- ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------- FORM 10-K (Mark One) [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (Fee Required) For the Fiscal Year Ended December 31, 1999 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (No Fee Required) for the transition period from to Commission File Number 0-7974 CHITTENDEN CORPORATION (Exact name of Registrant as specified in its charter) Vermont 03-0228404 (State of Incorporation) (IRS Employer Identification No.) Two Burlington Square Burlington, Vermont 05401 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number: 802-658-4000 Securities registered pursuant to Section 12(b) of the Act: $1.00 Par Value Common Stock (Title of Class) Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the registrant: (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the Registrant's common stock held by non- affiliates of the Registrant, computed by reference to the last reported sale price on the NYSE on February 29, 2000 was $722,204,508. At February 29, 2000 there were 28,391,332 shares of the Registrant's common stock issued and outstanding. DOCUMENTS INCORPORATED BY REFERENCE The following documents, in whole or in part, are specifically incorporated by reference in the indicated Part of this Annual Report on Form 10-K: 1. Joint Proxy Statement/Prospectus for 1999 Annual Meeting of Registrant's Stockholders: Part III, Items 10, 11, 12, 13. This Form 10-K contains certain statements that may be considered forward- looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Company's actual results could differ materially from those projected in the forward-looking statements as a result of, among other factors, changes in general, national or regional economic conditions, changes in loan default and charge-off rates, reductions in deposit levels necessitating increased borrowing to fund loans and investments, changes in interest rates, changes in levels of income and expense in noninterest income and expense related activities, and changes in the assumptions used in making such forward-looking statements. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PART I ITEM 1 BUSINESS Chittenden Corporation (the "Company" or "CC"), a Vermont corporation organized in 1971, is a registered bank holding company under the Bank Holding Company Act of 1956, as amended. At December 31, 1999, the Company had total consolidated assets of approximately $3.8 billion. The Company is the holding company parent and owns 100% of the outstanding common stock of Chittenden Trust Company ("CTC"), Flagship Bank and Trust Company ("FBT"), The Bank of Western Massachusetts ("BWM"), Vermont National Bank ("VNB") (collectively "The Banks") and Chittenden Connecticut Corporation ("CCC"), a non-bank mortgage company. On May 28, 1999, Chittenden Corporation completed its acquisition of Vermont Financial Services Corp. ("VFSC") in a stock-for-stock merger. The acquisition has been accounted for as a pooling of interests and accordingly, all financial data has been restated to reflect the combined financial condition and results of operations as if the acquisition had been in effect for all periods presented. Acquired in the VFSC acquisition were its subsidiary banks: Vermont National Bank and United Bank. United Bank merged into The Bank of Western Massachusetts in the third quarter of 1999. Under the agreement, VFSC shareholders received 1.07 shares of Chittenden Corporation common stock for each share of VFSC stock. Total shares outstanding of Chittenden Corporation common stock increased by approximately 14 million shares as a result of the acquisition. Based on the closing price of Chittenden stock as of May 28, 1999, the market value of the shares exchanged totaled $387.2 million. The Company engages in one line of business, that of providing financial services through its banking subsidiaries. Through its subsidiaries, the Company offers a variety of lending services, with loans and leases totaling approximately $2.9 billion at December 31, 1999. The largest loan categories are commercial loans and residential real estate loans. Commercial loans include those secured by commercial real estate, and others made to a variety of businesses, including retail concerns, small manufacturing businesses, larger corporations, other commercial banks, and to political subdivisions in the U.S. Commercial loans amounted to 42% of the total loans outstanding at December 31, 1999. Loans secured by residential properties, including closed-ended home equity loans comprised 37% of total loans outstanding at December 31, 1999. The Company underwrites substantially all of its residential mortgages based upon secondary market standards and sells substantially all of its fixed-rate residential mortgage loans on a servicing-retained basis. Variable or adjustable rate mortgage loans are typically held in portfolio. Revolving home equity loans as a separate group amounted to 5% of loans at December 31, 1999. These loans are generally underwritten based upon the same standards as first mortgages. The remaining real estate loans, which are 2% of total loans outstanding at December 31, 1999, are construction loans secured by residential and commercial land under development. Consumer loans outstanding at December 31, 1999 were 19% of total loans. Indirect installment loans and auto leases comprise 10%, while the remaining loans consist of direct installment and revolving credit. The Company's lending activities are conducted primarily in Vermont, Massachusetts and New Hampshire, with additional activity related to nearby market areas in Quebec, New York, Maine and Connecticut. In addition to the portfolio diversification described above, the loans are diversified by borrowers and industry groups. In making commercial loans, the Banks occasionally solicit the participation of other banks and financial investors. The Company, through its subsidiaries, also occasionally participates in loans originated by other banks. Certain of the Company's commercial loans are made under programs administered by the Vermont Industrial Development Authority, the U.S. Small Business Administration, the U.S. Farmers Home Administration or other local government agencies within the Company's market. Loan terms include repayment guarantees by the agency involved in varying amounts up to 90% of the original loan. The Banks offer a wide range of banking services, including the acceptance of demand, savings, and time deposits. As of December 31, 1999, total interest-bearing deposits and noninterest-bearing demand deposits amounted to approximately $2.7 billion and $532 million, respectively. The Banks also provide personal trust 1 services, including services as executor, trustee, administrator, custodian and guardian. Corporate trust services are also provided, including services as trustee for pension and profit sharing plans. Asset management services are provided for both personal and corporate trust clients. Trust assets under administration totaled $4.8 billion at December 31, 1999. The Company offers data processing services consisting primarily of payroll and automated clearing house for several outside clients. Financial and investment counseling is provided to municipalities and school districts within the Company's service area, as well as central depository, lending, payroll, and other banking services. The Banks offer a variety of other services including safe deposit facilities, MasterCard and VISA credit card services, credit card processing, certain non-deposit investment products through the brokerage services of Chittenden Securities, Inc, and various insurance related products through The Pomerleau Agency. Chittenden Securities and The Pomerleau Agency are subsidiaries of Chittenden Bank. The Company's principal executive offices are located at Two Burlington Square, Burlington, Vermont 05401; telephone number: 802-658-4000. Chittenden Trust Company and Vermont National Bank CTC was chartered by the Vermont Legislature as a commercial bank in 1904. It is the largest bank in Vermont, based on total assets of approximately $1.6 billion and total deposits of approximately $1.4 billion, at December 31, 1999. CTC's principal offices are in Burlington, Vermont and it has 35 additional locations in Vermont. There are six free standing automated teller machines ("ATM's") at other locations. (See Item 2, "Properties"). The trade name "Chittenden Bank" is used at all locations. On May 31, 1997, CTC acquired The Pomerleau Agency, which offers various insurance related products including: personal, commercial and life/health policies, as well as specialized coverages and a consulting and risk management service. In October 1998, CTC established a registered broker/dealer, Chittenden Securities, Inc., as a subsidiary. Chittenden Securities, Inc. is a full service broker-dealer registered with the Securities and Exchange Commission (SEC) and is a member of both the National Association of Securities Dealers, Inc. (NASD) and the Securities Investor Protection Corporation (SIPC). VNB, a national banking association, is the successor to the original Bank of Brattleborough, which was chartered in 1821. At December 31, 1999, VNB had total assets of approximately $1.5 billion and total deposits of approximately $1.0 billion. VNB's principal offices are in Brattleboro, Vermont and it has 22 additional locations in Vermont, along with 13 offices located in New Hampshire. The Bank of Western Massachusetts BWM was chartered by the Commonwealth of Massachusetts as a commercial bank in 1986. In September 1999, it merged with United Bank, VFSC's subsidiary bank formerly headquartered in Greenfield, Massachusetts. At December 31, 1999, BWM had total assets of $514 million and total deposits of $438 million. BWM's principal offices are in Springfield, Massachusetts and it has eleven additional locations in the western Massachusetts area. Flagship Bank and Trust Company FBT was chartered by the Commonwealth of Massachusetts as a commercial bank in 1986. At December 31, 1999, FBT had total assets of $353 million and total deposits of $328 million. FBT's principal offices are in Worcester, Massachusetts and it has seven additional locations in the greater Worcester, Massachusetts area. Chittenden Connecticut Corporation CCC was chartered by the State of Vermont as a mortgage company in 1996 and its principal offices are in Burlington, Vermont. CCC has additional offices in Brattleboro, Vermont, Southbury, Connecticut and 2 Lexington, Massachusetts (See Item 2, "Properties"). CCC's primary business is the origination of conforming residential real estate mortgage loans for resale to the secondary market. CCC originates these loans for resale through correspondent relationships with credit unions and through other mortgage brokers in the state of Connecticut who receive loan applications. These applications are underwritten by CTC in Vermont based upon secondary market standards and then sold. In addition, CCC uses brokers that are directly employed by and working through various financial institutions in Connecticut. Economy The New England economy continues to expand at a moderate pace. Retail sales were strong, as were the commercial real estate markets in the Company's service areas. New England unemployment levels have remained at steady lows. The ability and willingness of the Company's borrowers to honor their repayment commitments are impacted by many factors, including the prevailing market interest rates and the level of overall economic activity within the borrowers' geographic area. Competition There is vigorous competition in the Company's marketplace for all aspects of banking and related financial service activities presently engaged in by the Company and its subsidiaries. In the retail financial services market, competitors also include other banks, credit unions, finance companies, thrift institutions and, increasingly, brokerage firms, insurance companies, and mortgage loan companies. Money market deposit accounts and short-term flexible-maturity certificates of deposit offered by the Banks compete with investment account offerings of brokerage firms and with new products offered by insurance companies. The Company also competes for personal and commercial trust business with investment advisory firms, mutual funds, and insurance companies. Moreover, under the Gramm-Leach-Bliley Act of 1999 (the "Gramm-Leach-Bliley Act"), effective March 11, 2000, securities firms, insurance companies and other financial services providers that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach- Bliley Act may significantly change the competitive environment in which the Company and its subsidiaries conduct business. See "The Financial Services Modernization Legislation" below. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties. CTC competes with Vermont banks and metropolitan banks based in southern New England and New York to provide commercial banking services to businesses. Many of these out-of-state banks have greater financial resources than the Vermont banks and are actively seeking financial relationships with promising Vermont enterprises. BWM and FBT compete with other similar financial institutions in the western Massachusetts and Worcester, Massachusetts markets. BWM and FBT also operate in areas in which competition among financial institutions is continuously increasing. BWM has focused on meeting the needs of the smaller and medium-sized businesses and professionals in its market area, while FBT has taken a balanced approach in serving the needs of both smaller and medium-sized businesses, as well as retail consumers in its market. Supervision and Regulation The Company and its banking subsidiaries ("The Banks") are subject to extensive regulation under federal and state banking laws and regulations. The following discussion of certain of the material elements of the regulatory framework applicable to banks and bank holding companies is not intended to be complete and is qualified in its entirety by the text of the relevant state and federal statutes and regulations. A change in the applicable laws or regulations may have a material effect on the business of the Company and/or its banking subsidiaries. Regulation of the Company General. As a corporation incorporated under Vermont law, the Company is subject to regulation by the Secretary of the State of Vermont and the rights of its stockholders are governed by Vermont corporate law. As 3 a bank holding company, the Company is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act of 1956, as amended (the "BHC Act"). Under the BHC Act, bank holding companies generally may not acquire ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. In addition, bank holding companies are generally prohibited under the BHC Act from engaging in non- banking activities, subject to certain exceptions. As a bank holding company, the Company's activities are limited generally to the business of banking and activities determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. The Federal Reserve Board has authority to issue cease and desist orders to terminate or prevent unsafe or unsound banking practices or violations of laws or regulations and to assess civil money penalties against bank holding companies and their non-bank subsidiaries, officers, directors and other institution-affiliated parties, and to remove officers, directors and other institution-affiliated parties. Financial Services Modernization Legislation. On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act. The Gramm-Leach- Bliley Act repeals provisions of the Glass-Steagall Act: Section 20, which restricted the affiliation of Federal Reserve member banks with firms "engaged principally" in specified securities activities; and Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the Gramm-Leach-Bliley Act also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system, such as the Company, to engage in a full range of financial activities through a new entity known as a Financial Holding Company. "Financial activities" is broadly defined to include not only banking, insurance, and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Generally, the Gramm-Leach-Bliley Act: . repeals historical restrictions on, and eliminates many federal and state law barriers to, affiliations among banks, securities firms, insurance companies, and other financial service providers; . provides a uniform framework for the functional regulation of the activities of banks, savings institutions, and their holding companies; . broadens the activities that may be conducted by national banks (and derivatively state banks), banking subsidiaries of bank holding companies, and their financial subsidiaries; . provides an enhanced framework for protecting the privacy of consumer information; . adopts a number of provisions related to the capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system; . modifies the laws governing the implementation of the Community Reinvestment Act of 1977 (See "Supervision and Regulation,--Regulation of the Banks,--CRA Regulations"); and . addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. In order to engage in the new activities, a bank holding company, such as the Company, must meet certain tests. Specifically, all of a bank holding company's banks must be well-capitalized and well-managed, as measured by regulatory guidelines, and all of the bank holding company's banks must have been rated "satisfactory" or better in the most recent Community Reinvestment Act evaluation of each bank. See "Supervision and Regulation,--Regulation of the Banks,--CRA Regulations." At this time, the Company has not determined whether it will become a financial holding company. 4 Dividends. The Federal Reserve Board has authority to prohibit bank holding companies from paying dividends if such payment is deemed to be an unsafe or unsound practice. The Federal Reserve Board has indicated generally that it may be an unsafe and an unsound practice for bank holding companies to pay dividends unless the bank holding company's net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the organization's capital needs, asset quality, and overall financial condition. The Company's ability to pay dividends is dependent upon the flow of dividend income to it from its banking subsidiaries, which may be affected or limited by regulatory restrictions imposed by federal or state bank regulatory agencies. See "--Regulation of The Banks--Dividends." Certain Transactions by Bank Holding Companies with their Affiliates. There are various legal restrictions on the extent to which bank holding companies and their non-bank subsidiaries may borrow, obtain credit from or otherwise engage in "covered transactions" with their insured depository institution subsidiaries. Such borrowings and other covered transactions by an insured depository institution subsidiary (and its subsidiaries) with its non- depository institution affiliates are limited to the following amounts: (a) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 10% of the capital stock and surplus of the insured depository institution; and (b) in the case of all affiliates, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 20% of the capital stock and surplus of the insured depository institution. "Covered transactions" are defined by statute for these purposes to include a loan or extension of credit to an affiliate, a purchase of or investment in securities issued by an affiliate, a purchase of assets from an affiliate unless exempted by the Federal Reserve Board, the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any person or company, or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Covered transactions are also subject to certain collateral security requirements. Other types of transactions between a bank and a bank holding company must be on market terms and not otherwise unduly favorable to the holding company or an affiliate thereof. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit, lease or sale of property of any kind, or furnishing of any service. Holding Company Support of Subsidiary Banks. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support such subsidiaries. This support of its subsidiary banks may be required at times when, absent such Federal Reserve Board policy, the Company might not otherwise be inclined to provide it. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. Liability of Commonly Controlled Depository Institutions. Under the Federal Deposit Insurance Act, as amended ("FDI Act"), an FDIC-insured depository institution, such as CTC, BWM or FBT, can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the "default" of a commonly controlled FDIC-insured depository institution, or (ii) any assistance provided by the FDIC to any commonly controlled depository institution in "danger of default." For these purposes, the term "default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur without Federal regulatory assistance. Regulation of The Banks General. As FDIC-insured state-chartered banks, the banks are subject to supervision of and regulation by the Commissioner of Banking, Insurance, Securities and Health Care Administration of the State of Vermont, in the case of CTC, and the Commissioner of Banks of the Commonwealth of Massachusetts in the case of BWM and FBT (individually, a Commissioner and collectively, the "Commissioners") and, for all three banks, by the FDIC. This supervision and regulation is for the protection of depositors, the BIF (as hereinafter defined), and consumers, and is not for the protection of the Company's stockholders. The prior approval of the FDIC and the 5 relevant Commissioner is required for the banks to establish or relocate an additional branch office, assume deposits, or engage in any merger, consolidation or purchase or sale of all or substantially all of the assets of any bank or savings association. Examinations and Supervision. The FDIC and the Commissioners regularly examine the condition and the operations of the banks, including (but not limited to) their capital adequacy, reserves, loans, investments, earnings, liquidity, compliance with laws and regulations, record of performance under the Community Reinvestment Act and management practices. In addition, the banks are required to furnish quarterly and annual reports of income and condition to the FDIC and periodic reports to the Commissioners. The enforcement authority of the FDIC includes the power to impose civil money penalties, terminate insurance coverage, remove officers and directors and issue cease-and-desist orders to prevent unsafe or unsound practices or violations of laws or regulations. In addition, under recent federal banking legislation, the FDIC has authority to impose additional restrictions and requirements with respect to banks that do not satisfy applicable regulatory capital requirements. See "--Capital Requirements and FDICIA--Prompt Corrective Action" below. Dividends. The principal source of the Company's revenue is dividends from the Banks. Payments of dividends by the Banks are subject to certain Vermont and Massachusetts banking law restrictions. Payment of dividends by CTC is subject to Vermont banking law restrictions which require that, except when surplus and paid-in capital together amount to 10% or more of deposits and other liabilities (not including surplus, paid-in capital, capital notes and debentures, and funds held in a fiduciary capacity), at least one-tenth of its net profits must be set aside annually and added to surplus. Payment of dividends by BWM and FBT is subject to Massachusetts banking law restrictions which require that the capital stock and surplus account of the bank must amount, in the aggregate, to at least 10% of the bank's deposit liability or there shall be transferred from net profits to the surplus account (1) the amount required to increase the surplus account so that it, together with the capital stock, will amount to at least 10% of deposit liability or (2) the amount required to increase the surplus account so that it shall amount to 50% of the common stock, and thereafter, the amount , not exceeding 50% of net profits, required to increase the surplus account so that it shall amount to 100% of capital stock. The FDIC has authority to prevent the banks from paying dividends if such payment would constitute an unsafe or unsound banking practice or reduce the respective bank's capital below safe and sound levels. In addition, federal legislation prohibits FDIC-insured depository institutions from paying dividends or making capital distributions that would cause the institution to fail to meet minimum capital requirements. See "Capital Requirements and FDICIA--Prompt Corrective Action" below. Affiliate Transactions. As noted above, banks are subject to restrictions imposed by federal law on extensions of credit to, purchases of assets from, and certain other transactions with, affiliates, and on investments in stock or other securities issued by affiliates. Such restrictions prevent the banks from making loans to affiliates unless the loans are secured by collateral in specified amounts and have terms at least as favorable to the bank as the terms of comparable transactions between the bank and non-affiliates. Further, federal and applicable state laws significantly restrict extensions of credit by the banks to directors, executive officers and principal stockholders and related interests of such persons. Deposit Insurance. The Bank's deposits are insured by the Bank Insurance Fund ("BIF") of the FDIC to the legal maximum of $100,000 for each insured depositor. The FDI Act provides that the FDIC shall set deposit insurance assessment rates on a semi-annual basis at a level sufficient to increase the ratio of BIF reserves to BIF-insured deposits to at least 1.25% over a 15-year period commencing in 1991, and to maintain that ratio. Although the established framework of risk-based insurance assessments accomplished this increase in May 1995, and the FDIC has made a substantial reduction in the assessment rate schedule, the BIF insurance assessments may be increased in the future if necessary to maintain BIF reserves at the required level. In addition, legislation enacted in 1996 to recapitalize the Savings Association Insurance Fund ("SAIF"), which insures the deposits of savings associations and certain savings banks, resulted in increased BIF assessments. See "Capital Requirements and FDICIA--Risk-Based Deposit Insurance and FICO Assessments" below. Federal Reserve Board Policies. The monetary policies and regulations of the Federal Reserve Board have had a significant effect on the operating results of banks in the past and are expected to continue to do so in the future. Federal Reserve Board Policies affect the levels of bank earnings on loans and investments and the levels 6 of interest paid on bank deposits through the Federal Reserve System's open- market operations in United States government securities, regulation of the discount rate on bank borrowings from Federal Reserve Banks and regulation of non-earning reserve requirements applicable to bank deposit account balances. Consumer Protection Regulation; Bank Secrecy Act. Other aspects of the lending and deposit businesses of the banks that are subject to regulation by the FDIC and the Commissioners include disclosure requirements with respect to interest, payment and other terms of consumer and residential mortgage loans and disclosure of interest and fees and other terms of, and the availability of, funds for withdrawal from consumer deposit accounts. In addition, the banks are subject to federal and state laws and regulations prohibiting certain forms of discrimination in credit transactions, and imposing certain record keeping, reporting and disclosure requirements with respect to residential mortgage loan applications. The banks are also subject to federal laws establishing certain record keeping, customer identification, and reporting requirements with respect to certain large cash transactions, sales of travelers checks or other monetary instruments and the international transportation of cash or monetary instruments. CRA Regulations. The Community Reinvestment Act ("CRA") requires lenders to identify the communities served by the institution's offices and to identify the types of credit the institution is prepared to extend within such communities. The FDIC conducts examinations of insured institutions' CRA compliance and rates such institutions as "Outstanding", "Satisfactory", "Needs to Improve" and "Substantial Noncompliance". As of their last CRA examinations, CTC, BWM and FBT all received a rating of "Outstanding". Failure of an institution to receive at least a "Satisfactory" rating could inhibit such institution or its holding company from undertaking certain activities, including engaging in activities newly permitted under the Gramm-Leach-Bliley Act and acquisitions of other financial institutions, which require regulatory approval based, in part, on CRA compliance considerations. The Federal Reserve Board must take into account the record of performance of banks in meeting the credit needs of the entire community served, including low and moderate income neighborhoods. As a result of certain amendments in 1996, current CRA regulations rely more than the former CRA regulations upon objective criteria of the performance of institutions under three key assessment tests: a lending test, a service test and an investment test. The Banks are committed to meeting the existing or anticipated credit needs of their entire communities, including low and moderate-income neighborhoods, consistent with safe and sound operations. Capital Requirements and FDICIA General. The FDIC has established guidelines with respect to the maintenance of appropriate levels of capital by FDIC-insured banks. The Federal Reserve Board has established substantially identical guidelines with respect to the maintenance of appropriate levels of capital, on a consolidated basis, by bank holding companies. If a banking organization's capital levels fall below the minimum requirements established by such guidelines, a bank or bank holding company will be expected to develop and implement a plan acceptable to the FDIC or the Federal Reserve Board, respectively, to achieve adequate levels of capital within a reasonable period, and may be denied approval to acquire or establish additional banks or non-bank businesses, merge with other institutions or open branch facilities until such capital levels are achieved. Federal legislation requires federal bank regulators to take "prompt corrective action" with respect to insured depository institutions that fail to satisfy minimum capital requirements and imposes significant restrictions on such institutions. See "Prompt Corrective Action" below. Leverage Capital Ratio. The regulations of the FDIC require FDIC-insured banks to maintain a minimum "Leverage Capital Ratio" or "Tier 1 Capital" (as defined in the Risk-Based Capital Guidelines discussed in the following paragraphs) to Total Assets of 3.0%. The regulations of the FDIC state that only banks with the highest federal bank regulatory examination rating will be permitted to operate at or near such minimum level of capital. All other banks are expected to maintain an additional margin of capital, equal to at least 1% to 2% of Total Assets, above the minimum ratio. Any bank experiencing or anticipating significant growth is expected to maintain capital well above the minimum levels. The Federal Reserve Board's guidelines impose substantially similar leverage capital requirements on bank holding companies on a consolidated basis. 7 Risk-Based Capital Requirements. The regulations of the FDIC also require FDIC-insured banks to maintain minimum capital levels measured as a percentage of such banks' risk-adjusted assets. A bank's qualifying total capital ("Total Capital") for this purpose may include two components--"Core" (Tier 1) Capital and "Supplementary" (Tier 2) Capital. Core Capital consists primarily of common stockholders' equity, which generally includes common stock, related surplus and retained earnings, certain non-cumulative perpetual preferred stock and related surplus, and minority interests in the equity accounts of consolidated subsidiaries, and (subject to certain limitations) mortgage servicing rights and purchased credit card relationships, less all other intangible assets (primarily goodwill). Supplementary Capital elements include, subject to certain limitations, a portion of the allowance for losses on loans and leases, perpetual preferred stock that does not qualify for inclusion in Tier 1 capital, long-term preferred stock with an original maturity of at least 20 years and related surplus, certain forms of perpetual debt and mandatory convertible securities, and certain forms of subordinated debt and intermediate-term preferred stock. The risk-based capital rules of the FDIC and the Federal Reserve Board assign a bank's balance sheet assets and the credit equivalent amounts of the bank's off-balance sheet obligations to one of four risk categories, weighted at 0%, 20%, 50% or 100%, respectively. Applying these risk-weights to each category of the bank's balance sheet assets and to the credit equivalent amounts of the bank's off-balance sheet obligations and summing the totals results in the amount of the bank's total Risk-Adjusted Assets for purposes of the risk-based capital requirements. Risk-Adjusted Assets can either exceed or be less than reported balance sheet assets, depending on the risk profile of the banking organization. Risk-Adjusted Assets for institutions such as The Banks will generally be less than reported balance sheet assets because its retail banking activities include proportionally more residential mortgage loans and certain investment securities with a lower risk weighting and relatively smaller off-balance sheet obligations. The risk-based capital regulations require all banks to maintain a minimum ratio of Total Capital to Risk-Adjusted Assets of 8.0%, of which at least one- half (4.0%) must be Core (Tier 1) Capital. For the purpose of calculating these ratios: (i) a banking organization's Supplementary Capital eligible for inclusion in Total Capital is limited to no more than 100% of Core Capital; and (ii) the aggregate amount of certain types of Supplementary Capital eligible for inclusion in Total Capital is further limited. For example, the regulations limit the portion of the allowance for loan losses eligible for inclusion in Total Capital to 1.25% of Risk-Adjusted Assets. The Federal Reserve Board has established substantially identical risk-based capital requirements, which are applied to bank holding companies on a consolidated basis. The risk-based capital regulations provide explicitly for consideration of interest rate risk in the FDIC's overall evaluation of a bank's capital adequacy to ensure that banks effectively measure and monitor their interest rate risk, and that they maintain capital adequate for that risk. A bank deemed by the FDIC to have excessive interest rate risk exposure may be required by the FDIC to maintain additional capital (that is, capital in excess of the minimum ratios discussed above). The Banks believe that this provision will not have a material adverse effect on them. At December 31, 1999, the Company's consolidated Total and Tier 1 Risk-Based Capital Ratios were 13.23% and 11.96%, respectively, and its Leverage Capital Ratio was 8.17%. Based on the above figures and accompanying discussion, CC exceeds all regulatory capital requirements and is considered well capitalized. Prompt Corrective Action. Among other things, the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") requires the federal banking regulators to take "prompt corrective action" with respect to, and imposes significant restrictions on, any bank that fails to satisfy its applicable minimum capital requirements. FDICIA establishes five capital categories consisting of "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under applicable regulations, a bank that has a Total Risk-Based Capital Ratio of 10.0% or greater, a Tier 1 Risk-Based Capital Ratio of 6.0% or greater and a Leverage Capital Ratio of 5.0% or greater, and is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure is deemed to be "well capitalized." A bank that has a Total Risk-Based Capital Ratio of 8.0% or greater, a Tier 1 Risk-Based Capital Ratio of 4.0% or greater and a Leverage Capital Ratio of 4.0% or greater and does not meet the definition of a well capitalized bank is considered to be "adequately capitalized." A bank that has a Total Risk-Based Capital Ratio of less than 8.0% or has a Tier 1 Risk-Based 8 Capital Ratio that is less than 4.0% or generally a Leverage Capital Ratio of less than 4.0% is considered "undercapitalized." A bank that has a Total Risk- Based Capital Ratio of less than 6.0%, or a Tier 1 Risk-Based Capital Ratio that is less than 3.0% or a Leverage Capital Ratio that is less than 3.0% is considered to be "significantly undercapitalized," and a bank that has a ratio of tangible equity to total assets equal to or less than 2% is deemed to be "critically undercapitalized." A bank may be deemed to be in a capital category lower than is indicated by its actual capital position if it is determined to be in an unsafe or unsound condition or receives an unsatisfactory examination rating. FDICIA generally prohibits a bank from making capital distributions (including payment of dividends) or paying management fees to controlling stockholders or their affiliates if, after such payment, the bank would be undercapitalized. Under FDICIA and the applicable implementing regulations, an undercapitalized bank will be (i) subject to increased monitoring by the FDIC; (ii) required to submit to the FDIC an acceptable capital restoration plan (guaranteed, subject to certain limits, by the bank's holding company) within 45 days; (iii) subject to strict asset growth limitations; and (iv) required to obtain prior regulatory approval for certain acquisitions, transactions not in the ordinary course of business, and entry into new lines of business. In addition to the foregoing, the FDIC may issue a "prompt corrective action directive" to any undercapitalized institution. Such a directive may require sale or re-capitalization of the bank, impose additional restrictions on transactions between the bank and its affiliates, limit interest rates paid by the bank on deposits, limit asset growth and other activities, require divestiture of subsidiaries, require replacement of directors and officers, and restrict capital distributions by the bank's parent holding company. In addition to the foregoing, a significantly undercapitalized institution may not award bonuses or increases in compensation to its senior executive officers until it has submitted an acceptable capital restoration plan and received approval from the FDIC. Not later than 90 days after an institution becomes critically undercapitalized, the appropriate federal banking agency for the institution must appoint a receiver or, with the concurrence of the FDIC, a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. FDICIA requires that any alternative determination be "documented" and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the appropriate federal banking agency and the FDIC certify that the institution is viable and not expected to fail. Risk-Based Deposit Insurance and FICO Assessments. The FDIC has adopted a rule establishing a risk-based system which assigns an institution to one of three capital categories consisting of (1) well capitalized, (2) adequately capitalized, or (3) undercapitalized, and one of three supervisory categories. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Under this rule there are nine assessment risk classifications (i.e. combinations of capital categories and supervisory subgroups within each capital group). An institution's deposit insurance assessment rate is determined by assigning the institution to a capital category and a supervisory subgroup to determine which one of the nine risk classification categories is applicable. The FDIC is authorized to raise the assessment rates in certain circumstances. If the FDIC determines to increase the assessment rates for all institutions, institutions in all risk categories could be affected. The FDIC has exercised this authority several times in the past and may raise BIF insurance premiums again in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of The Banks, the extent of which is not currently quantifiable. The risk classification to which an institution is assigned by the FDIC is confidential and may not be disclosed. Assessment rates in 1999 ranged from 0% of domestic deposits for an institution in the lowest risk category (i.e., well-capitalized and healthy from a supervisory standpoint) to 0.27% of domestic deposits for institutions in the highest risk category (i.e., undercapitalized and unhealthy from a supervisory standpoint). During 1999, assessment rates also included a minimum annual assessment of $2,000 per institution. The Banks qualified for, and paid in 1999, the minimum annual assessment under this rate schedule. The Deposit Insurance Funds Act of 1996 eliminates the minimum assessment and authorizes the Financing Corporation (FICO) to levy assessments on BIF- assessable deposits and stipulates that the rate must equal one- 9 fifth the FICO assessment rate that is applied to deposits assessable by the SAIF. The actual assessment rates for FICO were determined by deposit data from the September 30, 1997, Call Reports. Based on the 1996 Act, the Banks paid assessments totaling $797,000 or 2.5 cents per $100 of deposits in 1999. Brokered Deposits and Pass-Through Deposit Insurance Limitations. Under FDICIA, a bank cannot accept brokered deposits unless it either (i) is "Well Capitalized" or (ii) is "Adequately Capitalized" and has received a written waiver from the FDIC. For this purpose, "Well Capitalized" and "Adequately Capitalized" have the same definitions as in the Prompt Corrective Action regulations. See "--Prompt Corrective Action" above. Banks that are not in the "Well Capitalized" category are subject to certain limits on the rates of interest they may offer on any deposits (whether or not obtained through a third-party deposit broker). Pass-through insurance coverage is not available for deposits of certain employee benefit plans in banks that do not satisfy the requirements for acceptance of brokered deposits, except that pass-through insurance coverage will be provided for employee benefit plan deposits in institutions which at the time of acceptance of the deposit meet all applicable regulatory capital requirements and send written notice to their depositors that their funds are eligible for pass-through deposit insurance. Although eligible to do so, the Banks have not accepted brokered deposits. Conservatorship and Receivership Amendments. FDICIA authorizes the FDIC to appoint itself conservator or receiver for a state-chartered bank under certain circumstances and expands the grounds for appointment of a conservator or receiver for an insured depository institution to include (i) consent to such action by the board of directors of the institution; (ii) cessation of the institution's status as an insured depository institution; (iii) the institution is undercapitalized and has no reasonable prospect of becoming adequately capitalized, or fails to become adequately capitalized when required to do so, or fails to timely submit an acceptable capital plan, or materially fails to implement an acceptable capital plan; and (iv) the institution is critically undercapitalized or otherwise has substantially insufficient capital. FDICIA provides that an institution's directors shall not be liable to its stockholders or creditors for acquiescing in or consenting to the appointment of the FDIC as receiver or conservator for, or as a supervisor in the acquisition of, the institution. Real Estate Lending Standards. FDICIA requires the federal bank regulatory agencies to adopt uniform real estate lending standards. The FDIC has adopted implementing regulations, which establish supervisory limitations on Loan-to- Value ("LTV") ratios in real estate loans by FDIC-insured banks. The regulations require FDIC-insured banks to establish LTV ratio limitations within or below the prescribed uniform range of supervisory limits. Standards for Safety and Soundness. FDICIA requires the federal bank regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits. The compensation standards would prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that would provide "excessive" compensation, fees or benefits, or that could lead to material financial loss. In addition, the federal bank regulatory agencies are required by FDICIA to prescribe standards specifying; (i) maximum classified assets to capital ratios; (ii) minimum earnings sufficient to absorb losses without impairing capital; and (iii) to the extent feasible, a minimum ratio of market value to book value for publicly-traded shares of depository institutions and depository institution holding companies. The FDIC has issued regulations implementing certain of these provisions. Activities and Investments of Insured State Banks. FDICIA provides that FDIC-insured state banks such as CTC, BWM and FBT may not engage as a principal, directly or through a subsidiary, in any activity that is not permissible for a national bank unless the FDIC determines that the activity does not pose a significant risk to the BIF, and the bank is in compliance with its applicable capital standards. In addition, an insured state bank may not acquire or retain, directly or through a subsidiary, any equity investment of a type, or in an amount, that is not permissible for a national bank, unless such investments meet certain grandfather requirements. The Gramm-Leach-Bliley Act includes a new section of the FDI Act governing subsidiaries of state banks that engage in "actvities as principal that would only be permissible" for a national bank to conduct in a 10 financial subsidiary. This provision will permit state banks, to the extent permitted under state law, to engage in certain new activities which are permissible for subsidiaries of a financial holding company. See "Supervision and Regulation, Regulation of the Company." Further, it expressly preserves the ability of a state bank to retain all existing subsidiaries. Because Vermont does not explicitly permit banks chartered by the state to engage in all activities permissible for national banks, Chittenden will be permitted to form subsidiaries to engage in the activities authorized by the Gramm-Leach- Bliley Act, only to the extent permitted by Vermont Law. Massachusetts permits banks chartered by that state to engage in activities which are permissible for a national bank and that are approved by the Massachusetts Commissioner of Banks. Thus, BWM and FBT would only be permitted to engage in the activities authorized by the Gramm-Leach-Bliley Act that are also approved by the Massachusetts Commissioner of Banks or otherwise authorized by Massachusetts law. In order to form a financial subsidiary, a state bank must be well- capitalized, and the state bank would be subject to certain capital deduction, risk management and affiliate transaction rules which are applicable to national banks. Consumer Protection Provisions. FDICIA also includes provisions requiring advance notice to regulators and customers for any proposed branch closing and authorizing (subject to future appropriation of the necessary funds) reduced insurance assessments for institutions offering "lifeline" banking accounts or engaged in lending in distressed communities. FDICIA also includes provisions requiring depository institutions to make additional and uniform disclosures to depositors with respect to the rates of interest, fees and other terms applicable to consumer deposit accounts. Depositor Priority Statute. The FDI Act provides that, in the liquidation or other resolution by any receiver of a bank insured by the FDIC, the claims of depositors have priority over the general claims of other creditors. Hence, in the event of the liquidation or other resolution of a banking subsidiary of the Company, the general claims of the Company as creditor of such banking subsidiary would be subordinate to the claims of the depositors of such banking subsidiary, even if the claims of CC were not by their terms so subordinated. In addition, this statute may, in certain circumstances, increase the costs to banks of obtaining funds through non-deposit liabilities. Employees At December 31, 1999, the Company and its subsidiaries employed 1,883 persons, with a full-time equivalency of 1,689 employees. The Company enjoys good relations with its employees. A variety of employee benefits, including health, group life and disability income replacement insurance, a funded, non- contributory pension plan, and an incentive savings and profit sharing plan, are available to qualifying officers and employees. ITEM 2 PROPERTIES The Company's principal banking subsidiary, CTC, operates banking facilities in 36 locations in Vermont. The offices of the Company are located in an owned facility at Two Burlington Square in Burlington, Vermont. BWM's principal offices are in Springfield, Massachusetts and it has eleven additional locations in the western Massachusetts area. FBT's principal offices are in Worcester, Massachusetts and it has seven additional locations in the greater Worcester, Massachusetts area. VNB's principal offices are in Brattleboro, Vermont and it has 35 additional locations in Vermont and New Hampshire. CCC operates two mortgage company facilities in Connecticut and Massachusetts. Except for the CTC property, all of the properties mentioned above are leased. The offices of CTC, BWM, FBT, VNB and CCC are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities served. ITEM 3 LEGAL PROCEEDINGS A number of legal claims against the Company arising in the normal course of business were outstanding at December 31, 1999. Management, after reviewing these claims with legal counsel, is of the opinion that these matters, when resolved, will not have a material effect on the consolidated financial statements. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 11 PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The $1 par value common stock of Chittenden Corporation has been publicly traded since November 14, 1974. As of February 29, 2000, there were 5,304 holders of record of the Company's common stock. As of February 18, 1998, the Company's stock initiated trading on the NYSE under the symbol "CHZ". Prior to that date, the Company's stock traded on the NASDAQ, under the symbol "CNDN". The following table sets forth the range of the high and low sales prices for the Company's common stock, and the dividends declared, for each quarterly period within the past two years: Dividends Quarter ended High Low Paid (1) ------------- ------ ------ --------- 1999 March 31.......................................... $33.63 $26.00 $0.20 June 30........................................... 31.75 26.44 0.22 September 30...................................... 31.50 26.31 0.22 December 31....................................... 33.25 27.75 0.22 1998 March 31.......................................... $39.00 $32.00 $0.18 June 30........................................... 40.00 32.75 0.20 September 30...................................... 36.88 27.13 0.20 December 31....................................... 33.38 25.44 0.20 - -------- (1) Amounts reflect historical Chittenden dividend payments For a discussion of dividend restrictions on the Company's common stock, see "Dividends" under the caption Regulation on page 5 of this report. 12 ITEM 6 SELECTED FINANCIAL DATA Years Ended December 31, --------------------------------------------------------------- 1999 1998 1997 1996 1995 ----------- ----------- ----------- ----------- ----------- (In thousands, except share and per share amounts) Statements of income: Interest income........ $ 288,216 $ 299,865 $ 276,323 $ 239,164 $ 231,531 Interest expense....... 113,235 126,159 115,462 99,950 98,741 ----------- ----------- ----------- ----------- ----------- Net interest income.... 174,981 173,706 160,861 139,214 132,790 Provision for possible loan losses........... 8,700 8,235 7,300 7,533 8,900 Net interest income after provision for possible loan losses................ 166,281 165,471 153,561 131,681 123,890 Noninterest income .... 64,226 66,694 55,519 42,660 37,903 Noninterest expense.... 145,457 152,547 136,443 109,014 105,868 Special charges ....... 58,472 -- -- -- -- ----------- ----------- ----------- ----------- ----------- Income before income taxes................. 26,578 79,618 72,637 65,327 55,925 Income tax expense..... 29,074 29,840 26,105 21,991 19,077 ----------- ----------- ----------- ----------- ----------- Net income (loss)...... $ (2,496) $ 49,778 $ 46,532 $ 43,336 $ 36,848 =========== =========== =========== =========== =========== Total assets at year- end.................... $ 3,827,297 $ 4,256,052 $ 4,074,602 $ 3,301,727 $ 3,041,373 Common shares outstanding at year-end ....................... 28,378,232 27,937,070 28,591,977 25,429,846 25,208,550 Balance sheets--average daily balances: Total assets........... $ 4,104,497 $ 4,090,244 $ 3,656,334 $ 3,104,486 $ 2,900,149 Loans, net of allowance............. 2,834,961 2,694,097 2,463,250 2,189,681 2,097,556 Investment securities and interest-bearing cash equivalents .......... 931,076 1,009,881 852,355 661,703 565,826 Deposits............... 3,528,426 3,494,945 3,098,744 2,678,158 2,489,791 Stockholders' equity... 373,742 379,615 337,871 280,075 245,115 Per common share: Basic earnings (loss)................ $ (0.09) $ 1.76 $ 1.73 $ 1.72 $ 1.49 Diluted earnings (loss)................ (0.09) 1.73 1.70 1.70 1.47 Operating basic earnings (4) ......... 1.95 1.76 1.73 1.72 1.49 Operating diluted earnings (4).......... 1.92 1.73 1.70 1.70 1.47 Cash dividends declared.............. 0.81 0.69 0.95 0.54 0.52 Book value............. 12.77 14.02 13.21 11.62 10.59 Weighted average common shares outstanding..... 28,172,425 28,322,911 26,857,510 25,163,652 24,709,148 Weighted average common and common equivalent shares outstanding..... 28,635,839 28,830,483 27,327,021 25,563,864 25,115,520 Selected financial percentages: Return on average stockholders' equity (1)(4)................ 14.69% 13.05% 13.77% 15.47% 15.03% Return on average total assets (1) (4)................... 1.34 1.22 1.27 1.40 1.27 Net yield on earning assets................ 4.67 4.71 4.88 4.88 4.99 Interest rate spread... 3.98 4.01 4.20 4.21 4.37 Net charge-offs as a percent of average loans ................ 0.30 0.46 0.43 0.37 0.42 Nonperforming assets ratio (2)............. 0.33 0.72 1.02 1.00 1.40 Allowance for possible loan losses as a percent of year-end loans................. 1.42 1.50 1.68 1.85 1.99 Year-end leverage capital ratio......... 8.17 7.58 7.35 8.68 8.37 Risk-based capital ratios: Tier 1............... 11.96 10.76 10.82 12.53 12.05 Total................ 13.23 12.02 12.14 13.85 13.38 Average stockholders' equity to average assets................ 9.11 9.28 9.24 9.02 8.45 Common stock dividend payout ratio (1)(3)(4)............. 41.55 39.30 55.03 31.56 34.72 - -------- (1) Ratios calculated based on operating net income for the year. (2) The sum of nonperforming assets (nonaccrual loans, restructured loans, and other real estate owned) divided by the sum of total loans and other real estate owned. (3) Common stock cash dividends declared divided by operating net income; dividends declared during 1997 included a special cash dividend of $0.60 per share. (4) Operating earnings per share are computed by adding back the impact of one-time special charges (net of the effect of income taxes) to net income (loss). (5) All information for the years 1995-1998 has been restated to include VFSC, which was acquired May 28, 1999, in a transaction accounted for as a pooling of interests. 13 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the Years Ended December 31, 1999, 1998, and 1997 Overview The following discussion and analysis of financial condition and results of operations of the Company and its subsidiaries should be read in conjunction with reference to the consolidated financial statements and notes thereto and selected statistical information appearing elsewhere in this report. On May 31, 1997, CTC acquired certain assets and assumed certain liabilities of The Pomerleau Agency, Inc. This transaction has been accounted for as a purchase and, accordingly, all results of operations subsequent to the transaction have been included in the consolidated statements of operations. On May 28, 1999, the Company completed the acquisition of Vermont Financial Services Corp. in a stock-for-stock transaction accounted for as a pooling of interests. Accordingly, the consolidated financial statements of the Company have been restated to reflect the acquisition as of the beginning of the earliest period presented. The Company recognized $57.4 million of after-tax special charges in 1999 and the results excluding these special charges are referred to in the following discussion as operating. A reconciliation of the Company's net income (loss) to its operating net income for the years ended December 31, 1999, 1998, and 1997 is presented below: 1999 1998 1997 ------- ------- ------- Net income (loss)..................................... $(2,496) $49,778 $46,532 Less: Gain on branch sales................................ 12,524 -- -- Impaired goodwill written off upon merger........... (21,129) -- -- Merger costs........................................ (49,866) -- -- Tax effect of gain on branch sales.................. (13,399) -- -- Tax effect of merger costs.......................... 14,465 -- -- ------- ------- ------- Operating Net Income.................................. $54,909 $49,778 $46,532 ======= ======= ======= Diluted Operating EPS................................. $ 1.92 $ 1.73 $ 1.70 Chittenden recorded operating earnings of $54.9 million or basic operating earnings per share of $1.95 and diluted operating earnings per share of $1.92 for the year ended December 31, 1999. This compares to operating net income of $49.8 million and basic earnings per share of $1.76 and diluted earnings per share of $1.73 for 1998 and operating net income of $46.5 million, basic earnings per share of $1.73 and diluted earnings per share of $1.70 in 1997. For 1999, operating return on average equity was 14.69% and the operating return on average assets was 1.34%. These compare to returns on average equity of 13.05% and 13.77% and returns on average assets of 1.22% and 1.27% for 1998 and 1997, respectively. The increases in operating return on equity were attributable to higher levels of operating net income and lower levels of average stockholders' equity in the third and fourth quarters of 1999, which resulted from the special charges taken in 1999. Total assets decreased from $4.256 billion in 1998 to $3.827 billion in 1999, as a result of the sale of seventeen VNB branches, which were required as a condition of regulatory approval of the VFSC acquisition. Divested in the branch sales were $127.6 million in loans, $442.2 million in deposits and $8.3 million of fixed assets. Total cash transferred to the buyers was $265.1 million. To fund the cash transferred $70.0 million in securities available for sale were sold at a loss of $1.2 million. The loss on sale of securities is netted against the overall gain on sale of branches of $12.5 million. The divestiture of these branches did not have a material impact on operating income in 1999. The $5.1 million increase in operating net income from 1998 to 1999 was primarily attributable to reductions in noninterest expenses, which net of special charges, totaled $145.4 million for 1999, down from $152.5 million for 1998. The reduction in noninterest expenses was due to lower levels of amortization of 14 intangibles resulting from the writedown of goodwill related to the merger, reduced compensation expense caused by lower staffing levels, and reduced depreciation expense related to duplicative fixed assets written off as a result of the merger. The $3.2 million increase in earnings from 1997 to 1998 was caused primarily by the inclusion of VFSC's Eastern acquisition for the full year of 1998 versus only the second half of 1997. Eastern Bancorp was acquired by VFSC on June 26, 1997 in a transaction accounted for as a purchase. Financial Condition Loans Chittenden's gross loan portfolio at December 31, 1999 totaled $2.896 billion compared to $2.739 billion in 1998. As noted above, $127.6 million in loans were divested in branch sales. Excluding the divested loans, overall loan growth was $285 million or 10% from 1998. The overall proportions of commercial-related and consumer types of loans continued to increase in 1999. The reduction in the balances of residential real estate were caused by relatively normal payment activity, including some prepayments on adjustable rate loans, although at much lower levels than in 1998. The overall proportion of the loan portfolio comprised of residential real estate loans is reducing since new loans are being added to the portfolio at a slower rate than the existing portfolio is paying down. Over time, this will increase the percentage of the portfolio comprised of higher yielding commercial and consumer loans. The total real estate portfolio, including home equity credit lines, increased $32.3 million or 1.85% from year-end 1998, after adjusting for the effect of divested real estate loans. Growth in consumer loans including automobile leasing, was $131.1 million or 31.6% from year-end 1998. Non-real estate commercial loans increased by $4.8 million or 0.8% from the previous year. However, the bulk of the loans divested were in this category. After adjusting for the divested loans, growth from year end 1998 was $117 million or 20%. Commercial real estate loans increased $67.5 million or 11.8% from 1998. The classification of the Company's loan portfolio is based on underlying collateral. At December 31, 1999, commercial loans secured by non- real estate business assets totaled $585.3 million or 20% of total loans, up from the $580.5 million posted at year-end 1998. Commercial real estate loans, representing 22% of the portfolio, stood at $641.7 million at year-end 1999, up from $574.2 million at December 31, 1998. Construction loans amounted to $55.3 million at December 31, 1999, down from $68.1 million the year before. Residential real estate loans stood at $1,067.5 million at year-end 1999, down from $1,101.6 million at December 31, 1998. Reflecting the shift in the Company's strategy to commercial and consumer lending, as well as the higher prepayments on residential loans, this category represented 37% of the portfolio at year-end 1999, compared to 40% at year-end 1998. Residential mortgages originated during 1999 totaled $501.7 million, compared to $887.2 million during 1998, due to heavy volumes of fixed rate residential loans caused by declining market rates in 1998. The Company underwrites substantially all of its residential mortgages to secondary market standards. The Company continued to follow its policy of selling substantially all of its fixed-rate residential mortgage production on a servicing-retained non- recourse basis. Secondary market sales of mortgage loans totaled $381.6 million in 1999, compared to $671.3 million in 1998. Included in the real estate portfolio are home equity credit lines, which totaled $152.4 million at December 31, 1999, compared to $162.9 million the previous year. The unused portion of these lines totaled $206.1 million at December 31, 1999, compared to $202.6 million at year-end 1998. The portfolio of residential mortgages serviced for investors totaled $2.079 billion at December 31, 1999, compared to $2.124 billion at year-end 1998. These assets are owned by investors other than Chittenden and therefore are not included in the consolidated balance sheets of the Company. Of the loans serviced, the Company originated $1.612 billion and the balance consisted of loans whose mortgage-servicing rights were purchased by the Company in prior years. Consumer loans increased significantly in 1999, ending the year at $546.0 million, compared with $414.9 million at year-end 1998. This increase reflects the Company's continued development of the indirect auto lending and leasing market, and its emphasis on responding to the marketplace through the continued 15 expansion of dealer relationships within its existing deposit franchise area, as well as into the franchise areas of the subsidiary banks located in Massachusetts. The Company underwrites all of its indirect automotive loans, maintaining substantially the same credit standards as for car loans originated in its branch offices. Indirect installment lending through auto dealers was up $114.9 million from year-end 1998 to $290.5 million at the end of 1999. The Company also offers auto leases through its dealer base. This product is underwritten and priced similarly to indirect installment auto loans. Lease financing receivables outstanding at December 31, 1999 were $134.9 million, up from $107.1 million a year earlier, of which $84.7 million and $68.5 million represented the residual value of these leases. The Company has insurance through outside insurance companies which substantially eliminates the risk associated with the residual values of its leased vehicle portfolio. Contrary to the trend in indirect lending and leasing, direct installment and credit card balances at December 31, 1999 stood at $69.1 million and $51.5 million, respectively, compared with $72.2 million and $60.0 million at the end of 1998. Unused portions of credit card lines totaled $169.1 million at the end of 1999, down from $191.1 million one year earlier. The Company's lending activities are conducted in market areas focused in Vermont, western and central Massachusetts, and southern New Hampshire, with additional activity related to nearby trading areas in Quebec, New York, Maine, and Connecticut. In addition to the geographic portfolio diversification described above, the loans are widely diversified by borrowers and industry groups. The following table shows the composition of the loan portfolio for the five years ended December 31, 1999: December 31, ---------------------------------------------------------- 1999 1998 1997 1996 1995 ---------- ---------- ---------- ---------- ---------- (in thousands) Commercial.............. $ 585,268 $ 580,474 $ 531,282 $ 502,257 $ 461,658 Real estate: Residential........... 915,081 938,638 1,038,561 796,166 760,013 Commercial............ 641,660 574,178 548,871 481,869 488,174 Construction.......... 55,329 68,133 60,595 50,289 50,612 Home equity............. 152,382 162,979 183,531 124,731 122,828 Consumer................ 411,043 307,829 278,237 258,674 248,418 Lease financing......... 134,967 107,058 72,562 41,117 12,420 ---------- ---------- ---------- ---------- ---------- Total gross loans....... 2,895,730 2,739,289 2,713,639 2,255,103 2,144,123 Allowance for possible loan losses............ (41,079) (41,209) (45,664) (41,743) (42,579) ---------- ---------- ---------- ---------- ---------- Net loans............... $2,854,651 $2,698,080 $2,667,975 $2,213,360 $2,101,544 ========== ========== ========== ========== ========== Mortgage loans held for sale................... $ 2,926 $ 53,684 $ 49,651 $ 18,438 $ 17,772 Nonperforming Assets Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Management classifies loans, except consumer and residential loans, as nonaccrual loans when they become 90 days past due as to principal or interest, unless they are adequately secured and are in the process of collection. In addition, loans that have not met this delinquency test may be placed on nonaccrual at management's discretion. Consumer and residential loans are included when management considers it to be appropriate, based upon evidence of collectibility, the value of any underlying collateral, and other general criteria. Nonaccrual loans with a related guarantee by a governmental agency are reflected net of those guarantees in nonperforming statistics. Generally, a loan remains on nonaccrual status until the factors which indicated doubtful collectibility no longer exist or the loan is determined to be uncollectible and is charged off against the allowance for possible loan losses. A loan is classified as a restructured loan when the interest rate is reduced and/or other terms are modified because of the inability of the borrower to service debt at current market rates and terms. Other real estate owned ("OREO") is real estate that has been formally acquired through foreclosure. 16 The following table shows the composition of nonperforming assets and loans past due 90 days or more and still accruing for the five years ended December 31, 1999: December 31, ------------------------------------------ 1999 1998 1997 1996 1995 ------ ------- ------- ------- ------- (in thousands) Loans on nonaccrual................ $9,172 $17,865 $23,487 $18,413 $21,634 Troubled debt restructurings ...... -- -- 767 638 2,502 Other real estate owned............ 416 1,870 3,541 2,948 5,629 Restructured loans accruing ....... -- -- -- 661 316 ------ ------- ------- ------- ------- Total nonperforming assets......... $9,588 $19,735 $27,795 $22,660 $30,081 ====== ======= ======= ======= ======= Loans past due 90 days or more and still accruing.................... $5,016 $ 4,184 $ 8,893 $ 2,899 $ 3,062 Percentage of nonperforming assets to total loans and other real estate owned. 0.33% 0.72% 1.02% 1.00% 1.40% Nonperforming assets to total assets............................ 0.25 0.46 0.68 0.69 0.99 Allowance for possible loan losses to nonperforming loans, excluding OREO............. 447.87 230.66 188.27 211.76 174.13 Nonaccrual loans consisted of approximately 194 loans, which were diversified across a range of industries, sectors, and geography. Allowance for possible loan losses Credit quality of the commercial loan and lease portfolios is quantified by a corporate credit rating system designed to parallel regulatory criteria and categories of loan risk. Individual lenders monitor their loans to ensure appropriate rating assignments are made on a timely basis. Risk ratings and quality of both commercial and consumer credit portfolios are also assessed on a regular basis by an independent Loan Review Department, which reports to the Executive Vice President in charge of Asset Quality. Loan Review personnel conduct ongoing portfolio trend analyses and individual credit reviews to evaluate loan risk and compliance with corporate lending policies. Results and recommendations from this process provide senior management and the Board of Directors with independent information on loan portfolio condition. The Board of Directors monitors asset quality throughout the year. Consumer loan quality is evaluated on the basis of delinquency data due to the large number of such loans and the relatively small size of individual credits. Historical trend analyses are reviewed on a monthly basis by senior management and the Company's Board of Directors. The allowance for possible loan losses is based on management's estimate of the amount required to reflect the risks in the loan portfolio, based on circumstances and conditions known at each reporting date. Adequacy of the allowance is determined using a consistent, systematic methodology which analyzes the size and risk of the loan portfolio. In addition to evaluating the collectibility of specific loans when determining the adequacy of the allowance for possible loan losses, management also takes into consideration other factors such as changes in the mix and volume of the loan portfolio, historic loss experience, the amount of delinquencies and loans adversely classified, and economic trends. The adequacy of the allowance for possible loan losses is assessed by an allocation process whereby specific loss allocations are made against certain adversely classified loans, and general loss allocations are made against segments of the loan portfolio which have similar attributes. The Company's historical loss experience, industry trends, and the impact of the local and regional economy on the Company's borrowers, were considered by management in determining the adequacy of the allowance for possible loan losses. The allowance for possible loan losses is increased by provisions charged against current earnings. Loan losses are charged against the allowance when management believes that the collectibility of the loan principal is unlikely. Recoveries on loans previously charged off are credited to the allowance. Management believes that the allowance for possible loan losses is adequate. While management uses available information to assess possible losses on loans, future additions to the allowance may be necessary. In addition, various regulatory agencies periodically review the Company's allowance for possible loan losses as an integral part of their examination process. Such agencies may require the Company to recognize additions to the allowance based on judgements different from those of management. 17 The following table summarizes the activity in the Company's allowance for possible loan losses for the five years ended December 31, 1999: December 31, ---------------------------------------------------------- 1999 1998 1997 1996 1995 ---------- ---------- ---------- ---------- ---------- (in thousands) Balance of allowance for possible loan losses at beginning of year...... $ 41,209 $ 45,664 $ 41,743 $ 42,579 $ 38,399 Eastern (1997) and BWM (1995) allowance acquired..... -- -- 7,488 -- 4,135 Provision charged to expense................ 8,700 8,235 7,300 7,533 8,900 ---------- ---------- ---------- ---------- ---------- Balance of allowance for possible loan losses after provision.............. 49,909 53,899 56,531 50,112 51,434 ---------- ---------- ---------- ---------- ---------- Loans charged off: Commercial............ 4,747 6,941 6,127 4,769 3,735 Real estate: Residential......... 600 2,647 1,593 1,876 2,121 Commercial.......... 248 399 2,088 1,208 2,778 Construction........ -- 101 204 185 969 Home equity........... 124 502 235 304 108 Consumer.............. 7,697 7,101 4,695 3,800 3,384 ---------- ---------- ---------- ---------- ---------- Total loans charged off.................. 13,416 17,691 14,942 12,142 13,095 ---------- ---------- ---------- ---------- ---------- Recoveries of loans previously charged off: Commercial............ 1,661 1,779 1,380 1,873 1,683 Real estate: Residential......... 116 329 165 219 97 Commercial.......... 272 320 1,390 597 1,166 Construction........ 64 5 12 104 214 Home equity........... 67 110 59 13 -- Consumer.............. 2,406 2,458 1,069 967 1,080 ---------- ---------- ---------- ---------- ---------- Total recoveries.... 4,586 5,001 4,075 3,773 4,240 ---------- ---------- ---------- ---------- ---------- Net loans charged off... 8,830 12,690 10,867 8,369 8,855 ---------- ---------- ---------- ---------- ---------- Balance of allowance for possible loan losses at year end............... $ 41,079 $ 41,209 $ 45,664 $ 41,743 $ 42,579 ========== ========== ========== ========== ========== Amount of loans outstanding at end of year................... $2,895,730 $2,739,289 $2,713,639 $2,255,103 $2,144,123 Average amount of loans outstanding............ 2,877,218 2,739,617 2,508,559 $2,232,602 $2,139,747 Ratio of net charge-offs during year to average loans outstanding...... 0.30% 0.46% 0.43% 0.37% 0.41% Allowance as a percent of loans outstanding at end of year .................. 1.42 1.50 1.68 1.85 1.99 At December 31, 1999, the allowance for possible loan losses was $41.1 million, or 1.42% of total loans, compared with $41.2 million, or 1.50% of loans one year ago. The coverage ratio, or allowance for possible loan losses to nonperforming loans, stood at 448% at year-end 1999, compared with 231% at the end of 1998. 18 The following table summarizes the allocation of the allowance for possible loan losses for the five years ended December 31, 1999: December 31, ----------------------------------------------------------------------------------------------------- 1999 1998 1997 1996 ---------------------- ---------------------- ---------------------- ---------------------- Amount Loan Amount Loan Amount Loan Amount Loan Amount Allocated Distribution Allocated Distribution Allocated Distribution Allocated Distribution Allocated --------- ------------ --------- ------------ --------- ------------ --------- ------------ --------- (in thousands) Commercial....... $ 8,207 20% $ 6,885 21% $ 7,253 20% $ 7,131 22% $ 6,627 Real estate: Residential..... 2,985 32 3,818 34 4,942 38 2,764 35 2,850 Commercial...... 11,333 22 5,919 21 10,141 20 8,121 21 7,034 Construction.... 882 2 2,276 3 576 2 907 2 2,472 Home equity...... 616 5 928 6 1,091 7 599 6 291 Consumer and leasing......... 7,912 19 7,488 15 6,196 13 4,853 14 3,153 Other............ 9,144 -- 13,895 -- 15,465 -- 17,368 -- 20,152 ------- --- ------- --- ------- --- ------- --- ------- $41,079 100% $41,209 100% $45,664 100% $41,743 100% $42,579 ======= === ======= === ======= === ======= === ======= 1995 ------------ Loan Distribution ------------ Commercial....... 22% Real estate: Residential..... 35 Commercial...... 23 Construction.... 2 Home equity...... 6 Consumer and leasing......... 12 Other............ -- ------------ 100% ============ Over the last five years, the percentage of the allowance for loan losses allocated to consumer (including leasing) loans and commercial real estate loans has increased from 7% and 17%, respectively, to 19% and 28%, respectively. The shifts in these allocations reflect the trends in the overall mix of the Company's portfolio (described above in "Overview" and "Loans") to increased levels of commercial and consumer loans. Although the distribution in commercial loans declined from 22% to 20% from 1995 to 1999, the allowance for possible loan losses allocated to commercial loans increased from 17% to 28%. This resulted primarily from differences in the allocation methodology employed by VFSC. As noted in the Nonperforming Assets table, the overall level of the allowance for loan losses at December 31, 1999, when viewed as a percentage of nonperforming loans, excluding OREO, increased to 447.87% from 230.66% in 1998. This increase is primarily due to decreases in the balance of loans on nonaccrual status. The other category is the allowance considered necessary by management based on its assessment of historical loss experience, industry trends, and the impact of the local and regional economy on the Company's borrowers that may not have been captured in the specific risk classifications. Notwithstanding the foregoing analytical allocations, the entire allowance for possible loan losses is available to absorb charge-offs in any category of loans. (See "Provision for Possible Loan Losses.") Investment Securities The investment portfolio is used to meet liquidity demands, mitigate interest rate sensitivity, invest excess liquidity, and generate interest income. At December 31, 1999, the Company held investments available for sale totaling $649.5 million. This compares with investments of $990.8 million available for sale at December 31, 1998. The decline from 1998 to 1999 is primarily attributable to the sale of securities to fund loan growth and to fund the sale of deposits related to the seventeen branches sold as a condition of the merger with VFSC. At December 31, 1999, unrealized losses (net of taxes) of $7,018,000 resulted from marking the available for sale portfolio to market value. This compares with unrealized gains (net of taxes) of $6,462,000 at December 31, 1998. These amounts are reflected as a decrease and an increase, respectively, in stockholders' equity as the change in accumulated other comprehensive income. 19 The following tables show the composition of the Company's investment portfolio, at: December 31, ----------------------------------- 1999 1998 1997 1996 -------- -------- -------- -------- (in thousands) Securities available for sale (at market value) U.S. Treasury securities.................. $ 18,942 $ 53,519 $ 57,713 $139,796 U.S. government agency obligations........ 230,479 388,434 399,599 241,109 Obligations of states and political subdivisions............................. 8,297 8,123 10,301 10,558 Mortgage-backed securities................ 197,596 289,086 290,559 118,659 Corporate bonds and notes................. 193,208 216,570 90,812 65,690 Government bond mutual funds.............. -- 9,000 9,050 10,103 Marketable equity securities.............. 307 25,941 25,425 25,075 Other debt securities..................... 642 142 121 -- -------- -------- -------- -------- Total Securities available for sale..... 649,471 990,815 883,580 610,990 -------- -------- -------- -------- Securities held for investment (at amortized cost) U.S. government agency obligation......... -- -- -- $ 198 Obligations of states and political subdivisions............................. -- -- -- 490 Mortgage-backed securities................ -- -- -- 34,761 Corporate bonds and notes................. -- -- -- 25 Other debt securities..................... -- -- -- 106 -------- -------- -------- -------- Total Securities held for investment.... -- -- -- 35,580 -------- -------- -------- -------- Total Investment Securities........... $649,471 $990,815 $883,580 $646,570 ======== ======== ======== ======== The following table shows the maturity distribution of the amortized cost of the Company's investment securities and weighted average yields of such securities on a fully taxable equivalent basis at December 31, 1999, with comparative totals for 1998. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations: After One After Five Within But Within But Within After No Fixed One Year Five Years Ten Years Ten Years Maturity Total -------------- -------------- ------------- ------------ ------------ -------------- Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield -------- ----- -------- ----- ------- ----- ------ ----- ------ ----- -------- ----- Securities available for (in thousands) sale US Treasury securities.. $ 14,448 5.63% $ 4,498 6.13% $ -- --% $ -- --% $ -- --% $ 18,946 5.74% US government agency obligations............ 2,522 5.80 217,811 5.98 14,993 7.09 -- -- -- -- 235,326 6.05 Obligations of states and political subdivisions........... 2,216 7.01 4,939 6.58 1,120 6.07 70 9.00 -- -- 8,345 6.63 Mortgage-backed securities (1)......... 53,386 6.21 131,227 6.37 14,448 7.06 1,353 7.45 -- -- 200,414 6.39 Corporate bonds and notes.................. 18,083 6.29 176,164 6.25 1,147 6.33 1,008 6.18 -- -- 196,402 6.25 Government bond mutual funds.................. -- -- -- -- -- -- -- -- -- -- -- -- Marketable equity securities............. -- -- -- -- -- -- -- -- 274 -- 274 -- Other debt securities... 10 4.98 580 6.48 52 8.36 -- -- -- -- 642 6.61 -------- ---- -------- ---- ------- ---- ------ ---- ------ ---- -------- ---- Total available for sale.................. $ 90,665 6.14% $535,219 6.17% $31,760 7.01% $2,431 6.97% $ 274 --% $660,349 6.21% ======== ==== ======== ==== ======= ==== ====== ==== ====== ==== ======== ==== Comparative totals for 1998................... $309,551 5.68% $632,662 6.22% $28,359 6.99% $ 244 6.58% $9,866 6.37% $980,682 6.07% - -------- (1) Maturities of mortgage-backed securities are based on contractual payments and estimated mortgage loan prepayments. 20 Deposits During 1999, total deposits averaged $3.528 billion, up from $3.495 billion in 1998. Noninterest-bearing demand deposits averaged $580 million, up from $556 million in 1998. Average savings deposits increased $72 million, to $1.975 billion for 1999. This category includes non-contractual interest bearing deposit products, such as savings, money market, and N.O.W. accounts. During 1999, time accounts (retirement and certificates of deposit) averaged $974 million, decreasing compared to $1,036 million in 1998. The Company has a number of institutional customers within its franchise whose investment needs are frequently met by purchasing certificates of deposit over $100,000. Depositors in this category tend to seek bids regularly, and the Company raises or lowers the interest rates it offers depending on its liquidity needs and investment opportunities. The following table shows average balances of the Company's deposits for the periods indicated: Years Ended December 31, ------------------------------------------- 1999 1998 1997 1996 ---------- ---------- ---------- ---------- (in thousands) Demand deposits.................... $ 579,631 $ 555,635 $ 464,208 $ 386,434 Savings deposits................... 1,975,125 1,903,265 1,657,072 1,445,457 Certificates of deposit less than $100,000 and other time deposits.. 795,361 856,290 805,510 694,544 Certificates of deposit $100,000 and over.......................... 178,309 179,755 171,954 151,723 ---------- ---------- ---------- ---------- Total deposits................... $3,528,426 $3,494,945 $3,098,744 $2,678,158 ========== ========== ========== ========== The Company's ending balances of outstanding certificates of deposit and other time deposits in denominations of $100,000 and over had maturities as follows: Years Ended December 31, -------------------------- 1999 1998 1997 -------- -------- -------- (in thousands) Three months or less................................ $135,371 $108,597 $101,967 Over three months to six months..................... 39,647 48,471 36,637 Over six months to twelve months.................... 45,439 45,978 40,260 Over twelve months.................................. 15,252 23,311 29,475 -------- -------- -------- $235,709 $226,357 $208,339 ======== ======== ======== Borrowings During 1999, short-term borrowings averaged $139.3 million, down from the $158.9 million posted in 1998. This funding consists of treasury, tax and loan deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (FHLB) borrowings, and federal funds purchased. FHLB borrowings averaged $29.7 million for 1999, down from $47.7 million in 1998. This decrease in the average is primarily attributable to a decline in FHLB borrowing activity after VNB became part of Chittenden Corporation. Treasury borrowings averaged $13.1 million for 1999 compared with $20.8 million during 1998. Treasury funding is attractive to the Company because the rate of interest paid on borrowings floats at 25 basis points below the federal funds rate, there are no reserve requirements, and there are no FDIC insurance costs. Repurchase agreements averaged $89.6 million for 1999, up slightly from $83.7 million in 1998. These borrowings are with franchise customers, primarily municipalities and corporate customers, and have neither reserve requirements nor FDIC insurance costs. Capital Resources The Company's capital forms the foundation for maintaining investor confidence as well as for developing programs for growth and new activities. Because of the Company's profitability over the past several years, total capital increased from $295.5 million at December 31, 1996 to $362.5 million at December 31, 1999. During 1997, the Company adopted measures to maintain a capital level consistent with the needs for its activities. An additional special $0.60 per share dividend was declared in October 1997 to maintain capital at a level consistent 21 with the Company's requirements at that time. Additionally, a share repurchase plan was implemented, in which up to 1,250,000 shares could be repurchased during 1997 and 1998. During 1998, the repurchase plan was expanded to allow an additional 500,000 shares to be repurchased during 1998 and 1999. However, the repurchase plan was rescinded prior to the announcement of the agreement to merge with Vermont Financial Services Corporation in a transaction to be accounted for as a pooling of interests. On January 19, 2000, the Board of Directors authorized the repurchase of up to 2,000,000 shares of the Corporation's common stock in negotiated transactions or open market purchases. Chittenden, depending on market conditions, may repurchase its Common Stock without further Board authorization for two years. At December 31, 1999, capital stood at $362.5 million, a decrease of $29.1 million from $391.6 million at December 31, 1998. Dividend payments totaling $22.8 million and the net loss of $2.5 million reduced the capital position during 1999. The capital position was also reduced by the change in unrealized gains and losses in the available for sale investment portfolio of $13.5 million. Repurchases of the Company's common stock totaling $22.6 million and dividend payments totaling $19.6 million reduced the capital position during 1998. The reductions in capital were offset by earnings of $49.8 million, $3.6 million in proceeds from common stock issued in connection with benefit plans and an increase in the net unrealized gain on securities available for sale of $2.6 million. Both the Board of Governors of the Federal Reserve System (the "FRB") and the Federal Deposit Insurance Corporation (the "FDIC") have defined leverage capital requirements. At December 31, 1999, the Company's leverage capital ratio (which is calculated pursuant to the FRB's regulations) was 8.17%, CTC's, BWM's, FBT's, and VNB's leverage capital ratios (which are calculated pursuant to the FDIC's regulations) were 7.14%, 6.77%, 6.72% and 8.91%, respectively. The ratios in 1998 were 7.58% for the Company, 6.89% for CTC, 8.05% for BWM, 6.33% for FBT, and 6.55% for VNB. Additionally, the FRB and the FDIC have a risk-based capital standard. Under this measure of capital, banks are required to hold more capital against certain assets perceived as more-risky, such as commercial loans, than against other assets perceived as less-risky, such as residential mortgage loans and U.S. Treasury securities. Further, off-balance sheet items such as unfunded loan commitments and standby letters of credit, are included for the purposes of determining risk-weighted assets. Commercial banking organizations are required to have total capital equal to 8% of risk-weighted assets, and Tier 1 capital--consisting of common stock and certain types of preferred stock-- equal to at least 4% of risk-weighted assets. Tier 2 capital, included in total capital, includes the allowance for possible loan losses up to a maximum of 1.25% of risk-weighted assets. At December 31, 1999, the Company's risk- based capital ratio was 13.23% and its Tier 1 capital, consisting entirely of common stock, was 11.96% of risk-weighted assets. This compares with year-end 1998 ratios of 12.02% and 10.76%, respectively. FDIC regulations pertaining to capital adequacy, which apply to the Banks, require a minimum 3% leverage capital ratio for those institutions with the most favorable composite regulatory examination rating. In addition, a 4% Tier 1 risk-based capital ratio, and an 8% total risk-based capital ratio are required for a bank to be considered adequately capitalized. Leverage, Tier 1 risk-based, and total risk-based capital ratios exceeding 5%, 6%, and 10%, respectively, qualify a bank for the "well-capitalized" designation. At December 31, 1999, CTC's leverage capital ratio was 7.14%, its Tier 1 risk- based capital ratio was 9.22%, and its total risk-based capital ratio was 10.46%; BWM's ratios were 6.77%, 9.78%, and 11.12%, respectively; FBT's ratios were 6.72%, 9.26%, and 10.52%, respectively; VNB's ratios were 8.91%, 14.13%, and 15.39%, respectively. These ratios placed the Banks in the FDIC's highest capital category of "well capitalized". Capital ratios in excess of minimum requirements indicate capacity to take advantage of profitable and credit- worthy opportunities as well as the potential to respond to unforeseen adverse conditions. 22 The following table presents capital components and ratios of the Company at: December 31, ---------------------------------------------- 1999 1998 1997 1996 ---------- ---------- ---------- ---------- (in thousands) Leverage Stockholders' equity............ $ 350,715 $ 313,273 $ 295,717 $ 278,108 Total average assets (1)........ 4,294,030 4,135,637 4,022,061 3,202,866 8.17% 7.58% 7.35% 8.68% Risk-based Capital components: Tier 1........................ $ 350,715 $ 313,273 $ 295,717 $ 278,108 Tier 2........................ 36,647 36,394 34,186 27,784 ---------- ---------- ---------- ---------- Total....................... $ 387,362 $ 349,667 $ 329,903 $ 305,892 ========== ========== ========== ========== Risk-weighted assets: On-balance sheet.............. $2,824,133 $3,628,633 $3,461,939 $2,137,870 Off-balance sheet............. 126,100 118,628 128,885 101,581 ---------- ---------- ---------- ---------- $2,950,233 $3,747,261 $3,590,824 $2,239,451 ========== ========== ========== ========== Ratios: Tier 1........................ 11.96% 10.76% 10.82% 12.53% Total (including Tier 2)...... 13.23 12.02 12.14 13.85 - -------- (1) Total average assets for the most recent quarter. Liquidity and Rate Sensitivity The Company's liquidity and rate sensitivity are monitored by the asset and liability committee, based upon policies approved by the Board of Directors. Strategies are implemented by the Banks' asset and liability committee. This committee meets periodically to review and direct the Banks' lending and deposit-gathering functions. Investment and borrowing activities are managed by the Company's Treasury function. The measure of an institution's liquidity is its ability to meet its cash commitments at all times with available cash or by conversion of other assets to cash at a reasonable price. At December 31, 1999, the Company maintained cash balances and short-term investments of approximately $150.4 million, compared with $267.9 million at December 31, 1998. The decline was primarily attributable to the required divestitures, in which cash totalling $265 million was paid to the acquiring institutions in exchange for liabilities assumed net of assets acquired. During 1999, the Company continued to be an average daily net seller of Federal Funds. To measure the sensitivity of its income to changes in interest rates, the Company uses a variety of methods, including simulation, valuation techniques and gap analyses. Interest rate risk is the sensitivity of income to variations in interest rates over both short-term and long-term horizons. The primary goal of interest-rate management is to control this risk within limits approved by the Board of Directors. These limits and guidelines reflect the Company's tolerance for interest-rate risk. The Company attempts to control interest-rate risk by identifying exposures, quantifying them and taking appropriate actions. The Company uses simulation analyses to measure the exposure of net interest income to changes in interest rates over a relatively short (i.e., within one year) time horizon. Simulation analysis incorporates what management believes to be the most appropriate assumptions about customer and competitor behavior in the specified interest rate scenario. These assumptions are the basis for projecting future interest income and expense from the Company's assets and liabilities under various scenarios. Simulation analysis may have certain limitations caused by market conditions varying from those assumed in a model. Actual results can often differ due to the effects of prepayments and refinancing of loans and investments, as well as deposits ability to reprice or runoff, which may be different from that which has been assumed. 23 The Company's limits on interest-rate risk specify that if interest rates were to shift immediately, (shocked) up or down 200 basis points, estimated net interest income for the next 12 months should neither improve or be impacted by greater than 10%. The results of the simulations over the next 12 months based on an increase in interest rates of 200 basis points will result in a decrease of .07% in net interest income and a decline of 200 basis points will result in a decrease of .38% in net interest income. An additional analysis is performed to review results if interest rates were to shift quarterly, (ramped) up or down 100 and 200 basis points over a twelve month period. The results of the simulations over the next 12 months based on a gradual increase in interest rates of 100 and 200 basis points will result in a decrease of .15% and .33% respectively, in net interest income and a decline of 100 and 200 basis points will result in an increase of .11% and .22% respectively, in net interest income. As noted above, one of the tools used to measure rate sensitivity is the funds gap. The funds gap is defined as the amount by which a bank's rate sensitive assets exceed its rate sensitive liabilities. A positive gap exists when rate sensitive assets exceed rate sensitive liabilities. This indicates that a greater volume of assets than liabilities will reprice during a given period. This mismatch will improve earnings in a rising rate environment and inhibit earnings when rates decline. Conversely, when rate sensitive liabilities exceed rate sensitive assets, the gap is referred to as negative and indicates that a greater volume of liabilities than assets will reprice during the period. In this case, a rising rate environment will inhibit earnings and declining rates will improve earnings. Notwithstanding this general description of the effect on income of the gap position, it may not be an accurate predictor of changes in net interest income. The Company's limits on interest-rate risk specify that the cumulative one-year gap should be less than 15% of total assets. As of December 31, 1999, the estimated exposure was 3.5% and the Company was liability-sensitive. The following table shows the amounts of interest-earning assets and interest-bearing liabilities at December 31, 1999 that reprice during the periods indicated: Repricing Date ------------------------------------------------------- One Day Over Six Over One Over To Six Months To Year To Five Months One Year Five Years Years Total ---------- --------- ---------- --------- ---------- (in thousands) Interest-earning assets: Loans................... $1,371,119 $ 388,078 $ 983,529 $ 155,926 $2,898,652 Investment securities (1).................... 119,603 79,485 454,898 11,448 665,434 Interest-bearing cash equivalents............ 1,896 125 615 27 2,663 ---------- --------- ---------- --------- ---------- Total interest-earning assets............... 1,492,618 467,688 1,439,042 167,401 3,566,749 ---------- --------- ---------- --------- ---------- Interest-bearing liabilities: Deposits................ 1,699,817 229,137 248,464 494,561 2,671,979 Borrowings ............. 166,433 130 27,204 3,304 197,071 ---------- --------- ---------- --------- ---------- Total interest-bearing liabilities.......... 1,866,250 229,267 275,668 497,865 2,869,050 ---------- --------- ---------- --------- ---------- Net interest rate sensitivity gap........ $ (373,632) $ 238,421 $1,163,374 $(330,464) $ 697,699 ========== ========= ========== ========= ========== Cumulative gap at December 31, 1999...... $ (373,632) $(135,211) $1,028,163 $ 697,699 Cumulative gap at December 31, 1998...... $ (307,647) $(231,955) $ 582,087 $ 704,923 - -------- (1)Amounts are based on amortized cost balances. 24 The following table shows scheduled maturities of selected loans at December 31, 1999: Less Over Than One One Year to Five Year Five Years Years Total -------- ----------- -------- -------- (in thousands) Predetermined rates: Commercial............................ $ 37,538 $ 99,485 $ 43,514 $180,537 Commercial real estate and construction......................... 44,136 220,751 142,434 407,321 -------- -------- -------- -------- 81,674 320,236 185,948 587,858 ======== ======== ======== ======== Floating or adjustable rates: Commercial............................ 109,855 104,214 100,515 314,584 Commercial real estate and construction......................... 44,833 156,207 88,626 289,666 -------- -------- -------- -------- $154,688 $260,421 $189,141 $604,250 ======== ======== ======== ======== The most significant factor affecting the interest-rate risk position during 1999 was the divestiture of loans and deposits related to the VFSC merger. Results of Operations Comparison of Years Ended December 31, 1999 and 1998 Net Interest Income The primary source of recurring income for the Company is the net interest income of the Banks, which is the difference between interest income on loans and investments, and interest paid on deposits and borrowings. Net interest income is affected by changes in interest rates and the volumes of interest earning assets and interest bearing liabilities. For 1999, net interest income was $175.0 million, up $1.3 million from the 1998 level. On a fully taxable equivalent basis, net interest income increased $1.4 million from 1998, to $178.0 million in 1999. These improvements resulted from higher levels of interest earning assets, which were up $58.8 million from 1998, to $3.808 billion for 1999. The increased level of earning assets offset a decline in the net yield on earning assets from 4.71% in 1998 to 4.67% in 1999. The decrease in the net yield on earning assets was due to lower yields in both the loan and investment portfolios. 25 The following table presents an analysis of average rates and yields on a fully taxable equivalent basis for the years indicated: 1999 1998 1997 ------------------------------- ------------------------------- -------------------------------- Average Average Interest Yield/ Interest Yield/ Interest Average Average Income/ Rate Average Income/ Rate Average Income/ Yield/ Balance Expense (1) (1) Balance Expense (1) (1) Balance Expense (1) Rate (1) ---------- ----------- ------- ---------- ----------- ------- ---------- ----------- -------- (in thousands) Assets Interest-earning assets: Loans................. $2,877,218 $235,393 8.18% $2,739,617 238,785 8.72% $2,508,559 $224,736 8.96% Investments: Taxable............... 847,076 51,408 6.07 893,649 57,117 6.39 770,101 49,641 6.45 Tax-favored debt securities............ 41,108 2,319 5.64 49,978 3,233 6.47 32,225 2,245 6.97 Interest-bearing deposits in banks.... 1,423 71 4.99 3,356 200 5.96 1,360 51 3.75 Federal funds sold.... 41,469 2,032 4.90 62,898 3,458 5.50 48,669 2,659 5.46 ---------- -------- ---------- -------- ---------- -------- Total interest-earning assets................ 3,808,294 291,223 7.65 3,749,498 302,793 8.08 3,360,914 279,332 8.31 -------- -------- -------- Noninterest-earning assets................ 338,460 386,266 340,729 Allowance for possible loan losses.......... (42,257) (45,520) (45,309) ---------- ---------- ---------- Total assets.......... $4,104,497 $4,090,244 $3,656,334 ========== ========== ========== Interest-bearing liabilities: Savings and interest- bearing transactional accounts............. $1,975,125 $ 57,875 2.93 $1,903,265 $ 61,969 3.26 $1,657,072 $ 54,689 3.30 Certificates of deposit under $100,000 and other time deposits........ 795,361 40,018 5.03 856,290 45,638 5.33 805,510 42,350 5.26 Certificates of deposit $100,000 and over............. 178,309 8,471 4.75 179,755 9,861 5.49 171,954 9,097 5.29 ---------- -------- ---------- -------- ---------- -------- Total interest-bearing deposits.............. 2,948,795 106,364 3.61 2,939,310 117,468 4.00 2,634,536 106,136 4.03 Short-term borrowings. 139,340 6,871 4.93 158,931 8,691 5.47 172,249 9,326 5.41 ---------- -------- ---------- -------- ---------- -------- Total interest-bearing liabilities........... 3,088,135 113,235 3.67 3,098,241 126,159 4.07 2,806,785 115,462 4.11 -------- -------- -------- Noninterest-bearing liabilities: Demand deposits....... 579,631 555,635 464,208 Other liabilities..... 62,989 56,753 47,470 ---------- ---------- ---------- Total liabilities..... 3,730,755 3,710,629 3,318,463 Stockholders' equity... 373,742 379,615 337,871 ---------- ---------- ---------- Total liabilities and Stockholders' equity ..................... $4,104,497 $4,090,244 $3,656,334 ========== ========== ========== Net interest income.... $177,988 $176,634 $163,870 ======== ======== ======== Interest rate spread (2).................... 3.98% 4.01% 4.20% Net yield on earning assets (3)............. 4.67% 4.71% 4.88% - -------- (1)On a fully taxable equivalent basis. Calculated using a Federal income tax rate of 35%. Loan income includes fees. (2)Interest rate spread is the average rate earned on total interest-earning assets less the average rate paid on interest-bearing liabilities. (3)Net yield on earning assets is net interest income divided by total interest-earning assets 26 The following table attributes changes in the Company's net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates. Changes due to both interest rate and volume have been allocated to change due to balance and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each. 1999 Compared With 1998 1998 Compared With 1997 ----------------------------- --------------------------------- Increase (Decrease) Due Increase (Decrease) to Change in: Due to Change in: ----------------- Total --------------------- Total Average Average Increase Average Average Increase Rate Balance (Decrease) Rate Balance (Decrease) -------- ------- ---------- --------- ---------- ---------- (in thousands) Interest income: Loans.................. $(14,731) $11,339 $ (3,392) $ (6,090) $ 20,139 $ 14,049 Investments: Taxable................ (2,883) (2,826) (5,709) (421) 7,897 7,476 Tax-favored debt securities............ (414) (500) (914) (160) 1,148 988 Interest-bearing deposits in banks..... (33) (96) (129) 30 119 149 Federal funds sold..... (376) (1,050) (1,426) 17 782 799 -------- ------- -------- --------- ---------- -------- Total interest income.. (18,437) 6,867 (11,570) (6,624) 30,085 23,461 -------- ------- -------- --------- ---------- -------- Interest expense: Savings and interest- bearing transactional accounts ...................... 6,200 (2,106) 4,094 781 (8,061) (7,280) Certificates of deposit under $100,000 and other time deposits... 2,554 3,066 5,620 (582) (2,706) (3,288) Certificates of deposit $100,000 and over..... 1,321 69 1,390 (336) (428) (764) -------- ------- -------- --------- ---------- -------- Total deposits......... 10,075 1,029 11,104 (137) (11,195) (11,332) Short-term borrowings.. 854 966 1,820 (93) 728 635 -------- ------- -------- --------- ---------- -------- Total interest expense. 10,929 1,995 12,924 (230) (10,467) (10,697) -------- ------- -------- --------- ---------- -------- Change in net interest income................. $ (7,508) $ 8,862 $ 1,354 $ (6,853) $ 19,618 $ 12,764 ======== ======= ======== ========= ========== ======== Noninterest Income and Noninterest Expense Noninterest income was $64.2 million in 1999, down $2.5 million from the $66.7 million reported in 1998. The decline was primarily attributable to lower gains on sales of mortgage loans, which decreased $2.5 million to $5.3 million, compared to gains of $7.7 million in 1998. This was a result of decreases in the volume of loans sold from $671.3 million in 1998 to $381.6 million in 1999, due to increases in mortgage loan rates which caused lower levels of fixed rate production. Investment management income was up $1.4 million from the 1998 level, to $14.3 million. This was due to the effects of an increase in the number of investment management clients served and higher levels of administered assets, which were enhanced by the impact of advances in the stock market during the year. Service charges on deposit accounts declined $2.3 million from the 1998 level to $17.5 million. This was caused primarily by lower levels of overdraft charges related to the no fee checking product acquired by VFSC in the Eastern acquisition. Noninterest expense, including special charges of $58.5 million, totaled $203.9 million in 1999, compared to $152.5 million in 1998. Excluding special charges, noninterest expenses were $7.1 million lower in 1999 than in 1998. Salaries decreased $2.1 million from $60.4 million in 1998. This was primarily attributable to lower staffing levels after the merger with VFSC and to the divestiture of seventeen VNB branches between September and November 1999. Occupancy expenses decreased $1.8 million from 1998 due to lower levels of depreciation expense resulting from the write-off of duplicative fixed assets and the elimination of occupancy expenses relating to the divested branches. Finally, amortization of intangible assets was $1.9 million lower than in 1998 27 due to the write off of goodwill recorded by VFSC relative to the Eastern acquisition. Upon the effective date of the Chittenden-VFSC merger, impaired goodwill totaling $21.1 million related to former Eastern locations in markets already occupied by Chittenden was written off. In addition, $25.7 million of goodwill allocated to the branches sold was recovered. Total other noninterest expense for 1999 totaled $43.1 million, down from $44.4 million in 1998. The components of other noninterest expense for the years presented are as follows: 1999 1998 1997 ------- ------- ------- (in thousands) Data processing................................. $ 8,635 $ 6,937 $ 7,516 Legal and professional.......................... 2,518 4,234 2,562 Marketing....................................... 3,199 3,608 3,249 Software and Supplies........................... 4,710 4,641 4,320 Net OREO and collection expenses ............... (146) 472 1,019 Telephone....................................... 3,970 4,133 3,103 Postage......................................... 3,143 3,112 2,565 Other........................................... 17,076 17,290 18,461 ------- ------- ------- $43,105 $44,427 $42,795 ======= ======= ======= Income Taxes The Company and the Banks are taxed on income by the IRS at the Federal level and by various states in which they do business. The majority of the Company's income is generated in the State of Vermont, which levies franchise taxes on banking institutions based upon average deposit levels in lieu of taxing income. Franchise taxes are included in income tax expense in the consolidated statements of income. For the years ended December 31, 1999 and 1998, Federal and state income tax provisions amounted to $29.1 million and $29.8 million, respectively. The provision for 1999 includes a $14.4 million tax benefit associated with the tax-deductible portion of the merger related one-time charge, and a $13.3 million provision related to the branch gains recognized upon the sale of divested branches. Excluding the effect of the special provision and benefit, the effective tax rates for the respective periods were 35.4% and 37.5%. During both periods, the Company's statutory Federal corporate tax rate was 35%. The Company's effective tax rates differed from the statutory rates primarily because of non-tax-deductible amortization of goodwill related to VFSC's acquisition of Eastern Bancorp. The higher effective rate produced by these nondeductible expenses was partially reduced by 1) the proportion of interest income from state and municipal securities and loans and corporate dividend income, which are partially exempt from Federal taxation and 2) tax credits on investments in qualified low income housing projects. The reduction in the Company's effective tax rate from 1998 to 1999 reflects lower levels of non-tax deductible goodwill resulting from the impaired goodwill written off in the second quarter of 1999 upon the consummation of the merger of Chittenden and VFSC and to the goodwill recovered in relation to the branch sales in the fourth quarter. As noted above, the Company recorded $58.5 million in special charges in 1999, which included $49.9 million of merger related expenses and $21.1 million related to the write-off of impaired goodwill, offset by a $12.5 million gain recorded on sales of branches. No tax benefit was recorded in relation to the goodwill reductions since that expense is not tax deductible. In addition, no tax benefit was recognized in relation to certain non- deductible merger related expenses including investment advisory, legal and accounting fees incurred as part of the transaction. Tax benefits were recognized at the Company's marginal federal tax rate of 35% in relation to all deductible merger related expenses including severance and related expenses, conversion of systems, and dispositions of duplicative assets. Year 2000 The Year 2000 problem, which is common to most corporations, concerns the inability of information systems, primarily computer software programs, to properly recognize and process date sensitive information as the year 2000 approaches. In April 1997, the Company formed a task force to manage the completion of the five 28 phases of the Year 2000 (Y2K) readiness process which had informally started in November 1996. These phases include awareness of the Y2K problem; the assessment of its impact on the Company; the subsequent renovation of affected systems; the validation of designed Y2K renovations; and the implementation of the validated renovations. The Company's information systems include larger programs that run on mainframe systems and smaller programs that reside on individual or networked personal computers. The vast majority of the systems considered by the Company to be mission-critical (vital to the successful continuance of the Company's core business activities) are mainframe-based systems. The assessment, renovation, testing, and implementation of the renovations to all mission- critical mainframe systems were completed by June 30, 1999. In addition, the Company developed an internal reporting system to track its deadlines relating to the renovation, testing, and implementation of Y2K related tasks to ensure that they were completed on schedule. The personal computer (PC) based systems considered to be mission-critical by management are smaller in scope than the mainframe-based systems. Mission critical PC-based systems were completely assessed, renovated and tested by June 30, 1999. All non-critical mainframe systems were complete by September 30, 1999, and all non-critical PC-based systems were complete by November 30, 1999. The Company's Y2K readiness is also affected by the readiness of its vendors. The Company's most significant vendors are those that provide the mainframe software that the Company uses to process its mission-critical systems. The Company has two major vendors that provide the majority of the mainframe based computer programs used in mission-critical systems. The Company confirmed with each of these vendors that they expected to be ready for the Year 2000 within mandated timeframes. The Company also contacted the remainder of its vendors to determine their compliance and developed a tracking mechanism that will provide immediate notification if a vendor does not meet a promised deadline. The Company also performed ongoing evaluations of the Y2K readiness of its significant customers. The results of this evaluation included responses from approximately 92% of the Company's significant customers. These customers responded to a questionnaire which asked them detailed questions regarding their Year 2000 readiness, including: . whether or not they had developed a comprehensive plan for Year 2000 compliance; . whether or not a specific individual had been assigned responsibility for managing Y2K compliance; . whether or not senior management had reviewed and approved the plan; . whether or not the customer had inventoried its hardware, software, telecommunications, and facilities for Y2K compliance; . whether or not the customer had budgeted sufficient resources to accomplish its Y2K mission; . whether or not the plan had been reviewed by outside auditors; . the timing for the completion of testing of critical systems and the preparation of contingency plans for those systems; . whether or not the customers had discussed Y2K related issues with their attorneys and insurers. The responses were directed to the customer's primary customer service contact, who reviewed their responses and then forwarded them to a specific individual responsible for coordinating all responses and assessing their impact on the Company. Responses were rated from 1 to 6, with 1 representing the most progress and 6 representing the least. Of those customers who responded, 90% have been rated as either 1 or 2. None of the responses indicated the existence of any Y2K related issues which might have a material impact on the Company. Alternative assessments were performed on a case-by- case basis for the two significant customers who did not respond to the questionnaire. These assessments included any procedures considered necessary to satisfy the Company that there were no Y2K related issues associated with these two significant customers. 29 The monitoring of the Y2K readiness of these customers has continued after January 1, 2000 and could result in future increased credit risk to the Company in the event that these customers do not successfully remediate any Y2K issues that they might have. The Company has not become aware of any to date. The Company incurred costs to replace existing hardware and software which were capitalized and depreciated in accordance with the Company's existing accounting policy as well as maintenance and software modification costs which were expensed as incurred. A summary of costs incurred relative to Y2K follows: Costs incurred through December 31, 1999 -------------- Software Modification...................................... $2,346,252 Replacement of non-compliant software...................... 1,047,935 Replacement of non-compliant hardware...................... 827,643 ---------- Total.................................................... $4,221,830 ========== Of the $4.22 million in costs of Y2K compliance, approximately 80% consisted of hardware and software purchases with future utility and expanded functionality which were therefore capitalized and depreciated in accordance with the Company's existing accounting policy. The above costs do not include salaries and benefits of Company personnel or allocated costs of the Company's two major mainframe contracts as these costs would have been incurred regardless of the Y2K problem. The Company did not defer any significant information technology (IT) projects that would have had a material adverse effect on its future operations if not performed in a timely manner. Funds allocated for remediation of Year 2000 issues were not appropriated from the Company's ongoing IT budget. The agencies that regulate the Company (the Federal Reserve Board) and its subsidiary banks (the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the State of Vermont and the Commonwealth of Massachusetts) have issued guidance as to the standards they will use in assessing Year 2000 readiness. If, in the judgment of these regulatory agencies, a regulated institution, such as the Company and its subsidiaries, fails to take appropriate action to address its Y2K issues, the regulatory agencies could impose enforcement actions which could have a material adverse impact on such an institution, including the imposition of civil money penalties, or the delay of applications seeking to complete acquisitions. Through the date of this filing, the Company has not experienced any significant or moderate Y2K related problems with any of its mission critical or non-critical systems. Results of Operations Comparison of Years Ended December 31, 1998 and 1997 Net Interest Income For 1998, net interest income was $173.7 million, compared with $160.9 million for 1997. On a fully taxable equivalent basis, net interest income increased $12.8 million from 1997 to $176.6 million in 1998. These improvements resulted from higher levels of interest-earning assets which outpaced the decline in the net yield on those assets. Average interest- earning assets totaled $3.749 billion for 1998, up $388.6 million from the 1997 level. The taxable equivalent net yield on earning assets was 4.71% in 1998, a decrease of 17 basis points from 4.88% in 1997. Noninterest Income and Noninterest Expense Noninterest income was $66.7 million in 1998, up $11.2 million from the $55.5 million reported in 1997. Investment management income was up $1.6 million from the 1997 level, to $12.9 million, due to trends similar to those experienced in 1999. Service charges on deposit accounts increased in 1998, rising to $19.8 million from $17.2 million in the previous year. This was primarily attributable to VFSC's acquisition of Eastern Bancorp in late June 1997, in a transaction accounted for as a purchase. Net insurance commissions generated by the insurance agency acquired in May 1997 totaled $2.9 million. 30 Noninterest expense totaled $152.6 million in 1998, up $16.1 million from the 1997 level. Salaries increased to $60.4 million from $52.9 million in 1997. Employee benefits increased by $852,000 to $16.6 million in 1998. The increases in salaries and benefits during 1998 were primarily attributable to the acquisition of Eastern Bancorp. Of the $8.4 million increase in salaries and benefits, $7.1 million was attributable to the inclusion of Eastern's operations for the full year of 1998 versus only six months in 1997. Other noninterest expense for 1998 totaled $44.4 million, up from $42.8 million in 1997, due primarily to the full year impact of the Eastern acquisition. Income Taxes For 1998, the Federal and state income tax provisions amounted to $29.8 million. This compares with an income tax provision of $26.1 million for 1997. The effective tax rates for 1998 and 1997 were 37.5% and 35.9%, respectively. During 1998 and 1997, the Company's statutory Federal corporate tax rate was 35%. The Company's effective tax rates differed from the statutory rates primarily because of non tax-deductible amortization of goodwill related to VFSC's acquisition of Eastern Bancorp. The higher effective rate produced by these nondeductible expenses was partially reduced by 1) the proportion of interest income from state and municipal securities and loans and corporate dividend income, which are partially exempt from Federal taxation and 2) tax credits on investments in qualified low income housing projects. The lower effective tax rate in 1997 was due to only six months worth of nondeductible goodwill amortization being included in that year because VFSC's acquisition of Eastern occurred on June 27 of that year. 31 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CHITTENDEN CORPORATION CONSOLIDATED BALANCE SHEETS December 31, ---------------------- 1999 1998 ---------- ---------- (in thousands) (Restated) Assets Cash and cash equivalents.............................. $ 150,415 $ 267,999 Securities available for sale.......................... 649,471 990,815 FHLB and FRB stock .................................... 16,879 21,979 Mortgage loans held for sale........................... 2,926 53,684 Loans ................................................. 2,895,730 2,739,289 Less: Allowance for possible loan losses .............. (41,079) (41,209) ---------- ---------- Net loans............................................ 2,854,651 2,698,080 Accrued interest receivable............................ 25,399 27,237 Other real estate owned................................ 416 1,870 Other assets........................................... 67,499 52,664 Premises and equipment, net............................ 41,052 72,263 Intangible assets...................................... 18,589 69,461 ---------- ---------- Total assets......................................... $3,827,297 $4,256,052 ========== ========== Liabilities and Stockholders' Equity Liabilities: Deposits: Demand............................................... $ 532,120 $ 614,729 Savings.............................................. 1,807,843 2,032,717 Certificates of deposit less than $100,000 and other time deposits....................................... 649,051 834,709 Certificates of deposit $100,000 and over............ 215,084 198,090 ---------- ---------- Total deposits..................................... 3,204,098 3,680,245 Short-term borrowings.................................. 197,072 135,913 Accrued expenses and other liabilities................. 63,667 48,332 ---------- ---------- Total liabilities.................................... 3,464,837 3,864,490 Commitments and contingencies Stockholders' equity: Preferred stock--$100 par value--authorized: 200,000 shares--issued and outstanding: none.................. -- -- Common stock--$1 par value--authorized: 60,000,000 shares--issued and outstanding: 28,380,040 in 1999 and 30,153,669 in 1998.................................... 28,380 30,154 Surplus................................................ 149,502 188,431 Retained earnings...................................... 189,344 214,329 Treasury stock, at cost--1,808 shares in 1999 and 2,216,599 shares in 1998.............................. (24) (49,650) Accumulated other comprehensive income................. (7,018) 6,462 Directors deferred compensation to be settled in stock. 2,449 2,102 Unearned portion of employee restricted stock.......... (173) (266) ---------- ---------- Total stockholders' equity........................... 362,460 391,562 ---------- ---------- Total liabilities and stockholders' equity........... $3,827,297 $4,256,052 ========== ========== The accompanying notes are an integral part of these consolidated financial statements. 32 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, --------------------------- 1999 1998 1997 -------- -------- -------- (in thousands, except per share amounts) (Restated) Interest income: Interest on loans................................ $233,059 $237,172 $222,470 Interest on investment securities: Taxable........................................ 51,505 57,167 49,630 Tax-favored.................................... 1,549 1,868 1,513 Short-term investments........................... 2,103 3,658 2,710 -------- -------- -------- Total interest income.......................... 288,216 299,865 276,323 -------- -------- -------- Interest expense: Deposits: Savings........................................ 57,875 61,969 54,689 Time........................................... 48,489 55,499 51,447 -------- -------- -------- Total interest on deposits................... 106,364 117,468 106,136 Short-term borrowings............................ 6,871 8,691 9,326 -------- -------- -------- Total interest expense......................... 113,235 126,159 115,462 -------- -------- -------- Net interest income................................ 174,981 173,706 160,861 Provision for possible loan losses ................ 8,700 8,235 7,300 -------- -------- -------- Net interest income after provision for possible loan losses ...................................... 166,281 165,471 153,561 -------- -------- -------- Noninterest income: Investment management income..................... 14,290 12,913 11,363 Service charges on deposit accounts.............. 17,534 19,785 17,172 Mortgage servicing income ....................... 3,589 3,274 4,114 Gains on sales of mortgage loans, net............ 5,254 7,734 3,584 Credit card income, net.......................... 6,248 6,114 6,069 Insurance commissions, net....................... 2,538 2,878 1,327 Other............................................ 14,773 13,996 11,890 -------- -------- -------- Total noninterest income....................... 64,226 66,694 55,519 -------- -------- -------- Noninterest expense: Salaries......................................... 58,268 60,414 52,883 Employee benefits ............................... 16,609 16,563 15,711 Net occupancy expense............................ 23,452 25,248 21,143 Amortization of intangibles...................... 4,023 5,895 3,911 Special charges.................................. 58,472 -- -- Other ........................................... 43,105 44,427 42,795 -------- -------- -------- Total noninterest expense...................... 203,929 152,547 136,443 -------- -------- -------- Income before income taxes ........................ 26,578 79,618 72,637 Income tax expense ................................ 29,074 29,840 26,105 -------- -------- -------- Net income (loss).................................. $ (2,496) $ 49,778 $ 46,532 ======== ======== ======== Basic earnings (loss) per share.................... $ (0.09) $ 1.76 $ 1.73 Diluted earnings (loss) per share.................. (0.09) 1.73 1.70 Dividends per share................................ 0.81 0.69 0.95 Weighted average common shares outstanding......... 28,172 28,323 26,858 Weighted average common and common equivalent shares outstanding................................ 28,636 28,830 27,327 The accompanying notes are an integral part of these consolidated financial statements. 33 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME Years ended December 31, 1999, 1998, 1997 (In thousands) Accum- Unearned ulated Director's Portion of Total Comp- Other Comp- Deferred Employee Stock- rehensive Common Retained Treasury rehensive Comp- Restricted holders' Income Stock Surplus Earnings Stock Income Stock Stock Equity --------- ------- -------- -------- -------- ----------- ---------- ---------- -------- Balance at December 31, 1996, as previously stated in the 1998 Form 10-K.......................... $15,848 $ 71,537 $ 92,039 $(4,770) $ (208) $1,401 $ (45) $175,802 Adjustments for the Vermont Financial Services Corp. pooling of interests.......... 10,085 39,510 71,151 -- (1,029) -- -- 119,717 ------- -------- -------- ------- ------- ------ ----- -------- Balance at December 31, 1996, as restated .................. 25,933 111,047 163,190 (4,770) (1,237) 1,401 (45) 295,519 Comprehensive Income: Net income (loss).............. $ 46,532 -- -- 46,532 -- -- -- -- 46,532 Total Other Comprehensive Income (Note 8)..................... 5,064 -- -- -- -- 5,064 -- -- 5,064 -------- Total Comprehensive Income.... $ 51,596 ======== Cash dividends declared ($0.95 per share).................... -- -- (25,607) -- -- -- -- (25,607) Shares issued/forfeited under various stock plans, net...... 669 11,464 -- 642 -- (58) (444) 12,273 Issuance of 3,742,264 shares in merger transaction............ 3,742 68,621 -- -- -- -- -- 72,363 Retirement of 244,364 shares related to dissenting WMBS shareholder suit.............. (244) (2,782) -- -- -- -- -- (3,026) Amortization of deferred compensation for restricted stock earned.................. -- -- -- -- -- -- 77 77 Directors compensation deferred...................... -- -- -- -- -- 434 -- 434 Purchase of treasury stock..... -- -- -- (25,956) -- -- -- (25,956) Cash paid for fractional shares........................ -- (27) -- -- -- -- -- (27) ------- -------- -------- ------- ------- ------ ----- -------- Balance at December 31, 1997... 30,100 188,323 184,115 (30,084) 3,827 1,777 (412) 377,646 Comprehensive Income: Net income (loss).............. $ 49,778 -- -- 49,778 -- -- -- -- 49,778 Total Other Comprehensive Income (Note 8).............. 2,635 -- -- -- -- 2,635 -- -- 2,635 -------- Total Comprehensive Income.... $ 52,413 ======== Cash dividends declared ($0.69 per share).................... -- -- (19,564) -- -- -- -- (19,564) Shares issued/forfeited under various stock plans, net...... 54 201 -- 2,993 -- (143) 42 3,147 Amortization of deferred compensation for restricted stock earned.................. -- -- -- -- -- -- 104 104 Directors compensation deferred...................... -- -- -- -- -- 468 -- 468 Purchase of treasury stock..... -- -- -- (22,559) -- -- -- (22,559) Cost associated with listing on NYSE, net of tax.............. -- (93) -- -- -- -- -- (93) ------- -------- -------- ------- ------- ------ ----- -------- Balance at December 31, 1998... 30,154 188,431 214,329 (49,650) 6,462 2,102 (266) 391,562 Comprehensive Income: Net income (loss).............. $ (2,496) -- -- (2,496) -- -- -- -- (2,496) Total Other Comprehensive Income (Note 8).............. (13,480) -- -- -- -- (13,480) -- -- (13,480) -------- Total Comprehensive Income.... $(15,976) ======== Cash dividends declared ($0.81 per share).................... -- -- (22,815) -- -- -- -- (22,815) Shares issued/forfeited under various stock plans, net...... 187 2,523 326 6,250 -- (68) -- 9,218 Amortization of deferred compensation for restricted stock earned.................. -- -- -- -- -- -- 93 93 Directors compensation deferred...................... -- -- -- -- -- 415 -- 415 Cash paid for fractional shares........................ -- (37) -- -- -- -- -- (37) Treasury stock retired in connection with acquisition of VFSC.......................... (1,961) (41,415) -- 43,376 -- -- -- -- ------- -------- -------- ------- ------- ------ ----- -------- Balance at December 31, 1999... $28,380 $149,502 $189,344 $ (24) $(7,018) $2,449 $(173) $362,460 ======= ======== ======== ======= ======= ====== ===== ======== The accompanying notes are an integral part of these consolidated financial statements. 34 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, ------------------------------- 1999 1998 1997 --------- --------- --------- (in thousands) Cash flows from operating activities: (Restated) Net income (loss)............................ $ (2,496) $ 49,778 $ 46,532 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Provision for possible loan losses......... 8,700 8,235 7,300 Depreciation and amortization.............. 8,780 10,797 8,459 Amortization of intangible assets ......... 4,023 5,895 3,911 Accretion (amortization) of premiums, fees, and discounts, net........................ (1,696) 3,473 (3,333) Merger related expenses ................... 49,866 -- -- Write-off of impaired intangible assets ... 21,129 -- -- Gain on branch sales ...................... (12,524) -- -- Investment securities (gains) losses....... -- (785) (741) Deferred (prepaid) income taxes............ (18,344) (3,678) 5,567 Loans originated and purchased for sale ... (330,832) (695,778) (311,217) Proceeds from sales of loans .............. 386,844 679,033 320,678 Gains on sales of loans ................... (5,254) (7,734) (3,584) Changes in assets and liabilities, net of effect from purchase of acquired companies: Accrued interest receivable................ 1,838 1,964 5,240 Other assets............................... (5,650) 19,760 (19,709) Accrued expenses and other liabilities..... 5,615 3,625 7,644 --------- --------- --------- Net cash provided by operating activities ........................................ 109,999 74,585 66,747 --------- --------- --------- Cash flows from investing activities: Net cash acquired in relation to acquisitions................................ -- -- 14,540 Net cash used in branch divestitures......... (265,142) -- -- Proceeds from sale of Federal Home Loan Bank stock ...................................... 5,100 -- -- Proceeds from sales of securities available for sale.................................... 109,394 52,984 301,737 Proceeds from maturing securities and principal payments on securities available for sale.................................... 922,556 636,831 313,668 Purchases of securities available for sale... (711,153) (815,700) (581,901) Proceeds from sales of securities held for investment.................................. -- -- 6,843 Proceeds from principal payments on securities held for investment.............. -- -- 6,960 Purchases of securities held for investment.. -- -- (199) Loans originated, net of principal repayments ................................. (292,433) (59,493) (30,221) Purchases of premises and equipment.......... (9,715) (10,636) (17,635) --------- --------- --------- Net cash provided by (used in) investing activities.............................. (241,393) (196,014) 13,792 --------- --------- --------- Cash flows from financing activities: Net increase (decrease) in deposits.......... (33,980) 240,552 (43,668) Net increase (decrease) in short-term borrowings ................................. 61,158 (64,930) (30,966) Cash paid to list on New York Stock Exchange, net of taxes ..................... -- (93) -- Cash paid for fractional shares ............. (37) -- (27) Proceeds from issuance of treasury and common stock................................ 9,484 2,491 11,858 Dividends on common stock.................... (22,815) (19,564) (25,607) Repurchase of common stock................... -- (22,559) (25,956) Retirement of shares related to dissenting WMBS shareholder suit....................... -- -- (3,026) --------- --------- --------- Net cash provided by (used in) financing activities.............................. 13,810 135,897 (117,392) --------- --------- --------- Net increase (decrease) in cash and cash equivalents.................................. (117,584) 14,468 (36,853) Cash and cash equivalents at beginning of year......................................... 267,999 253,531 290,384 --------- --------- --------- Cash and cash equivalents at end of year...... $ 150,415 $ 267,999 $ 253,531 ========= ========= ========= Supplemental disclosure of cash flow information: Cash paid during the year for: Interest................................... $ 114,340 $ 120,174 $ 114,640 Income taxes............................... 18,160 18,197 16,847 Non-cash investing and financing activities: Securities transferred from held for investment to held for sale............... -- 1,124 21,920 Loans transferred to other real estate owned .................................... 1,066 2,551 4,713 Issuance of treasury and restricted stock.. 52 -- 502 Assets acquired and liabilities assumed through acquisitions: Fair value of assets acquired ............. -- -- $ 865,937 Liabilities assumed ....................... -- -- (761,906) Stock issued............................... -- -- (72,363) Debt issued................................ -- -- (3,700) --------- --------- --------- Cash paid ................................. -- -- $ 27,968 ========= ========= ========= The accompanying notes are an integral part of these consolidated financial statements. 35 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Chittenden Corporation (the "Company") and its subsidiaries: Chittenden Trust Company (CTC), and its subsidiaries The Pomerleau Agency (Pomerleau) and Chittenden Securities, Inc. (CSI); Vermont National Bank (VNB); The Bank of Western Massachusetts (BWM); Flagship Bank & Trust Company (FBT); and Chittenden Connecticut Corporation (CCC). (CTC, VNB, BWM, and FBT are collectively referred to as the "Banks.") All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior year balances to conform with the current year presentation. All applicable prior-period amounts included in these financial statements have been restated to reflect the May 28, 1999 acquisition of Vermont Financial Services Corp. (VFSC) in a transaction accounted for as a pooling of interests. Refer to Note 2 for a further discussion of this acquisition. Nature of Operations CTC operates thirty-six branches throughout the state of Vermont; VNB operates 36 branches in Vermont and New Hampshire; BWM operates 11 branches in the western Massachusetts area and FBT operates seven branches in the greater Worcester, Massachusetts area. The Banks' primary business is providing loans, deposits, and other banking services to commercial, individual, and public sector customers. CCC is a mortgage banking operation with offices in Brattleboro, Vermont, Lexington, Massachusetts and Southbury, Connecticut. The Pomerleau Agency is an independent insurance agency with offices in Waterbury and Burlington, Vermont. Chittenden Securities, Inc. is a registered broker/dealer providing brokerage services to its customers through existing branch locations in Vermont, Massachusetts and New Hampshire. Use of Estimates in the preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, and deferred tax assets. Securities Investments in debt securities may be classified as held for investment and measured at amortized cost only if the Company has the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held for investment and equity securities that have readily determinable fair values are classified as either trading securities or securities available for sale. Trading securities are investments purchased and held principally for the purpose of selling in the near term; securities available for sale are investments not classified as trading or held for investment. Securities transferred between categories are accounted for at market value. Unrealized holding gains and losses on trading securities are included in earnings; unrealized holding gains and losses on securities available for sale or on securities transferred into the available for sale category from the held for investment category are reported as a separate component of stockholders' equity, net of applicable income taxes. Unrealized losses, which are considered other than temporary in nature, are recognized in earnings. Loans Loans are stated at the amount of unpaid principal, net of unearned discounts, unearned net loan origination fees and net any government agency guarantees. Such fees and discounts are accreted using methods that approximate the effective-interest method. 36 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Interest on loans is included in income as earned based upon interest rates applied to unpaid principal. Interest is not accrued on loans 90 days or more past due unless they are adequately secured and in the process of collection, or on other loans when management believes collection is doubtful. All loans considered impaired (except troubled debt restructurings), as defined below, are nonaccruing. Interest on nonaccruing loans is recognized as payments are received when the ultimate collectibility of interest is no longer considered doubtful. When a loan is placed on nonaccrual status, all interest previously accrued is reversed against current-period interest income. Allowance for Possible Loan Losses The allowance for possible loan losses is based on management's estimate of the amount required to reflect the risks in the loan portfolio, based on circumstances and conditions known or anticipated at each reporting date. There are inherent uncertainties with respect to the final outcome of the Banks' loans. Because of these inherent uncertainties, it is reasonably possible that actual losses experienced in the near term may differ from the amounts reflected in these consolidated financial statements. Factors considered in evaluating the adequacy of the allowance for possible loan losses include previous loss experience, current economic conditions and their effect on borrowers, the performance of individual loans in relation to contract terms, and estimated fair values of underlying collateral. Losses are charged against the allowance for possible loan losses when management believes that the collectibility of principal is doubtful. Key elements of the above estimates, including assumptions used in developing independent appraisals, are dependent on the economic conditions prevailing at the time such estimates are made. Accordingly, uncertainty exists as to the final outcome of certain valuation judgments as a result of changes in economic conditions in the Banks' lending areas. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate. In the case of collateral dependent loans, impairment may be measured based on the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Loan Origination and Commitment Fees Loan origination and commitment fees, and certain loan origination costs, are deferred and amortized over the contractual term of the related loans as yield adjustments using primarily the level-yield method. When loans are sold or paid off, the unamortized net fees and costs are recognized in income. Net deferred loan fees amounted to $4,889,000 and $2,925,000 at December 31, 1999 and 1998, respectively. Mortgage Servicing Rights Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. 37 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Mortgage Loans Held for Sale Mortgage loans held for sale are carried at the lower of aggregate cost or market value. Gains and losses on sales of mortgage loans are recognized at the time of the sale and are adjusted when the interest rate charged to the borrower and the interest rate paid to the purchaser, after considering a normal servicing fee (and, in the case of mortgage-backed securities, a guarantee fee), differ. Premises and Equipment Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is provided using the straight line method over the estimated useful lives of the premises and equipment. Leasehold improvements are amortized over the shorter of the terms of the respective leases or the estimated useful lives of the improvements. Expenditures for maintenance, repairs, and renewals of minor items are charged to expense as incurred. Other Real Estate Owned Collateral acquired through foreclosure ("Other Real Estate Owned" or "OREO") is recorded at the lower of the carrying amount of the loan or the fair value of the property, less estimated costs to sell, at the time of acquisition. Net operating income or expense related to OREO is included in noninterest expense in the accompanying consolidated statements of operations. Intangible Assets Intangible assets include the excess of the purchase price over the fair value of net assets acquired (goodwill) in the acquisitions of Eastern Bancorp, BWM and Pomerleau, as well as a core deposit intangible related to BWM and the acquisition of certain trust business by VNB. Goodwill is being amortized on a straight-line basis over 15 years. The core deposit intangible is being amortized on an accelerated basis over 10 years. The Company periodically evaluates intangible assets for impairment on the basis of whether these assets are fully recoverable from projected, undiscounted net cash flows of the related acquired entity. Income Taxes The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109), which recognizes income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are established for the temporary differences between the accounting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when the amounts related to such temporary differences are realized or settled. Earnings Per Share The calculation of basic earnings per share is based on the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is based on the weighted average number of shares of common stock outstanding adjusted for the incremental shares attributed to outstanding common stock equivalents, using the treasury stock method. Common stock equivalents include options granted under the Company's stock plans and shares to be issued under the Company's Directors' Deferred Compensation Plan. Cash and Cash Equivalents Cash and cash equivalents consist of cash on hand, amounts due from banks, interest-bearing deposits and certain money market fund investments. Cash equivalents are accounted for at cost, which approximates fair value. 38 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Trust Trust administered assets of approximately $4.8 billion and $4.6 billion at December 31, 1999 and 1998, respectively, held by the Banks in a fiduciary or agency capacity for customers, are not included in the accompanying consolidated balance sheets as they are not assets of the Company. Trust income is recorded on the cash basis (which approximates the accrual basis) in accordance with industry practice. Credit Card Income Credit card income includes annual fees and interchange income from credit cards issued by the Company, and merchant discount income. Merchant discount income consists of the fees charged on credit card receipts submitted by the Company's commercial customers. Credit card income is presented net of credit card expense, which includes fees paid by the Company to credit card issuers and third-party processors. Such amounts are recognized on the accrual basis, and are presented in the noninterest income section of the statement of operations. Stock-Based Compensation Statement of Financial Accounting Standards No. 123, Accounting for Stock- Based Compensation, encourages but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock. The Company has provided Pro Forma disclosures of net income and earnings per share and other disclosures, as if the fair value based method had been applied. The Pro Forma disclosures include effects of all awards granted on or after January 1, 1995. (See Note 9) Pensions Effective January 1, 1998, The Company adopted SFAS No. 132, Employers Disclosures about Pensions and Other Postretirement Benefits--an amendment to FASB Statements No. 87, 88, and 106. This statement revises employer's disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans but standardizes the disclosure requirements. This statement requires restatement for disclosures for earlier periods as well. The adoption of SFAS 132 did not have a material effect on the Company's financial position or results of operations, but did affect the disclosure of employee benefits expenses presented in Note 10. Recently Adopted Accounting Policies Effective January 1, 1999, the Company adopted SFAS No. 134, Accounting for Mortgage-Backed Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise. This statement requires that after the securitization of mortgage loans held for sale, an entity engaged in mortgage banking activities classify the resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold those investments. SFAS No. 134 did not have a material impact on the Company's financial position or results of operations. Effective January 1, 1999, the Company adopted Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1 requires computer software costs associated with internal-use software to be expensed as incurred until certain capitalization criteria are met. The adoption of SOP 98-1 did not have a material effect on the Company's financial position or its results of operations. 39 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) As of January 1, 1999, the Company adopted Statement of Position (SOP) 98-5, Reporting on the Costs of Start-Up Activities. SOP 98-5 requires all costs associated with pre-opening, pre-operating and organization activities to be expensed as incurred. The adoption of SOP 98-5 did not have a material impact on the Company's financial position or results of operations. Reclassificatons Certain amounts in the 1999 and 1998 financial statements have been reclassified to be consistent with current year presentation. Note 2 Acquisitions And Divestitures Vermont Financial Services Corporation On May 28, 1999, the Company acquired Vermont Financial Services Corp. of Brattleboro, Vermont for stock. VFSC's subsidiary banks included Vermont National Bank, headquartered in Brattleboro, Vermont and United Bank, headquartered in Greenfield, Massachusetts. Under the agreement, VFSC shareholders received 1.07 shares of Chittenden Corporation common stock for each share of VFSC stock. Total shares outstanding of Chittenden Corporation stock increased by approximately 14 million shares as a result of the acquisition. Based on the closing price of Chittenden stock as of May 28, 1999, the market value of the shares exchanged totaled $387.2 million. The acquisition was accounted for as a pooling of interests. Accordingly, the consolidated financial statements for the periods presented have been restated to include VFSC. Total revenue, income before taxes, net income, and earnings per share data of the separate companies for the periods preceding the acquisition were: For the Three Months For the Year For the Year Ended March 31, 1999 Ended December 31, 1998 Ended December 31, 1997 ---------------------------- ----------------------------- ---------------------------- Chittenden Chittenden Chittenden Corporation VFSC Combined Corporation VFSC Combined Corporation VFSC Combined ----------- ------- -------- ----------- -------- -------- ----------- ------- -------- Total Revenue........... $30,673 $28,654 $59,327 $123,405 $116,995 $240,400 $118,729 $97,651 $216,380 Income before Income Taxes.................. 11,072 7,722 18,794 46,538 33,080 79,618 44,732 27,905 72,637 Net Income.............. 7,495 4,424 11,919 30,665 19,113 49,778 29,406 17,126 46,532 Diluted Earnings Per Share.................. $ 0.52 $ 0.34 $ 0.42 $ 2.09 $ 1.45 $ 1.73 $ 1.94 $ 1.51 $ 1.70 Special charges of $58.5 million (pre-tax) were recorded during 1999 related to the VFSC transaction. These charges included merger related expenses of $49.9 million, and $21.1 million related to the write-off of impaired goodwill, less a net gain of $12.5 million from branch sales (see below). The merger related expenses included asset disposal write-downs of $23.9 million, and conversion, severance and transaction costs, such as legal, advisory and accounting fees which totaled $26.0 million. The impaired goodwill, which related to VFSC's purchase of Eastern Bancorp, was written-off as a result of divestitures required by the U.S. Department of Justice and the Federal Reserve. On an after-tax basis, special charges amounted to $57.4 million in 1999. Included in accrued expenses and other liabilities at December 31, 1999, are merger related expenses totaling $9.6 million which will be paid in future periods. 40 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The change in accrued merger related expenses at December 31, 1999 is summarized below: Original Accrual As of Less: Accrual Balance as May 28, 1999 Cash Transactions of December 31, 1999 ---------------- ----------------- -------------------- Compensation and Benefits............... $10,030 $ 2,072 $7,958 System Conversion....... 8,278 6,614 1,664 Legal and Professional.. 7,109 7,109 -- Other................... 587 571 16 ------- ------- ------ Total................. $26,004 $16,366 $9,638 ======= ======= ====== As noted above, the Company recognized a net $12.5 million gain on branch sales in 1999. One of the conditions of regulatory approval of the VFSC transaction was the divestiture of eighteen VNB branches. Seventeen of the required divestitures were completed in 1999. The final branch divestiture is scheduled to be completed in March 2000. Divested in the sale of the seventeen branches were $127.6 million in loans, $442.2 million in deposits and $8.3 million in fixed assets. Total cash transferred to the buyers was $265.1 million. To fund the cash transferred, $70 million in securities available for sale were sold at a loss of $1.2 million, which was netted in the $12.5 million gain on the branch sales. The Pomerleau Agency On May 31, 1997, CTC acquired certain assets and assumed certain liabilities of Pomerleau. This transaction was accounted for as a purchase and, accordingly, all results of operations subsequent to the transaction have been included in the Company's consolidated statement of operations. The purchase price was allocated to assets acquired and liabilities assumed based on estimates of fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired has been recorded as goodwill. The impact of the acquisition was not material to consolidated operations and therefore, pro forma disclosures have been omitted. Note 3 Securities Investment securities at December 31, 1999 and 1998 are as follows: Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- ---------- ---------- -------- 1999 (in thousands) Securities available for sale: U.S. Treasury securities............ $ 18,946 $ 8 $ (12) $ 18,942 U.S. government agency obligations.. 235,326 70 (4,917) 230,479 Obligations of states and political subdivisions....................... 8,345 25 (73) 8,297 Mortgage-backed securities.......... 200,414 218 (3,036) 197,596 Corporate bonds and notes........... 196,402 47 (3,241) 193,208 Other debt securities............... 642 -- -- 642 Marketable equity securities........ 274 40 (7) 307 -------- ---- -------- -------- Total securities available for sale... $660,349 $408 $(11,286) $649,471 ======== ==== ======== ======== 41 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- ---------- ---------- -------- 1998 (in thousands) Securities available for sale: U.S. Treasury securities............ $ 52,870 $ 649 -- $ 53,519 U.S. government agency obligations.. 384,922 3,812 (300) 388,434 Obligations of states and political subdivisions....................... 7,968 166 (11) 8,123 Mortgage-backed securities.......... 286,084 3,438 (436) 289,086 Corporate bonds and notes........... 213,330 3,352 (112) 216,570 Government bond mutual funds........ 9,526 -- (526) 9,000 Other debt securities............... 142 -- -- 142 Marketable equity securities........ 25,840 102 (1) 25,941 -------- ------- ------- -------- Total securities available for sale... $980,682 $11,519 $(1,386) $990,815 ======== ======= ======= ======== Proceeds from sales of debt securities amounted to $109,394,000, $52,984,000 and $301,737,000 in 1999, 1998, and 1997, respectively. Realized losses on sales of debt securities were $1,148,000, $96,000 and $2,047,000 in 1999, 1998 and 1997, respectively. Realized losses in 1999 were netted against the gain on sale of branches, since all investment sales were to fund cash transferred to the acquirors. Realized gains on sales of debt securities were $881,000 and $2,732,000 in 1998 and 1997, respectively. During 1997, the Company sold government bond mutual funds at a loss of $58,000 and marketable equity securities for gains of $114,000. The market value of securities pledged to secure U.S. Treasury borrowings, public deposits, securities sold under agreements to repurchase, and for other purposes required by law, amounted to $316,303,000 and $253,072,000 at December 31, 1999 and 1998, respectively. The following table shows the maturity distribution of the amortized cost of the Company's investment securities at December 31, 1999, with comparative totals for 1998. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations: After One After Five After Within But Within But Within Ten No Fixed One Year Five Years Ten Years Years Maturity Total -------- ---------- ---------- ------ -------- -------- (in thousands) Investment securities: U.S. Treasury securities........... $ 14,448 $ 4,498 $ -- $ -- $ -- $ 18,946 U.S. government agency obligations.......... 2,522 217,811 14,993 -- -- 235,326 Obligations of states and political subdivisions......... 2,216 4,939 1,120 70 -- 8,345 Mortgage-backed securities (1)....... 53,386 131,227 14,448 1,353 -- 200,414 Corporate bonds and notes................ 18,083 176,164 1,147 1,008 -- 196,402 Other debt securities. 10 580 52 -- -- 642 Marketable equity securities........... -- -- -- -- 274 274 -------- -------- ------- ------ ------ -------- Total investment securities............. $ 90,665 $535,219 $31,760 $2,431 $ 274 $660,349 ======== ======== ======= ====== ====== ======== Comparative totals for 1998................... $309,551 $632,662 $28,359 $ 244 $9,866 $980,682 - -------- (1) Maturities of mortgage-backed securities are based on contractual payments and estimated mortgage loan prepayments. 42 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following table shows the maturity distribution of the fair value of the Company's investment securities at December 31, 1999, with comparative totals for 1998. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations: After One After Five After Within But Within But Within Ten No Fixed One Year Five Years Ten Years Years Maturity Total -------- ---------- ---------- ------ -------- -------- (in thousands) Investment securities: U.S. Treasury securities........... $ 14,451 $ 4,491 $ -- $ -- $ -- $ 18,942 U.S. government agency obligations.......... 2,516 213,301 14,662 -- -- 230,479 Obligations of states and political subdivisions......... 2,226 4,927 1,074 70 -- 8,297 Mortgage-backed securities (1)....... 52,633 129,384 14,245 1,334 -- 197,596 Corporate bonds and notes................ 18,057 173,070 1,100 981 -- 193,208 Other debt securities. 10 580 52 -- -- 642 Marketable equity securities........... -- -- -- -- 307 307 -------- -------- ------- ------ ------ -------- Total investment securities............. $ 89,893 $525,753 $31,133 $2,385 $ 307 $649,471 ======== ======== ======= ====== ====== ======== Comparative totals for 1998................... $310,861 $641,510 $28,757 $ 246 $9,441 $990,815 - -------- (1) Maturities of mortgage-backed securities are based on contractual repayments and estimated mortgage loan prepayments. Note 4 Loans Major classifications of loans at December 31, 1999 and 1998 are as follows: 1999 1998 ---------- ---------- (in thousands) Commercial.............................................. $ 585,268 $ 580,474 Real estate: Residential........................................... 915,081 938,638 Commercial............................................ 641,660 574,178 Construction.......................................... 55,329 68,133 ---------- ---------- Total real estate................................... 1,612,070 1,580,949 Home equity............................................. 152,382 162,979 Consumer................................................ 411,043 307,829 Lease financing......................................... 134,967 107,058 ---------- ---------- Total gross loans..................................... 2,895,730 2,739,289 Allowance for possible loan losses...................... (41,079) (41,209) ---------- ---------- Net loans............................................... $2,854,651 $2,698,080 ========== ========== Mortgage loans held for sale............................ $ 2,926 $ 53,684 ========== ========== Lease financing receivable includes the estimated residual value of leased vehicles of approximately $84,745,000 and $ 68,516,000 at December 31, 1999 and 1998, respectively, and is net of unearned interest income of approximately $21,826,000 and $17,134,000 at those dates. 43 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Lending activities of CTC and VNB are conducted primarily in Vermont and New Hampshire, with additional activity relating to nearby trading areas in Quebec, New York, Maine, and Connecticut. BWM's lending activities are conducted primarily in the western Massachusetts area while FBT's lending activities are conducted primarily in the greater Worcester, Massachusetts area. The Banks make single-family and multi-family residential loans, commercial real estate loans, commercial loans, and a variety of consumer loans. In addition, the Banks make loans for the construction of residential homes, multi-family and commercial properties, and for land development. The ability and willingness of the Banks' borrowers to honor their repayment commitments are impacted by many factors, including the level of overall economic activity within the borrowers' geographic areas. Changes in the allowance for possible loan losses are summarized as follows: 1999 1998 1997 -------- -------- -------- (in thousands) Balance at beginning of year................... $ 41,209 $ 45,664 $ 41,743 Provision for possible loan losses............ 8,700 8,235 7,300 Loan recoveries......... 4,586 5,001 4,075 Loans charged off....... (13,416) (17,691) (14,942) -------- -------- -------- Addition of Eastern's Allowance.............. -- -- 7,488 -------- -------- -------- --- --- Balance at end of year.. $ 41,079 $ 41,209 $ 45,664 ======== ======== ======== === The principal amount of loans on nonaccrual status was $9,172,000 and $17,865,000 at December 31, 1999 and 1998, respectively. Loans whose terms have been substantially modified in troubled debt restructurings amounted to $767,000 at December 31, 1997. There were no such loans at December 31, 1999 and 1998. At December 31, 1999, the Banks were not committed to lend any additional funds to borrowers with loans whose terms have been restructured. The amount of interest which was not earned but which would have been earned had the nonaccrual and restructured loans performed in accordance with their original terms and conditions was as follows: 1999 1998 1997 ------ ------ ------ (in thousands) Interest income in accordance with original loan terms..... $1,365 $2,467 $2,506 Interest income recognized................................. 454 1,226 1,470 ------ ------ ------ Reduction in interest income............................... $ 911 $1,241 $1,036 ====== ====== ====== At December 31, 1999, the recorded investment in loans that are considered to be impaired under SFAS 114 was $4,049,000 (all such loans, except troubled debt restructurings, were on a nonaccrual basis). Included in this amount is $2,100,000 of impaired loans for which the related allowance for possible loan losses is $637,000 and $1,949,000 of impaired loans for which no specific allowance for possible loan losses has been allocated. The average recorded investment in impaired loans during the year ended December 31, 1999 was approximately $4,412,000. For the year ended December 31, 1999, interest income on impaired loans totaled $58,000, all of which was recognized on a cash basis. Residential mortgage loans serviced for others, which are not reflected in the consolidated balance sheets, totaled approximately $2.079 billion and $2.124 billion at December 31, 1999 and 1998, respectively. No recourse provisions exist in connection with such servicing. 44 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following table is a summary of activity for mortgage servicing rights purchased and originated for three years ended December 31, 1999: Purchased Originated Total --------- ---------- ------- (in thousands) Balance at December 31, 1996...................... $1,836 $ 3,923 $ 5,759 Additions....................................... 4,229 2,280 6,509 Amortization.................................... (580) (1,019) (1,599) ------ ------- ------- Balance at December 31, 1997...................... 5,485 5,184 10,669 Additions....................................... -- 5,147 5,147 Amortization.................................... (696) (1,948) (2,644) ------ ------- ------- Balance at December 31, 1998...................... 4,789 8,383 13,172 Additions....................................... -- 3,259 3,259 Amortization.................................... (598) (1,590) (2,188) ------ ------- ------- Balance at December 31, 1999...................... $4,191 $10,052 $14,243 ====== ======= ======= SFAS 125 requires enterprises to measure the impairment of servicing rights based on the difference between the carrying amount of the servicing rights and current fair value. At December 31, 1999 no allowance for impairment in the Company's mortgage servicing rights was necessary. Impairment of mortgage servicing rights of $219,000 was recorded in 1998. Note 5 Premises and Equipment Premises and equipment at December 31, 1999 and 1998 are summarized as follows: Estimated Original 1999 1998 Useful Lives -------- -------- ------------------ (in thousands) Land.................................... $ 6,716 $ 8,051 -- Buildings and improvements.............. 32,837 36,601 25-50 years Leasehold improvements.................. 22,431 25,008 2-50 years Furniture and equipment................. 45,307 65,730 3-15 years Construction in progress................ 4,681 2,592 -- -------- -------- 111,972 137,982 Accumulated depreciation and amortization........................... (70,920) (65,719) -------- -------- $ 41,052 $ 72,263 ======== ======== The Company is obligated under various noncancelable operating leases for premises and equipment expiring in various years through the year 2021. Total lease expense, less income from subleases, amounted to approximately $4,694,000, $4,546,000 and $3,311,000 in 1999, 1998, and 1997, respectively. 45 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Future minimum rental commitments for noncancelable operating leases on premises and equipment with initial or remaining terms of one year or more at December 31, 1999 are as follows: Year Lease Obligations - ---- ----------------- (in thousands) 2000.......................................................... $ 3,945 2001 ......................................................... 3,021 2002 ......................................................... 2,306 2003 ......................................................... 1,909 2004 ......................................................... 1,642 Thereafter.................................................... 8,475 ------- Total minimum lease payments.................................. $21,298 ======= Note 6 Borrowings Borrowings at December 31, 1999 and 1998 consist of the following: 1999 1998 -------- -------- (in thousands) Federal funds purchased, rate 5.50%, maturing January 3, 2000........................................................ $ 1,000 $ -- Federal funds purchased, rate 5.25%, maturing January 4, 1999........................................................ -- 1,000 Securities sold under agreements to repurchase: Due through January 3, 2000, weighted average rate of 9.20%..................................................... 10,000 -- Due through January 4, 1999, weighted average rate of 9.20%..................................................... -- 10,000 Securities sold under agreements to repurchase............. 80,115 83,815 U.S. Treasury borrowings, 4.54% in 1999 and 4.12% in 1998, due on demand............................................... 35,149 11,932 Note Payable, 7.74% in 1999 and 8.04% in 1998, due January 1, 2015........................................................ 205 190 Note Payable, 5.75% in 1999 and 5.90% in 1998, due on June 1, 2001........................................................ 381 642 FHLB Advances: Affordable Housing Program, 5.15% in 1999 and 5.09% in 1998, due on May 29, 2018........................................... 337 343 Maturing February 2, 1999 @ 5.50%.......................... -- 5,000 Maturing January 3, 2000 @ 4.19%........................... 10,000 -- Maturing May 3, 2000 @ 5.82%............................... 40,000 -- Maturing February 2, 2001 @ 5.88%.......................... 5,000 5,000 Maturing February 27, 2003 @ 5.77%......................... 11,925 11,925 Maturing August 6, 2007 @ 6.42%............................ -- 363 Maturing September 21, 2007 @ 6.53%........................ -- 35 Maturing April 19, 2011 @ 3.50%............................ 1,671 1,709 Maturing August 1, 2011 @ 5.00%............................ 560 560 Maturing October 29, 2013 @ 5.50%.......................... 32 32 Maturing April 2, 2013 @ 5.50%............................. 586 586 Maturing October 20, 2014 @8.24%........................... -- 587 Maturing May 1, 2014 @ 6.29%............................... -- 201 Maturing May 6, 2014 @ 7.61%............................... -- 507 Maturing August 19, 2016 @ 5.50%........................... -- 279 Maturing January 30, 2017 @ 7.27%.......................... -- 602 Capital Lease Obligation..................................... 111 605 -------- -------- Total Borrowings:............................................ $197,072 $135,913 ======== ======== 46 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Short-term borrowings, excluding repurchase agreements, are collateralized by U.S. Treasury and agency securities, mortgage-backed securities, corporate notes, and residential mortgage loans. These assets had a carrying value and a market value of $130,067,000 and $127,565,000 respectively, at December 31, 1999, and $109,380,000 and $110,824,000, respectively, at December 31, 1998. The following information relates to securities sold under agreements to repurchase: 1999 1998 1997 ------- ------- ------- (in thousands) Average balance outstanding during the year.......... $89,583 $83,744 $83,427 Average interest rate during the year................ 4.85% 5.38% 5.32% Maximum amount outstanding at any month-end.......... $99,995 $95,278 $98,509 The following information relates to U.S. Treasury borrowings: 1999 1998 1997 ------- ------- ------- (in thousands) Average balance outstanding during the year.......... $13,138 $20,753 $22,442 Average interest rate during the year................ 4.73% 5.19% 5.28% Maximum amount outstanding at any month-end.......... $37,369 $60,295 $62,381 The following information relates to FHLB borrowings: 1999 1998 1997 ------- ------- ------- (in thousands) Average balance outstanding during the year.......... $29,663 $47,663 $39,333 Average interest rate during the year................ 5.82% 5.81% 5.46% Maximum amount outstanding at any month-end.......... $96,865 $69,403 $94,344 Note 7 Income Taxes Income tax expense consists of the following: 1999 1998 1997 ------- ------- ------- (in thousands) Current payable Federal............................................ $33,785 $26,168 $17,565 State.............................................. 4,184 4,215 2,973 ------- ------- ------- 37,969 30,383 20,538 Deferred (prepaid) Federal............................................ (8,548) (847) 5,725 State.............................................. (347) 304 (158) ------- ------- ------- (8,895) (543) 5,567 ------- ------- ------- Income tax expense................................... $29,074 $29,840 $26,105 ======= ======= ======= Current income taxes receivable, included in other assets, were $43,000 and $2,305,000, at December 31, 1999 and 1998, respectively. Current income taxes payable, included in accrued expenses and other liabilities, was $17,502,000 and $298,000 at December 31, 1999 and 1998, respectively. The State of Vermont assesses a franchise tax for banks in lieu of a bank income tax. The franchise tax, assessed based on deposits, amounted to approximately $2,975,000, $3,063,000, and $1,663,000 in 1999, 1998, 47 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) and 1997, respectively. These amounts are included in income tax expense in the accompanying consolidated statements of operations. The Company is also taxed on income in the other states in which it operates. The following is a reconciliation of the provision for Federal income taxes, calculated at the statutory rate, to the recorded income tax expense: 1999 1998 1997 ------- ------- ------- (in thousands) Computed tax at statutory Federal rate.............. $ 9,331 $27,297 $25,155 Increase (decrease) in taxes from: Amortization of intangible assets (1)............. 17,223 1,684 1,041 Tax-exempt interest, net.......................... (1,638) (1,411) (1,617) Dividends received deduction...................... (315) (354) (187) Merger expenses................................... 1,599 -- -- State taxes, net of Federal tax benefit........... 2,494 3,380 2,203 Other, net........................................ 380 (756) ( 490) ------- ------- ------- Total........................................... $29,074 $29,840 $26,105 ======= ======= ======= Effective income tax rate........................... 109.7% 37.5% 35.9% Effective income tax rate excluding the effect of special provision and benefit...................... 35.4% 37.5% 35.9% - -------- (1) The goodwill arising from the acquisition of Eastern Bancorp was not tax deductible and therefore appears as a non-deductible item. The components of the net deferred tax asset (liability) at December 31, 1999 and 1998 are as follows: 1999 1998 -------- -------- (in thousands) Allowance for possible loan losses.......................... $ 15,080 $ 14,701 Deferred compensation and pension........................... 4,773 5,614 Other real estate owned writedowns.......................... 164 34 Depreciation................................................ 10,651 (2,364) Accrued liabilities......................................... 1,118 1,398 Unrealized (gain) loss on securities available for sale..... 3,967 (3,606) Basis differences, purchase accounting...................... 1,167 174 Core deposit intangible..................................... (959) (1,152) Lease financing............................................. (12,644) (11,044) Mortgage servicing.......................................... (3,900) (1,324) Other....................................................... (2,929) (2,411) -------- -------- $ 16,488 $ 20 ======== ======== Note 8 Stockholders' Equity Treasury Stock On June 17, 1998, the Company's Board of Directors authorized an expansion of the Company's common stock repurchase program by 500,000 shares to a total of 1.75 million shares of the Company's common stock to be repurchased in negotiated transactions or on the open market. In May 1998, VFSC's Board of Directors authorized the repurchase of up to 500,000 of its shares (equivalent to 535,000 shares of Chittenden stock). Both the Chittenden and VFSC plans were rescinded prior to the announcement of the definitive agreement to acquire VFSC. During 1998, the Company repurchased 805,446 shares of its common stock at a total cost of $22.6 million. Prior to the May 28, 1999 acquisition of VFSC by the Company, VFSC retired all of its common stock held in treasury (a total of 330,000 equivalent Chittenden shares). 48 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) On January 19, 2000, the Company's Board of Directors authorized the repurchase of up to 2,000,000 shares of the Corporation's common stock (approximately 7% of the Company's outstanding Common Stock) in negotiated transactions or open market purchases. Chittenden, depending on market conditions, may repurchase its Common Stock without further Board authorization for two years. Dividends Dividends paid by the Banks are the primary source of funds available to the Company for payment of dividends to its stockholders and for other corporate needs. Applicable federal and state statutes, regulations, and guidelines impose restrictions on the amount of dividends that may be declared by the Banks. The Company paid dividends of $22,815,000, $19,564,000, and $25,607,000 during 1999, 1998, and 1997, respectively. These amounts represented $0.81, $0.69, and $0.95 per share. Included in dividends for 1997 was a special cash dividend of $8,675,000 or $0.60 per share, which was paid to shareholders to maintain capital at a level consistent with the Company's requirements at that time. Surplus CTC is required by Vermont statute to transfer a minimum of 10% of net income from retained earnings to surplus on an annual basis. No transfer is required if net worth as a percentage of deposits and other liabilities exceeds 10%. The payments of dividends by BWM and FBT are subject to Massachusetts banking law restrictions which require that the capital stock and surplus account of the bank must amount, in the aggregate, to at least 10% of the bank's deposit liability or there shall be transferred from net profits to the surplus account: (1) the amount required to increase the surplus account so that it, together with the capital stock, will amount to at least 10% of deposit liability or; (2) the amount required to increase the surplus account so that it shall amount to 50% of the common stock, and thereafter, the amount, not exceeding 50% of net profits, required to increase the surplus account so that it shall amount to 100% of capital stock. Because one or both of these tests were met at the individual banks, no transfers were made during the year. Earnings Per Share The following table summarizes the calculation of basic and diluted earnings per share: 1999 1998 1997 ------- ------- ------- (in thousands except per share information) Net income........................................... $(2,496) $49,778 $46,532 ------- ------- ------- Weighted average common shares outstanding........... 28,172 28,323 26,858 Dilutive effect of common stock equivalents.......... 464 507 470 ------- ------- ------- Weighted average common and common equivalent shares outstanding................................ 28,636 28,830 27,328 ======= ======= ======= Basic earnings per share............................. $ (0.09) $ 1.76 $ 1.73 Dilutive effect of common stock equivalents.......... -- (0.03) (0.03) ------- ------- ------- Diluted earnings per share........................... $ (0.09) $ 1.73 $ 1.70 ======= ======= ======= For 1999 and 1998 options that could potentially dilute earnings per share in the future were not included in the computation of the common stock equivalents because to do so would have been antidilutive. There were 386,250 and 122,250 of these options with a weighted average exercise price of $36.43 and $35.78 respectively, at December 31, 1999 and 1998. There were no antidilutive options excluded from the 1997 calculation. 49 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Comprehensive Income On January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"). SFAS 130 established standards for the reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general purpose financial statements. Comprehensive income is the total of net income and all other non-owner changes in equity. The statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements in the year end financial statements. The statement does not require a specific format for that financial statement. The Company has chosen to display comprehensive income in the Consolidated Statements of Changes in Stockholders' Equity. The following table summarizes reclassification detail for other comprehensive income for the years: 1999 1998 1997 -------- ------ ------ (in thousands) Unrealized holding gains (losses) on available for sale for period, net of tax......................... $(14,254) $2,698 $5,547 Reclassification adjustment for (gains) losses arising during period, net of tax................... 774 (63) (483) -------- ------ ------ Total Other Comprehensive Income..................... $(13,480) $2,635 $5,064 ======== ====== ====== Note 9 Stock Plans The Company has three stock option plans: a 1988 Employee Stock Option plan, a 1993 Stock Incentive Plan, and a 1998 Directors' Omnibus Long-term Incentive Plan. The Company accounts for these plans in accordance with APB Opinion No. 25, under which no compensation cost for stock options has been recognized, since all options qualify for fixed plan accounting and all options are granted at fair market value, or higher in the case of stepped options. Under the plans, certain key employees and directors are eligible to receive various types of stock incentives, including options to purchase a specified number of shares of stock at a specified price (including incentive stock options and non-qualified stock options); restricted stock which vests after a specified period of time; and non-employee directors' stock options to purchase stock at predetermined fixed prices over a five-year period. At December 31, 1999 and 1998, there were a total of 1,640,528 and 1,640,528 shares, respectively, available to be issued under the plans. Of these shares, 1,211,150 and 1,174,420 shares were issued at December 31, 1999 and 1998, respectively. During 1998, 1,000 shares of restricted stock were granted, with a weighted average grant-date fair value of $38.25 per share. These shares vest five years from the grant date. There were no similar grants of restricted stock issued in 1999. 50 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The following tables summarize information regarding the Company's stock option plans: Weighted Average Price Per Share Options -------------- --------- December 31, 1996..................................... $11.11 1,512,334 Granted............................................. 23.30 193,888 Exercised........................................... 8.74 (635,789) Expired............................................. 21.00 (1,250) ------ --------- December 31, 1997..................................... 14.73 1,069,183 Granted............................................. 32.07 430,890 Exercised........................................... 9.42 (135,786) Expired............................................. 32.10 (17,149) ------ --------- December 31, 1998..................................... 20.59 1,347,138 Granted............................................. 36.84 135,000 Exercised........................................... 17.19 (378,082) Expired............................................. 28.80 (6,958) ------ --------- December 31, 1999..................................... $23.71 1,097,098 ====== ========= Options Outstanding and Exercisable December Options Outstanding Options Exercisable 31, 1999 --------------------------------------------- ---------------------------- Range of Weighted Average Weighted Weighted Exercise Options Remaining Average exercise Options Average exercise Prices: Outstanding Contractual Life Price Outstanding Price - -------- ----------- ---------------- ---------------- ----------- ---------------- $3.17- $17.80 421,218 5.18 $12.41 421,218 $12.41 $18.80- $29.09 396,130 7.67 24.76 362,150 24.36 $31.91- $56.28 279,750 8.95 39.23 185,750 35.45 --------- ---- ------ ------- ------ $3.17- $56.28 1,097,098 7.04 $23.71 969,118 $21.29 ========= ==== ====== ======= ====== If compensation cost for these plans had been determined in accordance with SFAS 123, the Company's net income (loss) and earnings per share would have been reduced to the following pro forma amounts: 1999 1998 1997 ------------ ------------ ------------ (in thousands, except per share data) Net Income(Loss): As Reported........................... $ (2,496) $ 49,778 $ 46,532 Pro Forma............................. (4,427) 47,091 45,441 Earnings Per Share: Basic: As Reported........................... $ (0.09) $ 1.76 $ 1.73 Pro Forma............................. (0.16) 1.66 1.69 Diluted: As Reported........................... $ (0.09) $ 1.73 1.70 Pro Forma............................. (0.16) 1.63 1.66 The SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995; the resulting pro forma compensation cost may not be representative of that to be expected in future years. 51 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted- average assumptions used for grants in 1999, 1998 and 1997: 1999 1998 1997 ---- ---- ---- Expected life (years)......................................... 7.60 7.03 7.53 Interest rate................................................. 6.40% 5.06% 6.12% Volatility.................................................... 29.6 32.4 26.4 Dividend yield................................................ 2.72% 2.23% 2.63% Using these assumptions, the weighted average fair value of options granted was $9.59, $7.80 and $7.66 in 1999, 1998 and 1997, respectively. Note 10 Employee Benefits Pension Plan CTC has a noncontributory pension plan covering substantially all of its employees. Benefits are based on years of service and the level of compensation during the final years of employment. CTC's funding policy for the plan is to contribute annually the amount necessary to meet the minimum funding standards established by the Employee Retirement Income Security Act (ERISA). Additional contributions may be made at the election of the Company. This contribution is based on an actuarial method that recognizes estimated future salary levels and service. The changes in the benefit obligation for the years ended December 31, 1999 and 1998 are as follows: 1999 1998 ------- ------- (in thousands) Projected Benefit Obligation at beginning of year............ $43,666 $38,249 Service cost............................................... 2,438 1,756 Interest cost.............................................. 3,014 2,695 Plan Amendments............................................ (4,873) -- Actuarial gain (loss)...................................... (4,234) 2,621 Disbursements.............................................. (2,268) (1,655) ------- ------- Projected Benefit Obligation at end of year.................. $37,743 $43,666 ======= ======= The changes in the plan assets for the years ended December 31, 1999 and 1998 are as follows: 1999 1998 ------- ------- (in thousands) Fair Value of Assets at beginning of year.................... $44,491 $38,738 Actual return on plan assets............................... 1,785 5,852 Company Contributions...................................... 1,800 1,556 Disbursements.............................................. (2,268) (1,655) ------- ------- Fair Value of Assets at end of year.......................... $45,808 $44,491 ======= ======= 1999 1998 ------- ------- (in thousands) Funded status................................................ $ 8,066 $ 824 Prior service cost not yet recognized in net periodic pension cost........................................................ (6,408) (1,795) Unrecognized net transition asset being amortized over participants' period of service............................. (626) (756) Unrecognized net (gain) loss from past experience different from that assumed........................................... (4,339) (2,079) ------- ------- Accrued pension cost included in accrued expenses and other liabilities................................................. $(3,307) $(3,806) ======= ======= 52 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Weighted-average assumptions as of December 31, 1999 and 1998: 1999 1998 ---- ---- Discount Rate....................................................... 7.50% 6.63% Expected return on plan assets...................................... 9.00% 8.50% Rate of compensation increase....................................... 5.00% 5.25% Net pension expense components included in employee benefits in the consolidated statements of operations are as follows: December 31, ------------------------- 1999 1998 1997 ------- ------- ------- (in thousands) Service cost......................................... $ 2,438 $ 1,756 $ 1,483 Interest cost........................................ 3,013 2,695 2,556 Expected return on plan assets....................... (3,706) (3,297) (2,877) ------- ------- ------- Net Amortization: Prior service cost................................. (260) (260) (260) Net Actuarial loss/(gain).......................... (53) (53) (33) Transition amount.................................. (131) (131) (131) ------- ------- ------- Total Amortization................................... (444) (444) (424) Net pension expense.................................. $ 1,301 $ 710 $ 738 ======= ======= ======= Amounts resulting from changes in actuarial assumptions used to measure the Bank's benefit obligations are not recognized as they occur, but are amortized systematically over subsequent periods. CTC has supplemental pension arrangements with certain retired employees. The liability, included in accrued expenses and other liabilities, related to such arrangements was $1,691,000 and $1,785,000 at December 31, 1999 and 1998, respectively. The Company has established a supplemental executive retirement plan (SERP) for members of the executive management group. This plan is intended to cover only those benefits excluded from coverage under the Bank's qualified defined benefit pension plan as a result of IRS regulations. The design elements of this SERP mirror those of the Bank's qualified plan. In addition to the SERP, the Company has a separate arrangement with its Chief Executive Officer under which contributions are accrued based upon the Company's Return on Equity (ROE). An ROE of 10% is the minimum threshold at which any contribution will be made. Benefits are payable upon attaining the age of 55, except in the event of death or disability. The liability related to the SERPs, included in accrued expenses and other liabilities, was $1,469,000 and $961,000 at December 31, 1999 and 1998, respectively. Other Benefit Plans CTC has an incentive savings and profit sharing plan to provide eligible employees with a means to save and invest a portion of their earnings, supplemented by contributions from CTC. Investment in the Company's common stock is one of seven investment options available to employees. Eligible employees of CTC may contribute, by salary reductions, up to 6% of their compensation as a basic employee contribution and may contribute up to an additional 10% of their compensation as a supplemental employee contribution. CTC makes an incentive savings contribution in an amount equal to 35% of each employee's basic contribution. In 1999, 1998, and 1997, 66,253, 39,981, and 74,631 shares, respectively, of the 53 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Company's common stock were purchased through the incentive savings and profit sharing plan; $1,084,000, $942,000, and $698,000, respectively, were charged to expense for contributions and payments made or to be made under the plan. In 1997, the Company established a supplemental executive savings plan. This plan is intended to cover only those benefits excluded from coverage under the Bank's qualified defined benefit pension plan as a result of IRS regulations. Under this plan, participants agree to elect a reduction in their earnings and the Company credits their retirement account in the amount of the reduction. This contribution, when combined with the regular pre-tax contributions, shall not exceed 16% of the individual's earnings. Expenses related to this plan were $22,789 and $27,500 in 1999 and 1998, respectively, and are included in the contribution expenses above. CTC may also make an additional matching contribution based on the extent to which the annual corporate profitability goals established by the Board of Directors are met. Expenses related to achievement of profitability goals totaled $153,000, $238,000, and $345,000, in 1999, 1998, and 1997, respectively. Similar expenses at VNB were $203,000, $500,000, and $750,000 in the respective years. CTC also has an Executive Management Incentive Compensation Plan. Executives at defined levels of responsibility are eligible to participate in the plan. Incentive award payments are determined on the basis of corporate profitability and individual performance, with incentive awards ranging from zero to 100% of annual compensation. Expenses for this plan totaled $671,000, $938,000, and $1,099,000 in 1999, 1998, and 1997, respectively. The Company has a Directors' Deferred Compensation Plan. Under the plan, Directors may defer fees and retainers that would otherwise be payable currently. Deferrals may be made to an uninsured interest account or an account recorded in equivalents of the Company's common stock. Expenses for this plan totaled $876,000, $1,155,000, and $1,164,000 for 1999, 1998, and 1997, respectively. Included in the expenses for 1997 was $116,000 related to the $0.60 per share special dividend paid in during the year. Directors are required to defer 50% of their compensation (and may defer as much as 100%) in the Company's common stock. Based on these elections, shares which will be issued under the plan totaled 242,333 at December 31, 1999. BWM and FBT have separate 401(k) plans under which those banks contributed $263,000, $292,000 and $222,000 in 1999, 1998 and 1997 respectively. Pomerleau has a separate 401(k) under which they contributed $41,000 and $47,000 in 1999 and 1998, respectively. Note 11 Financial Instruments with Off-Balance Sheet Risk In the normal course of business, to meet the financing needs of their customers and to reduce their own exposure to fluctuations in interest rates, the Banks are parties 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. The Banks' 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. The Banks use the same credit policies in making commitments and conditional obligations as they do for on-balance sheet instruments. The Banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks 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 unadvanced 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 54 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 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 Banks 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. Financial instruments whose contractual amounts represent off-balance sheet risk at December 31, 1999 and 1998 are as follows: 1999 1998 -------- -------- (in thousands) Commitments to originate loans............................... $ 64,541 $ 77,579 Unused lines of credit....................................... 323,957 353,544 Standby letters of credit.................................... 54,564 49,156 Unadvanced portions of construction loans.................... 74,301 76,114 Equity commitments to limited partnerships................... 3,084 250 Note 12 Commitments and Contingencies As nonmembers of the Federal Reserve System, the Banks are required to maintain certain reserve requirements of vault cash and/or deposits with the Federal Reserve Bank of Boston. The amount of this reserve requirement, included in cash and cash equivalents, was $12,349,000 and $15,296,000 at December 31, 1999 and 1998, respectively. CTC and FBT have contracts for data processing services that extend to June 2005 and April 2001, respectively. Base fees to be paid during the remaining term of the contract are approximately $41,614,000. Total fees to be paid may be the same as or exceed the base fees depending on additional services rendered and consumer price index changes during the remaining term of the contract. The Company has entered into severance agreements with the Chief Executive Officer and several members of senior management. These agreements are triggered by a change of control under certain circumstances. Payments are equal to 2.99 times annual salary for the Chief Executive Officer and from 1 to 2 times annual salary for the individual participating members of senior management. Various legal claims against the Company arising in the normal course of business were outstanding at December 31, 1999. Management, after reviewing these claims with legal counsel, is of the opinion that the resolution of these claims will not have a material effect on the financial condition or results of operations of the Company. Note 13 Other Noninterest Expense The components of other noninterest expense for the years presented are as follows: 1999 1998 1997 ------- ------- ------- (in thousands) Data processing....................................... $ 8,635 $ 6,937 $ 7,516 Legal and professional................................ 2,518 4,234 2,562 Marketing............................................. 3,199 3,608 3,249 Software and supplies................................. 4,710 4,641 4,320 Net OREO and collection expenses...................... (146) 472 1,019 Telephone............................................. 3,970 4,133 3,103 Postage............................................... 3,143 3,112 2,565 Other................................................. 17,076 17,290 18,461 ------- ------- ------- $43,105 $44,427 $42,795 ======= ======= ======= 55 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Note 14 Related Party Transactions Directors and executive officers of the Banks and their associates are credit customers of the Banks in the normal course of business. All loans and commitments included in such transactions are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons, and do not involve more than normal risk of collectibility or present other unfavorable features. An analysis of loans to directors and executive officers of the Banks and their associates, for 1999, is as follows (in thousands): Balance at Balance at December 31, 1998 Additions Reductions December 31, 1999 ----------------- --------- ---------- ----------------- $25,762 $6,845 $6,834 $25,773 ======= ====== ====== ======= Note 15 Fair Value of Financial Instruments Cash and Cash Equivalents The carrying amounts for cash and cash equivalents approximate fair value because they mature in 90 days or less and do not present unanticipated valuation risk. Securities The fair value of investment securities, other than obligations of states, political subdivisions, and Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB) stock, is based on quoted market prices. The fair value of obligations of states and political subdivisions is estimated to be equal to amortized cost. The carrying value of FHLB and FRB stock represents its redemption value. Loans Fair values are estimated for portfolios of loans with similar financial and credit characteristics. The loan portfolio was evaluated in the following segments: commercial, residential real estate, commercial real estate, construction, home equity, lease financing and other consumer loans. The fair value of performing commercial and real estate loans is estimated by discounting cash flows through the estimated maturity using discount rates that reflect the expected maturity and the credit and interest rate risk inherent in such loans. The fair value of nonperforming commercial and real estate loans is estimated using historical net charge-off experience applied to the nonperforming balances. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for prepayment estimates using discount rates based on secondary market sources. The fair value of municipal loans is estimated to be equal to amortized cost since most of these loans mature within six months. The fair value of home equity, credit card, lease financing and other consumer loans is estimated based on secondary market prices for asset-backed securities with similar characteristics. Mortgage Servicing Rights The fair value is estimated by discounting the future cash flows through the estimated maturity of the underlying mortgage loans. 56 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Deposits The fair value of deposits with no stated maturity, such as noninterest- bearing demand deposits, savings and N.O.W. accounts, and money market and checking accounts, is equal to the amount payable on demand, that is, the carrying amount. The fair value of certificates of deposit and retirement accounts is based on the discounted value of contractual cash flows. The discount rate used is based on the estimated rates currently offered for deposits of similar remaining maturities. Borrowings The carrying amounts for short-term borrowings approximate fair value because they mature or are callable in ten days or less and do not present unanticipated valuation risk. Long-term debt has an estimated fair value equal to its carrying amount. Commitments to Extend Credit and Standby Letters of Credit The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. Assumptions Fair value estimates are made at a specific point in time, based on relevant market information and information about specific financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Banks' entire holdings of a particular financial instrument. Because no active observable market exists for a significant portion of the Banks' financial instruments, fair value estimates are based on 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 assumptions could significantly affect the estimates. 57 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The estimated fair values of the Company's financial instruments are as follows: December 31, ------------------------------------------- 1999 1998 --------------------- --------------------- Carrying Carrying Amount Fair Value Amount Fair Value ---------- ---------- ---------- ---------- (in thousands) Financial assets: Cash and cash equivalents........ $ 150,415 $ 150,415 $ 267,999 $ 267,999 Securities available for sale.... 649,471 649,471 990,815 990,815 FHLB and FRB Stock............... 16,879 16,879 21,979 21,979 Loans, net....................... 2,854,651 2,840,280 2,698,080 2,730,664 Mortgage loans held for sale..... 2,926 2,926 53,684 53,684 Mortgage servicing rights........ 14,243 21,091 13,172 16,324 Financial liabilities: Deposits: Demand......................... 532,120 532,120 614,729 614,729 Savings........................ 1,807,843 1,807,843 2,032,717 2,032,717 Certificates of deposit less than $100,000 and other time deposits...................... 649,051 649,566 834,709 838,489 Certificates of deposit $100,000 and over............. 215,084 214,678 198,090 198,492 Short-term borrowings............ 197,072 195,993 135,913 135,974 Commitments...................... 268 268 143 143 Note 16 Parent Company Financial Statements Chittenden Corporation (Parent Company Only) Balance Sheets December 31, ----------------- 1999 1998 -------- -------- (in thousands) Assets Cash and cash equivalents.................................... $ 9,749 $ 11,602 Investment in subsidiaries at equity in net assets........... 335,291 371,951 Investment securities........................................ 753 1,707 Other assets................................................. 18,234 11,289 -------- -------- Total assets............................................... $364,027 $396,549 ======== ======== Liabilities and stockholders' equity Liabilities: Accrued expenses and other liabilities..................... 1,567 6,930 -------- -------- Total liabilities......................................... 1,567 6,930 -------- -------- Total stockholders' equity................................... 362,460 389,619 -------- -------- Total liabilities and stockholders' equity................ $364,027 $396,549 ======== ======== 58 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Statements of Operations Years Ended December 31, ---------------------------- 1999 1998 1997 -------- -------- -------- (in thousands) Operating income: Dividends from bank subsidiaries.............. $ 32,033 $ 31,967 $ 53,305 Interest income............................... 356 109 276 Gain on sale of securities.................... -- 15 34 Other......................................... 186 501 1,071 -------- -------- -------- Total operating income...................... 32,575 32,592 54,686 -------- -------- -------- Operating expense............................... 1,211 2,267 1,899 Special charges................................. 12,173 -- -- -------- -------- -------- Total expense............................... 13,384 2,267 1,899 -------- -------- -------- Income before income taxes and equity in undistributed earnings of subsidiaries......... 19,191 30,325 52,787 Income tax benefit.............................. 1,052 420 195 -------- -------- -------- Income before equity in undistributed earnings of subsidiaries................................ 20,243 30,745 52,982 Equity in undistributed earnings of bank subsidiaries .................................. (22,739) 19,033 (6,450) -------- -------- -------- Net income (loss)............................... $ (2,496) $ 49,778 $ 46,532 ======== ======== ======== Statements of Cash Flows Years Ended December 31, ---------------------------- 1999 1998 1997 -------- -------- -------- (in thousands) Cash flows from operating activities: Net income (loss)............................. $ (2,496) $ 49,778 $ 46,532 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Equity in undistributed earnings of bank subsidiaries .............................. 22,739 (19,033) 6,450 Gain on sale of securities.................. -- (15) (34) (Increase) decrease in other assets........... (3,479) (699) (3,060) Increase (decrease) in accrued expenses and other liabilities............................ (5,249) 826 5,047 -------- -------- -------- Net cash provided by operating activities... 11,515 30,857 54,935 -------- -------- -------- Cash flows from investing activities: Investments in and advanced to subsidiaries... -- (48) (35,644) Purchase of securities........................ -- -- (23,801) Proceeds from the sale of securities.......... -- 3,217 50,754 -------- -------- -------- Net cash provided by (used in) investing activities................................. -- 3,169 (8,691) -------- -------- -------- Cash flows from financing activities: Proceeds from issuance of treasury and common stock........................................ 9,484 1,608 11,858 Dividends paid on common stock................ (22,815) (19,564) (25,607) Repurchase of common stock.................... -- (21,678) (29,009) Cash paid to list on New York Stock Exchange, net of taxes................................. -- (93) -- Cash paid for fractional shares............... (37) -- -- -------- -------- -------- Net cash used in financing activities....... (13,368) (39,727) (42,758) -------- -------- -------- Net increase (decrease) in cash and cash equivalents.................................. (1,853) (5,701) 3,486 Cash and cash equivalents at beginning of year......................................... 11,602 17,303 13,817 -------- -------- -------- Cash and cash equivalents at end of year...... $ 9,749 $ 11,602 $ 17,303 ======== ======== ======== 59 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Note 17 Regulatory Matters The Company and the Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks 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. Each entity's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Banks to maintain minimum amounts and ratios (set forth in the tables below) of total and Tier I capital (as defined in the regulation) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). Management believes, as of December 31, 1999, that the Company and the Banks meet all capital adequacy requirements. As of December 31, 1999, the most recent notification from the Federal Deposit Insurance Corporation categorized the Company and the Banks as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as adequately or well capitalized, the Company and the Banks must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the tables below. There are no conditions or events since that notification that management believes have changed the institutions' categories. The Company's and the Banks' actual capital amounts (dollars in thousands) and ratios are presented in the following tables: To Be Well Capitalized Under Prompt Corrective For Capital Adequacy Action Actual Purposes Provisions: -------------- -------------------- -------------- Amount Ratio Amount Ratio Amount Ratio -------- ----- ------------ --------- -------- ----- As of December 31, 1999 Total Capital (to Risk Weighted Assets): Consolidated.......... $387,362 13.23% $ 234,184 8.00% N/A N/A Chittenden Trust Company ............. 134,367 10.46 102,817 8.00 $128,521 10.00% Vermont National Bank ..................... 158,877 15.39 82,587 8.00 103,234 10.00 Bank of Western Massachusetts........ 43,841 11.12 31,541 8.00 39,426 10.00 Flagship Bank & Trust. 26,695 10.52 20,304 8.00 25,380 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated.......... 350,715 11.96 117,269 4.00 N/A N/A Chittenden Trust Company.............. 118,470 9.22 51,408 4.00 77,112 6.00 Vermont National Bank. 145,965 14.13 41,320 4.00 61,980 6.00 Bank of Western Massachusetts........ 38,871 9.78 15,904 4.00 23,856 6.00 Flagship Bank & Trust. 23,521 9.26 10,157 4.00 15,236 6.00 Tier 1 Capital (to Average Assets): Consolidated.......... 350,715 8.17 171,761 4.00 N/A N/A Chittenden Trust Company.............. 118,470 7.14 66,403 4.00 83,004 5.00 Vermont National Bank. 145,965 8.91 65,515 4.00 81,894 5.00 Bank of Western Massachusetts........ 38,871 6.77 22,985 4.00 28,731 5.00 Flagship Bank & Trust. 23,521 6.72 14,001 4.00 17,501 5.00 60 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) To Be Well Capitalized Under Prompt Corrective For Capital Action Actual Adequacy Purposes Provisions: -------------- ------------------- -------------- Amount Ratio Amount Ratio Amount Ratio -------- ----- ---------- -------- -------- ----- As of December 31, 1998: Total Capital (to Risk Weighted Assets): Consolidated............ $349,667 12.02% $ 232,536 8.00% N/A N/A Chittenden Trust Company ....................... 119,335 10.49 90,978 8.00 $113,722 10.00% Vermont National Bank... 145,206 12.75 91,100 8.00 113,875 10.00 Bank of Western Massachusetts ......... 49,529 12.06 32,851 8.00 41,064 10.00 Flagship Bank & Trust... 24,480 10.58 18,502 8.00 23,128 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated............ 313,273 10.76 116,461 4.00 N/A N/A Chittenden Trust Company................ 105,094 9.22 45,572 4.00 68,358 6.00 Vermont National Bank... 130,965 11.50 45,550 4.00 68,325 6.00 Bank of Western Massachusetts.......... 44,365 10.74 16,521 4.00 24,782 6.00 Flagship Bank & Trust... 21,957 9.49 9,251 4.00 13,877 6.00 Tier 1 Capital (to Average Assets): Consolidated............ 313,273 7.58 165,425 4.00 N/A N/A Chittenden Trust Company................ 105,094 6.89 61,034 4.00 76,293 5.00 Vermont National Bank .. 130,965 6.55 71,707 4.00 89,633 5.00 Bank of Western Massachusetts.......... 44,365 8.05 22,047 4.00 27,559 5.00 Flagship Bank & Trust... 21,957 6.33 13,875 4.00 17,344 5.00 Note 18 Business Segments On January 1, 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, which establishes standards for reporting operating segments of a business enterprise. SFAS No. 131 has established revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company's chief operating decision maker is the President and Chief Executive Officer of the Company. The adoption of SFAS 131 did not have a material effect on the Company's primary financial statements, but did result in the disclosure of segment information contained herein. The Company has identified Commercial Banking as its reportable operating business segment based on the fact that the results of operations are viewed as a single strategic unit by the chief operating decision maker. The Commercial Banking segment is comprised of the four Commercial Banking subsidiaries and CCC, which provide similar products and services, have similar distribution methods, types of customers and regulatory responsibilities. Commercial Banking derives its revenue from a wide range of banking services, including lending activities, acceptance of demand, savings and time deposits, safe deposit facilities, merchant credit card services, trust and investment management, data processing, brokerage services, mortgage banking, and loan servicing for investor portfolios. Immaterial operating segments of the Company's operations, which do not have similar characteristics to the commercial banking operations and do not meet the quantitative thresholds requiring disclosure, are included in the Other category in the disclosure of business segments below. 61 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies. The consolidation adjustment reflects certain eliminations of inter-segment revenue, cash and Parent Company investments in subsidiaries. The following tables present the results of the Company's reportable operating business segment results as of December 31, 1999, 1998 and 1997: Commercial Consolidation Banking Other (2) Adjustments Consolidated ---------- --------- ------------- ------------ Year Ended December 31, 1999 Net Interest Revenue (1)....... $ 174,951 $ 404 $ (374) $ 174,981 Non Interest Income: Investment management income.. 14,290 -- -- 14,290 Service charges on deposit accounts..................... 17,534 -- -- 17,534 Mortgage servicing income..... 3,589 -- -- 3,589 Gains on sales of mortgage loans, net................... 5,254 -- -- 5,254 Credit card income, net....... 6,248 -- -- 6,248 Insurance commissions, net.... -- 2,603 (65) 2,538 Other non-interest income..... 14,593 180 -- 14,773 ---------- -------- --------- ---------- Total non-interest income...... 61,508 2,783 (65) 64,226 ---------- -------- --------- ---------- Total income................... 236,459 3,187 (439) 239,207 Provision for possible loan losses........................ 8,700 -- -- 8,700 Depreciation and amortization expense....................... 12,270 533 -- 12,803 Salaries and employee benefits. 73,467 1,410 -- 74,877 Special charges................ 46,299 12,173 -- 58,472 Other non-interest expense..... 56,097 1,680 -- 57,777 ---------- -------- --------- ---------- Total non-interest expense..... 188,133 15,796 -- 203,929 ---------- -------- --------- ---------- Income (loss) before income taxes......................... 39,626 (12,609) (439) 26,578 Income tax expense (benefit)... 29,972 (898) -- 29,074 ---------- -------- --------- ---------- Net Income (Loss).............. $ 9,654 $(11,711) $ (439) $ (2,496) ========== ======== ========= ========== End of Period Assets........... 3,829,290 387,457 (389,450) 3,827,297 End of Period Loans, net....... 2,854,651 -- -- 2,854,651 End of Period Deposits......... 3,187,210 -- 16,888 3,204,098 Expenditures for long-lived assets........................ 9,631 84 -- 9,715 62 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Commercial Consolidation Banking Other(2) Adjustments Consolidated ---------- -------- ------------- ------------ Year Ended December 31, 1998 Net Interest Revenue(1)........ $ 173,526 $ 391 $ (211) $ 173,706 Non Interest Income: Investment management income.. 12,913 -- -- 12,913 Service charges on deposit accounts..................... 19,785 -- -- 19,785 Mortgage servicing income..... 3,274 -- -- 3,274 Gains on sales of mortgage loans, net................... 7,734 -- -- 7,734 Credit card income, net....... 6,114 -- -- 6,114 Insurance commissions, net.... -- 2,917 (39) 2,878 Other non-interest income..... 13,633 363 -- 13,996 ---------- -------- --------- ---------- Total non-interest income...... 63,453 3,280 (39) 66,694 ---------- -------- --------- ---------- Total income................... 236,979 3,671 (250) 240,400 Provision for possible loan losses........................ 8,235 -- -- 8,235 Depreciation and amortization expense....................... 15,951 721 -- 16,672 Salaries and employee benefits. 75,581 1,396 -- 76,977 Other non-interest expense..... 56,389 2,509 -- 58,898 ---------- -------- --------- ---------- Total non-interest expense..... 147,921 4,626 -- 152,547 ---------- -------- --------- ---------- Income (loss) before income taxes......................... 80,823 (955) (250) 79,618 Income tax expense (benefit)... 29,985 (145) -- 29,840 ---------- -------- --------- ---------- Net Income (Loss).............. $ 50,838 $ (810) $ (250) $ 49,778 ========== ======== ========= ========== End of Period Assets........... 4,238,790 404,621 (387,359) 4,256,052 End of Period Loans, net....... 2,698,080 -- -- 2,698,080 End of Period Deposits......... 3,691,182 -- (10,937) 3,680,245 Expenditures for long-lived assets........................ 10,434 202 -- 10,636 Commercial Consolidation Banking Other(2) Adjustments Consolidated ---------- -------- ------------- ------------ Year Ended December 31, 1997 Net Interest Revenue(1)........ $ 159,855 $ 1,227 $ (221) $ 160,861 Non Interest Income: Investment management income.. 11,363 -- -- 11,363 Service charges on deposit accounts..................... 17,172 -- -- 17,172 Mortgage servicing income..... 4,114 -- -- 4,114 Gains on sales of mortgage loans, net................... 3,584 -- -- 3,584 Credit card income, net....... 6,069 -- -- 6,069 Insurance commissions, net.... -- 1,380 (53) 1,327 Other non-interest income..... 11,691 199 -- 11,890 ---------- -------- --------- ---------- Total non-interest income...... 53,993 1,579 (53) 55,519 ---------- -------- --------- ---------- Total income................... 213,848 2,806 (274) 216,380 Provision for possible loan losses........................ 7,300 -- -- 7,300 Depreciation and amortization expense....................... 11,971 399 -- 12,370 Salaries and employee benefits. 67,743 851 -- 68,594 Other non-interest expense..... 53,377 2,102 -- 55,479 ---------- -------- --------- ---------- Total non-interest expense..... 133,091 3,352 -- 136,443 ---------- -------- --------- ---------- Income (loss) before income taxes......................... 73,457 (546) (274) 72,637 Income tax expense (benefit)... 26,311 (206) -- 26,105 ---------- -------- --------- ---------- Net Income (Loss).............. $ 47,146 $ (340) $ (274) $ 46,532 ========== ======== ========= ========== End of Period Assets........... 4,051,803 390,038 (367,239) 4,074,602 End of Period Loans, net....... 2,684,408 -- -- 2,684,408 End of Period Deposits......... 3,447,315 -- (8,096) 3,439,219 Expenditures for long-lived assets........................ 17,601 34 -- 17,635 - -------- (1) The Commercial Banking segment derives a majority of its revenue from interest. In addition, management primarily relies on net interest revenue, not the gross revenue and expense amounts, in managing that segment. Therefore, only the net amount has been disclosed. (2) Revenue derived from these non-reportable segments includes insurance commissions from various insurance related products and services, which began during 1997. 63 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Note 19 Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS 133 establishes the accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or a liability measured at its fair value. The Statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the statement of operations, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting treatment. Statement 133, as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of the Effective Date of FASB Statement No. 133," is effective for the Company's fiscal year beginning January 1, 2001. The Company has the option to elect to early adopt the Statement at the beginning of its next fiscal quarter. The statement cannot be applied retroactively. Statement 133 must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997 (and, at the Company's election, before January 1, 1998). The Company has not yet quantified the impact of adopting Statement 133 on its consolidated financial statements and has not determined the timing of or method of its adoption of the Statement. However, the Company does not expect that the adoption will have a material impact on its financial position or results of operation. Note 20 Quarterly Financial Data (Unaudited) A summary of quarterly financial data for 1999 and 1998 is presented below: Three Months Ended ------------------------------------------------- March 31 June 30 September 30 December 31 ------------ ----------- ------------ ----------- (in thousands, except per share amounts) 1999 Total interest income........ $ 72,195 $ 71,744 $ 73,104 $ 71,173 Total interest expense....... 29,026 28,430 28,360 27,419 -------- -------- -------- -------- Net interest income.......... 43,169 43,314 44,744 43,754 Provision for possible loan losses...................... 2,175 2,175 2,175 2,175 Noninterest income........... 16,158 16,358 16,074 15,636 Special charges.............. -- 70,995 (1,739) (10,785) Noninterest expense.......... 38,358 38,075 35,636 33,389 -------- -------- -------- -------- Income (loss) before income taxes (benefit)............. 18,794 (51,573) 24,746 34,611 Income taxes (benefit)....... 6,875 (7,169) 8,834 20,534 -------- -------- -------- -------- Net income (loss)............ $ 11,919 $(44,404) $ 15,912 $ 14,077 ======== ======== ======== ======== Basic earnings (loss) per share....................... $ 0.43 $ (1.58) $ 0.56 $ 0.50 Diluted earnings (loss) per share....................... 0.42 (1.58) 0.55 0.49 Dividends paid per share (Chittenden historical amounts).................... 0.20 0.22 0.22 0.22 64 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) Three Months Ended ----------------------------------------- March 31 June 30 September 30 December 31 -------- ------- ------------ ----------- (in thousands, except per share amounts) 1998 Total interest income................ $74,584 $74,572 $75,392 $75,317 Total interest expense............... 31,765 31,409 31,711 31,274 ------- ------- ------- ------- Net interest income.................. 42,819 43,163 43,681 44,043 Provision for possible loan losses... 2,400 2,310 2,250 1,275 Noninterest income .................. 16,054 17,026 16,981 16,731 Noninterest expense ................. 38,055 37,632 38,271 39,005 ------- ------- ------- ------- Income before income taxes........... 18,418 20,247 20,141 20,494 Income taxes ........................ 6,803 7,607 7,622 7,490 ------- ------- ------- ------- Net income........................... $11,615 $12,640 $12,519 $13,004 ======= ======= ======= ======= Basic earnings per share............. $ 0.41 $ 0.44 $ 0.44 $ 0.47 Diluted earnings per share........... 0.40 0.44 0.44 0.46 Dividends paid per share (Chittenden historical amounts)................. 0.18 0.20 0.20 0.20 65 To the Board of Directors and Stockholders of Chittenden Corporation: We have audited the accompanying consolidated balance sheets of Chittenden Corporation and its subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, changes in stockholders' equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of Vermont Financial Services Corp. (a bank holding company acquired during 1999 in a transaction accounted for as a pooling of interests, as discussed in Note 2) as of December 31, 1998 and for each of the two years in the period ended December 31, 1998. Such statements are included in the consolidated financial statements of Chittenden Corporation and subsidiaries and reflect total assets of 50.3 percent in 1998 and net interest income of 47.5 percent and 43.7 percent, respectively, in 1998 and 1997 of the related consolidated totals. These statements were audited by other auditors whose report has been furnished to us and our opinion on the consolidated financial statements of Chittenden Corporation and subsidiaries for the years ending December 31, 1998 and 1997, insofar as it relates to amounts included for Vermont Financial Services Corp., is based solely upon the report of the other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chittenden Corporation and its subsidiaries as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP Boston, Massachusetts January 13, 2000 66 To the Stockholders and Board of Directors of: Vermont Financial Services Corporation: We have audited the consolidated balance sheets of Vermont Financial Services Corp. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for the years then ended. These consolidated financial statements (not presented separately herein) are the responsibility of the Company's management. Our responsibility is to express and opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Vermont Financial Services Corp. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. /s/ KPMG LLP KPMG LLP Hartford, Connecticut January 22, 1999 67 MANAGEMENT'S STATEMENT OF RESPONSIBILITY The consolidated financial statements contained in this annual report on Form 10-K have been prepared in accordance with generally accepted accounting principles and, where appropriate, include amounts based upon management's best estimates and judgements. Management is responsible for the integrity and the fair presentation of the consolidated financial statements and related information. Management maintains an extensive system of internal controls to provide reasonable assurance that the Company's assets are safeguarded against loss and that financial information is reliable. These internal controls include the establishment and communication of policies and procedures, the selection and training of qualified personnel and an internal auditing program that evaluates the adequacy and effectiveness of such internal controls, policies and procedures. The Audit Committee, which is comprised entirely of non-employee directors, is responsible for ensuring that management, internal auditors, and the independent public accountants fulfill their respective responsibilities with regard to the consolidated financial statements. The Audit Committee meets periodically with management, internal auditors and the independent public accountants to assure that each is carrying out its responsibilities. The internal auditors and the independent public accountants have full and free access to the Audit Committee and meet with it, with and without management being present, to discuss the scope and results of their audits and any recommendations regarding the system of internal controls. The responsibility of the Company's independent public accountants, Arthur Andersen LLP, is limited to an expression of their opinion as to the fairness of the consolidated financial statements presented. Their opinion is based on an audit conducted in accordance with generally accepted auditing standards as described in the second paragraph of their report. [Signature of Paul A. Perrault] [Signature of Kirk W. Walters] Paul A. Perrault Kirk W. Walters President, Chief Executive Officer Executive Vice President and and Chair of Board of Directors Chief Financial Officer 68 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Registrant is included in the Company's Definitive Proxy Statement for the 2000 Annual Meeting of Stockholders of Chittenden Corporation at pages 6-11, and is specifically incorporated herein by reference. At December 31, 1999, the principal officers of the Company and its principal subsidiary, CTC, with their ages, positions, and years of appointment, were as follows: Year Name Age Appointed Positions ---- --- --------- --------- Paul A. Perrault........... 48 1990 President, Chief Executive Officer of the Company and CTC, and Chair of the Company, CTC & VNB John P. Barnes............. 44 1990 Executive Vice President of the Company, CTC & VNB Lawrence W. DeShaw......... 54 1990 Executive Vice President of the Company, CTC & VNB John W. Kelly.............. 50 1990 Executive Vice President of the Company, CTC & VNB Danny H. O'Brien........... 50 1990 Executive Vice President of the Company, CTC & VNB Kirk W. Walters............ 44 1996 Executive Vice President, Chief Financial Officer, and Treasurer of the Company, CTC & VNB F. Sheldon Prentice........ 49 1985 Senior Vice President, General Counsel, and Secretary of the Company, CTC & VNB Howard L. Atkinson......... 55 1996 Chief Auditor of the Company, CTC & VNB All of the current officers, except Mr. Walters and Mr. Atkinson, have been principally employed in executive positions with CTC for more than seven years. In accordance with the provisions of the Company's By-laws, the officers, with the exception of the Secretary, hold office at the pleasure of the Board of Directors. The Secretary is elected annually by the Board of Directors. ITEM 11 EXECUTIVE COMPENSATION Information regarding remuneration of the directors and officers of the Company is included in the Company's Definitive Proxy Statement for the 2000 Annual Meeting of Stockholders of Chittenden Corporation at pages 11-17 and is specifically incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding the security ownership of directors and director- nominees of the Company, all directors and officers of the Company as a group, and certain beneficial owners of the Company's common stock, as of January 31, 2000, is included in the Company's Definitive Proxy Statement for its 2000 Annual Meeting of Stockholders of Chittenden Corporation at pages 4-5, and is specifically incorporated herein by reference. There are no arrangements known to the registrant that may, at a subsequent date, result in a change of control of the registrant. 69 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and transactions between the Company and its Directors, Director-Nominees, Executive Officers, and family members of these individuals, is included in the Company's Definitive Proxy Statement for its 2000 Annual Meeting of Stockholders of Chittenden Corporation at pages 18-19, and is specifically incorporated herein by reference. PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The financial statements of the Company and its subsidiaries are included in Part II, Item 8 hereof and are incorporated herein by reference. (2) Financial Statement Schedules There are no financial statement schedules required to be included in this report. (3) Exhibits (a) The following are included as exhibits to this report: 2.1 Agreement and Plan of Merger, dated as of December 16, 1998, between the Company, Chittenden Acquisition Subsidiary, Inc. and Vermont Financial Services Corp., incorporated by reference to the Company's Registration Statement No. 333-75769 on Form S-4 filed with the SEC on April 6, 1999. 3 (i).1 Amended and restated Articles of Incorporation of the Company, incorporated herein by reference to the Company's Registration Statement No. 333-75769 on Form S-4 filed with the SEC on April 6, 1999. 3 (ii).1 By-laws of the Company, as amended and restated as of October 18, 1997, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. 4. Statement of the Company regarding its Dividend Reinvestment Plan is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1993. 10.1 Directors' Deferred Compensation Plan, dated April 1972, as amended May 20, 1992, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10.2 Amended and Restated Pension Plan, incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the period ended September 30, 1996. 10.3 Incentive Savings and Profit Sharing Plan, attached to the Company's Annual Report on Form 10-K for the year ended December 31, 1994, as amended for the year ended December 31, 1995. 10.4 Letter from the Company to Paul A. Perrault, dated July 26, 1990, regarding terms of employment, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. 10.5 The Company's 1988 Stock Option Plan, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 10.6 The Company's Restricted Stock Plan, incorporated herein by reference to the Company's Proxy Statement in connection with the 1986 Annual Meeting of Stockholders. 10.8 Executive Management Incentive Compensation Plan ("EMICP"), incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1994. 70 10.9 Amendment to EMICP to increase cap on awards from 60% to 100% of base salary, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1996. 10.10 The Company's Stock Incentive Plan, amended and restated January 1, 1997, incorporated herein by reference to the Company's Proxy Statement for the 1997 Annual Meeting of Stockholders. 10.11 Compensation plan of Paul A. Perrault, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1996. 10.12 Supplemental Executive Retirement Plan of Paul A. Perrault, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1996. 10.13 Supplemental Executive Cash Balance Restoration Plan incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.14 Supplemental Executive Savings Plan, incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. 10.15 The 1998 Directors' Omnibus Long-Term Incentive Plan, incorporated herein by reference to the Company's Proxy Statement for the 1998 Annual Meeting of Stockholders. 10.16 Stock Option Agreement, dated as of December 16, 1998, between the Company and Vermont Financial Services Corp., incorporated by reference to the Company's Form 8-K/A filed with the SEC on January 6, 1999. 21. List of subsidiaries of the Registrant. 23. Consent of Arthur Andersen LLP 24. Consent of KPMG LLP 27. Financial Data Schedule (b) Reports on Form 8-K None 71 EXHIBITS (c) EXHIBIT 21 LIST OF SUBSIDIARIES OF CHITTENDEN CORPORATION Chittenden Trust Company, Vermont, d/b/a Chittenden Bank, Mortgage Service Center of New England and CUMEX Mortgage Service Center, and Chittenden Trust Company's subsidiaries Chittenden Securities, Inc. and Chittenden Insurance Products and Services, Inc, d/b/a The Pomerleau Agency Vermont National Bank, Vermont The Bank of Western Massachusetts, Massachusetts Flagship Bank and Trust Company, Massachusetts Chittenden Connecticut Corporation, Vermont, d/b/a Mortgage Service Center of New England and CUMEX Mortgage Service Center EXHIBIT 23 CONSENT OF ARTHUR ANDERSEN LLP HAS BEEN FILED AS AN EXHIBIT EXHIBIT 24 CONSENT OF KPMG LLP HAS BEEN FILED AS AN EXHIBIT EXHIBIT 27 FINANCIAL DATA SCHEDULE HAS BEEN FILED AS AN EXHIBIT 72 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, thereto duly authorized. Date: March 15, 2000 CHITTENDEN CORPORATION /s/ Paul A. Perrault By: _________________________________ Paul A. Perrault President, Chief Executive Officer and Chairman of the Board of Directors 73 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Name Title Date ---- ----- ---- /s/ Paul A. Perrault President, Chief Executive March 15, 2000 ___________________________________________ Officer and Chairman of Paul A. Perrault the Board of Directors /s/ Kirk W. Walters Executive Vice President, March 15, 2000 ___________________________________________ Chief Financial Officer Kirk W. Walters and Treasurer (principal accounting officer) /s/ Frederic H. Bertrand Director March 15, 2000 ___________________________________________ Frederic H. Bertrand /s/ David M. Boardman Director March 15, 2000 ___________________________________________ David M. Boardman /s/ Paul J. Carrara Director March 15, 2000 ___________________________________________ Paul J. Carrara /s/ William P. Cody Director March 15, 2000 ___________________________________________ William P. Cody /s/ Sally W. Crawford Director March 15, 2000 ___________________________________________ Sally W. Crawford /s/ Richard D. Driscoll Director March 15, 2000 ___________________________________________ Richard D. Driscoll /s/ Philip M. Drumheller Director March 15, 2000 ___________________________________________ Philip M. Drumheller /s/ John K. Dwight Director March 15, 2000 ___________________________________________ John K. Dwight 74 Name Title Date ---- ----- ---- /s/ Lyn Hutton Director March 15, 2000 ___________________________________________ Lyn Hutton /s/ Philip A. Kolvoord Director March 15, 2000 ___________________________________________ Philip A. Kolvoord /s/ Stephan A. Morse Director March 15, 2000 ___________________________________________ Stephan A. Morse /s/ James C. Pizzagalli Director March 15, 2000 ___________________________________________ James C. Pizzagalli /s/ Ernest A. Pomerleau Director March 15, 2000 ___________________________________________ Ernest A. Pomerleau /s/ Mark W. Richards Director March 15, 2000 ___________________________________________ Mark W. Richards /s/ Pall D. Spera Director March 15, 2000 ___________________________________________ Pall D. Spera /s/ Martel D. Wilson, Jr. Director March 15, 2000 ___________________________________________ Martel D. Wilson, Jr. 75 CHITTENDEN CORPORATION SKU#667-10K-00