Item 1. Business
General
Alliance Financial Corporation is a New York corporation and a registered financial holding company formed on November 25, 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc. Alliance is the holding company of Alliance Bank, N.A. which was formed as the result of the merger of First National Bank of Cortland and Oneida Valley National Bank in 1999.
We provide financial services from 29 retail branches and customer service facilities in the New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a Trust Administration Center in Buffalo, NY. Our primary services include commercial, retail and municipal banking, consumer finance, mortgage financing and servicing, trust and investment management services. The Bank has a substantially wholly owned subsidiary, Alliance Preferred Funding Corp., which is engaged in residential real estate activity, and a wholly owned subsidiary, Alliance Leasing, Inc.
Our corporate and administrative offices are located on the 18th Floor, AXA Tower II, 120 Madison St., Syracuse, New York. Banking services are provided at the administrative offices as well as at Alliance’s 29 customer service facilities.
We formed Alliance Financial Capital Trust I and Alliance Financial Capital Trust II (collectively “Capital Trusts”) for the purpose of issuing corporation-obligated mandatorily redeemable capital securities to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of Alliance.
At December 31, 2012, we had 331 full-time equivalent employees. Our employees are not represented by any collective bargaining group. We consider our employee relations to be good.
The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank System, and its deposits are insured by the Federal Deposit Insurance Corporation up to applicable limits.
Pending Merger
On October 8, 2012, we reported that we entered into a definitive merger agreement (“Merger Agreement’) with NBT Bancorp Inc. (“NBT”). Under the terms of the Merger Agreement, NBT will acquire us for approximately $233.4 million based on the 5-day average closing price of NBT’s common stock for the period ended October 5, 2012, and we will merge with and into NBT, with NBT being the surviving corporation (the “Merger”). Immediately following the Merger, the Bank will be merged with and into NBT’s subsidiary bank, NBT Bank, N.A. (“NBT Bank”) and NBT Bank will continue as the surviving bank. Merger related expenses in non-interest expense totaled $3.4 million in 2012 and included $2.7 million for professional fees and $676,000 for personnel related accrual for estimated retention awards. The NBT stockholders voted to approve the Merger Agreement on March 5, 2013, and our shareholders voted to approve the Merger Agreement on March 7, 2013. The Merger is scheduled to be completed on March 8, 2013.
Services
We offer full-service banking with a broad range of financial products to meet the needs of our commercial, retail, government, and investment management customers. Depository account services include interest and non-interest-bearing checking accounts, money market accounts, savings accounts, time deposit accounts, and individual retirement accounts. Our lending activities include the making of residential and commercial mortgage loans, business lines of credit, working capital facilities and business term loans, as well as installment loans, home equity loans, and personal lines of credit to individuals. Investment management and trust services include personal trust, employee benefit trust, investment management, custodial, and financial planning. Through UVEST Financial Services, a subsidiary of LPL Financial Institution Services and member NASD/SIPC, we provide financial counseling and brokerage services. We also offer safe deposit boxes, wire transfers, collection services, drive-up banking facilities, 24-hour night depositories, automated teller machines, 24-hour telephone banking, and on-line internet banking.
Competition
Our business is extremely competitive. We compete not only with other commercial banks, but also with other financial institutions such as thrifts, credit unions, money market and mutual funds, insurance companies, brokerage firms, and a variety of other financial services companies.
Supervision and Regulation
The following discussion summarizes some of the laws and regulations applicable to bank holding companies and national banks and provides certain specific information relevant to Alliance. This regulatory framework is primarily intended for the protection of depositors, consumers, and the deposit insurance funds that insure bank deposits, and not for the protection of shareholders or creditors of bank holding companies and banks. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Moreover, Congress, regulatory agencies, and state legislatures frequently propose changes to the law and regulations affecting the banking industry. The likelihood and timing of any changes and the impact such changes might have on us are impossible to accurately predict. A change in the statutes, regulations, or regulatory policies applicable to us or our subsidiaries may have a material adverse effect on our business.
Recent Legislative and Regulatory Changes
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”), passed into law on July 21, 2010, is a broad-ranging financial reform law that affects numerous aspects of the U.S. financial regulatory system. It calls for over 200 rulemakings by numerous federal agencies, some of which have begun to issue rules. However, numerous rules have yet to be proposed or finalized. The Dodd-Frank Act covers subject matter including, but not limited to, systemic risk, corporate governance, executive compensation, credit rating agencies, capital and derivatives. Many of Dodd-Frank’s effects will not be known for months or years to come, pending, for instance, the issuance of final regulations implementing all of its provisions.
The Dodd-Frank Act also created a Bureau of Consumer Financial Protection (“CFPB”) as an independent bureau of the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). The CFPB has the authority to write regulations on consumer financial products and services that will apply to depository institutions and many other entities that provide consumer financial products and services. The CFPB began operations on July 21, 2011.
Bank Holding Company Regulation
General
Alliance is a bank holding company registered under the Bank Holding Company Act of 1956 and, as such, is subject to supervision, regulation and examination by the Federal Reserve Board. The Bank Holding Company Act and other federal laws and regulations subject bank holding companies to restrictions on the types of activities in which they may engage, as well as to a supervisory regime that provides for possible regulatory enforcement actions for violations of laws and regulations. Alliance elected to also become a financial holding company on June 21, 2006. A bank holding company that also qualifies as a financial holding company can expand into a wide variety of services that are deemed by the Federal Reserve Board to be financial in nature, including securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting; and merchant banking. In order for a bank holding company to qualify for, and retain, financial holding company status, the holding company must be deemed to be “well managed” and “well capitalized” and each one of the bank holding company’s subsidiary depository institutions must be deemed “well capitalized” and “well managed” by regulators and must have received at least a “Satisfactory” rating on its last Community Reinvestment Act (“CRA”) examination.
The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of any class of voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider factors including, among others, the financial and managerial resources and future prospects of the bank holding company and the banks concerned; the convenience and needs of the
communities to be served; and competitive factors. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank or bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of our outstanding common stock, or otherwise obtaining control or a “controlling influence” over us.
The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries that represent unsafe or unsound practices or which constitute violations of laws or regulations, and can bring enforcement actions, including the assessment of civil money penalties, for certain violations or practices.
Under Federal Reserve Board regulations, a bank holding company is expected to act as a source of financial and managerial strength to each of its banking subsidiaries and to commit resources to their support. The Federal Reserve Board may charge the holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. Any capital loans by Alliance to its subsidiary bank would be subordinate in right of payment to depositors and to certain other indebtedness of the subsidiary bank.
Our ability to pay dividends to our shareholders is primarily dependent on the ability of the Bank to pay dividends to Alliance. The ability of both Alliance and the Bank to pay dividends is limited by federal statutes, regulations and policies. For example, it is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the holding company’s expected future needs and financial condition. The policy provides that holding companies should not maintain a level of cash dividends that undermines the holding company’s ability to serve as a source of strength to its banking subsidiaries.
Furthermore, the Bank must obtain the prior approval of the Office of the Comptroller of the Currency (“OCC”) for the payment of dividends if the total of all dividends declared in any calendar year would exceed the sum of the Bank’s net profits, as defined by applicable regulations, for that year, combined with its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits the Bank from paying a dividend in an amount greater than its undivided profits after deducting statutory bad debt in excess of the Bank’s allowance for loan losses, as defined by applicable regulations.
Capital Adequacy Guidelines for Bank Holding Companies
The Federal Reserve Board has established risk-based capital guidelines that are applicable to bank holding companies. The guidelines apply on a consolidated basis and require bank holding companies to maintain a minimum ratio of Tier 1 capital to total assets (“leverage ratio”) of 4%. For the most highly rated bank holding companies, the minimum ratio is 3%. The Federal Reserve Board capital adequacy guidelines also require bank holding companies to maintain a minimum ratio of Tier 1 capital to risk-weighted assets of 4% and a minimum ratio of qualifying total capital to risk-weighted assets of 8%. Any bank holding company whose capital does not meet the minimum capital adequacy guidelines is considered to be undercapitalized, and is required to submit an acceptable plan to the Federal Reserve Board for achieving capital adequacy. In addition, an undercapitalized company’s ability to pay dividends to its shareholders and expand its lines of business through the acquisition of new banking or non-banking subsidiaries also could be restricted by the Federal Reserve Board. The Federal Reserve Board may set higher minimum capital requirements for bank holding companies where circumstances warrant, such as companies anticipating significant growth or facing unusual risks. The sum of Tier 1 capital and Tier 2 capital is “total risk-based capital.” Alliance’s Tier 1 and total risk-based capital ratios as of December 31, 2012 were 14.48% and 15.43%, respectively. In addition, the Federal Reserve Board has established a minimum leverage ratio of Tier 1 capital to total assets (“Tier 1 leverage ratio”) of 3.00% for the bank holding companies with the highest supervisory ratings. All other bank holding companies are required to maintain a Tier 1 leverage ratio of at least 4.00%. Alliance’s Tier 1 leverage ratio as of December 31, 2012 was 9.37%. The guidelines also provide that banking organizations with supervisory, financial, operational, or managerial weaknesses, as well as organizations that are anticipating or experiencing internal growth, are expected to maintain capital ratios well above the minimum supervisory levels.
On March 1, 2005 the Federal Reserve Board issued a final rule allowing the continued inclusion of trust preferred securities in the Tier 1 capital of bank holding companies within certain limits. At December 31, 2012, Alliance’s trust preferred securities comprised 20% of the sum of Alliance’s Tier 1 capital. However, pursuant to the Dodd-Frank Act, the ability of bank holding companies to continue to include trust preferred securities in Tier 1 capital
will be limited in the future. Under Section 171 of the Dodd-Frank Act, the Federal Reserve must promulgate regulations implementing capital requirements for bank holding companies with assets greater than $500 million that are no less stringent than those applicable to insured depository institutions. Since depository institutions may not count trust preferred securities in Tier 1 capital (but may count them in Tier 2 capital), bank holding companies with over $500 million in assets will no longer be able to do so. Thus, trust preferred securities issued on or after May 19, 2010 may no longer be counted in Tier 1 capital of bank holding companies with over $500 million in assets. Trust preferred securities issued before May 19, 2010 by bank holding companies with assets of less than $15 billion as of year-end 2009 may continue to be included in Tier 1 capital until their original maturity. However, in its proposed capital rules, the Federal Reserve Board included a provision requiring bank holding companies with assets of less than $15 billion to phase-out the inclusion of trust preferred securities over a 10-year period. This rule is still pending. Alliance’s trust preferred securities are scheduled to mature in 2034 and 2036.
Transactions with Affiliates
The Bank’s authority to engage in transactions with its affiliates is limited by Sections 23A and 23B of the Federal Reserve Act and the Federal Reserve Board’s Regulation W. In general, these transactions must be on terms that are at least as favorable to the Bank as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the Bank’s capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the Bank.
Loans to Insiders
The Bank’s authority to extend credit to its directors, executive officers and principal shareholders, as well as to entities controlled by such persons (collectively, “insiders”), is governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders: (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features; and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the Bank’s capital. In addition, extensions for credit in excess of established limits must be approved by the Bank’s Board of Directors.
Bank Regulation
As a national bank, the Bank is subject to primary supervision, regulation, and examination by the OCC. The Bank must file periodic reports with the OCC concerning its activities and financial condition, and must obtain regulatory approval to enter into certain transactions or conduct certain activities. Like other federal banking regulators, the OCC has broad authority to examine and supervise the Bank and to evaluate the Bank’s compliance with applicable laws, regulations and guidance. The OCC may initiate enforcement actions to sanction, remedy, or prevent unsafe or unsound banking practices, breaches of fiduciary duty, and/or violations of law.
The Bank is subject to a wide variety of statutes and regulations that significantly affect its business and activities. Such statutes and regulations include those relating to capital requirements, allowable investments, underwriting of loans, reserves against deposits, trust activities, mergers and consolidations, payment of dividends, establishment of branches and certain other facilities, limitations on loans to one borrower and loans to affiliated persons, and numerous other aspects of the business of banks. Additionally, bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates.
Consumer Compliance
The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. These laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Fair Credit Reporting Act, provisions of the Gramm-Leach-Bliley Act of 1999 relating to privacy and safeguarding of consumer information, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosures and, in certain cases, restrict the terms on which the Bank may offer products and services to consumers.
Community Reinvestment
Additionally, the Bank is subject to the Community Reinvestment Act of 1977 (“CRA”) and the regulations issued thereunder, which are intended to encourage banks to help meet the credit needs of their service area, including low-to-moderate-income (“LMI”) neighborhoods, consistent with safe and sound operations. The CRA also provides for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications regarding establishing branches, mergers or other bank or branch acquisitions. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. The Bank received a rating of “Satisfactory” at its last CRA exam.
Anti-money Laundering
Alliance and the Bank are also subject to the Bank Secrecy Act, as amended by the USA PATRIOT Act, which gives the federal government powers to address money laundering and terrorist threats through enhanced domestic security measures, expanded surveillance powers, and mandatory transaction reporting obligations. For example, the Bank Secrecy Act imposes an affirmative obligation on the Bank to report currency transactions that exceed certain thresholds and to report other transactions determined to be suspicious. Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among financial institutions, bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act. Among other provisions, the USA PATRIOT Act and the related regulations require banks operating in the United States to supplement and enhance the anti-money laundering compliance programs, due diligence policies and controls required by the Bank Secrecy Act and Office of Foreign Assets Control regulations to ensure the detection and reporting of money laundering.
The Bank has in place a comprehensive program to ensure compliance with these requirements. In 2012, the Bank engaged in a very limited number of transactions of any kind with foreign financial institutions or foreign persons.
Capital and Prompt Corrective Action
Under the Prompt Corrective Action (“PCA”) provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), federal banking regulators are required to take “prompt corrective action” regarding depository institutions that do not meet certain minimum capital requirements. The PCA provisions impose progressively more restrictive constraints on banks as their capital levels decline. The PCA provisions identify the following capital categories for financial institutions: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” Rules adopted by the federal banking agencies implementing PCA provide that an institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive, or PCA directive to meet and maintain a specific level for any capital measure. Additionally, under FDIC regulations, no FDIC-insured bank can accept brokered deposits unless it is well capitalized, or is adequately capitalized and receives a waiver from the FDIC. In addition, these regulations prohibit any bank that is not well capitalized from paying an interest rate on brokered deposits above certain levels.
At December 31, 2012, the Bank was in the “well capitalized” category.
Insurance of Deposits
The deposits of the Bank are insured up to the applicable limits established by law and are subject to the deposit insurance premium assessments of the Deposit Insurance Fund (“DIF”). Under Dodd-Frank, the standard deposit insurance amount has been permanently increased to $250,000. The FDIC currently maintains a risk-based assessment system under which assessment rates vary based on the level of risk posed by the institution to the DIF.
In February 2011, the FDIC adopted a final rule making certain changes to the deposit insurance assessment system, many of which were made as a result of provisions of the Dodd-Frank Act. The final rule also revised the assessment rate schedule effective April 1, 2011, and adopted additional rate schedules that will go into effect when the DIF reserve ratio reaches various milestones. The final rule changed the deposit insurance assessment system from one that is based on domestic deposits to one that is based on average consolidated total assets minus average
tangible equity. In addition, the rule will suspend FDIC dividend payments if the DIF reserve ratio exceeds 1.5 percent at the end of any year but provides for decreasing assessment rates when the DIF reserve ratio reaches certain thresholds.
In calculating assessment rates, the rule adopts a new “scorecard” assessment scheme for insured depository institutions with $10 billion or more in assets. It retains the risk category system for insured depository institutions with less than $10 billion in assets, assigning each institution to one of four risk categories based upon the institution’s capital evaluation and supervisory evaluation, as defined by the rule.
Monetary and Fiscal Policies
The earnings of Alliance are significantly affected by the monetary and fiscal policies of governmental authorities, including the Federal Reserve Board. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open-market operations in U.S. government securities and federal funds, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, and the interest rates charged on loans and paid for deposits. The Federal Reserve Board frequently uses these instruments of monetary policy, especially its open-market operations and the discount rate, to influence the level of interest rates and to affect the strength of the economy, the level of inflation or the price of the dollar in foreign exchange markets. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banking institutions in the past and are expected to continue to do so in the future. It is not possible to predict the nature of future changes in monetary and fiscal policies, or the effect that they may have on Alliance’s business and earnings.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) also imposes numerous requirements designed to address corporate and accounting fraud. Sarbanes-Oxley requires chief executive officers and chief financial officers, or their equivalent, to certify the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under Sarbanes-Oxley, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to the chief executive officer or chief financial officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the Board of Directors or the Board itself. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives are restricted.
Available Information
We file annual reports, quarterly reports, proxy statements and other documents with the SEC under the Securities Exchange Act of 1934 (the “Exchange Act”). The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F. Street, N.E., Room 1580, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including Alliance, that file electronically with the SEC. The public can obtain any documents that we file with the SEC at www.sec.gov.
We also make available, free of charge through our website (www.alliancebankna.com), our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnishes it to, the SEC.
Item 1A.
Item 1A. Risk Factors
There are risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.
Risks Related to Our Business
We Are Subject to Interest Rate Risk
Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond our control, including general economic and credit market conditions and policies of various governmental and regulatory agencies, particularly the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could not only influence the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but could also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates earned on loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates earned on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations.
See the section captioned “Net Interest Income” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 7A, Quantitative and Qualitative Disclosure About Market Risk located elsewhere in this report for further discussion related to our management of interest rate risk.
We Are Subject to Lending Risk
There are inherent risks associated with our lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic or credit market conditions in the markets where we operate as well as the State of New York and the United States. Increases in interest rates and/or weakening economic or credit market conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. We are also subject to various laws and regulations that affect our lending activities. Failure to comply with applicable laws and regulations could subject us to regulatory enforcement action that could result in the assessment of significant civil money penalties against us.
As of December 31, 2012, approximately 33% of our loan and lease portfolio consisted of commercial loans and leases net of unearned income. These types of loans are generally viewed as having more risk of default than conventional residential real estate loans or most consumer loans. Commercial loans are also typically larger than residential real estate loans and consumer loans. Because our loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in nonperforming loans. An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for credit losses and an increase in loan charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.
See the section captioned “Loans and Leases” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial loans and leases.
Our Allowance for Credit Losses May Be Insufficient
We maintain an allowance for credit losses, which is a reserve established through a provision for credit losses charged to expense, that represents management’s best estimate of probable losses incurred within the existing portfolio of loans and leases. The allowance is necessary to provide for estimated credit losses and risks inherent in the loan and lease portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan and lease portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan and lease portfolio. The determination of the appropriate level of the allowance for credit losses inherently involves a significant degree of subjectivity and requires us to make estimates of current credit risks, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for credit losses. In addition, bank regulatory agencies periodically review our allowance for credit losses and may require an increase in the provision for credit losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for credit losses, we will need additional provisions to increase the allowance for credit losses. These increases in the allowance for credit losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations.
See the section captioned “Asset Quality and the Allowance for Credit Losses” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to our process for determining the appropriate level of the allowance for credit losses.
Our Profitability Depends Significantly on Economic Conditions in Upstate New York
Our profitability depends significantly on the general economic conditions of Upstate New York and the specific local markets in which we operate. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers primarily in the Upstate New York counties of Cortland, Erie, Madison, Oneida, Onondaga, Oswego and nearby counties. The local economic conditions in these areas have a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities or credit markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our financial condition and results of operations.
We Operate in a Highly Competitive Industry and Market Area
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets where we operate. We also face competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can. Our ability to compete successfully depends on a number of factors, including, among other things:
•
The ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe and sound practices.
•
The ability to maintain high asset quality.
•
The ability to expand our market position.
•
The scope, relevance and pricing of products and services offered to meet customer needs and demands.
•
The rate at which we introduce new products and services relative to our competitors.
•
Customer satisfaction with our level of service.
•
Industry and general economic trends.
•
Our ability to upgrade and acquire technology and information systems to support the sales and service of deposit and loan products.
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.
We Are Subject to Extensive Government Regulation and Supervision
We are subject to extensive federal regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for areas warranting changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties, private lawsuits, and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
See the section captioned “Supervision and Regulation” in Item 1. Business, which is located elsewhere in this report, for further discussion.
Compliance with the Dodd-Frank Act Will Increase Our Regulatory Compliance Burdens, and May Increase Our Operating Costs and/or Adversely Impact Our Earnings and/or Capital Ratios
On July 21, 2010, President Obama signed the Dodd-Frank Act into law. The Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial-services industry. Among other things, the Dodd-Frank Act creates a new federal CFPB, tightens capital standards, imposes clearing and margining requirements on many derivatives activities, and generally increases oversight and regulation of financial institutions and financial activities.
The CFPB began operations on July 21, 2011. It has broad authority to write regulations regarding consumer financial products and services. These regulations will apply to numerous types of entities, including insured depository institutions such as the Bank, and mortgage servicing providers. It is impossible to predict at this time the content or number of such regulations.
The Dodd-Frank Act also requires depository institution holding companies with assets greater than $500 million to be subject to capital requirements at least as stringent as those applicable to insured depository institutions, meaning, for instance, that such holding companies will no longer be able to count trust preferred securities issued on or after May 19, 2010 as Tier 1 capital. The Dodd-Frank Act permits holding companies with total consolidated assets of less than $15 billion to continue to count securities, including trust preferred securities, issued before May 19, 2010 in Tier 1 capital if the securities qualified as Tier 1 capital on that date for the remaining life of the security. However, in its proposed capital rules, the Federal Reserve Board included a provision requiring bank holding companies with assets of less than $15 billion to phase-out the inclusion of trust preferred securities over a 10-year period. Holding companies with total consolidated assets of $15 billion or greater will be required to phase out existing trust preferred and other non-qualifying securities from Tier 1 capital over a 3-year period beginning on January 1, 2013. Moreover, agreements among bank regulators across the world (including the United States) known as the Basel III capital accord also call for the removal of trust preferred securities from Tier 1 capital, encourage more reliance on common equity as the main component of capital, and call for increased levels of capital. Rules implementing Basel III have been proposed in the United States and are still pending.
In addition to the self-implementing provisions of the statute, the Dodd-Frank Act calls for over 200 administrative rulemakings by various federal agencies to implement various parts of the legislation. While some rules have been
finalized and/or issued in proposed form, many have yet to be proposed. It is impossible to predict when all such additional rules will be issued or finalized, and what the content of such rules will be. We will have to apply resources to ensure that we are in compliance with all applicable provisions of the Dodd-Frank Act and any implementing rules, which may increase our costs of operations and adversely impact our earnings.
The Dodd-Frank Act and any implementing rules that are ultimately issued could have adverse implications on the financial industry, the competitive environment, and/or our ability to conduct business.
We Cannot Predict the Effect On Our Operations of Any Future Legislative or Regulatory Initiatives
We cannot predict what, if any, additional legislative or regulatory initiatives any governmental entity may undertake in the future, and what, if any, effects such initiatives may have on our operations. The U.S. federal and state governments and many foreign governments have taken or are considering extraordinary actions in response to the worldwide financial crisis and the severe decline in the global economy.
There can be no assurance that the enactment or adoption of any such initiative will be effective at dealing with the ongoing economic crisis or will have the effect of improving economic conditions globally, nationally or in our markets, or that any such initiative will not have adverse consequences to us.
A Change to the Conservatorship of Fannie Mae and Freddie Mac and Related Actions, Along with Any Changes in Laws and Regulations Affecting the Relationship Between Fannie Mae and Freddie Mac and the U.S. Federal Government, Could Adversely Affect Our Business
There continues to be substantial uncertainty regarding the future of GSEs Fannie Mae and Freddie Mac, including whether they both will continue to exist in their current form. We sell the majority of our residential mortgages to Fannie Mae, Freddie Mac, and the Federal Home Loan Bank. Our ability to sell our residential mortgages into the secondary market is an important part of our overall interest rate risk, liquidity risk and capital management strategies.
Due to increased market concerns about the ability of Fannie Mae and Freddie Mac to withstand future credit losses associated with securities on which they provide guarantees and loans held in their investment portfolios without the direct support of the U.S. federal government, in September 2008, the Federal Housing Finance Agency (the “FHFA”) placed Fannie Mae and Freddie Mac into conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae and Freddie Mac by supporting the availability of mortgage financing and protecting taxpayers. The U.S. government program includes contracts between the U.S. Treasury and each of Fannie Mae and Freddie Mac that seek to ensure that each GSE maintains a positive net worth by providing for the provision of cash by the U.S. Treasury to Fannie Mae and Freddie Mac if FHFA determines that its liabilities exceed its assets. Although the U.S. government has described some specific steps that it intends to take as part of the conservatorship process, efforts to stabilize these entities may not be successful and the outcome and impact of these events remain highly uncertain.
Future legislation could further change the relationship between Fannie Mae and Freddie Mac and the U.S. government, could change their business charters or structure, or could nationalize or eliminate such entities entirely. We cannot predict whether, or when, any such legislation may be enacted.
The Soundness of Other Financial Services Institutions May Adversely Affect Our Credit Risk
We rely on other financial services institutions through trading, clearing, counterparty, and other relationships. We maintain limits and monitor concentration levels of our counterparties as specified in our internal policies. Our reliance on other financial services institutions exposes us to credit risk in the event of default by these institutions or counterparties. These losses could adversely affect our results of operations and financial condition.
Certain of Our Intangible Assets May Become Impaired in the Future
Intangible assets are tested for impairment on a periodic basis. Impairment testing incorporates the current market price of our common stock, the estimated fair value of our assets and liabilities, and certain information of similar companies. It is possible that future impairment testing could result in a decline in value of our intangibles which may be less than the carrying value, which may adversely affect our financial condition. If we determine that an impairment exists at a given point in time, our earnings and the book value of the related intangibles will be reduced by the amount of the impairment. Notwithstanding the foregoing, the results of impairment testing on our intangible assets have no impact on our tangible book value or regulatory capital levels.
Our Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
New Lines of Business or New Products and Services May Subject Us to Additional Risks
From time to time, we may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services, we may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of our system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on our business, results of operations and financial condition.
We Rely on Dividends from the Bank for Most of Our Revenue
We receive substantially all of our revenue from dividends from the Bank. These dividends are the principal source of funds to pay dividends on our common stock and interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that the Bank may pay to us. Also, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event the Bank is unable to pay dividends to us, we may not be able to service debt, pay obligations or pay dividends on our common stock.
The inability to receive dividends from the Bank could have a material adverse effect on our business, financial condition and results of operations. See the section captioned “Supervision and Regulation” in Item 1. Business and Note 16 - Dividends and Restrictions in the notes to consolidated financial statements included elsewhere in this report.
We May Not Be Able to Attract and Retain Skilled People
Our success depends, in large part, on our ability to attract and retain key human resource talent. Competition for the best employees in most activities and functions we are engaged in can be intense and we may not be able to hire employees or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
Our Information Systems May Experience an Interruption or Breach in Security
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny and/or enforcement actions, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We Continually Encounter Technological Changes
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological enhancements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
Our Articles of Incorporation, By-Laws and Shareholder Rights Plan As Well As Certain Banking Laws May Have an Anti-Takeover Effect
Provisions of our articles of incorporation and by-laws, federal banking laws, including regulatory approval requirements, and our stock purchase rights plan could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
Risks Related to the Merger with NBT Bancorp Inc.
After the merger is completed, our shareholders will become NBT stockholders and will have different rights that may be less advantageous than their current rights.
Upon completion of the merger, our shareholders will become NBT stockholders. Differences in our certificate of incorporation and bylaws and NBT’s certificate of incorporation and bylaws will result in changes to the rights of our shareholders who become NBT stockholders.
Our shareholders will have a reduced ownership and voting interest after the merger and will exercise less influence over management of the combined organization.
Our shareholders currently have the right to vote in the election of our board of directors and on various other matters affecting our company. After the merger, our shareholders will hold a percentage ownership of the combined organization that is much smaller than such shareholder’s current percentage ownership of Alliance. Accordingly, our shareholders will have less influence on the management and policies of the combined company than they now have on the management and policies of our company.
Item 1B.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2.
Item 2. Properties
We conduct business in Upstate New York through 29 banking offices and 2 administrative centers. We lease our corporate headquarters located in Syracuse, NY. Eleven banking offices and one of the administrative centers are subject to leases and/or long-term land leases. The remaining banking offices and administrative center are owned.
Item 3.
Item 3. Legal Proceedings
We are subject to various claims, legal proceedings and matters that arise in the ordinary course of business. In management’s opinion, no pending action, if adversely decided, would materially affect our financial condition. See Note 15 to our consolidated financial statements included elsewhere in this report for additional information.
In connection with the proposed merger with NBT, three plaintiffs filed purported class action lawsuits against Alliance, Alliance’s directors and NBT. All three purported class actions were brought in the Supreme Court of the State of New York, in the County of Onondaga, or the Court, and are captioned Oughterson v. Alliance Financial Corporation, et al. (No. 2012EF73, filed October 11, 2012), Stanard v. Alliance Financial Corporation, et al. (No. 2012EF75, filed October 22, 2012) and The Wire Family Trust of 1997 v. Alliance Financial Corporation et al. (No. 2012-5950, filed November 1, 2012). By Order dated December 10, 2012, the three cases were consolidated by the Court into a single action. The lawsuits allege that the Alliance directors breached their fiduciary duties to Alliance’s shareholders by seeking to sell Alliance through an allegedly unfair process and for an unfair price and on unfair terms, by soliciting shareholder approval of the proposed transaction through a Form S-4 that was alleged to be materially misleading, and that Alliance and NBT aided and abetted that breach. The lawsuits seek, among other things, equitable relief that would enjoin the merger, damages, and attorneys’ fees and costs. The plaintiffs also seek rescission of the merger (to the extent it has already been completed at the time that the court grants any relief). The parties have reached an agreement in principle to settle these cases and entered into a memorandum of understanding on January 15, 2013. As part of this memorandum of understanding, NBT and Alliance have agreed to disclose additional information in this joint proxy statement/prospectus, including information about matters discussed between the parties during the process of negotiating the merger, as well as information about the data that was analyzed and presented to the Alliance board of directors by its financial advisor. No substantive terms of the merger agreement will be modified as part of this settlement. The settlement is subject to review and approval by the Court.
Item 4.
Item 4. Mine Safety Disclosures
None.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
Common Stock Data
Our common stock is listed on the NASDAQ Global Market under the symbol “ALNC.” There were 842 shareholders of record as of December 31, 2012. The following table presents the high and low sales price during the periods indicated, as well as dividends declared.
Dividends
We have historically paid regular quarterly cash dividends on our common stock, and the Board of Directors presently intends to continue the payment of regular quarterly cash dividends, subject to the need for those funds for debt service and other purposes. However, because substantially all of the funds available for the payment of dividends are derived from the Bank, future dividends will depend upon the earnings of the Bank, its financial condition and its need for funds. Furthermore, there are a number of federal banking policies and regulations that restrict our ability to pay dividends. In particular, because the Bank is a depository institution whose deposits are insured by the FDIC, it may not pay dividends or distribute capital assets if it is in default on any assessment due the FDIC. Also, as a national bank, the Bank is subject to OCC regulations which impose certain minimum capital requirements that would affect the amount of cash available for distribution to us. In addition, under Federal Reserve policy, we are required to maintain adequate regulatory capital, are expected to serve as a source of financial strength to the Bank and to commit resources to support the Bank. These policies and regulations may have the effect of reducing the amount of dividends that we can declare to our shareholders.
Under the Merger Agreement, Alliance has agreed that, until the effective time of the merger or the termination of the merger agreement, Alliance and its subsidiaries will not, except as expressly permitted by the merger agreement or with the prior written consent of NBT (which consent NBT will not unreasonably withhold) declare or pay any dividend or other distribution on its capital stock other than: (a) dividends paid by wholly owned subsidiaries to Alliance or any other wholly owned subsidiary of Alliance; or (b) regular quarterly cash dividends not to exceed the rate paid during the fiscal quarter immediately preceding the date of the merger agreement.
Sales of Unregistered Securities and Purchases of Equity Securities
There were no sales by us of unregistered securities during the year ended December 31, 2012. There were no purchases made by or on behalf of us of our common stock during the fourth quarter of 2012.
Stock Performance Graph
The graph below matches our cumulative 5-year total shareholder return on common stock with the cumulative total returns of the Russell 3000 index and the SNL Bank NASDAQ index. The graph tracks the performance of a $100 investment in our common stock and in each of the indexes (with the reinvestment of all dividends) from 12/31/2007 to 12/31/2012.
Item 6.
Item 6. Selected Financial Data
The summary information presented below at or for each of the years presented is derived in part from our consolidated financial statements. The following information is only a summary, and you should read it in conjunction with our consolidated financial statements and notes beginning on page.
(1) Cash dividends declared per common share divided by diluted earnings per share.
(2) Common shareholders’ equity less goodwill and intangible assets divided by common shares outstanding.
(3) Averages presented are daily averages.
(4) Non-interest income (net of realized gains and losses on securities and non-recurring items) divided by the sum of net interest income and non-interest income (net of realized gains and losses on securities and non-recurring items).
(5) Non-interest expense divided by the sum of net interest income and non-interest income (net of realized gains and losses on securities and non-recurring items).
(6) Tax equivalent net interest income divided by average interest-earning assets.
(7) We use certain non-GAAP U.S. generally accepted accounting principles or GAAP financial measures, such as the Tangible Common Equity to Tangible Assets ratio (TCE), to provide information for investors to effectively analyze financial trends of ongoing business activities, and to enhance comparability with peers across the financial sector. We believe TCE is useful because it is a measure utilized by regulators, market analysts and investors in evaluating a company’s financial condition and capital strength. TCE, as defined by us, represents common equity less goodwill and intangible assets. The following table presents a reconciliation from our GAAP Total Equity to Total Assets ratio to the Non-GAAP Tangible Common Equity to Tangible Assets ratio (dollars in thousands):
(8) Tier 1 capital excluding junior subordinated obligations issued to unconsolidated trusts divided by total risk-adjusted assets
Summarized quarterly financial information for the years ended December 31, 2012 and 2011 is as follows:
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
2012 Highlights and Overview
Our results of operations are dependent primarily on net interest income, which is the difference between the income earned on our loans and leases and securities and our cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the provision for credit losses, securities and loan sale activities, loan servicing activities, service charges and fees collected on our deposit accounts, income collected from trust and investment advisory services and the income earned on our investment in bank-owned life insurance. Our expenses primarily consist of salaries and employee benefits, occupancy and equipment expense, marketing expense, professional services, technology expense, amortization of intangible assets, other expense and income tax expense. Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, inflation, government policies and the actions of regulatory authorities.
The following is a summary of key financial results for the year ended December 31, 2012:
•
Total assets were $1.4 billion and total deposits were $1.1 billion at December 31, 2012 and December 31, 2011.
•
Net income was $9.2 million in 2012, compared with $13.3 million in 2011. After-tax merger related expenses were $2.0 million in 2012.
•
Net income per diluted common share was $1.92 in 2012 compared with $2.80 in 2011. After-tax merger related expenses were $0.43 per diluted common share in 2012.
•
Net interest income was $39.4 million in 2012, compared with $43.3 million in 2011.
•
The tax-equivalent net interest margin was 3.21% in 2012 compared with 3.43% in 2011.
•
A negative provision for credit losses of $300,000 was recorded in 2012, compared with provision expense of $1.9 million in 2011.
•
Total non-performing assets were $5.5 million or 0.39% of total assets at December 31, 2012 compared with $11.8 million, or 0.84% at December 31, 2011.
•
Non-interest income, excluding securities gains, was 32.3% of total revenue in 2012 compared with 30.1% in 2011.
•
Our efficiency ratio was 79.7% in 2012 compared with 70.4% in 2011. Excluding merger related expenses, our efficiency ratio was 73.9% in 2012.
On October 8, 2012, we reported that we entered into a definitive Merger Agreement with NBT. Under the terms of the Merger Agreement, NBT will acquire us for approximately $233.4 million based on the 5-day average closing price of NBT’s common stock for the period ended October 5, 2012, and we will merge with and into NBT, with NBT being the surviving corporation (the “Merger”). Immediately following the Merger, the Bank will be merged with and into NBT’s subsidiary bank, NBT Bank and NBT Bank will continue as the surviving bank. Merger related expenses in non-interest expense totaled $3.4 million in 2012 and included $2.7 million for professional fees and $676,000 for personnel related accrual for estimated retention awards. The NBT stockholders voted to approve the Merger Agreement on March 5, 2013, and our shareholders voted to approve the Merger Agreement on March 7, 2013. The Merger is scheduled to be completed on March 8, 2013.
The following discussion is intended to assist in understanding our financial condition and results of operations. This discussion should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report.
Average Balance Sheet
The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon. Interest income and yield information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Non-accrual loans have been included in the average balances. Securities are shown at average amortized cost.
Rate/Volume Analysis
The following table sets forth the dollar volume of increase (decrease) in interest income and interest expense resulting from changes in the volume of interest-earning assets and interest-bearing liabilities, and from changes in rates. Volume changes are computed by multiplying the volume difference by the prior year’s rate. Rate changes are computed by multiplying the rate difference by the prior year’s volume. The change in interest due to both rate and volume has been allocated proportionally between the volume and rate variances.
Comparison of Operating Results for the Years Ended December 31, 2012 and 2011
General
Net income was $9.2 million or $1.92 per diluted common share for the year ended December 31, 2012, compared with $13.3 million or $2.80 per diluted common share in 2011. Expenses related to our pending merger with NBT totaled $2.0 million after tax or $0.43 per share in 2012. The return on average assets and return on average shareholders’ equity were 0.65% and 6.40%, respectively, in 2012, compared with 0.92% and 9.88%, respectively, in 2011.
Net interest income decreased $3.9 million in 2012 compared with 2011 due to the continuing pressure on our net interest margin caused by the exceptionally low interest rate environment.
Net Interest Income
Net interest income totaled $39.4 million in 2012, which was a decrease of $3.9 million or 8.9% compared with $43.3 million in 2011. The decrease in net-interest income resulted from a decline in the net interest margin and a slight decrease in average interest-earning assets in 2012.
Average interest-earning assets were $1.3 billion in 2012, which was a decrease of $34.5 million compared with 2011. An $85.8 million decrease in securities was partially offset by a $12.7 million increase in loans and leases.
The tax-equivalent net interest margin was 3.21% in 2012, compared with 3.43% in 2011. The tax-equivalent yield on interest-earning assets decreased 48 basis points in 2012 compared with 2011, which was partially offset by a 28 basis point decrease in our cost of interest-bearing liabilities over the same period. The tax-equivalent yield on our interest-earning assets was 3.89% in 2012, compared with 4.37% in 2011. Our cost of interest-bearing liabilities was 0.83% in 2012, compared with 1.11% in 2011.
Since December 2008, the Federal Reserve has maintained its target fed funds rate between zero and 0.25%, and has carried out a number of policy actions designed to lower long-term interest rates. These monetary policy actions, along with volatility in equity markets, weak economic conditions and federal government economic stimulus efforts, among other factors, have caused yields on U.S. Treasury securities to drop to exceptionally low levels throughout much of the past four years. This persistently low interest rate environment has caused an ongoing decline over the past four years in the returns on our interest-earning assets, consistent with much of the financial industry. As a result the tax-equivalent yield on our securities portfolio decreased 50 basis points in 2012 compared to 2011. The yield on our commercial loans, residential loans and consumer (including indirect) loans decreased 15 basis points, 31 basis points and 74 basis points, respectively, in 2012 compared to 2011.
The cost of our interest-bearing liabilities decreased in 2012 compared to 2011 due to a combination of the low interest rate environment, our deposit pricing strategies and a deposit mix that remains heavily weighted in low-cost interest-bearing transaction accounts (demand, savings and money market) whose rates can be immediately changed at our discretion. However, we have not been able to reduce our cost of our interest-bearing liabilities sufficient to offset our declining asset yields in recent quarters due to the absolute low levels of our deposit rates. The average cost of money market and time deposits dropped 16 basis points and 38 basis points, respectively in 2012 compared to 2011. Average interest-bearing transaction accounts comprised 70.2% of total average interest-bearing deposits in 2012, compared to 65.0% in 2011. We also reduced our cost of borrowings by 30 basis points in 2012 compared to 2011 primarily through a restructuring of FHLB advances totaling $50.0 million in June 2012. The restructurings resulted in prepayment penalties of $2.1 million, which are being amortized as an adjustment to interest expense over the remaining term of the restructured debt in accordance with U.S. generally accepted accounting principles. The restructuring had the effect of extending the maturities of the restructured borrowings by 3.3 years and lowering the annual average effective cost by 148 basis points.
Our liability mix remained favorably weighted towards transaction accounts (including non-interest bearing demand deposits) in 2012 as retail and municipal depositors continue to refrain from investing funds in time accounts at very low, yet competitive rates, and also because of the buildup of cash on corporate customers’ balance sheets. The aggregate average balance of transaction accounts was $839.7 million or 75.7% of total deposits in 2012, compared with $799.4 million or 70.6% in 2011. Average time account balances in 2012 were $269.4 million or 24.3% of total average deposits, compared with $333.1 million or 29.4% in 2011. Our ability to gather and retain transaction deposits in recent years has been greatly enhanced by our strong financial position and earnings performance, enhanced product offerings including upgraded treasury management and internet banking platforms, and a high positive awareness of our brand. Environmental factors such as equity market volatility and risk aversion among retail investors have also played a role in the growth in our transaction accounts.
Our tax-equivalent net interest margin declined in recent quarters as decreases in the cost of our interest-bearing liabilities did not keep pace with declines in the yield on our interest-earning assets. The declining trend in our net interest margin that we have experienced in recent quarters is likely to continue in coming quarters as the persistently low interest rate environment continues to negatively affect the return on our loan and investment portfolios, while our ability to further reduce our funding costs is limited. The pressure on our net interest margin along with weak economic conditions, uneven loan demand and competition may result in further declines in net interest income in coming quarters.
Non-Interest Income
Our non-interest income is comprised of service charges on deposits, fees from investment management and brokerage services, mortgage banking operations that include gains from sales and income from servicing, and other recurring operating income fees from normal banking operations, along with non-core components that primarily consist of net gains or losses from sales of investment securities.
The following table sets forth certain information on non-interest income for the years indicated:
Non-interest income was $18.9 million in 2012, compared with $20.0 million in 2011. We did not sell securities in 2012 and therefore gains on sales of investment securities decreased $1.3 million compared with 2011. The increase in income from bank-owned life insurance resulted from the settlement of a policy on a former employee in 2012. Gains on the sale of loans increased $526,000 compared with 2011 due to a combination of higher volumes of mortgages originated and sold in 2012 along with higher premiums on mortgages sold.
Non-interest income (excluding gains on securities sales) accounted for 32.3% of total revenue in 2012, compared with 30.1% in 2011.
Non-Interest Expenses
The following table sets forth certain information on non-interest expenses for the years indicated:
Non-interest expenses were $46.4 million in 2012, compared with $43.6 million in 2011. Merger related expenses totaled $3.4 million in 2012 and included $2.7 million for professional fees and $676,000 for employee related accruals for estimated retention awards.
Our efficiency ratio was 79.7% in 2012, compared with 70.4% in 2011. Excluding merger related expenses and other non-recurring items, the efficiency ratio was 73.9% in 2012.
Income Tax Expense
Our effective tax rate was 24.4% in 2012, compared with 25.3% in 2011. The decrease in our effective tax rate from 2011 was due to a higher level of tax-exempt income as a percentage to total taxable income.
Comparison of Operating Results for the Years Ended December 31, 2011 and 2010
General
Net income was $13.3 million for the year ended December 31, 2011, compared with $11.6 million in 2010. Net income available to common shareholders was $13.3 million or $2.80 per diluted share in 2011, compared with $11.6 million or $2.48 per diluted share in 2010.
Net Interest Income
Net interest income totaled $43.3 million in 2011, a decrease of $989,000 or 2.2% compared with $44.3 million in 2010. The decrease in net interest income resulted from a decline in the net interest margin partially offset by an increase in average interest-earning assets.
Average interest-earning assets increased $14.4 million in 2011 compared with 2010, with a $33.8 million increase in securities offsetting a $25.0 million decrease in loans and leases. The tax equivalent net interest margin was 3.43% in 2011 compared with 3.55% in 2010. The tax-equivalent yield on interest-earning assets decreased 40 basis points in 2011 compared with 2010, which was partially offset by a 31 basis point decrease in our cost of interest-bearing liabilities over the same period. The tax-equivalent yield on our interest-earning assets was 4.37% in 2011, compared to 4.78% in 2010. Our cost of interest-bearing liabilities was 1.11% in 2011, compared with 1.42% in 2010.
The low interest rate environment of the last few years has resulted in declining yields for all of our interest- earning asset, consistent with much of the financial industry. Yields on our securities portfolio and on our commercial loans and consumer loans were most affected in 2011 by the low interest rate environment. The tax-equivalent yield on our securities portfolio decreased 38 basis points in 2011 compared with 2010. The yield on our commercial loans and consumer (including indirect) loans decreased 42 basis points and 56 basis points, respectively, in 2011.
Changes in our asset mix also contributed to the decline in the interest-earning assets yield in 2011, as securities comprised a larger portion of our earning assets in 2011 as compared to 2010 due to difficulty in growing our loan portfolio as the result of weak economic and credit market conditions and the decision to sell many of our fixed rate residential mortgage originations for interest rate risk management purposes. The yields on the securities we hold are typically lower than the yields on our loans and leases. Securities comprised 32.0% of average interest-earning assets in 2011, compared with 29.8% in 2010.
The cost of our interest-bearing liabilities decreased 31 basis points in 2011 due to a combination of the low interest rate environment, our deposit pricing strategies and a favorable change in the mix of our interest-bearing liabilities, with lower-cost interest-bearing transaction accounts (savings, demand and money market) comprising a larger portion of our interest-bearing liabilities in 2011 compared to 2010. The average balance of interest-bearing transaction accounts increased $19.8 million or 3.3% in 2011 and totaled $618.3 million or 65.0% of total interest-bearing deposits in 2011, compared with $598.5 million or 62.5% of average interest-bearing deposits in 2011.
Our liability mix remained favorably weighted toward transaction accounts in 2011 as we continued to focus on increasing our transaction account balances and as we refrained from offering premium rates on time accounts. The aggregate average balance of transaction accounts (including non-interest bearing demand deposits) was $799.4 million in 2011, which was an increase of $32.9 million or 4.3% from the aggregate average balances of $766.4 million in 2010. Average transaction account balances comprised 70.6% of total average deposits in 2011, compared with 68.1% in 2010. Average time account balances in 2011 were $333.1 million or 29.4% of total average deposits, compared with $359.5 million or 31.9% in 2010.
Non-Interest Income
The following table sets forth certain information on non-interest income for the years indicated:
Non-interest income decreased $503,000 or 2.5% to $20.0 million in 2011. Investment management income increased $430,000 or 5.9% in 2011 primarily as a result of the impact of changes in equity and debt markets on the value of assets under management. Insurance agency income decreased $1.3 million due to the sale of our insurance agency operations in December 2010. The elimination of the operating expenses associated with our insurance
agency substantially offset the revenue decline in 2011. Gains on the sale of securities available-for-sale increased to $1.3 million in 2011 compared with $308,000 in 2010 due to increased sales activity in 2011. Other non-interest income decreased $608,000 in 2011 compared with 2010 due primarily to the gain of $815,000 recognized on the sale of the insurance agency in 2010.
Non-interest income (excluding securities gains and the gain on the sale of the insurance agency) comprised 30.1% of total revenue in 2011 compared with 30.41% in 2010.
Non-Interest Expenses
The following table sets forth certain information on operating expenses for the years indicated:
Non-interest expenses decreased $899,000 or 2.0% to $43.6 million in 2011. Salaries and benefits expense decreased $417,000 or 1.9% due to discontinuation of salaries and benefits for the insurance agency’s employees in 2011. FDIC insurance expense decreased $540,000 or 33.7% in 2011 compared with 2010 primarily due to the change implemented by the FDIC in the basis for calculating insurance premiums Other non-interest expense increased $747,000 or 12.6% in 2011 compared with 2010 due primarily to the $555,000 write-down of vacant bank-owned property recorded in the third quarter of 2011.
Our efficiency ratio was 70.3% in 2011 compared with 69.9% in 2010.
Income Tax Expense
Our effective tax rate (excluding the gain and related tax on the sale of the insurance agency) was 25.3% in 2011 and 24.6% in 2010.
Comparison of Financial Condition at December 31, 2012 and December 31, 2011
General
Total assets were $1.4 billion at December 31, 2012, which was nearly unchanged from the end of 2011. Loans and leases (net of unearned income) were $928.1 million at the end of 2012, representing growth of $55.4 million from the end of 2011. The growth in our loan portfolio was funded primarily through cash generated from amortization and maturities of investment securities, which decreased $37.8 million in 2012.
Securities
The securities portfolio is designed to provide a favorable total return utilizing low-risk, high-quality securities while at the same time assisting in meeting the liquidity needs of our loan and deposit operations, and supporting our interest rate risk objectives. Our securities portfolio is predominately comprised of investment grade mortgage-backed securities, securities issued by U.S. government sponsored corporations and municipal securities. We classify the majority of our securities as available-for-sale. We do not engage in securities trading or derivatives activities in carrying out our investment strategies.
The following table sets forth the amortized cost and market value for our available-for-sale securities portfolio:
Investment securities totaled $336.5 million at December 31, 2012, compared with $374.3 million at December 31, 2011. Our portfolio is comprised entirely of investment grade securities, the majority of which are rated “AAA” by one or more of the nationally recognized rating agencies. The breakdown of the securities portfolio at December 31, 2012 was 73.4% government-sponsored entity guaranteed mortgage-backed securities, 21.2% municipal securities and 4.5% obligations of U.S. government-sponsored corporations. Mortgage-backed securities, which totaled $247.0 million at December 31, 2012, are comprised primarily of pass-through securities backed by conventional residential mortgages and guaranteed by Fannie-Mae, Freddie-Mac or Ginnie Mae, which in turn are backed by the U.S. government. Our municipal securities portfolio, which totaled $71.2 million at the end of 2012, is primarily comprised of highly rated general obligation bonds issued by local municipalities in New York State.
We had net unrealized gains of approximately $10.4 million in our securities portfolio at December 31, 2012, compared with net unrealized gains of $11.2 million at December 31, 2011.
In the first quarter of 2013, we sold mortgage-backed securities with an aggregate carrying value of $70.4 million, and recognized $1.6 million of gains before taxes. The securities sold had an aggregate par value of $66.8 million, a weighted average maturity of 2.7 years, a weighted average coupon of 3.94%, and a weighted average yield of 1.75%. The proceeds were reinvested in similar government-guaranteed mortgage-backed securities with a weighted average maturity of 4.7 years, a weighted average coupon of 1.48% and a weighted average yield of 1.51%. The purpose of the sale and reinvestment transactions was to reduce our exposure to higher coupon securities and the associated risk that an increase in prepayments on the underlying mortgage loans could negatively impact the value of these securities.
The following table sets forth as of December 31, 2012, the maturities and the weighted-average yields of our debt securities, which have been calculated on the basis of the amortized cost, weighted for scheduled maturity of each security, and adjusted to a fully tax-equivalent basis (in thousands):
(1) Weighted average yields on the tax-exempt obligations have been computed on a fully tax-equivalent basis assuming a marginal federal tax rate of 34%. These yields are an arithmetic computation of interest income divided by average balance and may differ from the yield to maturity, which considers the time value of money.
Loans and Leases
The loan and lease portfolio is the largest component of our interest-earning assets and it generates the largest portion of our interest income. We provide a full range of credit products through our branch network and through our commercial lending line of business. Consistent with our focus on providing community banking services, we generally do not attempt to diversify geographically by making a significant amount of loans to borrowers outside of our primary service area. Loans are primarily generated internally and the majority of our lending activity takes place in the New York State counties of Cortland, Madison, Onondaga, Oneida, Oswego and nearby counties. In addition, we originate indirect auto loans in the western counties of New York State. In connection with our ongoing strategic planning and balance sheet management processes, Alliance Leasing, Inc. ceased origination of new transactions in the third quarter of 2008. The operations of Alliance Leasing are currently limited to servicing the existing lease portfolio.
Total loans and leases, net of unearned income and deferred costs, were $928.1 million at December 31, 2012, compared with $872.7 million at December 31, 2011. Loan origination volumes in 2012 increased $106.6 million, or 42%, to $361.9 million, compared with $255.3 million in 2011 on increased demand in each of our commercial, residential mortgage and indirect lending businesses.
Residential mortgages outstanding increased $12.2 million to $329.0 million at the end of 2012. Originations of residential mortgages totaled $151.2 million in 2012, compared with $107.5 million in 2011. We retained in portfolio approximately $68.5 million of the 2012 originations that were bi-weekly payment mortgages or monthly payment mortgages with maturities of 15 years or less.
Commercial loans and mortgages increased $19.0 million in 2012 and totaled $297.3 million at December 31, 2012. Originations of commercial loans and mortgages in 2012 (excluding lines of credit) totaled $76.5 million, compared with $75.9 million in 2011.
Leases (net of unearned income) decreased $15.4 million in 2012 as a result of our previously announced decision to cease new lease originations.
Indirect auto loan balances were $199.3 million at the end of 2012, which was an increase of $40.5 million from the end of 2011. We originated $129.6 million of indirect auto loans in 2012, compared with $68.8 million in 2011. The increase in originations in 2012 is attributable to a change in the rate structure designed to increase our market share without lowering our underwriting standards, along with the implementation of an electronic application system. We originate auto loans through a network of reputable, well-established automobile dealers located in central and western New York. Applications received through our indirect lending program are subject to the same comprehensive underwriting criteria and procedures as employed in its direct lending programs.
The following table sets forth the composition of our loan and lease portfolio at the dates indicated:
The following table shows the amount of loans and leases outstanding as of December 31, 2012, which, based on remaining scheduled payments of principal, are due in the periods indicated:
The following table sets forth the sensitivity to changes in interest rates as of December 31, 2012:
Asset Quality and the Allowance for Credit Losses
The following table summarizes delinquent loans and leases grouped by the number of days delinquent at the dates indicated:
(1) As a percentage of total loans and leases, excluding deferred costs
The following table represents information concerning the aggregate amount of nonperforming assets:
Delinquent loans and leases (including non-performing) totaled $12.2 million at December 31, 2012, compared with $17.1 million at December 31, 2011. Non-performing assets, defined as non-accruing loans and leases plus loans and leases 90 days or more past due, along with other real estate owned and repossessed assets, were $5.5 million or 0.39% of total assets at December 31, 2012, compared with $11.8 million or 0.84% of total assets at December 31, 2011. The decline in non-performing assets in 2012 resulted primarily from non-accrual loans returning to accrual status as a result of satisfactory payment performance, charge-offs and pay-offs of non-performing loans.
Included in nonperforming assets at the end of 2012 are non-performing loans and leases totaling $4.8 million, compared with $11.3 million at December 31, 2011. Conventional residential mortgages comprised $2.5 million (43 loans) or 52.7% of non-performing loans and leases, and commercial loans and mortgages totaled $938,000 (16 loans) or 19.5% of non-performing loans and leases at the end of 2012.
The economy in our market area is a relatively stable, slow growth economy, with few conditions that give rise to boom and bust cycles. The housing market generally does not exhibit significant volatility and is not significantly impacted by speculative influences. These external factors, combined with our disciplined credit culture and consistently sound underwriting guidelines, are the primary reasons that our levels of delinquent loans and nonperforming assets have remained relatively low in recent years despite significant industry-wide asset quality issues.
As a recurring part of our portfolio management program, we have identified approximately $9.3 million in potential problem loans at December 31, 2012, as compared with $10.2 million at December 31, 2011. The average balance of identified potential problem loans was $301,000 and $237,000 at December 31, 2012 and December 31, 2011, respectively. Potential problem loans are loans that are currently performing, but where the borrower’s operating performance or other relevant factors could result in potential credit problems, and are classified by our loan rating system as “substandard.” At December 31, 2012, potential problem loans primarily consisted of commercial loans and leases and commercial real estate. There can be no assurance that additional loans will not become nonperforming, require restructuring, or require increased provision for loan losses.
We have a loan and lease monitoring program that evaluates nonperforming loans and leases and the loan and lease portfolio in general. The loan and lease review program continually audits the loan and lease portfolio to confirm management’s loan and lease risk rating system, and systematically tracks such problem loans and leases to ensure compliance with loan and lease policy underwriting guidelines, and to evaluate the adequacy of the allowance for credit losses.
Our policy is to place a loan or lease on non-accrual status and recognize income on a cash basis when a loan or lease is more than 90 days past due, unless in the opinion of management, the loan or lease is well secured and in the process of collection. The impact of interest not recognized on non-accrual loans and leases was $85,000 in 2012,
$301,000 in 2011, and $277,000 in 2010. We consider a loan or lease impaired when, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan or lease agreement.
The allowance for credit losses represents management’s best estimate of probable incurred losses in our loan and lease portfolio. Management’s quarterly evaluation of the allowance for credit losses is a comprehensive analysis that builds a total allowance by evaluating the probable incurred losses within each loan and lease portfolio segment. Our portfolio segments are as follows: commercial loan and commercial real estate loans, commercial leases, residential real estate, indirect consumer loans and other consumer loans. Our allowance for credit losses consists of specific valuation allowances based on probable credit losses on specific loans, historical valuation allowances based on loan loss experience for similar loans with similar characteristics and trends and general valuation allowances based on general economic conditions and other qualitative risk factors both internal and external to the organization.
Historical valuation allowances are calculated for commercial loans and leases based on the historical loss experience of specific types of loans and leases and the internal risk grade 24 months prior to the time they were charged off. The internal credit risk grading process evaluates, among other things, the borrower’s ability to repay, the underlying collateral, if any, and the economic environment and industry in which the borrower operates. Historical valuation allowances for residential real estate and consumer loan segments are based on the average loss rates for each class of loans for the time period that includes the current year and two full prior years. We calculate historical loss ratios for pools of similar consumer loans based upon the product of the historical loss ratio and the principal balance of the loans in the pool. Historical loss ratios are updated quarterly based on actual loss experience. Our general valuation allowances are based on general economic conditions and other qualitative risk factors which affect our company. Factors considered include trends in our delinquency rates, macro-economic and credit market conditions, changes in asset quality, changes in loan and lease portfolio volumes, concentrations of credit risk, the changes in internal loan policies, procedures and internal controls, experience and effectiveness of lending personnel. Management evaluates the degree of risk that each one of these components has on the quality of the loan and lease portfolio on a quarterly basis.
During the third quarter of 2012, we added a qualitative factor to address the potential risk of credit losses that could result from conversion related distractions and potential turnover that may occur in connection with the proposed merger with NBT, and the potential effects on the underwriting process and relationship management. Management believes the development of a qualitative factor for this risk is appropriate since the risk of such negative events occurring cannot be eliminated. Management is committed to the continuation of loan portfolio monitoring and underwriting standards that was in place prior to the merger announcement. The merger related qualitative factor increased our qualitative allocation by $305,000 as of December 31, 2012.
For commercial loan and lease segments, we maintain a specific allocation methodology for those classified in our internal risk grading system as substandard, doubtful or loss with a principal balance in excess of $200,000. A loan or lease is considered impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally discounted at the historical effective interest rate, except that all collateral-dependent loans and leases are measured for impairment based on the estimated fair value of the collateral. Loans with modified terms in which a concession to the borrower has been made that it would not otherwise consider unless the borrower was experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. As of December 31, 2012, there was $4.3 million in impaired loans for which $265,000 in related allowance for credit losses was allocated. There was $9.1 million in impaired loans for which $2.1 million in related allowance for credit losses was allocated as of December 31, 2011.
Loans and leases are charged against the allowance for credit losses, in accordance with our loan and lease policy, when they are determined by management to be uncollectible. Recoveries on loans and leases previously charged off are credited to the allowance for credit losses when they are received. When management determines that the allowance for credit losses is less than adequate to provide for probable incurred losses, a direct charge to operating income is recorded.
The following table summarizes changes in the allowance for credit losses arising from loans and leases charged off, recoveries on loans and leases previously charged off and additions to the allowance, which have been charged to expense.
Net charge-offs were $1.9 million in 2012, compared with $1.8 million in 2011. As was previously disclosed in our 2012 quarterly reports on Form 10-Q, we recorded write-downs totaling $2.7 million on one $3.6 million impaired commercial relationship between the fourth quarter of 2011 and the third quarter of 2012. Approximately $1.7 million or 52% of the gross charge-offs recognized in 2012 were on this one relationship, which was transferred to real estate owned at a net amount of $898,000 in the third quarter of 2012. Net charge-offs annualized equaled 0.21% of average loans and leases in 2012, compared with 0.21% in 2011. Our annualized net charge-off rate has averaged 0.26% over the past six quarters, of which all but 5 basis points is attributable to the losses recognized on the one $3.6 million commercial relationship.
Approximately $1.9 million or 58% of the gross charge-offs recognized in 2012 were on loans that were considered impaired at the end of 2011 and for which impairment reserves were largely established due to the identification of probable “loss events” in the fourth quarter of 2011. Charge-offs on these impaired credits were recognized in 2012 upon the occurrence of events confirming the existence of the losses, including further deterioration in the respective borrower’s financial condition and negotiated settlements. A substantial portion of the allowance allocated to these impaired credits in 2011 came from the release of a portion of the general allowance for our lease portfolio. During 2011, approximately $1.2 million of the allowance that had been allocated from our lease portfolio prior to 2011 was released due to a substantial decline in charge-offs in our lease portfolio in 2011 compared with 2010 and 2009 (the years in which provisions for possible lease losses were charged to earnings) and to a $16.8 million decrease in the balance of that portfolio during 2011.
A negative provision expense of $300,000 was recorded in 2012, compared to provision expense of $1.9 million in 2011. Alliance assesses a number of quantitative and qualitative factors at the individual portfolio level in determining the adequacy of the allowance for credit losses and the required provision expense each quarter. In addition, Alliance analyzes certain broader, non-portfolio specific factors in assessing the adequacy of the allowance for credit losses, such as the allowance as a percentage of total loans and leases, the allowance as a percentage of non-performing loans and leases and the provision expense as a percentage of net charge-offs. In doing so, a portion of the allowance has been considered “unallocated”, which means it is not based on either quantitative or qualitative factors, but on the broader, non-portfolio specific factors mentioned above. At December 31, 2012, $279,000 or 3% of the allowance for credit losses was considered to be “unallocated,” compared to $991,000 or 9% at December 31, 2011. Consistent with the improvement in our asset quality metrics and net charge-off levels in recent quarters (excluding the charge-offs related to the one commercial relationship discussed above), the relative level of unallocated allowance to the total allowance has trended downward in 2012. Absent any material deterioration in credit quality or material growth in the loan and lease portfolio, some portion of this “unallocated” allowance may be reduced by future probable credit losses, which would have the effect of lowering the amount of provision expense relative to net charge-offs compared with past quarters, which was the case in the fourth quarter of 2012.
The allowance for credit losses was $8.6 million at December 31, 2012, compared with $10.8 million at December 31, 2011. The ratio of the allowance for credit losses to total loans and leases was 0.93% at December 31, 2012, compared with 1.24% at December 31, 2011. The ratio of the allowance for credit losses to non-performing loans and leases was 178% at December 31, 2012, compared with 96% at December 31, 2011.
The allowance for credit losses has been allocated within the following categories of loans and leases at the dates indicated with the corresponding percent of loans to total loans for each category (dollars in thousands):
(1) Includes commercial real estate loans
The allowance for credit losses is allocated according to the amount deemed to be reasonably necessary to provide for the probable incurred losses within each category of loans and leases. Increases in the amount allocated to the commercial and lease portfolios reflect the higher outstanding balances of these portfolios coupled with the higher inherent risk of these portfolios compared with residential and consumer lending.
Deposits
Our primary source of funds is deposits, consisting of demand, savings, money market and time accounts, of retail, commercial and municipal customers gathered through our branch network. We continuously monitor market pricing, competitors’ rates, and internal interest rate spreads to maintain and promote growth and profitability.
The following table sets forth the composition of our deposits by business line at year-end (dollars in thousands):
Total deposits were $1.1 billion at December 31, 2012, which was nearly unchanged from December 31, 2011. Our deposit mix at the end of the year continued to be weighted heavily in lower cost demand, savings and money market accounts (transaction accounts). Transaction accounts totaled $858.5 million or 78.4% of total deposits at the end of 2012, compared to $769.9 million or 71.1% of total deposits at the end of 2011, as we continued to
experience a shift in customer deposits from maturing time accounts into transaction accounts as retail and municipal depositors continue to prefer transaction accounts over time accounts in the low interest rate environment.
Our ability to gather and retain transaction deposits over the past three years has been greatly enhanced by our strong financial position and earnings performance, enhanced product offerings including upgraded treasury management and internet banking platforms, and a high positive awareness of our brand. Environmental factors such as equity market volatility and risk aversion among retail investors, and the buildup of cash on corporate balance sheets have also played a role in the growth in our transaction accounts.
Time deposits in excess of $100,000, which tend to be more volatile and sensitive to interest rates, totaled $100.9 million at December 31, 2012, representing 43% of total time deposits and 9% of total deposits. These deposits totaled $123.4 million, representing 39% of total time deposits and 11% of total deposits at year-end 2011.
The following table schedules the amount of our time deposits of $100,000 or more by time remaining until maturity as of December 31, 2012 (in thousands):
Borrowings
We offer retail repurchase agreements primarily to our larger business customers. Under the terms of the agreements, we sell investment portfolio securities to the customer and agree to repurchase the securities on the next business day. We use this arrangement as a deposit alternative for our business customers. As of December 31, 2012, retail repurchase agreement balances amounted to $21.2 million compared with balances of $26.3 million at December 31, 2011.
During 2012, we utilized collateralized repurchase agreements with various brokers and advances from the Federal Home Loan Bank of New York (FHLB) as alternative sources of funding and as a liability management tool. At December 31, 2012, the combination of repurchase agreements and FHLB advances was $100.0 million, compared with $110.0 million at December 31, 2011. Detailed information regarding our borrowings is included in Note 7 in the consolidated financial statements included elsewhere in this report.
Total borrowings decreased $15.1 million or 11.1% in 2012 as we used our net cash inflows from securities and loan and lease amortization to pay down borrowings maturing during the year.
Capital
We use certain non-GAAP financial measures, such as the Tangible Common Equity to Tangible Assets ratio (TCE), to provide information for investors to effectively analyze financial trends of ongoing business activities, and to enhance comparability with peers across the financial sector. We believe TCE is useful because it is a measure utilized by regulators, market analysts and investors in evaluating a company’s financial condition and capital strength. TCE, as defined by us, represents common equity less goodwill and intangible assets. A reconciliation from the our GAAP Total Equity to Total Assets ratio to the Non-GAAP Tangible Common Equity to Tangible Assets ratio is presented below:
Shareholders’ equity was $146.9 million at December 31, 2012, compared with $144.0 million at December 31, 2011. Net income for 2012 increased shareholders’ equity by $9.2 million and was partially offset by common stock dividends declared of $6.0 million or $1.26 per common share.
Our consolidated Tier 1 leverage ratio was 9.37% and our consolidated total risk-based capital ratio was 15.27% at the end of 2012, both of which exceeded regulatory minimum thresholds for capital adequacy purposes. Our tangible common equity capital ratio was 7.98% at the end of 2012.
We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require Alliance and the Bank to maintain minimum amounts and ratios, as defined in the regulations, of total and risk-based capital, Tier 1 capital to risk-weighted assets and of Tier 1 Capital to average assets.
As of December 31, 2012, the most recent notification from the OCC categorized the Bank as “well capitalized,” under the regulatory framework for prompt corrective action. Management believes that, as of December 31, 2012, Alliance and the Bank met all capital adequacy requirements to which they were subject. A more comprehensive analysis of regulatory capital requirements, including ratios for Alliance and the Bank, is included in Note 18 of the consolidated financial statements included elsewhere in this report.
Liquidity and Capital Resources
Our liquidity is primarily measured by our ability to provide funds to meet loan requests, to accommodate possible outflows of deposits, and to take advantage of market interest rate opportunities. Funding of loan commitments, providing for liability outflows, and management of interest rate fluctuations require continuous analysis in order to match the maturities of specific categories of short-term loans and investments with specific types of deposits and borrowings. Liquidity is normally considered in terms of the nature and mix of our sources and uses of funds. Our Asset Liability Management Committee (ALCO) is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. Management believes, as of December 31, 2012, that our liquidity measurements are in compliance with our policy guidelines.
Our principal sources of funds for operations are cash flows generated from earnings, deposits, securities, loan and lease repayments, borrowings from the FHLB, and securities sold under repurchase agreements. During the year ended December 31, 2012, cash and cash equivalents decreased by $19.1 million, as net cash provided by operating activities of $17.1 million was offset by net cash used in investing financing activities of $36.2 million. Net cash used in investing activities primarily resulted from a net increase in loans and leases of $58.3 million, partly offset by net cash used in securities sales, maturities and principal repayments exceeding securities purchased by $33.0 million. Net cash used in financing activities primarily resulted from $15.1 million in net repayments on borrowings and $7.5 million in cash dividends paid to common shareholders, partly offset by a net increase in time deposits of $11.9 million.
As a member of the FHLB, the Bank is eligible to borrow up to an established credit limit against certain residential mortgage loans and investment securities that have been pledged as collateral. As of December 31, 2012, the Bank’s credit limit with the FHLB was $164.3 million with outstanding borrowings in the amount of $100.0 million.
The Bank had a $164.3 million line of credit at December 31, 2012 with the Federal Reserve Bank of New York through its Discount Window, and has pledged as collateral indirect auto loans and securities totaling $160.1 million and $4.2 million, respectively, at December 31, 2012. We did not draw any funds on this line of credit in 2012. At December 31, 2012 and 2011, the Bank also had available $62.5 million of federal funds lines of credit with other financial institutions, none of which was in use at December 31, 2012 and 2011, respectively.
In December 2003, we formed Alliance Financial Capital Trust I, a wholly owned subsidiary of Alliance. The trust was formed for the purpose of issuing $10.0 million of Company-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in our junior subordinated debt securities. The debentures held by the trust are the sole assets of that trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities have a variable annual coupon rate that resets quarterly based upon three-month LIBOR plus 285 basis points (3.16% at December 31, 2012). The capital securities have a 30-year maturity and are redeemable at par beginning in January 2009.
In September 2006, we formed Alliance Financial Capital Trust II, a wholly owned subsidiary of the Company. The trust was formed for the purpose of issuing $15.0 million of Company-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in our junior subordinated debt securities. The debentures held by the trust are the sole assets of that trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities have a variable annual coupon rate that resets quarterly based upon three-month LIBOR plus 165 basis points (1.96% at December 31, 2012). The capital securities have a 30-year maturity and are redeemable at par in September 2011 and any time thereafter.
Contractual Obligations, Commitments, and Off-Balance Sheet Arrangements
Contractual Obligations
We have various financial obligations, including contractual obligations and commitments that may require future cash payments. The following table presents as of December 31, 2012, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements included elsewhere in this report.
* Excludes interest
We have obligations under our pension, post-retirement plan, directors’ retirement and supplemental executive retirement plans as described in Note 12 to the consolidated financial statements. The supplemental executive retirement, pension and postretirement benefit and directors’ retirement payments represent actuarially determined future benefit payments to eligible plan participants.
Commitments and Off-Balance Sheet Arrangements
In the normal course of business, to meet the financing needs of our customers and to reduce our exposure to fluctuations in interest rates, we are a party to financial instruments with off-balance sheet risk, held for purposes other than trading. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument, for loan commitments and standby letters of credit, is represented by the contractual amount of those instruments, assuming that the amounts are fully advanced and that collateral or other security is of no value. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet loans. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Commitments to originate loans, unused lines of credit, and un-advanced portions of construction loans are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Many of the commitments are expected to expire without being drawn upon. Therefore, the amounts presented below do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance by a customer to a third party. These guarantees are issued primarily to support public and private borrowing arrangements, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
The following table details the amounts and expected maturities of significant commitments and off-balance sheet arrangements as of December 31, 2012. Further discussion of these commitments and off-balance sheet arrangements is included in Note 15 to the consolidated financial statements included elsewhere in this report.
Application of Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with GAAP. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management.
Our most significant accounting policies are presented in Note 1 to the consolidated financial statements included elsewhere in this report. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for credit losses, accrued income taxes, retirement plan obligations, the fair value analysis of goodwill and intangible assets and the fair value of financial instruments to be the accounting areas that require the most subjective and complex judgments, and as such could be the most subject to revision as new information becomes available. Actual results could differ from those estimates.
The allowance for credit losses represents management’s estimate of probable incurred loan and lease losses in the loan and lease portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements included elsewhere in this report describes the methodology used to determine the allowance for credit losses, and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in this report.
We utilized significant estimates and assumptions in determining the fair value of our goodwill and intangible assets for purposes of impairment testing. The valuation requires the use of assumptions, including, among others, discount rates, rates of return on assets, account attrition rates and costs of servicing. Impairment testing for goodwill requires that the fair value of our reporting unit be compared to the carrying amount of its net assets, including goodwill. In 2012, the fair value of our reporting unit was determined using the acquisition price that NBT will acquire Alliance specified in the Merger Agreement. Future changes in the economic environment or operations of our reporting units could cause changes to these variables, which could result in impairment being identified.
We estimate our tax expense based on the amount we expect to owe the respective tax authorities. Taxes are discussed in more detail in Note 10 to the consolidated financial statements included elsewhere in this report. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account statutory, judicial and regulatory guidance in the context of our tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.
The valuation of our obligations associated with pension, post-retirement, directors’ retirement and supplemental executive retirement plans utilize various actuarial assumptions. These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Specific discussion of the assumptions used by management is discussed in Note 12 to the consolidated financial statements included elsewhere in this report.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Alliance’s market risk arises principally from interest rate risk in its lending, investing, deposit gathering and borrowing activities. Other types of market risks do not arise in the normal course of our business activities.
The Bank’s ALCO is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and manage exposure to interest rate risk. The policies and guidelines established by the ALCO are reviewed and approved by the Company’s Board of Directors annually.
Interest rate risk is monitored primarily through financial modeling of net interest income and net portfolio value estimation (discounted present value of assets minus discounted present value of liabilities). Both measures are highly assumption dependent and change regularly as the balance sheet and interest rates change; however, taken together, they represent a reasonably comprehensive view of the magnitude of interest rate risk, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. The key assumptions employed by these measures are analyzed and reviewed monthly by the ALCO.
The table that follows is provided pursuant to the market risk disclosure rules set forth in Item 305 of Regulation S-K of the Securities and Exchange Commission. The information provided in the following table is based on significant estimates and assumptions and constitutes, like certain other statements included herein, a forward-looking statement. The base case (no rate change) information in the table shows (1) an estimate of our net portfolio value at December 31, 2012, arrived at by discounting estimated future cash flows at current market rates and (2) an estimate of net interest income for the 12 months ending December 31, 2013, assuming that maturing assets or liabilities are replaced with new balances of the same type, in the same amount, and at current (December 31, 2012) rate levels and repricing balances are adjusted to current (December 31, 2012) rate levels. The rate change information (rate shocks) in the table shows estimates of net portfolio value at December 31, 2012 and net interest income for the 12 months ending December 31, 2013, assuming instantaneous rate changes of up 100, 200, and 300
basis points. Cash flows for non-maturity deposits are based on a decay or runoff rate based on average account age. Rate changes in the rate shock scenario are assumed to be shock or immediate changes and occur uniformly across the yield curve. In projecting future net interest income under the rate shock scenarios, activity is simulated by replacing maturing balances with new balances of the same type, in the same amount, but at the assumed post shock rate levels. Balances that reprice are assumed to reprice at post shock rate levels.
Based on the foregoing assumptions and as depicted in the table that follows, an immediate increase in interest rates of 100, 200, or 300 basis points would have a negative effect on net interest income over a 12 month time period. This is principally because the Bank’s interest-bearing deposit accounts are assumed to reprice faster than its loans and investment securities. However, if the Bank does not increase the rates paid on its deposit accounts as quickly or to the same magnitude as increases in market interest rates, the negative impact on net interest income will likely be lower. Over a longer period of time, and assuming that interest rates remain stable after the initial rate increase and the Bank purchases securities and originates loans at yields higher than those maturing and reprices loans at higher yields, the impact of an increase in interest rates should be positive. This occurs primarily because with the passage of time more loans and investment securities will reprice at the higher rates and there will be no offsetting increase in interest expense for those loans and investment securities funded by noninterest-bearing checking deposits and capital. In previous years, Net Portfolio Value and Net Interest Income resulting from an immediate and sustained 100 basis point decrease in rates were reported; however these measures have been omitted this quarter as the absolute low level of rates renders the results under this scenario not meaningful.
Item 8.
Item 8. Financial Statements and Supplementary Data
Our consolidated financial statements and accompanying notes may be found beginning on page of this report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Management, including our President and Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act (i) is recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely discussion regarding required disclosure.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate. Our internal control over financial reporting is a process designed under the supervision of our principal executive officer and principal financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under that framework, management concluded that our internal control over financial reporting was effective as of December 31, 2012. In addition, based on our assessment, management has determined that there were no material weaknesses in our internal controls over financial reporting.
Attestation Report of the Registered Public Accounting Firm
The effectiveness of our internal control over financial reporting as of December 31, 2012 has been audited by Crowe Horwath LLP, our independent registered public accounting firm, as stated in its report, which is set forth on Page under the heading “Report of Independent Registered Public Accounting Firm” and is incorporated herein by reference.
Changes in Internal Control Over Financial Reporting
We regularly assess the adequacy of our internal control over financial reporting and enhance our controls in response to internal control assessments and internal and external audit and regulatory recommendations. There have been no changes in our internal control over financial reporting identified in connection with the evaluation that occurred during our last fiscal quarter that has materially affected, or that is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant and Corporate Governance
Information About Our Board Of Directors
Our Board of Directors currently consists of 12 members. The name, age and length of service of each of our members of our Board of Directors are set forth below:
(1) At February 18, 2013.
(2) Represents the year in which the Director was first elected or appointed to the Board of Directors of Alliance or of the Bank.
The principal occupation and business experience of each director are set forth below:
Donald H. Dew was the Chairman and Chief Executive Officer of Diemolding Corporation until his retirement in 2007 and as Director until 2009. Mr. Dew is a Director of the Rotary Club of Oneida. Additionally, Mr. Dew is a member of the advisory board of the Board of Cooperative Educational Services. Mr. Dew formerly was a Director of the Manufacturers Association of Central New York and Higbee Gaskets. Mr. Dew received a B.S degree from Ripon College and attended the Executive Management Program and Manufacturing Management Program at The Pennsylvania State University and the Wharton School of Business at the University of Pennsylvania.
Charles E. Shafer is founder and owner of Green Lake Associates, LLC. Additionally, Mr. Shafer is the co-founder and co-owner of a power supply manufacturer, Applied Concepts, Inc. and was the managing partner of Riehlman, Shafer and Shafer. Mr. Shafer serves as Director and Secretary for People’s Equal Action and Community Effort, Inc. and is a member of the Vermont Law School Board of Trustees. Mr. Shafer received a B.A. from the State University of New York at Brockport and a J.D. degree from the Vermont Law School.
Charles H. Spaulding is currently President and Director of George B. Bailey Agency, Inc. and Director of Mid York Associates, Inc. Mr. Spaulding additionally serves on the Board of Directors of the SUNY Cortland College Foundation and J.M. Murray Center Inc. Mr. Spaulding received a B.A. degree from Union College and a J.D. degree from Syracuse University.
Deborah F. Stanley has been the President and Chief Administrative Officer of the State University of New York at Oswego since 1997. Ms. Stanley was interim president from 1995 to 1997. Prior to 1995, Ms. Stanley held the office of Vice President for academic affairs and provost and served as executive assistant to the president. Ms. Stanley is a Director on the board of CenterState CEO (formerly Metropolitan Development Association) and serves on its Executive Committee, and is a Director on the board of the Metropolitan Development Foundation and serves as its Chair. Ms. Stanley also serves on the board of the Oswego College Foundation. Ms. Stanley was formerly a Director and Chairman of Oswego County National Bank and Bridge Street Financial, both of which were acquired by Alliance Financial. Ms. Stanley received a J.D. and a B.A. degree from Syracuse University.
Mary Pat Adams is a licensed Associate Broker, CRS, GRI with Hunt Real Estate ERA, formerly Prudential First Properties, and is currently Vice President and a member of the Board of Directors of the Oneida City School District Foundation and is also a member of the Board of Directors of United Way of Greater Oneida. Previously, Mrs. Adams was a member of the Board of Directors of Oneida Valley Securities Corporation until its dissolution in December 2008. Mrs. Adams received a B.B.A. degree from James Madison University.
Samuel J. Lanzafame was the President, Chief Executive Officer and Director of Datacom Systems, Inc. until February 2012 when he became Chairman of the Board. Mr. Lanzafame has over 30 years of executive management experience in overseeing the operations in both public and private companies, including Oneida Ltd. and The Cambridge Filter Corporation. Mr. Lanzafame currently serves as the Chairman of the Audit Committee of the Board of Directors of the Madison County Industrial Development Agency. Mr. Lanzafame received an M.B.A. degree from The University of Notre Dame and a B.A. degree from Holy Cross.
Lowell A. Seifter is a Senior Vice President and General Counsel of St. Joseph’s Hospital Health Center. He was a founding member of Green & Seifter Attorneys, PLLC (now known as Bousquet Holstein Attorneys, PLLC) and served as the senior member of the board of managers until January 2012 when he joined St. Joseph’s Hospital Health Center. From 2002 until 2006, Mr. Seifter was a member of the Board of Directors of Bridge Street Financial, Inc. and its banking subsidiary, Oswego County National Bank. Mr. Seifter also serves on the Board of Directors of G&S Northway Plaza, Inc. and GSA Development Corp. and formerly served on the Board of Directors of the Sagamore Institute of the Adirondacks, Inc. Mr. Seifter received a J.D. and a B.A. degree from Syracuse University and is a certified public accountant.
Jack H. Webb has been our Chairman and Chief Executive Officer since January 2002 and is also the President and Chief Executive Officer of the Bank. Mr. Webb joined us in May 2000 as President of the Bank after a 26-year career with Chase Manhattan Bank. Mr. Webb is also a Director of Alliance Leasing, Inc. Mr. Webb is President of the Board of Trustees of The Gifford Foundation and serves on the Advisory Board of CNY Lifetime Healthcare. Mr. Webb graduated from the Rochester Business Institute.
Donald S. Ames is the owner and President of Cortland Laundry, Inc., and has been in the commercial laundry business for over 45 years providing services to several businesses including major health care organizations around central New York. Mr. Ames also founded and operated Ames Linen Service from 1964 until his retirement in 2008. Mr. Ames received a B.A. degree from Hobart College.
Margaret G. Ogden is the founder and principal of Peggy Ogden LLC. Prior to founding Peggy Ogden LLC in 2008, Ms. Ogden was the President and Chief Executive Officer of Central New York Community Foundation. Ms. Ogden is a Director of United Way of CNY and Allyn Foundation and serves on the Museum of Science and Technology Foundation Board. Ms. Ogden received an M.B.A. degree from Syracuse University and a B.A. degree from Albion College.
Paul M. Solomon is currently managing partner of a venture capital firm, PJ Equities, LLP. In July 2005, Mr. Solomon co-founded US Beverage Net and currently serves as Chairman of its Board of Directors. Additionally, Mr. Solomon is a member and Director of bc Restaurant LLC. Mr. Solomon serves as a Vice Chairman and Treasurer as a Board Member of the Board of Trustees of Millbrook School. Mr. Solomon received a degree from Syracuse University and is a graduate of the Millbrook School.
John H. Watt, Jr. has been our Executive Vice President since September 2005. Mr. Watt is also a Director of Alliance Leasing, Inc. and is an Advisory Board Member of the Summer Street Capital Partners Fund II. Mr. Watt is President of the Board of OnPoint for College, a Syracuse based not-for-profit and serves as a member of the Investment Committee of The Episcopal Diocese of Central New York. Mr. Watt spent 18 years at J.P. Morgan Chase and its predecessors in various capacities. Mr. Watt received a J.D. from George Washington University and a B.A. degree from Rutgers University.
Information About Our Executive Officers
The principal occupation and business experience of each of our executive officers are set forth below:
J. Daniel Mohr, age 47, has been our Treasurer and Chief Financial Officer since May 2006 and Executive Vice President since January 2010. Prior to joining us, Mr. Mohr was Senior Vice President and Chief Financial Officer of Partners Trust Financial Group and was also the Chief Financial Officer of the Pioneer Companies. Mr. Mohr has more than 16 years of banking and financial experience, including 11 years as a chief financial officer and approximately four years as a Certified Public Accountant with KPMG LLP where he concentrated in the financial institutions audit practice group. Mr. Mohr received a B.S. in accounting from the State University of New York at Binghamton.
James W. Getman, age 64, has been our Executive Vice President and Senior Loan Officer since February 1999. Mr. Getman is also Chief Executive Officer of Alliance Leasing, Inc. Prior to joining us, Mr. Getman served as Vice President and Senior Credit Officer of Cayuga Bank and as Vice President and Group Manager responsible for corporate and personal banking relationships at Chase Manhattan Bank. Mr. Getman attended the NACM Graduate School at Dartmouth College, the Credit Management School at the University of Buffalo and received his B.A. in economics from Union College.
Steven G. Cacchio, age 49, has been our Senior Vice President of Retail Banking Sales and Service since February 2005. Prior to joining us, Mr. Cacchio was a bank examiner with the Comptroller of the Currency focusing on compiling and analyzing federal regulatory requirements for various banks. Mr. Cacchio received a Master of Science in Accounting from Syracuse University and a B.S. in economics and finance from the University of Hartford.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our directors and executive officers, and persons who own more than 10% of our common stock, to report to the Securities and Exchange Commission their initial ownership of our common stock and any subsequent changes in that ownership. Specific due dates for these reports have been established by the Securities and Exchange Commission and we are required to disclose in this proxy statement any late filings or failures to file.
Based solely on its review of the copies of such reports furnished to us and written representations that no other reports were required during the fiscal year ended December 31, 2012, all Section 16(a) filing requirements applicable to our executive officers and directors during fiscal 2012 were met with the exception of Donald S. Ames, who failed to timely file a Form 4 reporting one transaction.
Code of Ethics
We have adopted a Code of Conduct, which applies to all employees and officers of Alliance and the Bank. We have also adopted a Code of Ethics for Chief Executive Officer and Senior Financial Officers, which applies to our chief executive officer, chief financial officer, chief accounting officer, controller and the senior vice president of marketing and investor relations. The Code of Ethics for Chief Executive Officer and Senior Financial Officers (“Code of Ethics”) meets the requirements of a “code of ethics” as defined by Item 406 of Regulation S-K. The Code of Ethics for Chief Executive Officer and Senior Financial Officers is available to shareholders on our website at www.alliancefinancialcorporation.com under the tab “Investor Relations.”
We intend to satisfy the disclosure requirement under Item 5.05(c) of Form 8-K regarding an amendment to, or a waiver from, a provision of our Code of Ethics that applies to our chief executive officer, chief financial officer, chief accounting officer, or other persons performing similar functions, by posting such information on our website at the Internet address set forth above. We did not amend or grant any waivers of a provision of our Code of Ethics during 2012.
Audit Committee
During 2012, the Audit Committee was chaired by Director Lanzafame, with Directors Ogden, Solomon and Spaulding as members. The Audit Committee assists the Board by overseeing the audit coverage and monitoring the accounting, financial reporting, data processing, regulatory and internal control environments.
As set forth in the Audit Committee Charter, the primary duties and responsibilities, among other responsibilities, of the Audit Committee are to:
(1) oversee the accounting and financial reporting principles and policies and internal accounting controls and procedures;
(2) oversee the financial statements and the independent audit thereof;
(3) select, oversee and, where deemed appropriate, replace the independent auditors;
(4) evaluate the qualifications, independence and performance of the independent auditors;
(5) monitor the performance of the internal audit function;
(6) monitor compliance with legal and regulatory requirements; and
(7) prepare the report required by the rules of the Securities and Exchange Commission to be included in the annual proxy statement.
The Board of Directors reviews the Nasdaq listing standards definition of independence for Audit Committee members on an annual basis and has determined that all members of our Audit Committee are independent (as independence is currently defined in Rule 5605(a)(2) of the Nasdaq listing standards). The Board of Directors has also determined that Mr. Lanzafame qualifies as an “audit committee financial expert” as defined in applicable SEC rules. The Board of Directors has adopted a written charter for the Audit Committee that is available to shareholders on our website at www.alliancefinancialcorporation.com under the tab “Investor Relations.”
Director Nominations
In accordance with our Bylaws, nominations of individuals for election to the Board at an annual meeting of shareholders may be made by any shareholder of record entitled to vote for the election of directors at such meeting who provides timely notice in writing to our Secretary. To be timely, a shareholder’s notice must be delivered to the Secretary not less than 90 days nor more than 120 days immediately preceding the date of the meeting. The notice must contain (i) the name, age, business address and residence address of each proposed nominee; (ii) the principal occupation and employment of each proposed nominee; (iii) the total number of shares of our stock owned by each proposed nominee; (iv) the name and residence address of the notifying shareholder; (v) the number of shares of our stock owned by the notifying shareholder; and (vi) any other information relating to such person that is required to be disclosed in solicitations for proxies for the election of directors, or otherwise required pursuant to Regulation 14A under the Securities Exchange Act of 1934. Nominations not made in accordance with this procedure may be disregarded at the annual meeting. Shareholder nominations are evaluated in the same manner as other nominations.
Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
Overview
The Compensation Committee of our board of directors, comprises five independent directors and has responsibility for establishing and implementing our executive compensation philosophy as well as monitoring adherence to the policies and practices of the compensation programs maintained by us for our employees. This section is intended to help our shareholders understand our compensation philosophy, objectives, components and practices. The section also describes decisions made by the Compensation Committee in 2012 related to the compensation of our named executive officers, (“NEOs”).
The following officers have been identified as NEOs by our board of directors:
•
Jack H. Webb, Chief Executive Officer
•
John H. Watt, Jr., Executive Vice President
•
J. Daniel Mohr, Executive Vice President and Chief Financial Officer
•
James W. Getman, Executive Vice President and Senior Loan Officer, Alliance Bank
•
Steven G. Cacchio, Senior Vice President, Retail Banking Sales and Service, Alliance Bank
At our annual meeting of shareholders held on May 10, 2011, (the “2012 Annual Meeting”), we held an advisory vote on executive compensation. Although the vote was non-binding, the Compensation Committee has considered and will continue to consider the outcome of the vote when determining compensation policies and setting NEO compensation. Approximately 93% of the shares of our common stock that were voted on the proposal were voted for the approval of the compensation of the NEOs as disclosed in our 2011 proxy statement. The Compensation Committee believes that the result of this advisory vote shows especially strong support for our compensation policies and procedures. Additionally, at the 2012 Annual Meeting, shareholders voted, on a non-binding, advisory basis, to conduct the advisory vote on executive compensation every three years. Based upon the voting results, our board of directors determined that we will hold such vote every three years.
Executive Summary
It is the intent of the Compensation Committee to provide the NEOs with a market competitive compensation package that promotes the achievement of our strategic objectives and maximizes shareholder value without encouraging excessive risk. Base salary is the largest component of the NEOs total compensation. NEOs are also eligible to participate in our incentive compensation programs.
The Compensation Committee took the following actions related to the NEO’s 2012 compensation:
•
Base salaries and annual incentive opportunities for 2012 were tied to our financial performance and the roles, responsibilities and performance of each NEO, and were supported by the competitive executive compensation assessment conducted by an independent compensation consultant in 2012.
•
Equity awards were granted to the NEOs in February 2012 pursuant to the 2010 Restricted Stock Plan. The board of directors considers long-term equity compensation an important component of compensation by which shareholder and management interests are aligned.
•
As a result of our financial performance in 2012, the NEOs earned payments under its short-term incentive program, which were paid in December 2012. The performance goals and related payments under this program are discussed more fully under the caption “Short-Term Incentive Compensation” below.
Compensation Philosophy and Objectives
The Compensation Committee believes that the most effective compensation programs are those designed to attract, develop and retain the best available executive officers in key leadership positions as well as the best available employees at all levels in the organization. In implementing this philosophy, the compensation plans in which the NEOs participate are intended to motivate them to maximize performance for our shareholders and to reward them for the achievement of specific annual, strategic and long-term goals, including the appreciation of shareholder value.
Our compensation programs:
•
are not overly complex in design or administration;
•
are designed with prudent defined objectives and goals that prevent an expectation of receiving rewards for inappropriate or excessive risk that could have a material effect on Alliance;
•
have base salary as the largest component of total compensation for all employees, including those eligible to earn incentive compensation;
•
are not excessive in that they are designed to provide incentive compensation opportunities that are a percentage of base salary rather than a multiple of base salary; and
•
do not reward employees, including the NEOs, in a way that results in the receipt of compensation that is excessive for the position, or the performance and contribution of the employee.
Generally, the types of compensation paid to the NEOs are similar to those provided to other executive officers. To support Alliance’s compensation philosophy and objectives, the NEOs compensation package provides the following:
•
competitive base salary and benefits;
•
short-term incentive compensation programs intended to reward employee contributions to the attainment of Alliance’s annual performance or line of business goals; and
•
long-term equity compensation intended to reward the NEOs and other key executives for their contributions to Alliance’s sustainable, long-term success and growth in shareholder value.
Our board of directors considers long-term equity compensation an important component of total compensation, a retention tool, and an effective means of linking the executives’ compensation with the value of our common stock and long-term success of the organization. The 2010 Restricted Stock Plan enables the our board of directors to continue using this vital component of compensation.
Executive Compensation Administration
The Compensation Committee is responsible for the design and approval of our executive compensation programs and the specific compensation for each executive officer, including the NEOs, taking into consideration the recommendations of the Chief Executive Officer and the Compensation Committee’s own deliberations. The Chief Executive Officer recommends salary adjustments, short-term incentive plan opportunities and payouts as well as equity grants for each executive. These recommendations are based upon our financial performance, an assessment of each executive’s individual performance, performance of the executive’s respective business unit or function, retention considerations, periodic competitive executive compensation assessments and market factors.
The Chief Executive Officer does not play any role in the Compensation Committee’s deliberation of matters impacting his own compensation.
The Compensation Committee periodically engages an independent compensation consultant to advise it on board and executive compensation matters and to provide guidance on compensation plan structure and design. The most recent such engagement was in 2011 when the Compensation Committee hired Pearl Meyer & Partners, or Pearl Meyer, to conduct a competitive assessment of the compensation programs provided to the Alliance NEOs, also referred to as the Assessment. Pearl Meyer does not perform any additional services for Alliance.
The Assessment included publicly reported compensation information for comparable executive officers of financial institutions, which the Compensation Committee determined to be appropriate to consider as our peer group. The peer group consisted of 21 publicly traded banks with asset size between $1.0 billion and $4.0 billion located in the Mid-Atlantic and Northeast regions. The 21 banks, as listed below, are located in non-metropolitan markets in New York, Pennsylvania, western Massachusetts, Vermont and Maine.
• ACNB Corp. (ACNB)
• ESSA Bancorp, Inc. (ESSA)
• Arrow Financial Corporation (AROW)
• Financial Institutions, Inc. (FISI)
• Bar Harbor Bankshares (BHB)
• Hingham Institution for Savings (HIFS)
• Berkshire Hills Bancorp, Inc. (BHLB)
• Merchant Bancshares, Inc. (MBVT)
• Bryn Mawr Bank Corp. (BMTC)
• Metro Bancorp, Inc. (METR)
• Camden National Corp. (CAC)
• Orrstown Financial Services, Inc. (ORRF)
• Century Bancorp, Inc. (CNBKA)
• Tompkins Financial Corporation (TMP)
• Citizens & Northern Corp. (CZNC)
• United Financial Bancorp, Inc. (UBNK)
• CNB Financial Corporation (CCNE)
• Univest Corporation of Pennsylvania (UVSP)
• Enterprise Bancorp, Inc. (EBTC)
• Westfield Financial, Inc. (WFD)
• ESB Financial Corporation (ESBF)
The Compensation Committee considered the results of the Assessment and its own compensation philosophy, among other considerations, in setting base salaries and annual incentive plan design targets effective in 2012, which are described in this section.
2012 Executive Compensation Components
For the fiscal year ended December 31, 2012, the NEOs were eligible to receive the following compensation components:
•
base salary;
•
performance-based short-term incentive compensation;
•
discretionary bonus awards;
•
long-term incentive compensation awards;
•
retirement and other benefits; and
•
perquisites and other personal benefits.
In making decisions regarding compensation for the NEOs, the Compensation Committee believes that a certain level of discretion is appropriate in determining the amount of compensation to be paid, the mix of compensation components, and the relationship between compensation levels provided to the Chief Executive Officer and other NEOs. As such, the Compensation Committee has not established formal policies for the following:
•
the allocation between cash and non-cash compensation;
•
the allocation of short-term and long-term equity incentive compensation; or
•
the percentage in which other NEOs compensation opportunity should be in relation to the Chief Executive Officer’s compensation.
The Compensation Committee concluded that, based on the individual NEO’s performance and our financial performance in 2011 relative to its own internal goals and to that of its peer group, the total cash compensation of the NEOs for 2012 should be approximately that of the 70th percentile of the peer group. The amount of total cash compensation paid to the NEOs will vary year-to-year based on the factors discussed previously in this section. The Short-Term Incentive Compensation Plan is the primary means by which changes to total cash compensation is affected.
Base Salary
Base salaries are determined based on the NEOs position, scope of responsibilities, assessment of individual performance and expected future contributions, competitive assessments, as well as their professional, interactive, leadership and business area related technical skills. The NEOs are also eligible for merit-based salary increases in accordance with the same annual evaluation process that is applicable to all employees.
The Compensation Committee conducts an annual performance review of Mr. Webb, based on input from the entire board of directors, and makes recommendations to the board of directors, for its approval, regarding his compensation. Mr. Webb completes the annual performance reviews for Messrs. Watt, Mohr, Getman and Cacchio, which establishes the basis for his recommendation to the Compensation Committee for any salary increases for these executives.
In February 2012, the NEOs, except for Messrs. Mohr and Cacchio, received merit increases to their 2012 base salary averaging approximately 3%. The 2012 base salary increases for Messrs. Mohr and Cacchio were at the discretion of the peer group in the Assessment. The 2012 merit increases were paid retroactively to the beginning of the year. In January 2013, the Compensation Committee and the Alliance board of directors approved 2013 base salaries for the NEOs as follows:
Short-term Compensation
The NEOs and certain key executives in leadership positions are eligible to participate in a short-term incentive program that rewards employees upon the attainment of certain annual performance goals. The Compensation Committee has concluded that awards granted pursuant to the short-term incentive program should be determined based on actual performance against multiple metrics. The Compensation Committee, in its discretion, chose return on equity, tangible common equity and non-performing assets/total assets as the performance metrics for 2012, collectively referred herein as the 2012 Performance Goals. The 2012 Performance Goals were based on our 2012 business plan, which contained details regarding our short-term goals and objectives, and assumptions regarding environmental factors such as market interest rates and economic and financial market conditions.
The 2012 Performance Goals must be met for payment of awards under the “base” component of the program and net income must exceed budget to trigger payment of awards under the “incremental” component of the program. Under the base component of the program, if the 2012 Performance Goals are met, the NEOs and other senior executives are eligible for a certain percentage of their base salary, which may be increased or decreased based on the executive’s job performance and area of responsibility. Under the incremental component of the program, if the 2012 net income exceeds budget, the NEOs and other senior executives are eligible for additional incentive compensation. A pool is established of up to 25% of the net income that exceeds the target goal and is allocated as additional incentive compensation to each eligible executive based on their job performance and area of responsibility.
We did not include any assumptions for mergers or acquisitions in setting its 2012 Performance Goals, which is consistent with past practice. As a result, the Compensation Committee, in its discretion, adjusted our actual 2012 net income to exclude pre-tax merger related expenses of $3.4 million ($2.0 million after tax) from the determination of the amounts to be paid for 2012 under the Short-Term Incentive Compensation Plan, as these costs are outside of its normal business operations upon which 2012’s Performance Goals were based.
Below is a summary of the target, actual and adjusted 2012 Performance Goals:
(1) Net income divided by average shareholders’ equity.
(2) Total common equity less goodwill and intangible assets divided by total assets less goodwill and intangible assets.
A weighted point system is used to set the threshold for our Short-Term Incentive Compensation Plan. Attainment of 100 points or more is required for payments to be made under the Short-Term Incentive Compensation Plan. The three 2012 Performance Goals were weighted as follows:
The weighting factor for each of the 2012 Performance Goals is multiplied by the percentage attained for each goal. Alliance achieved an adjusted return on equity, or ROE, for 2012 of 7.98%, which was 113.2% of the 2012 goal of 7.05%. The points “earned” for this performance goal under the terms of the Short-Term Incentive Compensation Plan were 84.9 (113.2% times 75). Our tangible common equity was 102.3% of goal in 2012, while the non-performing assets to total assets was 45.1% better than goal, resulting in a total of 115 points, which exceeded the threshold for payment of incentive compensation of 100 points.
We believe these three metrics and their weightings appropriately balances the short-term performance considerations of the plan (ROE) with metrics (tangible common equity and non-performing assets/total assets) designed to avoid excessive risk taking.
Our 2012 adjust net income exceeded the target goal, thus qualifying the NEOs and other executives for additional incentive compensation payments under the Short-Term Incentive Compensation Plan, which were approved by the Compensation Committee and our board of directors in December 2012. The following table presents, for each NEO, the 2012 short-term incentive award amounts that were paid in December 2012 for achieving and exceeding the 2012 Performance Goals.
The NEOs received approximately 60% of the amount of incentives paid under the Short-Term Incentive Compensation Plan.
Payments under the Short-Term Incentive Compensation Plan for 2012 performance were made to all participating employees in December 2012, which was approximately three months earlier than past practice. Our board of directors elected to accelerate the payment schedule due to the close proximity of the normal February payment date to the anticipated closing date of the proposed merger.
The employment agreements with Messrs. Webb, Watt and Mohr contain certain “claw-back” language, as further discussed below, which would be applicable to this program.
Discretionary Bonus Awards
Our board of directors considers discretionary cash bonus awards in certain situations to recognize significant efforts or individual contributions. None of the NEOs received discretionary bonus compensation for 2012.
Long-Term Incentive Compensation
Our board of directors believes that long-term equity-based incentive compensation is an important component of our total compensation philosophy. Restricted stock awards are issued to recognize the responsibility and contributions of the NEOs, and other key executives, in meeting our long-term goals and strategies. Additionally, long-term incentive compensation is considered necessary to compete with other organizations in the recruitment and retention of key executives.
The decision to grant restricted stock to the NEOs and certain key employees is at the discretion of the Compensation Committee, and the decision is generally made annually in the first quarter. Should a grant be authorized by the Compensation Committee, the dollar value of shares granted to the NEOs is equal to a fixed percentage of their base salary. The fixed percentages are 30% for Mr. Webb and 25% for Messrs. Watt, Mohr, Getman and Cacchio. The number of shares granted is equal to the dollar value of the grant divided by the closing price for our common stock as reported on the NASDAQ Stock Market on the date of the grant. In addition, the Compensation Committee establishes a pool of restricted stock to be allocated to other key employees at the discretion of Mr. Webb. Our board of directors approves grants of restricted stock to the NEOs. There were 18,465 restricted shares granted in February 2012, with 10,068 shares allocated to the NEOs and a pool of 8,397 shares allocated to 15 key employees.
All restricted stock awards will automatically vest in the event of the death or disability of a participant or in the event of a Change of Control of Alliance (each as defined in the 2010 Restricted Stock Plan). In awarding restricted stock, the Compensation Committee considered the individual’s role and their contributions toward our success.
The following table sets forth grants of restricted stock to the NEOs in 2012:
All such grants are made pursuant to the terms of the 2010 Restricted Stock Plan, which permits the grant of shares of restricted stock to our directors, certain key officers and employees and such grants are evidenced by restricted stock agreements with each participant setting forth the terms, conditions and restrictions of the restricted stock award. Subject to the terms and conditions of the restricted stock agreement, a participant holding restricted stock will have the right to receive cash dividends on the shares of restricted stock during the restriction period and to vote the vested and unvested shares of restricted stock. Subject to the terms of the 2010 Restricted Stock Plan and the restricted stock agreement, the restrictions on the restricted stock lapse at the end of the restriction period and the participant is entitled to receive unrestricted shares of common stock at that time. Subject to adjustments allowed under the 2010 Restricted Stock Plan, we may award up to 200,000 shares of restricted stock under the 2010 Restricted Stock Plan. Currently, 130,149 shares remain eligible for award. If any award of restricted stock expires or is terminated, surrendered or canceled without being fully vested, the unused shares covered by such award shall again be available for grants under the 2010 Restricted Stock Plan.
Under the terms of the Merger Agreement, we are not permitted to issue any additional restricted stock awards.
Retirement and Other Benefits
Executive Incentive Retirement Program
Our board of directors approved our Executive Incentive Retirement Program, (“EIRP”), in March 2008. The EIRP was designed to assist us in retaining and attracting officers of exceptional ability and rewarding them for meeting or exceeding specific business program objectives or performance measurements. There are eight officers currently participating in the EIRP, including all of the NEOs except Mr. Webb.
The deferred bonus award vests at the rate of 20% per year while the participant is employed by the Bank Bank, and automatically vests upon (i) the participant’s death or disability, (ii) upon the occurrence of a change of control, or (iii) upon the participant’s separation from service at or after attaining normal retirement age. Our board of directors elected to cease paying deferred bonuses under this plan in 2009 because it determined that the total compensation paid to the NEOs was appropriate without additional benefits from the EIRP.
Supplemental Executive Retirement Agreement (SERP) and Split Dollar Life Insurance Agreement
Mr. Webb has a SERP, which was negotiated as a component of his total compensation package when he joined us. Pursuant to the SERP, we are required to pay Mr. Webb an annual benefit equal to 70% of his final average compensation in excess of his other retirement benefits. The retirement benefit will be paid to Mr. Webb in the form of a straight life annuity in monthly installments for life. For purposes of the SERP, Mr. Webb’s final average compensation means the annualized monthly base salary actually paid by us over the three-year period ending on the date of his termination of employment. The amounts due to him under the SERP are to be distributed upon the occurrence of a triggering event, including:
•
Mr. Webb’s termination of employment with us, except upon his termination with cause; or
•
His attaining the age of 65.
We must begin paying the benefit to Mr. Webb either on the first day of the seventh month following Mr. Webb’s termination of employment or on the first day of the first month following his attaining age 65, whichever is earlier. The benefit due Mr. Webb may be reduced if payment commences prior to August 1, 2017. In addition, the SERP provides Mr. Webb the right to receive payment of the benefit upon a change of control of Alliance. Mr. Webb is the only NEO covered by a SERP.
On January 27, 2010, we entered into the first amendment to the Amended and Restated Supplemental Retirement Agreement, dated November 28, 2006, with Mr. Webb (the “Restated SERP”). The Restated SERP amended and restated the original Supplemental Retirement Agreement, dated May 1, 2000, for certain changes related to the requirements of Section 409A of the Code. The first amendment provides the ability to designate beneficiaries, clarifies the definition of “Death” for purposes of determining time of payment under the agreement, and requires Mr. Webb to prudently manage his other retirement benefits (outside of the Restated SERP) in order to preserve the potential offset of benefits otherwise payable under the Restated SERP.
Additionally, on January 27, 2010, we entered into a split dollar life insurance agreement with Mr. Webb. If Mr. Webb is employed by us at the time of his death, then Mr. Webb’s designated beneficiaries will receive a lump sum payment equal to the employee’s interest, as defined in the agreement. The remainder of the insurance proceeds will be paid to us. We pay the premiums to keep the insurance policies in force, it retains the right to terminate the insurance policies and is the owner of the cash surrender value of the insurance policies. Any successor to us will be required to assume and perform this split dollar life insurance agreement as if no succession had occurred.
In connection with the execution of the Merger Agreement, Mr. Webb entered into an employment agreement with NBT pursuant to which Mr. Webb will be employed by NBT following the Merger. Mr. Webb’s employment agreement with NBT provides that the SERP will remain in full force and effect following the commencement of Mr. Webb’s employment with NBT the (“Commencement Date”). In accordance with the terms of the SERP, Mr. Webb will continue to accrue a benefit under the SERP during his employment with NBT. Mr. Webb’s employment agreement further provides that the SERP will be amended to provide that “Final Average Compensation” for purposes of the SERP shall mean the annualized salary of Mr. Webb’s monthly base salary actually paid by us over the 36 consecutive month period ending on the Commencement Date.
Mr. Webb’s employment agreement with NBT also provides that the split dollar life insurance agreement will be amended to provide that Mr. Webb’s employment with NBT shall constitute continued employment for purposes of the split dollar life insurance agreement and shall not trigger a “Termination of Employment” as defined therein.
401(k) Retirement Program
The NEOs are eligible to participate in the 401(k) retirement program on the same terms as other employees. Employees are eligible to make salary deferrals (contributions) at the beginning of the month following their hire date. We will match the employee’s contributions $0.50 per dollar deferred up to a maximum of 6% of the employees covered compensation. In addition, 1% of an eligible employee’s annual earnings are contributed by us regardless of whether the employee is contributing to the program.
Group Term Life Insurance
The NEOs are covered under the same benefit program available to all other employees, which are paid for by us. Employees are covered for four-times their annual earnings up to a maximum of $750,000. Accidental death and dismemberment insurance is provided in an amount equal to the life insurance.
Group Long-Term Disability Insurance
The NEOs are covered under the same benefit program available to all other employees, which are paid for by us. The coverage provides for 60% salary continuation in the event of disability, as defined in the policy, up to a maximum monthly benefit of $15,000. The NEOs are insured for the following monthly income replacement amounts.
Other Benefits
The NEOs are eligible for the same benefits available to all other employees such as health and dental insurance, personal and sick leave, vacations, and holidays.
Perquisites and Personal Benefits
The NEOs are provided with perquisites and other personal benefits that the Compensation Committee believes are modest, reasonable, and similar in nature to those provided to executives at competing financial institutions, and are designed to assist these executives in carrying out their duties.
The NEOs have the use of a company-provided automobile. Club memberships are provided to Messrs. Webb, Watt and Getman for business meeting purposes and for their personal use. At the recommendation of the Compensation Committee, a health club membership is also provided to Mr. Webb.
Employment, Separation Agreements and Change of Control Agreements
We have employment and change of control agreements with the NEOs and certain key executives. Our board of directors views these agreements as integral in ensuring the continued dedication of our executives and promoting stability of management, particularly in the event of a change of control.
Employment Agreements
Messrs. Webb, Watt and Mohr each have employment agreements with us effective as of January 26, 2010, which have an initial term of one year. Thereafter, each of the employment agreements will automatically extend for successive one-year terms, unless previously terminated or either us or the executive provides notice that it will not be extended. In addition to the base annual salary, the employment agreements provide for, among other things, participation in incentive programs and other employee benefit plans applicable to executive employees.
In the event of involuntary termination without “cause” or voluntary termination with “good reason” (each as defined in the agreements), each executive is entitled to receive a severance benefit equal to the greater of the unpaid compensation and benefits that would have been paid under the terms of this employment agreement if the executive had remained employed, or the unpaid compensation and benefits that would have been paid under the terms of this employment agreement (including any accrued bonus) for a period of one year following the termination. Upon change of control (as defined in the agreements), which results in the termination of the executive without cause or certain resignations for good reason, the executive will receive a lump sum payment equivalent to a multiple of the average annual compensation paid to the executive by us and included in the executive’s gross income for income tax purposes for the three full taxable years that immediately precede the year during which the change of control occurs (adjusted to include bonuses paid, rather than accrued, in respect of such years) which multiple shall be three times such annual average amount in the case of Mr. Webb and two times the annual average amount in the case of
Messrs. Watt and Mohr. In addition, under such circumstances, each executive will also receive a lump sum payment equal to a multiple of our annual cost of providing health, life and long-term disability coverages and other fringe benefits equal to three times such amount in the case of Mr. Webb and equal to two times such amount in the case of Messrs. Watt and Mohr. Further, if there is a change of control, then all forms of equity-based compensation, including unexpired stock options and unvested restricted stock will accelerate. In the event that any amounts payable under the employment agreements would be nondeductible to us by reason of Section 280G of the Code, then such amounts shall be reduced to the extent necessary that such payments will no longer be ineligible for deduction by reason of Section 280G.
The employment agreements also provide for a clawback of any incentive paid to, credit to an account on behalf of, or vested to the executive within the prior 24 months under certain circumstances if it is later determined that the incentive is directly attributable to materially misleading financial statements.
In connection with the execution of the Merger Agreement, Mr. Webb entered into an employment agreement with NBT pursuant to which Mr. Webb will be employed by NBT following the Merger.
Settlement Agreements
In connection with the execution of the Merger Agreement, each of Messrs. Watt and Mohr entered into a settlement agreement with NBT and us, with identical terms, pursuant to which each executive will receive the payments and benefits provided under the executive’s settlement agreement in satisfaction of all rights to payments and benefits under the executive’s individual employment agreement with us. Rights to these payments under the executive’s employment agreement would have otherwise been triggered absent the settlement agreement due to the executive’s termination of employment in connection with the merger. Under the settlement agreements, upon termination of their employment on the closing date of the merger, Messrs. Watt and Mohr will receive lump sum severance payments of $725,850 and $677,570, respectively. The settlement agreements also provide that the executives will receive ownership and title of the company-provided automobile utilized by the executive at the time of his termination of employment. The executives must enter into a general release of claims in favor of NBT and us to receive the settlement payment under the settlement agreement.
Change of Control Agreements
Messrs. Getman and Cacchio have change of control agreements with us with identical terms. Upon a “change of control” (as defined in the agreement) resulting in termination, the executive will receive a lump sum severance payment equal to 200% of the executive’s annual base salary in effect as of the date of termination. If the executive constitutes a qualified beneficiary and elects continued coverage under COBRA, his health care coverage will be paid for by us for up to two years following termination or shorter period until obtaining new employment offering health insurance. In December 2012, we amended the change of control agreements to include the transfer to the executive of ownership and title of the company-provided automobile utilized by the executive at the time of his termination of employment following a change of control.
Compensation Committee Report(1)
The Compensation Committee has reviewed and discussed the foregoing Compensation Discussion and Analysis with management. Based upon such review, the related discussions and such other matters deemed relevant and appropriate by the Compensation Committee, the Compensation Committee has recommended to the board of directors that the Compensation Discussion and Analysis be included in our Annual Report on Form 10-K, for the year-ended December 31, 2012
Lowell A. Seifter, Chairperson
Donald S. Ames
Donald H. Dew
Samuel J. Lanzafame
Deborah F. Stanley
(1) The material in this report is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any filing we make under the Securities Act of 1933 or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee is composed of five directors: Donald S. Ames, Donald H. Dew, Samuel J. Lanzafame, Lowell A. Seifter and Deborah F. Stanley, with Director Seifter serving as Chairperson. None of our executive officers served as a member of another entity’s board of directors or as a member of the compensation committee (or other board committee performing equivalent functions) during 2012, which entity had an executive officer serving on our board of directors or as a member of our Compensation Committee. There are no interlocking relationships between us and other entities that might affect the determination of the compensation of our executive officers or NEOs.
Summary Compensation Table
The following table sets forth information regarding compensation earned by the NEOs for service during each of the last three completed fiscal years, as applicable:
(1) The figures shown for salary represents amounts earned for the fiscal year, whether or not actually paid during such year.
(2) Amounts in this column reflect the aggregate grant date fair value computed in accordance with FASB ASC Topic 718 with respect to restricted stock awards granted to the NEOs. For more information concerning the assumptions used for these calculations, please refer to the notes to the consolidated financial statements included elsewhere in this report.
(3) Amounts for all years in this column reflect the short-term incentive compensation earned by each NEO. The Short-Term Incentive Compensation Plan is described in greater detail elsewhere in this report.
(4) Amounts in this column reflect the increase (if any) for each respective year in the present value of the NEOs accrued benefit under each tax-qualified and non-qualified actuarial or defined benefit plan calculated by comparing the present value of each individual’s accrued benefit under each such plan in accordance with FASB ASC Topic 715 as of the plan’s measurement date in such year to the present value of the individual’s accrued benefit as of the plan’s measurement date in the prior fiscal year.
(5) Amounts in this column are set forth in the table below and include perquisites, dividends paid on restricted stock and 401(k) employer contributions, as applicable. The NEOs participate in certain group life, health, disability insurance and medical reimbursement plans, not disclosed in the Summary Compensation Table, that are generally available to salaried employees and do not discriminate in scope, terms and operation. In addition, we provide certain non-cash perquisites and personal benefits to each NEO, including country club memberships and the use of a company-provided automobile.
Grants of Plan-Based Awards
The following table sets for information regarding plan-based awards granted to the NEOs during the last fiscal year.
(1) The Short-Term Incentive Compensation Plan does not contain predetermined maximum amounts.
(2) Reflects the aggregate grant date fair value computed in accordance with FASB ASC Topic 718 with respect to restricted stock awards granted to our NEOs.
Outstanding Equity Awards at Year-End
The following table sets forth information regarding the NEOs’ stock awards outstanding at December 31, 2012.
(1) Restricted stock awards granted on February 26, 2006 vest on February 16, 2013.
(2) Restricted stock awards granted on January 30, 2007 vest on January 30, 2014.
(3) Restricted stock awards granted on January 29, 2008 vest on January 29, 2015.
(4) Restricted stock awards granted on August 31, 2010 under the 2010 Restricted Plan vest in 20% increments beginning on August 31, 2011.
(5) Restricted stock awards granted on February 22, 2011 under the 2010 Restricted Plan vest in 20% increments beginning on February 22, 2011.
(6) Restricted stock awards granted on February 28, 2012 under the 2010 Restricted Plan vest in 20% increments beginning on February 28, 2013.
(7) Restricted stock awards granted on May 1, 2006 vest on May 1, 2013.
(8) Market value is calculated on the basis of $43.51 per share, which is the closing sales price for our common stock on December 31, 2012.
Option Exercises and Stock Vested
No options were exercised during the last fiscal year. The following table sets forth the stock awards that vested for the NEOs during the last fiscal year.
(1) The figures shown include the amount realized during the fiscal year upon the vesting of restricted stock, based on the closing sales price for a share of our common stock on the vesting date.
Pension Benefits
The following table sets forth information regarding pension benefits accrued by the NEOs during the last fiscal year.
(1) This agreement is discussed above in the Compensation Discussion and Analysis section under the caption “Retirement and Other Benefits-Supplemental Executive Retirement Agreement (SERP) and Split Dollar Life Insurance Agreement.”
(2) The figures shown are determined as of the plan’s measurement date during 2012 under ASC Number 715-20-65-1 for purposes of our consolidated financial statements. The discount rate of 3.95% that was used to determine benefit obligation for the plan was based upon the Citibank pension liability index. The Citibank pension liability index, less an adjustment of 10 basis points, was determined to appropriately reflect the rate at which the pension liability could be effectively settled based upon the expected duration of the plan. Salary was assumed to increase at an annual rate of 4.0% in 2012.
Termination and Change of Control Benefits
As discussed previously under “Employment Agreements, Separation Agreements and Change of Control Agreements”, we have employment and change of control agreements with Messrs. Webb, Watt, Mohr, Getman and Cacchio. The follow table summarizes and quantifies the estimated payments under the agreements, assuming a termination event occurred on December 31, 2012.
(1) With the exception of pension benefits payable under Mr. Webb’s Supplemental Retirement Agreement, there are no additional benefits paid upon retirement pursuant to the employment agreements or change of control agreements in effect at December 31, 2012, or pursuant to the 1998 Long-Term Incentive Compensation Plan and the 2010 Restricted Stock Plan.
(2) All restricted stock granted under the 1998 Long Term Incentive Compensation Plan and the 2010 Restricted Stock Plan provide for full vesting upon death, disability or change of control. The figures shown reflect the value of those restricted stock awards that would accelerate, calculated based on the closing sales price for a share of our common stock on December 31, 2012. The change of control agreements with other officers also provide acceleration of restricted stock awards that otherwise were not vested.
(3) The employment agreements in effect for Messrs. Webb, Watt and Mohr provide for salary continuation payments following termination due to death for a period of 60 days.
(4) The employment agreements in effect for Messrs. Webb, Watt and Mohr provide for a payment equal to the total of accrued and unpaid vacation pay, continued benefits and 100% of the executive’s then current base salary for a period of 30 weeks following termination due to disability. The amount disclosed for accrued and unpaid vacation pay assumes a payout of the maximum four weeks of unused vacation time.
(5) The employment agreements in effect for Messrs. Webb, Watt and Mohr provide for a lump sum cash payment equal to the unpaid compensation, including any accrued bonus, and the benefits that the executive would have been paid under the agreement for a period of one year following a termination without cause or voluntary termination with “good reason,” including base salary, vacation and benefits. The amount disclosed for accrued and unpaid vacation pay assumes a payout of the maximum four weeks of unused vacation time.
(6) The employment agreements provide for a lump sum payment equivalent to a multiple of the average annual compensation paid to the executive by us and included in the executive’s gross income for income tax purposes for the three full taxable years that immediately precede the year during which the change of control occurs (adjusted to include bonuses paid, rather than accrued, in respect of such years) which multiple shall be three times such annual average amount in the case of Mr. Webb and two times the annual average amount in the case of Messrs. Watt and Mohr. In addition, under such circumstances, each executive will also receive a lump sum payment equal to a multiple of our annual cost of providing health, life and long-term disability
coverages and other fringe benefits equal to three times such amount in the case of Mr. Webb and equal to two times such amount in the case of Messrs. Watt and Mohr. The change of control agreements with Messrs. Getman and Cacchio provide for a lump sum payment equal to 200% of his annual cash compensation and the cost of providing health, life and long-term disability coverages and other fringe benefits for a period of up to 24 months. In the event that any amounts payable under the employment agreements or change of control agreements would be nondeductible to us by reason of Section 280G of the Code, then such amounts shall be reduced to the extent necessary that such payments will no longer be ineligible for deduction by reason of Section 280G of the Code.
Director Compensation
Meeting Fees
Each non-employee director receives an annual retainer fee of $12,500 for service on our board of directors, $600 for each board of directors meeting attended, and $600 for each committee meeting attended. Committee chairs receive an additional $100 for each committee meeting attended. The Audit Committee Chairman and Governance Committee Chairman each receive an additional annual retainer fee of $5,000, and the Compensation Committee Chairman receives an additional annual retainer fee of $3,500.
Stock-Based Deferral Plan
We have a Stock-Based Deferral Plan that was adopted in March 2008, which currently provides non-employee directors with the option to defer receipt of all or a portion of their directors’ fees. Amounts deferred under the Stock-Based Deferral Plan are invested in shares of our common stock through open market purchases executed by a trustee. Dividends paid on shares of stock in the Stock-Based Deferral Plan are reinvested in our common stock. Participants in the Stock-Based Deferral Plan can elect to receive stock distributions in a lump sum or in equal installments over at least two years and not more than 10 years. During 2012, the directors elected to defer a total of $261,410 in director fees under the Stock-Based Deferral Plan.
Director Retirement Plan
We also provide an additional source of retirement income to non-employee directors in recognition of their service on our board of directors through the Director Retirement Plan. In the event that a director ceases to serve after completing at least three years of service, the director is entitled to a normal retirement benefit, payable in either a lump sum or in ten equal annual installments. In the event of the death of the director, remaining benefits, if any, are payable to a designated beneficiary. The normal retirement benefit is equal to 35 percent of the director’s average annual director’s fees increased by (i) 1 percent for each full year of service up to a maximum of 25 percent and (ii) by an additional 10 percent if the director served as a committee chair on our board of directors for at least three years, which may be nonconsecutive.
The following table sets forth information regarding compensation earned by our non-employee directors during the last fiscal year.
(1) Includes retainer payments, meeting fees, and committee and/or chairmanship fees earned during the fiscal year. All non-employee directors elected to defer 100% of their 2012 fees under the Stock-Based Deferral Plan, except Ms. Ogden who elected to receive 70% of her total fees in cash.
(2) Amounts in this column represent the change in the value of accumulated benefits under the Director Retirement Plan and nonqualified deferred compensation earnings under the Stock-Based Deferral Plan.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Securities Authorized For Issuance Under Equity Compensation Plans
The following table sets forth the aggregate information of our equity compensation plans in effect as of December 31, 2012.
(1) Represents shares available for issuance under our 2010 Restricted Stock Plan, which was approved by our shareholders in May 2010.
Security Ownership of Certain Beneficial Owners and Management
Under SEC rules, beneficial ownership includes any shares of common stock which a person has sole or shared voting power or investment power and any shares of common stock which the person has the right to acquire within 60 days through the exercise of any option, warrant or right, through conversion of any security or pursuant to the automatic termination of a power of attorney or revocation of a trust, discretionary account or similar arrangement.
The following table sets forth certain information regarding the beneficial ownership of our common stock as of February 18, 2013 by: (i) each director; (ii) each of the named executive officer’s listed in Summary Compensation Table; (iii) all our directors and executive officers as a group and (iv) all those known by us to be beneficial owners of more than 5% of its common stock. Except as otherwise indicated, each person and each group shown in the table has sole voting and investment power with respect to the shares of common stock listed next to his or her name.
* Less than 1% of the total outstanding shares of common stock.
(1) This table is based solely upon information supplied by officers, directors and principal shareholders and Schedules 13D and 13G filed with the SEC. Unless otherwise indicated in the footnotes to this table and subject to community property laws where applicable, the Company believes that each of the shareholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned. Applicable percentages are based on 4,779,290 shares outstanding on February 18, 2013, adjusted as required by rules promulgated by the SEC.
(2) Consists of: a) 41,457 shares as to which Mr. Webb has sole voting and investment power and b) 14,122 unvested shares of restricted stock as to which he has sole voting power. Excludes 100 shares held by his spouse and 200 shares held by his daughter as to which he does not have voting or investment power, and as such, disclaims beneficial ownership.
(3) Consists of: a) 693 shares as to which Mr. Watt has sole voting and investment power, b) 10,934 shares as to which Mr. Watt holds jointly with his spouse as to which he has shared voting and investment power and c) 8,027 unvested shares of restricted stock as to which he has sole voting power.,
(4) Consists of: a) 1,969 shares as to which Mr. Mohr has sole voting and investment power and b) 8,498 unvested shares of restricted stock as to which he has sole voting power.
(5) Consists of: a) 6,889 shares as to which Mr. Getman has sole voting and investment power and b) 5,159 unvested shares of restricted stock as to which he has sole voting power.
(6) Consists of: a) 5,534 shares as to which Mr. Cacchio has sole voting and investment power and b) 6,324 unvested shares of restricted stock as to which he has sole voting power.
(7) Consists of: a) 9,650 shares as to which Ms. Adams has sole voting and investment power, b) 13,900 shares held in trust as to which she has shared voting and investment power, and c) 14,372 shares held by the Stock-Based Deferral Plan for her account as to which she has sole voting power. Excludes 1,231 shares held by her spouse and 850 shares held by her children as to which she does not have voting or investment power and, as such, disclaims beneficial ownership.
(8) Consists of: a) 91,917 shares as to which Mr. Ames’ spouse has shared voting and investment power as co-trustee of the Donald S. Ames Irrevocable Trust and b) 28,142 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power.
(9) Consists of: a) 14,911 shares as to which Mr. Dew has sole voting and investment power and b) 7,031 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power.
(10) Consists of: a) 1,115 shares as to which Mr. Lanzafame has sole voting and investment power and b) 33,642 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power. Excludes 15,980 shares held by his spouse as to which he does not have voting or investment power and, as such, disclaims beneficial ownership.
(11) Consists of: a) 2,758 shares as to which Ms. Ogden has sole voting and investment power, b) 2,293 shares held jointly with her spouse as to which she has shared voting and investment power, and c) 4,225 shares held by the Stock-Based Deferral Plan for her account as to which she has sole voting power.
(12) Consists of: a) 7,651 shares as to which Mr. Seifter has sole voting and investment power and b) 8,126 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting.
(13) Consists of: a) 3,838 shares as to which Mr. Shafer has sole voting and investment power, b) 10,243 shares held jointly with his spouse as to which he has shared voting and investment power, and c) 16,265 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power. Excludes 2,286 shares held by his spouse as to which he does not have voting or investment power and as such, disclaims beneficial ownership.
(14) Consists of: a) 11,804 shares as to which Mr. Solomon has sole voting and investment power and b) 16,545 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power.
(15) Consists of: a) 15,837 shares as to which Mr. Spaulding has sole voting and investment power and b) 12,762 shares held by the Stock-Based Deferral Plan for his account as to which he has sole voting power.
(16) Consists of: a) 5,026 shares as to which Ms. Stanley has sole voting and investment power, b) 4,756 shares held jointly with her spouse as to which she has shared voting and investment power and c) 6,968 shares held by the Stock-Based Deferral Plan for her account as to which she has sole voting power.
(17) As disclosed on Schedule 13G/A, filed February 6,2013, BlackRock, Inc. has sole voting power and sole dispositive power with respect to all shares listed.
(18) As disclosed on Schedule 13G/A, filed December 12, 2012, Edward C. Johnson 3d, Chairman of FMR LLC, and FMR LLC, through its control of Fidelity Management & Research Company (“Fidelity”), has sole power to dispose of all shares listed. Neither FMR LLC nor Edward C. Johnson 3d has the sole power to vote or direct the voting of the shares owned directly by the Fidelity Funds, which power resides with the Funds’ Boards of Trustees. Fidelity carries out the voting of the shares under written guidelines established by the Fund’’ Boards of Trustees.
Item 13.
Item 13. Certain Relationships and Related Transactions and Director Independence
Board of Directors Independence
As required under the Nasdaq listing standards, a majority of the members of our Board of Directors must qualify as “independent,” as affirmatively determined by the Board of Directors. The Board consults with the company’s counsel to ensure that the Board’s determinations are consistent with relevant securities and other laws and regulations regarding the definition of “independent,” including those set forth in pertinent listing standards of the Nasdaq, as in effect from time to time.
Consistent with these considerations, the Board has affirmatively determined that the following current directors are independent directors within the meaning of the applicable Nasdaq listing standards: Mary Pat Adams, Donald S. Ames, Donald H. Dew, Samuel J. Lanzafame, Margaret G. Ogden, Lowell A. Seifter, Charles E. Shafer, Paul M. Solomon, Charles H. Spaulding and Deborah F. Stanley. In making this determination, the Board found that none of these directors had a material or other disqualifying relationship with us. The Board has determined that Jack H. Webb, our Chairman of the Board, President and Chief Executive Officer and John H. Watt, Jr., our Executive Vice President, are not independent directors by virtue of their employment with us.
Transactions with Related Persons
Related-Person Transactions Policy and Procedures
Pursuant to the terms of its written charter, the Audit Committee is responsible for reviewing and approving all related-party transactions. Consistent with this responsibility, the Audit Committee has reviewed and approved the following related-person relationships as being consistent with the policy. Except for the specific transactions described below, no director, executive officer or beneficial owner of more than five percent of our outstanding voting securities (or any member of their immediate families) engaged in any transaction (other than such transaction as described) with us during 2012, or proposes to engage in any transaction with us, in which the amount involved exceeds $120,000.
Transactions with Certain Related Persons
We make loans to our executive officers, employees and directors. These loans are made in the ordinary course of business and on substantially the same terms and conditions as those of comparable transactions with the general public prevailing at the time, in accordance with our underwriting guidelines, and do not involve more than the normal risk of collectability or present other unfavorable features.
The law firm of Riehlman, Shafer & Shafer, of which Director Charles E. Shafer’s brother is sole owner, received $198,944 for legal services rendered to us during 2012, including commercial and consumer loan closings and collection activities.
Item 14.
Item 14. Principal Accountant Fees and Services
Independent Registered Public Accounting Firm Fees and Services
During the fiscal years ended December 31, 2012 and December 31, 2011, respectively, we retained and paid Crowe Horwath LLP to provide audit and other services as follows:
(1) Audit fees principally include those for services related to the annual audit of the consolidated financial statements, annual audit of internal control over financial reporting, U.S. Department of Housing and Urban Development loan audit and consultation on accounting matters.
(2) Audit-related fees in 2012 principally include service rendered in connection with a Form S-4 registration statement.
(3) Tax fees include assistance with matters related to tax compliance and counseling.
(4) All other fees consists of fees for all other services other than those reported above.
Pre-approval of Services
The Audit Committee shall pre-approve all auditing services and permissible non-audit services (including the fees and terms) to be performed for us by our independent registered public accounting firm. Unless a type of service to be provided by the auditor has received general pre-approval, it requires specific pre-approval by the Audit Committee, and any proposed services exceeding pre-approved expense levels require specific pre-approval by the Audit Committee.
The Audit Committee pre-approved 100% of the services performed by the independent registered public accounting firm pursuant to the policies outlined above.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
The financial statement schedules and exhibits filed as part of this form 10-K are as follows:
(a)(1) Financial Statements
Reference is made to the consolidated financial statements and accompanying notes included in Item 8 of Part II hereof.
(a)(2) Financial Statement Schedules
Consolidated financial statement schedules have been omitted because the required information is not present, or not present in amounts sufficient to require submission of the schedules, or because the required information is provided in the consolidated financial statements or notes thereto.
(a)(3) Exhibits
The exhibits required to be filed as part of the Annual Report on Form 10-K are listed in the Exhibit Index attached hereto and are incorporated herein by reference.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant on March 8, 2013, and in the capacities indicated.
/s/ Jack H. Webb
Jack H. Webb, Chairman, President & CEO
(Principal Executive Officer)
/s/ J. Daniel Mohr
J. Daniel Mohr, Executive Vice President & CFO
(Principal Financial and Accounting Officer)
/s/ Mary Pat Adams
Mary Pat Adams, Director
/s/ Donald S. Ames
Donald S. Ames, Director
/s/ Donald H. Dew
Donald H. Dew, Director
/s/ Samuel J. Lanzafame
Samuel J. Lanzafame, Director
/s/ Margaret G. Ogden
Margaret G. Ogden, Director
/s/ Lowell A. Seifter
Lowell A. Seifter, Director
/s/ Charles E. Shafer
Charles E. Shafer, Director
/s/ Charles H. Spaulding
Charles H. Spaulding, Director
/s/ Paul M. Solomon
Paul M. Solomon, Director
/s/ Deborah F. Stanley
Deborah F. Stanley, Director
/s/ John H. Watt, Jr.
John H. Watt, Jr., Executive Vice President & Director
ALLIANCE FINANCIAL CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm on Internal Controls and Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
& 8
Notes to Consolidated Financial Statements
Item 8. Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Alliance Financial Corporation
Syracuse, New York
We have audited the accompanying consolidated balance sheets of Alliance Financial Corporation as of December 31, 2012 and 2011 and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2012. We also have audited Alliance Financial Corporation’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Alliance Financial Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the company’s internal control over financial reporting 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 audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alliance Financial Corporation as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Alliance Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/Crowe Horwath LLP
Crowe Horwath LLP
Cleveland, Ohio
March 8, 2013
Alliance Financial Corporation and Subsidiaries
Consolidated Balance Sheets
December 31, 2012 and 2011
(In thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements
Alliance Financial Corporation and Subsidiaries
Consolidated Statements of Income
Years Ended December 31, 2012, 2011 and 2010
(In thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
Alliance Financial Corporation and Subsidiaries
Consolidated Statements of Comprehensive Income
Years Ended December 31, 2012, 2011 and 2010
(In thousands)
The accompanying notes are an integral part of the consolidated financial statements.
Alliance Financial Corporation and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
Years Ended December 31, 2012, 2011 and 2010
(In thousands, except per share data)
The accompanying notes are an integral part of the consolidated financial statements.
Alliance Financial Corporation and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2012, 2011 and 2010
(In thousands)
Alliance Financial Corporation and Subsidiaries
Consolidated Statements of Cash Flows (cont’d)
Years Ended December 31, 2012, 2011 and 2010
(In thousands)
The accompanying notes are an integral part of the consolidated financial statements.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Nature of Operations
Alliance Financial Corporation (the “Company” or “Alliance”) is a financial holding company which owns and operates Alliance Bank, N.A. (the “Bank”), Alliance Financial Capital Trust I, Alliance Financial Capital Trust II (collectively the “Capital Trusts”) and Alliance Agency, Inc. (formerly Ladd’s Agency, Inc.). In December 2010, Alliance sold substantially all of the assets of Alliance Agency Inc. and discontinued its operations. Alliance provides financial services through the Bank in 29 retail branches and customer service facilities in the New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a Trust Administration Center in Buffalo, NY. Primary services include commercial, retail and municipal banking, consumer finance, mortgage financing and servicing, and investment management services. The Capital Trusts were formed for the purpose of issuing company-obligated mandatorily redeemable capital securities to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of Alliance. The Bank has a substantially wholly owned subsidiary, Alliance Preferred Funding Corp., which is engaged in residential real estate activity, and a wholly owned subsidiary, Alliance Leasing, Inc., which was engaged in commercial equipment financing activity in over thirty states until the third quarter of 2008, at which time Alliance Leasing, Inc. ceased the origination of new leases.
On October 8, 2012, Alliance reported that it entered into a definitive merger agreement (“Merger Agreement’) with NBT Bancorp Inc. (“NBT”). Under the terms of the Merger Agreement, NBT will acquire Alliance for approximately $233.4 million, based on the 5-day average closing price of NBT’s common stock for the period ended October 5, 2012, and Alliance will merge with and into NBT, with NBT being the surviving corporation (the “Merger”). Immediately following the Merger, the Bank will be merged with and into NBT’s subsidiary bank, NBT Bank, NA (“NBT Bank”) and NBT Bank will continue as the surviving bank. Merger related expenses in non-interest expense totaled $3.4 million in 2012 and included $2.7 million for professional fees and $676,000 for personnel related accrual for estimated retention awards. The NBT stockholders voted to approve the Merger on March 5, 2013 and the Alliance shareholders voted to approve the Merger on March 7, 2013. The Merger is scheduled to be completed on March 8, 2013.
1. Basis of Presentation and Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Alliance, the Bank, and Alliance Agency, Inc., after elimination of intercompany accounts and transactions. The Capital Trusts qualify as variable interest entities under Accounting Standards Topic 810-10-05, “Consolidation of Variable Interest Entities.” However, Alliance is not the primary beneficiary and therefore has not consolidated the accounts of the Capital Trusts in its consolidated financial statements.
Critical Accounting Estimates and Policies
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management has identified the allowance for credit losses, income taxes, retirement plan obligations, the carrying value of goodwill and intangible assets and the fair value of financial instruments to be the accounting areas that require the most subjective and complex judgments, and as such could be the most subject to revision as new information becomes available. Actual results could differ from those estimates.
Risk and Uncertainties
In the normal course of its business, Alliance encounters economic and regulatory risks. There are three main components of economic risk: interest rate risk, credit risk and market risk. Alliance is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, from its interest-earning assets. Alliance’s primary credit risk is the risk of default on Alliance’s loan and lease portfolio that results from the borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects potential changes in the value of collateral underlying loans, the fair value of investment securities, and the value of loans held for sale.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Alliance is subject to regulations of various governmental agencies. These regulations can and do change significantly from period to period. Alliance also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loan and lease loss allowances, and operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examinations.
Alliance is also subject to liquidity risk which is the current and prospective risk to earnings or capital arising from a bank’s ability to meet its obligations when they come due without incurring unacceptable losses. Alliance’s liquidity is primarily measured by the Bank’s ability to provide funds to meet loans requests, to accommodate possible outflows of deposits, and to take advantage of market interest rate opportunities.
Cash Flows
Cash and cash equivalents include cash, deposits with other financial institutions with maturities fewer than 90 days, and federal funds sold. Net cash flows are reported for customer loan, lease and deposit transactions, interest-bearing deposits in other financial institutions, and federal funds purchased and repurchase agreements.
Securities
Alliance classifies debt securities as held-to-maturity or available-for-sale at the time of purchase. Held-to-maturity debt securities are those that Alliance has the positive intent and ability to hold to maturity, and are reported at cost, adjusted for amortization of premiums and accretion of discounts. Debt securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair value, with net unrealized gains and losses reflected as a separate component of accumulated other comprehensive income, net of taxes. None of Alliance’s debt securities have been classified as trading securities or held-to-maturity. Equity securities with readily determinable fair values are classified as available-for-sale.
Gains and losses on the sale of securities are based on the specific identification method. Premiums and discounts on securities are amortized and accreted into income using the interest method over the life of the security without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Purchases and sales of securities are recognized on a trade-date basis.
Securities are reviewed regularly for other than temporary impairment. When an investment is impaired, we assess whether we intend to sell the security, or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other than temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is calculated as the difference between the investment’s amortized cost basis and the present value of its expected future cash flows discounted at the accretable yield. The cost basis of individual equity securities is written down to estimated fair value through a charge to earnings when decline in value below cost are considered to be other than temporary.
FHLB and FRB Stock
Alliance is a member of the FHLB system and the FRB. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB and FRB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Securities Sold Under Agreements to Repurchase
Repurchase agreements are accounted for as collateralized borrowings, and the obligations to repurchase securities sold are reflected as a liability in the balance sheet, since Alliance maintains effective control over the transferred securities. The securities underlying the agreements remain in Alliance’s securities portfolio. The fair value of the collateral provided to a third party is continually monitored, and additional collateral is provided to the third party, or surplus collateral is returned to Alliance as deemed appropriate.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Loans Held for Sale and Mortgage Servicing Rights
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are charged to earnings. Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.
Mortgage servicing rights are recognized separately when they are acquired through sales of loans. When mortgage loans are sold, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sale of loans. Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If Alliance later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income which is reported on the income statement as other non-interest income is recorded for fees earned for servicing loans and recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from Alliance, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and we do not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Loans and Leases
Loans and leases held for investment are stated at unpaid principal balances, unearned interest income, net deferred loan origination fees and costs, and the allowance for credit losses. Interest on loans is based upon the principal amount outstanding. Interest on loans is accrued except when in management’s opinion the collectibility of interest is doubtful, at which time the accrual of interest on the loan is discontinued and the amount of accrued interest is reversed. Loan and lease origination fees and certain direct origination costs are deferred and the net amount is amortized as a yield adjustment over the life of the loan or lease. For disclosure purposes, the unpaid principal balance approximates the recorded investment in loans and leases which is net of any partial charge-offs, but excludes accrued interest receivable and net deferred costs.
Loans are made to individuals as well as commercial and tax exempt entities. Specific loan terms vary as to interest rate, repayment and collateral requirements based on the type of loan and credit worthiness of the prospective borrower. Credit risk tends to be geographically concentrated in that a majority of the loan customers are located in the markets serviced by Alliance.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Commercial credits typically comprise working capital loans, loans for physical asset expansion, acquisition loans and other business purposes. Commercial loans are made based primarily on the historical and projected cash flows of the borrower and secondarily the underlying collateral provided by the borrower. Loans to closely held businesses will generally be guaranteed in full or for a meaningful amount by the business’ major owners. The cash flows of borrowers, however, may not behave as forecasted and collateral values may fluctuate due to economic or individual performance factors. Minimum standards and underwriting guidelines have been established for all commercial loan types.
Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans. These loans are viewed primarily as cash flow loans and the repayment of these loans is largely dependent on the successful operation of the property. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or the general economy.
Lease financings, included in portfolio loans and leases on the consolidated balance sheet consist of direct financing leases of commercial equipment, primarily computers and office equipment, manufacturing equipment, commercial trucks and trailers, and medical equipment. Income attributable to finance leases is initially recorded as unearned income and subsequently recognized as finance income at level rates of return over the term of the leases. The recorded residual values of Alliance’s leased assets are estimated at the inception of the lease to be the expected fair value of the assets at the end of the lease term. Alliance reviews commercial lease residual values at least annually and recognizes residual value impairments deemed to be other than temporary. In accordance with U.S. generally accepted accounting principles, anticipated increases in specific future residual values are not recognized before realization. Operating leases are stated at cost of the equipment less scheduled depreciation. Equipment on operating leases is depreciated on a straight-line basis to its estimated residual value over the lease term. Operating lease income is recognized on a straight-line basis over the term of the lease.
Alliance originates direct and indirect consumer loans including residential real estate, home equity lines and loans, indirect vehicle loans, and other consumer direct loan types. Each loan type has a separate automated decision system which consists of several factors including debt to income, type of collateral and loan to collateral value, credit history and our relationship with the borrower.
Alliance’s credit policy includes an external independent loan review process that reviews and validates the credit risk program on a periodic basis.
Allowance for Credit Losses
The allowance for credit losses represents management’s best estimate of probable incurred losses in Alliance’s loan and lease portfolio. Management’s quarterly evaluation of the allowance for credit losses is a comprehensive analysis that builds a total allowance by evaluating the probable incurred losses within each loan and lease portfolio segment. Alliance’s portfolio segments are as follows: commercial loan and commercial real estate loans, commercial leases, residential real estate, indirect consumer loans and other consumer loans. Alliance’s allowance for credit losses consists of specific valuation allowances based on probable credit losses on specific loans, historical valuation allowances based on loan loss experience for similar loans with similar characteristics and trends and general valuation allowances based on general economic conditions and other qualitative risk factors both internal and external to the organization.
Historical valuation allowances are calculated for commercial loans and leases based on the historical loss experience of specific types of loans and leases and the internal risk grade 24 months prior to the time they were charged off. The internal credit risk grading process evaluates, among other things, the borrower’s ability to repay, the underlying collateral, if any, and the economic environment and industry in which the borrower operates. Historical valuation allowances for residential real estate and consumer loan segments are based on the average loss rates for each class of loans for the time period that includes the current year and two full prior years. Alliance calculates historical loss ratios for pools of similar consumer loans based upon the product of the historical loss ratio and the principal balance of the loans in the pool. Historical loss ratios are updated quarterly based on actual loss experience.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
For commercial loan and lease segments, Alliance evaluates those classified in our internal risk grading system as substandard, doubtful or loss with a principal balance in excess of $200,000 to determine if they are impaired. A loan or lease is considered impaired, based on current information and events, if it is probable that Alliance will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally discounted at the historical effective interest rate, except that all collateral-dependent loans and leases are measured for impairment based on the estimated fair value of the collateral. Loans with modified terms in which a concession to the borrower has been made that we would not otherwise consider unless the borrower was experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Impaired loans and leases arising from troubled debt restructuring are measured at the present value of their estimated future cash flows using the instruments’ effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, Alliance determines the amount of reserve in accordance with the accounting policy for the allowance for credit losses. Large groups of smaller balance homogenous loans, such as consumer and residential real estate loans less than $200,000, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
General valuation allowances are based on general economic conditions and other qualitative risk factors which affect our company. Factors considered include trends in our delinquency rates, macro-economic and credit market conditions, changes in asset quality, changes in loan and lease portfolio volumes, concentrations of credit risk, the changes in internal loan policies, procedures and internal controls, experience and effectiveness of lending personnel. Management evaluates the degree of risk that each one of these components has on the quality of the loan and lease portfolio on a quarterly basis.
Loans and leases are charged off when they are considered a loss regardless of the delinquency status. From a delinquency standpoint, the policy of Alliance is to charge off loans when they are 120 days past due unless extenuating circumstances are documented that attest to the ability to collect the loan. Special circumstances to include fraudulent loans and loans in bankruptcy will be charged off no later than 90 days of discovery or 120 days delinquent, whichever is shorter. In lieu of charging off the entire loan balance, loans with collateral may be written down to the value of the collateral, less cost to sell, if foreclosure or repossession of collateral is assured and is in process.
Income Recognition on Impaired and Non-Accrual Loans and Leases
Loans and leases, including impaired loans or leases, are generally classified as non-accrual if they are past due as to maturity of payment of principal or interest for a period of more than 90 days unless they are well secured and are in the process of collection. Past due status is based on the contractual terms of the loan or lease. While a loan or lease is classified as non-accrual and the future collectibility of the recorded loan or lease balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. Loans and leases are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of net assets acquired for transactions accounted for under the purchase method of accounting for business combinations. Goodwill is not amortized, but evaluated at least annually for impairment. Alliance has selected October 31 as the date to perform the annual impairment test. Intangible assets resulting from the acquisition of Bridge Street Financial, Inc. in 2006 included core deposit intangibles, customer relationship intangibles and a covenant to not compete. The core deposit intangible is being amortized over 10 years using an accelerated method. The non-compete covenant was amortized on a straight-line basis over a period of 3 years based on the agreement. The customer list intangible related to the Ladd’s Agency was amortized over 10 years using an accelerated method and was sold in December 2010. The investment management intangible related to the purchase of certain trust accounts and related assets under management from HSBC, USA, N.A. in 2005 is being amortized over the expected useful life of the relationships acquired. These intangibles are tested for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. Goodwill is the only intangible asset with an indefinite life on Alliance’s balance sheet.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Premises and Equipment
Land is carried at cost. Bank premises, furniture, and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. Useful lives range from one year to 10 years for furniture, fixtures and equipment; three to five years for software, hardware, and data handling equipment; and 10 to 39 years for buildings and building improvements. Leasehold improvements are amortized over the term of the respective lease. Maintenance and repairs are charged to operating expenses as incurred. The asset cost and accumulated depreciation are removed from the accounts for assets sold or retired and any resulting gain or loss is included in the determination of the income.
Long-Term Assets
Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Bank-Owned Life Insurance
The Bank has purchased life insurance policies on certain employees, key executives and directors. Bank-owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Foreclosed Assets
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Retirement Plans
Pension expense is the net of service and interest cost, return on plan assets and amortization of gains and losses not immediately recognized. Employee 401(k) and profit sharing plan expense is the amount of matching contributions and employer fixed and discretionary contributions. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.
Stock-Based Compensation
Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model was utilized to estimate the fair value of stock options, while the market price of Alliance’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Directors Stock-Based Deferral Plan
In accordance with Accounting Standards Codification Topic 710-10-25 “Deferred Compensation - Rabbi Trusts,” the stock held in the trust is classified in equity similar to the manner in which treasury stock is classified.
Earnings Per Common Share
Earnings per share is computed using the two-class method. Basic earnings per common share is computed by dividing net income allocated to common stock by the weighted average number of common shares outstanding during the period which excludes the participating securities. All outstanding unvested restricted stock awards containing rights to nonforfeitable dividends are considered participating securities for this calculation. Diluted earnings per common share includes the dilutive effect of additional potential common shares from stock compensation awards, but excludes awards considered participating securities.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale and changes in funded status of the pension plan, post-retirement medical plan, supplemental executive retirement plans, and directors’ retirement plan which are also recognized as separate components of equity.
Income Taxes
Provision for income taxes is based on taxes currently payable or refundable and deferred income taxes on temporary differences between the tax basis of assets and liabilities and their reported amount in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.
A tax position is recognized as a benefit only if it is more likely than not that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. Alliance accounts for interest and penalties related to uncertain tax positions as part of its provision for federal and state income taxes.
Dividend Restriction
Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the holding company or by the holding company to shareholders.
Fair Value of Financial Instruments
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Segment Reporting
Alliance’s operations are solely in the financial services industry and include providing to its customers traditional banking, equipment leasing and other financial services including investment management services. Alliance operates primarily in the geographical regions of Cortland, Madison, Oneida, Onondaga, and Oswego counties of New York State, and from a Trust Administration Center in Buffalo, NY. In addition, Alliance Leasing conducted business in over thirty states. While Alliance’s chief decision-makers monitor the revenue streams of the various company products and services, the segments that could be separated from Alliance’s primary business of banking do not meet the criteria for separate disclosure. Accordingly, all of Alliance’s financial service operations are considered by management to be combined in one reportable operating segment.
Investment Assets Under Management
Assets held in fiduciary or agency capacities for customers are not included in the accompanying consolidated balance sheets, since such items are not assets of Alliance. Fees associated with providing investment management services are recorded using a method that approximates the accrual basis.
Reclassifications
Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no affect on prior year net income or shareholders’ equity.
Adoption of New Accounting Standards
In June 2011, the Financial Accounting Standards Board (“FASB”) amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholder’s equity. The amendment requires that comprehensive income be presented in either a single continuous statement or in two separate consecutive statements. The guidance required changes in presentation only and had no significant impact on our consolidated financial statements.
In May 2011, FASB issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The effect of adopting this standard did not have a material effect on our operating results or financial condition.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
2. Securities
The amortized cost and estimated fair value of securities at December 31, 2012 and 2011 are as follows (in thousands):
Mortgage-backed securities are comprised primarily of pass-through securities backed by conventional residential mortgages and guaranteed by Fannie-Mae, Freddie-Mac or Ginnie Mae, which in turn are backed by the U.S. government. At December 31, 2012 and 2011, there were no holdings of securities of any one issuer other than the U.S. government and its agencies in an amount greater than 10% of shareholders’ equity.
The carrying value and estimated fair value of debt securities at December 31, 2012 and 2011 by contractual maturity, are shown in the following tables (in thousands). The maturities of mortgage-backed securities are based on average life of the security. All other expected maturities differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2012 and 2011, securities with a carrying value of $260.3 million and $361.8 million, respectively, were pledged as collateral for certain deposits and other purposes as required or permitted by law.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
There were no gains on sales of securities in 2012. Alliance recognized gross gains on sales of securities of $1.3 million and $313,000 for 2011 and 2010, respectively. Gross losses of $5,000 were recognized in 2010 while there were no gross losses in 2012 and 2011. The tax provision related to these net realized gains was $513,000 and $119,000 in 2011 and 2010, respectively.
During 2013, Alliance sold approximately $70.4 million of securities available for sale. Gross gains recognized were $1.6 million and gross losses were $53,000. The tax provision related to these realized gains was approximately $623,000.
The following tables show the securities with unrealized losses at December 31, 2012 and 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at the dates indicated (in thousands):
Management does not believe any individual unrealized loss as of December 31, 2012 represents an other-than-temporary impairment. A total of 18 available-for-sale securities were in a continuous unrealized loss position for less than 12 months and 2 securities for 12 months or longer. The unrealized losses relate primarily to debt securities issued by FNMA, GNMA, FHLMC and FHLB. These unrealized losses are primarily attributable to changes in interest rates and other market conditions such as the variability of risk premiums demanded by investors. Alliance does not intend to sell these securities and does not believe it will be required to sell them prior to recovery of the amortized cost.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
3. Loans and Leases
Major classifications of loans and leases at December 31, 2012 and 2011 are as follows (in thousands):
Mortgage Loans Serviced for Others
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheet. The unpaid principal balances of mortgage loans serviced for others are as follows (in thousands):
Custodial escrow balances maintained in connection with serviced loans were $2.9 million and $1.9 million at December 31, 2012 and 2011, respectively. Servicing fee income, net of mortgage servicing rights amortization, totaled $105,000, $107,000, and $90,000 for the years ended December 31, 2012, 2011 and 2010, respectively.
The following table summarizes the changes in the carrying value of mortgage servicing rights (in thousands):
The fair value of mortgage servicing rights was $1.5 million and $1.3 million at December 31, 2012 and 2011. Fair value at December 31, 2012 was determined using a discount rate of 7.18%, prepayment speed assumptions (PSA) ranging from 361% in the first year to 268% in the third year and servicing cost per loan of $57. Fair value at December 31, 2011 was determined using a discount rate of 7.28%, PSA ranging from 352% in the first year to 259% in the third year and servicing cost per loan of $56.
Leases
The estimated residual value of leased assets was $215,000 at December 31, 2012 and 2011.
At December 31, 2012, the minimum future lease payments, excluding residual values, to be received from lease financings were as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Loans to Insiders
Certain directors and executive officers of Alliance and their affiliated companies were customers of, and had other transactions with, Alliance during 2012. Loan transactions with related parties are summarized as follows (in thousands):
Non-accrual and Past Due Loans and Leases
Non-accrual loans and leases and loans past due 90 days still accruing include: a) smaller balance homogeneous loans and leases that are collectively evaluated for impairment, and b) individually classified as impaired loans. The following table presents the recorded investment in non-accrual and loans and leases and loans and leases 90 days past due and still accruing at the dates indicated (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The following table presents the aging of the recorded investment in past due loans and leases, including non-performing loans and leases, at the dates indicated (in thousands):
Allowance for Credit Losses
The following table details activity in the allowance for credit losses by portfolio segment at the dates indicated (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Impaired Loans and Leases
The following table presents information related to impaired loans and leases as of December 31 (in thousands):
(1) Unpaid contractual principal balance has not been reduced by any partial charge-offs taken on loans and leases.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The allocation of the allowance for credit losses summarized on the basis of Alliance’s impairment methodology was as follows at the dates indicated (in thousands):
The recorded investment in loans and leases summarized on the basis of Alliance’s impairment methodology at the dates indicated was as follows (in thousands):
The following table presents the average recorded investment and interest income recognized in impaired loans and leases for the periods indicated (in thousands):
There was no interest recognized on impaired loans in 2010 while they were considered to be impaired.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Troubled Debt Restructurings
The following table presents the recorded investment in troubled debt restructured loans and leases as of December 31, 2012 and 2011 based on payment performance status (in thousands):
Troubled debt restructured loans and leases are considered impaired and are included in the previous impaired loans and leases disclosures in this footnote. As of December 31, 2012, we have not committed to lend additional amounts to customers with outstanding loans and leases that are classified as troubled debt restructurings.
During the periods ending December 31, 2012 and 2011, certain loans and lease modifications were executed which constituted troubled debt restructurings. Substantially all of these modifications included one or a combination of the following: an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; temporary reduction in the interest rate; change in scheduled payment amount; permanent reduction of the principal of the loan; or an extension of additional credit for payment of delinquent real estate taxes.
The following table summarizes troubled debt restructurings that occurred during the periods indicated (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The troubled debt restructurings described above required a net allocation of the allowance for credit losses of $61,000 and $1.1 million at December 31, 2012 and 2011, respectively. Charge-offs of $1.5 million and $1.1 million were recorded on loans and leases modified during 2012 and 2011, respectively.
The following table summarizes the troubled debt restructurings for which there was a payment default within 12 months following the date of the restructuring for the periods indicated (in thousands):
Loans and leases are considered to be in payment default once it is greater than 30 days contractually past due under the modified terms. The troubled debt restructurings described above that subsequently defaulted resulted in a net allocation of the allowance for credit losses of $0 and $1.1 million at December 31, 2012 and 2011, respectively. Charge-offs of $1.5 million and $1.1 million were recorded on defaulted troubled debt restructurings during 2012 and 2011, respectively.
Credit Quality Indicators
Alliance establishes a risk rating at origination for commercial loan, commercial real estate and commercial lease relationships over $250,000 based on relevant information about the ability of the borrowers to service their debt such as current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. Commercial relationship managers monitor the loans and leases in their portfolios on an ongoing basis for any changes in the borrower’s ability to service their debt and affirm the risk ratings for the loans and leases in their respective portfolios on a quarterly basis.
Alliance uses the risk rating system to identify criticized and classified loans and leases. Commercial relationships within the criticized and classified risk ratings are analyzed quarterly. Alliance uses the following definitions for criticized and classified loans and leases which are consistent with regulatory guidelines:
Special Mention
A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the institution’s credit position at some future date.
Substandard
A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.
Doubtful
A loan classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Loss
Loans classified as Loss are considered non-collectable and of such little value that their continuance as bankable assets are not warranted.
Loans and leases not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans and leases. Commercial loans and leases listed as not rated are credits less than $250,000. In some instances, the commercial loans and lease portfolios were further segmented from their risk grade categories into groups of homogeneous pools based on similar risk and loss characteristics.
As of December 31, 2012 and 2011, based on the most recent analysis performed, the recorded investment by risk category and class of loans and leases is as follows (in thousands):
For residential real estate and consumer loan classes, Alliance evaluates credit quality primarily based upon the aging status of the loan, which was previously presented, and by payment activity.
The following table presents the recorded investment in residential real estate and consumer loans based on payment activity at the dates indicated (in thousands):
4. Premises and Equipment
Bank premises, furniture and equipment at December 31, 2012 and 2011 consist of the following (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
At December 31, 2012 and 2011, furniture and equipment included $860,000 and $1.0 million, respectively, in equipment leased to others under operating leases. The related accumulated depreciation was $699,000 and $720,000 at December 31, 2012 and 2011, respectively. Depreciation expense on equipment leased to others totaled $120,000, $182,000, and $212,000 in 2012, 2011 and 2010, respectively.
At December 31, 2012, the minimum future lease payments to be received from equipment leased to others were $117,000 in 2013.
5. Goodwill and Other Intangible Assets
The carrying value of goodwill was $30.8 million at December 31, 2012 and 2011. No goodwill impairment adjustments were recognized in 2012 or 2011. The following table summarizes Alliance’s intangible assets that are subject to amortization (in thousands):
Amortization expense for intangible assets for the next five years is estimated as follows (in thousands):
6. Deposits
Deposits consisted of the following at December 31 (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The following table indicates the maturities of Alliance’s time deposits at December 31 (in thousands):
Total time deposits in excess of $100,000 as of December 31, 2012 and 2011 were $100.9 million and $123.4 million, respectively. Time deposits include $10.0 million and $42.8 million in accounts acquired through third party brokers at December 31, 2012 and 2011.
7. Borrowings
The following is a summary of borrowings outstanding at December 31 (in thousands):
The following table sets forth certain information with respect to the overnight lines of credit, federal funds purchased and short term repurchase agreements (dollars in thousands):
As of the dates indicated, the contractual amounts of FHLB long term advances mature as follows (dollars in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
As of the dates indicated, the contractual amounts of long-term repurchase agreements mature as follows (in thousands):
In June 2012, we restructured $50.0 million of FHLB advances. The restructurings resulted in prepayment penalties of $2.1 million which are being amortized as an adjustment to interest expense over the remaining term of the restructured debt in accordance with U.S. generally accepted accounting principles. The restructuring had the effect of extending the maturities of the restructured borrowings by 3.3 years lowering the annual average effective cost by 148 basis points.
Alliance has access to various credit facilities through the FHLB, including an overnight line of credit, a one-month line of credit, and a Term Advance Program, under which it can borrow at various terms and interest rates. All of the credit facilities are subject to meeting certain ongoing collateral requirements of the FHLB. In addition to pledging securities, Alliance has also pledged, under a blanket collateral agreement, certain residential mortgage loans with balances at December 31, 2012 of $301.7 million. At December 31, 2012, Alliance had borrowed $80.0 million against the pledged mortgages. At December 31, 2012, Alliance had $221.6 million available under its various credit facilities with the FHLB.
Alliance had a $164.3 million line of credit with no outstanding balance at December 31, 2012 with the Federal Reserve Bank of New York through its Discount Window. Alliance has pledged indirect loans and securities totaling $160.1 million and $4.2 million, respectively, at December 31, 2012. At December 31, 2012, Alliance also had available $62.5 million of federal funds lines of credit with other financial institutions, none of which was in use at December 31, 2012.
Alliance offers retail repurchase agreements primarily to certain business customers. Under the terms of the agreement, Alliance sells investment portfolio securities to such customers agreeing to repurchase the securities on the next business day. Alliance views the borrowing as a deposit alternative for its business customers. On December 31, 2012, Alliance had securities with a market value of $22.1 million pledged as collateral for these agreements. Alliance also has agreements with the FHLB and Bank approved brokers to sell securities under agreements to repurchase. At December 31, 2012, securities with a market value of $20.0 million were pledged against repurchase agreements in the amount of $20.0 million. All of these repurchase agreements at December 31, 2012 were transacted with the FHLB.
8. Junior Subordinated Obligations
In December 2003, Alliance formed a wholly-owned subsidiary, Alliance Financial Capital Trust I, a Delaware business trust (“Capital Trust I”). Capital Trust I issued $10.0 million of 30-year floating rate Company-obligated pooled capital securities. Alliance borrowed the proceeds of the capital securities from its subsidiary by issuing floating rate junior subordinated deferrable interest debentures having substantially similar terms. The capital securities mature in 2034, but may be redeemed at Alliance’s option on predetermined dates with the first redemption date at par in five years. The capital securities of the trust are a pooled trust preferred fund of ALESCO Preferred Funding II, Ltd., and interest rates on the securities adjust quarterly based on the 3-month LIBOR plus 2.85% (3.16% at December 31, 2012). Alliance guarantees all of the securities.
In September 2006, Alliance formed a wholly-owned subsidiary, Alliance Financial Capital Trust II, a Delaware business trust (“Capital Trust II”). Capital Trust II issued $15.0 million of 30-year floating rate company-obligated pooled capital securities. Alliance borrowed the proceeds of the capital securities from its subsidiary by issuing floating rate junior subordinated deferrable interest debentures having substantially similar terms. The capital securities mature in 2036, but may be redeemed at Alliance’s option on predetermined dates with the first redemption date at par in five years. The capital securities of the trust are a pooled trust preferred fund of Preferred Term Securities XXIV, Ltd., and interest rates on the securities adjust quarterly based on the 3-month LIBOR plus 1.65% (1.96% at December 31, 2012). Alliance guarantees all of the securities.
Alliance had a $310,000 investment in Capital Trust I at December 31, 2012 and 2011 and a $464,000 investment in Capital Trust II at December 31, 2012 and 2011.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The Capital Trusts are variable interest entities (“VIE’s”). Alliance is not the primary beneficiary of the VIE’s and as such they are not consolidated in Alliance’s financial statements in accordance with accounting guidance. Liabilities owed to the Capital Trusts, totaling $25.8 million, were reflected as liabilities in the consolidated balance sheets at December 31, 2012 and 2011, respectively.
9. Earnings Per Common Share
Alliance has granted stock compensation awards with non-forfeitable dividend rights which are considered participating securities. As such, earnings per share is computed using the two-class method as required by Accounting Standard Codification (“ASC”) 206-10-45. Basic earnings per common share is computed by dividing net income allocated to common stock by the weighted average number of common shares outstanding during the period which excludes the participating securities. Diluted earnings per common share includes the dilutive effect of additional potential common shares from stock compensation awards and warrants, but excludes awards considered participating securities.
Basic and diluted net income per common share calculations for the years ended December 31 are as follows (in thousands, except share and per share amounts):
Dividends of $100,000, $95,000 and $63,000 for the years ended December 31, 2012, 2011 and 2010, respectively, were paid on unvested shares with non-forfeitable dividend rights. There were no anti-dilutive stock options for the periods presented.
10. Income Taxes
The provision for income taxes for the years ended December 31 is summarized as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
A reconciliation between the statutory federal income tax rate and the effective income tax rate for the years indicated is as follows:
The components of deferred income taxes, included in other assets, at December 31, are as follows (in thousands):
Realization of deferred tax assets is dependent upon the generation of future taxable income or the existence of sufficient taxable income. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, management considers the scheduled reversal of the deferred tax liabilities, the level of historical taxable income, and the projected future taxable income over the periods in which the temporary differences comprising the deferred tax assets will be deductible. Based on its assessment, management determined that no valuation allowance is necessary.
At December 31, 2012 and 2011, Alliance did not have any unrecognized tax benefits.
A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest and the federal income tax benefit of unrecognized state tax benefits) is as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Alliance accounts for interest and penalties related to uncertain tax positions as part of its provision for federal and state income taxes. We do not expect the amount of unrecognized tax benefits to significantly increase in the next twelve months.
Alliance or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. Alliance is no longer subject to U.S. federal examination for tax years prior to 2009 and state examination for tax years prior to 2010.
11. Accumulated Other Comprehensive Income
A summary of activity in other comprehensive income, at December 31, is as follows (in thousands):
A summary of activity in accumulated other comprehensive income, at December 31, is as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
12. Employee and Director Benefit Plans
Defined Contribution Plan
Alliance provides retirement benefits through a defined contribution 401(k) plan that covers substantially all of its employees. Participants in the 401(k) plan may contribute from 1% of their compensation up to certain annual limitations imposed by the Internal Revenue Service. Alliance matches $0.50 for each $1.00 contributed up to 6% of the participant’s eligible compensation. Participants meeting certain eligibility requirements will receive an employer contribution equal to 1% of their annual eligible compensation. Company contributions to the plan were $614,000, $492,000 and $505,000 in 2012, 2011 and 2010, respectively.
Defined Benefit Plan and Post-Retirement Benefits
Alliance has a noncontributory defined benefit pension plan (“Pension Plan”) which it assumed from its acquisition of Bridge Street Financial, Inc. The Pension Plan covers substantially all former Bridge Street full-time employees who met eligibility requirements on October 6, 2006, at which time all benefits were frozen. Under the Pension Plan, retirement benefits are primarily a function of both the years of service and the level of compensation. The amount contributed to the Pension Plan is determined annually on the basis of (a) the maximum amount that can be deducted for federal income tax purposes, or (b) the amount certified by an actuary as necessary to avoid an accumulated funding deficiency as defined by the Employee Retirement Income Security Act of 1974.
Alliance provides post-retirement medical and life insurance benefits (“Post-Retirement Plan”) to certain retirees who met plan eligibility requirements and their respective spouses.
The following table represents a reconciliation of the change in the benefit obligation, plan assets and funded status of the Pension Plan and Post-Retirement Plan at December 31 (using a measurement date of December 31) (in thousands):
Pre-tax amounts recognized in accumulated other comprehensive income at December 31 that has not been recognized as components of net periodic benefit or cost consist of (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The composition of the plan’s net periodic cost for the years ended December 31 is as follows (in thousands):
The estimated prior service benefit for the Post-Retirement Plan that is expected to be amortized from accumulated other comprehensive income into net periodic benefit over the next fiscal year is $44,000. The estimated unrecognized actuarial loss for the Pension Plan and Post-Retirement Plan that is expected to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year is $244,000 and $19,000, respectively.
The following weighted average assumptions were used to determine benefit obligations for these plans:
The discount rates used in determining the benefit obligations for the Pension Plan and Post-Retirement Plan as of December 31, 2012, 2011 and 2010 were based upon the Citibank pension liability index. The Citibank pension liability index was determined to appropriately reflect the rate at which the Pension Plan and Post-Retirement Plan obligations could be effectively settled, based upon the expected duration of each plan.
The Pension Plan’s weighted-average asset allocations by asset category at December 31 are as follows:
Plan assets are invested in diversified investment funds of the RSI Retirement Trust, a private placement investment fund. The investment funds include a series of equity and bond mutual funds or comingled trust funds, each with its own investment objectives, investment strategies and risks, as detailed in the Trust’s Statement of Investment Objectives and Guidelines. The RSI Retirement Trust has been given discretion by the Plan Sponsor to determine the appropriate strategic asset allocation versus plan liabilities, as governed by the RSI Retirement Trust’s Statement of Investment Objectives and Guidelines (the “Guidelines”).
The long-term investment objectives are to maintain plan assets at a level that will sufficiently cover long-term obligations and to generate a return on plan assets that will meet or exceed the rate at which long-term obligations will grow. A broadly diversified combination of equity and fixed income portfolios and various risk management techniques are used to help achieve these objectives.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The investment goal is to achieve investment results that will contribute to the proper funding of the pension plan by exceeding the rate of inflation over the long-term. In addition, RSI Retirement Trust’s actively managed portfolios are expected to provide above-average performance when compared to their peers, while the passively managed portfolios are expected to provide performance in line with the appropriate index. Performance volatility is also monitored. Risk/volatility is further managed by the distinct investment objectives of each of the RSI Retirement Trust funds and the diversification within each fund.
Prior to October 1, 2011, the plan’s targeted asset allocation structure was for an allocation of 65% to equities and 35% to fixed-income securities. Effective October 1, 2011, the Trustees established a framework to eventually transition the investment policy to a Liability Driven Investment approach, with a higher weighting of long-duration fixed income securities. To date, market conditions have not been deemed favorable enough to start in this transition.
Determination of Long-Term Rate-of-Return
The long-term rate-of-return-on-assets assumption was set based on historical returns earned by equities and fixed income securities, adjusted to reflect expectations of future returns as applied to the plan’s target allocation of asset classes. Equities and fixed income securities were assumed to earn real rates of return in the ranges of 5-9% and 2-6%, respectively. The long- term inflation rate was estimated to be 3%. When these overall return expectations are applied to the plan’s target allocation, the result is an expected rate of return of 7% to 11%.
Fair Value of Pension Plan Assets
Fair value is the exchange price that would be received for an asset in the principal or most advantageous market for the asset in an orderly transaction between market participants on the measurement date.
Alliance used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Equity, Debt, Investment Funds and Other Securities
The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). At December 31, 2012, there are no Level 3 investment securities in the Pension Plan.
The fair value of the Plan assets at December 31, 2012, by asset category, is as follows (in thousands):
The fair value of the Plan assets at December 31, 2011, by asset category, is as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(1) This category consists of investments whose sector and industry exposures are maintained within a narrow band around Russell 1000 index. The portfolio holds approximately 150 stocks.
(2) This category contains stocks whose sector weightings are maintained within a narrow band around those of the Russell 2000 Index. The portfolio will typically hold more than 150 stocks.
(3) This category consists of a mutual fund that seeks fast growing large cap companies with suitable franchises and positive price momentum. The portfolio holds 60 to 90 stocks.
(4) This category has investments in medium to large non-US companies, including high quality, durable growth companies and companies based in countries with stable economic and political systems.
(5) This fund tracks the performance of the S&P 500 Index by purchasing the securities represented in the Index in approximately the same weightings as the Index.
(6) This category contains large-cap stocks with above-average yield. The portfolio typically holds between 60 and 70 stocks.
(7) This category consists of a portfolio of between 35 and 55 stocks of fast-growing, predictable and cyclical large cap growth companies.
(8) This category consists of an index fund that tracks the Barclays Capital U.S. Aggregate Bond Index. The fund invests in Treasury, agency, corporate, mortgage-backed and asset-backed securities.
(9) This category consists of a portfolio of between 45 and 65 stocks that will typically overweight technology and health care.
(10) This category consists of a broadly diversified portfolio of non-U.S. domiciled stocks. The portfolio will typically hold more than 200 stocks, with 0-35% invested in emerging markets securities.
Alliance’s estimated contribution to the Pension Plan for 2013 is $104,000.
For measurement purposes, with respect to the Post-Retirement Plan, a 9.0% annual rate of increase in the per capita cost of covered health care benefits is assumed for 2013. The rate is assumed to decrease gradually to 4.5% by the year 2017 and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans. A one percentage point change in assumed health care cost trend rates would have the following effects on the Post-Retirement Plan (in thousands):
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid from the Pension Plan (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The following healthcare benefits are expected to be paid under the Post-Retirement Plan (in thousands):
The above benefit payments include expected life insurance claims, rather than the premiums that Alliance is paying to provide the life insurance.
Directors Retirement Plan
Alliance has a noncontributory defined benefit plan for non-employee directors (the “Directors Plan”). The Directors Plan provides for a normal retirement cash benefit equivalent to 35% of their average annual director’s fees, subject to increases based on the directors’ length and extent of service, payable in a number of circumstances, including normal retirement, death or disability and a change in control. Upon termination of service, the normal retirement benefit is payable in a lump sum or in ten equal installments.
The following table represents a reconciliation of the change in the benefit obligations, plan assets and funded status of the Directors Plan at December 31 (in thousands):
Pre-tax amounts recognized in accumulated other comprehensive income at December 31 that have not been recognized as components of net periodic benefit or cost consist of (in thousands):
The composition of the Directors Plan’s net periodic cost for the year ended December 31 is as follows (in thousands):
The following weighted average assumptions were used to determine benefit obligations for the Directors’ Plans:
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The discount rate used to determine benefit obligations for the Directors Plan was based upon the Citibank pension liability index. The Citibank pension liability index was determined to appropriately reflect the rate at which the pension liabilities could be effectively settled based upon the expected duration of the Directors Plan. Directors’ fees were assumed to increase at an annual rate of 3.00%.
The following directors’ retirement benefit payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands):
In 2013, $46,000 in unrecognized prior service costs and $114,000 in unrecognized actuarial losses are estimated to be amortized from accumulated other comprehensive income into the net periodic cost for the Directors’ Plan.
Supplemental Executive Retirement Plans
Alliance has supplemental executive retirement plans (“SERP”) for certain current and former employees. Included in other assets, Alliance had segregated assets of $102,000 and $127,000 at December 31, 2012 and 2011, respectively, to fund the estimated benefit obligation associated with certain SERP plans.
The following table represents a reconciliation of the change in the benefit obligations, plan assets and funded status of the SERP’s at December 31 (in thousands):
Pre-tax amounts recognized in accumulated other comprehensive income at December 31, 2012 and 2011 that has not been recognized as components of net periodic benefit or cost consist of (in thousands):
The composition of the SERP’s net periodic cost for the years ended December 31 is as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Alliance amortizes unrecognized gain or losses and prior service costs in the SERP’s on a straight line basis over the future working lifetime of the participant expected to receive benefits under the plan. In the year of a participant’s retirement, any unrecognized gains or losses and prior service costs are fully recognized. Future unrecognized gains or losses arising after retirement are amortized over the participant’s remaining life expectancy.
The following weighted average assumptions were used to determine benefit obligations and net period cost for the years ended December 31:
The discount rate used to determine benefit obligations for the plans was based upon the Citibank pension liability index. The Citibank pension liability index, less an adjustment of 10 basis points, was determined to appropriately reflect the rate at which the pension liabilities could be effectively settled based upon the expected duration of the plans. Salaries were assumed to increase at an annual rate of 4.0% in 2012, 2011 and 2010.
The following SERP payments, which reflect expected future service, as appropriate, are expected to be paid (in thousands):
In 2013, $22,000 in unrecognized prior service costs and $43,000 in unrecognized actuarial losses are estimated to be amortized from accumulated other comprehensive income into the net periodic cost for the SERP’s.
Alliance assumed a SERP for directors from Bridge Street, providing for extended compensation after retirement. Alliance owns life insurance policies on these individuals to provide for the estimated benefit obligations for the SRP. Cash surrender value of these policies approximated $2.7 million and $2.6 million, respectively, at December 31, 2012 and 2011. At December 31, 2012 and 2011 other liabilities include approximately $657,000 and $649,000, respectively, accrued under the directors’ SERP from Bridge Street. Deferred compensation expense related to the SRP from Bridge Street for the year ended December 31, 2012, 2011 and 2010 approximated $102,000, $77,000 and $64,000, respectively.
13. Directors’ Deferred Compensation
Alliance has a stock-based deferral plan which provides directors and officers designated by the Board of Directors the opportunity to defer receipt of cash compensation and, thereby, accumulate additional shares of Alliance’s common stock. Only directors are deferring compensation under this plan. Alliance contributes the amount of compensation deferred to a trust, which purchases shares of Alliance’s common stock, and distributions are made in shares of Alliance’s common stock upon such events as are elected by participants. Dividends paid on shares are also converted to common stock. At December 31, 2012 and 2011, there were 148,083 and 134,260 shares held in trust with a cost basis of $3.9 million and $3.4 million, respectively.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Alliance maintained an optional deferred compensation plan for its directors, whereby fees normally received were deferred and paid by Alliance upon the retirement of the director. In March 2008, active directors transferred their plan balances into the stock-based deferred compensation plan and the remaining liability consists of the retired directors balances. At December 31, 2012 and 2011, other liabilities included approximately $257,000 and $324,000, respectively, relating to deferred compensation. Deferred compensation expense resulting from the earnings on deferred balances for the years ended December 31, 2012, 2011 and 2010 approximated $1,000, $2,000 and $5,000, respectively.
Alliance assumed a nonqualified deferred compensation plan for former directors of Bridge Street, under which participants were eligible to elect to defer all or part of their annual director fees. The plan provides that deferred fees are to be invested in mutual funds, as selected by the individual directors. Deferrals under the plan were discontinued effective with the acquisition of Bridge Street. At December 31, 2012 and 2011, deferred director fees included in other liabilities, and the corresponding assets included in other assets, aggregated approximately $259,000 and $275,000, respectively.
14. Stock Based Compensation Plans
The 2010 Restricted Stock Plan (“2010 Plan”) was approved by shareholders in May of 2010 authorizing 200,000 shares of authorized but unissued common stock of Alliance. The purpose of the 2010 Plan is to promote the growth and profitability of Alliance and to provide eligible directors, certain key officers and employees of Alliance with an incentive to achieve corporate objectives, to attract and retain directors, key officers and employees of outstanding competence and to provide such directors, officers and employees with an equity interest in Alliance. Awards granted under this plan vest ratably over a five year period. In 2012 and 2011, 18,465 and 17,839 restricted shares were granted, respectively, to certain key officers under this plan.
Alliance also has a long-term incentive compensation plan (the “1998 Plan”) authorizing 550,000 shares of authorized but unissued common stock of Alliance. Pursuant to the 1998 Plan, eligible individuals received incentive stock options, non-qualified stock options, and/or restricted stock awards. The 1998 Plan expired in 2009 and no further awards will be granted from this Plan.
Restricted shares granted under the 1998 Plan vest at the end of a 7-year period. Furthermore, 50% of the shares awarded to all grantees except Alliance’s Chief Executive Officer, become vested on the date at least three years after the award date that Alliance’s stock price has closed at a price that is at least 160% of the award price for 15 consecutive days.
In 2009, Alliance’s Board of Directors approved a modification of the vesting schedule of restricted stock awards granted to all participating employees under the 1998 Plan. The modification provided for the immediate vesting of all restricted shares which would have vested as of November 24, 2009 had the original cliff-vesting schedule instead been a pro-rata vesting schedule over the same seven year period. The modification did not change the seven year cliff-vesting schedule for the remaining unvested shares held by plan participants.
Restricted stock awards are recorded as deferred compensation, a component of shareholders’ equity, at fair value at the date of the grant and amortized to compensation expense over the specified vesting periods.
Compensation expense associated with the amortization of the cost of all restricted shares issued for the years ended December 31, 2012, 2011 and 2010 was $512,000, $456,000, and $357,000, respectively. The fair value of the vested restricted shares was $477,000 in 2012. The unrecognized compensation cost for restricted stock awards was $1.4 million at December 31, 2012, which will be recognized as compensation expense over a weighted average period of 2.6 years.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The following is a summary of Alliance’s restricted stock activity for the year ended December 31, 2012:
There were no options outstanding at December 31, 2012. No options were granted during 2012, 2011 and 2010.
15. Commitments and Contingent Liabilities
Alliance is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and letters of credit which involve, to varying degrees, elements of credit risk in excess of amounts recognized in the consolidated statements of condition. The contract amount of those commitments and letters of credit reflects the extent of involvement Alliance has in those particular classes of financial instruments. Alliance’s exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of the instruments. Alliance uses the same credit policies in making commitments and letters of credit as it does for on-balance-sheet instruments.
Financial instruments whose contract amounts represent credit risk (in thousands):
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payments of a fee. Since some of the commitment amounts are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit written are conditional commitments issued by Alliance to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. Since the letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. For both commitments to extend credit and standby letters of credit, the amount of collateral obtained, if deemed necessary by Alliance upon the extension of credit, is based on management’s credit evaluation of the counterparty.
Alliance leases office space and certain branches under noncancelable operating lease agreements having initial terms expiring at various dates through 2025. Total rental expense was approximately $1.2 million in 2012, 2011 and 2010.
Minimum rental payments under the initial terms of these leases are summarized as follows (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The Bank entered into an agreement in 2005 with Onondaga County whereby the Bank obtained the naming rights to a sports stadium in Syracuse, NY for a 20-year term. Under the agreement, the Bank paid $152,000 in 2012, 2011 and 2010, and will pay $152,000 annually from 2013 through 2024.
Alliance is required to maintain a reserve balance as established by the Federal Reserve Bank of New York. The required average total reserve for the 14-day maintenance period ended December 31, 2012 was $600,000.
Alliance is subject to ordinary routine litigation incidental to its business in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability arising out of litigation pending or threatened against the Company will be material to its consolidated financial statements. On an on-going basis Alliance assesses its liabilities and contingencies in connection with such legal proceedings. For those matters where it is probable that Alliance will incur losses and the amounts of the losses can be reasonably estimated, the Company recognizes an expense and corresponding liability in its consolidated financial statements. When those conditions of probable and estimable are not met but it is reasonably possible that Alliance will incur a loss, it is required to disclose the existence of such litigation. Reasonably possible is defined as the chance of a future event occurring is more than remote but less than probable. Alliance has a current pending legal matter related to a commercial loan relationship that the chance of Alliance incurring a loss is reasonably possible. The range of reasonably possible loss for this matter was between $0 and $1 million as of December 31, 2012.
In connection with the pending merger with NBT, three plaintiffs filed purported class action lawsuits against Alliance, Alliance’s directors and NBT. All three purported class actions were brought in the Supreme Court of the State of New York, in the County of Onondaga, or the Court, and are captioned Oughterson v. Alliance Financial Corporation, et al. (No. 2012EF73, filed October 11, 2012), Stanard v. Alliance Financial Corporation, et al. (No. 2012EF75, filed October 22, 2012) and The Wire Family Trust of 1997 v. Alliance Financial Corporation et al. (No. 2012-5950, filed November 1, 2012). By Order dated December 10, 2012, the three cases were consolidated by the Court into a single action. The lawsuits allege that the Alliance directors breached their fiduciary duties to Alliance’s shareholders by seeking to sell Alliance through an allegedly unfair process and for an unfair price and on unfair terms, by soliciting shareholder approval of the proposed transaction through a Form S-4 that was alleged to be materially misleading, and that Alliance and NBT aided and abetted that breach. The lawsuits seek, among other things, equitable relief that would enjoin the merger, damages, and attorneys’ fees and costs. The plaintiffs also seek rescission of the merger (to the extent it has already been completed at the time that the court grants any relief). The parties have reached an agreement in principle to settle these cases and entered into a memorandum of understanding on January 15, 2013. As part of this memorandum of understanding, NBT and Alliance agreed to disclose additional information in the joint proxy statement/prospectus on Form S-4 with NBT, including information about matters discussed between the parties during the process of negotiating the merger, as well as information about the data that was analyzed and presented to the Alliance Board of Directors by its financial advisor. No substantive terms of the merger agreement will be modified as part of this settlement. The settlement is subject to review and approval by the Court. The range of reasonably possible loss for this matter related to litigation costs was between $300,000 and $500,000 as of December 31, 2012. Alliance has insurance coverage that limits our liability to $75,000.
The ASC Topic on Asset Retirement Obligations refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of Alliance. Alliance is required to recognize a liability for the fair value of a conditional asset retirement obligation when it is incurred, generally upon acquisition, construction, or development and (or) through the normal operation of the asset, and if the fair value of the liability can be reasonably estimated. The guidance acknowledges that in some cases sufficient information may not be available to reasonably estimate the fair value of an asset retirement obligation. Alliance acknowledges that some of its facilities were constructed years ago when asbestos was used for insulation and other construction purposes. Of our current 29 branches, 9 are estimated to have been constructed when some use of asbestos was common. Regulations are now in place that require Alliance to handle and dispose of asbestos in a special manner if major renovations or demolition of a facility are to be completed. Alliance does not believe that it has sufficient information to estimate the fair value of the obligation at this time since no major renovations or demolition of any of its facilities have been planned and if undertaken, would occur at an unknown future date. Accordingly, Alliance has not recognized a liability or a contingent liability in connection with potential future costs to remove and dispose of asbestos from its facilities.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
16. Dividends and Restrictions
The primary source of cash to pay dividends to Alliance’s shareholders is through dividends from its banking subsidiary. The FRB and the Office of the Comptroller of the Currency are authorized to determine certain circumstances that the payment of dividends would be an unsafe or unsound practice and to prohibit payment of such dividends. The payment of dividends that deplete a bank’s capital base could be deemed to constitute such an unsafe or unsound practice. Banking organizations may generally only pay dividends from the combined current year and prior two years’ net income less any dividends previously paid during that period. At December 31, 2012, approximately $21.4 million was available for the declaration of dividends by the Bank. There were no loans or advances from the Bank to Alliance at December 31, 2012.
Under the Merger Agreement, Alliance has agreed that, until the effective time of the merger or the termination of the Merger Agreement, Alliance and its subsidiaries will not, except as expressly permitted by the Merger Agreement or with the prior written consent of NBT (which consent NBT will not unreasonably withhold) declare or pay any dividend or other distribution on its capital stock other than: (a) dividends paid by wholly owned subsidiaries to Alliance or any other wholly owned subsidiary of Alliance; or (b) regular quarterly cash dividends not to exceed the rate paid during the fiscal quarter immediately preceding the date of the merger agreement.
17. Fair Value Measurements
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
Assets Measured on a Recurring Basis
The fair values of debt securities available-for-sale are determined by obtaining matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2). The fair value of mutual fund securities available-for-sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available (Level 1). There were no transfers between Level 1 and Level 2 during 2012 or 2011.
Assets measured at fair value on a recurring basis are summarized below (in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Assets Measured on a Non-Recurring Basis
Impaired loans and leases - Loans and leases are generally not recorded at fair value on a recurring basis. Periodically, Alliance records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans calculated when establishing the allowance for credit losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated valuation amount does not necessarily represent the fair value of the loan. Real estate collateral is typically valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace. These valuations are adjusted based on non-observable inputs and the related nonrecurring fair value measurement adjustments have generally been classified as Level 3. Estimates of fair value used for other collateral supporting commercial loans generally are based on assumptions not observable in the marketplace and, therefore, such valuations have been classified as Level 3. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Foreclosed real estate owned - assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals which are updated no less frequently than annually. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Foreclosed real estate owned properties are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Appraisals for both collateral-dependent impaired loans and real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Alliance. Once received, a member of the Managed Assets Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
statistics. A discount may be applied to an appraised value to arrive at fair value based on management’s knowledge of the market conditions and individual circumstances of the property being evaluated. For residential property appraisals, we compare the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value. The most recent analysis performed indicated that a discount of 20% should be applied to properties appraised values to arrive at fair value.
Assets measured at fair value on a non-recurring basis by fair value measurement used are summarized below (in thousands):
Changes in fair value recognized for partial charge-offs of loans and leases and impairment reserves on loans and leases were $224,000, $3.3 million and $1.6 million during 2012, 2011 and 2010, respectively. The fair value of one commercial impaired loan is measured using equipment and inventory collateral values from customer prepared interim financial statements that management discounted 40% and 70% for the equipment and inventory, respectively. The fair value of foreclosed real estate owned was measured based upon the average of a real estate appraisal and a broker listing for the commercial property using a sales comparison approach. Unobservable inputs adjustments by the appraiser for differences between the comparable sales ranging from 5% to 20%.
The carrying amounts and estimated fair values of financial instruments at December 31, 2012 are as follows (in thousands):
(1) includes impaired loans and leases
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
The carrying amounts and estimated fair values of financial instruments at December 31, 2011 are as follows (in thousands):
(1) includes impaired loans and leases
The fair value of commitments to extend credit and standby letters of credit is not significant.
Alliance’s fair value estimates are based on our existing on and off balance sheet financial instruments without attempting to estimate the value of any anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on our fair value estimates and have not been considered in these estimates.
The fair value estimates are made as of a specific point in time, based on relevant market information and information about the financial instruments, including our judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in our assumptions could significantly affect the estimates.
The following methods and assumptions were used by Alliance in estimating its fair value disclosures for financial instruments:
Cash and Cash Equivalents
The carrying amounts reported in the consolidated balance sheet for cash and short-term instruments approximate those assets’ fair value and are classified as Level 1.
FHLB and FRB Stock
It is not practicable to determine the fair value of FHLB and FRB stock due to restrictions placed on its transferability.
Loans and Leases
The fair value of our fixed-rate and adjustable-rate loans and leases were calculated by discounting scheduled cash flows through the estimated maturity using current origination rates, credit adjusted for delinquent loans and leases resulting in a Level 3 classification. Our estimate of maturity is based on the contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. The fair value of loans held for sale approximates carrying value resulting in a Level 2 classification.
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Accrued Interest Receivable
The fair value of accrued interest approximates carrying value. The fair value level classification is consistent with the related financial instrument.
Deposits
The fair values disclosed for non-interest-bearing accounts and accounts with no stated maturity are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The fair value of time deposits was estimated by discounting expected monthly maturities at interest rates approximating those currently being offered at the FHLB on similar terms resulting in a Level 2 classification.
Borrowings
The fair value of borrowings are estimated using discounted cash flow analysis, based on interest rates approximating those currently being offered for borrowings with similar terms resulting in a Level 2 classification.
Junior Subordinated Obligations
The fair value of trust preferred debentures has been estimated using a discounted cash flow analysis to maturity resulting in a Level 3 classification.
Accrued Interest Payable
The fair value of accrued interest approximates carrying value. The fair value level classification is consistent with the related financial instrument.
Off-Balance-Sheet Instruments
Off-balance-sheet financial instruments consist of commitments to extend credit and standby letters of credit, with fair value based on fees currently charged to enter into agreements with similar terms and credit quality. Amounts are not significant.
18. Capital and Regulatory Matters
Capital Requirements
Alliance and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by regulators that, if undertaken, could have a direct material effect on Alliance’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Alliance and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Alliance’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require Alliance and the Bank to maintain minimum amounts and ratios, as defined in the regulations, of total risk-based capital and Tier 1 capital to risk-weighted assets. The leverage ratio reflects Tier 1 capital divided by the average total assets for the period. Average assets used in the calculation exclude Alliance’s intangible assets.
The capital levels at the Bank are maintained at or above the well-capitalized minimums of 10%, 6% and 5% for the total risk-based, Tier 1 capital, and leverage ratio, respectively. As of December 31, 2012, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as “well-capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category.
Alliance’s and the Bank’s regulatory capital measures are presented in the following table (dollars in thousands):
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
19. Parent Company Financial Information
Condensed financial statement information of Alliance Financial Corporation for the years ended December 31 is as follows (in thousands):
Condensed Balance Sheets
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
Condensed Statements of Income
Condensed Statements of Cash Flows
Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements
EXHIBIT INDEX
 Filed herewith
* Management contract or compensatory plan or arrangement
** Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.