- ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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, 1997 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: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: $1.00 Par Value Common Stock (Title of Class) 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 [ ]. The aggregate market value of the Registrant's common stock held by non- affiliates of the Registrant, on February 27, 1998 as reported on NYSE, was $472,346,917. At February 27, 1998, there were 14,405,671 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. Proxy Statement for 1998 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, among other factors, of 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, 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, 1997, the Company had total consolidated assets of $1,977,150,000. 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") (collectively "The Banks") and Chittenden Connecticut Corporation ("CCC"), a non-bank mortgage company. Through its subsidiaries, the Company offers a variety of lending services, with loans and leases totaling $1,399,138,000 at December 31, 1997. The largest loan category is commercial loans, including 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 49% of the total loans outstanding at December 31, 1997. Loans secured by residential properties, including closed-ended home equity loans comprised 27% of total loans outstanding at December 31, 1997. 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. The remaining real estate loans, which are 1% of total loans outstanding at December 31, 1997, are construction loans secured by residential and commercial land under development. Consumer loans outstanding at December 31, 1997 were 17% of total loans. These include direct and indirect installment loans, auto leases, and revolving credit which accounted for 3%, 7%, 2% and 5% of total loans respectively. Revolving home equity loans as a separate group amounted to 6% of loans at December 31, 1997. These loans are generally underwritten based upon the same standards as first mortgages. The Company's lending activities are conducted primarily in Vermont and Massachusetts, with additional activity related to nearby market areas in Quebec, New York, New Hampshire, 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 other 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, 1997, total interest-bearing deposits and noninterest-bearing demand deposits amounted to $1,454,990,000 and $302,555,000 respectively. The Banks also provide personal trust 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 with both personal and corporate trust services. Trust administered assets totaled $2.8 billion at December 31, 1997. 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 for such customers. The Banks offer a variety of other services including safe deposit facilities, MasterCard and VISA credit card services, credit card processing, and certain non-deposit, investment products through a dual-employee contractual relationship with Fiserv Investor Services, Inc. 1 The Company's principal executive offices are located at Two Burlington Square, Burlington, Vermont 05401; telephone number: 802-658-4000. CHITTENDEN TRUST COMPANY CTC was chartered by the Vermont Legislature as a commercial bank in 1904. It is the second largest bank in Vermont, based on total assets of $1,384,526,000 and total deposits of $1,227,624,000 at December 31, 1997. CTC's principal offices are in Burlington, Vermont and it has 35 additional locations in Vermont, of which three are free standing automated teller machines ("ATM's"). (See Item 2, "Properties"). All of these offices use the trade name "Chittenden Bank". On May 31, 1997, Chittenden Bank acquired certain assets and assumed certain liabilities of The Pomerleau Agency. The Pomerleau Agency offers various insurance related products including: personal, commercial and life/health policies, as well as specialized coverages and a consulting and risk management service. THE BANK OF WESTERN MASSACHUSETTS BWM was chartered by the Commonwealth of Massachusetts as a commercial bank in 1986. At December 31, 1997, BWM had total assets of $270,484,000 and total deposits of $235,533,000. BWM's principal offices are in Springfield, Massachusetts and it has four additional locations in the greater Springfield, Massachusetts area. FLAGSHIP BANK AND TRUST COMPANY FBT was chartered by the Commonwealth of Massachusetts as a commercial bank in 1986. At December 31, 1997, FBT had total assets of $327,483,000 and total deposits of $301,921,000. FBT's principal offices are in Worcester, Massachusetts and it has five 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 and Southbury, Connecticut (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 showed signs of continued improvement in 1997. Retail sales improved along with increases in both housing permits and new construction contracts. New England unemployment levels also continued to decrease. The ability and willingness of the Company's borrowers to honor their repayment commitments are impacted by many factors, including 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 include other banks, credit unions, finance companies, thrift institutions and, increasingly, brokerage firms, insurance companies, and mortgage loan companies. Money 2 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. CTC competes with Vermont banks and metropolitan banks based in southern New England and New York City to provide commercial banking services to businesses. Many of these out-of-state banks have greater financial resources than those of Vermont banks and are actively seeking financial relationships with promising Vermont enterprises. BWM and FBT compete with other financial institutions in their respective franchises of Springfield and Worcester Massachusetts. 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 (CTC, BWM and FBT) 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 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. Interstate Acquisitions. Prior to September 29, 1995, under the BHC Act a bank holding company was permitted to acquire a bank in another state only if the law of the state in which the bank to be acquired was located specifically authorized such acquisition of an in-state bank by an out-of-state bank holding company. As described below under "Capital Requirements and FDICIA-- Interstate Banking and Branching", the BHC Act was amended, effective September 29, 1995, to remove this prohibition. Even prior to this amendment to the BHC Act, previously enacted state legislation substantially lessened prior legislative restrictions on geographic expansion by bank holding companies from and into Massachusetts and Vermont. For example, under nationwide reciprocal interstate banking legislation adopted by both states which became effective in 1990, bank holding companies whose subsidiaries' banking operations were principally conducted in any state outside Massachusetts or Vermont were authorized to acquire Massachusetts or Vermont banking organizations, provided that such 3 companies' home states afforded Massachusetts or Vermont banking organizations reciprocal rights to acquire banks in such states. 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 CTC, BWM and FBT--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 CTC, BWM and FBT General. As FDIC-insured state-chartered banks, CTC, BWM and FBT are subject to supervision of and regulation by the Commissioner of Banking, Insurance, Securities and Heath Care Administration of the State of 4 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 relevant Commissioner is required for CTC, BWM or FBT 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 CTC, BWM and FBT, 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, CTC, BWM and FBT 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 CTC, BWM and FBT 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 CTC, BWM and FBT 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 CTC, BWM and FBT to directors, executive officers and principal stockholders and related interests of such persons. Deposit Insurance. CTC's, BWM's and FBT'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 5 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 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 business of CTC, BWM and FBT 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, CTC, BWM and FBT 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. In addition, CTC, BWM and FBT are 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 received a rating of "Outstanding". Failure of an institution to receive at least a "Satisfactory" rating could inhibit such institution's undertaking certain activities, including 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. CTC, BWM and FBT 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. 6 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. 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 credit the 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 CTC, BWM and FBT will generally be less than reported balance sheet assets because its retail banking activities include proportionally more residential mortgage loans with a lower risk weighing 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). CTC, BWM and FBT believe that this provision will not have a material adverse effect on them. At December 31, 1997, the Company's consolidated Total and Tier 1 Risk-Based Capital Ratios were 11.17% and 9.86%, respectively, and its Leverage Capital Ratio was 7.43%. 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 7 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 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 8 again in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of CTC, BWM and FBT, 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 1996 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), for the first semiannual period of 1997. During 1996, assessment rates also included a minimum annual assessment of $2,000 per institution. CTC, BWM and FBT qualified for, and paid in 1996, 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-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, 1996, Call Reports. Based on the 1996 Act, the Banks paid assessments totaling $231,000 or 1.3 cents per $100 of deposits in 1997. 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, CTC, BWM and FBT 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" 9 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. Subject to certain limited exceptions, the foregoing provisions of FDICIA prohibit insured state banks such as CTC, BWM and FBT or any subsidiary of such insured state banks from retaining or acquiring equity investments. However, under an exception in the statute, an insured state bank that (i) is located in a state such as Vermont or Massachusetts which authorized, as of September 30, 1991, state banks to invest in common or preferred stock listed on a national securities exchange ("listed stock") or shares of an investment company registered under the Investment Company Act of 1940 ("registered shares") and (ii) during the period beginning September 30, 1990 and ending on November 26, 1991 made or maintained investments in listed stocks and registered shares, may retain whatever listed stock or registered shares it lawfully acquired or held prior to December 19, 1991 and may continue to acquire listed stock or registered shares which may not exceed, taken together in the aggregate, 100% of the bank's Tier 1 Capital. In order to acquire or retain any listed stock or registered shares under this exception, the bank must file a one-time notice with the FDIC containing specified information, and the FDIC must determine that acquiring or retaining the listed stock or registered shares will not pose a significant risk to the BIF. Any such approval may be subject to whatever conditions or restrictions the FDIC determines to be necessary or appropriate and will terminate with respect to further acquisitions of listed stock or registered shares if the bank or its holding company experiences a change in control and in certain other circumstances. CTC filed the one-time notice with the FDIC and the FDIC did not object. 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. Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal Act") provides that an adequately capitalized and managed bank holding company may (with Federal Reserve Board approval) acquire control of banks outside its principal state of operations, without regard to whether such acquisitions are permissible under state law. States may, however, limit the eligibility of banks to be acquired by an out-of-state bank holding company to banks in existence for a minimum period of time (not in excess of five years). No bank holding company may make an acquisition outside its principal state of operations which would result in it controlling more than 10% of the total amount of deposits of all insured 10 depository institutions in the United States, or 30% or more of the total deposits of insured depository institutions in any state (unless such limit is waived, or a more restrictive or permissible limit is established, by a particular state). In addition, since June 1, 1997, banks may branch across state lines either by merging with banks in other states or by establishing new branches in other states. The date relating to interstate branching through mergers may be accelerated by any state. The provision relating to establishing new branches in another state requires a state's specific approval. Effective in 1996, the Vermont and Massachusetts legislatures adopted legislation to accelerate the effective date of interstate branching through mergers (that is, to "opt-in early"). Since 1990, Massachusetts has had nationwide reciprocal interstate banking legislation permitting out-of- state banks to conduct banking operations in that state both by mergers and by establishing new banks, subject to the reciprocity requirements that banks from another state may acquire banks in Massachusetts only if Massachusetts banks may conduct banking operations in that state. The Company is unable to predict the ultimate impact of this interstate banking legislation on it or its competitors. The United States Congress has periodically considered and adopted legislation which has resulted in and could result in further regulation or deregulation of both banks and other financial institutions. Such legislation could place the Company, CTC, BWM, FBT or CCC in more direct competition with other financial institutions, including mutual funds, securities brokerage firms and investment banking firms. No assurance can be given as to whether any additional legislation will be enacted or as to the effect of such legislation on the business of the Company or its subsidiaries. EMPLOYEES At December 31, 1997 the Company and its subsidiaries employed 986 persons, with a full-time equivalency of 923 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 four additional locations in the greater Springfield, Massachusetts. FBT's principal offices are in Worcester, Massachusetts and it has five additional locations in the greater Worcester, Massachusetts area. CCC operates two mortgage company facilities in Connecticut. Except for the CTC property, all of the properties mentioned above are leased. The offices of CTC, BWM, FBT and CCC are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities serviced. ITEM 3 LEGAL PROCEEDINGS A number of legal claims against the Company arising in the normal course of business were outstanding at December 31, 1997. 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 December 31, 1997, there were 3,085 holders of record of the Company's common stock. As of February 18, 1998 the Corporation's stock initiated trading on the NYSE under the symbol "CHZ". Prior to that date, the Corporation'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 Corporation's common stock, and the dividends declared, for each quarterly period within the past two years: DIVIDENDS QUARTER ENDED HIGH LOW DECLARED ------------- ------ ------ --------- 1997 March 31........................................ $24.00 $18.50 $0.160 June 30......................................... 27.60 21.50 0.176 September 30.................................... 31.70 25.60 0.176 December 31..................................... 36.00 30.40 0.776(1) 1996 March 31........................................ 20.48 15.36 0.088 June 30......................................... 18.20 16.48 0.160 September 30.................................... 20.60 16.60 0.160 December 31..................................... 21.00 19.10 0.160 - -------- (1) Dividends declared during the fourth quarter of 1997 included a special cash dividend of $0.60 per share. For a discussion of dividend restrictions on the Corporation's common stock, see "Dividends" under the caption Regulation on page 6 of this report. 12 ITEM 6 SELECTED FINANCIAL DATA YEARS ENDED DECEMBER 31, --------------------------------------------------------------- 1997 1996 1995 1994 1993 ----------- ----------- ----------- ----------- ----------- (IN THOUSANDS, EXCEPT SHARE AMOUNTS) Statements of income: Interest income........ $ 150,189 $ 142,592 $ 135,103 $ 101,383 $ 93,889 Interest expense....... 59,545 58,599 56,772 36,088 34,395 ----------- ----------- ----------- ----------- ----------- Net interest income.... 90,644 83,993 78,331 65,295 59,494 Provision for possible loan losses........... 4,050 4,183 5,000 5,500 8,135 Net interest income after provision for possible loan losses.. 86,594 79,810 73,331 59,795 51,359 Noninterest income..... 28,210 24,920 22,040 19,352 22,793 Noninterest expense.... 70,072 64,557 61,584 51,393 54,263 ----------- ----------- ----------- ----------- ----------- Income before provision for income taxes................. 44,732 40,173 33,787 27,754 19,889 Provision for income taxes................. 15,326 13,452 11,656 9,717 6,387 ----------- ----------- ----------- ----------- ----------- Income before cumulative effect of change in accounting principle............. 29,406 26,721 22,131 18,037 13,502 Cumulative effect of change in accounting principle............. -- -- -- -- (575) ----------- ----------- ----------- ----------- ----------- Net income............. $ 29,406 $ 26,721 $ 22,131 $ 18,037 $ 12,927 =========== =========== =========== =========== =========== Total assets at year- end.................... $ 1,977,150 $ 1,988,746 $ 1,794,704 $ 1,461,419 $ 1,466,292 Long-term debt at year- end.................... 2,239 2,540 2,484 1,528 4,377 Common shares outstanding at year- end.................... 14,421,585 15,345,265 14,972,359 13,581,631 14,169,201 Balance sheets--average daily balances: Total assets........... $ 1,934,333 $ 1,841,944 $ 1,687,803 $ 1,436,462 $ 1,379,830 Loans, net of allowance............. 1,363,394 1,307,725 1,202,591 1,001,356 987,477 Investment securities and interest-bearing cash equivalents...... 417,767 385,111 348,028 328,296 278,964 Total deposits......... 1,695,953 1,627,834 1,486,500 1,268,338 1,200,778 Long-term debt......... 4,210 2,514 1,662 1,406 1,360 Total stockholders' equity................ 167,568 162,823 138,641 115,442 105,732 Per common share: Basic Earnings......... $ 1.99 $ 1.75 $ 1.50 $ 1.28 $ 0.93 Diluted Earnings....... 1.94 1.72 1.47 1.26 0.91 Cash dividends declared.............. 1.29 0.57 0.32 0.22 0.10 Book value............. 11.25 11.37 10.28 8.34 7.97 Weighted average common shares outstanding..... 14,812,208 15,228,820 14,763,133 14,087,763 13,877,032 Weighted average common and common equivalent shares outstanding..... 15,166,557 15,543,741 15,105,914 14,341,166 14,143,183 Selected financial percentages: Return on average total assets.......... 1.52% 1.45% 1.31% 1.25% 0.84% Return on average stockholders' equity.. 17.55 16.41 15.96 15.62 12.23 Interest rate spread... 4.31 4.23 4.34 4.37 4.22 Net yield on earning assets................ 5.11 4.99 5.08 4.95 4.70 Net charge-offs as a percent of average loans................. 0.39 0.29 0.28 0.49 0.58 Nonperforming assets ratio (1)............. 0.56 0.99 1.19 1.03 1.87 Allowance for possible loan losses as a percent of year-end loans................. 1.89 2.07 2.20 2.09 2.14 Year-end leverage capital ratio......... 7.43 8.58 8.05 8.10 7.94 Risk-based capital ratios: Tier 1............... 9.86 11.71 11.16 11.40 10.91 Total................ 11.17 13.06 12.53 12.76 12.25 Average stockholders' equity to average assets................ 8.66 8.84 8.21 8.03 7.66 Common stock dividend payout ratio (2)...... 64.25 32.73 21.71 17.38 11.70 - -------- (1) 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 (2) Common stock cash dividends declared divided by net income; dividends declared during 1997 include a special cash dividend of $0.60 per share. 13 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995 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 March 17, 1995, the Company acquired all of the outstanding shares of BWM for a combination of cash and common stock of the Company. The transaction has been accounted for as a purchase and, accordingly, the consolidated statements of income for 1997, 1996 and 1995 include BWM's results of operations for the period from the acquisition date. On February 29, 1996, the Company acquired all of the outstanding shares of FBT in exchange for 2.0 million shares of Chittenden stock. The transaction has been accounted for as a pooling of interests and, accordingly, all historical financial information has been restated to reflect the acquired bank. 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 statement of income. Chittenden recorded net income of $29.4 million or basic earnings per share of $1.99 and diluted earnings per share of $1.94 for the year ended December 31, 1997. This compares to net income of $26.7 million and basic earnings per share of $1.75 and diluted earnings per share of $1.72 for 1996 and net income of $22.1 million, basic earnings per share of $1.50 and diluted earnings per share of $1.47 in 1995. For 1997, return on average equity was 17.55% and the return on average assets was 1.52%. These compare to returns on average equity of 16.41% and 15.96% and returns on average assets of 1.45% and 1.31% for 1966 and 1995, respectively. Total assets decreased slightly from $1.989 billion in 1996 to $1.977 billion in 1997. Loans receivable increased by $54.5 million, largely due to the continued emphasis on commercial and consumer lending. This increase was partially offset by a $71.1 million decrease in cash and cash equivalents which was attributable to higher than usual deposits left on hand by governmental agencies at December 31, 1996. Total deposits were $1.758 billion at December 31, 1997 compared with $1.762 billion at December 31, 1996. The increase in earnings during 1997 compared to 1996 was primarily attributable to a higher level of interest earning assets as well as an increase in the net yield from 4.99% to 5.11%. These combined factors resulted in an increase in net interest income of $6.7 million to $90.6 million for 1997. Noninterest income totaled $28.2 million for 1997 up from $24.9 million for 1996. Commissions from insurance sales, which commenced with the May 1997 acquisition of the Pomerleau Agency, were $1.4 million in 1997. Credit card and merchant servicing income increased $606,000 to $4.8 million in 1997. Service charges on deposit accounts increased $692,000 to $7.0 million and trust income increased $509,000 to $5.4 million in 1997. Mortgage servicing income declined slightly in 1997 as a result of increased amortization expense related to originated mortgage-servicing rights. Gains on sales of mortgages decreased to $2.4 million in 1997, compared to $2.7 million in 1996 due to decreased market activity. Noninterest expense totaled $70.1 million in 1997, up 5.5 million from the 1996 level. Salaries increased $2.4 million from $25.8 million in 1996. Employee benefits increased by $1.8 million to $9.4 million in 1997. The increase in salaries and benefits during 1997 was primarily due to higher staffing levels and related recruitment expenses. FDIC insurance premiums totaled $231,000, up from $27,000 in 1996. Included in the 14 increases of the various noninterest expense categories (except FDIC Premium) during 1997 were administrative expenses for the insurance agency acquired during the second quarter of 1997, totaling $1.3 million. The $4.6 million increase in earnings from 1995 to 1996 was due to several factors. Net interest income increased $5.7 million to $84.0 million due to the higher level of average earning assets, which offset a decrease in the net yield from 5.08% to 4.99%. The provision for possible loan losses was $4.2 million, down $817,000 from the 1995 level reflecting continued strength in asset quality. Revenues from noninterest sources were $24.9 million, up $2.9 million, led by higher gains on sales of mortgage loans and by higher net credit card processing revenues. The increase in mortgage gains was attributable to the adoption of SFAS No. 122, effective January 1, 1996, which requires the capitalization of originated servicing rights related to loans sold on a servicing retained basis. An additional $1.3 million in gains representing the value of the mortgage servicing rights were recognized in 1996. Net credit card and merchant servicing income increased 16% to $4.2 million as a result of higher processing volumes in 1996 over 1995 levels. Total noninterest expense increased $3.0 million to $64.6 million for 1996, of which $1.6 million was due to the completion of the BWM acquisition late in the first quarter of 1995. Considering the effect of including BWM for the full year, noninterest expenses were up 2% for 1996 compared to the previous year. FINANCIAL CONDITION Loans Chittenden's gross loan portfolio increased by $54.5 million during 1997, to end the year at $1.399 billion. The overall proportions of commercial-related and consumer types of loans increased from the mix at the end of 1996. The Company continues to pursue its strategy of gradually shifting its loan mix through continued focus on commercial and non-real estate consumer lending while at the same time selling on the secondary market substantially all of its originated fixed-rate residential mortgage loans. Growth in non- residential consumer loans, including automobile leases, was $38.5 million or 19.0% from the previous year, while non-real estate commercial loan growth was $44.0 million or 13.7% from year-end 1996. The total real estate portfolio, including home equity credit lines, decreased $28.0 million or 3.4% from year- end 1996. The classification of the Company's loan portfolio is based on underlying collateral. At December 31, 1997, commercial loans secured by non-real estate business assets totaled $365.0 million or 26.1% of total loans, up from the $321.1 million posted at year-end 1996. Commercial real estate loans, representing 22.5% of the portfolio, stood at $314.5 million at year-end 1997, up slightly from $304.5 million at December 31, 1996. Construction loans amounted to $21.9 million at December 31, 1997, down slightly from $25.1 million the year before. Residential real estate loans stood at $456.4 million at year-end 1997, down from $491.2 million at December 31, 1996. Reflecting the shift in the Company's strategy, this category represented 32.6% of the portfolio at year- end 1997, compared to 36.5% at year-end 1996. In total, $219.3 million in residential mortgages were originated during 1997, compared to $264.2 million during 1996. Secondary market sales of mortgage loans totaled $182.4 million in 1997, compared to $201.4 million in 1996. The Company underwrites substantially all of its residential mortgages to secondary market standards. During 1997, 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. Included in the real estate portfolio are home equity credit lines, which totaled $80.4 million at December 31, 1997, compared to $84.3 million the previous year. The unused portion of these lines totaled $79.8 million at December 31, 1997, compared to $80.5 million at year-end 1996. The portfolio of residential mortgages serviced for investors totaled $1,024.4 million at December 31, 1997, compared to $1,006.9 million at year- end 1996. 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 15 Company originated $876.2 million and the balance consisted of purchased mortgage-servicing rights acquired prior to 1996. Consumer loans increased significantly in 1997, ending the year at $241.3 million, compared with $202.8 at year-end 1996. This increase resulted from the Company's continued development of the indirect auto lending and leasing market, which reflects the Company's emphasis on responding to the marketplace through dealer relationships within its existing deposit franchise area. The Company underwrites all of its indirect automotive loans, maintaining substantially the same credit standards as for car loans originated in its branch offices. The Company does not originate any subprime loans. Indirect installment lending through auto dealers was up $11.3 million from year-end 1996 to $106.0 million at the end of 1997. 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, 1997 were $72.6 million, up from $41.1 million a year earlier. The Company has residual insurance through outside insurance companies which substantially eliminates the risk associated with the residual values of its leased vehicle portfolio. Contrary to these trends, direct installment and credit card balances at December 31, 1997 stood at $40.4 million and $22.4 million, respectively, compared with $43.0 million and $24.0 million at the end of 1996. By emphasizing the indirect and leasing programs as well as limiting credit card lending to its existing retail and commercial base these trends should continue. Unused portions of credit card lines totaled $58.0 million at the end of 1997, down from $72.5 million one year earlier. The Company's lending activities are conducted in market areas focused in Vermont and western and central Massachusetts, with additional activity related to nearby trading areas in Quebec, New York, New Hampshire, Maine, and Connecticut. In addition to the 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, 1997: DECEMBER 31, ---------------------------------------------------------- 1997 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- (IN THOUSANDS) Commercial.............. $ 365,042 $ 321,068 $ 291,651 $ 188,568 $ 165,372 Real estate: Residential........... 375,967 406,850 388,705 372,344 362,292 Commercial............ 314,477 304,530 305,941 258,023 252,824 Construction.......... 21,900 25,084 25,796 18,813 20,994 Home equity............. 80,429 84,319 78,600 76,457 75,759 Consumer................ 168,761 161,699 147,540 143,250 125,423 Lease financing......... 72,562 41,117 12,420 -- -- ---------- ---------- ---------- ---------- ---------- Total gross loans....... 1,399,138 1,344,667 1,250,653 1,057,455 1,002,664 Allowance for possible loan losses............ (26,721) (28,096) (27,818) (22,163) (21,672) ---------- ---------- ---------- ---------- ---------- Net loans............... $1,372,417 $1,316,571 $1,222,853 $1,035,292 $ 980,992 ========== ========== ========== ========== ========== Mortgage loans held for sale................... $ 16,433 $ 9,870 $ 14,692 $ 2,870 $ 11,646 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. 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 16 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. 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, 1997: DECEMBER 31, ------------------------------------------ 1997 1996 1995 1994 1993 ------ ------- ------- ------- ------- (IN THOUSANDS) Loans on nonaccrual................ $6,481 $10,601 $ 9,939 $ 8,289 $13,992 Loans not included above which are troubled debt restructurings...... 767 638 2,502 515 1,030 Other real estate owned............ 747 2,251 2,652 2,141 3,816 ------ ------- ------- ------- ------- Total nonperforming assets......... $7,995 $13,490 $15,093 $10,945 $18,838 ====== ======= ======= ======= ======= Loans past due 90 days or more and still accruing.................... $2,838 $ 966 $ 1,054 $ 1,134 $ 1,576 Percentage of nonperforming assets to total loans and other real estate owned...................... 0.56% 0.99% 1.19% 1.03% 1.87% Nonperforming assets to total assets............................ 0.40 0.68 0.84 0.75 1.28 Allowance for possible loan losses to nonperforming loans............ 368.67 249.99 223.59 251.74 144.27 Nonaccrual loans consisted of approximately 200 loans, the largest of which amounted to $451,000 at year-end 1997 and were diversified across a range of industries, sectors, and geography. OREO totaled $747,000 at year-end 1997, compared with $2.3 million at the end of 1996. 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. 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 adversely classified loans, and general loss allocations are made against segments of the loan portfolio which have similar attributes. As previously mentioned, the mix of the Company's loan portfolio has changed during the past three years. This, and uncertainties concerning how changing interest rates and unclear, or contradictory economic indicators will affect the local and regional economy also were considered by management in determining the adequacy of the allowance for possible loan losses. 17 The following table summarizes the activity in the Company's allowance for possible loan losses for the five years ended December 31, 1997: DECEMBER 31, ---------------------------------------------------------- 1997 1996 1995 1994 1993 ---------- ---------- ---------- ---------- ---------- (IN THOUSANDS) Balance of allowance for possible loan losses at beginning of year...... $ 28,096 $ 27,818 $ 22,163 $ 21,672 $ 19,392 BWM allowance acquired.. -- -- 4,135 -- -- Provision charged to expense................ 4,050 4,183 5,000 5,500 8,135 ---------- ---------- ---------- ---------- ---------- Balance of allowance for possible loan losses after provision........ 32,146 32,001 31,298 27,172 27,527 ---------- ---------- ---------- ---------- ---------- Loans charged off: Commercial............ 3,903 1,770 1,353 1,085 2,606 Real estate: Residential......... 780 966 1,525 878 1,220 Commercial.......... 675 791 1,596 3,160 1,639 Construction........ 204 185 -- 4 63 Home equity........... 158 167 108 51 227 Consumer.............. 2,517 2,230 1,900 1,061 1,292 ---------- ---------- ---------- ---------- ---------- Total loans charged off................ 8,237 6,109 6,482 6,239 7,047 ---------- ---------- ---------- ---------- ---------- Recoveries of loans previously charged off: Commercial............ 859 822 1,161 555 241 Real estate: Residential......... 118 188 57 99 201 Commercial.......... 1,168 546 1,130 158 227 Construction........ 12 91 -- -- -- Home equity........... 49 8 -- 29 51 Consumer.............. 606 549 654 389 472 ---------- ---------- ---------- ---------- ---------- Total recoveries.... 2,812 2,204 3,002 1,230 1,192 ---------- ---------- ---------- ---------- ---------- Net loans charged off... 5,425 3,905 3,480 5,009 5,855 ---------- ---------- ---------- ---------- ---------- Balance of allowance for possible loan losses at year end............... $ 26,721 $ 28,096 $ 27,818 $ 22,163 $ 21,672 ========== ========== ========== ========== ========== Amount of loans outstanding at end of year................... $1,415,571 $1,354,537 $1,265,345 $1,060,325 $1,014,310 Average amount of loans outstanding............ 1,391,234 1,336,185 1,228,948 1,023,399 1,008,010 Ratio of net charge-offs during year to average loans outstanding...... 0.39% 0.29% 0.28% 0.49% 0.58% Allowance as a percent of loans outstanding at end of year............ 1.89 2.07 2.20 2.09 2.14 At December 31, 1997, the allowance for possible loan losses was $26.7 million, or 1.89% of total loans compared with $28.1 million, or 2.07% of loans one year ago. The coverage ratio, or allowance for possible loan losses to nonperforming loans, stood at 369% at year-end 1997, compared with 250% at the end of 1996. The provision for possible loan losses totaled $4.1 million in 1997, compared to $4.2 million in 1996, and $5.0 million in 1995. The lower provision during 1997 and 1996 was primarily attributable to the reduction in the level of nonperforming assets and the strength of the ratios in connection with the allowance for possible loan losses. Commercial charge-offs for 1997 include a $1.9 million charge related to CTC's commercial customer credit card processing business. The charge off related to a future services company, which had contracted with, 18 and accepted deposits, from customers, prior to discontinuing operations. This company was obligated to provide services to its customers upon the payment of a second amount. At the time this company discontinued operations, CTC chose to honor these obligations, leading to the charge-off of the resulting $1.9 million overdraft. The Company has assessed its merchant servicing customer base and has evaluated the processing volumes related to similar future services businesses. It has also taken steps to mitigate the risk of similar charge-offs in the future. The following table summarizes the allocation of the allowance for possible loan losses for the five years ended December 31, 1997: DECEMBER 31, ----------------------------------------------------------------------------------------------------- 1997 1996 1995 1994 ---------------------- ---------------------- ---------------------- ---------------------- AMOUNT LOAN AMOUNT LOAN AMOUNT LOAN AMOUNT LOAN AMOUNT ALLOCATED DISTRIBUTION ALLOCATED DISTRIBUTION ALLOCATED DISTRIBUTION ALLOCATED DISTRIBUTION ALLOCATED --------- ------------ --------- ------------ --------- ------------ --------- ------------ --------- (IN THOUSANDS) Commercial....... $ 5,075 26% $ 4,494 24% $ 3,901 23% $ 2,417 18% $ 2,468 Real estate: Residential..... 1,275 27 1,395 30 1,452 31 764 35 819 Commercial...... 6,143 23 5,960 23 6,024 25 5,692 24 6,259 Construction.... 455 1 500 2 439 2 770 2 510 Home equity...... 318 6 317 6 291 6 268 7 370 Consumer and leasing......... 4,093 17 3,149 15 1,754 13 1,916 14 2,146 Other............ 9,362 -- 12,281 -- 13,957 -- 10,336 -- 9,100 ------- --- ------- --- ------- --- ------- --- ------- $26,721 100% $28,096 100% $27,818 100% $22,163 100% $21,672 ======= === ======= === ======= === ======= === ======= 1993 ------------ LOAN DISTRIBUTION ------------ Commercial....... 16% Real estate: Residential..... 36 Commercial...... 25 Construction.... 2 Home equity...... 8 Consumer and leasing......... 13 Other............ -- ------------ 100% ============ 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, and generate interest income. At December 31, 1997, the Company held investments available for sale totaling $363.3 million. This compares with investments of $329.2 million available for sale and $35.6 million held for investment at December 31, 1996. During 1997, in order to improve the liquidity of the investment portfolio, investments previously classified as held to maturity with an amortized cost and market value of $6.8 million were sold. In addition, the remaining held for investment portfolio with an amortized cost of $21.9 million and unrealized loss of $385,000 was transferred to available for sale in accordance with Statement of Financial Accounting Standards No. 115. At December 31, 1997, unrealized gains (net of taxes) of $1,675,000 resulted from marking the available for sale portfolio to market value. This compares with unrealized losses (net of taxes) of $208,000 at December 31, 1996. These amounts are reflected as an increase and as a reduction, respectively, in stockholders' equity. 19 The following tables show the composition of the Company's investment portfolio, at December 31, 1997 and 1996: 1997 1996 -------- -------- Securities available for sale (at market value) (IN THOUSANDS) U.S. Treasury securities................................... $ 23,334 $109,471 U.S. government agency obligations......................... 138,203 76,707 Obligations of states and political subdivisions........... 314 -- Mortgage-backed securities................................. 91,438 51,604 Corporate bonds and notes.................................. 90,812 65,190 Government bond mutual funds............................... 9,050 10,103 Marketable equity securities............................... 10,007 16,138 Other debt securities...................................... 121 -- -------- -------- Total Securities available for sale...................... 363,279 329,213 -------- -------- 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............................ $363,279 $364,793 ======== ======== 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, 1997, with comparative totals for 1996. 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 sale (IN THOUSANDS) US Treasury securities. $10,574 6.74% $ 12,513 6.53% $ -- --% $ -- --% $ -- --% $ 23,087 6.63% US government agency obligations........... 9,963 5.60 122,109 6.43 3,000 7.82 1,800 7.25 -- -- 136,872 6.40 Obligations of states and political subdivisions.......... 16 9.96 17 9.96 170 9.61 111 9.14 -- -- 314 9.67 Mortgage-backed securities (1)........ 17,571 6.87 46,716 6.79 26,339 6.94 247 6.45 -- -- 90,873 6.84 Corporate bonds and notes................. 5,991 5.74 83,861 6.61 25 7.00 -- -- -- -- 89,877 6.55 Government bond mutual funds................. -- -- -- -- -- -- -- -- 9,526 6.91 9,526 6.91 Marketable equity securities............ 10,000 6.14 -- -- -- -- -- -- -- -- 10,000 6.41 Other debt securities.. -- -- 89 6.25 32 10.36 -- -- -- -- 121 7.34 ------- ---- -------- ---- ------- ----- ------ ---- ------- ---- -------- ---- Total available for sale................... 54,115 6.35 265,305 6.55 29,566 7.05 2,158 7.26 9,526 6.91 360,670 6.57 ------- ---- -------- ---- ------- ----- ------ ---- ------- ---- -------- ---- Comparative totals for 1996................... $85,640 6.08% $239,349 6.27% $22,350 6.98% $6,924 7.26% $10,840 5.44% $365,103 6.26% - -------- (1) Maturities of mortgage-backed securities are based on contractual payments and estimated mortgage loan prepayments. Deposits During 1997, total deposits averaged $1,696.0 million, up from $1,627.8 million in 1996. Noninterest-bearing demand deposits averaged $279.0 million, up from $251.3 million in 1996. Average savings deposits increased $53.8 million, to $886.5 million for 1997. This category includes non-contractual interest bearing deposit products, such as savings, money market, and N.O.W. accounts. During 1997, time accounts (retirement and certificates of deposit) totaling $530.4 million decreased 2% compared to $543.9 million in 1996. The Company has a number of institutional customers 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 on its investment opportunities. 20 The following table shows average daily balances of the Company's deposits for the periods indicated: YEARS ENDED DECEMBER 31, -------------------------------- 1997 1996 1995 ---------- ---------- ---------- (IN THOUSANDS) Demand deposits................................ $ 279,034 $ 251,276 $ 223,800 Savings deposits............................... 886,516 832,677 760,029 Other time..................................... 413,036 430,501 388,276 Certificates of deposit $100,000 and over...... 117,367 113,380 114,395 ---------- ---------- ---------- Total deposits............................... $1,695,953 $1,627,834 $1,486,500 ========== ========== ========== The Company's outstanding certificates of deposit and other time deposits in denominations of $100,000 and over had maturities as follows: DECEMBER 31, -------------- 1997 -------------- (IN THOUSANDS) Three months or less....................................... $ 82,886 Over three months to six months............................ 20,935 Over six months to twelve months........................... 24,957 Over twelve months......................................... 10,698 -------- $139,476 ======== BORROWINGS During 1997, short-term borrowings averaged $33.9 million, up from the $28.2 million posted in 1996. This funding consists of: Treasury, tax and loan deposits; securities sold under agreements to repurchase and Federal funds purchased. Treasury borrowings averaged $22.4 million for 1997 compared with $15.3 million during 1996. 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 $10.6 million for 1997, compared to $10.1 million posted during 1996. These borrowings have neither reserve requirements nor FDIC insurance costs. Short-term FHLB Borrowings averaged $194,000 for 1997 compared with $2.3 million for 1996. U.S. Treasury and agency securities, mortgage-backed securities and corporate notes are pledged as collateral for the Treasury borrowings and repurchase agreements. Federal funds purchased averaged $698,000 for 1997 compared with $382,000 for 1996. Long-term borrowings averaged $4.2 million in 1997 compared to $2.5 million in 1996. 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 $111.7 million at December 31, 1993 to $174.4 million at December 31, 1996. During 1997, the Company adopted measures to maintain a capital level consistent with the needs for its activities. The quarterly dividend rate was increased from $0.16 to $0.18 per share in the second quarter and an additional special $0.60 per share dividend was paid in the fourth quarter of 1997. Additionally, a share repurchase plan was implemented, in which up to 1,250,000 shares could be repurchased during 1997 and 1998. At December 31, 1997, capital stood at $162.3 million, a reduction of $12.1 million from $174.4 million at December 31, 1996. Repurchases of 1,043,000 shares of the Company's stock totaling $26.0 million and dividend payments totaling $18.9 million reduced the capital position during 1997. These reductions were partially offset by earnings of $29.4 million, $1.4 million of common stock issued in connection with benefit plans and a change in the net unrealized gain on securities available for sale of $1.9 million. The capital position increased during 1996 by $20.5 million. Earnings of $26.7 million and $3.5 million of common stock issued in connection with benefit plans added to capital during the year. Dividend payments totaling $8.7 million reduced the capital position, as did a change in the net unrealized gain on securities available for sale of $976,000. 21 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, 1997, the Company's leverage capital ratio (which is calculated pursuant to the FRB's regulations) was 7.43%, CTC's, BWM's, and FBT's leverage capital ratios (which are calculated pursuant to the FDIC's regulations) were 7.05%, 7.31% and 6.65%, respectively. The ratios in 1996 were 8.58% for the Company, 8.42% for CTC, 7.85% for BWM, and 6.85% for FBT. 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, 1997, the Company's risk- based capital ratio was 11.17% and its Tier 1 capital, consisting entirely of common stock, was 9.86% of risk-weighted assets. This compares with year-end 1996 ratios of 13.06% and 11.71%, 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, 1997, CTC's leverage capital ratio was 7.05%, its Tier 1 risk- based capital ratio was 9.30%, and its total risk-based capital ratio was 10.60%; BWM's ratios were 7.31 %, 8.79%, and 10.14%, respectively, while FBT's ratios were 6.65%, 9.70%, and 10.98%, 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. The following table presents capital components and ratios of the Company at December 31, 1997, 1996, and 1995: DECEMBER 31, ---------------------------------- 1997 1996 1995 ---------- ---------- ---------- (IN THOUSANDS) LEVERAGE Stockholders' equity........................ $ 146,434 $ 163,513 $ 141,453 Total average assets (1).................... 1,969,822 1,906,114 1,757,002 Leverage capital ratio...................... 7.43% 8.58% 8.05% RISK-BASED Capital components: Tier 1..................................... $ 146,434 $ 163,513 $ 141,453 Tier 2..................................... 18,570 17,449 15,873 ---------- ---------- ---------- Total..................................... $ 165,004 $ 180,962 $ 157,326 ========== ========== ========== Risk-weighted assets: On-balance sheet........................... $1,407,074 $1,331,203 $1,216,807 Off-balance sheet.......................... 92,441 75,308 62,347 ---------- ---------- ---------- $1,499,515 $1,406,511 $1,279,154 ========== ========== ========== Ratios: Tier 1..................................... 9.86% 11.71% 11.16% Total (including Tier 2)................... 11.17 13.06 12.53 - -------- (1) Total average assets for the most recent quarter. 22 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, 1997, the Company maintained cash balances and short-term investments of approximately $143.4 million, compared with $214.5 million at December 31, 1996. Cash on hand at December 31, 1996 was higher than usual due to a change in the timing of certain payments to municipalities by the State of Vermont. In addition, repurchases of the Company's stock totaling $26.0 million and dividend payments totaling $18.9 million reduced the Company's cash position during the year. During 1997, the Company continued to be an average daily net seller of Federal Funds. 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 quantifies its interest-rate risk exposure using sophisticated simulation and valuation models, as well as simpler gap analyses. 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 involves projecting future interest income and expense from the Company's assets and liabilities under various scenarios. The Company's limits on interest-rate risk specify that if interest rates were to shift immediately up or down 200 basis points, estimated net interest income for the next 12 months should decline by less than 10%. The following table reflects the Company's estimated exposure, as a percentage of estimated net interest income for the next 12 months, assuming an immediate shift in interest rates: RATE CHANGE ESTIMATED EXPOSURE AS A (BASIS POINTS) % OF NET INTEREST INCOME -------------- ------------------------ +200 4.33% -200 (4.77) 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 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, 1997, the estimated exposure was 2.7% asset-sensitive. 23 The following table shows the amounts of interest-earning assets and interest-bearing liabilities at December 31, 1997 that reprice during the periods indicated: REPRICING DATE -------------------------------------------------- OVER ONE DAY OVER SIX ONE YEAR OVER TO SIX MONTHS TO TO FIVE FIVE MONTHS ONE YEAR YEARS YEARS TOTAL -------- --------- -------- --------- ---------- (IN THOUSANDS) Interest-earning assets: Loans....................... $823,893 $178,474 $352,743 $ 60,461 $1,415,571 Investment securities (1)... 35,772 27,775 273,661 31,662 368,870 Interest-bearing cash equivalents................ 60,801 -- -- -- 60,801 -------- -------- -------- --------- ---------- Total interest-earning assets.................... 920,466 206,249 626,404 92,123 1,845,242 -------- -------- -------- --------- ---------- Interest-bearing liabilities: Deposits.................... 897,557 152,939 141,300 263,194 1,454,990 Borrowings.................. 22,250 1,000 2,239 -- 25,489 -------- -------- -------- --------- ---------- Total interest-bearing liabilities............... 919,807 153,939 143,539 263,194 1,480,479 -------- -------- -------- --------- ---------- Net interest rate sensitivity gap............ $ 659 $ 52,310 $482,865 $(171,071) $ 364,763 ======== ======== ======== ========= ========== Cumulative gap at December 31, 1997................... $ 659 $ 52,969 $535,834 $ 364,763 Cumulative gap at December 31, 1996................... $(12,922) $ 31,228 $382,924 $ 321,201 - -------- (1) Amounts are based on amortized cost balances. The following table shows scheduled maturities of selected loans at December 31, 1997: LESS THAN ONE YEAR TO OVER FIVE ONE YEAR FIVE YEARS YEARS TOTAL --------- ----------- --------- -------- (IN THOUSANDS) Predetermined rates: Commercial........................... $ 13,751 $ 69,827 $ 26,570 $110,148 Commercial real estate and construction........................ 7,351 67,605 40,969 115,925 -------- -------- -------- -------- 21,102 137,432 67,539 226,073 ======== ======== ======== ======== Floating or adjustable rates: Commercial........................... 95,286 98,835 60,773 254,894 Commercial real estate and construction........................ 24,281 99,856 96,315 220,452 -------- -------- -------- -------- 119,567 198,691 157,088 475,346 ======== ======== ======== ======== RESULTS OF OPERATIONS Comparison of Years Ended December 31, 1997 and 1996 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 the change in interest rates and the volumes of interest earning assets and interest bearing liabilities. For 1997, net interest income was $90.6 million, up $6.7 million from the 1996 level. On a fully taxable equivalent basis, net interest income increased $6.6 million from 1996, to $92.4 million in 1997. These improvements resulted from higher levels of interest earning assets and an increase in the net yield on interest bearing liabilities. Average interest-earning assets totaled $1,809.0 million for 1997, up $87.7 million from the 1996 level. The taxable equivalent net yield on earning assets was 5.11% in 1997, an increase of 12 basis points from 4.99% in 1996. 24 The following table presents an analysis of average rates and yields on a fully taxable equivalent basis for the years indicated: 1997 1996 1995 --------------------------------- -------------------------------- -------------------------------- INTEREST AVERAGE INTEREST AVERAGE INTEREST AVERAGE AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ BALANCE EXPENSE (1) RATE (1) BALANCE EXPENSE (1) RATE (1) BALANCE EXPENSE (1) RATE (1) ---------- ------------ -------- ---------- ----------- -------- ---------- ----------- -------- (IN THOUSANDS) ASSETS Interest-earning assets: Loans................. $1,386,772 $125,076 9.02% $1,331,199 $120,362 9.04% $1,222,790 $114,358 9.35% Industrial revenue bonds (2)............ 4,462 522 11.70 4,986 571 11.45 6,158 718 11.66 Investments: Taxable............... 360,284 22,992 6.38 327,099 20,232 6.19 292,495 18,313 6.26 Tax-favored debt securities........... 379 39 10.29 1,112 111 9.98 1,596 157 9.84 Tax-favored equity securities........... 21,475 1,417 6.60 28,488 1,684 5.91 19,927 1,289 6.47 Interest-bearing deposits in banks.... 100 3 3.25 100 3 3.00 100 3 3.00 Federal funds sold.... 35,529 1,936 5.45 28,312 1,524 5.38 33,910 1,988 5.86 ---------- -------- ---------- -------- ---------- -------- Total interest-earning assets............... 1,809,001 151,985 8.40 1,721,296 144,487 8.39 1,576,976 136,826 8.68 -------- -------- -------- Noninterest-earning assets............... 153,172 149,108 137,184 Allowance for possible loan losses.......... (27,840) (28,460) (26,357) ---------- ---------- ---------- Total assets.......... $1,934,333 $1,841,944 $1,687,803 ========== ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: Savings and interest- bearing transactional accounts............. $ 886,516 $ 29,637 3.34 $ 832,677 $ 27,268 3.27 $ 760,029 $ 26,211 3.45 Certificates of deposit $100,000 and over................. 117,367 6,267 5.34 113,380 6,259 5.52 114,395 7,144 6.25 Other time deposits... 413,036 21,193 5.13 430,501 22,988 5.34 388,276 20,416 5.26 ---------- -------- ---------- -------- ---------- -------- Total interest-bearing deposits............. 1,416,919 57,097 4.03 1,376,558 56,515 4.11 1,262,700 53,771 4.26 Short-term borrowings. 33,930 2,225 6.56 28,165 1,887 6.70 42,628 2,858 6.70 Long-term debt........ 4,210 223 5.30 2,514 197 7.84 1,662 143 8.60 ---------- -------- ---------- -------- ---------- -------- Total interest-bearing liabilities.......... 1,455,059 59,545 4.09 1,407,237 58,599 4.16 1,306,990 56,772 4.34 -------- -------- -------- Noninterest-bearing liabilities: Demand deposits....... 279,034 251,276 223,800 Other liabilities..... 32,672 20,608 18,372 ---------- ---------- ---------- Total liabilities..... 1,766,765 1,679,121 1,549,162 Stockholders' equity.. 167,568 162,823 138,641 ---------- ---------- ---------- Total liabilities and stockholders' equity. $1,934,333 $1,841,944 $1,687,803 ========== ========== ========== Net interest income... $ 92,440 85,888 $ 80,054 ======== ======== ======== Interest rate spread 4.31% 4.23% 4.34% (3).................. Net yield on earning assets (4)........... 5.11 4.99 5.08 - -------- (1) On a fully taxable equivalent basis. Calculated using a Federal income tax rate of 35%. Loan income includes fees. (2) Industrial revenue bonds are included in loans in the financial statements. (3) Interest rate spread is the average rate earned on total interest-earning assets less the average rate paid on interest-bearing liabilities. (4) Net yield on earning assets is net interest income divided by total interest-earning assets. 25 The following table attributes changes in the Company's net interest income (on a fully taxable equivalent basis) to changes in either average daily 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. 1997 COMPARED WITH 1996 1996 COMPARED WITH 1995 ----------------------------------- ---------------------------------- INCREASE (DECREASE) INCREASE (DECREASE) DUE TO CHANGE IN: TOTAL DUE TO CHANGE IN: TOTAL ---------------------- ----------- --------------------- ---------- AVERAGE AVERAGE INCREASE AVERAGE AVERAGE INCREASE RATE ^BALANCE (DECREASE) RATE BALANCE (DECREASE) --------- ---------- ----------- ---------- --------- ---------- (IN THOUSANDS) Interest income: Loans, including fees.. $ (298) $ 5,012 $4,714 $ (3,798) $ 9,802 $6,004 Industrial revenue bonds................. 12 (61) (49) (13) (134) (147) Investments: Taxable............... 642 2,118 2,760 (221) 2,140 1,919 Tax-favored debt securities........... 3 (75) (72) 2 (48) (46) Tax-favored equity securities........... 196 (463) (267) (111) 506 395 Federal funds sold..... 19 393 412 (163) (301) (464) --------- --------- ------ ---------- --------- ------ Total interest income. 574 6,924 7,498 (4,304) 11,965 7,661 --------- --------- ------ ---------- --------- ------ Interest expense: Savings and interest- bearing transactional accounts.............. 569 1,800 2,369 (1,366) 2,423 1,057 Certificates of deposit $100,000 and over..... (205) 213 8 (822) (63) (885) Other time deposits.... (899) (896) (1,795) 322 2,250 2,572 --------- --------- ------ ---------- --------- ------ Total deposits........ (535) 1,117 582 (1,866) 4,610 2,744 Short-term borrowings.. (40) 378 338 (2) (969) (971) Long-term debt......... (64) 90 26 (14) 68 54 --------- --------- ------ ---------- --------- ------ Total interest expense.............. (639) 1,585 946 (1,882) 3,709 1,827 --------- --------- ------ ---------- --------- ------ Change in net interest income................. $ 1,264 $ 5,288 $6,552 $ (2,391) $ 8,225 5,834 ========= ========= ====== ========== ========= ====== PROVISION FOR POSSIBLE LOAN LOSSES The Company provides for possible loan losses using the allowance method. 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. The allowance is the amount management believes is necessary to absorb possible loan losses based on evaluations of collectibility and prior loan loss experience, changes in the nature and volume of the loan portfolio, overall portfolio quality, specific problem loans, and current and anticipated economic conditions that may affect the borrowers' ability to pay. 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. The provision for possible loan losses totaled $4.1 million in 1997 compared to $4.2 million in 1996. (See "Allowance for Possible Loan Losses) 26 NONINTEREST INCOME AND NONINTEREST EXPENSE Noninterest income was $28.2 million in 1997, up $3.3 million from the $24.9 million reported in 1996. Trust income was up $509,000 from the 1996 level, to $5.4 million. The effects of an increase in the number of trust clients served and higher levels of administered assets were enhanced by the impact of the advances in the stock and bond markets during the year. Service charges on deposit accounts increased in 1997, rising to $7.0 million from $6.3 million in the previous year. This was partially attributable to CTC's new deposit fee schedule, which was implemented during the second quarter of 1997. Net income related to credit card activities includes fees and costs related to the issuance of credit cards and revenue generated (net of processing costs) when credit card transactions are processed through the Company's commercial customers. The Company has emphasized development of this business in recent years which has expanded to include local and national customers involved in retail, service, and mail order businesses. These activities generated net income of $4.8 million in 1997, up from $4.2 million in the prior year. This increase resulted primarily from an increase in the number of commercial customers serviced, and consequently, significantly higher levels of credit card processing volume; $1.137 billion was processed in 1997, compared with $800 million in 1996. Net insurance commissions generated by the insurance agency acquired in May 1997 totaled $1.4 million. In addition, the Company posted a total of $4.9 million in other noninterest income compared to $4.4 million in 1996. This category represents over thirty categories of fee income. Noninterest expense totaled $70.1 million in 1997, up $5.5 million from the 1996 level. Salaries increased $2.4 million from $25.8 million in 1996. Employee benefits increased by $1.8 million to $9.4 million in 1997. The increases in salaries and benefits during 1997 were primarily attributable to an increase of approximately $1.6 million resulting from higher staffing levels and related recruitment expenses and a $808,000 increase in accruals for incentive compensation plans due to stronger profits. FDIC insurance premiums totaled $231,000, up from $27,000 in 1996. The Banks paid minimal insurance assessments in 1996 as compared to 1997, when assessment rates were increased to 1.3 cents per $100 of deposits. In 1997 expenses associated with OREO were more than offset by recoveries on OREO properties sold, so that a net credit of $136,000 was posted. Net OREO expenses were $153,000 for 1996. Total other noninterest expense for 1997 totaled $22.9 million, up from $21.9 million in 1996. The components of other noninterest expense for the years presented are as follows: 1997 1996 ------- ------- (IN THOUSANDS) Data processing.......................................... $ 5,424 $ 5,023 Amortization of intangible assets........................ 1,310 1,223 Legal and professional................................... 1,443 1,453 Marketing................................................ 2,164 2,154 Other.................................................... 12,579 12,023 ------- ------- $22,920 $21,876 ======= ======= 27 Included in the increases of the various noninterest expense categories (except FDIC Premium) during 1997 were administrative expenses for The Pomerleau Insurance Agency acquired during the second quarter of 1997. Excluding the effects of Pomerleau total noninterest expenses increased 8.1% over 1996. 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. On August 1, 1997, the franchise tax rate increased from $0.04 to $.096 per $1,000 of deposits. This increased franchise tax expense from approximately $47,000 per month prior to August 1, 1997 to approximately $113,000 per month thereafter. For the year ended December 31, 1997, total franchise taxes of $898,000 were approximately $335,000 higher than in 1996. Franchise taxes are included in income tax expense in the consolidated statements of income. For 1997, the Federal and state income tax provisions amounted to $15.3 million. This compares with an income tax provision of $13.5 million for 1996. The effective tax rates for 1997 and 1996 were 34.3% and 33.5%, respectively. During 1997 and 1996, the Company's statutory Federal corporate tax rate was 35%. The Company's effective tax rates differed from the statutory rates primarily because of 1) the proportion of interest income from state and municipal securities and corporate dividend income which are partially exempt from Federal taxation and 2) tax credits on investments in qualified low income housing projects. 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. The Company has commenced an assessment of the majority of its systems and is in the process of developing a specific workplan to address this issue. The Company currently believes it will be able to modify or replace its affected systems in time to minimize any detrimental effect on operations. While it is not possible, at present, to give an accurate estimate of the cost of this work, these costs may be material to the Company's results of operations in one or more fiscal quarters or years, but are not expected to have material adverse impact on the long-term results of operations, liquidity, or consolidated financial position of the Company. RESULTS OF OPERATIONS Comparison of Years Ended December 31, 1996 and 1995 NET INTEREST INCOME For 1996, net interest income was $84.0 million, up $5.7 million from the 1995 level. On a fully taxable equivalent basis, net interest income increased $5.8 million from 1995, to $85.9 million in 1996. These improvements resulted from higher levels of interest-earning assets that outpaced a decrease in the net yield on earning assets. Average interest-earning assets totaled $1,721.3 million for 1996, up $144.3 million from the 1995 level. The taxable equivalent net yield on earning assets was 4.99% in 1996, down nine basis points from 5.08% in 1995. Because the reduction in the average yield on earning assets was greater than the reduction in the cost of interest-bearing liabilities, the net yield on earning assets declined from the year before, although growth in net earning assets produced a higher net interest income on a tax equivalent basis than a year ago. PROVISION FOR POSSIBLE LOAN LOSSES The provision for possible loan losses totaled $4.2 million in 1996 and $5.0 million in 1995. The provision was reduced due to, among other things, the reduction in the level of net losses experienced in the loan portfolio and the strength of the ratios in connection with the allowance for possible loan losses. 28 NONINTEREST INCOME AND NONINTEREST EXPENSE Noninterest income was $24.9 million in 1996, up $2.9 million from the $22.0 million reported in 1995. Trust income was up $420,000 from the 1995 level, to $4.9 million. The effects of an increase in the number of trust clients served and higher levels of administered assets were enhanced by the impact of the advances in the stock and bond markets during the year. Service charges on deposit accounts increased again in 1996, rising to $6.3 million from $5.9 million in the previous year. Mortgage banking activity was strong throughout 1996, as generally favorable interest rates impacted the business. Mortgage servicing income rose slightly to $2.5 million. The January 1, 1996 adoption of Financial Accounting Standards Board Statement No. 122, Accounting for Mortgage Servicing Rights, which requires the capitalization of mortgage servicing rights which relate to loans which have been originated and sold on a servicing retained basis, led to a $1.4 million increase in gain on sale of mortgages. Net income related to credit card activities includes fees and costs related to the issuance of credit cards and revenue generated (net of processing costs) when credit card transactions are processed through the Company's commercial customers. These activities generated net income of $4.2 million in 1996, up from $3.6 million in the prior year. This increase resulted primarily from an increase in the number of customers serviced, and consequently, significantly higher levels of credit card processing volume; $800 million was processed in 1996, compared with $477 million in 1995. The Company posted a total of $4.5 million in other noninterest income, up $320,000 from the 1995 level. This category represents over thirty categories of fee income. Noninterest expense totaled $64.6 million in 1996, up $3.0 million from the 1995 level. Salaries increased to $25.8 million from $23.7 million in 1995. Employee benefits declined by $610,000 to $7.6 million in 1996 due to reduced pension expense at CTC resulting from the conversion to a cash balance plan effective January 1, 1996. This $1.1 million savings was offset by higher performance-based incentive compensation expenses at FBT ($195,000) and by the inclusion of BWM for the entire year ($203,000). Occupancy expense was $9.1 million for 1996, up from $8.1 million in 1995. Additional depreciation at CTC, related to the branch automation project completed in the second half of 1995, accounted for approximately $400,000 of the increase while the inclusion of BWM for the entire year in 1996 accounted for approximately $300,000. FDIC insurance premiums totaled $27,000, down from $1.6 million in 1995. The Banks paid minimal insurance assessments in 1996 as compared to 1995, when assessment rates were ranged 23 cents to 4 cents per $100 of deposits. In 1996, expenses associated with OREO, net of recoveries on OREO properties sold, were $153,000. Net OREO recoveries of $243,000 were recorded in 1995. Total noninterest expense for 1996 totaled $21.9 million, up from $20.3 in 1995. This increase was spread across several areas; including data processing costs of $560,000, marketing of $357,000, professional fees of $199,000 and travel and training of $173,000, due to the expanded scope of the consolidated operations. INCOME TAXES For 1996, the Federal and state income tax provisions amounted to $13.4 million. This compares with an income tax provision of $11.7 million for 1995. The effective tax rates for 1996 and 1995 were 33.5% and 34.5%, respectively. During 1996 and 1995, the Company's statutory Federal corporate tax rate was 35%. The Company's effective tax rates differed from the statutory rates primarily because of 1) the proportion of interest income from state and municipal securities and corporate dividend income which are partially exempt from Federal taxation and 2) tax credits on investments in qualified low income housing projects. 29 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CHITTENDEN CORPORATION CONSOLIDATED BALANCE SHEETS DECEMBER 31, ---------------------- 1997 1996 ---------- ---------- (IN THOUSANDS) ASSETS Cash and cash equivalents.............................. $ 143,394 $ 214,459 Securities available for sale.......................... 363,279 329,213 Securities held for investment (market value $35,405,000 in 1996).................................. -- 35,580 Federal Home Loan Bank stock........................... 5,591 5,591 Mortgage loans held for sale........................... 16,433 9,870 Loans.................................................. 1,399,138 1,344,667 Less: Allowance for possible loan losses............... (26,721) (28,096) ---------- ---------- Net loans............................................ 1,372,417 1,316,571 Accrued interest receivable............................ 14,431 14,179 Other real estate owned................................ 747 2,251 Net deferred tax asset................................. 1,857 10,647 Other assets........................................... 17,736 15,797 Premises and equipment, net............................ 27,412 24,297 Intangible assets...................................... 13,853 10,291 ---------- ---------- Total assets......................................... $1,977,150 $1,988,746 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Deposits: Demand............................................... $ 302,555 $ 286,932 Savings.............................................. 924,846 951,989 Other time........................................... 409,055 418,363 Certificates of deposit $100,000 and over............ 121,089 104,295 ---------- ---------- Total deposits..................................... 1,757,545 1,761,579 Short-term borrowings.................................. 23,250 23,992 Accrued expenses and other liabilities................. 31,843 26,234 Long-term debt......................................... 2,239 2,540 ---------- ---------- Total liabilities.................................... 1,814,877 1,814,345 Commitments and contingencies Stockholders' Equity: Preferred stock--$100 par value authorized--200,000 shares issued and outstanding--none................................. -- -- Common stock--$1 par value authorized--30,000,000 shares issued-- 15,929,661 in 1997 and 15,848,281 in 1996............. 15,930 15,848 Surplus................................................ 72,611 71,537 Retained earnings...................................... 102,553 92,039 Treasury stock, at cost--1,508,076 shares in 1997 and 503,016 shares in 1996................................ (30,084) (4,770) Net unrealized gain (loss) on securities available for sale, net of taxes of $934,000 in 1997 and ($102,000) in 1996............... 1,675 (208) Unearned portion of employee restricted stock.......... (412) (45) ---------- ---------- Total stockholders' equity........................... 162,273 174,401 ---------- ---------- Total liabilities and stockholders' equity........... $1,977,150 $1,988,746 ========== ========== The accompanying notes are an integral part of these consolidated financial statements. 30 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, ------------------------------------------ 1997 1996 1995 ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) INTEREST INCOME: Interest on loans................ $124,201 $119,432 $113,675 Investment securities: Mortgage-backed securities..... 7,730 6,062 5,666 Taxable........................ 15,262 14,170 12,647 Tax-favored debt............... 28 81 99 Tax-favored equity............. 1,029 1,320 1,025 Short-term investments........... 1,939 1,527 1,991 ------------- ------------- ------------- Total interest income.......... 150,189 142,592 135,103 ------------- ------------- ------------- INTEREST EXPENSE: Deposits: Savings........................ 29,637 27,268 26,211 Time........................... 27,460 29,247 27,560 ------------- ------------- ------------- Total interest on deposits... 57,097 56,515 53,771 Short-term borrowings............ 2,225 1,887 2,858 Long-term debt................... 223 197 143 ------------- ------------- ------------- Total interest expense......... 59,545 58,599 56,772 ------------- ------------- ------------- Net interest income................ 90,644 83,993 78,331 Provision for possible loan losses. 4,050 4,183 5,000 ------------- ------------- ------------- Net interest income after provision for possible loan losses.......... 86,594 79,810 73,331 ------------- ------------- ------------- NONINTEREST INCOME: Trust income..................... 5,385 4,876 4,456 Service charges on deposit accounts........................ 6,952 6,260 5,860 Mortgage servicing income........ 2,314 2,454 2,427 Gains on sales of mortgage loans, net............................. 2,434 2,720 1,282 Credit card income, net.......... 4,818 4,212 3,634 Insurance commissions, net....... 1,372 -- -- Other............................ 4,935 4,398 4,381 ------------- ------------- ------------- Total noninterest income....... 28,210 24,920 22,040 ------------- ------------- ------------- NONINTEREST EXPENSE: Salaries......................... 28,180 25,802 23,701 Employee benefits................ 9,365 7,574 8,184 Net occupancy expense............ 9,512 9,125 8,096 FDIC deposit insurance........... 231 27 1,580 Other real estate owned, income and expense, net................ (136) 153 (243) Other............................ 22,920 21,876 20,266 ------------- ------------- ------------- Total noninterest expense...... 70,072 64,557 61,584 ------------- ------------- ------------- Income before income taxes......... 44,732 40,173 33,787 Provision for income taxes......... 15,326 13,452 11,656 ------------- ------------- ------------- Net income......................... $ 29,406 $ 26,721 $ 22,131 ============= ============= ============= Basic earnings per share........... $ 1.99 $ 1.75 $ 1.50 Diluted earning per share.......... 1.94 1.72 1.47 Dividends per share................ 1.29 0.57 0.32 The accompanying notes are an integral part of these consolidated financial statements. 31 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995 NET UNREALIZED GAIN (LOSS) UNEARNED ON SECURITIES PORTION OF TOTAL AVAILABLE EMPLOYEE STOCK- COMMON RETAINED TREASURY FOR SALE, RESTRICTED HOLDERS' STOCK SURPLUS EARNINGS STOCK NET OF TAXES STOCK EQUITY ------- ------- -------- -------- -------------- ---------- -------- (IN THOUSANDS) BALANCE AT DECEMBER 31, 1994................... $14,692 $58,522 $ 56,737 (9,586) $(6,941) $ (103) $113,321 Net income.............. -- -- 22,131 -- -- -- 22,131 Cash dividends declared ($0.32 per share)...... -- -- (4,803) -- -- -- (4,803) Shares issued in conjunction with acquisition of The Bank of Western Massachusetts.......... 588 8,174 -- 5,514 -- -- 14,276 Shares issued/forfeited under various stock plans, net............. 152 1,041 -- -- -- -- 1,193 Amortization of deferred compensation for restricted stock earned................. -- -- -- -- -- 35 35 Issuance of treasury stock.................. -- (18) -- 105 -- -- 87 Change in net unrealized gain on securities available for sale..... -- -- -- -- 7,709 -- 7,709 ------- ------- -------- -------- ------- ------- -------- BALANCE AT DECEMBER 31, 1995................... 15,432 67,719 74,065 (3,967) 768 (68) 153,949 Net income.............. -- -- 26,721 -- -- -- 26,721 Cash dividends declared ($0.57 per share)...... -- -- (8,747) -- -- -- (8,747) Shares issued/forfeited under various stock plans, net............. 416 3,835 -- (853) -- -- 3,398 Amortization of deferred compensation for restricted stock earned................. -- -- -- -- -- 23 23 Issuance of treasury stock.................. -- (17) -- 50 -- -- 33 Change in net unrealized gain/loss on securities available for sale..... -- -- -- -- (976) -- (976) ------- ------- -------- -------- ------- ------- -------- BALANCE AT DECEMBER 31, 1996................... 15,848 71,537 92,039 (4,770) (208) (45) 174,401 Net income.............. -- -- 29,406 -- -- -- 29,406 Cash dividends declared ($1.29 per share)...... -- -- (18,892) -- -- -- (18,892) Shares issued/forfeited under various stock plans, net............. 82 1,363 -- -- -- (444) 1,001 Amortization of deferred compensation for restricted stock earned................. -- -- -- -- -- 77 77 Purchase of treasury stock.................. -- -- -- (25,956) -- -- (25,956) Issuance of treasury stock.................. -- (262) -- 642 -- -- 380 Cash paid for fractional shares................. -- (27) -- -- -- -- (27) Change in net unrealized gain/loss on securities available for sale..... -- -- -- -- 1,883 -- 1,883 ------- ------- -------- -------- ------- ------- -------- BALANCE AT DECEMBER 31, 1997................... $15,930 $72,611 $102,553 $(30,084) $ 1,675 $(412) $162,273 ======= ======= ======== ======== ======= ======= ======== The accompanying notes are an integral part of these consolidated financial statements. 32 CHITTENDEN CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, ------------------------------- 1997 1996 1995 --------- --------- --------- (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net income................................... $ 29,406 $ 26,721 $ 22,131 Adjustments to reconcile net income to net cash provided by operating activities: Provision for possible loan losses......... 4,050 4,183 5,000 Depreciation and amortization.............. 3,581 3,551 2,840 Amortization of intangible assets.......... 1,311 1,223 1,031 Amortization of premiums, fees, and discounts, net............................ (1,119) (1,570) (622) Investment securities (gains) losses....... (53) 98 (205) Deferred (prepaid) income taxes............ 7,759 (133) (43) Loans originated and purchased for sale.... (186,773) (193,833) (159,895) Proceeds from sales of loans............... 182,393 201,375 150,771 Gains on sales of loans.................... (2,434) (2,720) (1,282) Increase in Federal Home Loan Bank stock... -- -- (374) Gains on sales of premises and equipment... -- -- (225) Changes in assets and liabilities, net of effect from purchase of acquired companies: Accrued interest receivable................ (252) (1,299) (108) Other assets............................... (3,775) (2,721) 1,474 Accrued expenses and other liabilities..... 5,957 896 (1,042) --------- --------- --------- Net cash provided by operating activities.............................. 40,051 35,771 19,451 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Net cash acquired (paid) in relation to acquisitions................................ 721 -- (3,455) Proceeds from sales of securities available for sale.................................... 199,497 9,291 9,473 Proceeds from maturing securities and principal payments on securities available for sale.................................... 208,729 256,506 160,505 Purchases of securities available for sale... (417,301) (329,832) (164,287) Proceeds from sales of securities held for investment.................................. 6,843 -- -- Proceeds from principal payments on securities held for investment.............. 6,960 4,352 6,054 Purchases of securities held for investment.. (199) (321) (5,464) Loans originated, net of principal repayments.................................. (60,611) (91,207) (38,007) Purchases of premises and equipment.......... (6,696) (2,901) (4,254) Proceeds from sales of premises and equipment................................... -- -- 488 --------- --------- --------- Net cash used in investing activities...... (62,057) (154,112) (38,947) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase (decrease) in deposits.......... (4,049) 173,653 115,637 Net decrease in short-term borrowings........ (742) (1,033) (24,884) Net increase (decrease) in long term borrowings.................................. (301) 56 54 Proceeds from issuance of treasury and common stock................................ 908 3,431 1,280 Dividends on common stock.................... (18,892) (8,747) (4,803) Repurchase of common stock................... (25,983) -- -- --------- --------- --------- Net cash provided by (used in) financing activities................................ (49,059) 167,360 87,284 --------- --------- --------- Net increase (decrease) in cash and cash equivalents.................................. (71,065) 49,019 67,788 Cash and cash equivalents at beginning of year......................................... 214,459 165,440 97,652 --------- --------- --------- Cash and cash equivalents at end of year...... $ 143,394 $ 214,459 $ 165,440 ========= ========= ========= Supplemental disclosure of cash flow information: Cash paid during the year for: Interest................................... $ 59,861 $ 58,201 $ 56,410 Income taxes............................... 8,882 9,950 11,668 Non-cash investing and financing activities: Securities transferred from held for investment to held for sale............... 21,920 -- -- Loans transferred to other real estate owned..................................... 1,810 2,444 5,152 Mortgage loans securitized................. -- -- 3,665 Issuance of treasury and restricted stock.. 502 3,216 1,280 Assets acquired and liabilities assumed through acquisitions: Fair value of assets acquired.............. 7,937 -- 229,971 Liabilities assumed........................ (3,182) -- (203,518) Debt issued................................ (3,700) -- -- Common stock issued........................ -- -- (14,276) Cash paid.................................. 1,055 -- 12,177 The accompanying notes are an integral part of these consolidated financial statements. 33 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 subsidiary The Pomerleau Agency (Pomerleau); The Bank of Western Massachusetts (BWM); Flagship Bank & Trust Company (FBT); and Chittenden Connecticut Corporation (CCC). (CTC, BWM, and FBT are collectively referred to as the "Banks.") All material intercompany accounts and transactions have been eliminated in consolidation. All information presented has been restated to include FBT, which was acquired on February 29, 1996 (see note 2). This transaction was accounted for as a pooling of interests. Nature of Operations CTC operates thirty-six branches throughout the state of Vermont, BWM operates five branches in the greater Springfield, Massachusetts area and FBT operates six 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 and Southbury, Connecticut. The Pomerleau Agency is an independent insurance agency with offices in Burlington, Vermont. 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. Securities Under Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115), 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. 34 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 under SFAS 114 (except troubled debt restructurings), as defined below, are nonaccruing. Interest on nonaccruing loans is recognized when 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. As of January 1, 1995, the Company adopted Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118 (hereafter collectively referred to as SFAS 114). 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. SFAS 114 requires that impaired loans be 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. This change in accounting policy, as prescribed by SFAS 114, did not result in a cumulative adjustment of the Company's reported financial condition and had no impact on the Company's income recognition policy for nonaccrual loans. Further, adoption of SFAS 114 did not affect the Company's provision for possible loan losses for the year ended December 31, 1995. Loan Origination and Commitment Fees Loan origination and commitment fees, and certain loan origination costs, are deferred and amortized over the contractual terms 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 $542,000 and $1,121,000 at December 31, 1997 and 1996, respectively. Purchased Mortgage Servicing Rights Purchased Mortgage Servicing Rights (PMSRs) are initially recorded at the lower of cost or the present value of the estimated future net servicing income. Such amounts are amortized in proportion to and over the period of the estimated net servicing income. The Company regularly evaluates the carrying value of PMSRs for individual servicing acquisitions, compared with the present value of estimated future net servicing income. Amortization is adjusted to reflect changes in prepayment experience. 35 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Originated Mortgage Servicing Rights As of January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 122, Accounting For Mortgage Servicing Rights ("SFAS 122"). SFAS 122 requires the recognition, as separate assets, rights to service mortgage loans for others, when the related loans are sold and the servicing rights are retained. The amount capitalized is based on an allocation of the total cost of the mortgage loans to the mortgage servicing rights and the loans (without the mortgage servicing rights) based on their relative fair values. SFAS 122 also requires capitalized mortgage servicing rights to be assessed for impairment based on the fair value of those rights. This change in accounting was adopted prospectively for mortgage loans sold on or after January 1, 1996. As of January 1, 1997, the Company adopted Statement of Financial Accounting Standards No. 125, Accounting For Transfers And Servicing Of Financial Assets And Extinguishment Of Liabilities ("SFAS 125"), which superseded SFAS 122, Accounting For Mortgage Servicing Rights. Under the financial-components approach set forth in SFAS 125, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. The Statement also provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. SFAS 125 did not have a significant impact on the Company's financial position or results of operations. 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. A valuation allowance for the estimated costs to sell is charged to expense. Subsequent changes in the fair value of OREO are reflected in the valuation allowance and charged or credited to expense. Such amounts and net operating income or expense related to OREO are included in noninterest expense in the accompanying consolidated statements of income. Intangible Assets Intangible assets include the excess of the purchase price over the fair value of net assets acquired (goodwill) in the acquisitions of BWM and Pomerleau, as well as a core deposit intangible (see Note 2). 36 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 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 In March 1997, the Financial Accounting Standards Board (the FASB) issued Statement of Financial Accounting Standards No. 128, Earnings Per Share ("SFAS 128"), which established new standards for calculating and presenting earnings per share. The Company has adopted this new standard for the current and prior periods in its financial statements as of December 31, 1997. The standard requires the reporting of basic earnings per share and diluted 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 mutual fund investments. Cash equivalents are accounted for at cost, which approximates fair value. Trust Trust administered assets of approximately $2.8 billion and $2.6 billion at December 31, 1997 and 1996, 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 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. 37 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 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. Reclassifications Certain amounts in the 1996 and 1995 financial statements have been reclassified to be consistent with current year presentation. NOTE 2 ACQUISITIONS The Bank of Western Massachusetts On March 17, 1995, the Company acquired all of the outstanding shares of the common stock of BWM. The Company issued 1,225,635 shares at a price of $11.65 per share; 638,429 of the shares issued were from treasury stock. The total cash outlay, including payments made with respect to outstanding stock options and warrants issued by BWM, was $12.2 million. This transaction has been accounted for as a purchase and, accordingly, the consolidated statement of income includes BWM's results of operations from the date of acquisition. The purchase price has been 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, including a core deposit intangible asset, has been recorded as goodwill. Following is supplemental information reflecting selected pro forma results for the Company as if this acquisition had been consummated Prior to January 1, 1995: 1995 ------------------------------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Total revenue............................. $103,037 Income before income taxes................ 33,379 Net income................................ 21,804 Basic earnings per share.................. 1.48 Diluted earnings per share................ 1.44 Total revenue includes net interest income and noninterest income. Flagship Bank and Trust Company On February 29, 1996, the Company acquired FBT for stock. Under the agreement, FBT shareholders received 1.5 shares of the Company's common stock for each share of FBT stock. Total shares outstanding of the Company's stock increased by 2.0 million shares as a result of the acquisition. Based on the closing price of Chittenden stock as of February 29, 1996, the market value of the shares exchanged totaled $35.2 million. The acquisition was accounted for as a pooling of interests. Accordingly, the financial statements for 1995 have been restated to include Flagship. 38 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Total revenue, income before income taxes, net income, and earnings per share data of the separate companies for the periods preceding the acquisition were: 1995 --------------------------------------------- CHITTENDEN FLAGSHIP CORPORATION BANK & TRUST COMBINED ------------- -------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Total Revenue........... $86,176 $14,195 $100,371 Income before income taxes.................. 31,178 2,609 33,787 Net Income.............. 20,885 1,246 22,131 Basic earnings per share.................. 1.66 0.61 1.50 Diluted earnings per share.................. 1.62 0.61 1.47 Total revenue includes net interest income and noninterest income. The Pomerleau Agency On May 31, 1997, CTC acquired certain assets and assumed certain liabilities of Pomerleau. This transaction has been 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 income. The purchase price has been 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. 39 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3 SECURITIES Investment securities at December 31, 1997 and 1996 are as follows: AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- -------- (IN THOUSANDS) 1997 SECURITIES AVAILABLE FOR SALE: U.S. Treasury securities............. $ 23,087 $ 247 $ -- $ 23,334 U.S. government agency obligations... 136,872 1,348 (17) 138,203 Obligations of states and political subdivisions........................ 314 -- -- 314 Mortgage-backed securities........... 90,873 987 (422) 91,438 Corporate bonds and notes............ 89,877 956 (21) 90,812 Government bond mutual funds......... 9,526 -- (476) 9,050 Marketable equity securities......... 10,000 7 -- 10,007 Other debt securities................ 121 -- -- 121 -------- ------ ------- -------- Total securities available for sale... $360,670 $3,545 $ (936) $363,279 ======== ====== ======= ======== 1996 SECURITIES AVAILABLE FOR SALE: U.S. Treasury securities............. $109,606 $ 440 $ (575) $109,471 U.S. government agency obligations... 76,179 695 (167) 76,707 Mortgage-backed securities........... 51,850 245 (491) 51,604 Corporate bonds and notes............ 65,248 133 (191) 65,190 Government bond mutual funds......... 10,605 -- (502) 10,103 Marketable equity securities......... 16,035 103 -- 16,138 -------- ------ ------- -------- Total securities available for sale... $329,523 $1,616 $(1,926) $329,213 ======== ====== ======= ======== SECURITIES HELD FOR INVESTMENT: U.S. government agency obligation.... $ 198 $ -- $ -- $ 198 Obligations of states and political subdivisions........................ 490 -- -- 490 Mortgage-backed securities........... 34,761 77 (252) 34,586 Corporate bonds and notes............ 25 -- -- 25 Other debt securities................ 106 -- -- 106 -------- ------ ------- -------- Total securities held for investment.. $ 35,580 $ 77 $ (252) $ 35,405 ======== ====== ======= ======== Proceeds from sales of debt securities amounted to $206,340,000, $9,291,000 and $9,473,000 in 1997, 1996, and 1995, respectively. Realized losses on sales of debt securities were $532,000, $98,000 and $73,000 in 1997, 1996, and 1995, respectively. Realized gains on sales of debt securities were $529,000 and $13,000 in 1997 and 1995, respectively. The Company sold marketable equity securities for gains of $114,000 in 1997 and $265,000 in 1995. During 1997, the Company sold government bond mutual funds at a loss of $58,000. 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 $101,932,000 and $179,642,000 at December 31, 1997 and 1996, respectively. The following table shows the maturity distribution of the amortized cost of the Company's investment securities at December 31, 1997, with a comparative total for 1996. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations: 40 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) AFTER AFTER ONE BUT FIVE BUT WITHIN WITHIN WITHIN AFTER ONE FIVE TEN TEN NO FIXED YEAR YEARS YEARS YEARS MATURITY TOTAL ------- -------- -------- ------ --------- -------- (IN THOUSANDS) INVESTMENT SECURITIES: U.S. Treasury securities.. $10,574 $ 12,513 $ -- $ -- $ -- $ 23,087 U.S. government agency obligations.............. 9,963 122,109 3,000 1,800 -- 136,872 Obligations of states and political subdivisions... 16 17 170 111 -- 314 Mortgage-backed securities (1)...................... 17,571 46,716 26,339 247 -- 90,873 Corporate bonds and notes. 5,991 83,861 25 -- -- 89,877 Government bond mutual funds.................... -- -- -- -- 9,526 9,526 Marketable equity securities............... 10,000 -- -- -- -- 10,000 Other debt securities..... -- 89 32 -- -- 121 ------- -------- ------- ------ ------- -------- Total investment securities................ $54,115 $265,305 $29,566 $2,158 $ 9,526 $360,670 ======= ======== ======= ====== ======= ======== Comparative totals for 1996...................... $85,640 $239,349 $22,350 $6,924 $10,840 $365,103 (1) Maturities of mortgage-backed securities are based on contractual payments and estimated mortgage loan prepayments. The following table shows the maturity distribution of the fair value of the Company's investment securities at December 31, 1997, with a comparative total for 1996. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations: AFTER AFTER ONE BUT FIVE BUT WITHIN WITHIN WITHIN AFTER ONE FIVE TEN TEN NO FIXED YEAR YEARS YEARS YEARS MATURITY TOTAL ------- -------- -------- ------ --------- -------- (IN THOUSANDS) INVESTMENT SECURITIES: U.S. Treasury securities............ $10,662 $ 12,672 $ -- $ $ -- $ 23,334 U.S. government agency obligations........... 9,954 123,363 3,085 1,801 -- 138,203 Obligations of states and political subdivisions.......... 16 17 170 111 -- 314 Mortgage-backed securities (1)........ 17,680 47,006 26,503 249 -- 91,438 Corporate bonds and notes................. 5,986 84,801 25 -- -- 90,812 Government bond mutual funds................. -- -- -- -- 9,050 9,050 Marketable equity securities............ 10,000 -- -- -- 7 10,007 Other debt securities.. -- 89 32 -- -- 121 ------- -------- ------- ------ ------- -------- Total investment securities............. $54,298 $267,948 $29,815 $2,161 $ 9,057 $363,279 ======= ======== ======= ====== ======= ======== === Comparative totals for 1996................... $85,580 $239,582 $22,139 $6,876 $10,441 $364,618 (1) Maturities of mortgage-backed securities are based on contractual repayments and estimated mortgage loan prepayments. 41 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 4 LOANS Major classifications of loans at December 31, 1997 and 1996 are as follows: 1997 1996 ---------- ---------- (IN THOUSANDS) Commercial.............................................. $ 365,042 $ 321,068 Real estate: Residential........................................... 375,967 406,850 Commercial............................................ 314,477 304,530 Construction.......................................... 21,900 25,084 ---------- ---------- Total real estate................................... 712,344 736,464 Home equity............................................. 80,429 84,319 Consumer................................................ 168,761 161,699 Lease financing......................................... 72,562 41,117 ---------- ---------- Total gross loans................................... 1,399,138 1,344,667 Allowance for possible loan losses...................... (26,721) (28,096) ---------- ---------- Net loans............................................... $1,372,417 $1,316,571 ========== ========== Mortgage loans held for sale............................ $ 16,433 $ 9,870 ========== ========== Lease financing receivable includes the estimated residual value of leased vehicles of approximately $46,295,000 and $24,207,000 at December 31, 1997 and 1996, respectively, and is net of unearned interest income of approximately $10,829,000 and $5,855,000 at those dates. CTC's lending activities are conducted primarily in Vermont, with additional activity relating to nearby trading areas in Quebec, New York, New Hampshire, Maine, and Connecticut. BWM's lending activities are conducted primarily in the greater Springfield, 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: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Balance at beginning of year......................... $28,096 $27,818 $22,163 Allowance of BWM at acquisition...................... -- -- 4,135 Provision for possible loan losses................... 4,050 4,183 5,000 Loan recoveries...................................... 2,812 2,204 3,002 Loans charged off.................................... (8,237) (6,109) (6,482) ------- ------- ------- Balance at end of year............................... $26,721 $28,096 $27,818 ======= ======= ======= The principal amount of loans on nonaccrual status was $6,481,000 and $10,601,000 at December 31, 1997 and 1996, respectively. Loans whose terms have been substantially modified in troubled debt restructurings amounted to $767,000 and $638,000 at December 31, 1997 and 1996, respectively. 42 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 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: 1997 1996 1995 ------ ------ ------ (IN THOUSANDS) Interest income in accordance with original loan terms..... $1,164 $1,668 $1,007 Interest income recognized................................. 353 721 513 ------ ------ ------ Reduction in interest income............................... $ 811 $ 947 $ 494 ====== ====== ====== At December 31, 1997, the Banks were not committed to lend any additional funds to borrowers with loans whose terms have been restructured. At December 31, 1997, the recorded investment in loans that are considered to be impaired under SFAS 114 was $2,977,000 (all such loans, except troubled debt restructurings, were on a nonaccrual basis). Included in this amount is $2,647,000 of impaired loans for which the related allowance for possible loan losses is $960,000 and $330,000 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, 1997 was approximately $3,704,000. For the year ended December 31, 1997, interest income on impaired loans totaled $54,000, of which $13,000 was recognized on a cash basis. Residential mortgage loans serviced for others, which are not reflected in the consolidated balance sheets, totaled approximately $1,024.4 million and $1,006.9 million at December 31, 1997 and 1996, respectively. No recourse provisions exist in connection with such servicing. The following table is a summary of activity for mortgage servicing rights purchased and originated for the years ended December 31, 1997 and 1996 (in thousands): PURCHASED ORIGINATED TOTAL --------- ---------- ------ (IN THOUSANDS) Balance at December 31, 1995....................... $2,126 $ -- $2,126 Additions........................................ 35 1,334 1,369 Amortization..................................... (325) (145) (470) ------ ------ ------ Balance at December 31, 1996....................... $1,836 $1,189 $3,025 Additions........................................ -- 1,250 1,250 Amortization..................................... (286) (422) (708) ------ ------ ------ Balance at December 31, 1997....................... $1,550 $2,017 $3,567 ====== ====== ====== 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, 1997 and 1996, no allowance for impairment in the Company's mortgage servicing rights was necessary. 43 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5 PREMISES AND EQUIPMENT Premises and equipment at December 31, 1997 and 1996 are summarized as follows: ESTIMATED ORIGINAL 1997 1996 USEFUL LIVES -------- -------- ------------------ (IN THOUSANDS) Land.................................... $ 3,158 $ 3,162 -- Buildings and improvements.............. 10,906 9,430 25-50 years Leasehold improvements.................. 15,050 12,962 2-50 years Furniture and equipment................. 23,848 20,802 3-15 years Construction in progress................ 883 593 -- -------- -------- 53,845 46,949 Accumulated depreciation and amortization........................... (26,433) (22,652) -------- -------- $ 27,412 $ 24,297 ======== ======== The Company is obligated under various noncancelable operating leases for premises and equipment expiring in various years through the year 2008. Total lease expense, less income from subleases, amounted to approximately $2,225,000, $2,031,000 and $1,849,000 in 1997, 1996, and 1995, respectively. 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, 1997 are as follows: YEAR CAPITAL LEASES OPERATING LEASES - ---- -------------- ---------------- (IN THOUSANDS) 1998............................................ $ 87 $ 2,013 1999............................................ 1,754 1,930 2000............................................ -- 1,776 2001............................................ -- 1,435 2002............................................ -- 1,154 Thereafter...................................... -- 4,986 ------ ------- Total minimum lease payments.................... 1,841 $13,294 ====== ======= Amounts representing interest................... 208 ------ Present value of net minimum lease payments..... $1,633 ====== NOTE 6 BORROWINGS Short-term borrowings at December 31, 1997 and 1996 consist of the following: 1997 1996 ------- ------- (IN THOUSANDS) Securities sold under agreements to repurchase: Due through January 6, 1997, weighted average rate of 9.20%.. $ -- $10,000 Due through January 5, 1998, weighted average rate of 9.20%.. 10,000 -- U.S. Treasury borrowings, 5.27% in 1997 and 5.18% in 1996, due on demand..................................................... 12,044 13,894 FHLB Term Advances, 5.81% due on October 18, 1998.............. 1,000 -- FHLB Affordable Housing Program Advance, no fixed maturity, 4.43% in 1997 and 5.79% in 1996............................... 206 98 ======= ======= $23,250 $23,992 ======= ======= 44 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Short-term borrowings are collateralized by U.S. Treasury and agency securities, mortgage-backed securities, and residential mortgage loans. These assets had a carrying value and a fair value of $27,474,000 and $27,848,000, respectively, at December 31, 1997, and $28,019,000 and $28,006,000, respectively, at December 31, 1996. The following information relates to securities sold under agreements to repurchase: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Average balance outstanding during the year.......... $10,596 $10,097 $11,304 Average interest rate during the year................ 8.99% 9.18% 8.83% Maximum amount outstanding at any month-end.......... $10,000 $10,000 $20,000 The following information relates to U.S. Treasury borrowings: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Average balance outstanding during the year.......... $22,442 $15,282 $19,556 Average interest rate during the year................ 5.28% 5.16% 5.73% Maximum amount outstanding at any month-end.......... $62,381 $62,858 $70,669 The following information relates to short-term FHLB borrowings: 1997 1996 1995 ------ ------ ------- (IN THOUSANDS) Average balance outstanding during the year............ $ 194 $2,307 $ 7,162 Average interest rate during the year.................. 4.60% 5.77% 5.96% Maximum amount outstanding at any month-end............ $1,348 $3,000 $12,725 The following information relates to long-term debt: 1997 1996 ------- ------- (IN THOUSANDS) FHLB Term Advance, 5.81%, due on October 19, 1998.............. $ -- $ 1,000 Note Payable, 5.90%, due on June 1, 1999....................... 642 -- Capitalized lease obligation................................... 1,597 1,540 ------- ------- $ 2,239 $ 2,540 ======= ======= The advance from the Federal Home Loan Bank of Boston is collateralized by the Company's holdings of Federal Home Loan Bank of Boston stock and residential real estate loans equal to at least 200% of the advance. 45 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7 INCOME TAXES The provision for income taxes consists of the following: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Current payable Federal............................................ $ 6,001 $12,414 $10,713 State.............................................. 1,566 1,171 986 ------- ------- ------- 7,567 13,585 11,699 Deferred (prepaid) Federal............................................ 7,920 (147) (45) State.............................................. (161) 14 2 ------- ------- ------- 7,759 (133) (43) ------- ------- ------- Provision for income taxes........................... $15,326 $13,452 $11,656 ======= ======= ======= Current income taxes receivable, included in other assets, were $2,445,000 and $993,000, at December 31, 1997 and 1996, respectively. Current income taxes payable, included in accrued expenses and other liabilities, was $219,000 at December 31, 1997. 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 $898,000, $562,000, and $530,000 in 1997, 1996, and 1995, respectively. These amounts are included in provision for income taxes in the accompanying consolidated statements of income. The following is a reconciliation of the provision for Federal income taxes, calculated at the statutory rate, to the recorded provision for income taxes: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Computed tax at statutory Federal rate............... $15,656 $14,061 $11,826 Increase (decrease) in taxes from: Amortization of intangible assets (1).............. 166 166 142 Tax-exempt interest, net........................... (908) (992) (1,109) Dividends received deduction....................... (187) (238) (214) State taxes, net of Federal Tax benefit............ 1,018 770 449 Other, net......................................... (419) (315) 562 ------- ------- ------- Total.............................................. $15,326 $13,452 $11,656 ======= ======= ======= Effective income tax rate............................ 34.3% 33.5% 34.5% - -------- (1) The goodwill expense related to the acquisition of Pomerleau is tax deductible and therefore not included in this reconciliation. 46 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The components of the net deferred tax asset at December 31, 1997 and 1996 are as follows: 1997 1996 ------- ------- (IN THOUSANDS) Allowance for possible loan losses............................ $ 9,077 $ 9,209 Deferred compensation and pension............................. 1,409 2,332 Other real estate owned writedowns............................ 26 94 Depreciation.................................................. (287) (535) Accrued liabilities........................................... 1,920 294 Unrealized (gain) loss on securities available for sale....... (934) 102 Basis differences, purchase accounting........................ 356 387 Core deposit intangible....................................... (1,364) (1,614) Leasing program............................................... (7,336) -- Mortgage servicing............................................ (706) 38 Other......................................................... (304) 340 ------- ------- $ 1,857 $10,647 ======= ======= NOTE 8 STOCKHOLDERS' EQUITY Treasury Stock On January 16, 1997, the Company's Board of Directors authorized the repurchase of up to 1.25 million shares of the Company's common stock in negotiated transactions or open market purchases. The authorized repurchases may be made over a period of up to two years and will be used to fund obligations for employee and director stock ownership plans. During 1997, the Company repurchased 1,043,000 shares of its common stock at a total cost of $26.0 million. 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 $18,892,000, $8,747,000, and $4,803,000 during 1997, 1996, and 1995, respectively. These amounts represented $1.29, $0.57, and $0.32 per share. Included in dividends for 1997 was a special cash dividend of $8,675,000 or $0.60 per share. 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. 47 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Stock Splits On December 12, 1997, May 24, 1996 and May 26, 1995, the Company distributed five-for-four stock splits. All historical share information presented in the consolidated financial statements has been restated to reflect these events. Earnings Per Share The following table summarizes the calculation of basic and diluted earnings per share: 1997 1996 1995 -------------- -------------- -------------- (IN THOUSANDS EXCEPT PER SHARE INFORMATION) Net Income..................... $ 29,406 $ 26,721 $ 22,131 Weighted average common shares outstanding................... 14,812,208 15,228,820 14,763,133 Common stock equivalents of dilutive stock options........ 354,349 314,921 342,781 -------------- -------------- -------------- Weighted average common and common equivalent shares outstanding................... 15,166,557 15,543,741 15,105,914 ============== ============== ============== Basic earnings per share....... $ 1.99 $ 1.75 $ 1.50 Effect of dilutive stock options....................... (0.05) (0.03) (0.03) -------------- -------------- -------------- Diluted earnings per share..... 1.94 1.72 1.47 ============== ============== ============== For 1996 and 1995 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 125,000 and 21,973 of these options with weighted average exercise prices of $22.52 and $15.31 at December 31, 1996 and 1995, respectively. There were no antidilutive options excluded from the 1997 calculation. NOTE 9 STOCK PLANS The Company has two stock option plans: a 1988 Employee Stock Option plan and a 1993 Stock Incentive Plan. The Company accounts for these plans in accordance with APB Opinion No. 25, under which no compensation cost has been recognized. Under the plans, certain key employees and directors are eligible to receive various types of stock incentives: 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; non-employee directors' stock options to purchase stock at predetermined prices over a five-year period. At December 31, 1997 and 1996 there were a total of 1,540,528 and 915,528 shares, respectively, allocated to the plans. Of these shares, 905,421 and 867,609 shares were reserved at December 31, 1997 and 1996, respectively. During 1997, 18,125 shares of restricted stock, with a weighted average grant-date fair value of $24.67 per share, were issued. During 1995, 18,080 shares of restricted stock were issued, with a weighted average grant-date fair value of $12.10 per share. These shares vest five years from the grant date. There were no similar shares issued during 1996. 48 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, 1994.................................... 6.14 716,342 Granted............................................ 11.37 243,519 Exercised.......................................... 7.86 (133,481) Expired............................................ 8.58 (12,781) ----- -------- December 31, 1995.................................... 7.50 813,599 Granted............................................ 20.38 221,916 Exercised.......................................... 4.70 (405,060) Expired............................................ 14.10 (32,380) ----- -------- December 31, 1996.................................... 13.82 598,075 Granted............................................ 25.71 22,756 Exercised.......................................... 9.92 (92,076) Expired............................................ 21.00 (1,250) ----- -------- December 31, 1997.................................... 15.00 527,505 ===== ======== OPTIONS OUTSTANDING AND EXERCISABLE DECEMBER 31, 1997 OPTIONS OUTSTANDING OPTIONS EXERCISABLE - ----------------- --------------------------------------------- ---------------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF EXERCISE OPTIONS REMAINING AVERAGE EXERCISE OPTIONS AVERAGE EXERCISE PRICES: OUTSTANDING CONTRACTUAL LIFE PRICE OUTSTANDING PRICE - ----------------- ----------- ---------------- ---------------- ----------- ---------------- $2.56-$8.76 72,536 3.90 $ 5.55 72,536 $ 3.90 $10.10-$19.65 311,901 6.37 13.67 256,282 13.79 $21.00-$25.85 143,068 6.37 22.70 18,068 25.80 ------- ---- ------ ------- ------ $2.56-$25.85 527,505 6.03 $15.00 346,886 $12.65 ------- ---- ------ ------- ------ If compensation cost for these plans had been determined in accordance with SFAS 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts: 1997 1996 1995 ------------ ------------ ------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Net Income: As Reported............................ $29,406 $26,721 $22,131 Pro Forma.............................. 28,989 26,434 22,049 Earnings Per Share: Basic: As Reported............................ $1.99 $1.75 $1.50 Pro Forma.............................. 1.96 1.74 1.49 Diluted: As Reported............................ 1.94 1.72 1.47 Pro Forma.............................. 1.91 1.70 1.46 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. 49 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 1997, 1996 and 1995: 1997 1996 1995 ------- ------- ------- Expected life (years)................................... 7.75 7.75 7.75 Interest rate........................................... 5.97% 6.75% 6.50% Volatility.............................................. 29.0 25.4 25.4 Dividend yield.......................................... 2.74 3.60 5.61 Using these assumptions, the weighted average fair value of options granted was $8.22, $4.62 and $2.19 in 1997, 1996 and 1995, 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. The funding policy of the Bank 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). This contribution is based on an actuarial method that recognizes estimated future salary levels and service. The funded status of the plan is as follows at December 31, 1997 and 1996: 1997 1996 ------- ------- (IN THOUSANDS) Vested benefits................................ $15,138 $13,851 Nonvested benefits............................. 215 195 ------- ------- Accumulated benefit obligation................. 15,353 14,046 Additional benefits related to future compensation levels........................... 2,376 1,680 ------- ------- Projected benefit obligation................... 17,729 15,726 Fair value of plan assets, invested primarily in equity securities and bonds................ 18,122 16,036 ------- ------- Plan assets in excess of (less than) projected benefit obligation............................ $ 393 $ 310 ======= ======= 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. Unrecognized amounts to be amortized and the reconciliation of the plan assets less than the projected benefit obligation to the amounts included in the consolidated balance sheets at December 31, 1997 and 1996 are shown below: 1997 1996 ------- ------- (IN THOUSANDS) Plan assets in excess of projected benefit obligation........ $ 393 $ 310 Unrecognized net transition asset being amortized over participants' period of service............................. (105) (118) Prior service cost not yet recognized in net periodic pension cost........................................................ (2,376) (2,659) Unrecognized net (gain) loss from past experience different from that assumed........................................... (193) 278 ------- ------- Accrued pension cost included in accrued expenses and other liabilities................................................. $(2,281) $(2,189) ======= ======= 50 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Net pension expense, included in employee benefits in the consolidated statements of income, includes the following components: 1997 1996 1995 ------ ------ ------- (IN THOUSANDS) Service cost--benefits attributable to service during the period........................................... $ 589 $ 441 $ 814 Interest cost on projected benefit obligation ........ 1,208 1,112 1,297 Actual return on plan assets.......................... (2,855) (1,947) (2,301) Net amortization and deferral......................... 1,150 419 1,257 ------ ------ ------- Net pension expense................................... $ 92 $ 25 $ 1,067 ====== ====== ======= The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0%, 7.5%, and 7.0% in 1997, 1996 and 1995, respectively. Future compensation levels were estimated using average salary increases of 5.0%, 5.25%, and 5.0% in 1997, 1996 and 1995, respectively. The expected long-term rate of return on plan assets was 9.0% in 1997, 1996, and 1995. In September 1995, the Company approved an amendment to the pension plan, effective January 1, 1996, adopting a cash balance approach. This amendment led to the reduction of the Company's pension expense from $1,067,000 in 1995 to $25,000 in 1996 and $92,000 in 1997. Management expects future annual pension expenses to level off at approximately $600,000. CTC has supplemental pension arrangements with certain retired employees. The liability, included in accrued expenses and other liabilities, related to such arrangements was $660,000 and $772,000 at December 31, 1997 and 1996, 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 $678,000 and $379,000 at December 31, 1997 and 1996, respectively. Postretirement and Postemployment Benefits In addition to providing pension benefits, CTC provides certain postretirement health care benefits to retirees and to current employees who meet certain age and length of service criteria. The Company accounts for postretirement and post employment benefits in accordance with Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106). This accounting standard requires that the expected cost of postretirement benefits be charged to expense during the years that the employees render service. The Company has elected to amortize the unfunded obligation that was measured as of January 1, 1993 over a period of 20 years. 51 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table reconciles the plan's funded status to the accrued postretirement health care liability as reflected in the balance sheets at December 31, 1997 and 1996: 1997 1996 ------- ------- (IN THOUSANDS) Accumulated postretirement benefit obligation: Retirees................................................... $ 667 $ 725 Other fully eligible participants.......................... 175 157 Other active participants.................................. 317 274 ------- ------- $ 1,159 $ 1,156 Unrecognized actuarial gain................................. 273 340 Unrecognized transition obligation.......................... (1,205) (1,286) ------- ------- Accrued postretirement health care liability................ $ 227 $ 210 ======= ======= Net postretirement health care expense includes the following components: Service cost--benefits attributed to service during the period.................................................... $ 11 $ 11 Interest cost on accumulated postretirement benefit obligation................................................ 83 83 Net amortization and deferral.............................. 43 48 ------- ------- Net postretirement health care expense ..................... $ 137 $ 142 ======= ======= The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1997 and 1996 was 7.0% and 7.5%, respectively. For measurement purposes, 6.0% and 7.0% annual rate of increase in the per capita cost of covered health care benefits was assumed for the respective periods. 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 six 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 1997, 1996, and 1995, 74,631, 49,422 and 38,580 shares, respectively, of the Company's common stock were purchased through the incentive savings and profit sharing plan; $330,000, $290,000, and $274,000, 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 $9,000 in 1997 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 goal established by the Board of Directors is met. Expenses related to achievement of profitability goals totaled $345,000, $319,000, and $364,000, in 1997, 1996, and 1995, respectively. 52 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) CTC also has an Executive Management Incentive Compensation Plan. Executives performing 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. These awards are paid over a four-year period, contingent upon meeting profitability goals in the subsequent three years. Expenses for this plan totaled $1,099,000, $769,000, and $599,000 in 1997, 1996, and 1995, 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 $519,000, $365,000, and $183,000 for 1997, 1996, and 1995, respectively. Included in the expenses for 1997 was $116,000 related to the $0.60 per share special dividend paid in during the year. Shares which will be issued under the plan totaled 217,396 at December 31, 1997. BWM and FBT have separate 401(k) plans under which those banks contributed $222,000, $178,000 and $157,000 in 1997, 1996 and 1995 respectively. Pomerleau has a separate 401(k) under which $40,000 was contributed by that company in 1997. 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 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. 53 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Financial instruments whose contractual amounts represent off-balance sheet risk at December 31, 1997 and 1996 are as follows: 1997 1996 -------- -------- (IN THOUSANDS) Commitments to originate loans............................... $ 54,834 $ 33,450 Unused lines of credit....................................... 188,570 172,240 Standby letters of credit.................................... 25,665 24,231 Unadvanced portions of construction loans ................... 16,658 11,635 Equity commitments to limited partnerships................... 675 675 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 $14,265,000 and $27,189,000 at December 31, 1997 and 1996, respectively. CTC and FBT have contracts for data processing services that extend to July 1998 and April 1999, respectively. Base fees required to be paid during the remaining term of the contract are approximately $2,666,000. 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 and subsequent termination of employment 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, 1997. 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: 1997 1996 1995 ------- ------- ------- (IN THOUSANDS) Data processing........................................ $ 5,424 $ 5,023 $ 4,463 Amortization of intangible assets...................... 1,310 1,223 1,031 Legal and professional................................. 1,443 1,453 1,254 Marketing.............................................. 2,164 2,154 1,797 Other.................................................. 12,579 12,023 11,721 ------- ------- ------- $22,920 $21,876 $20,266 ======= ======= ======= 54 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 other 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 1997, is as follows (in thousands): BALANCE AT BALANCE AT DECEMBER 31 1996 ADDITIONS REDUCTIONS DECEMBER 31, 1997 ---------------- --------- ----------- ----------------- $8,860 1,043 1,897 $8,006 ====== ===== ===== ====== BWM does business with several businesses controlled by members of its Board of Directors. Amounts paid for rent, marketing, legal services, and insurance to these businesses totaled $461,000, $439,000 and $370,000 in 1997, 1996 and 1995, respectively. All transactions are done at arms-length. FBT purchases loans from a finance company controlled by a member of its Board of Directors. Prepaid interest advanced to this company totaled $2,689,000, $1,205,000, and $238,000 in 1997, 1996, and 1995, respectively. NOTE 15 QUARTERLY FINANCIAL DATA (UNAUDITED) A summary of quarterly financial data for 1997 and 1996 is presented below: THREE MONTHS ENDED 1997 ------------------------------------------------ MARCH 31 JUNE 30 SEPT. 30 DEC. 31 ---------- ---------- ---------- ---------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Total interest income.......... $36,178 $37,507 $38,189 $38,315 Total interest expense......... 14,236 14,690 15,295 15,324 ---------- ---------- ---------- ---------- Net interest income............ 21,942 22,817 22,894 22,991 Provision for possible loan losses ....................... 1,013 1,012 1,013 1,012 Noninterest income (1)......... 6,411 7,209 7,137 7,453 Noninterest expense (1)........ 16,942 17,630 17,504 17,996 ---------- ---------- ---------- ---------- Income before income taxes..... 10,398 11,384 11,514 11,436 Provision for income taxes..... 3,514 3,867 3,978 3,967 ---------- ---------- ---------- ---------- Net income..................... $ 6,884 $ 7,517 $ 7,536 $ 7,469 ========== ========== ========== ========== Basic earnings per share....... $ 0.45 $ 0.50 $ 0.52 $ 0.52 Dilutive earnings per share.... 0.44 0.49 0.50 0.50 Dividends declared per share... 0.160 0.176 0.176 0.776 (1) Includes the operations of The Pomerleau Agency as of its acquisition in May 1997. 55 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) THREE MONTHS ENDED 1996 ------------------------------------------------ MARCH 31 JUNE 30 SEPT. 30 DEC. 31 ---------- ---------- ---------- ---------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Total interest income.......... $34,656 $35,040 $35,941 $36,955 Total interest expense......... 14,592 14,397 14,828 14,782 ---------- ---------- ---------- ---------- Net interest income............ 20,064 20,643 21,113 22,173 Provision for possible loan losses........................ 983 1,025 850 1,325 Noninterest income............. 6,132 6,337 6,306 6,145 Noninterest expense............ 16,092 15,934 16,252 16,279 ---------- ---------- ---------- ---------- Income before income taxes..... 9,121 10,021 10,317 10,714 Provision for income taxes..... 3,108 3,324 3,440 3,580 ---------- ---------- ---------- ---------- Net income..................... $ 6,013 $ 6,697 $ 6,877 $ 7,134 ========== ========== ========== ========== Basic earnings per share....... $ 0.40 $ 0.44 $ 0.45 $ 0.47 Dilutive earnings per share.... 0.39 0.43 0.44 0.46 Dividends declared per share... 0.088 0.160 0.160 0.160 NOTE 16 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) 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 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 receivables and other consumer loans. Other consumer loans include installment, credit card, and student loans. Each of these consumer portfolios also was evaluated separately. 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 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 receivables and other consumer loans is estimated based on secondary market prices for asset-backed securities with similar characteristics. 56 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Purchased Mortgage Service Rights & Originated Mortgage Service Rights The fair value is estimated by discounting the future cash flows through the estimated maturity of the underlying mortgage loans. 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, ------------------------------------------- 1997 1996 --------------------- --------------------- CARRYING CARRYING AMOUNT FAIR VALUE AMOUNT FAIR VALUE ---------- ---------- ---------- ---------- (IN THOUSANDS) FINANCIAL ASSETS: Cash and cash equivalents........ $ 143,394 $ 143,394 $ 214,459 $ 214,459 Securities available for sale.... 363,279 363,279 329,213 329,213 Securities held for investment... -- -- 35,580 35,405 Federal Home Loan Bank Stock..... 5,591 5,591 5,591 5,591 Loans, net ...................... 1,372,417 1,385,437 1,316,571 1,319,238 Mortgage loans held for sale..... 16,433 16,433 9,870 9,870 Mortgage servicing rights........ 3,567 3,959 3,025 3,938 FINANCIAL LIABILITIES: Deposits: Demand......................... 302,555 302,555 286,932 286,932 Savings........................ 924,846 924,846 951,989 951,989 Time: Certificates of deposit $100,000 and over........... 121,089 121,282 104,295 104,346 Other time deposits.......... 409,055 409,996 418,363 419,216 Short-term borrowings............ 23,250 23,250 23,992 23,992 Long-term debt................... 2,239 2,239 2,540 2,540 Commitments...................... 152 135 121 105 NOTE 17 PARENT COMPANY FINANCIAL STATEMENTS CHITTENDEN CORPORATION (PARENT COMPANY ONLY) BALANCE SHEETS DECEMBER 31, ----------------- 1997 1996 -------- -------- (IN THOUSANDS) ASSETS: Cash and cash equivalents..................................... $ 7,586 $ 9,732 Investment securities......................................... -- 330 Investment in bank subsidiaries at equity in net assets....... 153,589 164,240 Other assets.................................................. 1,493 376 -------- -------- Total assets................................................ $162,668 $174,678 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Accrued expenses and other liabilities........................ $ 395 $ 277 -------- -------- Total liabilities........................................... 395 277 -------- -------- Total stockholders' equity.................................... 162,273 174,401 -------- -------- Total liabilities and stockholders' equity.................. $162,668 $174,678 ======== ======== 58 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, ------------------------- 1997 1996 1995 -------- ------- ------- (IN THOUSANDS) Operating income: Dividends from bank subsidiaries................... $ 42,250 $10,383 $17,324 Dividends from investment securities............... 12 11 10 Interest income.................................... 163 92 135 Gain on sale of securities......................... 114 -- -- -------- ------- ------- Total operating income........................... 42,539 10,486 17,469 -------- ------- ------- Operating expense.................................... 782 929 610 -------- ------- ------- Total operating expense.......................... 782 929 610 -------- ------- ------- Income before income taxes and equity in undistributed earnings of subsidiaries.............. 41,757 9,557 16,859 Income tax benefit................................... 155 260 143 -------- ------- ------- Income before equity in undistributed earnings of subsidiaries........................................ 41,912 9,817 17,002 Equity in undistributed earnings of bank subsidiaries........................................ (12,506) 16,904 5,129 -------- ------- ------- Net income........................................... $ 29,406 $26,721 $22,131 ======== ======= ======= STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, ---------------------------- 1997 1996 1995 -------- -------- -------- (IN THOUSANDS) Cash flows from operating activities: Net income..................................... $ 29,406 $ 26,721 $ 22,131 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of bank subsidiaries................................ 12,506 (16,904) (5,129) Gain on sale of securities................... (114) -- -- (Increase) decrease in other assets............ (280) (136) 404 Decrease in accrued expenses and other liabilities................................... (100) (29) (96) -------- -------- -------- Net cash provided by operating activities.... 41,418 9,652 17,310 -------- -------- -------- Cash flows from investing activities: Proceeds form the sale of securities........... 345 -- -- Purchase of The Bank of Western Massachusetts.. -- -- (12,177) -------- -------- -------- Net cash used in investing activities........ 345 -- (12,177) -------- -------- -------- Cash flows from financing activities: Proceeds from issuance of treasury and common stock......................................... 966 2,206 1,280 Dividends on common stock...................... (18,892) (8,747) (4,803) Repurchase of common stock..................... (25,983) -- -- -------- -------- -------- Net cash used in financing activities........ (43,909) (6,541) (3,523) Net increase (decrease) in cash and cash equivalents................................... (2,146) 3,111 1,610 Cash and cash equivalents at beginning of year. $ 9,732 6,621 5,011 -------- -------- -------- Cash and cash equivalents at end of year....... $ 7,586 $ 9,732 $ 6,621 ======== ======== ======== 59 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 18 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, 1997, that the Company and the Banks meet all capital adequacy requirements to which they are subject. As of December 31, 1997, 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 FOR CAPITAL PROMPT CORRECTIVE ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS: -------------- ------------------- ------------------- AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO -------- ----- ---------- -------- ---------- -------- AS OF DECEMBER 31, 1997: Total Capital (to Risk Weighted Assets): Consolidated.......... $165,004 11.17% $118,201 8.00% N/A N/A Chittenden Trust Company.............. 111,312 10.60 84,016 8.00 $105,050 10.00% Bank of Western Massachusetts........ 21,181 10.14 16,708 8.00 20,885 10.00 Flagship Bank & Trust. 23,983 10.98 17,480 8.00 21,850 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated.......... 146,434 9.86 59,426 4.00 N/A N/A Chittenden Trust Company.............. 98,118 9.30 42,221 4.00 63,332 6.00 Bank of Western Massachusetts........ 18,543 8.79 8,443 4.00 12,664 6.00 Flagship Bank & Trust. 21,244 9.70 8,764 4.00 13,146 6.00 Tier 1 Capital (to Average Assets): Consolidated.......... 146,434 7.43 78,793 4.00 N/A N/A Chittenden Trust Company.............. 98,118 7.05 55,680 4.00 69,600 5.00 Bank of Western Massachusetts........ 18,543 7.31 10,141 4.00 12,676 5.00 Flagship Bank & Trust. 21,244 6.65 12,773 4.00 15,967 5.00 60 CHITTENDEN CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) TO BE WELL CAPITALIZED UNDER FOR CAPITAL PROMPT CORRECTIVE ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS: -------------- ------------------- ------------------- AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO -------- ----- ---------- -------- ---------- -------- AS OF DECEMBER 31, 1996: Total Capital (to Risk Weighted Assets): Consolidated.......... $180,962 13.06% $110,822 8.00% N/A N/A Chittenden Trust Company.............. 126,285 12.51 80,736 8.00 $100,920 10.00% Bank of Western Massachusetts........ 21,270 11.44 14,878 8.00 18,598 10.00 Flagship Bank & Trust. 23,364 12.21 15,302 8.00 19,128 10.00 Tier 1 Capital (to Risk Weighted Assets): Consolidated.......... 163,513 11.71 55,837 4.00 N/A N/A Chittenden Trust Company.............. 113,577 11.17 40,666 4.00 60,999 6.00 Bank of Western Massachusetts........ 18,918 10.05 7,528 4.00 11,292 6.00 Flagship Bank & Trust. 20,961 10.90 7,690 4.00 11,534 6.00 Tier 1 Capital (to Average Assets): Consolidated.......... 163,513 8.58 76,245 4.00 N/A N/A Chittenden Trust Company.............. 113,577 8.42 53,968 4.00 67,460 5.00 Bank of Western Massachusetts........ 18,918 7.85 9,642 4.00 12,053 5.00 Flagship Bank & Trust. 20,961 6.85 12,238 4.00 15,297 5.00 NOTE 19 RECENT ACCOUNTING PRONOUNCEMENTS In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income ("SFAS 130"). SFAS 130 establishes standards for reporting and display of comprehensive income and its components (revenue, expense, gains and losses) in a full set of general purpose financial statements. Comprehensive income is the total of net income and all other nonowner changes in equity. SFAS 130 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. SFAS 130 shall be effective for fiscal years beginning after December 15, 1997. 61 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, 1997 and 1996, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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 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 Chittenden Corporation and its subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. LOGO Boston, Massachusetts January 20, 1998 62 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. LOGO LOGO [Signature of Paul A. Perrault] [Signature of Kirk W. Walters] Paul A. Perrault Kirk W. Walters President and Chief Executive Officer Executive Vice President and Chief Financial Officer 63 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 1998 Annual Meeting of Stockholders at pages 6-9, and is specifically incorporated herein by reference. At December 31, 1997, the principal officers of the Company and its principal subsidiary, CTC, with their ages, positions, and years of appointment, were as follows: YEAR NAME AND AGE APPOINTED POSITIONS ----------------------- --------- -------------------------------------------- Barbara W. Snelling, 70 1990 Chair of the Company and CTC Paul A. Perrault, 46 1990 President and Chief Executive Officer of the Company and CTC Lawrence W. DeShaw, 51 1990 Executive Vice President of the Company and CTC John W. Kelly, 48 1990 Executive Vice President of the Company and CTC Kirk W. Walters, 42 1996 Executive Vice President, Chief Financial Officer, and Treasurer of the Company and CTC John P. Barnes, 42 1990 Executive Vice President of the Company and CTC Danny H. O'Brien, 47 1990 Executive Vice President of the Company and CTC F. Sheldon Prentice, 47 1985 Senior Vice President, General Counsel, and Secretary of the Company and CTC Howard L. Atkinson, 53 1996 Chief Auditor of the Company and CTC All of the current officers, except Mr. Walters and Mr. Atkinson, have been principally employed in executive positions with CTC for more than six 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 1998 Annual Meeting of Stockholders at pages 10-17 and is specifically incorporated herein by reference. 64 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, 1998, is included in the Company's definitive Proxy Statement for its 1998 Annual Meeting of Stockholders, at pages 4-9, 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. 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 1998 Annual Meeting of Stockholders at page 18, 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 The following are included as exhibits to this report: 3. By-laws of the Company, as amended and restated as of October 18, 1997. 3.1 Articles of Association of the Company, as amended, incorporated herein by reference to the Proxy Statement for the 1994 Annual Meeting of Stockholders. 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. 65 10.2 Amended and Restated Pension Plan, incorporated herein by reference to the Company's Annual 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. 10.7 Registration Statement under The Securities Act of 1933 on form S-8 dated February 27, 1996, incorporated herein by reference. 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. 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, restated and amended 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 10.14 Supplemental Executive Savings Plan 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. 21. List of subsidiaries of the Registrant. 23. Consent of Arthur Andersen LLP 27. Financial Data Schedule (B) REPORTS ON FORM 8-K None 66 EXHIBITS (C) EXHIBIT 10.13 SUPPLEMENTAL EXECUTIVE CASH BALANCE RESTORATION PLAN EXHIBIT 10.14 SUPPLEMENTAL EXECUTIVE SAVINGS PLAN 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 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 27 FINANCIAL DATA SCHEDULE HAS BEEN FILED AS AN EXHIBIT 67 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: February 18, 1998 Chittenden Corporation /s/ Paul A. Perrault By___________________________________ President, Chief Executive Officer And Director 68 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/ Barbara W. Snelling Chair of the Board of February 18, 1998 ____________________________________ Directors Barbara W. Snelling /s/ Paul A. Perrault President, Chief Executive February 18, 1998 ____________________________________ Officer Paul A. Perrault and Director /s/ Kirk W. Walters Executive Vice President, February 18, 1998 ____________________________________ Chief Kirk W. Walters Financial Officer and Treasurer (principal accounting officer) /s/ Frederic H. Bertrand Director February 18, 1998 ____________________________________ Frederic H. Bertrand /s/ David M. Boardman Director February 18, 1998 ____________________________________ David M. Boardman /s/ Paul J. Carrara Director February 18, 1998 ____________________________________ Paul J. Carrara /s/ Richard D. Driscoll Director February 18, 1998 ____________________________________ Richard D. Driscoll * Director February 18, 1998 ____________________________________ Lyn Hutton /s/ Philip A. Kolvoord Director February 18, 1998 ____________________________________ Philip A. Kolvoord /s/ James C. Pizzagalli Director February 18, 1998 ____________________________________ James C. Pizzagalli /s/ Pall D. Spera Director February 18, 1998 ____________________________________ Pall D. Spera * Director February 18, 1998 ____________________________________ Martel D. Wilson, Jr. 69 CHITTENDEN CORPORATION