2005, the gains included $1,523 from the liquidation of approximately $10,299 of impaired investments. The gains in 2004 included $9,278 from the sale of bank equity holdings.
Other income for 2006 increased $17,399, which included an increase in transaction fees, the gain on the sale of an insurance business, the gains recorded as part of the early extinguishment of debt and higher gains on the sales of loans.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Non-Interest Expense
Total non-interest expense increased $38,508 or 10% in 2006 compared with an increase of $43,523 or 12% in 2005. In 2006, the acquisitions of Union Federal and Wells River as well as the full-year impact of the 2005 merger transactions contributed to the increase. In addition, higher merger, integration and restructuring expenses and incentive compensation in 2006 related primarily to the Union Federal acquisition and conversion as well as additional employee costs incurred related to the sale of a portion of the insurance business also contributed to the increase. In 2005, the acquisitions of Belmont and Falls Bank as well as the full year impact of the 2004 merger transactions contributed to the increase in non-interest expenses partially offset by lower merger, integration and restructuring expenses. In addition, the adoption of FAS 123(R) for stock compensation for the full year of 2005 increased expense in 2005 over 2004. The efficiency ratio, which measures total non-interest expenses, including merger, integration and restructuring charges, as a
percent of total revenues, was 57.43% in 2006, 54.85% in 2005 and 54.17% in 2004. The efficiency ratio is defined as non-interest expense divided by the sum of fully taxable equivalent net interest income plus non-interest income.
As an active acquirer over the last three years, Sky Financial’s expenses have increased each year for expenses to complete and integrate the new mergers into Sky Financial’s regional financial services delivery structure. These expenses are included in merger, integration and restructuring expenses and are more thoroughly described in Note 16 to the financial statements. In addition, acquisitions have increased Sky Financial’s intangible assets and amortization of intangible assets expense.
Non-interest expense includes costs, other than interest, that are incurred in the operations of Sky Financial. Table 7 summarizes the components of Sky Financial’s non-interest expense.
Salaries and employee benefits increased $28,726 or 13% in 2006 and $20,944 or 11% in 2005. The increases in 2006 and 2005 were primarily due to higher staffing levels, mainly from acquisitions, annual merit increases, rising costs for health and retirement benefits and higher stock-based compensation. In addition, the 2006 increases include $1,480 related to additional incentive compensation related to the completion of the Union Federal acquisition and conversion and an additional $2,597 related to additional compensation expenses related to the sale of a portion of the insurance business. Sky Financial supports performance-based compensation and maintains commission and incentive plans, which cover all employees, with incentives related to profitability, growth, asset quality and client service. Performance-based compensation increased in 2006 and 2005. The 2006 and 2005 increases included $8,026 and $5,237 of stock-based compensation expense related to restricted stock and stock options. The impacts are further discussed in Note 1 to the consolidated financial statements. Sky Financial’s full-time equivalent employees were 4,369 at December 31, 2006, up from 4,117 at December 31, 2005 and 4,001 at December 31, 2004. In 2006, salaries, wages and incentives increased $19,965 or 12% and employee benefits rose $8,761 or 17%. In 2005, the increases were $13,513 or 9% and $7,430 or 17%, respectively.
Occupancy and equipment expenses increased $4,158 or 6% in 2006 and $9,306 or 16% in 2005. Occupancy expenses increased $2,726 or 8% in 2006 and $6,324 or 24% in 2005 as Sky Financial increased the number of financial centers to
330 at December 31, 2006 from 290 at December 31, 2005 and 280 at year-end 2004. The additional offices resulted from Sky Financial’s acquisitions and the opening of seven new offices in 2006 and four in 2005. In addition, higher building rental expenses, higher real estate taxes, higher utility cost and higher repairs and maintenance cost all contributed to the increase. Equipment expenses grew $1,432 or 4% in 2006 and $2,982 or 9% in 2005 as a result of higher costs for service agreements and ATM processing expenses, which are mostly volume related.
Merger, integration and restructuring charges were $6,575 in 2006, $1,771 in 2005 and $4,542 in 2004. The 2006 restructuring charges included $5,555 related to the Union Federal acquisition, $816 for the Wells River acquisition, $102 related to acquisitions by Sky Insurance and $102 related to prior year acquisitions. The 2005 restructuring charges included $1,168 related to the Belmont acquisition and $224 for the Falls Bank transaction. Additional charges of $379 were recorded in 2005 for costs associated with the acquisition of Union Federal. In 2004, restructuring charges included $3,597 related to the acquisition of Second National, $786 related to the acquisition of Prospect, and $159 of costs primarily associated with the divestiture of Sky Financial Solutions.
State franchise taxes decreased $2,681 or 67% in 2006 and increased $726 or 22% in 2005. The 2006 decrease was primarily the result of a $2,355 state franchise tax benefit related to prior year refunds recorded in the third quarter of 2006.
Legal and other professional fees were up $601 in 2006 over 2005 due to higher legal fees in connection with aggressive loan collection efforts.
Amortization of intangible assets increased $916 in 2006 from the 2005 amounts due to the fourth quarter addition of $21,532 in core deposit intangibles and the addition of $684 in customer relationship intangibles in 2006. Partially offsetting the additional amortization from these additional intangibles is the reduced amortization of core deposit intangibles from prior acquisitions as the amortization is higher in the first few years. Amortization
in 2005 increased $3,908 over 2004 due to the addition of $7.9 million in core deposit intangibles in 2005 and a full year of amortization related to 2004 acquisitions.
The other non-interest expense in 2006 was stable as compared to 2005 with marketing expenses increasing 6%, which was more than offset by the cost control initiatives during the year.
Loan Portfolio
Sky Financial’s loan portfolio at December 31, 2006 totaled $12.8 billion, up from $11.1 billion at December 31, 2005 and $10.6 billion at December 31, 2004. The growth in total loans of 15% in 2006 and 5% in 2005 included the impact from acquisitions, which added loans of $1.4 billion and $.2 billion in 2006 and 2005, respectively, and from Sky Financial’s emphasis on organic loan growth, which has focused on commercial lending, non-residential mortgages and home equity loans within residential mortgages.
Commercial, financial and agricultural loans comprised 31% of the total loan portfolio at December 31, 2006. This loan category includes loans to a wide variety of businesses, small and large, across many industries and regions. Sky Financial’s commercial lending policy requires each loan to have viable repayment sources.
Commercial loans are evaluated for the adequacy of repayment sources at the time of approval and are regularly reviewed for any possible deterioration in the ability of the borrower to repay the loan. In certain instances, collateral is required to provide an additional source of repayment in the event of default by a commercial borrower. The structure of the collateral package, including the type and amount of the collateral, varies from loan to loan depending on the financial strength of the borrower, the amount and terms of the loan, and the collateral available to be pledged by the borrower. Credit risk for commercial loans arises from borrowers lacking the ability or willingness to repay the loan, and in the case of secured loans, by a shortfall in the collateral value in relation to the outstanding loan balance in the event of a default and subsequent liquidation of collateral.
Residential mortgage loans were 29% of the total loan portfolio at December 31, 2006. The residential mortgage portfolio contains loans to consumers secured by residential mortgages. Sky Financial’s residential mortgage lending policy requires each loan to have viable repayment sources. Residential mortgage loans are evaluated for the adequacy of these repayment sources at the time of approval, including credit scores, debt-to-income ratios, and collateral values. Credit risk for residential mortgage loans arises from borrowers lacking the ability or willingness to repay the loan, and by a shortfall in the value of the residential mortgages in relation to the outstanding loan balance in the event of a default and subsequent liquidation of the real estate collateral.
The residential mortgage portfolio includes both conforming and nonconforming mortgage loans. Conforming mortgage loans represent loans originated in accordance with underwriting standards set forth by the government-sponsored entities (GSEs) of Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (GNMA), who serve as the primary purchasers of loans sold in the secondary mortgage market by mortgage lenders. These loans are generally collateralized by one-to-four-family residential real estate, have loan-to-collateral value ratios of 80% or less, and are made to borrowers in good credit standing. The right to service the loans and receive servicing fee income is generally retained when conforming loans are sold.
Included in the residential mortgage portfolio are home equity loans, which consist mainly of revolving lines of credit to consumers which are secured by residential real estate. Home equity lines are generally governed by the same lending policies and subject to credit risk as described above for residential real estate loans.
Construction loans totaled 6% of Sky Financial’s total loans at December 31, 2006. Construction loans are mainly to individuals for the construction of their residences and, from time to time, to established builders and developers for the construction of residential homes without an underlying sales contract. Construction loans to individuals are structured to be converted to permanent loans at the end of the construction phase, which typically runs from six months to one year. Substantially all of these loans are in Sky Financial’s local markets. Residential construction loans are generally under-written pursuant to the same guidelines used for originating permanent residential mortgage loans. Terms and rates typically match residential mortgage loans, except that during the construction phase the borrower pays interest only. The application process for construction loans includes a submission of the plans and costs of the project to be constructed.
Non-residential mortgage loans comprised 27% of total loans at December 31, 2006. The non-residential real estate portfolio contains mortgage loans to developers and owners of commercial real estate. Development lending activities in commercial real estate are based primarily on relationships with developers who are active in Sky Financial’s local markets. Commercial real estate loans are governed by the same lending policies and subject to credit risk as described for commercial loans.
Installment and credit cards loans were 6% of the total loans at December 31, 2006. This portfolio includes installment loans used by clients to purchase automobiles, boats, recreational vehicles, automobile leases and student loans. These consumer loans are generally governed by the same lending policies as described for residential real estate. Credit risk for installment loans arises from borrowers lacking the ability or willingness to repay the loan, and in the case of secured loans, by a shortfall in the value of the collateral in relation to the outstanding loan balance in the event of a default and subsequent liquidation of collateral. Credit card loans include the outstanding balances on open-ended credit card accounts and unsecured personal and business lines of credit. Credit card loans are typically unsecured and are generally governed by the same lending policies and subject to credit risk as described for residential real estate and consumer loans.
Real estate loans, including construction and mortgage loans, approximated 63% of total loans at December 31, 2006 and 2005.
Commercial loans comprise 31% of the total loan portfolio for both 2006 and 2005. As part of its commercial loan portfolio, Sky Financial engages in financing pools of loans with a specialty consumer finance company. This relationship currently has over 300 pools in this portfolio type. These pools are made up of almost exclusively 1-4 family residential mortgage loans located throughout the country that have some type of impairment associated with them. In addition, Sky Financial participated in a small portfolio of shared national credits.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
These individual credit relationships total less than one-half of one percent of the total loan portfolio with the businesses located in our current market area.
As of December 31, 2006, Sky Financial did not have any loan concentrations that exceeded 10% of total loans. Sky Financial monitors the levels of market segments contained in the loan portfolio.
The 2005 loan categories have been reclassified to conform to the current year presentation. In 2006, Sky Financial changed the method of classifying certain loans which resulted in a decrease to loans classified as construction and an increase in non-residential real estate and commercial, financial and agricultural loans.
Table 9 shows the amount of commercial, financial and agricultural loans and real estate construction loans outstanding as of December 31, 2006, which based on the remaining scheduled repayments of principal, are due in the periods indicated. Also, the amounts due after one year are classified according to their sensitivity to changes in interest rates.
Actual maturities of loans will differ from the contractual maturities presented in the table above because of prepayments, rollovers and renegotiation of payment terms, among other factors.
Under-Performing Assets
Residential mortgage, installment and other consumer loans are collectively evaluated for impairment. Individual commercial loans exceeding size thresholds established by management are evaluated for impairment. Impaired loans are recorded at the loan’s fair value by the establishment of a specific allowance where necessary. The fair value of the collateral-dependent loans is determined by the fair value of the underlying collateral. The fair value of noncollateral-dependent loans is determined by discounting expected future interest and principal payments at the loan’s effective interest rate. At December 31, 2006, impaired loans were $79,335 compared with $75,955 at December 31, 2005; the increase was due primarily to the 15% increase in total loans at year-end 2006 compared to year-end 2005, partially offset by the resolution and sale of certain non-accrual loans secured by pools of commercial leases.
Non-accrual loans are comprised principally of loans 90 days past due as well as certain loans, which are current but where serious doubt exists as to the ability of the borrower to comply with the repayment terms. Interest previously accrued and not yet paid on non-accrual loans is reversed or charged against the allowance for credit losses during the period in which the loan is placed in a non-accrual status, except where Sky Financial has determined that such loans are adequately secured as to principal and interest. Interest earned thereafter is included in income only to the extent that it is received in cash. In certain cases, interest received may be credited against principal outstanding under the cost recovery method.
Non-accrual loans increased $18,081 from $119,030 at December 31, 2005 to $137,111 at year-end 2006. The increase in non-accrual loans in 2006 was due primarily to the increase in total loans during 2006, including non-accrual loans from acquisitions. For the year ended December 31, 2006, the amount of interest income that would have been recorded under the original loan terms for total loans classified as non-accrual and restructured was $12,664. The amount actually collected and recorded, as interest income for these loans, was $2,975, which included $1,033 of interest from the collection of previously recorded non-accrual loans that were secured by pools of commercial leases.
At December 31, 2006, loans secured by pools of commercial leases on non-accrual status were $15,435 down from $20,400 at year-end 2005. The reduction in these loans is due to cash collections and settlements on the loans during the year. These loans are guaranteed by surety bonds issued by a creditworthy insurance company.
Sky is engaged in litigation with this insurance company to enforce their payment obligations, as are a number of other banks nationwide. These non-accrual loans are currently reflected in the consolidated balance sheet at the amount of the unpaid balance, under contractual terms. After consultation with its counsel as to the strength of its position, Sky Financial believes that the credits are well secured and that the prospects for recovery of its balance, net of reserves, is probable.
At December 31, 2006, non-performing assets were $158,822, an increase from $136,985 at the prior year-end. The increase included higher non-performing loans, which at year-end 2006, totaled $137,153 or 1.07% of total loans outstanding, compared with $119,509 or 1.07%, of total loans outstanding at year-end 2005.
Loans now performing, but where some concerns exist as to the ability of the borrower to comply with present loan repayment terms (defined as loans rated substandard or worse, but excluding non-accrual and restructured loans), approximated $113,395 and $140,220 at December 31, 2006 and 2005, respectively, and are being closely monitored by management and the boards of directors of Sky Financial and its subsidiaries. The classification of these loans, however, does not imply that management expects losses on each of these loans, but believes that a higher level of scrutiny is prudent under the circumstances.
The decrease in loans where some concern exists is indicative of the increased focus on credit quality and stricter credit standards in loan categories. These loans require close monitoring despite the fact that they are performing according to their terms. Such classifications relate to specific concerns relating to each individual borrower and do not relate to any concentrated risk elements common to all loans in this group.
Provision and Allowance for Credit Losses
The provision for credit losses represents the charge to income necessary to adjust the allowance for credit losses to an amount that represents management’s assessment of the estimated probable credit losses inherent in Sky Financial’s loan portfolio that have been incurred at each balance sheet date. All lending activity contains associated risks of loan losses. Sky Financial recognizes these credit risks as a necessary element of its business activity. To assist in identifying and managing potential loan losses, Sky Financial maintains a loan review function that continuously evaluates individual credit relationships as well as overall loan portfolio conditions. One of the primary objectives of this loan review function is to make recommendations to management as to both specific loss reserves and overall portfolio loss reserves.
The provision for credit losses for 2006 was $36,854 compared with $52,249 for 2005 and $37,660 in 2004. The lower provision in 2006 for credit losses represented a return to Sky Financial’s historical trend for net charge-offs as compared to the 2005 levels. The 2005 change in the provision for credit losses was attributable to higher levels of net charge-offs mostly related to several large commercial relationships and growth in the loan portfolio, partially offset by an overall reduction in the credit risk profile facilitated by a reduction in non-accrual loans.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
At December 31, 2006 and 2005, an allowance for unfunded commitments and letters of credit of $490 and $279, respectively, was included in accrued interest payable and other liabilities.
As a result of the Union Federal and Wells River acquisitions, Sky Financial transferred $29,892 and $487 of allowance for credit losses, respectively.
Sky Financial maintains an allowance for credit losses at a level adequate to absorb management’s estimate of probable losses inherent in the loan portfolio. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance.
The general allowance is determined by applying estimated loss factors to the credit exposures from outstanding loans. For construction, commercial and commercial real estate loans, loss factors are applied based on internal risk grades of these loans. For residential real estate, installment, credit card and other loans, loss factors are applied on a portfolio basis. Loss factors are based on Sky Financial’s historical loss experience and are reviewed for modification on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio.
Specific allowances are established for all classified loans, where management has determined that, due to identified significant conditions, it is probable that Sky Financial will be unable to collect all amounts due according to the contractual terms of the loan agreement. The unallocated allowance recognizes the estimation risk associated with the allocated general and specific allowances and incorporates management’s evaluation of existing conditions that are not included in the allocated allowance determinations. These conditions are reviewed quarterly by management and include general economic conditions, credit quality trends, recent acquisitions, and internal loan review and regulatory examination findings.
At December 31, 2006, the allowance for credit losses was $172,990 or 1.35% of total loans outstanding, and 126% of total non-performing loans compared to an allowance at December 31, 2005 of $144,461 or 1.30% of total loans outstanding, and 121% of total non-performing loans. At year-end 2006, the allocated portion of the allowance for credit losses was $151,111 compared with $133,274 at year-end 2005.
The increase in the allowance in 2006 was attributable to an overall increase in total loans including the allowance from acquired institutions. The decrease in the allowance in 2005 was attributable to an overall reduction in the credit risk profile facilitated by a reduction in non-accrual loans and loans requiring a specific reserve allocation.
At year-end 2006, the unallocated portion of the allowance for credit losses was $21,879 compared with $11,187 at year-end 2005 and $10,545 at year-end 2004. The increase in 2006 was mainly due to the unallocated allowance acquired from Union Federal.
Net charge-offs decreased to $38,699 compared with $61,785 in 2005 and $34,937 in 2004, mainly due to higher charge-offs in 2005 related to several large commercial relationships, the sale of a pool of non-performing real estate loans and the increased size of the loan portfolio. The 2006 net charge-offs were in line with Sky Financial’s historical trend. Net charge-offs as a percentage of average loans outstanding decreased in 2006 to .34% from .57% in 2005 and .37% in 2004.
Securities
The investment portfolio at Sky Financial is used as a management tool to maintain acceptable levels of liquidity and exposure to changes in market interest rates. The portfolio yield is maximized once these criteria are satisfied. In recent years, the portfolio has shifted to include a greater percentage of mortgage-backed securities. Mortgage-backed securities offer monthly principal and interest and may be used as collateral in a variety of financial transactions to secure sources of wholesale funding. The market for agency mortgage-backed securities is large and liquid. It is the practice of Sky Financial to purchase mortgage-backed securities with average expected lives of two-to-five years. Because this type of security may extend or contract, a pre-purchase analysis is completed. Most securities purchased have structures that limit changes to duration as market rates change. The following table documents the fair value of the available for sale portfolio by product.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
(1) Certain securities such as FHLB, FRB, and Bankers’ Bank stock are carried at amortized cost.
In 2006, total securities increased by $32,488. Although the net change was minimal, the impact of growth from acquisitions for the year was offset by a significant decrease in the investment portfolio due to Sky Financial completing a balance sheet restructuring in the fourth quarter of 2006. The reduction in assets included the sale of available-for-sale, fixed-rate investment securities with a book value totaling $505,629 with an average yield of 3.74%, and the elimination of federal funds sold coming from the Union Federal acquisition. The balance sheet restructuring was designed to strengthen capital ratios, maintain a sound interest rate risk position and enhance the net interest margin following the completion of the acquisitions of Union Federal and Wells River. This balance sheet restructuring resulted in realized losses on sales of securities of $19,435 recorded as a component of net securities gains (losses).
During the year, Sky purchased $1,029,908 in securities. Maturities, calls and principal repayments totaled $564,450 and sales of investments totaled $833,282 that resulted in a net loss of $19,503, including the restructuring mentioned above.
In order to achieve liquidity and interest rate risk management objectives, the available for sale investment portfolio along with wholesale funding and interest rate derivatives (e.g., interest rate swaps, caps and floors) provides the company with the ability to manage liquidity and interest rate risk as the broader balance sheet and market conditions warrant. From time to time adjustments in holdings of various types of investments may be necessary to maintain prudent positioning of the total balance sheet. The management team through the Asset Liability Committee reviews potential adjustments monthly.
Of the securities sold, $18,999 were corporate trust preferred issues that were sold due to management’s decision to minimize risk by liquidating these investments. A net gain of $242 was recognized on these sales.
Due to the length of time it had remained below market value, a common stock with a carrying value totaling $9,065 was written down to market value resulting in a loss of $1,681.
Other investments consisting primarily of equity and mortgage-backed securities in the amount of $3,903 were sold during the year for a net loss of $298.
In addition to the securities sold above, a combined total of $324,197 in securities was sold during the integration of Union Federal and Wells River into Sky Financial. These investments were liquidated because they did not conform to the extension risk parameters of the broader securities portfolio. To complete the restructuring process, proceeds from the sales were used to reinvest in securities that better fit the parameters of Sky Financial’s portfolio.
In 2005, total securities available for sale only increased by $5,659 as the impact of growth was not significant and liquidity and interest rate risk management factors were mostly stable throughout the year. During 2005, $722,371 in securities were purchased, while principal from maturities, calls and payments totaled $627,290 and sales totaled $127,667.
The portfolio contains mortgage-backed securities and, to a limited extent, other securities, that have uncertain cash flow characteristics. The variable cash flows present additional risk to Sky Financial in the form of prepayment or extension risk primarily caused by changes in market interest rates. This additional risk is generally rewarded in the form of higher yields.
Sky Financial utilizes a variety of tools to monitor and minimize this risk. All securities must pass a stress test at the time of purchase estimating how the security would perform in various interest rate environments. Additionally, the corporate investment policy defines certain types of high-risk securities ineligible for purchase, including securities that may not return full principal to Sky Financial. It is also the practice of Sky Financial to minimize premiums paid on mortgage securities to avoid yield reduction if prepayments accelerate. Mortgage securities were at a discount to par value of .21% as of December 2006 compared to a premium to par value of .30% in December 2005. These policies help to ensure that there will be no material impact from these investments to the financial statements due to changes in market interest rates, which may shorten the average life of the portfolio.
Expected maturities of individual securities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities are presented in the table based on current prepayment assumptions. The weighted average yields on income from tax-exempt obligations of state and political subdivisions have been adjusted to a tax equivalent basis. Table 14 shows (at amortized cost) the contractual maturities and weighted average yields of Sky Financial’s securities as of December 31, 2006.
Sky Financial evaluates its securities portfolio for other-than-temporary impairment throughout the year. Each investment, which has an indicative market value less than the book value is reviewed on a monthly basis by management. Management considers at a minimum the following factors that, both individually or in combination, could indicate that the decline is other-than-temporary: 1) the length of time and extent to which the market value has been less than book value; 2) the financial condition and near-term prospects of the issuer; or 3) the intent and ability of Sky Financial to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value. Among the factors that are considered in determining intent and ability is a review of capital adequacy, interest rate risk profile and liquidity at Sky Financial.
An impairment is recorded against individual securities if the review described above concludes that the decline in value is
other-than-temporary. In the fourth quarter of 2006, Sky Financial determined that an investment in a corporate equity security with a book value of $9,065 and a fair value at the end of the year of $7,384 was impaired. The fair value of the equity security had been below Sky Financial’s cost for the security in excess of a year and Sky Financial was unable to forecast the near-term recovery of the value of the security. As a result, Sky Financial recorded an other-than-temporary impairment of $1,681 related to this security.
The following table documents the amount of securities by type that are currently carried above fair market value. It also indicates the amount of securities that have been below market value for more than one year. In addition, the table indicates the anticipated recovery period that represents the market consensus on the duration of the investments based on market assumptions.
There are no securities of any single issuer where the aggregate carrying value of such securities exceed 10% of shareholders’ equity, except those of the U.S. Treasury, U.S. Government agencies and substantially all mortgage-backed securities issued by Federal Home Loan Mortgage Corporation, Federal National Mortgage Association and Government National Mortgage Association.
Funding Sources
Sky Financial obtains its funding through a variety of sources. Retail deposits are gathered from individuals and businesses within the local communities served by the banking affiliate. Deposits encompass the full range of banking products including checking, savings and time deposits. In addition, Sky Financial obtains funds under a number of borrowing arrangements. The banking affiliate is a member of the Federal Home Loan Bank and may obtain both overnight and term advances. The banking affiliate also obtains funds through securities sold under repurchase agreements and federal funds lines. The parent company maintains a line of credit with a group of non-affiliated banks.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Table 17 is a schedule of maturities of time deposits in denominations of $100,000 or more as of December 31, 2006 and 2005:
Short-Term Borrowings
Table 18 sets forth certain information relative to borrowed funds with original maturities of less than one year. Included in these borrowed funds are federal funds
purchased, advances from the FHLB, securities sold under agreements to repurchase and bank lines of credit.
Contractual Obligations and Commitments
Table 19 presents, as of December 31, 2006, Sky Financial’s significant fixed and determinable contractual obligations by payment date. The payment amounts represent those amounts due to the recipient and do not include any unamortized premiums or discounts or other similar carrying amount adjustments.
Deposits without a stated maturity have been placed in the one year and less category for this presentation based on the clients’ ability to withdraw on a daily basis. However, from a practical standpoint, these deposits provide a stable long-term source of funding.
(1) In the banking industry, interest-bearing obligations are principally utilized to fund interest-bearing assets. As such, interest charges on related contractual obligations were excluded from reported amounts as the potential cash outflows would have corresponding cash inflows from interest-bearing assets.
Liquidity Management
Management of liquidity is of continuing importance to the banking industry. The liquidity of a financial institution reflects its ability to meet loan requests, to accommodate possible outflows of deposits and to take advantage of interest rate market opportunities. The ability of a financial institution to meet its current financial obligations is a function of balance sheet structure, the ability to liquidate assets and the availability of alternative sources of funds. To meet the needs of the clients and manage the risk of the bank, financial institutions have developed innovative ways to meet client needs while at the same time managing both liquidity and interest rate risk. This is being done primarily through liquidity management and the balance of deposit growth and alternative sources of borrowing.
Certificates of deposit provide Sky Financial with a dependable source of funding. However, market pricing can be highly competitive and this source of funds must be prudently managed. As of December 31, 2006, a total of $5,175,600 of time deposits will mature in the next twelve months. The maturities are reasonably disbursed across the year and there are no unusual concentrations of individual clients. At Sky Financial, time deposit maturities are monitored through the corporate Asset/ Liability Committee (ALCO). Maturing balances are summarized by month, as well as original term and current rate. Heavy matu-
rity periods are monitored closely and proactive marketing plans are created that address both the client and Sky Financial’s needs and preferences. Regional management along with funds management meets weekly to discuss general economic and market conditions. During this meeting, each region reports the results of the prior week’s pricing and promotional efforts. Each region then determines its rates for the coming week. Regional pricing allows Sky Financial to attract deposits at the most efficient cost available. Time deposit maturities are monitored and the percent retained is reported monthly to ALCO.
Management of Sky Financial is confident that a significant portion of the scheduled maturities will be retained in 2007. In the unlikely event that these are not retained by Sky Financial, a minimum liquidity ratio has been established at 10% of non-collateralized liabilities. This 10% ratio consists of readily marketable securities and unused borrowing capacity. At least 8% of the assets must be in unencumbered marketable assets. In addition, Sky Financial has a standing contingent liquidity management plan that prioritizes the steps needed to compensate for temporary disruptions in liquidity.
In addition to maintaining a stable core deposit base, Sky Financial’s banking subsidiary maintains adequate liquidity primarily through the use of investment securities, unused
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
borrowing capacity, security repurchase agreements and federal funds purchased.
At December 31, 2006, securities with maturities of one year or less totaled $16,578. In addition, the mortgage-backed securities provide an estimated cash flow of approximately $646,779 over a twelve-month timeframe. The banking subsidiary is a member of the Federal Home Loan Bank (FHLB). The FHLB provides a reliable source of funds with a wide variety of terms and structures. As of December 31, 2006, the banking subsidiary had total credit availability with the FHLB of $1,943,666, of which, $903,645 was outstanding.
Sky Financial is a holding company and does not conduct operations. Its primary sources of liquidity are borrowings from outside sources and dividends received from its subsidiaries. For the banking subsidiary, regulatory approval is required in order to pay dividends in excess of the subsidiary’s earnings retained for the current year plus retained net profits for the prior two years. At December 31, 2006, $179,388 was available for distribution to Sky Financial as dividends without prior regulatory approval.
Sky Financial maintains a $100,000 line of credit with a group of unaffiliated banks that expires May 25, 2007. It is anticipated that the line will be renewed. As of December 31, 2006, Sky Financial had a $35,000 outstanding balance on the line of credit.
The corporation manages liquidity risk in accordance with established policies primarily through the ALCO. Management has increased its monitoring of liquidity levels and has implemented strategies to increase liquidity. Strategies implemented in 2005 and 2006 include new retail, deposit retention and growth initiatives, an increased portfolio of a laddered maturity of brokered CDs and additional federal funds lines. As part of the Union Federal acquisition, Sky Financial acquired over $700,000 of brokered deposits with a higher liquidity risk due to the nature of the deposits. Management will continue to monitor the liquidity risk associated with these deposits and implement strategies to mitigate the risk associated with these deposits.
Capital Resources
Shareholders’ equity at year-end 2006 totaled $1,880,648 compared to $1,553,877 at December 31, 2005, an increase of 21%. The increase was primarily due to net retained earnings (net income less dividends) of $86,080, the issuance of $200,566 of common stock for acquisitions and the exercise of stock options.
The Federal Reserve Board has established risk-based capital guidelines that must be observed by financial holding companies and banks. Sky Financial has consistently maintained the regulatory capital ratios of the corporation and its bank above “well capitalized” requirements. Under capital adequacy guidelines, Sky Financial and Sky Bank must meet specific quantitative measures of their assets, liabilities and certain off-balance sheet items as determined under regulatory accounting practices. Sky Financial’s and Sky Bank’s capital amounts and classifications are subject to qualitative judgments by the regulators about components, risk weighting and other factors. Management believes, as of December 31, 2006, Sky Financial and Sky Bank meet all capital adequacy requirements for which they are subject. At December 31, 2006, Sky Financial’s and Sky Bank’s ratio of total capital to risk-weighted assets as defined by the regulatory framework for prompt corrective action were 12.0% and 12.0%. The capital position is managed through changes to balance sheet size and composition, issuance of debt and equity instruments, treasury stock activities, dividend policies and retention of earnings.
During 2005 the Federal Reserve Board issued a final rule revising the existing capital standards, which limit the inclusion of restricted core capital elements, including perpetual preferred stock and Trust preferred securities. The rule will be phased in for
the quarter-ended March 31, 2009.
On December 5, 2006, the Federal Reserve Board published a draft interagency notice of proposed rulemaking regarding potential revisions to the existing risk-based capital framework. These changes would apply to banks, bank holding companies, and savings associations. The new rules known as Basel IA will be optional for organizations not required to adopt the Basel II advanced capital framework required only for the largest, most complex banks.
The potential modifications to the U.S. risk-based capital standards under Basel IA include:
n Allow banking organizations other than the advanced Basel II organizations to elect to adopt Basel IA or remain subject to the existing risk-based capital rules.
n Use loan-to-value ratios to determine risk-weights for most residential mortgages.
n Increase the number of risk weight categories to which credit exposures may be assigned.
n Expand the use of external credit ratings for certain externally-rated exposures.
n Expand the range of collateral and guarantors that may qualify an exposure for lower risk weights.
n Increase the credit conversion factors for certain commitments with an original maturity of less than one year.
n Assess a risk-based capital charge to reflect the risks in securitizations with early amortization provisions that are backed by revolving exposures.
n Remove the 50 percent limit on the risk weight that applies to certain derivative contracts.
Sky Financial will continue to monitor these potential changes to the risk-based capital standards and will make the necessary changes to ensure that it remains well-capitalized.
Sky Financial’s strategic plans include continued growth through acquisitions, which can potentially impact Sky Financial’s capital position. Sky Financial may issue additional common stock in conjunction with future acquisitions in order maintain its well capitalized status.
As of December 31, 2006, Sky Financial has $335,294 of capital securities with wholly-owned unconsolidated subsidiaries, which are considered to be Tier I capital for regulatory purposes. Under the Federal Reserve Board’s regulatory framework, certain capital securities offered by wholly-owned unconsolidated trust preferred entities of Sky Financial are currently included as “Tier I” regulatory capital. The new rule continues to allow this inclusion limiting the Tier I inclusion to 25% of core capital for entities that are not internationally active. Amounts in excess of the 25% limit are eligible for inclusion in Tier II capital.
Market Risk Management
Market risk is the risk that a financial institution’s earnings and capital, or its ability to meet its business objectives, will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices. Within Sky Financial, the dominant market risk exposure is changes in interest rates. The negative effect of this exposure is felt through the net interest spread, mortgage banking revenues and the market values of various assets and liabilities.
Sky Financial manages market risk through its ALCO at both the subsidiary and consolidated levels. The committee assesses interest rate risk exposure through three primary measurements: rate sensitive assets divided by rate sensitive liabilities (or “Gap ratios”), interest rate shock simulations of net interest income at risk, and economic value of equity risk simulation.
Sky Financial also utilizes interest rate swaps and caps to effectively modify its liability interest rate repricing to more effectively match the repricing characteristics of its assets. At December 31, 2006, the fair value of Sky Financial’s derivative
arrangements aggregated $(335) on contracts with notional amounts of $630,903. Sky Financial monitors and manages its rate sensitivity position to maximize net interest income, while minimizing the risk due to changes in interest rates.
Sky Financial also uses a rate sensitivity gap analysis to manage its interest rate risk. The difference between a financial institution’s interest rate sensitive assets (e.g., assets that will mature or reprice within a specific time period) and interest rate sensitive liabilities (e.g. liabilities that will mature or reprice within the same time period) is commonly referred to as its “interest rate sensitivity gap” or “gap.” An institution having more interest rate sensitive assets than interest rate sensitive liabilities within a given time period is said to have a “positive gap,” which generally means that if interest rates increase, a company’s net interest income will increase and if interest rates decrease, its net interest income will decrease. An institution having more interest rate sensitive liabilities than interest rate assets within a given time period is said to have a “negative gap,” which generally means that if interest rates increase, a company’s net interest income will decrease and if interest rates decrease, its net interest income will increase.
The current policy imposes limits at the six-month and 12-month time periods that is measured in terms of the ratio of cumulative rate sensitive assets divided by rate sensitive liabilities. Table 21 presents the gap position of Sky Financial at December 31, 2006 and 2005.
The interest rate shock simulation analysis measures the potential effect on earnings that an instantaneous parallel change in general interest rates could have on net interest income and economic value of equity. Sky Financial applies hypothetical interest rate shocks up 200 and 100 basis points and down 100 and 200 basis points to its financial instruments based on the assumed cash flows. The economic value of equity measures the price risk of the entire balance sheet by discounting expected cash flows of all assets and liabilities and netting the result. This provides a longer-term view of the interest rate risk profile of the company that is focused on the current economic value of assets and liabilities that make up the balance sheet at a static point in time. The shock then examines how the economic value of the company would change if market rates were different. As demonstrated in Table 22, as of December 31, 2006, the projected volatility of net interest income and economic value of equity due to the hypothetical changes in market rates are within ALCO guidelines.
The proceeding analysis is based on numerous assumptions, including relative levels of market interest rates, instantaneous and parallel shifts in the yield curve, loan prepayments and reactions of depositors to changes in interest rates, and should not be relied upon as being indicative of actual or future results. Further, the analysis does not necessarily contemplate all actions Sky Financial may undertake in response to changes in interest rates.
Effects of Inflation
The assets and liabilities of Sky Financial are primarily monetary in nature and are more directly affected by the fluctuation in interest rates than inflation. Movement in interest rates is a result of the perceived changes in inflation as well as monetary and fiscal policies. Interest rates and inflation do not necessarily move with the same velocity or within the same period; therefore, a direct relationship to the inflation rate cannot be shown. The financial information presented in this report has been prepared in accordance with generally accepted accounting principles, which require that Sky Financial measure financial position and operating results primarily in terms of historical dollars.
Critical Accounting Policies and Estimates
The accounting and reporting policies of Sky Financial are in accordance with accounting principles generally accepted within the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for the allowance for credit losses and mortgage servicing rights are deemed critical because they involve the use of estimates and require significant management judgments. Application of assumptions different from those used by management could result in material changes in Sky Financial’s financial position or results of operations.
Account - Allowance for Credit Losses
Balance Sheet Reference - Allowance for Credit Losses
Income Statement Reference - Provision for Credit Losses
Description
The allowance for credit losses is an amount that management believes will be adequate to absorb probable incurred losses in existing loans taking into consideration such factors as past loss experience, changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans and current economic conditions that affect the borrower’s ability to pay. Determination of the allowance is inherently subjective due to the aforementioned reasons. Loan losses are charged-off against the allowance when management believes that the full collectibility of the loan is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Allowances established to provide for losses under commitments to extend credit, or recourse provisions under loan sales agreements or servicing agreements are classified with other liabilities.
A loan is considered impaired when it is probable that not all principal and interest amounts will be collected according to the loan contract. Residential mortgage, installment and other consumer loans are collectively evaluated for impairment. Individual commercial loans exceeding size thresholds established by management are evaluated for impairment. Impaired loans are recorded at the loan’s fair value by the establishment of a specific allowance where necessary. The fair value of collateral-dependent loans is determined by the fair value of the underlying collateral. The fair value of noncollateral-dependent loans is determined by discounting expected future interest and principal payments at the loan’s effective interest rate.
Management’s Discussion and Analysis of
Financial Condition and Results of Operation
(Dollars and shares in thousands, except per share data)
Sky Financial maintains the allowance for credit losses at a level adequate to absorb management’s estimate of probable losses inherent in the loan portfolio. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance, which represent estimations done pursuant to either FAS No. 5 Accounting for Contingencies, or FAS No. 114, Accounting by Creditors for Impairment of a Loan.
The general allowance is determined by applying estimated loss factors to the credit exposures from outstanding loans. For construction, commercial and commercial real estate loans loss factors are applied based on internal risk grades of these loans. Many factors are considered when these grades are assigned to individual loans such as current and past delinquency, financial statements of the borrower, current net realizable value of collateral and the general economic environment and specific economic trends affecting the portfolio. For residential real estate, installment, credit card and other loans, loss factors are applied on a portfolio basis. Loss factors are based on Sky Financial’s historical loss experience and are reviewed for modification on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio.
Specific allowances are established for all classified loans, where management has determined that, due to identified significant conditions, it is probable that Sky Financial will be unable to collect all amounts due according to the contractual terms of the loan agreement. The unallocated allowance recognizes the estimation risk associated with the allocated general and specific allowances and incorporates management’s evaluation of existing conditions that are not included in the allocated allowance determinations. These conditions are reviewed quarterly by management and include general economic conditions, credit quality trends and internal loan review and regulatory examination findings.
Management believes that it uses the best information available to determine the adequacy of the allowance for loan losses. However, future adjustments to the allowance may be necessary and the results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations.
Account - Mortgage Servicing Rights
Balance Sheet Reference - Other Assets
Income Statement Reference - Mortgage Banking Income
Description
The cost of mortgage loans sold or securitized is allocated between the mortgage servicing rights and the mortgage loans based on the relative fair values of each. The fair value of the mortgage servicing rights is determined by using a discounted cash flow model, which estimates the present value of the future net cash flows of the servicing portfolio based on various factors, such as servicing costs, expected prepayment speeds and discount rates, about which management must make assumptions based on future expectations.
Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income. Management periodically evaluates mortgage servicing rights for impairment by stratifying the loans in the servicing portfolio primarily based on loan type, interest rate and region of origination. Impairment is measured by estimating the fair value of each stratum, taking into consideration the estimated level of prepayments based upon current industry expectations. An impairment allowance for a stratum is recorded when, and in an amount which, its fair value is less than its carrying value.
The value of mortgage servicing rights is subject to prepayment risk. Future expected net cash flows from servicing a loan in our servicing portfolio will not be realized if the loan pays off earlier than anticipated. Moreover, because most loans within our servicing portfolio do not contain penalty provisions for early payoff, we will not receive a corresponding economic benefit if the loan pays off earlier than expected. Mortgage servicing rights represent the discounted present value of the future net cash flows we expect to receive from our servicing portfolio.
New Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) (FAS 158), requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity. The requirement by FAS 158 to recognize the funded status of a benefit plan and the disclosure requirements of FAS 158 are effective as of the end of the fiscal year ending after December 15, 2006 for entities with publicly traded equity securities. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The adoption of FAS 158 did not have a material effect on the financial position of the company at December 31, 2006.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). FAS 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of FAS 157, guidance for applying fair value was incorporated in several accounting pronouncements. FAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. FAS 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under FAS 157, fair value measurements are disclosed by level within that hierarchy. While FAS 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Sky Financial has not determined the impact of adopting FAS 157 on its financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that Sky Financial recognize in the financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of the 2007 fiscal year, with the cumulative effect of the change in
accounting principle recorded as an adjustment to opening retained earnings. The cumulative change in accounting recorded directly to retained earnings and the effect on 2007 income from operations is not material.
In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets: an amendment of FASB Statement No. 140 (FAS 140 and FAS 156). FAS 140 establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends FAS 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This Statement permits, but does not require, the subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value. Under this Statement, an entity can elect subsequent fair value measurement to account for its separately recognized servicing assets and servicing liabilities. Adoption of this Statement is required as of the beginning of the first fiscal year that begins after September 15, 2006. Sky Financial adopted FAS 156 on January 1, 2007 and did not elect the fair value measurement option.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments: an amendment of FASB Statements No. 133 and 140 (FAS 155). FAS 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Sky Financial does not expect the adoption of FAS 155 to have a material effect on the results of operations or the statement of condition.
Forward Looking Statements
This report includes forward-looking statements by Sky Financial relating to such matters as anticipated operating
results, credit quality expectations, prospects for new lines of business, technological developments, economic trends (including interest rates), acquisition, reorganization and divestiture transactions and similar matters. Such statements are based upon the current beliefs and expectations of Sky Financial’s management and are subject to risks and uncertainties. While Sky Financial believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could prove to be inaccurate, and accordingly, actual results and experience could differ materially from the anticipated results or other expectations expressed by Sky Financial in its forward-looking statements. Factors that could cause actual results or experience to differ from results discussed in the forward-looking statements include, but are not limited to: economic conditions; volatility and direction of market interest rates; capital investment in and operating results of non-banking business ventures of Sky Financial; governmental legislation and regulation; material unforeseen changes in the financial condition or results of operations of Sky Financial’s clients; client reaction to and unforeseen complications with respect to Sky Financial’s integration of acquisitions; difficulties in realizing expected cost savings from acquisitions; difficulties associated with data conversions in acquisitions; and other risks identified from time-to-time in Sky Financial’s other public documents on file with the Securities and Exchange Commission. This report also contains certain forward-looking statements about the benefits of the merger between Huntington and Sky Financial Group, which are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those contained or implied by such statements for a variety of factors including: the businesses of Huntington and Sky Financial Group may not be integrated successfully or such integration may take longer to accomplish than expected; the expected cost savings and any revenue synergies from the merger may not be fully realized within the expected timeframes; disruption from the merger may make it more difficult to maintain relationships with clients, associates, or suppliers; the required governmental approvals of the merger may not be obtained on the proposed terms and schedule; Huntington and/or Sky Financial’s stockholders may not approve the merger; and other factors described in Huntington’s registration statement on Form S-4 regarding the merger. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements, and the purpose of this paragraph is to secure the use of the safe harbor provisions.
Item 7A.
Item 7A. Quantitative and Qualitative
Disclosures About Market Risk
The information contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of
Operations - Market Risk Management” on page 30 of this Form 10-K is incorporated herein by reference in response to this item.
Item 8.
Item 8. Financial Statements and Supplementary Data
Report of Independent Registered
Public Accounting Firm
To the Board of Directors and Shareholders of
Sky Financial Group, Inc.
Bowling Green, Ohio
We have audited the accompanying consolidated balance sheets of Sky Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Sky Financial Group, Inc. and subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment, in 2005.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 22, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Deloitte & Touche LLP
Cleveland, Ohio
February 22, 2007
Consolidated Balance Sheets
(Dollars and shares in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
Consolidated Statements of Income
(Dollars in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
Consolidated Statements of Changes in Shareholders’ Equity
(Dollars and shares in thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
Consolidated Statements of Cash Flows
(Dollars in thousands)
Non-cash activity related to the acquisitions included the purchase of assets with a fair value of $2,590,510 and the assumption of liabilities of $2,243,905 in 2006; the purchase of assets with a fair value of $438,505 and the assumption of liabilities of $342,622 in 2005; and the purchase of assets with a fair value of $2,494,497 and the assumption of liabilities of $2,135,005 in 2004.
The accompanying notes are an integral part of the consolidated financial statements.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 1 Summary of Significant Accounting Policies
Sky Financial Group, Inc. (Sky Financial) is a financial holding company headquartered in Bowling Green, Ohio that owns and operates Sky Bank, which is primarily engaged in the commercial and consumer banking business in Ohio, Pennsylvania, Indiana, Michigan and West Virginia. Sky Financial also operates businesses relating to insurance, brokerage, trust and other financial-related services.
Basis of Presentation
The accounting and reporting policies followed by Sky Financial conform to accounting principles generally accepted in the United States of America (U.S. GAAP) and to general practices within the financial services industry. The preparation of financial statements 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. Actual results could differ from those estimates. The allowance for credit losses, fair values of financial instruments, mortgage servicing rights and status of contingencies are particularly subject to change.
Consolidation
The consolidated financial statements of Sky Financial include the accounts of Sky Bank, Sky Trust, N.A. (Sky Trust), Sky Insurance, Inc. (Sky Insurance), and various other insignificant subsidiaries. On March 31, 2004, Sky Financial Solutions, Inc. (SFS) was sold and is included in the consolidated financial statements and related notes as discontinued operations. All significant intercompany transactions and accounts have been eliminated in consolidation.
Securities
Sky Financial classifies its securities as held to maturity, trading or available for sale. Securities classified as available for sale are those that management intends to sell or that could be sold for liquidity, investment management or similar reasons, even if there is not a present intention to make such a sale. Equity securities that have a readily determinable fair value are also classified as available for sale. Securities classified as available for sale are carried at estimated fair value with unrealized appreciation or depreciation recorded, net of tax, in other comprehensive income. Securities classified as held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts. Securities classified as held to maturity are those that management has the positive intent and ability to hold to maturity. Trading securities are acquired for sale in the near term and are carried at fair value, with unrealized holding gains and losses reflected in earnings. Sky Financial held no trading securities or securities classified as held to maturity during any period presented. Certain restricted equity securities, such as stock of the Federal Home Loan Bank of Cincinnati, are carried at cost. Amortization of premiums and accretion of discounts are recorded in interest income using the interest method over the period to maturity, which is sometimes estimated. Gains and losses on security sales are calculated using the specific identification method to determine the security’s cost. Purchases and sales of securities are recognized on a trade-date basis.
Derivative Financial Instruments
Sky Financial’s hedging policies permit the use of interest rate swaps, caps and floors to manage interest rate risk or to hedge specified assets and liabilities. Sky Financial does not use derivative financial instruments for trading purposes. Interest rate swaps were entered into as cash flow and fair value hedges for the purpose of modifying the interest rate characteristics of certain borrowings.
The interest rate swaps involve no exchange of principal either at inception or upon maturity; rather, it involves the periodic exchange of interest payments arising from an underlying notional value. Interest rate caps were entered into as cash flow hedges for purposes of modifying the interest rate characteristics of federal funds purchased.
Derivative instruments are recorded at their fair values. If derivative instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings. Fair value adjustments related to cash flow hedges are recorded in other comprehensive income (loss), net of tax and reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of hedges are reflected in earnings as they occur. Ineffectiveness is recorded as derivative gains (losses) on swaps as a component of non-interest income.
During 2005, Sky Financial began a program to provide clients the ability to swap from variable to fixed interest rates on commercial loans. Under these agreements, Sky Financial enters into a variable rate loan agreement with a client in addition to a swap agreement. This swap agreement effectively swaps the client’s variable rate loan into a fixed rate loan. Sky Financial then enters into a corresponding swap agreement with a third party in order to offset its exposure on the variable to fixed rate swap on the commercial loan. These arrangements are not designated as hedges under Financial Accounting Standards (FAS) No. 133, Accounting for Derivatives and Hedging Activities, as amended. Accordingly, the interest rate swaps with both the clients and third parties are carried at fair value while the changes in fair value offset each other in the income statement.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are carried at the outstanding principal amount, net of any loan origination and commitment fees and costs, and any premiums or discounts arising at the time of purchase or business acquisition. Interest is recorded when earned and includes amortization of any deferred loan origination fees, commitment fees, costs, premiums and discounts. When collection of the loan or interest becomes doubtful, the loan is placed on nonaccrual status and all accrued and unpaid interest relating to previous years and any remaining fees are charged against the allowance for credit losses. Current year’s accrued and unpaid interest is reversed against interest income. Payments on nonaccrual loans are recorded as principal reductions until repayment of the loan and interest is reasonably assured and the loan is returned to accrual status. Loan origination, commitment fees and costs and premium and discounts are amortized over the contractual life of the loan as an adjustment to the related loan’s yield using the interest method.
Loans Held for Sale
Certain residential mortgage loans are originated for sale in the secondary mortgage loan market. Additionally, certain other loans are periodically identified to be sold. These loans are classified as loans held for sale and carried at the lower of cost or estimated fair value. Fair value is determined on the basis of rates quoted in the respective secondary market for the type of loan held for sale. Loans are generally sold at a premium or discount from the carrying amount of the loans. Such premium or discount is recognized at the date of sale. Fixed commitments may be used at the time loans are originated or identified for sale to mitigate interest rate risk. The fair value of fixed commitments to originate and sell loans held for sale was not material.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 1 Summary of Significant Accounting Policies (continued)
Mortgage Servicing Rights
Mortgage servicing rights (MSRs) are stated at cost less accumulated amortization. The cost of mortgage loans sold or securitized is allocated between the mortgage servicing rights and the cost of the mortgage based on the relative fair values of each. The fair value of the mortgage servicing rights is determined by using a discounted cash flow model, which estimates the present value of the future net cash flows of the servicing portfolio based on various factors, such as servicing costs, expected prepayment speeds and discount rates, about which management must make assumptions based on future expectations.
Sky Financial does not use the fair value option for accounting for mortgage servicing rights. MSRs are amortized in proportion to, and over the period of, estimated net servicing income. Management periodically evaluates MSRs for impairment by stratifying the loans in the servicing portfolio primarily based on loan type, coupon rate and region. Impairment is measured by estimating the fair value of each stratum, taking into consideration the estimated level of prepayments based upon current market expectations. An impairment allowance for a stratum is recorded when its fair value is less than its carrying value, and the impairment is deemed by management to be temporary. Amortization and impairments are charged to mortgage banking income. Recoveries of impairment reduce the allowance and increase income.
MSRs are also reviewed for other-than-temporary impairment. Other-than-temporary impairment exists when the recoverability of a recorded valuation allowance is determined to be remote taking into consideration historical and projected interest rates and loan pay-off activity. When this situation occurs, the unrecoverable portion of the valuation allowance is applied as a direct write-down to the carrying value of the MSRs. Unlike a valuation allowance, a direct write-down permanently reduces the carrying value of the MSR and the valuation allowance, precluding subsequent recoveries.
Allowance for Credit Losses
The allowance for credit losses is an amount that management believes will be adequate to absorb probable incurred losses in existing loans, taking into consideration such factors as past loss experience, changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans and current economic conditions that affect the borrower’s ability to pay. Determination of the allowance is inherently subjective due to the aforementioned reasons. Changes in estimates are recorded currently through provision for credit losses. Loan losses are charged-off against the allowance when management believes that the full collectibility of the loan is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Allowances established to provide for losses under commitments to extend credit or recourse provisions under loan sales agreements or servicing agreements are classified within other liabilities.
A loan is considered impaired when it is probable that not all principal and interest amounts will be collected according to the loan contract. Residential mortgage, installment and other consumer loans are evaluated by portfolio for impairment. Individual commercial loans exceeding size thresholds established by management are evaluated for impairment, while the balance of the portfolio is evaluated collectively. Impaired loans are recorded at the loan’s fair value by the establishment of a specific allowance where necessary. The fair value of collateral-dependent loans is generally determined by the fair value of the underlying collateral. The fair value of noncollateral-dependent loans is determined by discounting expected future interest and principal payments at the loan’s effective interest rate.
Sky Financial maintains the allowance for credit losses at a level adequate to absorb management’s estimate of probable losses inherent in the loan portfolio. The allowance is comprised of a general allowance, a specific allowance for identified problem loans and an unallocated allowance representing estimations done pursuant to either FAS No. 5, Accounting for Contingencies, or FAS No. 114, Accounting by Creditors for Impairment of a Loan.
The general allowance is determined by applying estimated loss factors to the credit exposures from outstanding loans. For construction, commercial and commercial real estate loans, loss factors are applied based on internal risk grades of these loans. Many factors are considered when these grades are assigned to individual loans such as current and past delinquency, financial statements of the borrower, current net realizable value of collateral and the general economic environment and specific economic trends affecting the portfolio. For residential real estate, installment, credit card and other loans, loss factors are applied on a portfolio basis. Loss factors are based on Sky Financial’s historical loss experience and are reviewed for modification on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio.
Specific allowances are established for all classified loans, where management has determined that, due to identified significant conditions, it is probable that Sky Financial will be unable to collect all amounts due according to the contractual terms of the loan agreement. The unallocated allowance recognizes the estimation risk associated with the allocated general and specific allowances and incorporates management’s evaluation of existing conditions that are not included in the allocated allowance determinations. These conditions are reviewed quarterly by management and include general economic conditions, credit quality trends, recent acquisitions and internal loan review and regulatory examination findings.
Foreclosed Assets
Assets acquired through or instead of loan foreclosure are initially recorded in other assets at the lower of the loan balance or fair value less estimated selling costs when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs related to the development and improvement of foreclosed assets are capitalized. Costs related to holding and maintaining the property are charged to expense.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation, which is computed primarily using the straight-line method over the estimated useful life of the owned asset and, for leasehold improvements, generally over the lesser of the remaining term of the lease facility or the estimated economic life of the improvement. The useful lives range from three to 10 years for equipment, furniture and fixtures and 10 to 40 years for buildings and improvements. Maintenance and repairs are charged to expense as incurred, while major improvements are capitalized and amortized to operating expense over the identified useful life. The adjusted cost of the specific assets sold or disposed of is used to compute gains or losses on disposal. These assets are reviewed for impairment when events indicate their carrying value may not be recoverable. If management determines an impairment exists, the asset is reduced with an offsetting charge to expense.
Bank-Owned Life Insurance
Sky Financial has purchased life insurance polices on certain key employees. These policies are recorded in other assets at their cash surrender value, or the amount that can be realized. Income from these policies and changes in the cash surrender value are recorded in other income.
Resell and Repurchase Agreements
change in deferred tax assets and liabilities, net of amounts recorded through acquisitions and amounts recorded in accumulated other comprehensive income. Deferred income taxes are provided using the current tax rate for differences between the tax basis of assets and liabilities and their carrying amounts for financial reporting purposes.
Stock Dividends and Treasury Stock
Shares of Sky Financial stock may be acquired for reissuance in connection with stock option plans, for stock dividend declarations and for general corporate purposes. The treasury shares acquired are recorded at cost. The fair value of shares issued in stock dividends is transferred from retained earnings to common stock, to the extent of available retained earnings. Any excess of fair value over available retained earnings is considered a return of capital and thus is transferred from common stock.
Stock-Based Compensation
In 2005, Sky Financial adopted FAS No. 123(R), Share-Based Payment. Sky adopted FAS 123(R) using the modified retrospective method for interim periods. As a result, the results of operations for the full years of 2006 and 2005 include expense related to stock options, while the 2004 results of operations does not include expense related to stock options.
Sky Financial maintains a restricted stock plan for eligible employees. Compensation expense for restricted share awards is recognized ratably over the period of service, usually the restricted period, based upon the fair value of the stock on the date of grant.
The following table illustrates the total stock compensation expense recorded in salaries and employee benefits expense for the years ended December 31, 2006 and 2005:
Securities purchased under agreements to resell and securities sold under agreements to repurchase are generally treated as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. The fair value of collateral either received from or provided to a third party is continually monitored and additional collateral is obtained or is requested to be returned to Sky Financial as deemed appropriate.
Intangible Assets
Core deposit intangible assets are amortized on an accelerated basis over their estimated useful lives, which average 10 to 12 years. Goodwill is not amortized, but rather reviewed for impairment on an annual basis or more frequently if impairment indicators exist. Customer relationship intangibles are recorded for Sky Financial’s acquisitions of insurance agencies. These customer relationship intangibles are generally amortized on an accelerated basis over their estimated useful life, which average 8 to 12 years.
Merger, Integration and Restructuring Expense
Merger, integration and restructuring expenses primarily represent professional fees, severance and other personnel related costs, lease terminations, valuation adjustments for certain premises, equipment and other assets and integration costs related to mergers and acquisitions. (See Note 16.)
Income Taxes
Sky Financial utilizes an asset and liability approach for financial accounting and reporting of income taxes. The provision for income taxes is the sum of taxes currently payable and the
Sky Financial uses the Black-Scholes option pricing model for all grant date estimations of fair value under FAS 123 and FAS 123(R) and will continue to use this model, as Sky Financial believes that its stock options have characteristics for which the Black-Scholes model provides an acceptable measure of fair value. For all of Sky Financial’s option plans, options are issued to employees and directors at-the-money. The expected term of an option represents the period of time that Sky Financial expects the options granted to be outstanding. Sky Financial bases this estimate on a number of factors, including vesting period, historical data, expected volatility and blackout periods. The expected volatility used in the option pricing calculation is estimated considering both historical and implied volatility. Sky Financial believes that historical volatility alone is not a good predictor of the expected volatility. Given the absence of traded
options in Sky Financial shares and the effects of significant merger activity on the historical volatility, the expected volatility assumption for Sky Financial options incorporates both the historical volatility and an estimated implied volatility. The expected dividend yield represents the expected dividend rate that will be paid out on the underlying shares during the expected term of the option, taking into account any expected dividend increases. Sky Financial’s options do not permit option holders to receive dividends and therefore the expected dividend yield was factored into the calculation. The risk-free rate is assumed to be a short-term treasury rate on the date of grant, such as a U.S. Treasury zero-coupon issue with a term equal to the expected term of the option.
Stock option expense was computed with the following weighted average assumptions as of the grant dates:
Prior to the adoption of FAS 123(R), forfeitures were recognized as they occurred. The cumulative effect of adopting FAS 123(R), which includes the impact of changing from the prior
method of recognizing forfeitures as they occur to estimating forfeitures at the grant date, was not material.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 1 Summary of Significant Accounting Policies (continued)
In accordance with Sky Financial’s stock option and restricted shares plans, employee participants age 55 or older are eligible to retire, which has the effect of immediately vesting all non-vested options and restricted shares. Prior to the adoption of FAS 123(R), Sky Financial’s accounting policy was to recognize compensation cost over the contractual vesting period with no acceleration based on retirement age. Compensation cost for all awards granted prior to the adoption of FAS 123(R) continue to be recognized over the contractual vesting period and any remaining unrecognized compensation cost will be accelerated when an employee actually retires. Compensation cost for awards granted or modified after the adoption of FAS 123(R) will be recognized over a period to the date an employee first becomes eligible for retirement. In accordance with this change in policy, stock option
expense for 2006 and 2005 included expense of $447 and $403, respectively, for stock options that were granted to retirement eligible participants prior to the adoption of FAS 123(R) that are continuing to be expensed over the contractual terms of the option.
Prior to the adoption of FAS 123(R), employee compensation expense under stock option plans was accounted for under the intrinsic value method. No stock-based compensation cost was reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at grant date. The following table illustrates the effect on 2004 net income and earnings per share if expense was measured using the fair value recognition provisions of FAS No. 123, Accounting for Stock Options.
Statement of Cash Flows
Sky Financial considers cash on hand, deposits maintained with the Federal Reserve Bank and cash due from other banks, all of which are included in the caption “cash and due from banks,” as cash for purposes of the Statement of Cash Flows. Sky Financial reports net cash flows for federal funds sold and purchased, interest-bearing deposits with other financial institutions, client loan transactions, deposit transactions, repurchase agreements and short-term borrowings.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, adjustments related to cash flow hedges and adjustments to pension liabilities that are also recognized as separate components of equity.
Non-Bank Revenue Recognition
Trust service revenues include fees for services such as asset management, record keeping, retirement services and estate management. Income is recognized on an accrual basis at the time the related services are performed.
Brokerage and insurance revenues include commission and fees relating to the sales of policies and investments as well as fees for related insurance services. Commission income is recognized as of the effective date of the insurance policy with a reserve established for policy cancellations. Contingent performance-based commissions from insurance companies are recognized when earned and no contingencies remain.
New Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements
No. 87, 88, 106, and 132R) (FAS 158), requires an employer to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity. The requirement by FAS 158 to recognize the funded status of a benefit plan and the disclosure requirements of FAS 158 are effective as of the end of the fiscal year ending after December 15, 2006 for entities with publicly traded equity securities. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The adoption of FAS 158 did not have a material effect on the financial position of the company at December 31, 2006.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). FAS 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of FAS 157, guidance for applying fair value was incorporated in several accounting pronouncements. FAS 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. FAS 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in
active markets. Under FAS 157, fair value measurements are disclosed by level within that hierarchy. While FAS 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement
to adjust the value of restricted stock for the effect of the restriction, even if the restriction lapses within one year. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Sky Financial has not determined the impact of adopting FAS 157 on its financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that Sky Financial recognize in the financial statements, the impact of a tax position, if that position is more likely than not to be sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The cumulative change in accounting recorded directly to retained earnings and the effect on 2007 income from operations is not material.
In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets: An Amendment of FASB Statement No. 140 (FAS 140 and FAS 156). FAS 140 establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities. This Statement amends FAS 140 to require that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. This Statement permits, but does not require, the subsequent measurement of separately recognized servicing
assets and servicing liabilities at fair value. Under this Statement, an entity can elect subsequent fair value measurement to account for its separately recognized servicing assets and servicing liabilities. Adoption of this Statement is required as of the beginning of the first fiscal year that begins after September 15, 2006. Sky Financial adopted FAS 156 on January 1, 2007 and did not elect the fair value measurement option.
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments: An Amendment of FASB Statements No. 133 and 140 (FAS 155). FAS 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Sky Financial does not expect the adoption of FAS 155 to have a material effect on the results of operations or the statement of condition.
Note 2 Mergers, Acquisitions, Business Formations and Divestitures
Huntington Merger
On December 20, 2006, Sky Financial and Huntington Bancshares Incorporated (Huntington) announced the signing of a definitive agreement to merge the two companies in a stock (90%) and cash (10%) transaction valued at approximately $3.5 billion. Under the terms of the agreement, Sky Financial Group shareholders will receive 1.098 shares of Huntington common stock, on a tax-free basis, and a taxable cash payment of $3.023 for each share of Sky Financial Group.
The merger was unanimously approved by both companies’ boards of directors and is expected to close early in the 2007 third quarter, pending customary regulatory approvals, as well as the approval of Huntington’s and Sky Financial Group’s shareholders.
Community Banking Acquisitions
Wells River
On November 15, 2006, Sky Financial completed its acquisition of Wells River Bancorp, Inc. (Wells River) and its wholly-owned subsidiary, Perpetual Savings Bank, a $71.3 million bank that operates three full-service branches in Ohio’s Columbiana County. The aggregate purchase price was $10,992, including direct acquisition costs of $24. The acquisition of Wells River expands Sky Financial’s community banking business further in the eastern Ohio market. Wells River shareholders received approximately 178 shares of Sky Financial common stock and cash of $6,600. The total purchase price for Wells River has been allocated to the tangible and identifiable intangible assets and liabilities based upon their respective fair values. Such allocations have not been finalized and as such, the allocation of the purchase consideration included in the accompanying Consolidated Balance Sheet at December 31, 2006, is preliminary.
Union Federal
On October 17, 2006, Sky Financial completed its acquisition of Union Federal Bank of Indianapolis (Union Federal) and its parent company, Waterfield Mortgage Company, Inc., Ft. Wayne, Indiana. Sky Financial purchased Waterfield’s retail and commercial banking business conducted primarily through Union Federal Bank, which added approximately $2.3 billion in assets. The aggregate purchase price was $332,195 including direct acquisition costs of approximately $2,369. Waterfield shareholders received $136,505 in cash and 7,467 shares of Sky Financial common stock. The acquisition of Union Federal Bank expands Sky Financial’s Indiana presence into the growing Indianapolis market with the addition of 42 branches in this area. Sky Financial also acquired Waterfield Insurance as part of the acquisition. The total purchase price for Union Federal has been allocated to the tangible and identifiable intangible assets and liabilities based upon their respective fair values. Such allocations have not been finalized and as such, the allocation of the purchase consideration included in the accompanying Consolidated Balance Sheet at December 31, 2006, is preliminary.
Falls Bank
On November 29, 2005, Sky Financial completed its acquisition of Falls Bank, an $80 million bank that operates two full-service branches in the Akron, Ohio market. The aggregate purchase price was $12,273, including direct acquisition costs of $36. The acquisition of Falls Bank expanded Sky Financial’s community banking business further into the Akron market. Falls Bank shareholders received 350 shares of Sky Financial common stock and cash of $2,348. The total purchase price for Falls Bank has been allocated to the tangible and identifiable intangible assets and liabilities based upon their respective fair values.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 2 Mergers, Acquisitions, Business Formations and Divestitures (continued)
Belmont Bancorp
On June 1, 2005, Sky Financial completed its acquisition of Belmont Bancorp (Belmont), a $297 million bank holding company headquartered in St. Clairsville, Ohio, and its wholly-owned subsidiary, Belmont National Bank. The aggregate purchase price was $68,431, including direct acquisition costs of $37. Belmont’s offices located in Belmont, Harrison and Tuscarawas counties in Ohio, and Ohio County in West Virginia expanded Sky Financial’s community banking business further into these markets. Belmont Bancorp shareholders received approximately 1,765 shares of Sky Financial common stock and cash of $18,705. The total purchase price for Belmont has been allocated to the tangible and identifiable intangible assets and liabilities based upon their respective fair values.
Prospect Bancshares
On November 30, 2004, Sky Financial acquired Prospect Bancshares, Inc. (Prospect), a $202 million bank holding company headquartered in Worthington, Ohio, and its wholly-owned subsidiary Prospect Bank, by acquiring all of the outstanding capital stock of Prospect Bancshares for an aggregate purchase price of $46,754, including direct acquisition costs of $77. Prospect Bancshares shareholders received approximately 1,139 shares of Sky Financial common stock and cash of $17,600.
Second Bancorp
On July 1, 2004, Sky Financial acquired Second Bancorp Incorporated (Second Bancorp), a $2.0 billion bank holding company headquartered in Warren, Ohio, and its wholly-owned subsidiary Second National Bank of Warren by acquiring all of the outstanding capital stock of Second Bancorp for an aggregate purchase price of $312,738, including direct acquisition costs of $2,093. Second Bancorp shareholders received approximately 11,953 shares of Sky Financial common stock.
The acquisitions complement Sky Financial’s operations in its regional banking structure by enhancing its presence in these areas. The value of the common stock issued for each of the acquisitions was determined based on the market price of Sky Financial’s common stock on the date that the final terms of the acquisitions were agreed to and announced. The results of operations for the acquired institutions have been included in the consolidated financial statements since the date of acquisition. The following table presents the allocation of the purchase price, including direct acquisition costs, for the Wells River, Union Federal, Falls Bank, Belmont, Prospect and Second acquisitions to assets acquired and liabilities assumed, based on their fair values:
The following (unaudited) pro forma consolidated results of operations have been prepared as if the acquisitions of Wells River and Union Federal occurred as of the beginning of each period presented, with Falls Bank and Belmont being presented as of January 1, 2005:
The pro forma results for 2005 included losses of $22,512 from the sale of investment securities recorded by Union Federal and approximately $800 of merger costs recorded by Belmont.
Sky Financial recorded pre-tax merger, integration and restructuring charges totaling $6,575, $1,771 and $4,542 during 2006, 2005 and 2004, respectively,
related to the acquisitions noted above. See Note 16 for additional discussion. The pro forma information presented is for informational purposes only and is not indicative of the results of operations that actually would have been achieved had the acquisitions been consummated as of that time, nor is it intended to be a projection.
Financial Service Affiliate Acquisitions
On September 30, 2006, Sky Financial acquired Lindig Benefits Consultants located in Worthington, Ohio for 44 shares of Sky Financial common stock and $104 in cash.
On January 3, 2006, Sky Financial acquired the Peter B. Burke Insurance Agency in Pittsburgh, Pennsylvania for 64 shares of Sky Financial common stock and $206 in cash.
On October 4, 2005, Sky Financial acquired Becker- McDowell Agency, Inc. and Steiner Insurance Agency, Inc., both located in Wooster, Ohio. Becker-McDowell was acquired for 222 shares of Sky Financial common stock and $580 in cash. Steiner Insurance Agency was acquired for 111 shares of Sky Financial common stock and $288 in cash.
On August 1, 2005, Sky acquired B.K.M.’s Benefit Design
Agency of Ohio, Inc., located in Findlay, Ohio for 137 shares of Sky Financial common stock and $661 in cash.
On July 1, 2004, Sky Financial acquired Stouffer-Herzog Insurance Agency in conjunction with the purchase of Second Bancorp, as previously discussed.
On April 1, 2004, Sky Financial acquired EOB, Inc., a group benefit insurance agency headquartered in Canton, Ohio, for 177 shares of Sky Financial common stock and $516 in cash.
On January 5, 2004, Sky Financial acquired Spencer-Patterson Insurance Agency, a full-service professional liability, personal and commercial agency headquartered in Findlay, Ohio, for 297 shares of Sky Financial common stock and $793 in cash.
Disclosure of pro forma results of the acquisitions of the financial services affiliates is immaterial to Sky Financial’s consolidated financial statements.
Business Divestitures
In 2006, Sky Financial sold a portion of its insurance business related primarily to wholesale insurance and realized a pre-tax gain of $6,658.
On March 31, 2004, Sky Financial completed the sale of Sky Financial Solutions, its dental financing affiliate. The sale resulted in a $31.2 million pre-tax gain. See Note 26.
Note 3 Securities
The estimated fair values and unrealized gains and losses of securities at year-end are as follows:
(1) Certain securities such as FHLB, FRB, and Bankers’ Bank stock are carried at amortized cost.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 3 Securities (continued)
Sky Financial evaluates its securities portfolio for other-than-temporary impairment throughout the year. Each investment, which has an indicative market value less than the book value, is reviewed on a monthly basis by management. Management considers, at a minimum, the following factors that, both individually or in combination, could indicate that the decline is other-than- temporary: 1) the length of time and extent to which the market value has been less than book value; 2) the financial condition and near-term prospects of the issuer; or 3) the intent and ability of Sky Financial to retain the investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value. Among the factors that are considered in determining intent and ability is a review of capital adequacy, interest rate risk profile and liquidity at Sky Financial.
An impairment is recorded against individual securities if the review described above concludes that the decline in value is other than temporary. In fourth quarter of 2006, Sky Financial determined that an investment in a corporate equity security with a book value of $9,065 and a fair value at the end of the year of $7,384 was impaired. The fair value of the equity security had been below Sky Financial’s cost for the security in excess of a year and Sky Financial was unable to forecast the near-term recovery of the value of the security. As a result, Sky Financial recorded an other-than-temporary impairment of $1,681 related to this security.
The fair values of investments with an amortized cost in excess of their fair value at December 31, 2006 and 2005 are as follows:
The estimated fair value of debt securities at December 31, 2006, by contractual maturity, are shown in the accompanying table. Expected maturities will likely differ from contractual maturities because some issuers have the right to call or prepay obligations with or without call or prepayment penalties.
The gross realized gains and losses from the sales of securities are as follows:
The gross realized losses on sales do not include the $1,681 of losses related to the impairment discussed above.
During the fourth quarter of 2006, Sky Financial restructured its balance sheet to strengthen capital ratios, maintain a sound interest rate risk position and enhance the net interest margin following the completion of its recent acquisitions of Union Federal and Wells River. The restructuring actions resulted in a reduction in total assets, which included the sale of $505,629 of available-for-sale, fixed-rate investment securities with an average yield of 3.74% and the elimination of federal funds sold coming from the Union Federal acquisition. With the sale proceeds, Sky Financial paid off $254,702 of FHLB advances and $72,000 of borrowings, with a combined average cost of 5.92% and reduced federal funds purchased. In addition to de-leveraging the balance sheet, these actions should improve the net interest margin and increase net interest income in the upcoming quarters. This balance sheet restructuring resulted in realized losses on sales of securities of $19,435 recorded as a component of net securities gains (losses) and net gains of $4,183 recorded as other income related to the extinguishment of the debt and related derivative instruments.
Securities pledged to secure public deposits and repurchase agreements totaled $2,086,820 and $2,080,838 at December 31, 2006 and 2005, respectively.
Note 4 Loans and Allowance for Credit Losses
The loan portfolio at year-end was as follows:
The 2005 loan categories have been reclassified to conform to the current year presentation. In 2006, Sky Financial changed the method of classifying certain loans, which resulted in a decrease in loans classified as construction and an increase in non-residential real estate and commercial, financial and agricultural loans.
Most of Sky Financial’s business activity is conducted through Sky Bank with clients in the respective local areas of the bank. These areas encompass parts of eastern Ohio, western Ohio, central Indiana, southeastern Michigan, western Pennsylvania and northern West Virginia. Sky Bank’s loan portfolio is diversified, consisting of commercial, residential, agribusiness, consumer and small business loans. In Sky Bank’s loan portfolio, no significant industry concentrations exist and amounts related to highly-leveraged transactions are not significant. Total loans include overdrafts of $7,309 and $5,596 at December 31, 2006 and 2005, respectively.
Sky Financial evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained is based on management’s evaluation of the client. Collateral held relating to commercial, financial, agricultural and commercial mortgages varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Loans on which the accrual of interest has been discontinued totaled $137,111 and $119,030 at December 31, 2006 and 2005, respectively.
In conjunction with the Union Federal acquisition on October 17, 2006, Sky Financial acquired loans approximating $1,359,926. Union Federal’s allowance for credit losses at the acquisition date of October 17, 2006 was $36,017. Sky Financial determined that certain loans acquired in the Union Federal acquisition had evidence of deterioration of credit quality and it was probable that all contractual required payments would not be collected on these loans. Sky Financial determined that 47 loans with a book value totaling approximately $13,591 and with a fair value of $7,466 were within the guidelines set forth under SOP 03-3. These loans have been recorded by Sky Financial at their fair value and the allowance for credit losses was reduced by $6,125. Accordingly, Sky Financial recorded $29,892 of
allowance for credit losses on loans not subject to SOP 03-3 related to the Union Federal acquisition. The amount of interest income recorded on these loans during 2006 was not material.
In conjunction with the Wells River acquisition on November 15, 2006, Sky Financial acquired loans approximating $49,000 and determined that the entire $487 of allowance for credit losses was not subject to SOP 03-3.
The remaining loans acquired from the Belmont acquisition in 2005 that were being accounted for under SOP 03-3 were not material at December 31, 2006. There were no loans acquired from Falls Bank that were accounted for under SOP 03-3.
In the normal course of business, Sky Financial has made loans to certain directors, executive officers and their affiliates. Loan activity relating to these individuals for 2006 is as follows:
Information regarding impaired loans is as follows:
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 5 Premises and Equipment
Premises and equipment as of year-end are summarized as follows:
Included in premises and equipment are buildings, land and land improvements that secure capitalized leases with a cost of $1,784 and $3,368, less accumulated amortization and depreciation of $1,734 and $3,194 at December 31, 2006 and 2005, respectively. Depreciation expense was $19,658 in 2006, $20,647 in 2005 and $20,967 in 2004. Rental payments for land
and buildings are accounted for as operating lease expense. Total rent expense amounted to $16,873 in 2006, $15,347 in 2005 and $11,217 in 2004. Minimum future rentals under operating leases are as follows: 2007, $11,869; 2008, $9,874; 2009, $8,309; 2010, $7,316; 2011, $6,386; 2012 and thereafter, $21,734.
Note 6 Goodwill and Intangible Assets
Net goodwill activity by segment was as follows:
In 2006, as part of the sale of the portion of the insurance business discussed in Note 2, Sky Financial reduced the goodwill of the Financial Services Affiliates by $13,179.
Goodwill is reviewed annually for impairment or more frequently if impairment indicators exist. Sky Financial completed this review during the second quarter of 2006 and determined that goodwill was not impaired.
Other intangible assets at December 31, 2006 and 2005 were $73,442 and $67,077, respectively, net of accumulated amortization of $20,418 and $15,885, respectively. These assets consist primarily of core deposits intangibles and customer relationship intangibles.
The core deposit intangibles at December 31, 2006 and 2005 were $69,989 and $63,335, respectively, net of accumulated amortization of $19,445 and $15,583, respectively. The customer relationship intangibles at December 31, 2006 and 2005 were $3,453 and $3,742, respectively, net of accumulated amortization of $973 and $302, respectively.
During 2006, Sky Financial recorded additional intangible assets of $22,216 related to core deposit intangibles and customer relationships. This total amount will be amortized over a weighted average period of approximately eleven years. Of this total, $21,532 related to core deposit intangibles that will be amortized over a weighted average period of approximately eleven years. Also included in this total is $684 of customer relationship intangibles that will be amortized over a weighted-average period of approximately eight years.
Amortization expense related to the intangible assets was $15,803, $14,887 and $10,979 during 2006, 2005 and 2004, respectively. For the years ending 2007 through 2011, the estimated future amortization expense will be approximately $17,592, $16,161, $13,610, $11,758 and $10,411, respectively.
Note 7 Interest-Bearing Deposits
Total interest-bearing deposits as presented on the balance sheet are comprised of the following classifications at year-end (certain amounts from prior year have been reclassified to conform to current year presentation):
Note 8 Securities Sold Under Repurchase Agreements and Federal Funds Purchased
Sky Financial has retail repurchase agreements with clients within its local market areas, as well as federal funds purchased from other banks. These borrowings are collateralized with securities owned by Sky Bank and held in its safekeeping accounts at independent correspondent banks.
Sky Financial also has repurchase agreements with brokerage firms that are in possession of the underlying securities. The securities are returned to Sky Financial at the maturity of the agreements.
The following table summarizes certain information relative to these borrowings:
Included in the above as of December 31, 2006, are repurchase agreements in excess of one year as summarized below:
The weighted average rate on repurchase agreements in excess of one year was 7.12% at December 31, 2006 and 5.57% at December 31, 2005
At December 31, 2005, repurchase agreements in excess of one year were $311,806 with a weighted average life based on stated maturity of 2.3 years and a weighted average life based on call dates of 2.1 years.
Note 9 Debt and Federal Home Loan Bank Advances
Sky Financial’s debt and Federal Home Loan Bank (“FHLB”) advances are comprised of the following at December 31:
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 9 Debt and Federal Home Loan Bank Advances (continued)
Lines of Credit
Sky Financial maintains a credit facility with a group of financial institutions in the form of a short-term line of credit. This line of credit is subject to renewal on an annual basis. The commitment on the line was $100,000 in 2006 and 2005. Interest on advances taken on the facility is accrued at either a formula based on the London Interbank Offering Rate (LIBOR), or a formula based on the federal funds rate. Sky Financial may elect the interest rate method to be applied to amounts outstanding. The agreement provides for a quarterly fee of .150% on the commitment amount of the credit facility. The agreement contains covenants that require Sky Financial, among other things, to maintain an acceptable level of capital and asset quality as defined by the agreement. The average amount outstanding in 2006 was $288 with an average cost of 5.83%, compared to $578, with an average cost of 3.56% in 2005.
FHLB Advances
FHLB advances are collateralized by all shares of FHLB stock owned by the subsidiary bank and by 100% of the subsidiary bank’s qualified residential mortgage loans. The subsidiary bank may increase its borrowing capacity by pledging securities. Based on the carrying amount of FHLB stock owned by the subsidiary bank, total FHLB advances are limited to approximately $1,943,666, subject to the availability of qualified residential mortgage loans for pledging.
Junior Subordinated Debentures Owed to Unconsolidated Subsidiary Trusts
Beginning in 1997, Sky Financial has issued obligated mandatorily redeemable capital securities through fully-consolidated subsidiaries. The trust preferred entities were formed for the purpose of issuing capital securities to third parties and investing the proceeds from the sale of such securities solely in junior subordinated debentures of Sky Financial. The debentures held by each trust are the sole assets of that trust. Distributions on the capital securities issued by each trust are payable semi-annually or quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The borrowings are redeemable after a certain date at their stated face values or at a premium if redemption occurs before that date.
During the second quarter of 2006, Sky Financial issued $150,000 of trust preferred securities in advance of the fourth quarter acquisition of Union Federal Bank. In addition, as part of the acquisition, Sky Financial acquired the Waterfield Capital Trust I and Waterfield Capital Trust II. As part of its balance sheet restructuring in the fourth quarter, Sky Financial redeemed junior subordinated debentures with a par value of $32,000 related to the Second Bancorp Capital Trust I.
The following table summarizes the issuance date, par value, interest rate, redemption price, redemption date and hedged average rate for the junior subordinated debentures at December 31, 2006:
Debt obligations related to unconsolidated subsidiary trust follows:
Other
At December 31, 2006, required annual principal payments on debt and FHLB advances are presented in the following table:
Note 10 Derivative Instruments and Hedging Activities
Sky Financial’s hedging policies permit the use of interest rate swaps, caps and floors to manage interest rate risk or to hedge specified assets and liabilities. Sky Financial uses derivative instruments, primarily interest rate swaps, to manage interest rate risk on certain liabilities by hedging either the fair value of certain fixed-rate debt or the cash flow variability associated with certain variable rate debt.
The derivative instruments and hedging relationships have been designated and qualify as either fair value or cash flow hedges. To qualify for hedge accounting under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, the effectiveness of each hedging relationship is assessed both at hedge inception and at each reporting period thereafter. Also, at the end of each reporting period, ineffectiveness in the hedging relationships is measured as the difference between the change in fair value of the derivative instruments and the change in fair value of either the hedged items (fair value hedges) or expected cash flows (cash flow hedges). Ineffectiveness, if any, is recorded as derivative gains (losses) on swaps as a component of non-interest income.
Accounting Correction
During the second quarter 2006, Sky Financial identified and corrected immaterial accounting errors related to certain derivative hedging relationships. The misstatements related to Sky Financials’ interpretation and application of the “shortcut” method of hedge accounting under Statement No. 133. Sky Financial determined that these hedges did not qualify for hedge accounting using the “shortcut” method. As a result, changes in the market value of the derivatives should have been recorded through non-interest income with no corresponding offset to the hedged item. Sky Financial evaluated the impact of these errors and concluded that the impact was not material to prior quarterly and annual periods. Accordingly, an adjustment was recorded in the second quarter of 2006 to correct the cumulative impact of these errors.
The cumulative impact of these out-of-period adjustments resulted in a charge to non-interest income in the second quarter of 2006 of $9,930 ($6,603 after tax), which is included in derivative gains (losses) on swaps in the Consolidated Statements of Income.
During the third quarter of 2006, Sky Financial redesignated the affected derivatives related to the convertible advances from the Federal Home Loan Bank of Cincinnati as hedges using the long-haul method of hedge accounting and then in the fourth quarter, these derivatives were terminated. The breakage of these instruments with a total notional value of $205,000 resulted in a gain of $930 ($605 after-tax). Included in this gain is $457 related to recording ineffectiveness on the swaps and was recorded as derivative gains on swaps and the remaining $473 was recorded as a
component of other income. The swaps related to the junior subordinated debentures owed to unconsolidated subsidiary trust were not redesignated as hedges and Sky Financial terminated the swaps. The breakage of these instruments during the third quarter of 2006 with a total notional value of $108,600 resulted in a gain of $3,228 ($2,098 after-tax) recorded as derivative gains on swaps.
Fair Value Hedges - Interest Rate Swaps
Sky Financial uses interest rate swap agreements to hedge a portion of its fixed rate borrowings. The interest rate swaps effectively convert the fixed rate of interest on $284,150 of advances from the Federal Home Loan Bank of Cincinnati (FHLB) and $130,000 of wholesale repurchase agreements to variable rates based on LIBOR plus a spread as defined in the agreements. Sky Financial also uses interest rate swap agreements to hedge long-term fixed rate commercial loans. At December 31, 2006, Sky Financial had $18,153 of such agreements. The commercial loan swaps effectively convert the fixed rate of interest on these commercial loans to a variable rate based on LIBOR plus a spread as defined in the agreements. The interest rate swaps involve no exchange of principal either at inception or maturity and have maturities identical to the commercial loans. The arrangements have been designated as fair value hedges and both the change in the fair value of the hedges and the hedged transactions are reflected in earnings. The hedging arrangements of the advances from the FHLB, the wholesale repurchase agreements and the long-term fixed rate commercial loans are considered highly effective, and changes in the fair value of the interest rate swaps exactly offset the corresponding changes in the hedged items. As a result, the changes in the fair value do not result in an impact on net income.
During 2006, Sky Financial recorded income of $984 related to the ineffectiveness of the swaps of the convertible advances from the FHLB that is recorded as deriavative gains (losses) on swaps.
Cash Flow Hedges
In the first quarter of 2006, Sky Financial entered into two interest rate swaps that fix the rate on $150,000 of variable rate borrowings on junior subordinated debentures owed to unconsolidated subsidiary trusts. As part of its financing of the fourth quarter acquisition of Union Federal Bank, Sky Financial borrowed $150,000 under junior subordinated debentures in the second quarter. Under the terms of the arrangement, Sky Financial pays a fixed rate of interest and receives a variable rate based on LIBOR. Hedge effectiveness is assessed on a quarterly basis using the long-haul method. The effective portion of the change in the swap’s fair value is recorded in other comprehensive income, net of tax. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the variable-rate subordinated notes. The change in net unrealized losses on cash flow hedges reflects a reclassification of $200 of net unrealized gains from accumulated other comprehensive income to interest expense during 2006. During 2007, Sky Financial estimates that $266 of unrealized gains will be reclassified.
Interest Rate Caps
During 2002, Sky Financial entered into two interest rate cap arrangements, and paid $1,456 to hedge its interest risk on $48,600 of federal funds purchased. The interest rate caps are designed to offset the impact of changes in the federal fund purchased rate above the weighted average stated rate of 5.90%, and, as such, are considered to be highly effective. Any changes in the intrinsic values are recorded in other comprehensive income. The changes in the time values of the interest rate caps, which are excluded from the assessment of hedge effectiveness, increased interest expense by $219 in 2006 and 2005 and $220 in 2004. No deferred gains or losses in accumulated other comprehensive income at December 31, 2006 are expected to be reclassified to income from continuing operations in 2007.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 10 Derivative Instruments and Hedging Activities (continued)
The following table presents the contract/notional and fair value amounts of all derivative transactions at December 31, 2006 and 2005:
Interest Rate Swaps on Behalf of Clients
Sky Financial has entered into several commercial loan swaps in order to provide commercial loan clients the ability to swap from variable to fixed interest rates. Under these agreements, Sky Financial enters into a variable rate loan agreement with a client in addition to a swap agreement. This swap agreement effectively swaps the client’s variable rate loan into a fixed rate loan. Sky Financial then enters into a corresponding swap agreement with a third party in order to swap its
exposure on the variable to fixed rate swap on the commercial loan. At December 31, 2006 and 2005, Sky Financial had $159,371 and $65,138, respectively, of notional amount of such agreements. As the interest rate swaps with the clients and third parties are not designated as hedges under FAS No. 133, the instruments are marked to market in earnings. As the interest rate swaps are structured to offset each other, there was no net impact to earnings in 2006 and 2005 related to these swaps.
Note 11 Income Taxes
Income taxes consisted of the following:
Note 11 Income Taxes (continued)
The sources of gross deferred tax assets and liabilities were as follows at December 31 (certain amounts related to basis diference on acquired assets from prior years have been reclassified to conform to current year presentation):
Total federal income tax expense differs from the expected amounts computed by applying the statutory
federal tax rate of 35% to income before taxes. The reasons for this difference are as follows:
Tax (benefit) expense attributable to securities gains and losses totaled $(6,826), $1,281 and $5,099 in 2006, 2005 and 2004, respectively.
For the years ended 2006, 2005, and 2004, the tax benefit associated with stock option exercises directly to paid in capital was $1,745, $2,660, and $3,175, respectively.
At December 31, 2006, the Company had unused net operating losses and general business tax credits expiring from 2018 to 2024. Sky Financial anticipates all net operating losses and general business credits will be fully utilized.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 12 Other Comprehensive Income (Loss)
Other comprehensive income (loss) consisted of the following:
Accumulated other comprehensive income (loss) consisted of the following:
Note 13 Earnings Per Common Share
Basic earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted earnings per share is computed using the weighted average number of shares determined for the basic computation plus the dilutive effect of potential common shares issuable under stock options and restricted shares.
Basic and diluted earnings per share computations were as follows:
Weighted shares under option of 2,171 in 2006, 291 in 2005 and 38 in 2004 were excluded from the diluted earnings per share calculation, as they were anti-dilutive.
Note 14 Fair Values of Financial Instruments
The following table shows carrying values and the related estimated fair values of financial instruments at year-end. Items that are not financial instruments are not included.
For purposes of the above disclosures of estimated fair value, the following assumptions were used: the carrying values for cash and due from banks, interest-bearing deposits with financial institutions and federal funds sold were considered to approximate fair value; the estimated fair value for securities was based on quoted market values for the individual securities
or for equivalent securities; the estimated fair value for loans was based on estimates of the rate Sky Financial would charge for similar loans at December 31, 2006 and 2005, applied over estimated payment periods; the estimated fair value for demand and
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 14 Fair Values of Financial Instruments (continued)
savings deposits was based on their carrying value; the estimated fair value for certificates of deposit and borrowings was based on estimates of the rate Sky Financial would pay on such obligations at December 31, 2006 and 2005, applied for the time period until maturity. The fair value of interest rate swaps and caps represents the estimated amount the company would receive or pay to terminate the agreements, considering current interest rates, as well as the current creditworthiness of the counterparties. The capital lease obligations of $80 and $302 at December 31, 2006 and 2005 are not included in the carrying amounts or the estimated fair value. The estimated fair value of commitments was not material.
While these estimates of fair values are based on management’s judgment of appropriate factors, there is no assurance that, if Sky Financial had disposed of such items at December
31, 2006 or 2005, the estimated fair values would necessarily have been achieved at that date, because market values may differ depending on various circumstances. The estimated fair values at December 31, 2006 and 2005 should not necessarily be considered to apply at subsequent dates.
In addition, other assets and liabilities of Sky Financial that are not defined as financial instruments were excluded from the above disclosures, such as mortgage servicing rights and life insurance contracts. In addition, non-financial instruments typically not recognized in financial statements (but which may have value) were not included in the above disclosures. These include, among other items, the estimated earning power of core deposit accounts, the value of a trained work force, client goodwill and similar items.
Note 15 Other Income and Other Operating Expense
The following is a summary of other income and other operating expense:
Note 16 Merger, Integration and Restructuring Expenses
In 2006, Sky Financial recorded merger, integration and restructuring charges totaling $6,575 ($4,274 after-tax or $.04 per diluted share). Merger, integration and restructuring charges of $5,555 ($3,611 after-tax or $.03 per diluted share) related to the acquisition of Union Federal Bank. Included were data processing and conversion costs of $3,104, severance and other related employee costs of $703, professional fees and other costs of $1,708 and lease and contract termination costs of $40. Costs of $816 ($530 after-tax) were related to the Wells River acquisition. These charges consisted of data processing and conversion expense of $667, severance and other related employee costs of $117 and professional fees and other costs of $32. Costs of $102 ($ 66 after-tax) were related to acquisitions by Sky Insurance. These charges consisted of data processing and conversion costs of $65 and professional fees and other costs of $37. Costs of $102 ($67 after-tax) were also incurred related to prior year acquisitions.
During 2006, a total of 190 positions were eliminated as part of integrating the acquisitions, which involved
172 positions from Union Federal Bank and 18 positions from Wells River. Of this total, 72 employees from Union Federal Bank and seven from Wells River accepted outside employment. The remaining 100 employees from Union Federal Bank and 11 from Wells River Bancorp were involuntarily terminated with severance.
In 2005, Sky Financial recorded merger, integration and restructuring charges totaling $1,771 ($1,151 after-tax or $.01 per diluted share). Merger, integration and restructuring charges of $1,168 ($759 after-tax or $.01 per diluted share) related to the acquisition of Belmont Bancorp. Included were data processing and conversion costs of $222, severance and other related employee costs of $401, professional fees and other costs of $463 and lease and contract termination costs of $82. Costs of $224 ($146 after-tax) were related to the Falls Bank acquisition. These charges consisted of data processing and conversion expense of $45 and professional fees and other costs of $179. In addition to the above costs for acquisitions, Sky Financial recorded $379 ($246 after-tax) for professional and other costs related to the pending acquisition of Union Federal.
Note 16 Merger, Integration and Restructuring Expenses (continued)
During 2005, a total of 73 positions were eliminated as part of integrating the acquisitions, which involved 66 positions from Belmont Bancorp and seven positions from Falls Bank. Of this total, two Falls Bank employees accepted transfers to other positions. Additionally, 16 employees from Belmont Bancorp and two from Falls Bank accepted outside employment. The remaining 50 employees from Belmont Bancorp and three from Falls Bank were involuntarily terminated with severance.
In 2004, Sky Financial recorded merger, integration and restructuring charges totaling $4,542 ($2,952 after-tax or $.03 per diluted share). Merger, integration and restructuring charges of $3,597 ($2,338 after-tax or $.02 per diluted share) related to the acquisition of Second Bancorp. Included were data processing and conversion costs of $669, severance and other related employee costs of $839, professional fees and other costs of $1,953 and lease and contract termination costs of $136. Costs of $786 ($511 after-tax or $.01 per diluted share) were related to the Prospect Bancshares acquisition. These
charges consisted of severance and other related employee costs of $89, data processing and conversion expense of $203, and professional fees and other costs of $494. The remaining $159 ($103 after-tax or $.00 per diluted share) of costs are primarily related to the divestiture of Sky Financial Solutions.
During 2004, a total of 323 positions were eliminated as part of acquisitions, which involved 304 positions from Second Bancorp and 19 positions from Prospect Bancshares. Of this total, 139 employees accepted transfers to other positions, which consisted of 125 from Second Bancorp and 14 from Prospect Bancshares. Additionally, 40 employees from Second Bancorp and three from Prospect Bancshares accepted outside employment. The remaining 139 employees from Second Bancorp and two from Prospect Bancshares were involuntarily terminated with severance.
The following is a summary of category activity in the merger, integration and restructuring liabilities for 2006 and 2005.
Sky Financial expects to pay a majority of the
remainder of the accrued costs over the next one to two
years.
Note 17 Employee Benefits
The primary retirement plan of Sky is the Sky Financial Group Inc., Profit Sharing, 401(K) and ESOP Plan. Sky Financial also has a non-qualified supplemental retirement plan for certain individuals.
The Profit Sharing portion of the plan provides for contributions by Sky Financial as determined on a year-by-year basis. These contributions were 4%, 4.5% and 4% of eligible employee compensation in 2006, 2005 and 2004, respectively. Under the 401(k) portion of the plan, employees may contribute a percentage of their eligible compensation with a company match equal to 100% of the first 3% of the participant’s deferral contribution and 50% of the next 2% of the participant’s deferral contribution to a maximum match of 4%. Employees may contribute to this plan upon
employment. Employer matching contributions commence immediately upon entering the 401(k) and are 100% vested at all times. Expenses related to this portion of the plan were $5,216, $5,863 and $3,981 in 2006, 2005 and 2004, respectively. The ESOP (Employee Stock Ownership Plan) portion of the plan provides for an annual employer contribution equal to 3% of eligible employees’ annual compensation. Expense related to this portion of the plan were $3,912, $3,909, and $2,986 in 2006, 2005 and 2004.
Total shares of Sky Financial common stock held by the Profit Sharing, 401(K) and Employee Stock Ownership Plan as of December 31, 2006 were 3,343.
Supplemental Retirement Plan
This plan replaces retirement benefits not allowed under Sky Financial’s qualified retirement plans because of eligible compensation limitations under current tax law. Sky Financial’s contribution under the plan is determined by multiplying the excess of employees’ eligible compensation over the IRS established limitation by the contribution level established by the Board of Directors for Sky Financial’s qualified plans.
The contribution rates were 11%, 11.5% and 11% for all three portions of the retirement plan in 2006, 2005 and 2004, respectively. Expenses related to this plan were $197, $243 and $306 in 2006, 2005 and 2004.
Frozen Pension Plans
In connection with Sky Financial’s acquisition of Second National and Three Rivers, Sky Financial sponsors two funded, defined benefit pension plans for eligible employees who are 21 years of age with one or more years of service. The Second National plan was frozen during the fourth quarter of 2004. Because this was contemplated in the Second National acquisition, a curtailment gain was considered in arriving at the benefit obligation and prepaid pension cost recorded at the acquisition date. Sky Financial expects to make contributions of $179 to the plan in 2007. Benefits paid to retirees are based on age at retirement, years of credited service and average compensation. The Three Rivers’ plan was frozen during the fourth quarter of 2002. Sky Financial does not expect to make any contributions to the plan in 2007.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 17 Employee Benefits (continued)
The following table sets forth the benefit obligation, fair value of plan assets and the funded status of Sky Financial’s plans; amounts recognized in Sky Financial’s
financial statements; and the principal weighted average assumptions used at December 31, 2006 and 2005:
During 2007, Sky Financial expects to reclassify $46 of net loss included as a component of accumulated other comprehensive income into net periodic benefit costs.
The accumulated benefit obligation for all plans was $25,687 and exceeded the fair value of plan assets for all years presented.
Sky Financial expects to make the following benefit payments, which reflect expected future service:
The expected long-term rate of return on the plans’ assets reflects the average rate of earnings expected on the funds invested by each plan to provide for plan benefits. Management considers the long-term historical returns of the assets within the portfolio and adjusts the rate, as necessary, for expected future returns on the assets in the plans in determining the rate.
The plans’ asset allocations at December 31, 2006 by asset category are as follows:
Note 17 Employee Benefits (continued)
Management’s investment allocation is managed to provide an acceptable level of return to fund future benefit payments as well as provide liquidity to pay current benefits while minimizing the overall market risk to the plans.
Management believes that its current investment allocation meets these goals and does not anticipate significant changes to the investment allocation in the near future. Management has provided the external investment managers with general guidelines for them to make decisions regarding the nature and timing of investment decisions. The investment policy does not allow for significant changes in previously approved investments or in the use of derivatives in the investment strategy.
Other Plans of Merged Affiliates
Sky Financial, as part of its overall employee benefits design, settles plans of merged affiliates through consolidation into existing plans or termination of the plan. Perpetual Savings Bank participated in a multiple employer plan. On December 31, 2006, Sky Financial terminated its participation in the multiple employer plan. Perpetual Savings Bank’s multiple employer defined benefit plan which was frozen as of February 1, 2005 continues to be frozen as of the acquisition date. On January 1, 2007 Sky merged the Waterfield Group Savings and Investment Plan into the Sky Financial Group Inc., Profit Sharing, 401(k) and ESOP Plan.
On January 1, 2006 the following plans of acquired entities were merged into the Sky Financial Group Inc., Profit Sharing, 401(k) and ESOP Plan;
n Belmont National Bank 401(k) Profit Sharing Plan
n Benefits Design Agency of Ohio 401(k) Retirement Savings Plan
n Becker-McDowell Agency, Inc. 401(k) Plan
n Steiner Insurance Agency, Inc. 401(k) Employee Savings Plan
n Cuyahoga Falls Bank Savings Bank 401(k) Profit Sharing Plan
Sky sponsored two 401(k) plans as the result of its 2004 acquisitions of Second National Bank and Prospect Bank. These plans were merged into Sky’s Profit Sharing, 401(k) and ESOP Plan in January of 2005. Sky also sponsored three 401(k) plans as a result of prior acquisitions of Pennsylvania Capital Bank, Eastern Ohio Benefits and Meyer and Eckenrode. Eastern Ohio Benefits and Meyer and Eckenrode were merged into Sky’s Profit Sharing, 401(k) and ESOP Plan in January of 2005. Pennsylvania Capital Bank 401(k) was terminated in 2006.
Sky Financial pays health insurance premiums for certain employees after retirement. Sky Financial accrues the costs of retirees’ health and other post-retirement benefits during the working career of active employees. The expense and liability under this plan are not material in any period presented.
Note 18 Stock Options
Options to purchase Sky Financial’s stock have been granted to directors, officers and employees under various stock option plans. The Sky Financial Group, Inc. 2002 Stock Option and Stock Appreciation Rights Plan was approved by Sky Financial’s shareholders in 2002. Under the 2002 plan, options may be granted to purchase a maximum of 2.0 million common shares, or 2.5% of the number of issued and outstanding common shares at the time of adoption of the plan, adjusted for all subsequent stock dividends, splits and stock-for-stock acquisitions.
The Sky Financial Group, Inc. 1998 Stock Option Plan for Employees and the Amended and Restated Sky Financial Group, Inc. 1998 Stock Option Plan for Directors were approved by Sky Financial’s shareholders in 1998. Under these plans, options may be granted to purchase a maximum of 6.5 million common shares, or 7.5% of the number of issued and outstanding common shares at the time of the adoption of the plans, adjusted for all subsequent stock dividends, splits and stock-for-stock acquisitions.
Under both the 2002 and 1998 plans, options expire 10 years after the date of grant and are issued at an option price no less than the market price of Sky Financial’s stock on the date of grant. Certain individuals, including directors, may also elect to receive options, determined under a formula, in lieu of a portion of their salary or director fees, as applicable. Options granted to directors are fully vested and immediately exercisable at the time of grant. Options granted to officers and other key employees are generally exercisable at 40% after two years and in annual 20% increments thereafter, except for options received in lieu of salary, which are immediately exercisable.
The Sky Financial Group, Inc. 2004 Restricted Stock Plan was approved by Sky Financial’s shareholders in 2004. Under this plan, a total of 800,000 of authorized, but unissued shares of common stock shall be available. Compensation expense for restricted share awards is recognized ratably over the period of service, usually the restricted period, based upon the fair value of the stock on the date of grant.
A summary of the stock option activity in the plans is as follows:
The total intrinsic value of options exercised during the years ended December 31, 2006, 2005, and 2004, was $5,590, $7,805, and $9,920, respectively.
The total fair value of shares vested was $4,604 in 2006, $3,413 in 2005, and $4,382 in 2004.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 18 Stock Options (continued)
Options outstanding at year-end 2006 were as follows:
A summary of Sky Financial’s nonvested restricted shares as of December 31, 2006 and 2005 and changes during the years ended December 31, 2006 and 2005 were as follows:
As of December 31, 2006, there was $8,976 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the plans. That cost is expected to be recognized over a weighted-average period of 2.1 years.
Sky Financial maintains a Stock Appreciation Rights (SAR) plan under which SARs were granted in tandem with stock options until 1998. Expense (income) related to the SARs was $(143) in 2006, $(40) in 2005 and $72 in 2004.
Note 19 Other Financial Instruments
Credit Commitments and Letters of Credit
Sky Financial is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its clients located primarily within its local business areas. These instruments include commitments to extend credit, standby letters of credit and international commercial letters of credit.
Sky Financial’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and letters of credit is represented by the contractual amount of those instruments. Sky Financial uses the same credit policies in making commitments and conditional obligations as it does in extending loans to clients.
Financial instruments whose contract amounts represent credit risk at December 31 are presented below:
The majority of the unfunded commitments at December 31, 2006 and 2005 are variable rate commitments, with approximately 21% or $889,000 and 20% or $755,000 having fixed rates in 2006 and 2005, respectively.
Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates ranging from one to five years, variable interest rates tied to the prime rate and U.S. Treasury bill rates and may require payment of a fee. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued by Sky Financial to guarantee the performance of a client to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions. The expiration date of substantially all standby letters of credit extend for a period ranging from thirty days to seven years.
The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to clients. Sky Financial holds marketable securities, certificates of deposits, real estate, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary.
Letters of credit are instruments used to facilitate trade, most commonly international trade, by substituting Sky Financial’s credit for that of a commercial importing company. The terms are generally one to three months. The letters of credit are primarily unsecured.
Note 20 Mortgage Banking Activities
Sky Financial conducts mortgage banking operations through its banking subsidiary. The primary activity relates to the origination and sale of fixed and variable rate residential mortgages in the secondary market. Sky Financial normally retains the servicing of the loans it sells. Loans are primarily originated in Sky Financial’s community banking market areas of Ohio, Pennsylvania, Michigan, Indiana and West Virginia.
Mortgage banking income, a component of non-interest income, includes gain on sales of loans held for sale during 2006, 2005 and 2004 of $18,531, $22,246 and $25,572, respectively.
The following table summarizes information relating to Sky Financial’s mortgage banking activity as of December 31:
In 2006, Sky Financial sold certain servicing rights on mortgages that had an outstanding principal balance of $65,616 and realized no net gain or loss on the sale. In 2005, Sky Financial sold certain servicing rights on mortgages that had an outstanding principal balance of $25,599 and realized a net gain of approximately $22 on the sale. In 2004, Sky Financial sold certain servicing rights on mortgages that had an outstanding principal balance of $388,398 with a net gain of $1,020. At December 31, 2006, Sky Financial had firm commitments for the sale of approximately $42,317 of mortgage loans. The fair value of these commitments is not material.
Mortgage Servicing Rights:
The key economic assumptions used to estimate the value of the mortgage service rights at December 31, 2006 and 2005 are presented in the table that follows. A sensitivity analysis of the current fair value to immediate 10% and 20% adverse changes in those assumptions as of December 31, 2006 is also presented. These sensitivities are hypothetical. Changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the mortgage service rights is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in mortgage interest rates, which drive changes in prepayment rate estimates, could result in changes in the discount rates), which might magnify or counteract the sensitivities.
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 21 Regulatory Matters
Capital Maintenance Requirements
Sky Financial and Sky Bank must observe capital guidelines established by federal and state regulatory authorities. Failure to meet specified minimum capital requirements can result in certain mandatory actions by primary regulators of Sky Financial and Sky Bank that could have a material effect on Sky Financial’s financial condition or results of operations. Under capital adequacy guidelines, Sky Financial and Sky Bank must meet specific quantitative measures of their assets, liabilities and certain off-balance-sheet items as determined under regulatory accounting practices. Sky Financial’s and Sky Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Management believes, as of December 31, 2006, that Sky Financial and Sky Bank meet all capital adequacy requirements to which they are subject.
Sky Financial and Sky Bank have been notified by their respective regulators that, as of the most recent regulatory examinations, each is regarded as well-capitalized under the regulatory framework for prompt corrective action. Such determinations have been made evaluating Sky Financial and Sky Bank under Tier 1, total capital and leverage ratios. There are no conditions or events since these notifications that management believes have changed any of the well-capitalized categorizations of Sky Financial and Sky Bank.
Sky Financial and Sky Bank’s capital ratios are presented in the following table:
Restrictions on Subsidiary Dividends
Dividends paid by Sky Financial are mainly provided for by dividends from its subsidiaries. However, certain restrictions exist regarding the ability of Sky Bank to transfer funds to Sky Financial in the form of cash dividends, loans or advances.
Regulatory approval is required in order to pay dividends in excess of Sky Bank’s earnings retained for the current year plus retained net profits since January 1, 2002. As of December 31, 2006, $179,388 was available for distribution to Sky Financial as dividends without prior regulatory approval.
Note 22 Line of Business Reporting
Sky Financial manages and operates two major lines of business: community banking and financial service affiliates. Community banking includes lending and related services to businesses and consumers, mortgage banking and deposit-gathering. Other financial services consist of non-banking companies currently engaged in trust and wealth management, insurance and other financial-related services.
The reported line of business results reflect the underlying operating performance within the business units. Parent and Other is comprised of the parent company and several smaller business units. It includes the net funding cost of the parent company and intercompany eliminations. Expenses for centrally-provided services and support are allocated based principally upon estimated usage of services. All merger, integration and restructuring charges and other charges and gains that management does not consider to be reflective of ongoing operations or expected to recur are included in parent and other. Substantially all of Sky Financial’s assets are part of the community banking line of business.
Note 22 Line of Business Reporting
Selected segment information is included in the following table:
Note 1 - The parent and other segment for 2006 includes the following charges and gains: (1) A balance sheet restructuring that resulted in net after-tax charges of $9,914 ($15,252 before tax); (2) After-tax net derivative losses of $3,832 ($5,895 before tax), of which included gains of $297 ($457 before tax) which were related to the balance sheet restructuring activities; (3) After-tax merger, integration and restructuring expenses of $4,274 ($6,575 before tax) associated with the acquisitions during the year; (4) After-tax charges totaling $962 ($1,480 before tax) related to additional incentive compensation due to the completion of the Union Federal acquisition and conversion; (5) After-tax charges of $1,688 ($2,597 before tax) related to additional incentive compensation associated with the completion of the insurance sale; (6) An after-tax net gain of $4,328 ($6,658 before tax) from the sale of an insurance business; (7) An after-tax charge of $1,093 ($1,681 before tax) from the impairment of an equity security; and (8) An after-tax charge of $549 ($845 before tax) from an adjustment to the amortization of mortgage servicing rights.
Note 2 - The parent and other segment for 2005 includes after-tax merger, integration and restructuring expenses of $1,151 ($1,771 before tax).
Note 3 - The parent and other segment for 2004 includes after-tax merger, integration and restructuring expenses of $2,952 ($4,542 before tax).
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 23 Condensed Parent Company Financial Information
Condensed Parent Company Balance Sheets
Note 23 Condensed Parent Company Financial Information (continued)
Condensed Parent Company Statements of Cash Flows
Notes to Consolidated Financial Statements
(Dollars and shares in thousands, except per share data)
Note 24 Other Matters
Legal Matters
In re Commercial Money Center, Inc. Equipment Lease Litigation in the U. S. District Court for the Northern District of Ohio, Eastern Division, MDL Case No. 1:02-CV-16000
Between August 2000 and December 2001, Sky Bank and two of its predecessor banks provided financing to a commercial borrower and its affiliated entities for the purchase of six separate portfolios of commercial lease pools, and a warehouse line of credit to finance lease pools. These loans are secured by assignments of the payment streams from the underlying leases, surety bonds or insurance policies, and a limited guarantee from the sole member of the commercial borrower.
Upon default of these commercial loans, Sky Bank (and its predecessors) made demand for payment from Illinois Union Insurance Company (“IU”), RLI Insurance Company (“RLI”), and Royal Indemnity Company (“Royal”) under the relevant surety bonds and insurance policies. IU, RLI, and Royal (collectively, the “Sureties”) have failed to make the payments required under the surety bonds and insurance policies. As a result, in the spring of 2002, Sky Financial and its predecessors filed suit against each of the Sureties seeking to enforce Sky Bank’s rights under the surety bonds and insurance policies issued by the Sureties in connection with the commercial lease pools. Sky Financial’s complaints claim breach of contract, bad faith and allege that the Sureties are liable for the payments due to Sky Financial under the terms of the bonds and are estopped from asserting fraud as a defense to paying any claims under the bonds. In October, 2002, the suits were consolidated for pretrial purposes with more than 35 other lawsuits involving similar claims in the United States District Court for the Northern District of Ohio, Eastern Division, under the Federal Multi-district Litigation (“MDL”) Rules.
The key defense of the Sureties in denying Sky Bank’s claims under the surety bonds is that they were fraudulently induced by the originator of the commercial leases to issue the surety bonds in the first instance. The Sureties have also asserted related defenses that the underlying equipment leases are invalid, usurious, or otherwise unenforceable. Sky Bank believes that none of these defenses can defeat Sky Bank’s claims under the surety bonds, which, in the view of Sky Bank, provide for absolute and unconditional guarantees of payment. Moreover, Sky Bank believes that the Sureties are responsible to Sky Bank, as the Obligee or Named Insured under the bonds, for the underwriting of the lessees and leases, including all issues of fraud, and that the Sureties waived any defense of fraud to claims under the bonds.
On December 21, 2005, Sky Financial sold and assigned to a third party, without recourse, all of its rights and interests in three loans secured by commercial lease pools and surety bonds issued by Royal. On March 31, 2006, Sky Financial and IU settled in full its litigation pertaining to two loans secured by pools of leases and insurance policies issued by IU. The aggregate principal balance of the three loans sold to a third party and the two loans which were settled was $14.2 million, and the aggregate proceeds received by Sky Financial in the sale and the settlement was $14.9 million.
With respect to the remaining pool and the warehouse line of credit secured by surety bonds issued by RLI, which has a remaining principal balance of $15.4 million, Sky Financial has amended its complaint and is proceeding with pretrial discovery and motion practice in the MDL court in anticipation of trial.
Sky Financial has reviewed the relevant matters of fact and law with its special counsel and believes that it has substantial and meritorious claims against the remaining Surety. Sky Financial has and will continue to vigorously assert all the rights and remedies available to it to obtain payment under the bonds. While the ultimate outcome of this matter cannot be determined at this time, Sky Financial management does not believe that the outcome of these pending legal proceedings will materially effect the consolidated financial position or results of operations of Sky Financial.
American Home Mortgage Corp. v. Union Federal Bank of Indianapolis, Case No. 06-CV-7864 (JGK) (RLE), U.S. District Court for the Southern District of New York
Prior to its acquisition by Sky Financial, Waterfield Mortgage Company, Incorporated (“Waterfield”) sold its mortgage banking business to American Home Mortgage Corp. (“American Home”). As part of the sale agreement, an escrow in the amount of $55 million was established and any purchase price adjustment associated with the sale of the mortgage banking business was to be deducted from the escrow. Waterfield and American Home were unable to reach agreement as to the purchase price adjustment, and American Home filed the captioned lawsuit against Waterfield’s subsidiary, Union Federal Bank, for breach of contract, negligent misrepresentation and declaratory and injunctive relief, and has made a claim for relief in excess of $29 million.
Sky Financial completed its acquisition of Waterfield on October 17, 2006, and as a result, has become a party in interest in the litigation. Sky Financial, in conjunction with the former shareholders of Waterfield to the extent of their respective interests in the escrow, have filed, inter alia, a motion to dismiss the action as well a motion to substitute the entity representing Waterfield shareholders in place of Union Federal Bank as the party in interest in the litigation.
After consultation with special counsel, Sky Financial believes that it has substantial and meritorious defenses and that exposure, if any, should be absorbed by the escrow, and as such is not expected to have a material effect on the consolidated financial position or results of operations of Sky Financial.
Cash and Due from Banks
Sky Financial’s subsidiary bank is required to have cash on hand or on deposit with the Federal Reserve Bank to meet its regulatory reserve requirements. The reserve requirements at December 31, 2006 and 2005 was $86,638 and $59,109, respectively. These balances do not earn interest.
Treasury Shares
Included in treasury shares at December 31, 2006 and 2005 are 9 and 11, respectively, of shares held in rabbi trusts for certain employees of Sky Financial.
Note 25 Quarterly Financial Information (Unaudited)
(1) The first, second, third and fourth quarters of 2006 reflect the impact of merger, integration and restructuring charges after tax of $117, $237, $612 and $3,309, respectively.
(2) The second, third and fourth quarters of 2005 reflect the impact of merger, integration and restructuring charges after tax of $670, $79 and $402, respectively.
Note 26 Sale of Sky Financial Solutions, Inc. and Presentation as Discontinued Operations
On March 31, 2004, Sky Financial completed the sale of its dental financing affiliate, Sky Financial Solutions (SFS). SFS is reported as a discontinued operation. For the year ended December 31, 2005, Sky Financial recorded additional pretax gain of $572 for the adjustment of certain contingencies related to the sale. This gain was recorded as after tax income from discontinued operations. SFS results of operations for 2004 included revenues of $39,356 and pre-tax net income of $29,503.
SFS was sold to MB1NA on March 31, 2004 for $84,716. The closing equity of SFS was $50,242, resulting in an initial gain of $34,474. Sky Financial incurred an additional $3,234 in professional fees and other contractual obligations related to the transaction for a final calculated pre-tax gain of $31,240.
Separately, in 2004 Sky Financial recorded merger, integration and restructuring costs of $346 related primarily to employee costs.
A separate asset transfer agreement included $115,975 in Sky Bank portfolio loans, which represent unique products offered by Sky Bank to accommodate SFS clients. These loans were sold to MBNA at par value.
The SFS sales agreement contains a contingency based upon future charge-offs that may result in an adjustment to increase or decrease the sales price in future periods. Based on historical experience and expected future performance, management does not believe that this provision will have a significant impact on future earnings, cash flows or financial position.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
Sky Financial’s management carried out an evaluation, under the supervision and with the participation of the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of Sky Financial’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of December 31, 2006, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the chief executive officer along with the chief financial officer concluded that Sky Financial’s disclosure controls and procedures as of December 31, 2006, are effective in timely alerting them to material information relating to Sky Financial (including its consolidated subsidiaries) required to be included in Sky Financial’s periodic filings under the Exchange Act.
For purposes of this section, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
The management of Sky Financial Group is responsible for establishing and maintaining adequate internal control over financial reporting. Sky Financial’s internal control over financial reporting is a process designed under the supervision of the company’s chief executive officer and chief financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the company’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
Sky Financial’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2006 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control-Integrated Framework.” Based on the assessment, management determined that, as of December 31, 2006, the company’s internal control over financial reporting is effective, based on those criteria. Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of December 31, 2006 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report appearing on page 69.
Marty E. Adams
Kevin T. Thompson
Chairman, President and Chief Executive Officer
Executive Vice President and Chief Financial Officer
February 22, 2007
February 22, 2007
Changes in Internal Control over Financial Reporting
There have not been any changes in Sky Financial’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) that occurred during Sky Financial’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, Sky Financial’s internal control over financial reporting.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Sky Financial Group, Inc.
Bowling Green, Ohio
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Sky Financial Group, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2006 of the Company and our report dated February 22, 2007 expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the adoption of Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment, in 2005.
Deloitte & Touche LLP
Cleveland, Ohio
February 22, 2007
Item 9B.
Item 9B. Other Information
None
PART III
Item 10.
Item 10. Directors and Executive Officers of Registrant
Directors - Unless otherwise indicated, the business experience and principal occupations indicated for each director has extended for five or more years.
Officers - Unless otherwise indicated, the officer has served in the position indicated for five or more years.
Section 16(a) Beneficial ownership Reporting Compliance
Under Section 16(a) of the Securities Exchange Act of 1934, members of the Board of Directors, certain executive officers of the Company and its subsidiaries and holders of more than 10% of the Company’s common stock file periodic reports with the Securities and Exchange Commission disclosing their beneficial ownership of common stock. During 2006, and based solely upon a review of such reports, the Company believes that all filing requirements under Section 16(a) were complied with on a timely basis.
Ethics Policy and Code of Ethics
Sky Financial’s Ethics Policy, which is applicable to all directors, officers and employees of the company, and its Code of Ethics for Senior Financial Officers, which is applicable to the principal executive officer, the principal financial officer and the principal accounting officer, are each available on the Investor Relations section of the company’s website (www.skyfi.com). A copy of the Ethics Policy and Code of Ethics is also available in print to share owners upon request, addressed to the Corporate Secretary at Sky Financial Group, 221 South Church Street, Bowling Green, OH 43402. Sky Financial intends to post amendments to or waivers from its Code of Ethics on its website.
Meetings and Committees
The Board of Directors of the Company held twelve regular meetings and one special meeting in 2006. Each incumbent director attended at least 75% of the aggregate of the total meetings of the Board of Directors and the total number of meetings held by all committees of the Board on which the directors served in 2006. The Board of Directors schedules regular executive sessions, at which management is not in attendance, following each regularly scheduled meeting of the Board. Although the Company does not have a formal policy with respect to Board member attendance at annual meetings of shareholders, each member is encouraged to attend. All Board members attended the 2006 annual meeting of shareholders.
To assist in carrying out its responsibilities, the Board of Directors has established five standing committees, which are described below:
Executive Committee
The members of the Executive Committee of the Board of Directors are Marty E. Adams, Gerard P. Mastroianni, Gregory L. Ridler, Emerson J. Ross, Jr., C. Gregory Spangler and Jonathan A. Levy, who serves as chairperson. The Executive Committee met two times in 2006. Under the terms of the Company’s Code of Regulations and the Executive Committee Charter, which are available on the Company’s website, the Executive Committee is authorized to act on behalf of the Board of Directors in the oversight of the business and affairs of the Company while the Board of Directors is not in session, subject to certain limitations.
Audit Committee
The Company has a standing Audit Committee as defined in Section 3(a)(58)(A) of the Securities and Exchange Act of 1934. The members of the Audit Committee of the Board of Directors are Robert C. Duvall, Fred H. Johnson III and C. Gregory Spangler, who serves as chairperson. The Audit Committee met eleven times in 2006. Under the terms of the Audit Committee Charter, which is available on the Company’s website, the oversight functions of the Audit Committee include: (i) the appointment of the Company’s Independent Registered Public Accounting Firm; (ii) the review of the independent audit plan and the results of the auditing engagement; (iii) the review of the internal audit plan and results of the internal audits; (iv) the review of the adequacy of the Company’s financial reporting procedures; and (v) the review of the adequacy of the Company’s system of internal control. The Company’s securities are listed on the NASDAQ National Market, and all members of the Audit Committee have been deemed by the Board of Directors to meet the independence standards of Rule 4200(a)(15) of the National Association of Securities Dealers, Inc. and Rule 10A-3 of the Securities Exchange Act. The Board of Directors has determined that Mr. Duvall, an independent director and licensed CPA, satisfies the requirements of a “Financial Expert” as defined in Item 401(h)(2) of Regulation S-K and satisfies the definition of “financially sophisticated” under Rule 4350(d) of the National Association of Securities Dealers, Inc.
Risk Management Committee
The members of the Risk Management Committee of the Board of Directors are George N. Chandler II, Jonathan A. Levy and Gregory L. Ridler, who serves as chairperson. The Risk Management Committee met five times in 2006. Under the terms of the Risk Management Committee Charter, which is available on the Company’s website, the Risk Management Committee is responsible for reviewing the adequacy of systems and procedures controlling risk throughout the Company and its subsidiaries, including credit risk, liquidity risk, market risk, legal risk, reputation risk and operational risk.
Governance and Nominating Committee
The members of the Governance and Nominating Committee of the Board of Directors are Joseph N. Tosh II, R. John Wean III and Emerson J. Ross, Jr., who serves as chairperson. The Governance and Nominating Committee met six times in 2006. Under the terms of the Governance and Nominating Committee Charter, which is available on the Company’s website, the Committee is responsible for making independent recommendations to the Board of Directors as to best practices for Board governance, evaluation of Board performance and succession planning. The Committee further serves as the Company’s nominating committee, and is responsible for developing and implementing a process and guidelines for the selection of individuals for nomination to the Board of Directors and considering incumbent directors for nomination for re-election. The Governance and Nominating Committee considers shareholder nominations for directors in accordance with procedures contained in the Company’s Code of Regulations. The Board of Directors of the Company has determined that each member of the Governance and Nominating Committee meets the independence standards of Rule 4200(a)(15) of the National Association of Securities Dealers, Inc.
Process for Selection and Nomination of Directors
The Governance and Nominating Committee is responsible for the selection of the final slate of nominees for election to the Board of Directors. Those nominees recommended by the Committee are then submitted to the Board of Directors for approval. In making its annual recommendation, the Governance and Nominating Committee determines the appropriate qualifications, skills and characteristics necessary for the Board of Directors in the context of the strategic direction of the Company. Current directors are annually assessed through a Board self-assessment and peer evaluation process. The results of the assessment are used to determine Board member effectiveness, including whether to consider a member for re-nomination. In making its recommendations and selections, the Committee considers a variety of factors, including the candidate’s integrity, independence, qualifications, skills, experience (including experiences in finance and banking), familiarity with accounting rules and practices, and compatibility with existing members of the Board. Other than the foregoing, there are no stated minimum criteria for nominees, although the Committee may consider such other factors as it may deem are in the best interest of the Company and its shareholders, which may change from time-to-time. The Committee will consider candidates for nomination as a director, which are recommended by shareholders, directors and other sources, including the community and the Company’s subsidiary and regional boards. The Committee has the prerogative to employ and pay third-party search firms.
Compensation Committee
The Compensation Committee of the Board of Directors (the “Committee”) consists of Mr. Mastroianni, Mr. Hilliker, and Ms. Fennell. Mr. Mastroianni serves as the chairman of our Committee. The Committee reviews and recommends to the board policies, practices and procedures relating to the compensation of the Company’s chief executive officer, senior management team and directors and the establishment and administration of any new incentive compensation plans. The Committee has authority to administer the Company’s Annual Incentive Plan, 1998 Directors Stock Option Plan, 1998 Employee Stock Option Plan, 2002 Stock Option Plan, 2004 Restricted Stock Plan, and make policy recommendations from time to time with respect to the Company’s benefit plans. The Company’s board of directors has determined that Mr. Mastroianni, Mr. Hilliker and Ms. Fennell, meet the independence requirements under the Sarbanes-Oxley Act of 2002, The Nasdaq Stock Market, Inc. and the rules and regulations of the SEC. In addition, each of Mr. Mastroianni, Mr. Hilliker and Ms.
Fennell, is an “outside director,” as that term is defined in Section 162(m) of the Internal Revenue Code, and is a “non-employee” director within the meaning of Rule 16b-3 under the Securities Exchange Act of 1934.
The Committee meets at least quarterly. The Committee met four times during 2006.
Compensation Committee’s Processes and Procedures for Consideration and Determination of Executive Compensation
Authority and Responsibilities. The Committee administers the Company’s executive compensation program, including the oversight of executive compensation policies and decisions, administration of the Annual Incentive Plan applicable to executive officers and administration of the Company’s equity incentive plans. In particular, the Committee exercises all power and authority of the Board in the administration and interpretation of the Company’s benefit plans, including establishing guidelines, selecting participants in the plans, approving grants and awards, and exercise of other power and authority required and permitted under the plans. The Committee also reviews and approves executive officer (including Chief Executive Officer) compensation, including, as applicable, salary, bonus and incentive compensation levels, deferred compensation, executive perquisites, equity compensation (including awards to induce employment), severance arrangements and other forms of executive officer compensation. The Committee’s membership is determined annually by the full Board and includes only independent directors. The Committee meets at least quarterly during the year.
The Committee’s responsibilities are reflected in its Charter, a copy of which is available on the Company’s website, www.skyfi.com. The Committee reviews the Charter annually and recommends any proposed changes to the Board. Pursuant to its Charter, the Committee’s functions also include reviewing and approving contractual relationships between the Company or its subsidiaries and any officer or director relating to employment, severance, retirement or compensation; and producing the Committee’s report on executive compensation to be included in the Company’s proxy statements.
Delegation. From time to time the Committee may delegate authority to fulfill various functions of administering the Company’s plans to employees of the Company. Specifically, the Committee has delegated certain responsibilities with respect to the Company’s employee retirement and welfare benefit plans to the Sky Benefits Committee consisting of the Company’s general counsel, chief financial officer, chief human resources officer and other officers. The Sky Benefits Committee reports to the Committee on the performance of the retirement plan assets and other plan matters once each year.
The Committee also has delegated to Company’s CEO the authority to make awards to new employees of up to an aggregate of 30,000 stock options under the 2002 Stock Option Plan, or up to an aggregate of 6,000 shares of restricted stock, or a combination thereof.
Independent Compensation Consultant
In addition, the Committee has authority to engage the services of outside advisers to assist the Committee. In 2006, the Committee engaged Compensation Consulting Consortium (“3C”) as an independent compensation consulting firm. 3C has advised and assisted the Committee and management for many years. 3C is engaged at the direction of the Committee. A representative of 3C attended several of the Committee’s meetings in 2006 and reported directly to the Committee during these meetings.
3C provided benchmarking information on the amount and form of executive compensation, as discussed in detail under “Compensation Committee Decision-Making Process” on page 77. The Committee’s instruction to 3C as to the nature and scope of its assignment were to assist in the selection of peer group companies review relevant proxy and survey data in accordance to a defined methodology, and to obtain competitive external market total compensation data. For three years, directors compensation was analyzed by The Organizational Consulting Group. The Company’s human resources department performed the analysis in 2006.
Compensation Committee Interlocks and Insider Participation
None of the members of Committee at any time has been one of our officers or employees. None of our executive officers currently serves, or in the past year has served, as a member of the board of directors or compensation committee of any entity that has one or more executive officers who serve on our board or Compensation Committee.
Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
The following discuss the material factors involved in the Company’s decisions regarding the compensation of the Named Executive Officers (as defined on page 79) during 2006 (the “NEOs”). As discussed elsewhere in this Report, the Company entered into an Agreement and Plan of Merger with Huntington Bancshares Incorporated as of December 20, 2006 (the “Merger Agreement” or the “Merger”). Because of the Merger, a few changes in compensation occurred during 2006. Additionally, the Company’s compensation plans and programs have been operated in a semi-frozen basis for 2007, in anticipation of the Merger. That is, payments are being made and benefits accrued, but no new awards or changes to the compensation plans, policies and arrangements are being made (in accordance with the Merger Agreement), other than as described below.
The specific amounts paid or payable to the NEOs are disclosed in the tables and narrative beginning on page 78 of this Annual Report on Form 10-K. The following discussion cross-references those specific tabular and narrative disclosures where appropriate.
Compensation Overview
Compensation Philosophy and Objectives
We believe that, in order to manage and grow a well run financial services organization, it is necessary to establish compensation programs and related opportunities that are attractive, motivating and rewarding to executives, to managers and to a high quality staff. These programs and opportunities have to be balanced with their cost to Sky and its shareholders. In order to arrive at the balance, Sky has established the following compensation philosophy and guidelines for its overall compensation program:
1. In order to attract and retain highly qualified management, provide short term (annual) incentives that vary directly with Sky’s annual financial performance and provide long-term incentives tied directly to Sky’s stock price.
2. Wherever possible, establish performance-based compensation focused on individual results, team results, as well as contributions to Sky’s overall performance.
3. Link and align the wealth creation interests of management and shareholders by utilizing Sky stock or options as a material component to the compensation program.
4. Position target compensation opportunities at approximately the 50th percentile of the relevant external labor market and provide upside opportunity based on performance above the 50th percentile and downside risk also based on performance below the 50th percentile, except that the Company targets the 60th percentile for the Regional President position.
Each pay element is intended to generally match, in cost and type, the programs offered to similar positions in similar organizations that are deemed representative of Sky’s peer group as described below. The total of all pay elements are calibrated to generally reward at target levels consistent with the external market place but actual performance determines the actual aggregate value.
The annual and long-term incentive plans are highly performance sensitive in that they could result in no economic value to the participant or the values could increase above the expected target value if performance is higher than expected. For Sky’s executives these two components represent over 50% of the total compensation opportunity level, which is intentional as a majority of the compensation, is tied directly to Sky’s operational performance and share performance.
Each of the elements of Sky’s compensation and benefit programs are discussed and illustrated below. Unless otherwise stated, all plan elements are accrued as an expense and are deductible to Sky as compensation expense.
Components of Executive Compensation
Total compensation for executives is comprised of base salaries, annual cash incentive awards, long-term equity awards, retirement saving plan contributions, severance protection, and other benefits and perquisites. When we determine compensation levels for the NEOs and other executive officers, we review compensation survey data from independent sources to ensure that our total compensation program is competitive. We look at compensation data from companies in the financial services industry, by using publicly available peer company disclosures, as well as from companies in a broad cross-section of industries available from reputable compensation surveys. We target overall compensation levels competitive with our industry comparison peer group. The various components of executive compensation reflect the following policies:
Base Salary
The purpose the base salary program is to pay for the qualifications, experience, and marketability of the position consistent with market practices. A pay range for each position is anchored around the 50th percentile of the labor market with a minimum established at 80% of the 50th percentile and maximum rate established at 120% of the 50th percentile. Individual pay within the range is determined by individual performance, job proficiency, and contributions over a period of years.
Pay adjustments are tied directly to Sky’s Performance Appraisal process, which evaluates the employee on a series of criteria resulting in rating from 1 to 5. This process is used for all Sky employees including the NEOs. Pay adjustments, which are typically made annually, are tied directly to the rating. In addition to these performance-based base pay adjustments, it is periodically necessary to make additional market adjustments in those instances where market base salary levels move faster than anticipated or where additional duties and responsibilities are added to the job.
The base salary levels for all Sky Named Executives are currently within +/- 10% of the 50th percentile of the base salaries of peers in other similar-sized financial organizations. In 2006, an overall budget of 4.0% was established and base pay increases ranging from 4.0% to 9.4% were provided to the NEOs.
The amount of an NEO’s base salary is the reference point for much of the other compensation. For example, the relative ranges of potential annual incentive awards from executive to executive are proportionate to the NEOs’ respective base salaries. In addition, base salary is one component of the contribution formula under the Company’s retirement plans and the key component in the Company’s severance and change in control arrangements.
Annual Incentive
The purpose of the annual incentive program is to focus executives on achieving and possibly exceeding annual performance objectives, which can vary, based on business need. In 2006, the performance expectations were established around the following measures: earnings per share, demand deposit growth, loan growth, net loan losses, and services per household. These goals were selected as strong indicators of overall performance and are an integral part of Sky’s business strategy, plan and culture.
Each component of the annual incentive program has a separate measurement for threshold, target and maximum payout levels. The threshold amount represents the minimum result necessary to generate an incentive award. The target amount represents an achievable goal with a relatively high degree of difficulty to attain, consistent with the Company’s annual profit plan. The maximum amount represents outstanding results beyond those contained in the annual profit plan. Linkage exists between the components of performance measures, inasmuch as performance below a threshold amount will result in a reduction of the payout of other measures. The Compensation Committee retains the flexibility to make discretionary adjustments up or down based on performance that does not conveniently fit into an annual incentive plan. This discretion is not used to change the targets under the plan, only the rewards. For example, this discretion, in the past, has been used to recognize contributions that led or will lead to significant value to Sky based on work on an acquisition.
The targeted annual incentive opportunity is 50% of actual base salary level for all NEO’s except the CEO, who has a target of 70%. For 2006, the target core operating earnings per share was $1.85 ($1.99 maximum), the target services per household was 176,572 (185,334 maximum), the targeted demand deposits was $1.81 billion ($1.96 billion maximum), the targeted total loans was $11.76 billion ($11.99 billion maximum), and the target loan losses was $30.76 million ($23.07 million maximum).
In 2006, Mr. Adams (140%), Mr. Thompson (100%), Koch (100%) and Souder (100%) each received a modified payout equal to their maximum incentive payout for their work in mergers and acquisitions, including the acquisition of Union Federal Bank. Mr. Starr and other officers received a modified incentive payout for 2006 for similar work.
Ordinarily, payments to NEOs and other covered employees under the Annual Incentive Plan are made in the first quarter of the following fiscal year. However, the Annual Incentive Plan payment amounts for the 2006 fiscal year for Messrs. Adams, Thompson, and Souder were accelerated into 2006. This was done to try to minimize the adverse tax effects to the Company and the executives of Code Section 280G on these payments and any payments made under applicable employment agreements due to the Merger.
Long-Term Incentive
The purpose of the long-term incentive plan is to align the interests of the NEOs and other executives with shareholders by providing them the opportunity to benefit from share price increases in the future through option grants under the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, the 2002 Stock Option Plan and to provide actual ownership through restricted stock grants under the 2004 Restricted Stock Plan. Opportunities under the plans are intended to match prevailing market practices for similar positions in similar organizations. Other factors, however, that are considered in making grants include managing the pools of options and restricted stock available under shareholder approved plans over a multi-year period of time, the most recent performance of the Company and the individual, and the expected future growth and contributions of the individual.
In order to effectively manage the number of shares approved by shareholders under the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, the 2002 Stock Option Plan and the 2004 Restricted Stock Plan, and to meet the dual aims of (i) rewarding participants for increasing share prices and (ii) creating an ownership culture at Sky, NEOs and other participants are allowed to elect the receipt of options and restricted stock according to guidelines established each year by the Committee. In general, if a choice is allowed, the choices are 25% of the grant value in restricted stock and 75% in stock options or vice versa, or 50% in restricted stock and 50% in stock options. In some cases, certain classes of officers are only given one choice.
In 2006, the Committee established the value of one restricted share to be equal to 5 stock options using the relationship between the present value of the stock option as determined using the Black-Scholes option pricing model and the share value on the date of grant. Restricted stock award recipients also receive dividends on their restricted shares during the restriction period.
All long-term grants and awards to non-Directors have a five year vesting period with 40% of the grant vesting on the second anniversary of the grant and then 20% vesting on each successive grant anniversary. The purpose of the vesting is to limit awards under the plans to only those NEOs and other participants who make a long-term commitment to Sky and to make it difficult for a competitor to hire away Sky talent.
Grants under the 1998 Directors Stock Option Plan, by comparison, are fully vested at grant. Mr. Adams, who is also Chairman of the Board, has received all of his option grants from this plan and as a result is fully vested in these options on the date of grant.
In 2006, the Committee took into consideration the market pay practices of Sky’s peers, historical long-term grant values for the NEOs, the performance of Sky, a general assessment of the contributions of the individual NEOs, the available shares and projected lives of the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, 2002 Stock Options and 2004 Restricted Stock Plans, and the projected grant values in making its recommendations. The Committee also sought input from the Chief Executive Officer on his views of the grants for his direct reports.
Finally, the accounting and tax treatment of stock options and restricted stock grants is different from cash-based payments. For awards under the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, the 1998 Employee Stock Option Plan, the 2002 Stock Option Plan, Sky accrues an expense equal to the Black-Scholes value on the date of grant pro-ratably over the vesting period. Sky will receive a tax deduction equal to the difference in the share price and the exercise price on the option exercise date. For awards under the 2004 Restricted Stock Plan, Sky accrues an expense for the restricted stock grant, which is fixed on the value at the date of grant pro-ratably over the vesting period. Sky will receive a tax deduction equal to the value of stock at each vesting date equal to the vested percentage and stock value on that date. Sky also receives a tax deduction for all dividends paid on restricted stock that is not yet vested.
Stock Ownership Guidelines
The Board of Directors has requested that the Company’s NEOs and other senior management employees meet minimum stock ownership requirements that are consistent with industry standards. Accordingly, Sky maintains stock ownership requirements for its management staff according the following schedule:
Chief Executive Officer: 3 times annual base salary level
Executive Vice President: 2 times annual base salary level
Senior Vice President and Regional President: 1 times annual base salary level
Management has seven years from date-of-hire or implementation of this policy (whichever is longer) to meet these share ownership requirements.
Retirement and Other Post-Employment Benefits
Consistent with Sky’s desire to provide plans that allow employees to maintain the standard of living they have built during their working career, Sky maintains a Non-Qualified Retirement Plan for NEOs and other senior officers. The Non-Qualified Retirement Plan mirrors the construct and design of Sky qualified Profit Sharing, 401(k) and ESOP Plan, as the Non-Qualified Retirement Plan is an extension of qualified Profit Sharing, 401(k) and ESOP Plan for cash compensation above the IRS earnings limit. In 2006, this limit was $220,000. For example, NEOs and other participants in the Non-Qualified Retirement Plan could receive a Company contribution equal to 3% of their cash compensation above the earnings limit under the ESOP portion of Non-Qualified Retirement Plan; a Company matching contribution of 100% of the first 3% contributed by the participant and 50% of the next 2% contributed above the wage limit under the 401(k) supplemental portion of the Non-Qualified Retirement Plan; and, depending on actual profit levels, a supplemental Company contribution equal to 0% to 8% (the same as provided under the qualified Profit Sharing, 401(k) and ESOP Plan) of the participant’s cash compensation above the earnings limit under the supplemental profit sharing portion of the Non-Qualified Retirement Plan.
All contribution amounts are based on the NEOs’ base salary and annual (non-equity) incentive bonus. The Non-Qualified Retirement Plan is described in more detail on page 84, below the Nonqualified Deferred Compensation Table.
In addition, as described in more detail beginning on page 85, each of our NEOs receives certain benefits in the event of termination of employment and change in control scenarios.
Other Benefits and Perquisites
While the value of benefits including health and welfare, retirement, disability, vacation and the like are not required to be reported in the tables that follow, these benefits are important to a comprehensive view of the Sky’s total compensation and benefit program. All Sky employees, including the NEOs, participate in the same comprehensive benefit program, which is intended to provide financial protection to employees based on health and retirement needs as well as providing for well deserved time off. Sky also provides a disability insurance program to all employees including NEOs. However, Sky requires the NEOs to recognize the premiums paid as taxable income, which would allow the disability benefit, if paid, to be tax-free. Sky provides executives with additional income (gross-up) to offset the additional taxes owed on premiums. This allows the disability benefit to replace a greater portion of the NEO’s income in the event of disability, as these plans have a maximum pay limit of $15,000, which is materially below the income of the NEOs in the program.
Sky also provides certain perquisites and special benefits to its executives. In the case of Mr. Adams, Sky provides him with company car and all related expenses in order to assist him in visiting clients and offices across Sky’s multiple regions. Mr. Adams as Chairman of the Board receives, like all Board members, an annual retainer of $12,600 but does not receive any Board meeting or Committee meeting fees. In addition, Mr. Adams and Sky participate in a corporate owned life insurance policy where Mr. Adams’ beneficiaries receive a death benefit equal to three times his base salary and Sky is reimbursed for all premiums it has paid on the policy. Because financial services is a relationship-driven business, Sky pays country club dues for (i) Mr. Adams’ at Muirfield Village and Youngstown Country Clubs, (ii) Mr. Souder at Inverness Club, and (iii) Mr. Koch at the Salem Golf Club, to provide a facility to entertain Sky clients, members of the management staff, and executives and Board members of potential acquisition candidates.
Tax and Accounting Treatment of Compensation
As discussed above, the Company considered the tax and accounting treatment of stock options and restricted stock in comparison to cash compensation in determining the long-term incentive portion of the NEOs’ compensation.
Section 162(m) of the Internal Revenue Code limits the deductibility for federal income tax purposes of certain compensation paid in any year by a publicly held corporation to its chief executive officer and its four other highest compensated officers to $1 million per executive (the “$1 million cap”). The $1 million cap does not apply to “performance-based” compensation as defined under Section 162(m). It is intended that awards made under our 1998 Directors Stock Option Plan and 2002 Stock Option Plan are not subject to the $1 million cap due to the performance-based exception under Section 162(m). In 2006, Mr. Adams base salary and annual incentive payment amounts exceeded the $1 million cap and, thus, was not fully deductible. The other NEOs did not exceed the $1 million cap. Although the Committee seeks to design compensation programs and make awards that will be deductible under Section 162(m), in order to retain flexibility, the Committee has not adopted a formal policy that all compensation paid to the NEOs must be deductible.
Other provisions of the Internal Revenue Code also can affect the Company’s compensation decisions. Under Code Section 280G, a 20% excise tax is imposed upon NEOs and other executive officers who receive “excess” payments upon a change in control of a public corporation to the extent the payments received by them exceed an amount approximating three times their average annual compensation. The excise tax applies to all payments over one times annual compensation, determined by a five year average. A company also loses its tax deduction for “excess” payments. Our employment and change of control agreements do not provide for “gross-up” payments, except for Mr. Adams. However, because the loss of deductibility would increase the expense to the Company, we have restructured payments that could become due upon the Merger under his agreement, so that they do not become “excess payments.”
In addition, the Internal Revenue Code was recently amended to provide a surtax under Section 409A with respect to various features of deferred compensation arrangements of publicly-held corporations, mostly for compensation deferred on or after January 1, 2005. We have made the appropriate changes to our Non-Qualified Retirement Plans and employment agreements to help ensure there are no adverse affects on the Company or executive officers as a result of these Code amendments. We do not expect these changes to have a material tax or financial consequence on the Company.
The Company has calculated and discussed with the Committee the accounting treatment and tax impact to the Company and the executives of each of its cash and equity compensation awards and agreements. The Company also calculates and monitors the FAS 123R accounting expense related to equity-based compensation. To date, the FAS 123R expense has not been a significant factor in setting or changing equity compensation grant practices except insofar as the general parity of treatment of restricted stock and stock options under FAS 123R was a consideration in the Company’s decision to grant restricted stock in lieu of stock options.
Timing of Awards
The Company has always made awards under the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, the 2002 Stock Option Plan, the 2004 Restricted Stock Plan and their predecessor plans in the first quarter of each fiscal year following the approval of the grants by the Board of Directors. The exercise price for stock options is established as the closing share price on the day of the Board meeting where approval is given. The Company has not timed the award of stock options or other equity-based compensation to coincide with the release of favorable or unfavorable information about the Company. The Company does not intend to time the award of stock options or other equity-based compensation to coincide with the release of favorable or unfavorable information about the Company in the future.
Termination and Change in Control Terms
The Company has employment agreements with each of the NEOs. The employment agreements provide both Sky and the executives a mutual understanding of performance expectations, pay opportunities and employment terms. The employment agreements discuss the nature and changes in the employment relationship including performing on-going services and how retirement, disability, voluntary and involuntary terminations are handled.
In addition, the employment agreements provide for severance payments in the event of employment termination following a change in control of the Company. The purpose of the change in control severance policy is to help participants seek to maximize the value of Sky’s
shares without concern about losing their job. In addition, it requires an acquiring company to negotiate pro-actively new employment agreements with participants. All of the NEOs’ are covered by these agreements and the maximum cost of these CIC payments for each named executive is as follows:
All change in control provisions, except for Mr. Adams, are double-trigger meaning that benefits are paid only in the event of a change in control and involuntary employment termination. Mr. Adams can leave voluntarily during the 30 day period beginning one year after a change in control and receive benefits. This provision, which is unique to Mr. Adams, reflects his long service to Sky and the practical likelihood that if Sky were acquired, Mr. Adams role as Chairman and CEO would end. (Mr. Adams would also receive benefits if he was terminated without cause or left for Good Reason before the beginning of the 30-day window period.) Mr. Adams’ change in control agreement could be subject to the 280G limit resulting in a larger portion of the benefit being subject to a 20% excise tax and a loss of most of the tax deduction of the payment to Sky or an acquiror. Mr. Adams agreement would require Sky or an acquiror to provide additional cash compensation-a gross-up-to Mr. Adams to reimburse him for the excise tax as well as any additional income taxes owed by Mr. Adams due to this reimbursement. In connection with the Merger with Huntington, Mr. Adams will be entitled to receive an amount in value of approximately $8,371,311, which is approximately equal to the cash severance that is payable to Mr. Adams upon a termination without cause of for Good Reason, which will be paid to Mr. Adams as follows: (i) $4 million will be paid in lump sum within 30 days of the Merger, and (ii) Huntington will grant Mr. Adams an award of restricted stock with a fair market value, as of the grant date, equal to approximately $4,371,311, which is the balance of that amount. The restricted stock will vest in equal monthly installments until December 31, 2009.
In connection with the merger, Huntington agreed to make certain payments to Mr. Koch, Mr. Thompson and Mr. Souder within 30 days of completion of the Merger. Mr. Koch will be paid $717,000, which is the cash severance that is payable to him upon a “Termination of Employment” (as defined in his employment agreement) as of immediately following completion of the merger, using “Payment Period” (as defined in his employment agreement) of 24 months, and Messrs. Thompson and Souder will be paid $1,853,800 and $1,429,220, respectively, which amounts are the cash severance that are payable to them as if their employment was terminated other than for “cause,” death or “disability” or due to “good reason” (each, as defined in their employment agreements) as of immediately following completion of the merger. In addition, the 2006 fiscal year bonuses paid or payable to Messrs. Thompson and Souder will be used in lieu of their target bonuses for purposes of determining their cash severance. These payments will not affect Mr. Koch’s, Mr. Thompson’s or Mr. Souder’s other rights under their existing employment agreements with Sky. Prior to the completion of the merger, Sky will amend the employment agreements to reflect the foregoing.
Compensation Committee Decision-Making Process
The Committee is comprised of three independent, non-executive Board members whose responsibilities are, per its charter, the establishment of the compensation philosophy; the assessment of the design of Sky compensation and benefit programs; the monitoring of external market pay levels and practices; review and approval of incentive award opportunities, actual payments and grants; and, review and recommendations for broader Board of Director approval related to proposed implementation or material changes to pay or benefit programs.
In arriving at its decisions, the Committee seeks input from outside compensation and benefit experts, management (especially from the CEO and the Chief Human Resources Officer), shareholders, and other Board members. In addition, the recent performance of Sky, future business plans and individual contributions are factored in the pay decision making process. The Committee retains the services of 3C (Compensation Consulting Consortium) as its advisor on compensation related issues. 3C reports directly to the Committee.
In gauging the external market place, the Committee reviews published survey information on pay and benefit levels of positions in the financial service industry from leading compensation and benefit survey houses. In addition, the Committee tracks the pay and performance levels of a select group of financial organizations that are similar in size, scope and profitability of Sky. The list of primary peers utilized in 2006 is as follows:
Associated Banc-Corp
Green Bay, WI
BOK Financial Corporation
Tulsa, OK
Citizens Banking Corp
Flint, MI
Commerce Bancorp, Inc.
Cherry Hill, NJ
Commerce Bancshares, Inc.
Kansas City, MO
Cullen/Frost Bankers, Inc.
San Antonio, TX
First Merit Corporation
Akron, OH
Fulton Financial Corporation
Lancaster, PA
Hibernia Corporation
New Orleans, LA
Mercantile Bankshares Corporation
Baltimore, MD
North Fork Bancorporation, Inc.
Melville, NY
TCF Financial Corporation
Wayzata, MN
Trustmark Corporation
Jackson, MS
Valley National Bancorp
Wayne, NJ
These financial services firms range in size from approximately one-half of Sky’s asset level to two times Sky’s asset level and are generally strong performing organizations measured by profitability level.
This list changes from time-to-time as peers become acquired or acquire companies that materially changes their size or as Sky’s size changes. As a general principle, the Committee retains the right not to pay incentives or cancel unvested restricted stock and option grants in the event of financial restatement or fraud. The Committee would also seek to recover cash incentive payments made under erroneous financial reporting or to adjust future opportunities or payments in order to recapture these payments or awards.
Executive Compensation
The following table shows information concerning the annual compensation for services to the Company in all capacities of the Chief Executive Officer, Chief Financial Officer and the three other executive officers of the Company (collectively the “Named Executive Officers”) during the last completed year.
Summary Compensation Table
(1) The amounts set out in column (a) reflect the base salary earned by each NEO during the year. See page 74 of this Annual Report on Form 10-K for a discussion of how base salary was determined and its interrelationship with the other components of our executive compensation plan.
(2) Payments under the Company’s Annual Incentive Plan are reported in the Non-Equity Plan column (g), not the Bonus column (d), in accordance with SEC requirements.
(3) The values noted in columns (e) and (f) represent the value of stock option and restricted stock awards based on the FAS 123R value recognized for financial statement purposes to the NEO in 2006, which includes amounts that were awarded prior to 2006. See page 59 for a description of the 1998 Directors Stock Option Plan, the 1998 Employee Stock Option Plan, the 2002 Stock Option Plan and the 2004 Restricted Stock Plan. The following table contains awards by year of grant, which comprise the totals of columns (e) and (f).
The following table contains awards by year of grant, which comprise the totals of columns (e) and (f). (continued)
The assumptions underlying the Black-Scholes valuation of the Stock Options/Restricted Stock awarded can be found on page 41.
(4) See page 74 for a description of the Annual Incentive Plan.
(5) The Company does not maintain any defined benefit or actuarial pension plans for NEOs. The Company does not pay or provide any above-market earnings on deferred compensation.
(6) The values noted in column (i) reflect the value provided by Company-paid life insurance, tax-gross-up payments for disability insurance, Company matching, profit sharing and ESOP contributions received under the Sky Financial Group, Inc. Profit Sharing, 401(k) and ESOP Plan, Company matching, profit sharing and ESOP contributions received under the Sky Financial Group, Inc. Non-Qualified Retirement Plan, and perquisites, and are detailed as follows:
The following table provides a detailed accounting of the benefits and perquisites included in the “All Other Compensation” column of the Summary Compensation Table shown on page 78:
Other Compensation Table
The Named Executive Officers receive various perquisites provided by or paid for by the Company pursuant to Company policies or individual agreements with the executive. SEC rules require disclosure of the perquisites and other personal benefits, securities or property for a Named Executive Officer unless the amount of that type of compensation is less than $10,000 in the aggregate.
Perquisites Table
Footnotes to the Perquisites Table: Column (c)-The valuation of the company provided automobiles was calculated as follows: current year depreciation expense for the Company owned automobile plus all costs incurred related to the automobile (including, but not limited to, the cost of insurance, gas, car washes, repairs, and registration and inspection fees) less the Company’s mileage reimbursement allowance for business miles driven by employees who use their own automobile for business purposes. The valuation for all other perquisites shown above is the actual cost to the Company.
(7) The values noted in column (j) reflect the dollar value of the NEO’s total compensation for 2006 (e.g., the sum of columns (c) through (i)).
The foregoing Summary Compensation Table and its sub-tables do not include certain fringe benefits generally made available on a non-discriminatory basis to all of our salaried employees such as group health insurance, dental insurance, vision insurance, life insurance, accidental death and dismemberment insurance and long-term disability insurance, which we consider to be ordinary and incidental business costs and expenses.
Supplemental Narrative
Employment Agreements
The Company entered into an employment agreement with Mr. Adams on March 1, 2004, in replacement of an employment agreement from 1998. The agreement is for an initial three-year term and automatically renews for an additional one year upon each anniversary of the agreement commencing with the first such anniversary, unless either party gives the other advance notice that it does not intend to renew the agreement. The agreement provides for an initial base salary of $725,000 for Mr. Adams, which may not be reduced during the term of the agreement. Mr. Adams is eligible to receive an annual target bonus under the Company’s management incentive program equal to at least 50% of such base salary. The agreement also provides for long-term incentive equity-based compensation equal to at least 50% of such base salary. Long-term incentive equity-based compensation in excess of that level shall vary based upon the Company’s and Mr. Adams’ annual performance. The agreement also provides for the participation in certain benefit plans and programs on a basis no less favorable than any other senior executive of the Company.
Citizens Bancshares, Inc., the Company’s predecessor, entered into an employment agreement with Mr. Koch, which was assumed by the Company as a result of the 1998 merger that formed Sky Financial. The agreement is automatically extended for additional two-year periods on each anniversary of the agreement, unless the Company gives notice of non-renewal. The agreement provides for a base salary at least equal to the annual salary paid in the preceding year, a bonus at the discretion of the Company, and participation in the Company’s profit sharing, health and welfare plans on a basis consistent with other Company executives. In the event of the termination of the executive’s employment by the Company without “cause” (as defined in the agreement), the officer is entitled to the continuation of base salary and discretionary bonus compensation for the remainder of the term of the agreement, in addition to the continuation of participation in the Company’s profit sharing and health and welfare benefit plans on a basis consistent with other Company executives for the remainder of the term. The agreement further contains non-competition and confidentiality provisions.
The Company has entered into employment agreements with Messrs. Thompson, Souder, and Starr, which are identical in all material respects. The agreements provide for at-will employment with no specified term. They provide for a specified minimum base salary, which may not be reduced during the period of employment, and for incentive compensation, benefits and perquisites consistent with those to which similarly situated officers are entitled under the Company’s benefit plans.
Grants of Plan-Based Awards
(1) Non-Equity Incentive Awards were made under the Company’s Annual Incentive Plan. On December 22, 2006, awards were paid to Messrs. Thompson, Souder and Koch at the maximum level. On February 9, 2007, an award was paid to Mr, Starr at slightly below the target level.
(2) The applicable levels of potential payout under the Annual Incentive Plan must be reported in these columns, even though the amount already has been paid.
(3) Stock Options were awarded under the Company’s 1998 Directors Stock Option Plan and 2002 Stock Option Plan. The values of these awards are reported seperately on the Summary Compensation Table.
Supplemental Narrative
Annual Incentive Plan
The Annual Incentive Plan for 2006 is based upon the Company’s short term performance as measured by certain financial ratios tied to the Company’s strategic objectives. Specifically, rewards under the plan are tied to four key performance measures: Client Service Quality, Asset Quality, Profitability and Growth. The Annual Incentive Plan provides for a “Target” incentive award for Mr. Adams of 70% of base salary, with a maximum of up to 140% of base salary and a Target incentive award for the other NEOs of 50% of base salary, with a maximum of up to 100%. Payouts are based on base salary only. Blue Skies awards, bonuses, commissions, skill-based pay, and short-term disability earnings are excluded.
Performance goals may be set in any of five general categories:
n Corporate goals, which reflect measured results for the corporation and therefore emphasize teamwork and cooperation among all participants.
n Regional goals, which reflect the measured results for a region and therefore focus on results of a specific region.
n District goals, which reflect the measured results for a district and therefore focus on results of a specific district.
n Group goals, which reflect the measured results for a group and therefore focus on results of a specific group.
n Individual goals, which reflect the measured personal results by a single participant.
Each participant’s total opportunity can be based on any of the above types of goals selected by the CEO, at his sole discretion. The Compensation Committee sets the goals for the CEO. The mix and weighting of the types of goals and/or their use in determining awards need not be the same for all participants or any group of participants.
Goals will have three general levels of achievement. Award opportunities for results achieved between these levels will be interpolated. All goals and opportunity levels shall be reviewed and established in light of existing economic conditions and the company’s then existing strategic objectives so that the program retains its purpose of motivating and rewarding employees for producing those realistic, focused results.
n Program “Threshold” describes the minimum result necessary to generate an incentive award.
n Program “Target” describes a stretch goal that is set in conjunction with the company’s business plan.
n Program “Maximum” describes outstanding results for which the maximum available incentive awards will be payable.
Linkage has been created between the goals to ensure concentration on all of the performance measures. Performance below threshold of any goal will offset total payout.
For the NEOs other than the CEO, goals may be adjusted during the fiscal year by the CEO, at his sole discretion for circumstances such as restructuring, acquisitions, and general ledger reclassifications. The CEO also may adjust forecasts if unforeseen negative events affecting performance should occur. Changes to goals are infrequent. The approval of the CEO is required to make any changes. The CEO also reserves the right to adjust the credit on unusual transactions (“windfalls”), in his sole discretion, to reflect more appropriately the amount of effort involved. For the CEO, such decisions are made by the Compensation Committee.
1998 Directors Stock Option Plan
Under the Company’s 1998 Directors Stock Option Plan, as amended, 2% of the Company’s outstanding common stock is reserved for issuance for awards to Directors. In 2006, we issued options for shares of our common stock under this plan to Mr. Adams, which were vested immediately Mr. Adams is the only employee who has received stock options under this plan, due to his position as Chairman of the Board of Directors.
1998 Employee Stock Option Plan
Under the Company’s 1998 Employee Stock Option Plan, 5 1/2% of the Company’s outstanding common stock is reserved for issuance of awards to employees.
In 2006, we issued options for the shares of our common stock under our 1998 Employee Option Plan to Messrs. Thompson, Koch, Souder and Starr, each as indicated in the table on page 82. The options granted to Messrs. Thompson, Koch, Souder and Starr vest in installments over a period of five years. All options would become fully vested and exercisable upon the Merger.
2002 Stock Option Plan
Under our 2002 Stock Option Plan, 2,046,178 shares of our common stock were reserved for issuance in connection with stock options and/or stock appreciation rights awards that may be granted under the plan. As of December 31, 2006, 1,479,805 shares of common stock remain available for awards.
2004 Restricted Stock Plan
Under our 2004 Restricted Stock Plan, 800,000 shares of our common stock have been reserved for issuance in connection with restricted stock awards that may be granted under the plan. As of December 31, 2006, 722,408 shares of common stock remain available for awards.
In 2006, we issued restricted stock under our 2004 Restricted Stock Plan to Messrs. Adams, Thompson Koch, Souder and Starr as indicated in the table on page 82. The restricted stock granted to Messrs. Adams, Thompson, Koch, Souder and Starr vests in installments over a period of five years. All restricted stock would become fully vested upon the Merger.
Outstanding Equity Awards at Year-End
Outstanding Equity Awards at Year-End (continued)
(1) Unexercisable options vest according to the following schedule: 40% on the second anniversary of the date of grant, and an additional 20% vesting on each of the third, fourth and fifth anniveraries of the date of grant. All outstanding awards would become fully vested upon the consummation of the Merger.
(2) Unvested shares of restricted stock vest according to the following schedule: 40% on the second anniversary of the date award, and an additional 20% vesting on each of the third, fourth and fifth anniversary of the date of award. All outstanding awards would become fully vested upon the consumation of the Merger.
Option Exercises and Stock Vested
(1) The awards were made under the 1998 Directors Stock Option Plan, as amended.
(2) The awards were made under the 1998 Employee Stock Option Plan and the 2002 Stock Option Plan.
Pension Benefits
The Company does not maintain a qualified or non-qualified pension plan.
Non-Qualified Deferred Compensation1
(1) All contributions are under the Sky Financial Group, Inc. Non-Qualified Retirement Plan I or the Sky Financial Group, Inc. Non-Qualified Retirement Plan II, described below.
(2) Note that the amount of each NEO’s contributions also is included in either the “Salary” or the “Non-Equity Incentive Compensation” column of the Summary Compensation Table on page 78. The contribution is made from and reduces the NEO’s Salary or Non-Equity Incentive Compensation.
It is not in addition to those amounts.
(3) Note that the amount of the Registrant’s contributions also is included in the “All Other Compensation” column of the Summary Compensation Table on page 78. These contributions are not in addition to the amount reported there.
(4) The Plan does not provide for above-market interest.
Supplemental Narrative
Sky maintains the Sky Financial Group, Inc. Non-Qualified Retirement Plan I, and the Sky Financial Group, Inc. Non-Qualified Retirement Plan II for NEOs and other employees who want to contribute in excess of the IRS limits. These two Non-Qualified Plans are nearly identical, except that Plan I was frozen to qualify for grandfather treatment under Code Section 409A and Plan II was drafted to comply with Code Section 409A.
Non-Qualified Retirement Plans I and II each mirror the construct and design of the qualified Sky Financial Group, Inc. Profit Sharing, 401(k) and ESOP Plan, as the Non-Qualified Retirement Plans are an extension of the qualified plan for an NEO’s cash compensation above the IRS earnings limit. In 2006, this limit was $220,000. For example, NEOs and other participants in the Non-Qualified Retirement Plans could receive a Company contribution equal to 3% of their cash compensation above the earnings limit under the ESOP portion of Non-Qualified Retirement Plan; a Company matching contribution of 100% of the first 3% contributed by the participant and 50% of the next 2% contributed above the wage limit under the 401(k) supplemental portion of the Non-Qualified Retirement Plan; and, depending on actual profit levels, a supplemental Company contribution equal to 0% to 8% (the same as provided under the qualified Profit Sharing, 401(k) and ESOP Plan) of the participant’s cash compensation above the earnings limit under the supplemental profit sharing portion of the Non-Qualified Retirement Plan.
Under the Plans, Company contributions are based on “Compensation,” which means a participant’s salary and bonus payable in any calendar year. Under the Plans, “Bonus” means the additional cash remuneration payable to a participant annually pursuant to the Annual Incentive Plan. Under the Plans, the NEOs (and other participants) can elect to make pre-tax contributions above the IRS limits ($15,000 for 2006) from their “Additional Remuneration,” which means the Bonus and any additional cash remuneration payable to a participant annually pursuant to a performance compensation program or any other plan, program or arrangement under which the Company pays an amount of cash remuneration to a participant above such participant’s salary.
All Sky contributions, as well as deferral contributions elected by the participants are deemed invested, according to the participant’s direction, in the same fund choices as are made available under Sky’s qualified Profit Sharing, 401(k) and ESOP Plan. These contributions and the investment earnings, if any, do not result in taxable income to the participants until they receive a distribution, generally following the participant’s retirement or other termination of employment. A portion of the Sky and participant contributions are held in a rabbi trust, under which the entire balance remains subject to the claims of Sky’s general creditors. Under these plans, Sky accrues a liability equal to the plan balances and receives a tax deduction only when payments are made out of these plans, which are anticipated to be at retirement typically. Sky is subject to income taxes on income earned on these investments as well as capital gains treatment when sold.
The ESOP contribution equals 3% of cash compensation above the IRS wage limit of $220,000 and is paid in Sky Stock. The 401(k) provides a 100% match on the first 3% of cash compensation deferred and a 50% match on the next 2% of cash compensation deferred, or 4% of cash compensation taking into account all compensation. There is also a profit sharing contribution and the amount varies directly with Sky profits and can range from 0% to 8% of cash compensation above the IRS wage limit of $220,000. The Non-Qualified Plans provide investment alternatives in the following catagories: Sky stock, large cap, small cap, income and growth funds.
Potential Payments Upon Termination or Change In Control
The Company’s Named Executive Officers are each a party to an employment agreement that provides for certain salary and benefits upon termination of employment under various scenarios. The agreements are all described more fully in the narrative and tables below.
The tables below set forth the estimated current value of benefits that could be paid to each of our Named Executive Officers upon various termination events, which would only be known at the time that the benefits become payable. The tables reflect the amounts that could be payable under the various arrangements if the event in question occurred as of December 31, 2006.
The Named Executive Officers’ employment agreements do not provide for any additional payments or benefits under a voluntary termination of employment by the executive or involuntary termination by the Company for cause. Under those scenarios, the Named Executive Officers are only entitled to their accrued and unpaid obligations, such as salary and unused vacation. The following tables contain common information about the Company’s employment aggreements and benefit plans, and policies, as well as, assumptions used by the Company in arriving at the amounts contained in the tables.
Marty E. Adams
The following table shows the potential payments upon termination or change in control for Marty Adams, our Chairman, President, and is Chief Executive Officer. A description of the employment agreement with Mr. Adams providing the benefits specified in the table below and on page 88.
Potential Payments Upon Termination or Change In Control - Marty E. Adams
(1) In the event that the Company terminates Mr. Adams’ employment without Cause or if he terminates his employment for “Good Reason” (each as defined in the employment agreement and described below), he is entitled to receive the annual bonus for the remaining two years of his employment agreement. If Mr. Adams were terminated for any other reason, he is entitled to receive the bonus due in February 2007 because he was employed on December 31, 2006.
(2) Mr. Adams’ award agreement under the 2004 Restricted Stock Plan provides for full vesting upon a change in control. These figures were calculated according to the rules applicable to change in control payments under code section 2806.
(3) In the event the Company terminates Mr. Adams without Cause or if he terminates his employment for Good Reason, he is entitled to an amount sufficient to pay premiums for medical, health, disability and life insurance for the remaining two years of his employment agreement. In the case of termination for any other reason, Mr. Adams is not entitled to any additional amounts.
(4) Based on his years of service, Mr. Adams is 100% vested in his benefit under this plan. The amounts reflected represent additional benefit plan contributions he is entitled to receive under his employment agreement. Upon termination of employment for any reason, Mr. Adams would be entitled to receive a lump sum distribution of his entire account balance under this plan on the first of the month following six months from his termination of employment. In the case of a change in control that does not result in termination, no benefit is immediately payable.
(5) The Company maintains a split dollar life insurance policy with Mr. Adams through a third-party insurance company. The Company is the owner of the policy. However, an endorsement exists that entitles Mr. Adams to receive a death benefit equal to the lesser of three times his base annual salary, or $3 million. If Mr. Adams is terminated following a Change in Control, he can continue the face amount of the policy (minus the cash surrender value) equal to the greater of the amount set forth in the split dollar policy endorsement or three times his base annual salary, but no greater than $3 million.
(6) Mr. Adams’ employment agreement provides that if he dies, the Company will provide his base salary and health benefits for two years.
(7) Mr. Adams’ employment agreement provides that, if he is terminated due to disability, he will continue to receive for two years, his base salary plus health benefits.
Kevin T. Thompson
The following table shows the potential payments upon termination or change in control for Kevin Thompson, our Executive Vice President, Chief Financial Officer. A description of the employment agreement with Mr. Thompson providing the benefits specified in the table below are described in more detail beginning on page 89.
Potential Payments Upon Termination or Change In Control - Kevin T. Thompson
(1) Mr. Thompson’s award agreement under the 1998 Employee Stock Option Plan and the 2004 Restricted Stock Plan provide for full vesting upon a change in control. These figures were calculated according to the rules applicable to change in control payments under code section 2806.
W. Granger Souder, Jr
The following table shows the potential payments upon termination or change in control for W. Granger Souder, Jr. our Executive Vice President, General Counsel and Secretary. A description of the employment agreement with Mr. Souder providing the benefits specified in the table below are described in more detail beginning on page 89.
Potential Payments Upon Termination or Change In Control - W. Granger Souder, Jr.
(1) Mr. Souder’s award agreement under the 1998 Employee Stock Option Plan and the 2004 Restricted Stock Plan provide for full vesting upon a change in control. These figures were calculated according to the rules applicable to change in control payments under code section 2806.
Les V. Starr
The following table shows the potential payments upon termination or change in control for Les V. Starr, our Executive Vice President, Operations and Information Technology. A description of the employment agreement with Mr. Starr providing the benefits specified in the table below are described in more detail beginning on page 89.
Potential Payments Upon Termination or Change In Control - Les V. Starr
(1) Mr. Starr’s award agreement under the 1998 Employee Stock Option Plan and the 2004 Restricted Stock Plan provide for full vesting upon a change in control. These figures were calculated according to the rules applicable to change in control payments under code section 2806.
Frank J. Koch
The following table shows the potential payments upon termination or change in control for Frank Koch, our Executive Vice President, Chief Credit Officer. A description of the employment agreement with Mr. Koch providing the benefits specified in the table below are described in more detail beginning on page 89.
Potential Payments Upon Termination or Change In Control - Frank J. Koch
(1) Mr. Koch’s award agreement under the 1998 Employee Stock Option Plan and the 2004 Restricted Stock Plan provide for full vesting upon a change in control. These figures were calculated according to the rules applicable to change in control payments under code section 2806.
(2) Based on his years of service, Mr. Koch is 100% vested in his benefit under this plan. The amounts reflected represent additional benefit plan contributions he is entitled to receive under his employment agreement. Upon termination of employment for any reason, Mr. Koch would be entitled to receive a lump sum distribution of his entire account balance under this plan on the first of the month following six months from his termination of employment. In the case of a change in control that does not result in termination, no benefit is immediately payable.
Employment Agreement with Mr. Adams
In addition to the terms of Mr. Adams’ employment agreement described in the narrative accompanying the Summary Compensation Table, Mr. Adams’ employment agreement provides for payment of certain benefits under certain termination and change in control scenarios. The agreement provides that, in the event of termination of employment for any reason, the Company shall pay Mr. Adams in lump sum an amount equal to the unpaid base salary, any short term and long term incentive compensation payable and any benefit payments due Mr. Adams through the date of termination. The agreement also provides for the payment upon his termination for any reason other than for Cause or without Good Reason (each as defined in the agreement and below), of an amount equal to the targeted annual bonus prorated for the remainder of the year in which termination occurs.
In addition to those payments, in the event that Mr. Adams’ employment is terminated either prior to or within two years following a “change in control” of the Company (as defined in the agreement and below), either by the Company without Cause or by the executive for Good Reason, the Company shall pay Mr. Adams an amount equal to the greater of (i) the sum of Mr. Adams’ annual base salary plus targeted annual bonus (“Annual Cash Compensation”) multiplied by the number of whole and partial years remaining in the employment term as it existed immediately preceding termination, or (ii) three times Annual Cash Compensation. Welfare benefit continuation will be provided for the remainder of the term, or if longer, three years. If such termination occurs during the two-year period following a “change in control,” Mr. Adams would receive the greater of the termination payment described above, or three times the sum of (x) his highest annual rate of base salary, (y) his highest supplemental matching contributions and (z) his highest annual bonus and long-term compensation paid or awarded during the three-year period immediately prior to the date of termination, and continued welfare benefits for the longer of three years or the remaining period of the term as it existed immediately prior to termination. Upon any such termination, all stock options granted after the effective time shall vest and become immediately exercisable in full.
If any payments pursuant to the agreement or otherwise would be subject to any excise tax under the Internal Revenue Code, the Company will provide an additional payment such that Mr. Adams retains a net amount equal to the payments he would have received if such excise tax had not applied.
The agreement contains a covenant not to compete and related provisions that restrict Mr. Adams’ ability to compete with the Company during the term of the agreement and for a period of one year following termination under certain circumstances.
Definitions
“Cause,” as defined in Mr. Adams’ employment agreement, means: (i) the willful and continued failure to substantially perform his duties to the detriment of the Company (other than due to physical or mental illness), after a written demand for substantial performance is delivered to Mr. Adams by the Board; or (ii) willful engaging in gross misconduct materially and demonstrably injurious to the Company. No act or failure to act by Mr. Adams shall be considered “willful” unless done or omitted to be done by him in bad faith and without reasonable belief that his action or omission was in the best interests of the Company.
The employment agreement defines “Good Reason” as the Company’s: (i) removal of Mr. Adams from, or failure to re-appoint him to, his position as Chairman and/or his position as Chief Executive Officer of the Company, except in connection with the Company’s termination of Mr. Adams for Cause, or removal of Mr. Adams as Chairman in order to comply with statutory or regulatory requirements; (ii) failure to comply the employment agreement in any material respect; (iii) giving notice to Mr. Adams that it does not intend to renew the employment agreement; or (iv) imposing any requirement that Mr. Adams be based anywhere more than thirty miles from the Company’s office where he is located at the effective time of the agreement.
During the two year period following a Change in Control, “Good Reason” also shall include, without Mr. Adams’ consent, the Company’s: (i) assignment to Mr. Adams of any duties or responsibilities (including reporting responsibilities) inconsistent in any material and adverse respect with his duties and responsibilities with the Company immediately prior to such Change in Control (including any diminution of such duties or responsibilities), removal of Mr. Adams from, or failure to reappoint Mr. Adams to, his position as Chairman, President, and Chief Executive Officer, or the removal of Mr. Adams from such position, thereafter; (ii) reduction in Mr. Adams’ rate of annual base salary or short-term incentive compensation or long-term incentive compensation opportunities as in effect immediately prior to such Change in Control or as the same may be increased from time to time thereafter; (iii) failure to continue in effect any employee benefit plan, compensation plan, welfare benefit plan or material fringe benefit plan in which he is participating immediately prior to the Change in Control, or the taking of any action that would adversely affect Mr. Adams’ participation in or reduce his benefits under any such plan, unless Mr. Adams is permitted to participate in other plans providing Mr. Adams with substantially equivalent aggregate benefits, or provide Mr. Adams with paid vacation in accordance with the most favorable plans in effect for Mr. Adams immediately prior to such Change in Control; or (iv) refusal to continue to permit Mr. Adams to engage in activities not directly related to the business of the Company, which Mr. Adams was permitted to engage in prior to the Change in Control; (v) purported termination of Mr. Adams’ employment; or (vi) failure of to obtain the assumption agreement from any successor as contemplated in Mr. Adams’ employment agreement.
Termination of employment by Mr. Adams for any reason other than retirement during the 30 day period commencing one year after the date of a Change in Control also shall constitute Good Reason.
Pursuant to the agreement, “Change in Control” shall be deemed to have taken place if at anytime following the effective time of the agreement: (i) individuals who constitute the Board immediately after the Effective Time cease for any reason to constitute at least a majority of the Board; (ii) any “person” (as such term is defined in Section 3(a)(9) of the Securities Exchange Act of 1934 (the “Exchange Act”), directly or indirectly, of securities of the Company representing 25% or more of the combined voting power of the Company’s then outstanding securities; (iii) the consummation of a merger, consolidation, statutory share exchange or similar form of corporate transaction involving the Company or any of its Subsidiaries that requires the approval of the Company’s stockholders (a “Business Combination”), unless immediately following such Business Combination: (A) more than 60% of the total voting power of the corporation resulting from such Business Combination or (y) the ultimate parent corporation that directly or indirectly has beneficial ownership of 100% of the voting securities eligible to elect directors of the Surviving Company is represented by Company Voting Securities; or (iv) the Company’s stockholders approve a plan of complete liquidation or dissolution of the Company or a sale of substantially all of the Company’s assets or deposits.
The Merger, if consummated, will constitute a Change in Control.
Employment Agreements with Messrs. Thompson, Souder and Starr
We have entered into employment agreements with Messrs. Thompson, Souder and Starr with substantially similar terms. The agreements provide for at-will employment with no specified term. They provide for a specified minimum base salary, which may not be reduced during the period of employment, and for incentive compensation, benefits and perquisites consistent with those to which similarly situated officers are entitled under the Company’s benefit plans.
Pursuant to the employment agreements, if the Company terminates the NEO’s employment for any reason other than for Cause, death, or disability, or if the NEO terminates employment for Good Reason, the NEO is entitled to the following compensation: (a) continuation of base salary for eighteen months or in the event of a termination within six months of a Change in Control, a lump sum equal to the product of 2.99 times the base salary amount; (b) bonus compensation under the Company’s short-term incentive plan, if any, for 2006; (c) lump sum amount equal to the NEO’s annual “target” amount under the Company’s short-term incentive plan, or in the event of a termination within six months of a Change in Control, a lump sum amount equal to the product of 2.99 times the NEO’s “target” amount; (d) outplace-ment services, at a provider of NEO’s choice, up to a cost of $25,000; and (e) continuation of NEO’s medical, dental, and life insurance benefits for the lesser of eighteen months or until the NEO begins new full-time employment. The above payments are contingent upon the executive signing a mutual general release. In the event that the Company terminates the NEO’s employment for Cause, death or disability or if the NEO voluntarily terminates his employment other than for Good Reason, the NEO is only entitled to his earned salary and vested plan benefits up to and including the date of termination. The agreements also require the NEOs to abide by restrictive covenants relating to non-disclosure, as well as non-competition and non-solicitation for one year following termination of employment. In the case of Mr. Thompson and Mr. Souder, as part of the merger with Huntington, the actual 2006 bonuses will be used in lieu of “target” for purposes of calculating severance in clause (c) above.
“Cause” as defined in each agreement means: (a) the commission by the employee of an act or series of acts intended to cause and which results in material damage to the Company’s property, operations or business prospects; or (b) the employee’s gross misconduct, fraud, misappropriation of funds, or commission of a felony; or (c) the employee’s willful failure to perform his duties or the lawful and ethical directions, which failure has not been cured in all material respects within twenty days after the Company gives written notice thereof to the employee; or (d) the employee’s material breach of any provision of his employment agreement, which breach has not been cured in all material respects within twenty days after the Company gives written notice thereof to the employee.
The agreements define “Good Reason” as: (a) a material diminution of the duties, authority, responsibility level, or employment position of the employee; (b) a reduction, in the employee’s base salary from the amount specified in their employment agreement; (c) a material reduction of more than ten percent in the employee’s target incentive compensation as set forth in their employment agreement, except in the event that such reduction applies uniformly to all other employees with positions at the same level within the Company as that of the position of the employee; (d) any change in the employee’s principal place of work, which would increase the employee’s commute by thirty-five miles or more from the employee’s current principal place of work, or (e) a material breach by the Company of its obligations under the employee’s employment agreement. The agreements provide that Good Reason is not effective until the expiration of ten business days following written notice to the Company of the employee’s grounds for claiming Good Reason and that any action or inaction, which is remedied by the Company within ten business days following such written notice, shall not constitute Good Reason.
“Change in Control” means: (a) the consummation of a merger, consolidation, statutory share exchange or similar form of corporate transaction involving the Company or any of its subsidiaries that requires the approval of the Company’s stockholders, whether for such transaction or the issuance of securities in the transaction, unless immediately following such transaction: (i) more than sixty percent of the total voting power of (x) the company resulting from such transaction or (y) if applicable, the ultimate parent company thereof, is represented by voting securities that were outstanding immediately prior to such transaction (or, if applicable, is represented by shares into which such Company voting securities were converted pursuant to such transaction; (ii) no person (other than any employee benefit plan or related trust sponsored or maintained by the Company resulting from such transaction or the parent thereof is or becomes the beneficial owner, directly or indirectly, of 25% or more of the total voting power of the outstanding voting securities eligible to elect directors of the Company resulting from such transaction or the parent thereof; and (iii) at least fifty percent of the members of the board of directors of the Company resulting from such transaction or the parent thereof following the consummation of the transaction were directors of the Company at the time of the Board of Directors’ approval of the execution of the initial agreement providing for such transaction; or (b) the stockholders of the Company approve a plan of complete liquidation or dissolution of the Company or a sale of all or substantially all of the Company’s assets or deposits. Notwithstanding the foregoing, a Change in Control of the Company shall not be deemed to occur solely because any person acquires beneficial ownership of more than twenty-five percent of the Company voting securities as a result of the acquisition of Company voting securities by the Company, which reduces the number of Company voting securities outstanding; provided, however, that if after such acquisition by the Company, such person becomes the beneficial owner of additional Company voting securities that increases the percentage of outstanding Company voting securities beneficially owned by such person, a Change in Control of the Company shall then occur.
The Merger, if consummated, will constitute a Change in Control.
Employment Agreement with Mr. Koch
Mr. Koch’s employment agreement provides that, upon a change in control, the Company must continue to employ Mr. Koch until the earlier of age 65 or twenty-four months after the date of the change in control. During this period, Mr. Koch is entitled to: (i) a monthly salary of at least equal to his highest base salary for any month of the previous twelve months preceding the change-in-control and, during each subsequent year, an annual salary at least equal to his salary for the preceding year plus any increases calculated in a manner in which other pay increases are calculated for other executives, (ii) annual bonus equal to the greater of (a) his last annual bonus or (b) his annual bonus of the preceding year; (iii) all existing plans or through equivalent plans at least the types and amounts of group insurance coverage benefits, including life, health, disability, hospitalization, and surgical benefits, and health care benefits for Mr. Koch’s family; and (iv) participation in the profit sharing plan on the same basis as all other employees. In the event of a termination of Mr. Koch for any reason other than for cause, during this period, the Company must pay: (i) monthly salary equal to the greater of his highest salary for any month during the twelve months preceding the change-in-control and his termination of employment, (ii) profit sharing plan and trust contributions on the same basis as all other employees, provided continued participation is possible under the terms and provisions of the plan and (iii) the greater of the average of the annual bonuses received by Mr. Koch during the three calendar years preceding the change in control and the termination of employment. Mr. Koch’s compensation will be deducted by any amount he received during the year pur-
suant to the long-term disability policy. Mr. Koch may elect, within sixty days after the date of termination, to receive a single lump sum payment in an amount equal to the present value of the total unpaid amount due to him if there is a termination as a result of a change in control. Following a change in control, if Mr. Koch ceases to be employed for any reason, except misconduct, he and or his spouse shall receive health care benefits equal to the greater of the benefits to which he was entitled to before his termination or immediately preceding the change in control until Mr. Koch reaches normal retirement age. If, following a change in control, the Company requires Mr. Koch to relocate his office more than seventy miles from Salem, Ohio or forty miles from Salineville, Ohio, relocation expenses not to exceed $5,000 will be paid by the Company.
For purposes of Mr. Koch’s employment agreement, “Change in Control” means: (i) any person, partnership, corporation, or other entity becomes a beneficial owner, directly or indirectly, of shares of voting stock representing at least 20% or more of the Company issued and outstanding voting stock; or (ii) one-half or more of the membership of the Board consists of members not recommended for membership by the Company or the Board. The, merger, if consumated, will constitute a Change in Control. A termination by Mr. Koch for “cause” means: (i) the Company’s request that Mr. Koch resigns or retire; (ii) a change in location of Mr. Koch’s place of employment or office to a site more than seventy miles from Salem, Ohio, city limits or forty miles from Salineville, Ohio, city limits; (iii) or the breach by the Company of any provision of Mr. Koch’s employment agreement.
Compensation Committee Report
The Compensation Committee of the Board (the “Committee”) has reviewed and discussed the Compensation Discussion and Analysis on pages 73 through 90 of this Annual Report on Form 10-K with the Company’s management and, based on such review and discussions, the Committee recommended to the Board that the Compensation Discussion and Analysis be included in the Company’s Annual Report on Form 10-K for the Company’s fiscal year ended December 31, 2006.
Gerard P. Mastroianni, Chairman
D. James Hilliker
Marylouise Fennell
Director Compensation
(1) Includes annual retainer fees, Board and committee meeting attendance fees and committee chair fees.
(2) Represents the values of restricted stock awards based upon the FAS 123R value recognized for financial statement reporting purposes to the director in 2006, which includes amounts that were awarded prior to 2006.
(3) Represents the grant date fair value of the 2006 Option Awards using $4.96 per share, calculated using the Black-Scholes model and the assumptions described on page 41 of this Form 10-K, which is the same as the FAS 123R value recognized for financial statement reporting purposes to the director in 2006.
(4) Represents the full grant date fair value of the 2006 Stock Awards calculated using the Black-Sholes model and the assumptions described on page 41 of this Form 10-K.
The aggregate Restricted Stock and Stock Options outstanding, and the respective FAS 123R value recognized for financial statement purposes, for each person in the table set forth above as of December 31, 2006 is as follows:
General Description of Director Compensation
All directors of the Company receive as compensation for their service annual retainers of $12,600. In addition, non-employee directors receive a fee of $1,050 for each board meeting attended ($525 for each teleconference meeting) and a fee of $1,000 for each committee meeting attended ($500 for teleconference meeting). Committee chairmen receive an additional $600 for each committee meeting attended ($300 for teleconference meetings). In addition, under our 2002 Stock Option Plan, for the fiscal year ended December 31, 2006, each continuing non-employee director received a long-term equity award comprised of a mix of stock options and restricted stock. Options granted to continuing non-employee directors have ten-year terms and become exercisable in full immediately following the date of the grant. Employee directors receive separate compensation for Board service. The Governance Committee annually reviews the compensation of non-employee directors. Director compensation is set by the Board, based upon the recommendation of the Governance Committee.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Generally, under the rules of the Securities and Exchange Commission, a person is deemed to be the beneficial owner of a security with respect to which such person, through any contract, arrangement, understanding, relationship or otherwise, has or shares voting power (which includes power to vote or direct the voting of, such security) or investment power (which includes power to dispose of or direct the disposition of such security). In addition, a person is deemed to be the beneficial owner of a security if he or she has the right to acquire such voting or investment power over the security within 60 days, for example, through the exercise of a stock option.
The following table shows the beneficial ownership of the Company’s common stock as of December 31, 2006, by: (i) each person who is the beneficial owner of more than five percent of the outstanding shares of the Company’s common stock; (ii) each director of the Company; (iii) each executive officer named in the Summary Compensation Table and; (iv) all directors and named executive officers as a group.
(1) Includes shares held in the name of spouses, minor children, certain relatives, trusts, estates and certain affiliated companies as to which beneficial ownership may be disclaimed.
(2) The amounts shown represent the total shares owned outright by such individuals, shares issuable upon the exercise of currently vested but unexercised stock options, and shares of Restricted Stock. Specifically, vested but unexercised options entitle the following individuals to acquire the indicated number of shares: Mr. Adams, 576,808; Mr. Chandler, 57,203; Mr. Duvall, 70,836; Ms. Fennell, 21,000; Mr. Hilliker, 75,894; Mr. Johnson, 59,321; Mr. Koch, 44,649; Mr. Levy, 102,366; Mr. Mastroianni, 80,037; Mr. Ridler, 58,889; Mr. Ross, 59,991; Mr. Souder, 39,686; Mr. Spangler, 76,691; Mr. Starr, 27,600; Mr. Tosh, 76,007; Mr. Wean, 10,000; and all directors and named executive officers as a group, 1,436,984. Furthermore, the amounts shown reflect unvested shares of Restricted Stock, to which the holders are entitled to dividend and voting rights in the following amounts: Mr. Adams, 48,750; Mr. Chandler, 1,000; Mr. Duvall, 1,000; Ms. Fennell, 3,000; Mr. Hilliker, 2,000; Mr. Johnson, 1,000; Mr. Koch, 3,405; Mr. Levy, 1,860; Mr. Mastroianni, 1,590; Mr. Ridler, 2,650; Mr. Ross, 3,180; Mr. Souder, 4,965; Mr. Spangler, 2,650; Mr. Starr, 2,530; Mr. Thompson, 5,940; Mr. Tosh, 2,500; Mr. Wean, 2,000; and all directors and named executive officers as a group, 90,020.
(3) Sky Trust, National Association, the Company’s trust company subsidiary, was deemed beneficial owner of portions of the referenced number of shares based upon its sole or shared voting or investment power over the shares. Sky Trust holds the shares solely in a fiduciary or custodial capacity under numerous trust relationships, none of which represents more than five percent of the Company’s outstanding shares. The Company disclaims beneficial ownership of the shares that may be deemed to be beneficially owned by Sky Trust.
(4) The number of shares of common stock shown as beneficially owned by Mr. Chandler includes 1,700 shares owned by his wife, for which Mr. Chandler disclaims beneficial ownership.
(5) The number of shares of common stock shown as beneficially owned by Mr. Tosh includes 53,871 shares owned by a trust, for which Mr. Tosh disclaims beneficial ownership.
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2006, regarding compensation plans under which equity securities of Sky Financial are authorized for issuance:
(1) Represents options to purchase shares of Sky Financial common stock and stock appreciation rights. There are no outstanding warrants.
Item 13.
Item 13. Certain Relationships and Related Transactions
Directors and executive officers of the Company and their associates were clients of, or had transactions with, the Company or the Company’s banking or other subsidiaries in the ordinary course of business during 2006. Additional transactions may be expected to take place in the future. All outstanding loans to directors and executive officers and their associates were made in the ordinary course of business, on substantially the same terms, including interest rates and collateral where applicable, as those prevailing at the time for comparable transactions with other persons, and did not involve more than normal risk of collectibility or present other unfavorable features.
Independence of Directors
The Company’s Governance and Nominating Committee has established criteria for the determination of the independence of members of the Board of Directors and its committees. The Committee has utilized the definitional criteria of the National Association of Securities Dealers, Inc. and the Securities and Exchange Commission in their respective rulemakings promulgated under certain provisions of the Sarbanes Oxley Act of 2002. The Board of Directors of the Company has determined that a majority of the members of the Board are “independent” and that the membership of the Audit, Compensation and Governance Committees is comprised solely of “independent” directors. Directors deemed independent by the Board include directors: Chandler, Duvall, Fennell, Hilliker, Johnson, Levy, Mastroianni, Ridler, Ross, Spangler, Tosh and Wean.
Item 14.
Item 14. Principal Accounting Fees and Services
In accordance with rules related to auditor independence, the table below sets forth the aggregate fees billed by Deloitte & Touche LLP for services rendered to the Company and its affiliates during 2005 and 2006.
(1) Audit-Related services provided by Deloitte & Touche LLP in 2006 included: SAS 70 service auditors report; audits of common trust funds; audits of employee benefit plans; and other accounting consultations.
(2) No Other Fees were paid to Deloitte & Touche LLP in 2005 or 2006.
The Committee has reviewed the services provided by Deloitte & Touche LLP and has considered the compatibility of such services with maintaining the auditor’s independence. The Company did not retain Deloitte & Touche LPP in 2006 for internal audit services or information technology consulting services relating to financial information systems design and implementation.
In accordance with the requirements of the Audit Committee Charter, the Committee has established written
procedures for the pre-approval of all services provided by the Company’s Independent Registered Public Accounting Firm. The procedures identify specific permitted audit services, other permitted services and prohibited services. All services provided by the Company’s Independent Registered Public Accounting Firm must be approved in advance by the Audit Committee or a designated member of the Audit Committee. During 2006, approximately 2.5% of the total fees paid to Deloitte & Touche LLP related to non-audit services approved by the Audit Committee pursuant to Rule 2-01(c)(7) of Regulation S-X.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this report:
(b) The following exhibits required by Item 601 of Regulation S-K are filed as part of this report:
FORM 10-K EXHIBIT INDEX
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.
SKY FINANCIAL GROUP, INC.
By:
/s/ Kevin T. Thompson
Kevin T. Thompson
Executive Vice President and Chief Financial
Officer (Principal Financial Officer and Principal Accounting Officer)
February 23, 2007
Pursuant to the requirement 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 date indicated.
Signatures
* The undersigned attorney-in-fact, by signing his name below, does hereby sign this Report on Form 10-K on behalf of the above-named officers and directors pursuant to a power of attorney executed by such persons and filed with the Securities and Exchange Commission contemporaneously herewith.
By:
/s/ Kevin T. Thompson
Kevin T. Thompson
Attorney-In-Fact
www.skyfi.com