FORM 10-SB
GENERAL FORM FOR REGISTRATION OF
SECURITIES OF SMALL BUSINESS ISSUERS
Under Section 12(b) or (g) of The Securities Exchange Act of 1934
VSB Bancorp, Inc.
(Name of Small Business Issuer in its charter)
New York
(State or other jurisdiction of incorporation or organization)
11 - 3680128
(I. R. S. Employer Identification No.)
3155 Amboy Road, Staten Island, New York 10306
(Address of principal executive offices)
Issuer's telephone number (718) 979-1100
Securities to be registered pursuant to Section 12(b) of the Act: None
Securities to be registered pursuant to Section 12(g) of the Act:
Common Stock
(Title of Class)
Item 1. Description of Business.
Business of VSB Bancorp, Inc.
VSB Bancorp, Inc. ("VSB") is to become the holding company for Victory State
Bank (the "Bank"), a New York chartered commercial bank, upon the completion of
a reorganization of the Bank into the holding company form of organization
through the merger of the Bank with an interim bank, to be known as Victory
Interim Bank. The reorganization will be completed through what is commonly
known as a reverse triangular merger. Until the reorganization is complete, VSB
will be a wholly-owned subsidiary of the Bank. VSB and the Bank will accomplish
the reorganization in the following manner. First, VSB will form Victory Interim
Bank as a subsidiary of VSB. This will require the approval of the New York
State Banking Board. Second, Victory Interim Bank will merge into the Bank.
Third, all the outstanding stock of the Bank will be exchanged for stock of VSB
so that the stockholders of the Bank will own VSB and VSB will own all the stock
of the Bank. All the stock of VSB owned by the Bank immediately before the
merger will be cancelled. The securities of VSB issued in the transaction
qualify as exempt securities under Section 3(a)(12) of the Securities Act of
1933. 15 USC 77c (12).
VSB is not now engaged in any business. Upon the completion of the
reorganization described in the prior paragraph, VSB's sole business will
initially be owning all of the issued and outstanding stock of the Bank.
Business of the Bank
General
The Bank's principal business has been and continues to be attracting commercial
deposits from primarily the general public and investing those deposits,
together with funds generated from operations, primarily in commercial loans and
construction loans, and, to a lesser extent, investment securities. The Bank's
revenues are derived principally from interest on its commercial loan and
investment securities portfolios. The Bank's primary sources of funds are
deposits and principal and interest payments on loans and investment securities.
Market Area and Competition
The Bank has been, and continues to be, a community-oriented, state-chartered
commercial bank offering a variety of traditional financial services to meet the
needs of the communities in which it operates. Management considers the Bank's
reputation for customer service as its major competitive advantage in attracting
and retaining customers in its market area.
The Bank's primary market area is concentrated in the neighborhoods of the New
York City Borough of Staten Island. The Bank's main office is located in the
Oakwood section of the Borough of Staten Island; its Forest Avenue branch is
located in the West Brighton section of the Borough of Staten Island; its Hyatt
Street branch is located in the St. George section of the Borough of Staten
Island; and its Hylan Boulevard branch is located in the Dongan Hills section of
the Borough of Staten Island. Management believes that its branch offices are
located in communities that can generally be characterized as stable,
residential neighborhoods of predominantly one- to four-family residences and
middle income families.
The New York City Metropolitan area has a high density of financial
institutions, many of which are significantly larger and have greater financial
resources than the Bank, and all of which are competitors of the Bank to varying
degrees. The Bank's competition for loans comes principally from commercial
banks, savings banks and insurance companies. The Bank's most direct competition
for deposits has come from commercial banks and savings banks. In addition, the
Bank faces increasing competition for deposits from non-bank institutions such
as brokerage firms and insurance companies in such areas as short-term money
market funds, corporate and government securities funds, mutual funds and
annuities.
Lending Activities
Loan Portfolio Composition. The Bank's loan portfolio consists primarily of
commercial real estate and unsecured commercial loans. At December 31, 2002, the
Bank had total unsecured commercial loans outstanding of $11,322,164, or 17.8%
of the Bank's total loans and commercial real estate loans of $31,357,950 or
49.1% of the Bank's total loans. There
2
were $14,877,442 of construction loans secured by real estate, $13,562,442 of
which were commercial construction, or 21.2% of total loans at that date. Other
loans in the Bank's portfolio principally included commercial non-real estate
secured loans totaling $4,014,494 or 6.3% of total loans at December 31, 2002.
Other loans totaled $1,688,558 or 2.7% of total loans at that date. For the year
ended December 31, 2002, approximately $51,148,054, or 80.2% of the Bank's
commercial loans had adjustable interest rates based on the prime rate of
interest.
The Bank primarily invests in collateralized mortgage obligations ("CMO") and
agency Mortgage-Backed Securities ("MBS"), which totaled $42,192,075 at December
31, 2002. The CMOs and MBS are primarily agency backed (FNMA or FHLMC) and AAA
rated whole loans, each with an average life of 4.0 years or less.
3
The following table sets forth the composition of the Bank's loan portfolio in
dollar amounts and in percentages of the respective portfolios at the dates
indicated.
At December 31,
-----------------------------------------------
2002 2001
---------------------- ----------------------
Percent Percent
Amount of Total Amount of Total
----------- -------- ----------- --------
Commercial loans:
Commercial secured $ 4,014,494 6.3% $ 4,337,062 8.6%
Commercial unsecured 11,322,164 17.8 10,964,539 21.6
----------- ----- ----------- -----
Total commercial loans 15,336,658 24.1 15,301,601 30.2
Real Estate loans:
Commercial 31,357,950 49.1 21,553,696 42.5
One-to-four family 493,504 0.8 376,999 0.7
----------- ----- ----------- -----
Total real estate loans 31,851,454 49.9 21,930,695 43.2
Construction loans:
Commercial 13,562,442 21.2 10,477,294 20.7
One-to-four family 1,315,000 2.1 1,803,000 3.6
----------- ----- ----------- -----
Total construction loans 14,877,442 23.3 12,280,294 24.3
Other loans:
Consumer loans 1,179,485 1.9 796,987 1.6
Other loans 509,073 0.8 331,355 0.7
----------- ----- ----------- -----
Total other loans 1,688,558 2.7 1,128,342 2.3
Total loans 63,754,112 100.0% 50,640,932 100.0%
----------- ===== ----------- =====
Less:
Unearned discounts, net and
deferred loan fees, net 339,601 216,139
Allowance for loan losses 1,168,358 894,692
----------- -----------
Loans, net $62,246,153 $49,530,101
----------- -----------
The following table sets forth the Bank's loan originations, purchases, sales
and principal repayments for the periods indicated.
4
Year Ended Year Ended
December 31, December 31,
2002 2001
------------ ------------
Commercial Loans (gross):
At beginning of period $ 15,301,601 $ 16,689,008
Commercial loans originated:
Secured 1,716,300 3,645,746
Unsecured 27,621,629 24,277,267
------------ ------------
Total commercial loans 29,337,929 27,923,013
Principal repayments (29,302,872) (29,310,420)
------------ ------------
At end of period $ 15,336,658 $ 15,301,601
============ ============
Real Estate loans:
At beginning of period $ 21,930,695 $ 17,560,724
Real estate loans originated:
Commercial 17,601,051 10,547,478
One-to-four family 322,000 220,000
------------ ------------
Total real estate loans 17,923,051 10,767,478
Principal repayments (8,002,292) (6,397,507)
------------ ------------
At end of period $ 31,851,454 $ 21,930,695
============ ============
Construction loans
At beginning of period $ 12,280,294 $ 9,763,466
Construction loans originated 24,997,000 13,709,294
Principal repayments (22,399,852) (11,192,466)
------------ ------------
At end of period $ 14,877,442 $ 12,280,294
============ ============
Other loans (gross):
At beginning of period $ 1,128,342 $ 1,244,454
Other loans originated 1,485,843 1,279,204
Principal repayments (925,627) (1,395,316)
------------ ------------
At end of period $ 1,688,558 $ 1,128,342
============ ============
Loan Maturity. The following table shows the maturity of the Bank's loans at
December 31, 2002.
At December 31, 2002
--------------------------------------------------------------------------------
Commercial Commercial Other
Unsecured Secured Construction Real Estate Loans (1) Total
----------- ---------- ------------ ----------- ---------- -----------
Amounts due:
Within one year (1) $10,864,317 $3,183,858 $14,579,942 $30,840,691 $1,048,892 $60,517,700
After one year:
One to five years 457,847 830,636 297,500 1,010,763 639,666 3,236,412
Total due after five years -- -- -- -- -- --
----------- ---------- ----------- ----------- ---------- -----------
Total amount due 11,322,164 4,014,494 14,877,442 31,851,454 1,688,558 63,754,112
Less:
Unearned fees -- 2,020 182,973 154,608 -- 339,601
Allowance for loan
losses 290,496 55,186 206,920 576,286 39,470 1,168,358
----------- ---------- ----------- ----------- ---------- -----------
Loans, net $11,031,668 $3,957,288 $14,487,549 $31,120,560 $1,649,088 $62,246,153
=========== ========== =========== =========== ========== ===========
(1) Amount includes overdrawn deposit accounts.
5
The following table sets forth at December 31, 2002, the dollar amount of all
loans, due after December 31, 2002, and whether such loans have fixed or
variable interest rates.
Due After December 31, 2002
---------------------------------------
Fixed Variable Total
----------- ----------- -----------
Commercial Loans:
Unsecured $ 7,078,804 $ 4,243,360 $11,322,164
Secured 2,827,933 1,186,561 4,014,494
Real Estate
Commercial 517,259 30,840,691 31,357,950
One-to-four 493,504 -- 493,504
Construction -- 14,877,442 14,877,442
Other loans 1,688,558 -- 1,688,558
----------- ----------- -----------
Total loans $12,606,058 $51,148,054 $63,754,112
=========== =========== ===========
Commercial Business Lending. The Bank originates commercial business loans
directly to the professional and business community in its market area. The Bank
targets small to medium sized business, and professionals such as lawyers,
doctors and accountants. Applications for commercial business loans are obtained
primarily from customers that the Board of Directors and senior management has
direct knowledge of or from branch referrals. As of December 31, 2002,
commercial loans totaled $15,336,658 or 24.1% of total loans.
Commercial loans originated by the Bank generally have terms of five years or
less and have adjustable interest rates tied to the Wall Street Journal Prime
Rate plus a margin. Such loans may be secured or unsecured. Secured commercial
loans can be collateralized by real estate, receivables, inventory and other
assets. All commercial loans are backed by the personal guarantee of all the
principals of the borrower. Commercial loans generally have shorter maturities
and higher yields than residential lending. Commercial lending is generally
considered to involve a greater credit risk than certain other types of loans.
Management has extensive experience in originating commercials loans within its
marketplace.
Commercial Real Estate Lending. The Bank originates commercial real estate loans
that are generally secured by properties used exclusively for business purposes
such as retail stores, other mixed-use (business and residential) properties,
restaurants, light industrial and small office buildings located in the Bank's
primary market area. The Bank's commercial real estate loans are generally made
in amounts up to the lesser of 70% of the appraised value of the property or the
Bank's current loans-to-one borrower limit. These loans are generally made with
terms up to ten years for fixed rate loans and 20 years for adjustable rate
loans and bear interest rates at approximately 100 basis points above the
corresponding Prime Rate. A significant portion of these loans are subject to an
interest rate floor ranging between 7.00% to 7.50%. The Bank's underwriting
standards consider the collateral of the borrower, the net operating income of
the property and the borrower's expertise, credit history and profitability. The
Bank requires personal guarantees from the borrower or the principals of the
borrowing entity. At December 31, 2002, the Bank's commercial real estate loans
totaled $31,851,454, or 49.9% of total loans.
Construction Lending. The Bank's construction loans primarily have been made to
finance the construction of one- to four-family residential properties and, to a
lesser extent, multi-family residential real estate properties. The Bank's
policies provide that construction loans may be made in amounts up to the lesser
of 80% of the total hard and soft costs of the project or the Bank's loans-to
one-borrower limitation. The Bank generally requires personal guarantees.
Construction loans generally are made with primarily Prime-Based terms, up to 12
months. Loan proceeds are disbursed in increments as construction progresses and
as inspections warrant. At December 31, 2002, the Bank's construction loans
totaled $14,877,442 or 23.3% of total loans.
Other Loans The Bank also offers other loans in the form of secured equity
(second mortgage) loans and secured and unsecured personal loans. These second
mortgage loans are originated either as fixed-rate loans with terms up to ten
6
years or as Prime-Based loans with terms up to 10 years. These loans are
generally subject to a 75% combined loan-to-value limitation, including any
other outstanding mortgage or lien on the property. As of December 31, 2002
other loans totaled $1,688,558 or 2.7% of the Bank's total loan portfolio.
Second mortgage loans which are underwritten pursuant to the standards
applicable to one- to four-family residential loans, the underwriting standards
employed by the Bank for other loans include a determination of the applicant's
payment history on other debts and an assessment of the borrower's ability to
meet payments on the proposed loan along with the borrower's existing
obligations. In addition to the creditworthiness of the applicant, the
underwriting process also includes a comparison of the value of the security, if
any, in relation to the proposed loan amount. The combined mortgage debt on
properties securing consumer loans generally do not exceed 75% of its appraised
value.
Loan Approval Procedures and Authority. All unsecured loans in excess of
$200,000 and any secured loan over $350,000, are reviewed and approved by the
Loan Committee, which consists of seven board members, prior to commitment. Any
secured loan of $350,000 or less and unsecured loans of $200,000 or less may be
approved by underwriters designated by the Chief Executive Officer.
Consumer loans not secured by real estate and unsecured consumer loans,
depending on the amount of the loan and the loan to value ratio, where
applicable, require the approval of the Chief Lending Officer and/or Chief
Executive Officer.
For all loans originated by the Bank, upon receipt of a completed loan
application from a prospective borrower, a credit report is ordered and certain
other information is verified by an independent credit agency and, if necessary,
additional financial information is required. An appraisal of the real estate
intended to secure the proposed loan is required to be performed by an
independent appraiser designated and approved by the Bank. The Board annually
approves the independent appraisers used by the Bank and approves the Bank's
appraisal policy as set forth in the Bank's Loan Policy. It is the Bank's policy
to obtain title insurance on all real estate first mortgage loans. Borrowers
must also obtain hazard insurance prior to closing. Some borrowers are required
to advance funds on a monthly basis together with each payment of principal and
interest to a mortgage escrow account from which the Bank makes disbursements
for items such as real estate taxes.
Delinquencies and Classified Assets
Delinquent Loans. The Bank's collection procedures for mortgage loans include
sending a past due notice at 15 days and a late notice after payment is 30 days
past due. In the event that payment is not received after the late notice,
letters are sent or phone calls are made to the borrower. When contact is made
with the borrower at any time prior to foreclosure, the Bank will attempt to
obtain full payment or work out a repayment schedule with the borrower to avoid
foreclosure. Generally, foreclosure procedures are initiated when a loan is over
90 days delinquent. Property foreclosed upon is held by the Bank as real estate
owned at the lower of its appraised value less costs to dispose, or cost. The
Bank ceases to accrue interest on all loans 90 days past due and reverses all
interest due when the loan becomes non-accrual. The Bank continues to accrue
interest on construction loans that are 90 days past contractual maturity date
if the loan is expected to be paid in full in the next 60 days and all interest
is paid up to date.
The collection procedures for other loans generally include telephone calls to
the borrower after ten days of the delinquency and sending late notices at 15
and 25 days past due. Letters and telephone calls generally continue until the
matter is referred to a collection attorney or resolved. After the loan is 90
days past due, the matter is referred to counsel and are written-off by the Bank
and secured loans may be foreclosed upon or negotiations with the borrower
continued.
Classified Assets. Federal regulations and the Bank's Loan Review and Risk
Rating Policy provide for the classification of loans and other assets
considered by the NYSBD and the FDIC to be of lesser quality as "Substandard",
"Doubtful" or "Loss" assets. An asset is considered "Substandard" if it is
inadequately protected by the current net worth and paying capacity of the
obligor or of the collateral pledged, if any. "Substandard" assets include those
characterized by the "distinct possibility" that the insured institution will
sustain "some loss" if the deficiencies are not corrected.
7
Assets classified as "Doubtful" have all of the weaknesses inherent in those
classified "Substandard" with the added characteristic that the weaknesses
present make "collection or liquidation in full," on the basis of currently
existing facts, conditions, and values, "highly questionable and improbable."
Assets classified as "Loss" are those considered "uncollectible" and of such
little value that their continuance as assets without the establishment of a
specific loss reserve is not warranted. Assets which do not currently expose the
insured institution to sufficient risk to warrant classification in one of the
aforementioned categories but possess weaknesses are required to be designated
"Special Mention" by management. The Bank had twenty-four (24) loans, in the
aggregate amount of $2,923,233, classified as special mention, eleven (11)
loans, in the aggregate amount of $530,711, classified as substandard and two
(2) loans, in the aggregate amount of $56,490, classified as doubtful as of
December 31, 2002.
When an insured institution classifies one or more assets, or proportions
thereof, as Substandard or Doubtful, it is required to provide, as part of its
general allowance for loan losses, an amount deemed prudent by management with
respect to the classified assets. A general allowance represents loss allowances
which have been established to recognize the inherent risk associated with
lending activities, but which, unlike a specific allowance, has not been
allocated to particular problem assets. When an insured institution classifies
one or more assets, or proportions thereof, as "Loss," it is required either to
establish a specific allowance for losses equal to 100% of the amount of the
asset so classified or to charge off such amount.
The Bank's policies provide that the Loan Review Officer and the Board of
Directors regularly review problem loans and review all classified assets
reported to the NYSBD and the FDIC on a quarterly basis. The Bank believes its
policies are consistent with the regulatory requirements regarding classified
assets. A state-chartered banking institution's determination as to the
classification of its assets and the amount of its valuation allowances is
subject to review by the NYSBD and the FDIC, which can order the establishment
of additional general or specific loss allowances.
All assets classified by the Bank as Doubtful or Loss are included in
non-performing loans delinquent 90 days or more or are included in real estate
owned. At December 31, 2002, the Bank had two (2) loans, in the aggregate amount
of $56,490 classified as Doubtful and no assets classified as Loss.
The following table sets forth delinquencies in the Bank's loan portfolio as of
the dates indicated:
At December 31, 2002
---------------------------------------
60-89 Days 90 Days or more
------------------ ------------------
Number Principal Number Principal
------ --------- ------ ---------
Commercial real estate -- $ -- 2 $612,913
Commercial construction -- -- -- --
Commercial -- -- -- --
Other -- -- -- --
--- ----- --- --------
Total -- $ -- 2 $612,913
=== ===== === ========
Delinquent loans to total loans 0.00% 0.96%
At December 31, 2001
---------------------------------------
60-89 Days 90 Days or more
------------------ ------------------
Number Principal Number Principal
------ --------- ------ ---------
Commercial real estate -- $ -- -- $ --
Commercial construction 1 7,376 -- --
Commercial -- -- -- --
Other -- -- -- --
-- ------ -- -----
Total 1 $7,376 -- $ --
== ====== == =====
Delinquent loans to total loans 0.01% 0.00%
8
Loans past due 90 days or more at December 31, 2002 are classified as such
because they are contractually past maturity. However, they are still accruing
interest, which is being paid on a monthly basis. The Bank continues to accrue
interest on construction loans that are 90 days past contractual maturity date
if the loan is paid in full in the next 60 days and all accrued interest is paid
up to date. Therefore the loans are considered to be performing loans as of
December 31, 2002.
Non-performing Assets. The following table sets forth information about the
Bank's non-performing assets at December 31, 2002 and 2001.
At December 31, At December 31,
2002 2001
--------------- ---------------
Non-performing assets:
Commercial loans:
Unsecured $ 14,734 $ 70,000
Commercial real estate 313,039 579,601
-------- --------
Total non-performing
assets $327,773 $649,601
======== ========
Non-performing loans to total
loans 0.51% 1.28%
Non-performing loans to total
assets 0.24% 0.65%
Non-performing assets to total
assets 0.24% 0.65%
The following table sets forth the aggregate carrying value of the Bank's assets
classified as Substandard, Doubtful and Loss according to asset type:
At December 31, 2002 At December 31, 2002
Substandard Doubtful
-------------------- --------------------
Number Amount Number Amount
------ -------- ------ --------
Classification of assets:
Commercial Loans:
Unsecured 4 $ 91,533 -- --
Commercial Real Estate 6 435,691 2 56,490
Other 1 3,487 -- --
-- -------- -- -------
Total loans 11 $530,711 2 $56,490
-- -------- -- -------
No assets were classified as Loss at year end 2002.
Allowance for Loan Losses
The Banks' Allowance for Loan Losses is established through a provision for loan
losses based on management's evaluation of the risks inherent in its loan
portfolio and the general economy. Such evaluation, which includes a review of
all loans on which full collectibility may not be reasonably assured, considers
among other matters, the estimated net realizable value of the underlying
collateral, economic conditions, any historical loan loss experience and other
factors that warrant recognition in providing for an adequate loan loss
allowance. The Bank identifies and evaluates the following pools or similar loan
categories when evaluating the Allowance for Loan Losses: Commercial Loans -
Secured and Unsecured; Real Estate Loans - Commercial and One-to-four family;
Construction Loans - Commercial and One-to-four family and Other Loans -
Consumer and Other Loans. As of December 31, 2002, the Bank's allowance for loan
losses was $1,168,358, or 1.83% of total loans. The Bank will continue to
monitor and modify its allowance for loan losses as conditions dictate. Although
the Bank maintains its allowance at a level which it considers adequate to
provide for potential losses, there can be no assurance that such losses will
not exceed the estimated amounts.
The following table sets forth the activity in the Bank's Allowance for Loan
Losses:
9
For the Year
Ended
December 31,
----------------------
2002 2001
---------- ---------
Allowance for Loan Losses:
Balance at beginning of period $ 894,692 $ 766,377
Charge-offs:
Commercial loans:
Unsecured (130,191) (229,337)
Other loans (24,421) (15,444)
---------- ---------
Total charge-offs (154,612) (244,781)
Recoveries 73,278 68,096
Provision charged to income 355,000 305,000
---------- ---------
Balance at end of period $1,168,358 $ 894,692
========== =========
Ratio of net charge-offs during the period to
average loans outstanding during the period 0.27% 0.51%
Ratio of allowance for loan losses to
total loans at the end of period 1.83% 1.77%
Ratio of allowance for loan losses to
non-performing loans at the end of the period 356.45% 137.73%
Ratio of allowance for loan losses to
non-performing assets at the end of the period 356.45% 137.73%
The following table sets forth the allocation of the Bank's Allowance for Loan
Losses among each of the categories listed.
At December 31, At December 31,
2002 2001
------------------------ ----------------------
% of Loans % of Loans
in Category in Category
to to
Amount Total Loans Amount Total Loans
---------- ----------- -------- -----------
Allowance:
Commercial loans:
Unsecured $ 290,496 17.8% $218,772 21.6%
Secured 55,186 6.3 290,535 8.6
Commercial real estate 567,390 49.1 279,512 42.5
Residential real estate loans 8,896 0.8 2,351 0.7
Construction loans 206,920 23.3 79,030 24.3
Other loans 39,470 2.7 24,492 2.3
---------- ----- -------- -----
Total allowances 1,168,358 100.0% 894,692 100.0%
---------- ===== -------- =====
Total allowance for
loan losses $1,168,358 $894,692
========== ========
Investment Activities
State-chartered banking institutions have the authority to invest in various
types of liquid assets, including United States Treasury Obligations, securities
of various federal agencies, certain certificates of deposits of insured
10
banks and savings institutions, certain bankers' acceptances, repurchase
agreements and federal funds. Additionally, it is appropriate for the Bank to
maintain investments for ongoing liquidity needs and the Bank has maintained
liquid assets at a level believed to be adequate to meet its normal daily
activities.
The investment policy of the Bank, established by the Board of Directors and
implemented by the Asset/Liability Committee, attempts to provide and maintain
liquidity, generate a favorable return on investments without incurring undue
interest rate and credit risk, and complement the Bank's lending activities.
Although the Bank classifies most of its securities portfolio as available for
sale, it is the Bank's practice to retain most of its securities until they
mature.
Specifically, the Bank's policies generally limit investments to government and
federal agency backed securities or AAA rated securities, including corporate
debt obligations, that are investment grade with weighted average lives of seven
years or less. The Bank's policies provide that all investment purchases be
ratified by the Board and may only be initiated by the President or Chief
Financial Officer of the Bank. At December 31, 2002, the Bank did not have any
money market securities. Investment securities consist of collateralized
mortgage obligations ("CMO") with an average life of 4.0 years or less,
mortgage-backed securities ("MBS") with a balloon maturity within seven years
and U.S. Treasury Bills with a maturity of less than 1 year. These CMOs and MBS
are backed by federal agencies such as Federal National Mortgage Association
("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC") or are "AAA"
rated whole loan securities. At December 31, 2002, the Bank had investment
securities, in the aggregate amount of $42,192,075 with a market value of
$42,999,660. The entire investment portfolio at December 31, 2002, was
classified as available for sale and is accounted on a fair market value basis.
The following table sets forth certain information regarding the carrying and
market values of the Bank's money market securities portfolio, which was
classified as held to maturity, at the dates indicated:
At December 31,
--------------------------------------
2002 2001
----------------- ------------------
Carrying Market Carrying Market
Value Value Value Value
-------- ------ -------- -------
Money market investments
Federal funds sold and
overnight deposits $ -- $ -- $ -- $ --
FHLB Term Deposits -- -- 50,187 50,187
----- ----- ------- -------
Total $ -- $ -- $50,187 $50,187
===== ===== ======= =======
The table below sets forth certain information regarding the carrying value,
weighted average yields and stated maturities of the Bank's money market
securities at December 31, 2002 and 2001.
11
At December 31,
-------------------------------------------------------
2002 2001
-------------------------- --------------------------
Weighted Weighted
Under 1 Average Under 1 Average
Year Yield Total Year Yield Total
------- -------- ----- ------- -------- -----
Money Market Securities:
Federal funds sold and
overnight deposits $ -- --% $ -- $ -- --% $ --
FHLB Term Deposits -- -- -- 50,187 -- --
------- ----- ------- -----
Total $ -- --% $ -- $50,187 --% $ --
======= ===== ======= =====
The following table sets forth certain information regarding the amortized cost
and market values of the investment securities, available for sale portfolio at
the dates indicated:
At December 31,
-----------------------------------------------------
2002 2001
------------------------- -------------------------
Amortized Market Amortized Market
Cost Value Cost Value
----------- ----------- ----------- -----------
Investments securities, available for sale
U.S. Treasuries -- -- $ 994,363 $ 995,890
FNMA 7 Year Balloon 1,103,196 1,183,522 2,029,830 2,115,047
FHLMC 2,886,223 2,957,504 2,238,701 2,232,368
Collateralized mortgage obligations 38,202,656 38,858,634 33,755,633 33,943,693
----------- ----------- ----------- -----------
$42,192,075 $42,999,660 $39,018,527 $39,286,998
=========== =========== =========== ===========
The table below sets forth certain information regarding the amortized cost
value, weighted average yields and stated maturities of the Bank's investment
securities at December 31, 2002 and 2001.
12
At December 31,
2002
---------------------------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average
1 Year Yield Years Yield Years Yield Years Yield Total
--------- -------- ---------- -------- ---------- -------- ----------- -------- -----------
Investment Securities:
FNMA 7 Year Balloon $ -- --% $1,103,196 6.76% $ -- --% $ -- --% $ 1,103,196
FHLMC -- -- -- -- 2,886,223 5.42 -- -- 2,886,223
Collateralized Mortgage
Obligations 57,999 5.92 256,209 7.12 3,806,064 5.15 34,082,384 5.07 38,202,656
------- ---------- ---------- ----------- -----------
Total $57,999 5.92% $1,359,405 6.83% $6,692,287 5.27% $34,082,384 5.07% $42,192,075
======= ========== ========== =========== ===========
At December 31,
2001
----------------------------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average
1 Year Yield Years Yield Years Yield Years Yield Total
--------- -------- ---------- -------- ----------- -------- ----------- -------- -----------
Investment Securities:
U.S. Treasuries $994,363 2.42% $ -- --% $ -- --% $ -- --% $ 994,363
FNMA 7 Year Balloon -- -- 2,029,830 6.70 -- -- -- -- 2,029,830
FHLMC -- -- -- -- 2,238,701 5.48 -- -- 2,238,701
Collateralized Mortgage
Obligations -- -- 283,385 5.99 8,137,584 5.89 25,334,664 5.77 33,755,633
-------- ---------- ----------- ----------- -----------
Total $994,363 2.42% $2,313,215 6.61% $10,376,285 5.80% $25,334,664 5.77% $39,018,527
======== ========== =========== =========== ===========
Source of Funds
General. Deposits are the primary source of the Bank's funds for use in lending,
investing and for other general purposes. In addition to deposits, the Bank
derives funds from loan principal repayments and prepayments. Loan repayments
are a relatively stable source of funds, while deposit inflows and outflows are
influenced by general interest rates and money market conditions.
Deposits. The Bank offers a variety of deposit accounts having a range of
interest rates and terms. The Bank's deposits consist of non-interest bearing
checking accounts, money market accounts, time deposit ("certificate") accounts,
statement savings and NOW accounts. The flow of deposits is influenced
significantly by general economic conditions, changes in money market rates,
prevailing interest rates and competition. The Bank's deposits are obtained
primarily from the areas in which its offices are located. Certificate accounts
in excess of $100,000, are not actively solicited by the Bank nor does the Bank
use brokers to obtain deposits. Management constantly monitors the Bank's
deposit accounts and, based on historical experience, management believes it
will retain a large portion of such accounts upon maturity. Deposit account
terms offered by the Bank vary according to the minimum balance required, the
time periods that the funds must remain on deposit and the interest rates, among
other factors. The Bank is not limited with respect to the rates that it may
offer on its deposits. In determining the characteristics of its deposit
accounts, consideration is given to profitability to the Bank, matching terms of
the deposits with loan products, the attractiveness to the customers and the
rates offered by the Bank's competitors.
The Bank's focus on customer service, primarily focused on the business and
professional community in its marketplace, has facilitated its retention of
non-interest bearing checking accounts and low costing NOW and money market
accounts, which generally have interest rates substantially less than
certificate of deposits. At December 31, 2002, these types of low cost deposit
accounts amounted to $98,297,536, or 79.5% of total deposits.
The following table presents the deposit activity of the Bank for the periods
indicated.
13
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2002 2001 2000
------------ ------------ ------------
Beginning balance $ 91,132,816 $58,951,626 $44,195,266
Net increase before interest credited 31,747,263 31,102,924 13,825,840
Interest credited on deposits 822,286 1,078,266 930,520
------------ ----------- -----------
Ending balance $123,702,365 $91,132,816 $58,951,626
============ =========== ===========
The following table represents time deposits at December 31, 2002 over $100,000:
Maturity Period Amount
--------------- ----------
Three months or less $6,861,925
Over three through six months 908,935
Over six through 12 months 490,759
Over 12 months 202,333
----------
Total $8,463,952
==========
The following table presents by various rate categories, the amount and the
periods to maturity of the certificate accounts outstanding at December 31,
2002.
Over Six Mos. Over One Year Over Two Years
Six Months Through One Through Two Through Three Over Three
And Less Year Years Years Years Total
----------- ------------- ------------- -------------- ---------- -----------
Certificate accounts:
1.00% to 1.99% $13,310,087 $1,871,524 $484,349 $ -- $ -- $15,665,960
2.00% to 2.99% 429,372 150,654 51,109 1,083,095 -- 1,714,230
3.00% to 3.99% -- -- -- 397,841 -- 397,841
4.00% to 4.99% -- -- -- -- -- --
----------- ---------- -------- ---------- ------ -----------
$13,739,459 $2,022,178 $535,458 $1,480,936 $ -- $17,778,031
=========== ========== ======== ========== ====== ===========
Borrowings
The Bank does not routinely utilize borrowings. At December 31, 2002 and 2001,
the Bank had no borrowings outstanding.
Personnel
As of December 31, 2002, the Bank had 36 full-time employees and 15 part-time
employee. These employees are not represented by a collective bargaining unit
and the Bank considers its relationship with its employees to be good.
14
REGULATION AND SUPERVISION
Regulation of VSB Bancorp, Inc.
VSB, as a New York corporation, is subject to and governed by the New York
Business Corporation Law. VSB will be a bank holding company or a financial
holding company, and thus will be subject to regulation, supervision, and
examination by the Federal Reserve. The Bank is subject to regulation,
supervision, and examination by the FDIC as its primary federal regulator and by
the New York State Banking Department as its state regulator.
Bank Holding Company Regulation. As a bank holding company, VSB will be required
to file periodic reports and other information with the Federal Reserve, and the
Federal Reserve may conduct examinations of VSB.
After the holding company reorganization, VSB will be subject to capital
adequacy guidelines of the Federal Reserve. The guidelines apply on a
consolidated basis and require bank holding companies to maintain a minimum
ratio of tier 1 capital to total assets of 4.0%. The minimum ratio is 3.0% for
the most highly rated bank holding companies. The Federal Reserve's capital
adequacy guidelines also require bank holding companies to maintain a minimum
ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum
ratio of tier 1 capital to risk-weighted assets of 4.0%. As of December 31,
2002, the Bank's ratio of Tier 1 capital to total assets was 7.0%, its ratio of
Tier 1 capital to risk-weighted assets was 11.45%, and its ratio of qualifying
total capital to risk-weighted assets was 12.71%. Immediately after the holding
company reorganization, the capital ratios of VSB will be substantially
identical to the capital ratios of the Bank at that time.
VSB's ability to pay dividends can be restricted if its capital falls below
levels established by the Federal Reserve's guidelines.
Federal Reserve approval is required if VSB seeks to acquire direct or indirect
ownership or control of 5% or more of the voting shares of a bank or bank
holding company. Federal Reserve approval also must be obtained for VSB to
acquire all or substantially all the assets of a bank or merge or consolidate
with another bank holding company. These provisions also would apply to a bank
holding company that sought to acquire 5% or more of the common stock of or to
merge or consolidate with VSB.
Bank holding companies like VSB are currently prohibited from engaging in
activities other than banking and activities so closely related to banking or
managing or controlling banks as to be a proper incident thereto. The Federal
Reserve regulations contain a list of permissible non-banking activities, that
are closely related to banking or managing or controlling banks and the Federal
Reserve has identified a limited number of additional activities by order. These
activities include lending activities, certain data processing activities, and
securities brokerage and investment advisory services, trust activities and
leasing activities. A bank holding company must file an application or a notice
with the Federal Reserve prior to acquiring more than 5% of the voting shares of
a company engaged in such activities. A bank holding company that is well
capitalized and well managed and meets other conditions may provide notice after
making the acquisition.
After the holding company reorganization, VSB will have the right to elect to be
treated as a financial holding company if the Bank is well capitalized and well
managed and has at least a satisfactory record of performance under the
Community Reinvestment Act. Financial holding companies that meet certain
conditions may engage in activities that are financial in nature or incidental
to financial activities, or activities that are complementary to a financial
activity and do not pose a substantial risk to the safety and soundness of
depository institutions or the financial system generally. Federal law
identifies certain activities that are deemed to be financial in nature,
including non-banking activities currently permissible for bank holding
companies to engage in both within and outside the United States, as well as
insurance and securities underwriting and merchant banking activities. The
Federal Reserve may identify additional activities that are permissible
financial activities. No prior notice to the Federal Reserve is required for a
financial holding company to acquire a company engaged in these activities or to
15
commence these activities directly or indirectly through a subsidiary.
VSB has not elected to be treated as a financial holding company since it has no
current plans to use the authority to engage in expanded activities. However, it
may elect to do so in the future.
Restrictions on Acquisition of VSB and the Bank
Applicable provisions of the New York Banking Law, the federal Bank Holding
Company Act, and other federal statutes, restrict the ability of persons or
entities to acquire control of a bank holding company such as VSB. Under the
Change in Bank Control Act, persons who intend to acquire control of a bank
holding company, either directly or indirectly or through or in concert with one
or more persons must give 60 days' prior written notice to the Federal Reserve.
"Control" would exist when an acquiring party directly or indirectly has voting
control of at least 25% of VSB's voting securities or the power to direct the
management or policies of the company. Under Federal Reserve regulations, a
rebuttable presumption of control would arise with respect to an acquisition
where, after the transaction, the acquiring party has ownership control, or the
power to vote at least 10% (but less than 25%) of VSB's common stock.
The New York Banking Law requires prior approval of the New York Banking Board
before any action is taken that causes any company to acquire direct or indirect
control of a banking institution that is organized in the State of New York. The
term "control" is defined generally to mean the power to direct or cause the
direction of the management and policies of the banking institution and is
presumed to exist if the company owns, controls or holds with power to vote 10%
or more of the voting stock of the banking institution.
Section 912 of the New York Business Corporation Law, known as the New York
Anti-Takeover Law, restricts the ability of interested stockholders to engage in
business combinations with a New York corporation. In general terms, Section 912
prohibits any New York corporation covered by the statute from merging with an
interested shareholder (i.e., one who owns 20% or more of the outstanding voting
stock) for five years following the date on which the interested shareholder
first acquired 20% of the stock, unless before that date the Board of Directors
of the corporation had approved either the merger or the interested
shareholder's stock purchase.
Section 912 defines an interested stockholder as the beneficial owner, directly
or indirectly, of 20% or more of the outstanding voting stock of a corporation;
and certain other entities that have owned 20% or more of a corporation's stock
during the past five years. A business combination is defined as a merger,
consolidation, sale of 10% or more of the assets, or similar transaction.
Unless an interested stockholder waits five years after becoming an interested
stockholder to engage in a business combination, the business combination is
prohibited unless the Board of Directors of VSB has approved either (a) the
business combination or (b) the acquisition of stock by the interested
stockholder, before the interested stockholder acquired its 20% interest. Even
though the interested stockholder waits five years, the business combination is
prohibited unless either:
(i) the business combination or the acquisition of stock by the interested
stockholder was approved by the Board of Directors before the interested
stockholder acquired its 20% interest;
(ii) the business combination is approved by a majority vote of all
outstanding shares of stock not beneficially owned by the interested stockholder
or its affiliates or associates at a meeting held at least five years after the
interested stockholder becomes an interested stockholder; or
(iii) the price paid for common stock acquired in the business combination
is, in general terms, at least as much as the greater of (a) highest price paid
by the interested stockholder for any stock since the interested stockholder
first owned 5% of the stock of the corporation, or (b) the market value of the
stock as of the date of announcement of the business combination; and the price
paid for stock other than common stock is subject to comparable minimum
standards.
16
Regulation of the Bank
The Bank is subject to extensive regulation and examination by the New York
State Banking Department ("Department"), as its chartering authority, and by the
FDIC, as the insurer of its deposits. The federal and state laws and regulations
which are applicable to banks regulate, among other things, the scope of their
business, their investments, their reserves against deposits, the timing of the
availability of deposited funds and the nature and amount of and collateral for
certain loans. The Bank must file reports with the Department and the FDIC
concerning its activities and financial condition, in addition to obtaining
regulatory approvals prior to entering into certain transactions such as
establishing branches and mergers with, or acquisitions of, other depository
institutions. There are periodic examinations by the Department and the FDIC to
test the Bank's compliance with various regulatory requirements. This regulation
and supervision establishes a comprehensive framework of activities in which an
institution can engage and is intended primarily for the protection of the
insurance fund and depositors. The regulatory structure also gives the
regulatory authorities extensive discretion in connection with their supervisory
and enforcement activities and examination policies, including policies with
respect to the classification of assets and the establishment of adequate loan
loss reserves for regulatory purposes. Any change in such regulation, whether by
the Department, the FDIC or as a result of the enactment of legislation, could
have a material adverse impact on the Bank and their operations.
Capital Requirements
The FDIC promulgated regulations and adopted a statement of policy regarding the
capital adequacy of state-chartered banks, which, like the Bank, are not members
of the Federal Reserve System.
The FDIC's capital regulations establish a minimum 3.0% Tier I leverage capital
requirement for the most highly-rated state-chartered, non-member banks, with an
additional cushion of at least 100 to 200 basis points for all other
state-chartered, non-member banks, which effectively will increase the minimum
Tier I leverage ratio for such other banks to 4.0% to 5.0% or more. Under the
FDIC's regulation, the highest-rated banks are those that the FDIC determines
are not anticipating or experiencing significant growth and have well
diversified risk, including no undue interest rate risk exposure, excellent
asset quality, high liquidity, good earnings and, in general, which are
considered a strong banking organization and are rated composite 1 under the
Uniform Financial Institutions Rating System. Tier I or core capital is defined
as the sum of common stockholders' equity (including retained earnings),
non-cumulative perpetual preferred stock and related surplus, and minority
interests in consolidated subsidiaries, minus all intangible assets other than
certain qualifying supervisory goodwill and certain mortgage servicing rights.
The FDIC also requires that banks meet a risk-based capital standard. The
risk-based capital standard for banks requires the maintenance of a ratio of
total capital (which is defined as Tier I capital and supplementary capital) to
risk-weighted assets of 8.0% and Tier I capital to risk-weighted assets of 4%.
In determining the amount of risk-weighted assets, all assets, plus certain
off-balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based
on the risks the FDIC believes are inherent in the type of asset or item. The
components of Tier I capital are the same as for the leverage capital standard.
The components of supplementary capital include certain perpetual preferred
stock, certain mandatory convertible securities, certain subordinated debt and
intermediate preferred stock and general allowances for loan and lease losses.
Allowance for loan and lease losses includable in supplementary capital is
limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of
capital counted toward supplementary capital cannot exceed 100% of core capital.
At December 31, 2002, the Bank met each of its capital requirements.
In August 1995, the FDIC, along with the other federal banking agencies, adopted
a regulation providing that the agencies will take account of the exposure of a
bank's capital and economic value to changes in interest rate risk in assessing
a bank's capital adequacy. According to the agencies, applicable considerations
include the quality of the bank's interest rate risk management process, the
overall financial condition of the bank and the level of other risks at the bank
for which capital is needed. Institutions with significant interest rate risk
may be required to hold additional capital. The agencies issued a joint policy
statement providing guidance on interest rate risk management, including a
discussion of the critical factors affecting the agencies' evaluation of
interest rate risk in
17
connection with capital adequacy. The agencies have determined not to proceed
with a previously issued proposal to develop a supervisory framework for
measuring interest rate risk and an explicit capital component for interest rate
risk.
The following table is the Bank's actual capital amounts and ratios. No
deductions were made for qualitative judgments by regulators:
To be well-capitalized
For capital under prompt corrective
Actual adequacy purposes action provisions
------------------- ------------------ -----------------------
Amount Ratio Amount Ratio Amount Ratio
----------- ----- ---------- ----- ---------- -----
As of December 31, 2002
Tier 1 Capital
(to Average Assets) $ 9,336,000 7.00% $5,333,760 4.00% $6,667,200 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 9,336,000 11.43% 3,268,240 4.00% 4,902,360 6.00%
Total Capital
(to Risk Weighted Assets) 10,359,000 12.68% 6,536,480 8.00% 8,170,600 10.00%
Activities and Investments of New York-Chartered Banks.
The Bank derives its lending, investment and other authority primarily from the
applicable provisions of New York State Banking Law and the regulations of the
Department, as limited by FDIC regulations and other federal laws and
regulations. See "- Activities and Investments of FDIC Insured State-Chartered
Banks." These New York laws and regulations authorize banks, including the Bank,
to invest in real estate mortgages, consumer and commercial loans, certain types
of debt securities, including certain corporate debt securities and obligations
of federal, State and local governments and agencies, certain types of corporate
equity securities and certain other assets. Under the statutory authority for
investing in equity securities, a bank may directly invest up to 7.5% of its
assets in certain corporate stock and may also invest up to 7.5% of its assets
in certain mutual fund securities. Investment in stock of a single corporation
is limited to the lesser of 2% of the outstanding stock of such corporation or
1% of the bank's assets, except as set forth below. Such equity securities must
meet certain tests of financial performance. A bank's aggregate lending powers
are not subject to percentage of asset limitations, although there are limits
applicable to single borrowers. A New York-chartered bank may also exercise
trust powers upon approval of the Department. The Bank does not have trust
powers.
The New York Banking Board has the power to adopt regulations that enable state
chartered banks to exercise the rights, powers and privileges permitted for a
national bank. The statute granting the power to adopt such regulations expires
on September 10, 2003, but any regulations already adopted would continue to be
effective. The Bank has not engaged in material activities authorized by such
regulations.
With certain limited exceptions, a New York-chartered bank may not make loans or
extend credit for commercial, corporate or business purposes (including lease
financing) to a single borrower, the aggregate amount of which would be in
excess of 15% of the Bank's net worth, on an unsecured basis, and 25% of the net
worth if the loan is collateralized by readily marketable collateral or
collateral otherwise having a value equal to the amount by which the loan
exceeds 15% of the Bank's net worth. The Bank currently complies with all
applicable loans-to-one-borrower limitations.
Activities and Investments of FDIC-Insured State-Chartered Banks.
The activities and equity investments of FDIC-insured, state-chartered banks are
generally limited to those that are permissible for national banks. Under
regulations dealing with equity investments, an insured state bank generally may
not directly or indirectly acquire or retain any equity investment of a type, or
in an amount, that is not permissible for a national bank. An insured state bank
is not prohibited from, among other things, (i)
18
acquiring or retaining a majority interest in a subsidiary, (ii) investing as a
limited partner in a partnership the sole purpose of which is direct or indirect
investment in the acquisition, rehabilitation or new construction of a qualified
housing project, provided that such limited partnership investments may not
exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting
stock of a company that solely provides or reinsures directors', trustees' and
officers' liability insurance coverage or bankers' blanket bond group insurance
coverage for insured depository institutions, and (iv) acquiring or retaining
the voting shares of a depository institution if certain requirements are met.
In addition, an FDIC-insured state-chartered bank may not directly, or
indirectly through a subsidiary, engage as "principal" in any activity that is
not permissible for a national bank unless the FDIC has determined that such
activities would pose no risk to the insurance fund of which it is a member and
the bank is in compliance with applicable regulatory capital requirements.
Regulatory Enforcement Authority
Applicable banking laws include substantial enforcement powers available to
federal banking regulators. This enforcement authority includes, among other
things, the ability to assess civil money penalties, to issue cease-and-desist
or removal orders and to initiate injunctive actions against banking
organizations and institution-affiliated parties, as defined. In general, these
enforcement actions may be initiated for violations of laws and regulations and
unsafe or unsound practices. Other actions or inactions may provide the basis
for enforcement action, including misleading or untimely reports filed with
regulatory authorities.
Under the New York State Banking Law, the Department may issue an order to a New
York-chartered banking institution to appear and explain an apparent violation
of law, to discontinue unauthorized or unsafe practices and to keep prescribed
books and accounts. Upon a finding by the Department that any director, trustee
or officer of any banking organization has violated any law, or has continued
unauthorized or unsafe practices in conducting the business of the banking
organization after having been notified by the Department to discontinue such
practices, such director, trustee or officer may be removed from office by the
Department after notice and an opportunity to be heard. The Bank does not know
of any past or current practice, condition or violation that might lead to any
proceeding by the Department against the Bank or any of its directors or
officers. The Department also may take possession of a banking organization
under specified statutory criteria.
Prompt Corrective Action.
Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the federal
banking regulators with broad power to take "prompt corrective action" to
resolve the problems of undercapitalized institutions. The extent of the
regulators' powers depends on whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." Under regulations adopted by
the federal banking regulators, an institution shall be deemed to be (i) "well
capitalized" if it has total risk-based capital ratio of 10.0% or more, has a
Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital
ratio of 5.0% or more and is not subject to specified requirements to meet and
maintain a specific capital level for any capital measure, (ii) "adequately
capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier
I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio
of 4.0% or more (3.0% under certain circumstances) and does not meet the
definition of "well capitalized," (iii) "undercapitalized" if it has a total
risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital
ratio that is less than 4.0% or a Tier I leverage capital ratio that is less
than 4.0% (3.0% under certain circumstances), (iv) "significantly
undercapitalized" if it has a total risk-based capital ratio that is less than
6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I
leverage capital ratio that is less than 3.0%, and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. The regulations also provide that a federal banking
regulator may, after notice and an opportunity for a hearing, reclassify a "well
capitalized" institution as "adequately capitalized" and may require an
"adequately capitalized" institution or an "undercapitalized" institution to
comply with supervisory actions as if it were in the next lower category if the
institution is in an unsafe or unsound condition or engaging in an unsafe or
unsound practice. The federal banking regulator may not, however, reclassify a
"significantly undercapitalized" institution as "critically undercapitalized."
An institution generally must file a written capital restoration plan which
meets specified requirements, as well as
19
a performance guaranty by each company that controls the institution, with an
appropriate federal banking regulator within 45 days of the date that the
institution receives notice or is deemed to have notice that it is
"undercapitalized," "significantly undercapitalized" or "critically
undercapitalized." Immediately upon becoming undercapitalized, an institution
becomes subject to statutory provisions, which, among other things, set forth
various mandatory and discretionary restrictions on the operations of such an
institution.
At December 31, 2002, the Bank had capital levels, which qualified it as a
"well-capitalized" institution.
FDIC Insurance
The Bank is a member of the Bank Insurance Fund ("BIF") administered by the
FDIC. As insurer, the FDIC is authorized to conduct examinations of, and to
require reporting by, FDIC-insured institutions. It also may prohibit any
FDIC-insured institution from engaging in any activity the FDIC determines by
regulation or order to pose a serious threat to the FDIC.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines, after a hearing, that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances, which would result
in termination of the Bank's deposit insurance.
Brokered Deposits
The FDIA restricts the use of brokered deposits by certain depository
institutions. Under federal law and applicable regulations, (i) a "well
capitalized insured depository institution" may solicit and accept, renew or
roll over any brokered deposit without restriction, (ii) an "adequately
capitalized insured depository institution" may not accept, renew or roll over
any brokered deposit unless it has applied for and been granted a waiver of this
prohibition by the FDIC and (iii) an "undercapitalized insured depository
institution" may not (x) accept, renew or roll over any brokered deposit or (y)
solicit deposits by offering an effective yield that exceeds by more than 75
basis points the prevailing effective yields on insured deposits of comparable
maturity in such institution's normal market area or in the market area in which
such deposits are being solicited. The term "undercapitalized insured depository
institution" is defined to mean any insured depository institution that fails to
meet the minimum regulatory capital requirement prescribed by its appropriate
federal banking agency. The FDIC may, on a case-by-case basis and upon
application by an adequately capitalized insured depository institution, waive
the restriction on brokered deposits upon a finding that the acceptance of
brokered deposits does not constitute an unsafe or unsound practice with respect
to such institution. The Bank had no brokered deposits outstanding at December
31, 2002.
Community Investment and Consumer Protection Laws
In connection with its lending activities, the Bank is subject to a variety of
federal laws designed to protect borrowers and promote lending to various
sectors of the economy and population. Included among these are the Home
Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending
Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community
Reinvestment Act ("CRA").
The CRA requires insured institutions to define the assessment areas that they
serve, identify the credit needs of those assessment areas and take other
actions that respond to the credit needs of the community. The responsible
federal banking regulator (in the case of the Bank, the FDIC) must conduct
regular CRA examinations of insured financial institutions and assign to them a
CRA rating of "outstanding," "satisfactory," "needs improvement" or
"unsatisfactory." The Bank is also subject to provisions of
20
the New York State Banking Law which impose continuing and affirmative
obligations upon banking institutions organized in New York State to serve the
credit needs of its assessment areas ("NYCRA"), which are similar to those
imposed by the CRA. Pursuant to the NYCRA, a bank must file an annual NYCRA
report and copies of all federal CRA reports with the Department. The NYCRA
requires the Department to make a biennial written assessment of a bank's
compliance with the NYCRA, utilizing a four-tiered rating system, and make such
assessment available to the public. The NYCRA also requires the Department to
consider a bank's NYCRA rating when reviewing a bank's application to engage in
certain transactions, including mergers, asset purchases and the establishment
of branch offices or automated teller machines, and provides that such
assessment may serve as a basis for the denial of any such application. The Bank
has received "Satisfactory" ratings from both the Department and the FDIC.
Limitations on Dividends
The payment of dividends by the Bank is subject to various regulatory
requirements. Under New York State Banking Law, a New York-chartered stock bank
may declare and pay dividends out of its net profits, unless there is an
impairment of capital, but approval of the Department is required if the total
of all dividends declared in a calendar year would exceed the total of its net
profits for that year combined with its retained net profits of the preceding
two years, subject to certain adjustments.
Miscellaneous
The Bank is subject to certain restrictions on loans to its non-bank
subsidiaries, on investments in the stock or securities thereof, on the taking
of such stock or securities as collateral for loans to any borrower, and on the
issuance of a guarantee or letter of credit on behalf of the Bank or its
non-bank subsidiaries. The Bank also is subject to certain restrictions on most
types of transactions with the Bank or its non-bank subsidiaries, requiring that
the terms of such transactions be substantially equivalent to terms of similar
transactions with non-affiliated firms.
Assessments
Banking institutions are required by FDIC and NYSBD regulation to pay
assessments to both the FDIC and the NYSBD to fund their respective operations.
The FDIC general assessment, paid on a quarterly basis, is computed upon the
institution's total assets, including consolidated subsidiaries, as reported in
the Bank's latest quarterly call report. The NYSBD general assessment, paid on a
quarterly basis, is computed upon the institution's total assets, including
consolidated subsidiaries, as reported in the Bank's last fiscal year.
Additionally, the Bank is required to pay an examination fee to the NYSBD when
they conduct an examination. The assessments and examination fees paid by the
Bank in fiscal 2002 totaled $50,821.
Transactions with Related Parties
The Bank's authority to engage in transactions with related parties or
"affiliates" (i.e., any entity that controls or is under common control with an
institution, including the Bank) or to make loans to certain insiders, is
limited by Sections 23A and 23B of the Federal Reserve Act ("FRA"). Section 23A
limits the aggregate amount of transactions with any individual affiliate to 10%
of the capital and surplus of the institution and also limits the aggregate
amount of transactions with all affiliates to 20% of the institution's capital
and surplus.
Certain transactions with affiliates are required to be secured by collateral in
an amount and of a type described in Section 23A and the purchase of low quality
assets from affiliates is generally prohibited. Section 23B provides that
certain transactions with affiliates, including loans and asset purchases, must
be on terms and under circumstances, including credit standards, that are
substantially the same or at least as favorable to the institution as those
prevailing at the time for comparable transactions with nonaffiliated companies.
In the absence of comparable transactions, such transactions may only occur
under terms and circumstances, including credit standards that in good faith
would be offered to or would apply to nonaffiliated companies.
The Bank's authority to extend credit to executive officers, directors and 10%
shareholders, as well as entities
21
controlled by such persons, is currently governed by Regulation O of the Federal
Reserve Board. Regulation O generally requires such loans to be made on terms
substantially similar to those offered to unaffiliated individuals (except for
preferential loans made in accordance with broad based employee benefit plans),
places limits on the amount of loans the Bank may make to such persons based, in
part, on the Bank's capital position, and requires certain approval procedures
to be followed.
Standards for Safety and Soundness
FDICIA requires each federal banking agency to prescribe for all insured
depository institutions and their holding companies standards relating to
internal controls, information systems and audit systems, loan documentation,
credit underwriting, interest rate risk exposure, asset growth and compensation,
fees and benefits and such other operational and managerial standards as the
agency deems appropriate. In addition, FDICIA required the federal banking
regulatory agencies to prescribe by regulation standards specifying (i) maximum
classified assets-to-capital ratios; (ii) minimum earnings sufficient to absorb
losses without impairing capital; (iii) to the extent feasible, a minimum ratio
of market value to book value for publicly traded shares of depository
institutions or the depository institution holding companies and (iv) such other
standards relating to asset quality, earnings and valuation as the agency deems
appropriate. Finally, each federal banking agency is required to prescribe
standards for employment contracts and other compensation arrangements of
executive officers, employees, directors and principal stockholders of insured
depository institutions that would prohibit compensation and benefits and
arrangements that are excessive or that could lead to a material financial loss
for the institution. If an insured depository institution or its holding Bank
fails to meet any of its standards described above, it will be required to
submit to the appropriate federal banking agency a plan specifying the steps
that will be taken to cure the deficiency. If an institution fails to submit an
acceptable plan or fails to implement the plan, the appropriate federal banking
agency will require the institution or holding Bank to correct the deficiency
and until corrected, may impose restrictions on the institution or holding Bank,
including any of the restrictions applicable under the prompt corrective action
provisions of FDICIA. The federal banking agencies, including the NYSBD and the
FDIC, adopted a proposed rule regarding implementation of these standards.
FDICIA also requires each appropriate federal banking agency to adopt uniform
regulations prescribing standards for extensions of credit (i) secured by real
estate or (ii) made for the purpose of financing the construction of
improvements on real estate. In prescribing these standards, the banking
agencies must consider the risk posed to the deposit insurance funds by real
estate loans, the need for safe and sound operation of insured depository
institutions and the availability of credit. The NYSBD and the other federal
banking agencies adopted uniform regulations, effective March 19, 1997,
implementing such standards. Institutions also are permitted to make a limited
amount of loans that do not conform to the proposed loan-to-value limitations so
long as such exceptions are reviewed and justified appropriately. The guidelines
also list a number of lending situations in which exceptions to the
loan-to-value standards are justified.
Federal Reserve System
The Federal Reserve Board regulations require banks to maintain non-interest
earning reserves against their transaction accounts (primarily NOW and regular
checking accounts). The Federal Reserve Board regulations generally require that
reserves be maintained against aggregate transaction accounts as follows: for
accounts aggregating $35.6 million or less (subject to adjustment by the Federal
Reserve Board) the reserve requirement is 3%; for accounts greater than $35.6
million, the reserve requirement is $1.1 million plus 10% (subject to adjustment
by the Federal Reserve Board between 8% and 14%) against that portion of total
transaction accounts in excess of $35.6 million. The first $5.7 million of
otherwise reservable balances (subject to adjustments by the Federal Reserve
Board) are exempted from the reserve requirements. The Bank is in compliance
with the foregoing requirements. Because required reserves must be maintained in
the form of either vault cash, a non-interest-bearing account at a Federal
Reserve Bank or a pass-through account as defined by the Federal Reserve Board,
the effect of this reserve requirement is to reduce the Bank's interest-earning
assets.
22
TAXATION
Federal Taxation
General
VSB will be subject to federal income taxation in the same general manner as
other corporations with some exceptions discussed below. The following
discussion of federal taxation is intended only to summarize certain pertinent
federal income tax matters and is not a comprehensive description of the tax
rules applicable to the VSB and Bank. The Bank's federal income tax returns have
not been audited or closed without audit by the Internal Revenue Service.
Method of Accounting
VSB will report its income and expenses on the accrual method of accounting and
use a tax year ending December 31 for filing its consolidated federal income tax
returns. VSB will file consolidated tax returns with the Bank.
Bad Debt Reserves
The Bank uses the specific charge-off method in computing its bad debt
deductions for federal tax purposes.
Minimum Tax
The Internal Revenue Code imposes an alternative minimum tax ("AMT") at a rate
of 20% on a base of regular taxable income plus certain tax preferences
("alternative minimum taxable income" or "AMTI"). The AMT is payable to the
extent such AMTI is in excess of an exemption amount. Net operating losses can
offset no more than 90% of AMTI. Certain payments of alternative minimum tax may
be used as credits against regular tax liabilities in future years. The Bank has
not been subject to the alternative minimum tax and has no such amounts
available as credits for carryover.
State and Local Taxation
New York State and New York City Taxation.
VSB will report income on a combined calendar year basis to both New York State
and New York City. New York State Franchise Tax on corporations is imposed in an
amount equal to the greater of (a) 9% of "entire net income" allocable to New
York State (b) 3% of "alternative entire net income" allocable to New York State
(c) 0.01% of the average value of assets allocable to New York State or (d)
nominal minimum tax. Entire net income is based on federal taxable income,
subject to certain modifications. Alternative entire net income is equal to
entire net income without certain modifications. The New York City Corporation
Tax is imposed using similar alternative taxable income methods and rates.
A temporary Metropolitan Transportation Business Tax Surcharge on banking
corporations doing business in the Metropolitan District has been applied since
1982. The Bank transacts a significant portion of its business within this
District and is subject to this surcharge. For the tax year ended December 31,
1996, the surcharge rate is 17% of the State franchise tax liability. New York
City does not impose surcharges applicable to the Bank.
For New York State and City tax purposes, the bad debt deduction may be computed
using a specific formula based on the Bank's loss history ("Experience Method")
or a statutory percentage equal to 32% of the Bank's New York State or City
taxable income ("Percentage Method").
23
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
General
VSB Bancorp, Inc. ("VSB") currently engages in no business. Upon the completion
of the holding company reorganization, the financial condition and results of
operations of VSB will be consolidated with the financial condition and results
of operations of Victory State Bank (the "Bank"). The following presentation
discusses the financial condition and results of operations of the Bank, and
related matters, for prior periods.
The Bank is a state-chartered, stock commercial bank, which was formed on
November 13, 1997 with initial capital of $7,000,000. The initial capital was
raised in a public offering, primarily in the borough of Staten Island. The Bank
issued 700,000 shares of common stock at an offering price of $10.00 per share,
$5.00 per share par value. The Bank had net organization costs of $216,000,
which it fully expensed in 1997. The Bank's stock is quoted on the NASDAQ Over
the Counter Market ("OTC") under the symbol "VYSB". The Bank serves its primary
market of Staten Island.
The Bank's results of operations are dependent primarily on net interest income,
which is the difference between the income earned on its loan and investment
portfolios and its costs of funds, consisting of interest paid on its deposits.
The Bank's operating expenses principally consist of employee compensation and
benefits, occupancy expenses, professional fees, advertising and marketing
expenses and other general and administrative expenses. The Bank's results of
operations are significantly affected by general economic and competitive
conditions, particularly changes in market interest rates, government policies
and actions of regulatory authorities.
Asset/Liability Management
The Bank maintains its interest rate sensitivity "gap" position by maintaining a
portfolio of government guaranteed investments with short and intermediate terms
to maturity and originating and retaining Prime based loans whenever possible.
As of December 31, 2002, the Bank did not have any money market assets; and
Prime Rate based loans, which are loans tied to the Prime Rate, totaled
$51,148,054, or 80.2% of total loans. Many of these Prime based loans are
subject to interest rate floors of 7.00% to 7.50%. The Bank anticipates that it
will continue to originate Prime based loans in its principal market areas as
the primary investment of its assets. The Bank also expects to continue to
invest excess funds in short-term investment grade securities.
Interest Rate Sensitivity Analysis. The matching of assets and liabilities may
be analyzed by examining the extent to which such assets and liabilities are
"interest rate sensitive" and by monitoring an institution's interest rate
sensitivity "gap." An asset or liability is said to be interest rate sensitive
within a specific time period if it will mature or reprice within that time
period. The interest rate sensitivity gap is defined as the difference between
the amount of interest-earning assets maturing or repricing within a specific
time period and the amount of interest-bearing liabilities maturing or repricing
within that time period. A gap is considered positive when the amount of
interest rate sensitive assets exceeds the amount of interest rate sensitive
liabilities.
A gap is considered negative when the amount of interest rate sensitive
liabilities exceeds the amount of interest rate sensitive assets. During a
period of falling interest rates therefore, the net income of an institution
with a positive gap theoretically may be adversely affected due to its
interest-earning assets repricing faster than its interest-bearing liabilities.
Conversely, during a period of rising interest rates, theoretically the net
income of an institution with a positive gap position may increase as it is able
to invest in higher yielding interest-earning assets at a more rapid rate than
its interest-earning liabilities reprice. A positive gap may not protect an
institution with a large portfolio of adjustable rate based loans or
mortgage-backed securities from rises in interest rates for extended time
periods as such instruments generally have annual and lifetime interest rate
caps. Accordingly, interest rates and the resulting cost of funds increases in a
rapidly increasing rate environment could exceed the cap levels on these
instruments and negatively impact net interest income. The Bank's prime rate
based loans generally do not have any annual or lifetime caps.
In the current interest rate environment, the Bank generally has been investing
in government agency notes with maturities of six months or less. The Bank has
refrained from investing in securities with longer term maturities. As a result
of this strategy, and based upon the assumptions used in the following table at
December 31, 2002, the Bank's
24
total interest-earning assets maturing or repricing within one year exceeded its
total interest-bearing liabilities maturing or repricing in the same period by
$21,460,340 representing a one year cumulative gap ratio of positive 20.37%. The
Bank closely monitors its interest rate risk as such risk relates to its
operational strategies. The Bank's Board of Directors has established an
Asset/Liability Committee, responsible for reviewing its asset/liability
policies and interest rate risk position, which generally meets quarterly and
reports to the Board of Directors on interest rate risk and trends on a
quarterly basis. The Bank is currently attempting to maintain a positive gap
position in light of the current interest rate environment. There can be no
assurance, however, that the Bank will be able to maintain its positive gap
position or that its strategies will not result in a negative gap position in
the future. To the extent that the Bank's core deposits are reduced at a more
rapid rate than the Bank's decay assumptions on such deposits, the Bank's
current positive gap positions could be negatively impacted. Although the Bank
has not experienced a material runoff in its core deposits, there can be no
assurances that such a runoff will not occur in the future if depositors seek
higher yielding investments.
The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at December 31, 2002 which the Bank
estimates, based upon certain assumptions, will reprice or mature in each of the
future time periods shown. Except as stated below, the amount of assets and
liabilities shown which reprice or mature during a particular period were
determined in accordance with the earlier of term to repricing or the
contractual terms of the asset or liability. The Bank's loan prepayment
assumptions are based on peer banks' historical performance and statistics,
including a 26.7% prepayment assumption on other loans and a 38.0% prepayment
assumption on fixed-rate loans. Additionally, the Bank, based upon peer data,
utilized deposit decay rate assumptions of 10% for savings accounts, NOW
accounts and 85% for money market deposit accounts in the one year or less
category. Given the current interest rate environment, there can be no assurance
that deposits would reprice to peer bank's historical levels if interest rates
were to increase.
25
At December 31, 2002
--------------------------------------------------------------------
Three Four More than
months to twelve One year to More than
or less months five years five years Total
----------- ----------- ----------- ----------- ------------
Interest-earning assets:
Commercial loans (1) $58,845,505 $ 295,530 $ 1,805,743 $ -- $ 60,946,778
Consumer loans (1) 743,220 305,672 1,430,670 -- 2,479,562
Money market investments -- -- -- -- --
Mortgage-backed securities 3,697,747 11,093,241 27,138,636 -- 41,929,624
Investment securities -- -- -- -- --
----------- ----------- ----------- ----------- ------------
Total interest-earning assets 63,286,472 11,694,443 30,375,049 -- 105,355,964
Less:
Unearned discount and deferred fees(2) (61,755) (185,265) 169,870 -- (77,150)
----------- ----------- ----------- ----------- ------------
Net interest-earning assets 63,224,717 11,509,178 30,544,919 -- 105,278,814
Interest-bearing liabilities:
Savings accounts (3) 3,050,719 381,340 2,288,039 1,906,700 7,626,798
NOW accounts (3) 10,629,248 1,328,656 7,971,936 6,643,280 26,573,120
Money market accounts (3) 20,820,664 1,301,292 2,602,583 1,301,291 26,025,830
Certificate accounts 10,894,202 4,867,434 2,016,394 -- 17,778,030
----------- ----------- ----------- ----------- ------------
Total interest-bearing liabilities 45,394,833 7,878,722 14,878,952 9,851,271 78,003,778
Interest sensitivity gap $17,829,884 $ 3,630,456 $15,665,967 $(9,851,271) $ 27,275,036
=========== =========== =========== =========== ============
Cumulative interest sensitivity gap $17,829,884 $21,460,340 $37,126,307 $27,275,036 $ 27,275,036
=========== =========== =========== =========== ============
Cumulative interest sensitivity gap as
a percentage of total interest-earning
assets 16.92% 20.37% 35.24% 25.89% 25.89%
Cumulative net interest-earning assets
as a percentage of interest-bearing
liabilities 139.28% 140.28% 154.48% 134.97% 134.97%
(1) For purposes of the gap analysis, mortgage and other loans are reduced for
non-performing loans but are not reduced for the allowance for possible
loan losses.
(2) For purposes of the gap analysis, unearned discount and deferred fees are
pro-rated.
(3) The Bank, based upon peer data, utilizes deposit decay rate assumptions of
10% for savings accounts, NOW accounts and 85% for money market deposit
accounts in the one year or less category.
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. For example, although certain assets and liabilities may have
similar maturities or periods to repricing, they may react in different degrees
to changes in market interest rates. Also, the interest rates on certain types
of assets and liabilities may fluctuate in advance of changes in market interest
rates, while interest rates on other types may lag behind changes in market
rates. Additionally, certain assets may have features which restrict changes in
interest rates on a short-term basis and over the life of the asset. For
example, if a Prime Rate loan has a minimum interest rate of 7.5%, an increase
in the currently very low prime rate might not be sufficient to increase the
interest rate on the loan to more than the minimum. Further, in the event of a
change in interest rates, prepayment and early withdrawal levels would likely
deviate significantly from those assumed in calculating the table. Finally, the
ability of many borrowers to service their Prime Rate loans may decrease in the
event of an interest rate increase.
Analysis of Net Interest Income
The Bank's profitability is primarily dependent upon net interest income. Net
interest income represents the difference between income on interest-earning
assets and expense on interest-bearing liabilities. Net interest income depends
upon the volume of interest-earning assets and interest-bearing liabilities and
the interest rate earned or paid on them.
26
Average Balance Sheet
The following table sets forth certain information relating to the Bank's
consolidated statements of financial condition and the consolidated statements
of earnings for the fiscal years ended December 31, 2002, 2001 and 2000 and
reflects the average yield on assets and average cost of liabilities for the
period indicated. Such yields and costs are derived by dividing income or
expense by the average balance of assets or liabilities, respectively, for the
periods shown. Average balances are derived from average month-end balances. The
average balance of loan receivables does not include loans on which the Bank has
discontinued accruing interest. The yields and costs include fees, which are
considered adjustments to yields.
Year Ended December 31, Year Ended December 31,
2002 2001
---------------------------------- ---------------------------------
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
------------ ---------- ------ ----------- ---------- ------
Assets:
Interest-earning assets:
Loans receivable $ 57,353,099 $4,411,688 7.69% $47,593,053 $4,196,262 8.82%
Money market investments 13,536,459 184,906 1.37 6,439,973 272,439 4.23
Investment securities, afs 37,051,862 1,922,006 5.19 24,191,160 1,367,232 5.65
------------ ---------- ----------- ----------
Total interest-earning assets 107,941,420 6,518,600 6.04 78,224,186 5,835,933 7.46
Non-interest earning assets 6,668,093 5,560,494
------------ -----------
Total assets $114,609,513 $83,784,680
============ ===========
Liabilities and equity:
Interest-bearing liabilities:
Savings accounts $ 8,064,155 71,779 0.89 $ 6,326,683 84,931 1.34
Time accounts 17,186,114 387,257 2.25 15,132,408 634,293 4.19
Money market accounts 17,585,434 262,750 1.49 10,844,737 255,682 2.36
Now accounts 18,351,239 100,501 0.55 14,146,510 103,360 0.73
------------ ---------- ----------- ----------
Total interest-bearing liabilities 61,186,942 822,287 1.34 46,450,338 1,078,266 2.32
Checking accounts 43,345,527 28,671,910
------------ -----------
Total deposits 104,532,469 75,122,248
Other liabilities 1,222,576 856,683
------------ -----------
Total liabilities 105,755,045 75,978,931
Equity 8,854,468 7,805,748
------------ -----------
Total liabilities and equity $114,609,513 $83,784,679
============ ===========
Net interest income/net interest
rate spread $5,696,313 4.70% $4,757,667 5.14%
========== ==== ========== ====
Net interest earning assets/net
interest margin $ 46,754,478 5.28% $31,773,848 6.08%
============ ==== =========== ====
Ratio of interest-earning assets to
to interest-bearing liabilities 1.76x 1.68x
============ ===========
Year Ended December 31,
2000
---------------------------------
Average Yield/
Balance Interest Cost
----------- ---------- ------
Assets:
Interest-earning assets:
Loans receivable $36,514,349 $3,872,010 10.60%
Money market investments 4,160,142 267,955 6.44
Investment securities, afs 15,978,134 979,802 6.13
----------- ----------
Total interest-earning assets 56,652,625 5,119,767 9.04
Non-interest earning assets 4,664,916
-----------
Total assets $61,317,541
===========
Liabilities and equity:
Interest-bearing liabilities:
Savings accounts $ 4,112,325 70,526 1.71
Time accounts 10,126,727 510,561 5.04
Money market accounts 9,102,029 262,574 2.88
Now accounts 9,911,945 86,860 0.88
----------- ----------
Total interest-bearing liabilities 33,253,026 930,521 2.80
Checking accounts 20,788,186
-----------
Total deposits 54,041,212
Other liabilities 528,798
-----------
Total liabilities 54,570,010
Equity 6,747,531
-----------
Total liabilities and equity $61,317,541
===========
Net interest income/net interest
rate spread $4,189,246 6.24%
========== =====
Net interest earning assets/net
interest margin $23,399,599 7.39%
=========== =====
Ratio of interest-earning assets to
to interest-bearing liabilities 1.70x
===========
27
Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and
changes in the volume of interest-earning assets and interest-bearing
liabilities have affected the Bank's interest income and interest expense during
the periods indicated. Information is provided in each category with respect to
(i) changes attributable to changes in volume (changes in volume multiplied by
prior rate), (ii) changes attributable to changes in rate (changes in rate
multiplied by prior volume), and (iii) the net change. The changes attributable
to the combined impact of volume and rate have been allocated proportionately to
the changes due to volume and the changes due to rate.
Year Ended December 31, 2002 Year Ended December 31, 2001
Compared to Compared to
December 31, 2001 December 31, 2000
Increase/(Decrease) Increase/(Decrease)
In Net Interest Income In Net Interest Income
----------------------------------- ---------------------------------
Due to Due to
----------------------- ----------------------
Volume Rate Net Volume Rate Net
---------- ---------- --------- ---------- --------- --------
Interest-earning assets:
Loans receivable $ 860,836 ($645,410) $ 215,426 $ 977,142 ($652,890) $324,252
Money market investments 300,181 (387,714) (87,533) 96,105 (91,621) 4,484
Investment securities, afs 726,630 (171,856) 554,774 464,596 (77,166) 387,430
---------- ---------- --------- ---------- --------- --------
Total 1,887,647 (1,204,980) 682,667 1,537,843 (821,677) 716,166
Interest-bearing liabilities:
Savings accounts 23,282 (36,434) (13,152) 29,672 (15,267) 14,405
Time accounts 86,050 (333,086) (247,036) 252,286 (128,554) 123,732
Money Market accounts 41,128 (34,060) 7,068 50,190 (57,082) (6,892)
Now accounts 30,695 (33,554) (2,859) 37,264 (20,764) 16,500
---------- ----------- --------- ---------- --------- --------
Total 181,155 (437,134) (255,979) 369,412 (221,667) 147,745
---------- ---------- --------- ---------- --------- --------
Net change in net interest
income $1,706,492 ($767,846) $ 938,646 $1,168,431 ($600,010) $568,421
========== ========== ========= ========== ========= ========
Comparative Results for the Years Ended December 31, 2002 and December 31, 2001.
General. The Bank reported net income of $1,180,308 for the year ended December
31, 2002 as compared to a net income of $925,032 for the year ended December 31,
2001. This net income represents net interest income of $5,696,313 and
non-interest income of $1,315,583 offset by non-interest expenses, including
salary and benefits of $2,344,297, occupancy expenses of $815,543, computer
expenses of $236,563, loan loss provision of $355,000 and a provision for income
tax expense of $1,050,930. The rise in net income was attributed to the increase
of net interest income and non-interest income, a direct result of the Bank's
growth in assets and deposits, which was partially offset by an increase in
non-interest expenses and the provision for loan losses. The increase in
non-interest expense is primarily attributable to increased personnel expense
due to new hirings to support growth and increased benefit costs; and increased
occupancy costs due to increased rental and real estate tax expense (partially
attributable to the new Hylan Branch). The Bank opened its fourth branch office
at 1762 Hylan Boulevard in December 2002. The Bank has subleased two retail
stores at 1766 Hylan Boulevard. The ability of the Bank to earn a profit depends
on the level and mix of its deposit base, the corresponding level and the mix of
the loan and investment portfolio and the level of non-interest expense which
will increase as the Bank expands its branch network and reach.
28
Interest Income. Interest income was $6,518,600 for the year ended December 31,
2002 as compared to $5,835,933 for the year ended December 31, 2001. The
increase was primarily due to the increase in interest from loans of $215,426
and an increase in interest from investment securities of $555,334, partially
offset by the decrease in interest from money market investments of $88,093 from
the same period in 2001. The overall increase was a direct result of the growth
of the loan and investment securities portfolios, which was partially offset by
he lower interest rate environment. The Bank anticipates that the amount of
interest income from the loan portfolio will increase as the level of loans
receivable increases.
Interest Expense. Interest expense was $822,287 for the year ended December 31,
2002 as compared to $1,078,266 for the year ended December 31, 2001. The growth
in approximate average balances, for the year ended December 31, 2002 as
compared to December 31, 2001, for non-interest bearing checking, money market
accounts, NOW accounts, certificate of deposits and savings accounts were
$14,926,000, $6,741,000, $4,205,000, $2,053,000 and $1,737,000, respectively.
The increase in interest expense caused by the growth of interest-bearing
liabilities was primarily offset by the relative low cost mix of the Bank's
deposit portfolio and the lower interest rate environment, which resulted in a
98 basis point decline in the average cost of funds.
Net Interest Income Before Provision for Loan Losses. Net interest income before
provision for loan losses was $5,696,313 for the year ended December 31, 2002 as
compared to $4,757,667 for the year ended December 31, 2001. The average
interest rate spread was 4.70% for the year ended December 31, 2002 as compared
to 5.14% for the same period in 2001 and the average interest rate margin was
5.28% as compared to 6.08% for the same period in 2001. The relative disparity
between the average interest rate spread and the average interest rate margin
reflects the disproportionate amount of the Bank's interest-earning assets as
compared to its interest-bearing liabilities, due to the investment of the
Bank's capital and non-interest bearing deposits to total deposits. The current
deposit mix and low interest rate environment has helped maintain a lower cost
of funds, which may not necessarily be indicative of future years.
Provision for Loan Losses. The provision for loan losses amounted to $355,000
for the year ended December 31, 2002 as compared to $305,000 for the year ended
December 31, 2001. The increase in the provision was primarily the result of
growth in the loan portfolio and secondarily the result of net charge-offs
during 2002 of $81,334. Although management believes that the allowance for loan
losses is adequate, national, local and economic conditions may change. That may
cause increases in non-performing loans, requiring additional loan loss
provisions, which adversely affect net income. The ratio of the Bank's allowance
for loan losses to total loans was 1.83% at December 31, 2002.
Non-Interest Income. Non-interest income was $1,315,583 for the year ended
December 31, 2002 as compared to $967,089 for the year ended December 31, 2001.
The growth in non-interest income is primarily attributed to the growth of
service charges on deposits of $304,706 and is a direct result of the growth in
the Bank's deposit base.
Non-Interest Expense. Non-interest expenses were $4,425,658 for the year ended
December 31, 2002 as compared to $3,671,098 for the year ended December 31,
2001. The increase in non-interest expenses was primarily attributed to
increased salary and benefit costs of $486,453, increased occupancy expense of
$71,756 and increased other expenses of $194,262. These increases were all
primarily attributed to the increased staffing and benefits costs and the
additional expenses incurred as a result of the growth of the Bank and the costs
involved in opening the Hylan Branch.
Income Tax Expense. Income tax expense was $1,050,930 for the year ended
December 31, 2002 as compared to $823,626 for the year ended December 31, 2001.
The Bank recorded an income tax expense due to pre-tax income of $2,231,238 for
the year ended December 31, 2002 as compared to $1,748,658 for the year ended
December 31, 2001. Due to the profitability of the Bank, the Bank has reversed
the federal net operating loss ("NOL") in 2001, which resulted in a
corresponding deferred tax expense. The increase in income tax expense for the
year ended December
29
31, 2002 was attributed to the decrease in deferred tax expenses of $15,020 and
the increase of current income tax expense of $212,284 from the same period in
2001. Deferred income tax expense included the relevant portion of the five-year
tax amortization of the organization costs, temporary depreciation timing
differences, temporary non-deductible accrued expenses and the temporary timing
differences related to the loan loss provision. The Bank's effective tax rate
was 47.1% for both the year ended December 31, 2002 and the year ended December
31, 2001.
Comparative Results for the Years Ended December 31, 2001 and December 31, 2000.
General. The Bank reported net income of $925,032 for the year ended December
31, 2001 as compared to a net income of $568,615 for the year ended December 31,
2000. This net income represents net interest income of $4,757,667 and
non-interest income of $967,089 offset by non-interest expenses, including
salary and benefits of $1,857,844, occupancy expenses of $743,787, computer
expenses of $232,808, loan loss provision of $305,000 and a provision for income
tax expense of $823,626. The growth in net income was attributed to the growth
of net interest income and non-interest income, which was partially offset by an
increase in non-interest expenses and the provision for loan losses. The
increase in non-interest expense is primarily attributable to increased
personnel expense due to new hirings and increased benefit costs; occupancy
costs due to increased rental and real estate tax expense (partially
attributable to the new branch location at 1762 Hylan Boulevard or "Hylan
Branch"); and legal and professional expenses due to the new Hylan Branch. The
Bank expects to open its fourth branch office at 1762 Hylan Boulevard in the
spring of 2002. The Bank is also subleasing two retail stores at 1766 Hylan
Boulevard, and as such, will be reporting net rental income in 2002. The ability
of the Bank to earn a profit depends on the level and mix of its deposit base,
the corresponding level and the mix of the loan and investment portfolio and the
level of non-interest expense which will increase as the Bank expands its branch
network and reach.
Interest Income. Interest income was $5,835,933 for the year ended December 31,
2001 as compared to $5,119,767 for the year ended December 31, 2000. The
increase was primarily due to the increase in interest from loans of $324,252,
an increase in interest from money market investments of $4,484 and an increase
in interest from investment securities of $387,430 from the same period in 2000.
The increase was a direct result of the growth of the loan portfolio and
investment securities, which was partially offset by the lower interest rate
environment. The Bank anticipates that the amount of interest income from the
loan portfolio will increase as the level of loans receivable increase.
Interest Expense. Interest expense was $1,078,266 for the year ended December
31, 2001 as compared to $930,521 for the year ended December 31, 2000. The
growth in approximate average balances, for the year ended December 31, 2001 as
compared to December 31, 2000, for non-interest bearing checking, money market
accounts, NOW accounts, time accounts, and savings accounts were $7,884,000,
$1,743,000, $4,235,000, $5,006,000 and $2,214,000. The growth of
interest-bearing liabilities was partially offset by the relative low cost mix
of the Bank's deposit portfolio and the lower interest rate environment.
Net Interest Income Before Provision for Loan Losses. Net interest income before
provision for loan losses was $4,757,667 for the year ended December 31, 2001 as
compared to $4,189,246 for the year ended December 31, 2000. The average
interest rate spread was 5.14% for the year ended December 31, 2001 as compared
to 6.24% for the same period in 2000 and the average interest rate margin was
6.08% as compared to 7.39% for the same period in 2000. The relative disparity
between the average interest rate spread and the average interest rate margin
reflects the disproportionate amount of the Bank's interest-earning assets as
compared to its interest-bearing liabilities, due to the investment of the
Bank's capital and the percentage of non-interest bearing deposits. The current
deposit mix and low interest rate environment has helped maintain a lower cost
of funds, which may not necessarily be indicative of future years.
Provision for Loan Losses. The provision for loan losses amounted to $305,000
for the year ended December 31, 2001 as compared to $645,000 for the year ended
December 31, 2000. The decrease is attributable to the decline in
30
the loan portfolio growth rate and in the level of net charge-offs from the
previous year. The provision was set aside as the loan portfolio grows and may
be adjusted to reflect the changes in the risk level of the loan portfolio.
Although management believes that its allowance for loan losses is adequate,
national, local and economic trends may change and the Bank may experience
increases in its non-performing loans and additional loan loss provisions, which
may adversely affect net income. The ratio of the Bank's allowance for loan
losses to total loans was 1.77% at December 31, 2001.
Non-Interest Income. Non-interest income was $967,089 for the year ended
December 31, 2001 as compared to $707,175 for the year ended December 31, 2000.
The growth in non-interest income is primarily attributed to the growth of
service charges on deposits of $242,519 and is a direct result of the growth in
the Bank's deposit base.
Non-Interest Expense. Non-interest expenses were $3,671,098 for the year ended
December 31, 2001 as compared to $3,173,002 for the year ended December 31,
2000. The increase in non-interest expenses was primarily attributed to
increased salary and benefit costs of $337,327, increased occupancy expense of
$68,568, increased professional fees of $37,296 and increased other expenses of
$28,092. These increases were all primarily attributed to the increased staffing
and benefits costs and the additional expenses incurred as a result of the
growth of the Bank and the costs involved in leasing the Hylan Branch.
Income Tax Expense. Income tax expense was $823,626 for the year ended December
31, 2001 as compared to $509,804 for the year ended December 31, 2000. The Bank
recorded an income tax expense due to pre-tax income of $1,748,658 for the year
ended December 31, 2001 as compared to $1,078,419 for the year ended December
31, 2000. Due to the profitability of the Bank, the Bank has utilized the
federal Net Operating Loss carryforward ("NOL") in 2000, which resulted in a
corresponding deferred tax expense. Deferred income tax expense included the
relevant portion of the five-year tax amortization of the organization costs,
temporary depreciation timing differences, temporary non-deductible accrued
expenses and the temporary timing differences related to the loan loss
provision. The Bank's effective tax rate was 47.1% for the year ended December
31, 2001 as compared to 47.3% for the year ended December 31, 2000.
Changes in Financial Condition
Total assets were $134,844,626 at December 31, 2002, as compared to $100,425,649
at December 31, 2001, an increase of $34,418,977 or 34.3% due to the net inflow
of cash from the growth in deposits. The net loan portfolio totaled $62,246,153
at December 31, 2002, as compared to $49,530,101 at December 31, 2001, an
increase of $12,716,052 or 25.7%. Investment securities amounted to $42,999,660,
as compared to $39,286,998, an increase of $3,712,662 or 1.0%. Money market
investments totaled $0, as compared to $50,187. Bank premises and equipment
amounted to $2,399,163, as compared to $1,341,653, an increase of $1,057,510 or
78.8% due to the addition of the Hylan Branch. Deferred tax asset was $263,889,
as compared to $405,466, a decrease of $141,577 or 34.9%, due to the $539,114
increase in the net unrealized gains in the investment portfolio. Cash and due
from banks was at $26,095,803 at December 31, 2002, of which $21,620,693 was in
an interest-bearing account at the Federal Home Loan Bank, as compared to
$8,511,515 at December 31, 2001, an increase of $17,584,288 or 206.6%.
Total deposits were $123,702,365 at December 31, 2002, an increase of
$32,569,549 or 35.7%, from $91,132,816 at December 31, 2001. Demand and checking
accounts totaled $45,506,450, NOW accounts totaled $26,573,121, money market
accounts totaled $26,025,830, time accounts totaled $17,778,031 and savings
account totaled $7,626,798 at December 31, 2002. The increase in total deposits
was primarily attributed to the growth of demand and checking, NOW accounts,
money market, savings and time accounts of $8,598,862, $8,852,411, $12,634,380,
$1,778,536 and $614,389, respectively, from December 31, 2001.
Total shareholders' equity was $9,763.117 at December 31, 2002, of which
$7,000,000 resulted from the initial public offering completed on October 21,
1997. Total shareholders' equity increased $1,542,091 or 18.8% from December
31
31, 2001 due primarily to the increase in retained earnings of $1,180,308 in the
year ended December 31, 2002 and an increase in the unrealized gain on available
for sale securities of $285,191. Tier 1 leverage and Tier 1 risk-based capital
ratios of the Bank were 7.00% and 11.43%, respectively, at December 31, 2002.
The Bank's Total capital (risk-based capital) was 12.68% at December 31, 2002.
The Bank exceeded its Tier 1 leverage, Tier 1 risk-based and Total risk-based
capital requirements by $4,002,000, $6,068,000 and $3,822,000, respectively, at
December 31, 2002.
Liquidity and Capital Resources
The Bank's primary sources of funds are deposits and principal and interest
payments on commercial loans and investment securities. While maturities and
scheduled amortization of loans are predictable sources of funds, deposit flows
are greatly influenced by general interest rates, economic conditions, and
competition.
The Bank maintains a minimum level of liquid assets (short-term assets that
mature within one-year). The liquidity ratio is based upon a percentage of
liquid assets to deposits and short-term borrowings. The Bank's liquidity ratio
was 21.4% at December 31, 2002. Management currently expects that the liquidity
ratio will decrease as deposits grow and more assets are utilized in non-liquid
assets such as commercial loans.
The Bank's most liquid assets are cash and short term investments. The levels of
these assets are dependent on the Bank's operating, financing, lending and
investing activities during any given period. At December 31, 2002 cash and
short term investments totaled $26.1 million.
The primary investment activities of the Bank are the origination of commercial
loans and other loans and the purchase of investment and money market
securities. During the year ended December 31, 2002, the Bank originated net
loans in the amounts of $12.8 million. Investment in interest-bearing bank
accounts totaled $21.6 million, for the year ended December 31, 2002 and
purchases of investment securities totaled $28.2 million. Investing activities
include investing in U.S. government and federal agency obligations, and AAA
rate whole loan securities.
The Bank has other sources of liquidity if a need for additional funds arises.
These sources of funds include repurchase agreements and lines of credit. There
were no such advances outstanding at December 31, 2002.
At December 31, 2002, the Bank had outstanding loan commitments of $24.5
million. The Bank anticipates that it will have sufficient funds available to
meet its current loan origination commitments. Certificates of deposit which,
are scheduled to mature in one year or less from December 31, 2002, totaled
$15.8 million. Management believes that a significant portion of such deposits
will remain with the Bank.
The following table sets forth the Bank's contractual obligations and
commitments for future lease payments, time deposit maturities and loan
commitments.
32
Contractual Obligations and Commitments at December 31, 2002
Contractual Obligations Payment due by Period
----------------------------------------------------------------------
Less than One to three Four to five After Total Amounts
One Year years years five years committed
----------- ------------ ------------ ---------- -------------
Minimum annual rental payments under
non-cancelable operating leases $ 326,936 $ 663,486 $553,526 $1,841,866 $ 3,385,814
Remaining contractual maturities of time
deposits 15,761,637 2,016,394 -- -- 17,778,031
----------- ---------- -------- ---------- -----------
Total contractual cash obligations $16,088,573 $2,679,880 $553,526 $1,841,866 $21,163,845
=========== ========== ======== ========== ===========
Other commitments Amount of commitment Expiration by Period
----------------------------------------------------------------------
Less than One to three Four to five After Total Amounts
One Year years years five years committed
----------- ------------ ------------ ---------- -------------
----------- ----------- ------ ------ -----------
Loan commitments $12,759,367 $11,714,005 $ -- $ -- $24,473,372
=========== =========== ====== ====== ===========
Impact of Inflation and Changing Prices
The consolidated financial statements and related notes presented herein have
been prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars without considering the changes in the relative purchasing
power of money over time and due to inflation. Unlike industrial companies,
nearly all assets and liabilities of the Bank are monetary. As a result,
interest rates have a greater impact on the Bank's performance than do the
general levels of inflation. Interest rates do not necessarily move in the same
direction or to the same extent as the price of goods and services.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a description of the significant accounting and reporting
policies followed in preparing and presenting the accompanying financial
statements. These policies conform to accounting principles generally accepted
in the United States of America.
Risks and Uncertainties - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
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 amounts of revenues
and expenses during the reporting period. Actual results can differ from those
estimates.
Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash
equivalents include cash and amounts due from banks. The Bank maintains a
minimum cash balance of $2,331,000 with its correspondent bank. Such balance is
maintained for the purpose of conducting funding and check clearing
transactions, while reducing service fees and expenses. The minimum balances may
be withdrawn at the Bank's option without any interruption of the services
received from the correspondent bank.
Money Market Investments, Held to Maturity - Money market investments represent
short-term investments (with original maturities of one year or less) which are
held to maturity. These investments are carried at cost,
33
adjusted for the accretion of discount or the amortization of premium using a
method which approximates the level yield method over the period to maturity.
Carrying values of these investments approximate current market values.
Investment Securities, Available For Sale - Investment securities, available for
sale, are to be held for an indefinite period of time and include securities
that management intends to use as part of its asset/liability strategy. These
securities may be sold in response to changes in interest rates, prepayments or
other factors and are carried at estimated fair value. Gains or losses on the
sale of such securities are determined by the specific identification method.
Premium and discounts are recognized in interest income using a method that
approximates the level yield method. Unrealized holding gains or losses, net of
deferred income tax, are excluded from earnings and reported as other
comprehensive income (a net of tax amount in a separate component of
stockholders' equity) until realized.
The Bank invests primarily in agency Collateralized Mortgage-backed Obligations
("CMO") with average lives under 4.0 years and Mortgage Backed Securities. These
securities are primarily issued by the Federal National Mortgage Association
("FNMA"), the Government National Mortgage Association ("GNMA") or the Federal
Home Loan Mortgage Corporation ("FHLMC") and are primarily comprised of mortgage
pools guaranteed by FNMA, GNMA or FHLMC. The Bank also invests in whole loan
CMOs, all of which are AAA rated. These securities expose the Bank to risks such
as interest rate, prepayment and credit risk and thus pay a higher rate of
return than comparable treasury issues.
Loans Receivable - Loans receivable, that management has the intent and ability
to hold for the foreseeable future or until maturity or pay-off, are stated at
unpaid principal balances, adjusted for deferred net origination and commitment
fees and allowance for loan losses. Interest income on loans is credited as
earned.
It is the policy of the Bank to provide a valuation allowance for estimated
losses on loans based on the Bank's past loan loss experience, known and
inherent risks in the portfolio, adverse situations which may affect the
borrower's ability to repay, estimated value of underlying collateral and
current economic conditions in the Bank's lending area. The allowance is
increased by provisions for loan losses charged to operations and is reduced by
charge-offs, net of recoveries. While management uses available information to
estimate losses on loans, future additions to the allowance may be necessary
based upon the expected growth of the loan portfolio and any changes in economic
conditions beyond management's control. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
the Bank's allowance for loan losses. Such agencies may require the Bank to
recognize additions to the allowance based on judgments different from those of
management. Management believes, based upon all relevant and available
information, that the allowance for loan losses is adequate.
The Bank adopted a policy whereby all loans 90 days past due are placed on
non-accrual status. It is the Bank's policy to cease the accrual of interest on
loans to borrowers past due less than 90 days where a probable loss is estimated
and to reverse out of income all interest that is due. The Bank continues to
accrue interest on construction loans that are 90 days past contractual maturity
date if the loan is expected to be paid in full in the next 60 days and all
interest is paid up to date.
Loan origination fees and certain direct loan origination costs are deferred and
the net amount recognized over the contractual loan terms using the level-yield
method, adjusted for periodic prepayments in certain circumstances.
The Bank considers a loan to be impaired when, based on current information, it
is probable that the Bank will be unable to collect all principal and interest
payments due according to the contractual terms of the loan agreement. Impaired
loans are measured based on the present value of expected future cash flows
discounted at the loan's effective interest rate or, as a practical expedient,
at the loan's observable market price or the fair value of the
34
collateral. The fair value of the collateral, as reduced by costs to sell, is
utilized if a loan is collateral dependent or foreclosure is probable.
Long-Lived Assets -The Bank periodically evaluates the recoverability of
long-lived assets, such as premises and equipment, to ensure the carrying value
has not been impaired. In performing the review for recoverability, the Bank
would estimate the future cash flows expected to result from the use of the
asset and its eventual disposition. If the sum of the expected future cash flows
is less than the carrying amount, an impairment will be recognized. The Bank
reports these assets at the lower of the carrying value or fair value, less the
cost to sell.
Premises and Equipment - Premises, leasehold improvements, and furniture and
equipment are stated at cost less accumulated depreciation and amortization.
Depreciation and amortization are accumulated by the straight-line method over
the estimated useful lives of the respective assets, which range from 3 to 10
years.
Income Taxes - The Bank utilizes the liability method to account for income
taxes. Under this method, deferred tax assets and liabilities are determined on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws expected to be in effect
when the differences are expected to reverse. As changes in tax laws or rates
are enacted, deferred tax assets and liabilities are adjusted through the
provision for income taxes.
Financial Instruments - In the ordinary course of business, the Bank has entered
into off-balance sheet financial instruments, primarily consisting of
commitments to extend credit.
Basic and Fully Diluted Net Income Per Common Share - The basic net income per
share of common stock is based on 700,296, the weighted average number of common
stock outstanding. Fully diluted net income per share of common stock is based
on 721,344, the weighted average number of common stock and common stock
equivalents outstanding. Common stock equivalents were calculated using the
treasury stock method.
Stock-Based Compensation - At December 31, 2002, the Bank has stock-based
employee compensation plans, which are described more fully in Note 12 Stock
Option and Incentive Plan. The Bank accounts for these plans under APB Opinion
No. 25, "Accounting for Stock Issued to Employees," and related interpretations.
No stock-based employee compensation expense has been reflected in net income
for stock options as all rights and options to purchase the Bank's stock granted
under these plans has an exercise price equal to the market value of the
underlying stock on the date of grant. A table, which illustrates the income
from continuing operations and earnings per share as if the Bank had applied the
fair value of recognition provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation," as amended, to stock-based employee compensation
plans, is described more fully in Note 12 Stock Option and Incentive Plan.
Impact of New Accounting Pronouncements
In July 2001 the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 141 "Business Combinations" ("SFAS 141"),
which provides guidance on accounting for a business combination at the date a
business combination is completed. The Statement requires the use of the
purchase method of accounting for all business combinations initiated after June
30, 2001, thereby eliminating the use of the pooling of interests method. Also,
it provides new criteria that determine whether an acquired intangible asset
should be recognized separately from goodwill. The adoption of SFAS 141 did not
have any impact on the financial position or results of operations of the Bank.
In July 2001, the FASB issued SFAS No. 142 "Goodwill and Other Intangible
Assets" ("SFAS 142") which provides guidance on how to account for goodwill and
intangible assets after the acquisition is complete. The most substantive change
represented by this Statement is that goodwill will no longer be amortized;
instead, it will be tested for impairment at least annually. The Statement will
apply to existing goodwill and intangible
35
assets, beginning with fiscal years starting after December 15, 2001. The
adoption of this standard did not have any impact on the Bank's financial
statements.
In August 2001, the FASB released SFAS No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets". The provisions of this statement are
effective for financial statements issued for fiscal periods beginning after
December 15, 2001. The adoption of this standard did not have any impact on the
Bank's financial statements.
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4, Reporting
Gains and Losses from Extinguishment of Debt, and an amendment of that
Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement No. 44,
Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends FASB
Statement No. 13, Accounting for Leases, to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. SFAS 145 also amends other existing
authoritative pronouncements to make various technical corrections, clarify
meanings, or describe their applicability under changed conditions. The
provisions of SFAS 145 related to the rescission of FASB Statement No. 4 are
effective for fiscal years beginning after May 15, 2002. The provisions of SFAS
145 related to FASB Statement No. 13 are effective for transactions occurring
after May 15, 2002. All other provisions of SFAS 145 are effective for financial
statements issued on or after May 15, 2002. The adoption of SFAS 145 did not
have a material effect on the Bank's financial statements.
In July 2002, the FASB issued Statement of Financial Accounting Standards No.
146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS
146"). SFAS 146 requires companies to recognize costs associated with exit or
disposal activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. SFAS 146 replaces Emerging Issues Task
Force Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). SFAS 146 is to be applied prospectively to exit or disposal
activities initiated after December 31, 2002.
In October 2002, the FASB issued Statement of Financial Accounting Standards No.
147 "Acquisition of Certain Financial Institutions" (SFAS 147), which provides
guidance on the accounting for the acquisition of a financial institution. SFAS
147 requires that the excess of the fair value of tangible and identifiable
intangible assets acquired in a business combination represents goodwill that
should be accounted for under FASB Statement No. 142, Goodwill and Other
Intangible Assets. Thus, the specialized accounting guidance in paragraph 5 of
FASB Statement No. 72, Accounting for Certain Acquisitions of Banking and Thrift
Institutions, will not apply after September 30, 2002. If certain criteria in
Statement 147 are met, the amount of the unidentifiable intangible asset will be
reclassified to goodwill upon adoption of that Statement. Financial Institutions
meeting the conditions outlined in Statement 147 will be required to restate
previously issued financial statements as if the amount accounted for under
Statement 72 as an unidentifiable intangible asset had been reclassified to
goodwill as of the date Statement 142 was initially applied. The adoption of
SFAS 147 did not have a material effect on the Bank's financial statements.
On November 25, 2002, the FASB issued Financial Accounting Standards Board
Interpretation No. 45 ("FIN 45" or the Interpretation"), "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, an interpretation of FASB Statements No, 5, 57, and 107
and Rescission of FASB Interpretation No. 34." FIN 45 clarifies the requirements
of FASB Statement No. 5, "Accounting for Contingencies," relating to the
guarantor's accounting for, and disclosure of, the issuance of certain types of
guarantees. FIN 45 requires that upon issuance of a guarantee, the entity (i.e.,
the guarantor) must recognize a liability for the fair value of the obligation
it assumes under that guarantee. The disclosure provisions of the Interpretation
are effective for financial statements of interim or annual periods that end
after December 15,
36
2002. The Interpretation's provisions for initial recognition and measurement
should be applied on a prospective basis to guarantees issued or modified after
December 31, 2002, irrespective of the guarantor's fiscal year-end. The
guarantor's previous accounting for guarantees that were issued before the date
of FIN 45's initial application may not be revised or restated to reflect the
effect of the recognition and measurement provisions of the Interpretation. The
Bank was not a party to any guarantees that will be subject to the accounting
and disclosure requirements of Fin 45 at December 31, 2002.
In January 2003, the FASB issued Statement of Financial Accounting Standards No.
148 ("SFAS 148"), "Accounting for Stock-Based Compensation - Transition and
Disclosure." SFAS 148 amends FASB Statement No. 123 ("SFAS 123"), "Accounting
for Stock-Based Compensation," to provide alternative methods of transition for
a voluntary change to the fair value based method of accounting for stock-based
employee compensation. In addition, SFAS 148 amends the disclosure requirements
of SFAS 123 to require prominent disclosures in both annual and interim
financial statements of the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. SFAS 148 is
effective for fiscal years beginning after December 15, 2002. The Bank intends
to adopt SFAS 148 on January 1, 2003. The Bank does not expect to change to
using the fair value based method of accounting for stock-based employee
compensation; and therefore, adoption of SFAS 148 is expected to impact only the
future disclosures, not the financial results, of the Bank.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities - an Interpretation of ARB 51 ("FIN 46"). FIN 46
provides guidance on the consolidation of entities in which equity investors do
not have characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective immediately for entities created before February 1, 2003 no later than
the beginning of the first interim or annual reporting period beginning after
June 15, 2003. The Bank had no interest in a Variable Interest Entity as of
December 31, 2002.
Item 3. Description of Property.
The Bank conducts its business through four banking offices. The main office is
also its loan origination center.
37
Original Net Book Value
Date Date of of Leasehold
Leased or Leased or Lease Improvements at
Location Description Owned Acquired Expiration (1) December 31, 2002
------------- --------- --------- -------------- -----------------
3155 Amboy Road
Staten Island, N.Y. 10306 Main Office Leased 1997 12/31/2006 $ 61,244
755 Forest Avenue
Staten Island, N.Y. 10310 Branch Leased 1999 11/30/2013 $ 232,263
One Hyatt Street
Staten Island, N.Y. 10301 Branch Leased 1999 10/30/2014 $ 102,768
1762 Hylan Boulevard (2)
Staten Island, N.Y. 10301 Branch Leased 2001 6/30/2016 $ 872,021
1766 Hylan Boulevard (3)
Staten Island, N.Y. 10301 Retail Stores Leased 2001 6/30/2016 $ 261,226
----------
Total net book value $1,529,522
==========
(1) All lease agreements are renewable at the option of the Bank.
(2) Hylan Boulevard Branch commenced operations on December 4, 2002.
(3) The retail stores at 1766 Hylan Boulevard were leased by the Bank as a
component of its lease for the Hylan branch premises and are being
subleased by the Bank to retail tenants.
Item 4. Security Ownership of Certain Beneficial Owners and Management.
The following table sets forth, to the knowledge of VSB based upon a review of
the Bank's records and information provided in required filings, the beneficial
ownership of common stock of the Bank as of March 19, 2003 by directors and
executive officers including options exercisable now or within 60 days after
March 19, 2003. VSB does not know of any person other than the directors or
officers of the Bank who beneficially owns 5% or more of the Bank's stock.
Number Percent
Name of Shares of Total
- ---- --------- --------
Raffaele M. Branca ............................ 30,960(7)(9) 4.40%
Joan Nerlino Caddell .......................... 20,300(1)(5)(6) 2.88%
Merton Corn ................................... 68,200(7)(9) 9.69%
Robert S. Cutrona, Sr. ........................ 14,000(2)(5)(6)(8) 1.99%
Chaim Farkas .................................. 15,000(3)(5)(6) 2.13%
Lawrence J. De Maria .......................... 2,900(6) 0.41%
Joseph J. LiBassi ............................. 56,200(5)(6)(10) 7.98%
Carlos Perez .................................. 27,000(4)(5)(6) 3.84%
Savino Savo ................................... 35,500 5.04%
-------
All directors and executive officers
as a group (9 persons) ..................... 270,060 38.36%
======= =====
(1) Excludes 2,100 shares, which are owned by Scott R. Caddell, Ms. Nerlino
Caddell's spouse, as to which she disclaims voting power and beneficial
ownership. Includes 2,000 shares which are owned by Ms. Caddell's two minor
children.
(2) Owned as joint tenants with David P. Cutrona, his son.
38
(3) Owned as joint tenants with Gail Farkas, his spouse.
(4) Includes 23,000 shares owned by the Carlos Perez M.D. Trust, of which Dr.
Perez is a beneficiary. Excludes 1,500 shares owned by Dr. Perez' adult
children, as to which Dr. Perez disclaims voting power and beneficial
ownership.
(5) Includes, for each non-employee director, 2,000 stock options granted under
the 2000 Directors' Plan.
(6) Includes 2,000 stock options granted to each non-employee director under
the 1998 Directors' Plan and 4,000 stock options granted to Mr. LiBassi
under the 1998 Directors' Plan.
(7) Excludes, as to Mr. Corn, 12,500 SARs which do not carry voting rights and
3,800 unvested stock options, and as to Mr. Branca, excludes 3,480 unvested
stock options.
(8) Excludes 1,000 shares owned by Jennifer Gotlin Cutrona, Mr. Cutrona's
spouse, as to which Mr. Cutrona disclaims voting power and beneficial
ownership.
(9) Includes 7,600 options and 6,960 options granted to Mr. Corn and Mr.
Branca, respectively.
(10) Excludes 500 shares, which are owned by Melinda LiBassi, Mr. LiBassi's
spouse, as to which Mr. LiBassi disclaims voting power and beneficial
ownership.
Upon the holding company reorganization, each director will receive three shares
of VSB common stock for each share of Bank common stock that they own. Subject
to the effect of the exercise of dissenters' right and payments for fractional
shares, the percentage ownerships will not change.
Item 5. Directors and Executive Officers, Promoters and Control Persons.
The following table sets forth below sets forth information about the nine
directors of VSB, who also constitute all nine members of the Board of Directors
of the Bank. Each of the named individuals has been a director of VSB since its
formation in January 2003 and has been a director of the Bank since 1997, except
that Mr. DeMaria has been a director of the Bank since 2000. There are no
executive officers who are not directors. Ages are as of March 19, 2003.
Length of Service
Name as Director Principal Occupation During Past 5 Years and
and Age and Expiration of Term Directorships of Public Companies
- --------------------- ---------------------- --------------------------------------------------
Lawrence J. De Maria Director since 2000 President of the Staten Island Chamber of Commerce
(58) Term expires 2006 from 1997 to Present. Executive Director of Forbes
Investors Advisory Institute from 1989 until 1997.
Carlos Perez Director since 1997 Doctor of Gynecology.
(63) Term expires 2006
Savino Savo Director since 1997 President of S.L. Homes, Inc., Builder and Developer.
(71) Term expires 2006
Joseph J. LiBassi Director since 1997 Chairman, Victory State Bank; Self-employed Investor.
(67) Term expires 2004
39
Merton Corn Director since 1997 President and Chief Executive Officer, Victory
(68) Term expires 2004 State Bank; President and Chief Executive Officer
of Gateway State Bank from 1977 until its merger
with Staten Island Savings Bank in 1995; Senior
Vice President of Staten Island Savings Bank from
August 1995 to December 1995; President and Chief
Executive Officer of Community Capital Bank from
December 1995 to November 1997.
Joan Nerlino Caddell Director since 1997 Secretary, Victory State Bank; Partner, Nerlino &
(45) Term expires 2004 Gambale, LLP, Attorneys; Partner, Nerlino, Gambale
and Klapper LLP, Attorneys to the Bank through
February 28, 2002; Partner, Holzka, Donahue and
Nerlino, Attorneys to the Bank through October 1,
1998.
Raffaele M. Branca Director since 1997 Executive Vice President, Victory State Bank;
(38) Term expires 2005 formerly Vice President, Finance and Investment
Portfolio Manager for River Bank America; Formerly
Vice President for Finance and Investments of
Hamilton Bancorp. Inc.
Robert S. Cutrona Sr. Director since 1997 President and Owner of Project-One Services, Inc.
(65) Term expires 2005
Chaim Farkas Director since 1997 President and Owner of Dataware Systems Lease, Inc.
(49) Term expires 2005
Item 6. Executive Compensation.
Director Compensation
Non-employee directors, other than the Chairman of the Board, receive attendance
fees of $300 per board meeting and $100 per committee meeting. The committee
attendance fee for the chairman of the committee is $150 per meeting. The
Chairman of the Board will receive a fixed director's fee of $50,000 for 2003
but will not receive per meeting fees.
In addition, as discussed in detail below under the caption "Stock Option
Plans," directors have received options to purchase shares of the Bank's stock
with exercise prices equal to fair market value on the date of grant.
Management Compensation
The following table sets forth the aggregate remuneration for services in all
capacities paid by the Bank, for the last three calendar years, to the chief
executive officer and to each executive officer of the Bank whose aggregate
direct remuneration exceeded $100,000 for such year, for services rendered to
the Bank:
40
Compensation
----------------------------------------------------------------
Long Term All Other
Salary Bonus Compensation Compensation
Name and Principal Position Year ($) ($) (Options/SARs) ($)
- ------------------------------------- ---- ----------- ---------- -------------- ------------
Merton Corn 2002 $167,660.00 $64,600.00(3) -- $41,320.00(1)
President and Chief Executive Officer 2001 $157,182.00 $20,000.00 -- $23,270.00(1)
2000 $149,410.00 $10,000.00 3,500(2) $13,426.00(1)
Raffaele M. Branca 2002 $138,938.00 $23,140.00 -- $14,041.00(1)
Executive Vice President 2001 $131,407.00 $23,645.00 -- $10,112.00(1)
2000 $123,176.00 $15,000.00 3,250(2) $ 3,482.00(1)
(1) Represents the perquisites, employer match and discretionary profit sharing
component to the Bank's 401(k) plan and the vested value of SARs which
first vested in each year, although the SARs were originally granted in
1998 and 1999.
(2) Represents the stock options awarded from the 2000 Victory State Bank
Incentive Stock Option Plan which are exercisable at 20% after the first
anniversary of the initial grant and 20% each year thereafter.
(3) Includes the $34,000 signing bonus for Mr. Corn's execution of a 5-year
employment contract effective November 16, 2002.
Total 2002 compensation of all officers as a group was $899,678.
Option/Stock Appreciation Rights ("SAR") Grants in Last Fiscal Year
There were no Option/SAR grants for officers in 2002.
Aggregated Options/SAR Exercises in Last Fiscal Year and Fiscal Year End
Option/SAR Values
- ------------------ ------------ -------- ----------------------------- -----------------------------
Number of Securities
Shares Value Underlying Unexercised Value of Unexercised In-the-
Acquired on Realized Options/SAR at FY End Money Options/SAR at FY End
Name Exercise (#) ($) Exercisable/Unexercisable (#) Exercisable/Unexercisable ($)
- ------------------ ------------ -------- ----------------------------- -----------------------------
Merton Corn 0 $ -- 15,200/6,800 $219,650/$97,913(1)
Raffaele M. Branca 0 $ -- 5,220/3,480 $ 77,453/$45,704(1)
(1) The value of unexercised, in-the-money options at December 31, 2002 is the
difference between the closing price of the Common Stock on December 31,
2002 ($26.00) and the exercise price ($10.00) under such outstanding SARs
and the difference between the closing price of the Common Stock on
December 31, 2002 ($26.00) and the exercise price ($16.00 for 1998 grants,
$12.75 for 1999 Grants and $11.875 for 2000 Grants) under such outstanding
options.
Employment Agreement
The Bank has entered into an employment agreement with President Merton Corn.
This employment agreement is intended to ensure that the Bank will be able to
maintain a stable and competent management base. The continued success of the
Bank depends to a significant degree on the skills and competence of Mr. Corn.
Upon Mr. Corn's commencement of employment with the Bank in August of 1997, the
Bank entered into an employment agreement with him to serve as President and
Chief Executive Officer. That agreement was extended in 2002 for an additional
five year term. The agreement provides for severance payments if the contract is
terminated without cause. The agreement provides for a salary of $195,000 in
2003, with annual salary increases of at least 5% per year beginning in November
2004. In addition, Mr. Corn may receive annual bonuses based upon the Board's
evaluation of the Bank's performance and such other factors as the Board
determines are appropriate.
Mr. Corn was awarded 10,000 stock appreciation rights effective January 13,
1998, at an exercise price of $10.00 per share. Mr. Corn was awarded additional
2,500 stock appreciation rights on April 13, 1999, at an exercise price of
$10.00 per share. The stock appreciation rights must be held for at least two
years before being exercised and may be exchanged for employee incentive stock
options if such options are available.
41
Benefits
The Bank maintains a qualified 401(k) salary deferral plan for all eligible
employees of the Bank who are at least 21 years of age, who are in the service
of the Bank for one consecutive year and are credited with 1,000 hours of
service with the Bank in the plan year. Each participant may elect to make
salary deferral contributions to the 401(k) plan on a pre-tax basis. The Bank
matches 100 percent of the first three percent of salary deferred by Bank
employees, including Mr. Corn and Mr. Branca. Compensation for purposes of the
401(k) is capped at $200,000 annually (subject to cost of living adjustments).
Employee salary deferral contributions are immediately vested. The Bank, at its
sole discretion, can also make a discretionary (or profit sharing) contribution
to the Plan. This discretionary contribution is in addition to the employer
matching contribution. The Bank's matching contribution and the discretionary
contribution vest in annual installments of 20% beginning after the second
anniversary of eligibility in the 401(k) plan. For 2002, the Bank made a 5.50%
discretionary contribution to the Plan. Aggregate contributions to the accounts
of an employee under the 401(k) plan cannot exceed $30,000 annually (subject to
cost of living adjustments).
Stock Option Plans
The Bank has four stock options plans, all of which were approved by
stockholders, two plans for employees and two plans for non-employee directors.
The employee plans, which are incentive stock option plans under the Internal
Revenue Code, provide for the granting of options to purchase 42,000 shares of
the Bank's common stock. The non-employee director plans, which are
non-qualified plans under the Internal Revenue Code, provide for the granting of
options to purchase 28,000 shares of the Bank's common stock. The option
exercise price of options under the four plans may not be less than 100% of the
fair market value of the Common Stock on the date of the grant of the option.
The maximum option term is 10 years.
Each non-employee director has been granted options to acquire 4,000 shares of
the Bank's common stock under the plans, with 2,000 additional options to the
Chairman of the Board. Director De Maria has only 2,000 options because he was
not a director when the first director option plan was approved in 1998. Options
to purchase all 28,000 available shares under the two director plans have been
granted. All director options were immediately exercisable when they were
granted.
The employee stock option plans provide for the grant of options to officers or
other employees as a committee of the Board of Directors determines is
appropriate. The options granted under the employee plans gradually vest over
five years beginning with the first anniversary of the grant date.
Upon a change of control of the Bank, all options immediately vest. The holding
company reorganization will not constitute a change in control for the purposes
of the plans. No person may receive incentive stock options if, at the time of
the grant, such person owns, directly and indirectly, more than 10% of the total
combined voting power of the Bank unless the stock option price is at least 110%
of the fair market value of the common stock and the exercise of such incentive
stock option is limited by its terms to five years.
Payments for shares purchased upon the exercise of options may be made in cash
or cash equivalents. All stock options under the plans will be adjusted for
stock splits, reorganization, recapitalization, exchange of shares and stock
dividends. Any such changes to outstanding options will be made without a change
in the total price applicable to the unexercised portion of the option but with
a corresponding adjustment in the per share option.
If the holding company reorganization is completed, the stock option plans of
the Bank will become stock option plans of VSB Bancorp, with the same terms and
conditions, and all outstanding options to purchase stock of the Bank will
automatically become options to purchase shares of stock of VSB Bancorp. Because
of the three-for-two exchange ratio in the reorganization, each existing option
will become an option to purchase three shares of VSB
42
Bancorp for each two shares of the Bank now subject to that option. The exercise
price of the new option will be adjusted so that the new exercise price
multiplied by the new number of shares subject to the option will equal to the
former exercise price multiplied by the number of shares covered by the former
option.
Human Resource Committee Report on Executive Compensation
The following discussion addresses compensation information relating to the
President and Chief Executive Officer and executive officers of the Bank for
fiscal 2002 and sets forth the report of the Human Resource Committee (the
"Committee") of the Board of Directors of the Bank.
Compensation Philosophy. The Committee supervises the administration of the
compensation of all executive officers. The Committee annually reviews and
evaluates the base salary and incentive compensation for all officers, including
the President and Chief Executive Officer, and in conducting such reviews of the
Bank's officers other than the President and Chief Executive Officer, places
primary consideration upon the recommendations of the President and Chief
Executive Officer, along with the rationale for such recommendations. Merton
Corn, the President and Chief Executive Officer and Raffaele M. Branca, the
Executive Vice President, do not participate in the Committee's review of their
compensation. The Committee considers the objectives and performance of the
Bank, individual performance and surveys of compensation practices at comparable
financial institutions in establishing executive compensation. The compensation
of the President and Chief Executive Officer was specified under the terms and
conditions of his employment contract. The Committee does not use strict
numerical formulas to determine changes in the compensation of the other
officers of the Bank. While it weighs a variety of different factors in its
deliberations, it emphasizes earnings, profitability, capital position and
income level as factors in setting the compensation of the Bank's other
officers. It also takes into account non-quantitative factors such as the level
of responsibility and general management oversight. While the quantitative
factors approved by the Committee were considered in evaluating individual
officer performance, such factors were not assigned a specific weight in
evaluating the performance of the President and Chief Executive Officer or the
other officers.
The purposes of the Bank's executive compensation policies are to attract and
retain qualified individuals; reward high performance by the Bank and the
executive; and maintain compensation at levels that are competitive with other
financial institutions, particularly those in the New York metropolitan area.
The compensation structure is designed to support the achievement of the Bank's
performance and strategic objectives and to ensure that the executive officers'
interests are aligned with the success of the Bank.
Incentive Compensation. An important component of the Bank's executive
compensation package is an incentive compensation plan which provides for cash
payments to executive officers based on the performance of the Bank in relation
to a set of performance goals and targets. The institutional goals are
recommended by management each year and approved by the Committee and the Board
of Directors. The incentive compensation of other senior officers is closely
linked to Bank performance, while the incentive compensation of junior officers
is more closely linked to personal performance.
Chief Executive Officer. The Committee recommended and the Board of Directors
awarded the Bank's President and Chief Executive Officer a salary increase of
18.8%, or $30,906, for a new annual salary of $195,000 effective in November
2002. The decision to increase the Chief Executive Officer's salary was based on
the Bank's performance and growth, as well as a review of compensation surveys
of CEO compensation at comparable banks by two independent organizations. No
specific formula was used by the Committee to establish the other executive
officer's salary for 2002 nor did the Committee set specified salary levels
based on the achievement of particular quantitative financial measures or
performance targets.
43
The Human Resource Committee of Victory State Bank
Carlos Perez (Chairman) Merton Corn
Raffaele M. Branca Joseph J. LiBassi
Joan Nerlino Caddell
Compensation Committee Interlocks and Insider Participation
Both Merton Corn and Raffaele M. Branca are executive officers of the Bank. Ms
Nerlino Caddell is a partner in Nerlino & Gambale, LLP (formerly of "Nerlino,
Gambale & Klapper LLP"), which also serves as legal counsel to the Bank. See the
discussion below under the heading "Certain Transactions" for more detailed
information.
Performance Graph
The graph below compares the performance of the Bank's Common Stock with that of
the Nasdaq Composite Index (Nasdaq CI) and the Standard & Poors 500 Composite
Index ("S&P 500") from January 1, 1998 through December 31, 2002. The graph is
based on an investment of $100 in the Bank's Common Stock at its closing price
on December 31, 1998.
[THE FOLLOWING TABLE WAS REPRESENTED BY A LINE GRAPH IN THE PRINTED MATERIAL.]
The following table sets forth the values used in the above performance graph.
Victory State
Measurement Period Bank Nasdaq CI S&P 500
- ------------------------------------------ ------------- --------- -------
12/31/98 100.00 100.00 100.00
12/31/99 94.39 186.13 121.04
12/31/00 82.24 113.00 108.77
12/31/01 112.15 89.08 94.59
12/31/02 194.39 60.99 72.48
Item 7. Certain Relationships and Related Transactions.
Some of the directors and officers of the Bank and some of the corporations and
firms with which these individuals are associated also are customers of the Bank
in the ordinary course of business, or are indebted to the Bank with respect to
loans. It is anticipated that some of these individuals, corporations and firms
will continue to be customers of, and indebted to, the Bank on a similar basis
in the future. All loans extended to such individuals, corporations and firms
were made in the ordinary course of business, did not involve more than normal
risk of collectibility or present other unfavorable features, and were made on
substantially the same terms, including
44
interest rates and collateral, as those prevailing at the same time for
comparable Bank transactions with unaffiliated persons.
Director Joan Nerlino Caddell is a member of the law firm of Nerlino & Gambale,
LLP (formerly of "Nerlino, Gambale & Klapper LLP" and formerly of "Holzka,
Donahue & Nerlino") which the Bank retained during the last fiscal year for the
performance of legal services on a matter by matter basis. Fees paid to firms of
which Director Joan Nerlino Caddell was a partner totaled $98,327 in 2002, which
exceeded 5% of those firms' consolidated gross revenues for the last fiscal
year.
Director Chaim Farkas is President and shareholder of the firm of Dataware
Systems Lease, Inc. ("Dataware") from which the Bank purchased computer hardware
and related software in the ordinary course of business. During the last fiscal
year, the fees paid to Dataware in the aggregate, totaled $133,637, which
exceeded 5% of the firm's consolidated gross revenues for the last fiscal year.
Director Savino Savo is a member of Boardwalk Estates, LLC, a limited liability
company, which develops residential real estate for resale and is the president
of Village Green Shopping Center Inc., a real estate company, both of which had
loans from the Bank at December 31, 2003. The maximum indebtedness owed on those
loans, in the aggregate, during 2002 was $1,000,000. The loans were 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 the normal risk of collectibility or present other unfavorable
features.
Other than normal customer relationships, none of the directors or officers of
the Bank or the corporations or firms with which such individuals are associated
currently maintain or have maintained during the past fiscal year any
significant business or personal relationship with the Bank other than such as
arises by virtue of such individual's or entity's position with or ownership
interest in the Bank, except as set forth above.
Item 8. Description of Securities.
Description of the Capital Stock of VSB Bancorp, Inc.
General. VSB is authorized to issue 3,000,000 shares of common stock having a
par value of $.0001 per share and no other shares of capital stock. VSB
currently expects to issue up to 1,056,000 shares of common stock in the holding
company reorganization and reserve an additional 99,000 shares to satisfy the
exercise of stock options issued or issuable under existing stock option plans
of the Bank which are being assumed by VSB. VSB presently has no other plans to
issue its common stock. Each share of VSB's common stock will have the same
relative rights as, and will be identical in all respects with, each other share
of common stock. All stock issued in the holding company reorganization will be
duly authorized, fully paid and nonassessable.
The common stock of VSB will represent nonwithdrawable capital, will not be an
account of an insurable type, and will not be insured by the FDIC or any other
government agency.
Dividends. VSB can pay dividends out of statutory surplus or from certain net
profits if, as and when declared by its Board of Directors. Each share of common
stock will be entitled to share equally with all other chares of common stock
with respect to any dividend paid by VSB on account of its common stock.
Voting Rights. The holders of common stock of VSB will possess exclusive voting
rights in VSB. Each holder of common stock will be entitled to one vote per
share. Stockholders will not have any right to cumulate votes in the election of
directors, which means that a stockholder may not cast more votes for any one
nominee than the number of shares owned by that stockholder, even if there is
more than one seat up for election.
45
Liquidation. In the event of liquidation, dissolution or winding up of VSB, the
holders of its common stock would be entitled to receive, after payment or
provision for payment of all of its debts and liabilities, all of the assets of
VSB available for distribution.
Preemptive Rights and Redemption. Holders of the common stock of VSB will not be
entitled to preemptive rights with respect to any shares which may be issued.
The common stock is not subject to redemption.
Bylaw Provisions Regarding Stockholder Nominations, Stockholder Proposals, and
Related Matters
The bylaws of the Bank currently provide, and the bylaws of VSB after the
holding company reorganization will provide, that, except for proposals or
nominations by the Board of Directors, a stockholder will be permitted to
nominate a person to serve as a director or to present another proposal to
stockholders at a stockholders' meeting only by first satisfying certain
requirements. A stockholder must give advance written notice to the Secretary of
VSB before making any such nomination or submitting such a proposal. To be
timely, a stockholder's notice must be delivered to or mailed to and received at
the principal executive offices of VSB not less than ninety days prior to the
date of the annual meeting; provided, however, that as to the first annual
meeting, or any subsequent annual meeting held earlier than 30 days in advance
of the anniversary of the annual meeting in the previous year, the notice must
be received not later than the close of business on the 10th day following the
day on which notice of the date of the annual meeting was mailed or public
disclosure of the date of the meeting is made.
The notice must be signed by the stockholder. The notice must also state (i) the
name and address of such stockholder as they appear on VSB's books and (ii) the
class and number of shares of the VSB's capital stock that the stockholder
beneficially owns.
As to notices of intent to submit a proposal for stockholder vote, the notice
must state: (i) a brief description of the business desired to be brought before
the annual meeting and the reasons for conducting such business at the annual
meeting; and (ii) any material interest of the stockholder in the proposed
business. Only business which is a proper subject of stockholder action may be
proposed at or voted on at the meeting.
As to notices of intent to nominate a person as a director, the notice must
state: (i) all information relating to each proposed nominee that is required to
be disclosed in solicitations of proxies for election of directors, or is
otherwise required, in each case pursuant to applicable law and regulation; and
(ii) any business, familial or employment relationship between such Stockholder
and such nominees. The notice must be accompanied by the nominee's written
consent to being named in the proxy statement as a nominee and to serving as a
director if elected, provided, however, that VSB will not be required to name
such nominee in any proxy statement prepared by VSB or to solicit votes for such
nominee unless required by law to do so.
At any special meeting of the Stockholders, only such business shall be
conducted as shall have been brought before the meeting by or at the direction
of the Board of Directors.
The certificate of incorporation of VSB provides for 3,000,000 shares of common
stock. VSB expects to issue 1,056,000 shares in the holding company
reorganization and reserve an additional 99,000 shares to satisfy stock options.
The remaining shares will be available for sale or issuance by VSB without
stockholder approval, unless stockholder approval is required by law for the
transaction in which the stock will be issued, such as in connection with
certain mergers. The Board of Directors has no current plans to issue any of the
additional authorized shares of stock but may do so in the future if the Board
of Directors determines that it would be in the best interests of VSB to do so.
46
PART II
Item 1. Market Price of and Dividends on the Registrant's Common Equity and
Related Stockholder Matters.
There is currently no market for the common stock of VSB. The common stock of
the Bank is quoted on the NASDAQ Over the Counter Market ("OTC") under the
symbol "VYSB".
The following table reflects the high and low bid price for the Bank's common
stock during each calendar quarter of the last two fiscal years. Such
information is derived from quotations published by Bloomberg LP. These
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not represent actual transactions.
2001
---------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
------------- -------------- ------------- --------------
High Bid..................... $13.50 $13.50 $15.00 $15.25
Low Bid...................... $11.00 $12.12 $12.55 $13.35
2002
---------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
------------- -------------- ------------- --------------
High Bid..................... $19.40 $21.25 $21.25 $26.00
Low Bid...................... $14.55 $19.00 $19.70 $21.25
The Bank currently has 704,000 shares outstanding. Upon the completion of the
holding company reorganization, stockholders of the bank will receive three
shares of VSB common stock for each two shares of Bank stock that they own. Each
person who would be entitled to a fractional share of VSB common stock as a
result of the reorganization will receive, instead of one-half of a share of VSB
Bancorp stock, an amount in cash equal to one-third of the average of the best
bid and best ask price of the Bank's common stock on the last full trading day
of the Bank's common stock prior to the day the holding company reorganization
becomes effective.
Item 2. Legal Proceedings.
VSB Bancorp is not involved in any pending legal proceedings. The Bank is not
involved in any material pending legal proceedings other than routine legal
proceedings occurring in the ordinary course of business. Such other routine
legal proceedings in the aggregate are believed by management to be immaterial
to the Bank's financial condition or results of operations.
Item 3. Changes in and Disagreements with Accountants.
None
Item 4. Recent Sales of Unregistered Securities.
VSB's securities, when issued, will be issued in exchange for the outstanding
securities of the Bank in a holding company reorganization which is exempt from
registration under the Securities Act of 1933 pursuant to Section 3(a)(12). All
shares issued will be common stock. There is no underwriter in connection with
the transaction. The shares will be issued on a three for two exchange basis.
The Bank current has 704,000 shares outstanding, so VSB will issue 1,056,000
shares upon consummation of the reorganization, subject to adjustment based upon
the exercise of dissenters' rights or settlement for fractional shares in cash.
47
VSB and the Bank have filed applications or notices with the New York State
Superintendent of Banks, the Federal Deposit Insurance Corporation and the Board
of Governors of the Federal Reserve System to effectuate the reorganization. The
Board of Governors of the Federal Reserve System has already entered its
non-objection and the Federal Deposit Insurance Corporation has approved the
merger of Victory Interim Bank and Victory State Bank. VSB anticipates that the
New York State Banking Board will act on the transaction at its monthly meeting
in May 2003.
Item 5. Indemnification of Directors and Officers.
The certificate of incorporation of VSB provides, as permitted by Section 402(b)
of the New York Business Corporation Law, that a director will not be personally
liable to the corporation or its shareholders for damages for any breach of duty
in his or her capacity as a director. The limit on a director's liability does
not apply:
(a) if a judgment or other final adjudication adverse to the director
establishes that the director's acts or omissions were in bad faith or
involved intentional misconduct or a knowing violation of law or that
the director personally gained in fact a financial profit or other
advantage to which he or she was not legally entitled or
(b) if the director's acts violated Section 719 of the New York Business
Corporation Law regarding declaring unlawful dividends, approving
unlawful stock repurchases, making unlawful loans to directors or
making improper distributions upon liquidation.
In addition, Sections 722 through 726 of the New York Business Corporations Law
provide for the indemnification of Directors and Officers. The following is the
text of those provisions.
Section 722. Authorization for indemnification of directors and officers.
(a) A corporation may indemnify any person made, or threatened to be made,
a party to an action or proceeding (other than one by or in the right of the
corporation to procure a judgment in its favor), whether civil or criminal,
including an action by or in the right of any other corporation of any type or
kind, domestic or foreign, or any partnership, joint venture, trust, employee
benefit plan or other enterprise, which any director or officer of the
corporation served in any capacity at the request of the corporation, by reason
of the fact that he, his testator or intestate, was a director or officer of the
corporation, or served such other corporation, partnership, joint venture,
trust, employee benefit plan or other enterprise in any capacity, against
judgments, fines, amounts paid in settlement and reasonable expenses, including
attorneys' fees actually and necessarily incurred as a result of such action or
proceeding, or any appeal therein, if such director or officer acted, in good
faith, for a purpose which he reasonably believed to be in, or, in the case of
service for any other corporation or any partnership, joint venture, trust,
employee benefit plan or other enterprise, not opposed to, the best interests of
the corporation and, in criminal actions or proceedings, in addition, had no
reasonable cause to believe that his conduct was unlawful.
(b) The termination of any such civil or criminal action or proceeding by
judgment, settlement, conviction or upon a plea of nolo contendere, or its
equivalent, shall not in itself create a presumption that any such director or
officer did not act, in good faith, for a purpose which he reasonably believed
to be in, or, in the case of service for any other corporation or any
partnership, joint venture, trust, employee benefit plan or other enterprise,
not opposed to, the best interests of the corporation or that he had reasonable
cause to believe that his conduct was unlawful.
(c) A corporation may indemnify any person made, or threatened to be made,
a party to an action by or in the right of the corporation to procure a judgment
in its favor by reason of the fact that he, his testator or intestate, is or was
a director or officer of the corporation, or is or was serving at the request of
the corporation as a director
48
or officer of any other corporation of any type or kind, domestic or foreign, of
any partnership, joint venture, trust, employee benefit plan or other
enterprise, against amounts paid in settlement and reasonable expenses,
including attorneys' fees, actually and necessarily incurred by him in
connection with the defense or settlement of such action, or in connection with
an appeal therein, if such director or officer acted, in good faith, for a
purpose which he reasonably believed to be in, or, in the case of service for
any other corporation or any partnership, joint venture, trust, employee benefit
plan or other enterprise, not opposed to, the best interests of the corporation,
except that no indemnification under this paragraph shall be made in respect of
(1) a threatened action, or a pending action which is settled or otherwise
disposed of, or (2) any claim, issue or matter as to which such person shall
have been adjudged to be liable to the corporation, unless and only to the
extent that the court in which the action was brought, or, if no action was
brought, any court of competent jurisdiction, determines upon application that,
in view of all the circumstances of the case, the person is fairly and
reasonably entitled to indemnity for such portion of the settlement amount and
expenses as the court deems proper.
(d) For the purpose of this section, a corporation shall be deemed to have
requested a person to serve an employee benefit plan where the performance by
such person of his duties to the corporation also imposes duties on, or
otherwise involves services by, such person to the plan or participants or
beneficiaries of the plan; excise taxes assessed on a person with respect to an
employee benefit plan pursuant to applicable law shall be considered fines; and
action taken or omitted by a person with respect to an employee benefit plan in
the performance of such person's duties for a purpose reasonably believed by
such person to be in the interest of the participants and beneficiaries of the
plan shall be deemed to be for a purpose which is not opposed to the best
interests of the corporation.
Section 723. Payment of indemnification other than by court award.
(a) A person who has been successful, on the merits or otherwise, in the
defense of a civil or criminal action or proceeding of the character described
in section 722 shall be entitled to indemnification as authorized in such
section.
(b) Except as provided in paragraph (a), any indemnification under section
722 or otherwise permitted by section 721, unless ordered by a court under
section 724 (Indemnification of directors and officers by a court), shall be
made by the corporation, only if authorized in the specific case:
(1) By the board acting by a quorum consisting of directors who are not parties
to such action or proceeding upon a finding that the director or officer has met
the standard of conduct set forth in section 722 or established pursuant to
section 721, as the case may be, or,
(2) If a quorum under subparagraph (1) is not obtainable or, even if obtainable,
a quorum of disinterested directors so directs;
(A) By the board upon the opinion in writing of independent legal
counsel that indemnification is proper in the circumstances because the
applicable standard of conduct set forth in such sections has been met by such
director or officer, or
(B) By the shareholders upon a finding that the director or officer
has met the applicable standard of conduct set forth in such sections.
(c) Expenses incurred in defending a civil or criminal action or proceeding
may be paid by the corporation in advance of the final disposition of such
action or proceeding upon receipt of an undertaking by or on behalf of such
director or officer to repay such amount as, and to the extent, required by
paragraph (a) of section 725.
Section 724. Indemnification of directors and officers by a court.
(a) Notwithstanding the failure of a corporation to provide
indemnification, and despite any contrary resolution of the board or of the
shareholders in the specific case under section 723 (Payment of indemnification
49
other than by court award), indemnification shall be awarded by a court to the
extent authorized under section 722 (Authorization for indemnification of
directors and officers), and paragraph (a) of section 723. Application therefor
may be made, in every case, either:
(1) In the civil action or proceeding in which the expenses were incurred or
other amounts were paid, or
(2) To the supreme court in a separate proceeding, in which case the application
shall set forth the disposition of any previous application made to any court
for the same or similar relief and also reasonable cause for the failure to make
application for such relief in the action or proceeding in which the expenses
were incurred or other amounts were paid.
(b) The application shall be made in such manner and form as may be
required by the applicable rules of court or, in the absence thereof, by
direction of a court to which it is made. Such application shall be upon notice
to the corporation. The court may also direct that notice be given at the
expense of the corporation to the shareholders and such other persons as it may
designate in such manner as it may require.
(c) Where indemnification is sought by judicial action, the court may allow
a person such reasonable expenses, including attorneys' fees, during the
pendency of the litigation as are necessary in connection with his defense
therein, if the court shall find that the defendant has by his pleadings or
during the course of the litigation raised genuine issues of fact or law.
Section 725. Other provisions affecting indemnification of directors and
officers.
(a) All expenses incurred in defending a civil or criminal action or
proceeding which are advanced by the corporation under paragraph (c) of section
723 (Payment of indemnification other than by court award) or allowed by a court
under paragraph (c) of section 724 (Indemnification of directors and officers by
a court) shall be repaid in case the person receiving such advancement or
allowance is ultimately found, under the procedure set forth in this article,
not to be entitled to indemnification or, where indemnification is granted, to
the extent the expenses so advanced by the corporation or allowed by the court
exceed the indemnification to which he is entitled.
(b) No indemnification, advancement or allowance shall be made under this
article in any circumstance where it appears:
(1) That the indemnification would be inconsistent with the law of the
jurisdiction of incorporation of a foreign corporation which prohibits or
otherwise limits such indemnification;
(2) That the indemnification would be inconsistent with a provision of the
certificate of incorporation, a by-law, a resolution of the board or of the
shareholders, an agreement or other proper corporate action, in effect at the
time of the accrual of the alleged cause of action asserted in the threatened or
pending action or proceeding in which the expenses were incurred or other
amounts were paid, which prohibits or otherwise limits indemnification; or
(3) If there has been a settlement approved by the court, that the
indemnification would be inconsistent with any condition with respect to
indemnification expressly imposed by the court in approving the settlement.
(c) If any expenses or other amounts are paid by way of indemnification,
otherwise than by court order or action by the shareholders, the corporation
shall, not later than the next annual meeting of shareholders unless such
meeting is held within three months from the date of such payment, and, in any
event, within fifteen months from the date of such payment, mail to its
shareholders of record at the time entitled to vote for the election of
directors a statement specifying the persons paid, the amounts paid, and the
nature and status at the time of such payment of the litigation or threatened
litigation.
(d) If any action with respect to indemnification of directors and officers
is taken by way of amendment of the by-laws, resolution of directors, or by
agreement, then the corporation shall, not later than the next annual meeting of
shareholders, unless such meeting is held within three months from the date of
such action, and, in any event, within fifteen months from the date of such
action, mail to its shareholders of record at the time entitled to vote
50
for the election of directors a statement specifying the action taken.
(e) Any notification required to be made pursuant to the foregoing
paragraph (c) or (d) of this section by any domestic mutual insurer shall be
satisfied by compliance with the corresponding provisions of section one
thousand two hundred sixteen of the insurance law.
(f) The provisions of this article relating to indemnification of directors
and officers and insurance therefor shall apply to domestic corporations and
foreign corporations doing business in this state, except as provided in section
1320 (Exemption from certain provisions).
Section 726. Insurance for indemnification of directors and officers.
(a) Subject to paragraph (b), a corporation shall have power to purchase
and maintain insurance:
(1) To indemnify the corporation for any obligation which it incurs as a result
of the indemnification of directors and officers under the provisions of this
article, and
(2) To indemnify directors and officers in instances in which they may be
indemnified by the corporation under the provisions of this article, and
(3) To indemnify directors and officers in instances in which they may not
otherwise be indemnified by the corporation under the provisions of this article
provided the contract of insurance covering such directors and officers
provides, in a manner acceptable to the superintendent of insurance, for a
retention amount and for co-insurance.
(b) No insurance under paragraph (a) may provide for any payment, other
than cost of defense, to or on behalf of any director or officer:
(1) if a judgment or other final adjudication adverse to the insured director or
officer establishes that his acts of active and deliberate dishonesty were
material to the cause of action so adjudicated, or that he personally gained in
fact a financial profit or other advantage to which he was not legally entitled,
or
(2) in relation to any risk the insurance of which is prohibited under the
insurance law of this state.
(c) Insurance under any or all subparagraphs of paragraph (a) may be
included in a single contract or supplement thereto. Retrospective rated
contracts are prohibited.
(d) The corporation shall, within the time and to the persons provided in
paragraph (c) of section 725 (Other provisions affecting indemnification of
directors or officers), mail a statement in respect of any insurance it has
purchased or renewed under this section, specifying the insurance carrier, date
of the contract, cost of the insurance, corporate positions insured, and a
statement explaining all sums, not previously reported in a statement to
shareholders, paid under any indemnification insurance contract.
(e) This section is the public policy of this state to spread the risk of
corporate management, notwithstanding any other general or special law of this
state or of any other jurisdiction including the federal government.
51
PART F/S
The audited financial statements of the Bank are included in this Part F/S. Upon
completion of the reorganization of the Bank into the holding company form of
organization as a wholly-owned subsidiary of VSB, VSB will report consolidated
financial statements with the Bank. For reporting purposes on a historical
basis, the financial statements of the Bank prior to the reorganization will
shown as the financial statements of VSB.
INDEX TO FINANCIAL STATEMENTS
Independent Auditors' Report ............................................................. 53
Statements of Financial Condition as of December 31, 2002 and 2001........................ 54
Statements of Earnings for the Years Ended December 31, 2002, 2001 and 2000............... 55
Statements of Shareholders' Equity for the Years Ended December 31, 2002, 2001 and 2000... 56
Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000............. 57
Notes to Financial Statements............................................................. 58
52
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Victory State Bank:
We have audited the accompanying statements of financial condition of
Victory State Bank (the "Bank") as of December 31, 2002 and 2001 and the related
statements of earnings, shareholders' equity and comprehensive income and of
cash flows for each of the three years in the period ended December 31, 2002.
These financial statements are the responsibility of the Bank's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial condition of the Bank as of December 31, 2002 and 2001
and the results of its operations and cash flows for each of the three years in
the period ended December 31, 2002 in conformity with accounting principles
generally accepted in the United States of America.
/s/ Deloitte & Touche LLP
- -------------------------
Deloitte & Touche LLP
Princeton, New Jersey
March 5, 2003
53
VICTORY STATE BANK
STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2002 AND 2001
2002 2001
------------ ------------
ASSETS
Cash and due from banks $ 26,095,803 $ 8,511,515
Money market investments, held to maturity -- 50,187
Investment securities, available for sale 42,999,660 39,286,998
Loans receivable (net of allowance for loan losses
of $1,168,358 and $894,692, respectively) 62,246,153 49,530,101
Accrued interest receivable 424,636 366,113
Premises and equipment, net 2,399,163 1,341,653
Prepaid and other assets 415,322 933,616
Deferred income taxes, net 263,889 405,466
------------ ------------
Total assets $134,844,626 $100,425,649
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Deposits $123,702,365 $ 91,132,816
Accounts payable, accrued expenses and other liabilities 1,379,144 1,071,807
------------ ------------
Total liabilities 125,081,509 92,204,623
------------ ------------
COMMITMENTS AND CONTINGENT LIABILITIES
SHAREHOLDERS' EQUITY
Common stock ($5.00 par value, 800,000 shares authorized, 704,000
issued and outstanding, 700,000 issued and outstanding, respectively) 3,520,000 3,500,000
Additional paid-in capital 3,556,592 3,500,000
Retained earnings 2,259,313 1,079,005
Accumulated other comprehensive income, net of taxes
of $380,372 and $125,731, respectively 427,212 142,021
------------ ------------
Total shareholders' equity 9,763,117 8,221,026
------------ ------------
Total liabilities and shareholders' equity $134,844,626 $100,425,649
============ ============
See notes to financial statements.
54
VICTORY STATE BANK
STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 and 2000
2002 2001 2000
---------- ---------- ----------
INTEREST INCOME:
Loans receivable $4,411,688 $4,196,262 $3,872,010
Money market investments 184,906 272,439 267,955
Investment securities 1,922,006 1,367,232 979,802
---------- ---------- ----------
Total interest income 6,518,600 5,835,933 5,119,767
INTEREST EXPENSE:
Deposits 822,287 1,078,266 930,521
---------- ---------- ----------
Net interest income 5,696,313 4,757,667 4,189,246
PROVISION FOR LOAN LOSSES 355,000 305,000 645,000
---------- ---------- ----------
Net interest income after
provision for loan losses 5,341,313 4,452,667 3,544,246
---------- ---------- ----------
NON-INTEREST INCOME:
Deposit service fees 1,184,084 879,378 636,859
Other income 131,499 87,711 70,316
---------- ---------- ----------
Total non-interest income 1,315,583 967,089 707,175
---------- ---------- ----------
NON-INTEREST EXPENSES:
Salaries and employee benefits 2,344,297 1,857,844 1,520,517
Occupancy and equipment 815,543 743,787 675,219
Data processing service fees 236,563 232,808 222,093
Legal fees 76,037 77,823 61,725
Professional fees 139,730 141,396 104,100
Other 813,488 617,440 589,348
---------- ---------- ----------
Total non-interest expenses 4,425,658 3,671,098 3,173,002
---------- ---------- ----------
INCOME BEFORE INCOME TAXES 2,231,238 1,748,658 1,078,419
---------- ---------- ----------
PROVISION/(BENEFIT) FROM INCOME TAXES:
Current 1,232,511 1,020,227 584,653
Deferred (181,581) (196,601) (74,849)
---------- ---------- ----------
Total income taxes 1,050,930 823,626 509,804
---------- ---------- ----------
NET INCOME $1,180,308 $ 925,032 $ 568,615
========== ========== ==========
Basic net income per share of common stock $ 1.69 $ 1.32 $ 0.81
========== ========== ==========
Fully diluted net income per share of common stock $ 1.64 $ 1.31 $ 0.81
========== ========== ==========
See notes to financial statements.
55
VICTORY STATE BANK
STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME FOR THE YEARS
ENDED DECEMBER 31, 2002, 2001 AND 2000
Retained Accumulated
Number of Additional Earnings Other Total
Common Common Paid-in (Accumulated Comprehensive Shareholders'
Shares Stock Capital Deficit) Earnings/(Loss) Equity
--------- ---------- ---------- ------------ --------------- -------------
Balance at December 31, 1999 700,000 $3,500,000 $3,500,000 ($414,642) ($128,332) $6,457,026
Comprehensive income:
Net income -- -- -- 568,615 -- 568,615
Other comprehensive income:
Unrealized holding gains, net
of taxes -- -- -- -- 147,398 147,398
------- ---------- ---------- ---------- ---------- ----------
Total comprehensive income 716,013
Balance at December 31, 2000 700,000 3,500,000 3,500,000 153,973 19,066 7,173,039
Comprehensive income:
Net income -- -- -- 925,032 -- 925,032
Other comprehensive income:
Unrealized holding gains, net
of taxes -- -- -- -- 122,955 122,955
------- ---------- ---------- ---------- ---------- ----------
Total comprehensive income 1,047,987
Balance at December 31, 2001 700,000 3,500,000 3,500,000 1,079,005 142,021 8,221,026
Comprehensive income:
Exercise Stock Option 4,000 20,000 56,592 -- -- 76,592
Net income -- -- -- 1,180,308 -- 1,180,308
Other comprehensive income:
Unrealized holding gains, net
of taxes -- -- -- -- 285,191 285,191
------- ---------- ---------- ---------- ---------- ----------
Total comprehensive income 1,542,091
Balance at December 31, 2002 704,000 $3,520,000 $3,556,592 $2,259,313 $ 427,212 $9,763,117
======= ========== ========== ========== ========== ==========
See notes to financial statements.
56
VICTORY STATE BANK
STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 and 2000
2002 2001 2000
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,180,308 $ 925,032 $ 568,615
Adjustments to reconcile net income to net cash
used in operating activities:
Depreciation and amortization 379,245 354,355 380,803
Amortization of premium, net of accretion of discount (113,849) (167,884) (121,342)
Provision for loan losses 355,000 305,000 645,000
Other -- 86 --
Changes in operating assets and liabilities:
Decrease/(increase) in prepaid and other assets 488,294 (735,784) (39,554)
Increase in accrued interest receivable (58,523) (28,158) (118,758)
Increase in deferred income taxes (112,345) (196,601) (74,849)
Increase in accrued expenses, income tax payable
and other liabilities 307,337 473,429 184,966
------------ ------------ ------------
Net cash provided by operating activities 2,425,467 929,475 1,424,881
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans receivable (12,833,809) (5,332,319) (19,841,079)
Proceeds from sale and maturities of money market investments 550,187 77,798,467 86,853,096
Proceeds from repayments and calls of investment securities,
available for sale 24,856,565 12,538,557 6,986,553
Purchases of money market investments (500,000) (75,678,989) (84,432,325)
Purchase of investment securities, available for sale (28,153,508) (36,866,396) (4,078,295)
Proceeds from the sale of premises and equipment -- -- 11,000
Purchases of premises and equipment, net (1,436,755) (241,775) (574,898)
Proceeds from the sale of other assets 30,000 -- --
Other -- 765 --
------------ ------------ ------------
Net cash used in investing activities (17,487,320) (27,781,690) (15,075,948)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 32,569,549 32,181,190 14,756,360
Exercise stock Option 76,592 -- --
------------ ------------ ------------
Net cash provided by financing activities 32,646,141 32,181,190 14,756,360
------------ ------------ ------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 17,584,288 5,328,975 1,105,293
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR 8,511,515 3,182,540 2,077,247
------------ ------------ ------------
CASH AND CASH EQUIVALENTS,
END OF YEAR $ 26,095,803 $ 8,511,515 $ 3,182,540
============ ============ ============
SUPPLEMENTAL DISCLOSURE OF CASH
FLOW INFORMATION:
Cash paid during the period for:
Interest $ 830,829 $ 1,122,247 $ 912,357
============ ============ ============
Income taxes $ 1,181,607 $ 1,115,126 $ 535,055
============ ============ ============
See notes to financial statements.
57
VICTORY STATE BANK
NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND
2000
1. GENERAL
Victory State Bank (the "Bank") is a state-chartered, stock commercial
bank, which was formed on November 13, 1997 with initial capital of
$7,000,000 and commenced operations on November 17, 1997. The initial
capital was raised in a public offering, primarily in the borough of Staten
Island. The Bank issued 700,000 shares of common stock at an offering price
of $10.00 per share, $5.00 per share par value. The Bank is listed on the
NASDAQ Over the Counter Market ("OTC") under the symbol "VYSB". The Bank
operates a main office and three full service branches in its primary
market of Staten Island.
The Bank's results of operations are dependent primarily on net interest
income, which is the difference between the income earned on its loan and
investment portfolios and its costs of funds, consisting of interest paid
on its deposits. The Bank's operating expenses principally consist of
employee compensation and benefits, occupancy expenses, professional fees,
advertising and marketing expenses and other general and administrative
expenses. The Bank's results of operations are significantly affected by
general economic and competitive conditions, particularly changes in market
interest rates, government policies and actions of regulatory authorities.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a description of the significant accounting and reporting
policies followed in preparing and presenting the accompanying financial
statements. These policies conform to accounting principles generally
accepted in the United States of America.
Risks and Uncertainties - The preparation of financial statements in
conformity with accounting principles generally accepted in the United
States of America 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 amounts of revenues and expenses during the
reporting period. Actual results can differ from those estimates.
Cash and Cash Equivalents - For purposes of reporting cash flows, cash and
cash equivalents include cash and amounts due from banks. The Bank
maintains a minimum cash balance of $2,331,000 with its correspondent bank.
Such balance is maintained for the purpose of conducting funding and check
clearing transactions, while reducing service fees and expenses. The
minimum balances may be withdrawn at the Bank's option without any
interruption of the services received from the correspondent bank.
Money Market Investments, Held to Maturity - Money market investments
represent short-term investments (with original maturities of one year or
less) which are held to maturity. These investments are carried at cost,
adjusted for the accretion of discount or the amortization of
58
premium using a method which approximates the level yield method over the
period to maturity. Carrying values of these investments approximate
current market values.
Investment Securities, Available For Sale - Investment securities,
available for sale, are to be held for an indefinite period of time and
include securities that management intends to use as part of its
asset/liability strategy. These securities may be sold in response to
changes in interest rates, prepayments or other factors and are carried at
estimated fair value. Gains or losses on the sale of such securities are
determined by the specific identification method. Premium and discounts are
recognized in interest income using a method that approximates the level
yield method. Unrealized holding gains or losses, net of deferred income
tax, are excluded from earnings and reported as other comprehensive income
(a net of tax amount in a separate component of stockholders' equity) until
realized.
The Bank invests primarily in agency Collateralized Mortgage-backed
Obligations ("CMO") with average lives under 4.0 years and Mortgage Backed
Securities. These securities are primarily issued by the Federal National
Mortgage Association ("FNMA"), the Government National Mortgage Association
("GNMA") or the Federal Home Loan Mortgage Corporation ("FHLMC") and are
primarily comprised of mortgage pools guaranteed by FNMA, GNMA or FHLMC.
The Bank also invests in whole loan CMOs, all of which are AAA rated. These
securities expose the Bank to risks such as interest rate, prepayment and
credit risk and thus pay a higher rate of return than comparable treasury
issues.
Loans Receivable - Loans receivable, that management has the intent and
ability to hold for the foreseeable future or until maturity or pay-off,
are stated at unpaid principal balances, adjusted for deferred net
origination and commitment fees and allowance for loan losses. Interest
income on loans is credited as earned.
It is the policy of the Bank to provide a valuation allowance for estimated
losses on loans based on the Bank's past loan loss experience, known and
inherent risks in the portfolio, adverse situations which may affect the
borrower's ability to repay, estimated value of underlying collateral and
current economic conditions in the Bank's lending area. The allowance is
increased by provisions for loan losses charged to operations and is
reduced by charge-offs, net of recoveries. While management uses available
information to estimate losses on loans, future additions to the allowance
may be necessary based upon the expected growth of the loan portfolio and
any changes in economic conditions beyond management's control. In
addition, various regulatory agencies, as an integral part of their
examination process, periodically review the Bank's allowance for loan
losses. Such agencies may require the Bank to recognize additions to the
allowance based on judgments different from those of management. Management
believes, based upon all relevant and available information, that the
allowance for loan losses is adequate.
The Bank adopted a policy whereby all loans 90 days past due are placed on
non-accrual status. It is the Bank's policy to cease the accrual of
interest on loans to borrowers past due less than 90 days where a probable
loss is estimated and to reverse out of income all interest that is due.
The Bank continues to accrue interest on construction loans that are 90
days past contractual maturity date if the loan is expected to be paid in
full in the next 60 days and all interest is paid up to date.
Loan origination fees and certain direct loan origination costs are
deferred and the net amount recognized over the contractual loan terms
using the level-yield method, adjusted for periodic prepayments in certain
circumstances.
59
The Bank considers a loan to be impaired when, based on current
information, it is probable that the Bank will be unable to collect all
principal and interest payments due according to the contractual terms of
the loan agreement. Impaired loans are measured based on the present value
of expected future cash flows discounted at the loan's effective interest
rate or, as a practical expedient, at the loan's observable market price or
the fair value of the collateral. The fair value of the collateral, as
reduced by costs to sell, is utilized if a loan is collateral dependent or
foreclosure is probable.
Long-Lived Assets -The Bank periodically evaluates the recoverability of
long-lived assets, such as premises and equipment, to ensure the carrying
value has not been impaired. In performing the review for recoverability,
the Bank would estimate the future cash flows expected to result from the
use of the asset and its eventual disposition. If the sum of the expected
future cash flows is less than the carrying amount, an impairment will be
recognized. The Bank reports these assets at the lower of the carrying
value or fair value, less the cost to sell.
Premises and Equipment - Premises, leasehold improvements, and furniture
and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are accumulated by the
straight-line method over the estimated useful lives of the respective
assets, which range from 3 to 10 years.
Income Taxes - The Bank utilizes the liability method to account for income
taxes. Under this method, deferred tax assets and liabilities are
determined on differences between financial reporting and tax bases of
assets and liabilities and are measured using the enacted tax rates and
laws expected to be in effect when the differences are expected to reverse.
As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes.
Financial Instruments - In the ordinary course of business, the Bank has
entered into off-balance sheet financial instruments, primarily consisting
of commitments to extend credit.
Basic and Fully Diluted Net Income Per Common Share - The basic net income
per share of common stock is based on 700,296, the weighted average number
of common stock outstanding. Fully diluted net income per share of common
stock is based on 721,344, the weighted average number of common stock and
common stock equivalents outstanding. The weighted average number of common
stock equivalents excluded due to the anti-dilutive effect is 33,860.
Common stock equivalents were calculated using the treasury stock method.
Stock-Based Compensation - At December 31, 2002, the Bank has stock-based
employee compensation plans, which are described more fully in Note 12
Stock Option and Incentive Plan. The Bank accounts for these plans under
APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. No stock-based employee compensation expense has been
reflected in net income for stock options as all rights and options to
purchase the Bank's stock granted under these plans has an exercise price
equal to the market value of the underlying stock on the date of grant. A
table, which illustrates the income from continuing operations and earnings
per share as if the Bank had applied the fair value of recognition
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," as
amended, to stock-based employee compensation plans, is described more
fully in Note 12 Stock Option and Incentive Plan.
Recently Issued Accounting Standards
60
In July 2001 the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 141 "Business Combinations"
("SFAS 141"), which provides guidance on accounting for a business
combination at the date a business combination is completed. The Statement
requires the use of the purchase method of accounting for all business
combinations initiated after June 30, 2001, thereby eliminating the use of
the pooling of interests method. Also, it provides new criteria that
determine whether an acquired intangible asset should be recognized
separately from goodwill. The adoption of SFAS 141 did not have any impact
on the financial position or results of operations of the Bank.
In July 2001, the FASB issued SFAS No. 142 "Goodwill and Other Intangible
Assets" ("SFAS 142") which provides guidance on how to account for goodwill
and intangible assets after the acquisition is complete. The most
substantive change represented by this Statement is that goodwill will no
longer be amortized; instead, it will be tested for impairment at least
annually. The Statement will apply to existing goodwill and intangible
assets, beginning with fiscal years starting after December 15, 2001. The
adoption of this standard did not have any impact on the Bank's financial
statements.
In August 2001, the FASB released SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". The provisions of this
statement are effective for financial statements issued for fiscal periods
beginning after December 15, 2001. The adoption of this standard did not
have any impact on the Bank's financial statements.
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections ("SFAS 145"). SFAS 145 rescinds FASB Statement No. 4,
Reporting Gains and Losses from Extinguishment of Debt, and an amendment of
that Statement, FASB Statement No. 64, Extinguishments of Debt Made to
Satisfy Sinking-Fund Requirements. SFAS 145 also rescinds FASB Statement
No. 44, Accounting for Intangible Assets of Motor Carriers. SFAS 145 amends
FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency
between the required accounting for sale-leaseback transactions and the
required accounting for certain lease modifications that have economic
effects that are similar to sale-leaseback transactions. SFAS 145 also
amends other existing authoritative pronouncements to make various
technical corrections, clarify meanings, or describe their applicability
under changed conditions. The provisions of SFAS 145 related to the
rescission of FASB Statement No. 4 are effective for fiscal years beginning
after May 15, 2002. The provisions of SFAS 145 related to FASB Statement
No. 13 are effective for transactions occurring after May 15, 2002. All
other provisions of SFAS 145 are effective for financial statements issued
on or after May 15, 2002. The adoption of SFAS 145 did not have a material
effect on the Bank's financial statements.
In July 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, Accounting for Costs Associated with Exit or Disposal Activities
("SFAS 146"). SFAS 146 requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the
date of a commitment to an exit or disposal plan. SFAS 146 replaces
Emerging Issues Task Force Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). SFAS 146 is to be
applied prospectively to exit or disposal activities initiated after
December 31, 2002.
In October 2002, the FASB issued Statement of Financial Accounting
Standards No. 147 "Acquisition of Certain Financial Institutions" (SFAS
147), which provides guidance on the
61
accounting for the acquisition of a financial institution. SFAS 147
requires that the excess of the fair value of tangible and identifiable
intangible assets acquired in a business combination represents goodwill
that should be accounted for under FASB Statement No. 142, Goodwill and
Other Intangible Assets. Thus, the specialized accounting guidance in
paragraph 5 of FASB Statement No. 72, Accounting for Certain Acquisitions
of Banking and Thrift Institutions, will not apply after September 30,
2002. If certain criteria in Statement 147 are met, the amount of the
unidentifiable intangible asset will be reclassified to goodwill upon
adoption of that Statement. Financial Institutions meeting the conditions
outlined in Statement 147 will be required to restate previously issued
financial statements as if the amount accounted for under Statement 72 as
an unidentifiable intangible asset had been reclassified to goodwill as of
the date Statement 142 was initially applied. The adoption of SFAS 147 did
not have a material effect on the Bank's financial statements.
On November 25, 2002, the FASB issued Financial Accounting Standards Board
Interpretation No. 45 ("FIN 45" or the Interpretation"), "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, an interpretation of FASB Statements
No, 5, 57, and 107 and Rescission of FASB Interpretation No. 34." FIN 45
clarifies the requirements of FASB Statement No. 5, "Accounting for
Contingencies," relating to the guarantor's accounting for, and disclosure
of, the issuance of certain types of guarantees. FIN 45 requires that upon
issuance of a guarantee, the entity (i.e., the guarantor) must recognize a
liability for the fair value of the obligation it assumes under that
guarantee. The disclosure provisions of the Interpretation are effective
for financial statements of interim or annual periods that end after
December 15, 2002. The Interpretation's provisions for initial recognition
and measurement should be applied on a prospective basis to guarantees
issued or modified after December 31, 2002, irrespective of the guarantor's
fiscal year-end. The guarantor's previous accounting for guarantees that
were issued before the date of FIN 45's initial application may not be
revised or restated to reflect the effect of the recognition and
measurement provisions of the Interpretation. The Bank was not a party to
any guarantees that will be subject to the accounting and disclosure at
December 31, 2002.
In January 2003, the FASB issued Statement of Financial Accounting
Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based Compensation -
Transition and Disclosure." SFAS 148 amends FASB Statement No. 123 ("SFAS
123"), "Accounting for Stock-Based Compensation," to provide alternative
methods of transition for a voluntary change to the fair value based method
of accounting for stock-based employee compensation. In addition, SFAS 148
amends the disclosure requirements of SFAS 123 to require prominent
disclosures in both annual and interim financial statements of the method
of accounting for stock-based employee compensation and the effect of the
method used on reported results. SFAS 148 is effective for fiscal years
beginning after December 15, 2002. The Bank intends to adopt SFAS 148 on
January 1, 2003. The Bank does not expect to change to using the fair value
based method of accounting for stock-based employee compensation; and
therefore, adoption of SFAS 148 is expected to impact only the future
disclosures, not the financial results, of the Bank.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities - an Interpretation of ARB 51 ("FIN 46"). FIN 46
provides guidance on the consolidation of entities in which equity
investors do not have characteristics of a controlling financial interest
or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. FIN 46 is effective immediately for entities created before
February 1, 2003 no later than the beginning of the first interim or annual
reporting
62
period beginning after June 15, 2003. The Bank had no interest in a
Variable Interest Entity as of December 31, 2002.
3. MONEY MARKET INVESTMENTS, HELD TO MATURITY
The components of money market investments at December 31, 2002 and 2001
are as follows:
2002 2001
------- -------
FHLB term deposits $ -- $50,187
Total $ -- $50,187
------- -------
4. INVESTMENT SECURITIES, AVAILABLE FOR SALE
The components of investment securities, available for sale at December 31,
2002 and 2001 are as follows:
December 31, 2002
---------------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------- ---------- ---------- -----------
FNMA 7 Year Balloon $ 1,103,196 $ 80,326 $ -- $ 1,183,522
FHLMC 2,886,223 71,281 -- 2,957,504
Collateralized mortgage obligations 38,202,656 659,889 (3,911) 38,858,634
----------- -------- ------- -----------
$42,192,075 $811,496 $(3,911) $42,999,660
=========== ======== ======= ===========
December 31, 2001
---------------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------- ---------- ---------- -----------
U.S. Treasuries $ 994,363 $ 1,527 $ -- $ 995,890
FNMA 7 Year Balloon 2,029,830 85,217 -- 2,115,047
FHLMC 2,238,701 2,628 (8,961) 2,232,368
Collateralized mortgage obligations 33,755,633 309,287 (121,227) 33,943,693
----------- -------- --------- -----------
$39,018,527 $398,659 $(130,188) $39,286,998
=========== ======== ========= ===========
There were no gross realized gains or losses in 2002, 2001 or 2000.
63
The maturity schedule of all investment securities available for sale at
amortized cost and estimated fair values for December 31, 2002 was as follows:
Available for Sale Securities
-----------------------------
Estimated
Amortized Fair
Cost Value
----------- -----------
Less than one year $ 57,999 $ 58,455
Due after one year through 1,359,405 1,449,072
five years
Due after five years through 6,692,287 6,791,147
ten years
Due after ten years 34,082,384 34,700,986
----------- -----------
$42,192,075 $42,999,660
=========== ===========
Expected maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without
penalties.
5. LOANS RECEIVABLE, NET
Loans receivable, net at December 31, 2002 and 2001 are summarized as
follows:
64
2002 2001
----------- -----------
Commercial loans (principally variable rate):
Secured $ 4,014,494 $ 4,337,062
Unsecured 11,322,164 10,964,539
----------- -----------
Total commercial loans 15,336,658 15,301,601
Real estate loans:
Commercial 31,357,950 21,553,696
One-to-four family 493,504 376,999
----------- -----------
Total real estate loans 31,851,454 21,930,695
Construction loans (net of undisbursed funds of
$11,531,500 and $2,202,500, respectively) 14,877,442 12,280,294
Consumer loans 1,179,485 796,987
Other loans 509,073 331,355
----------- -----------
1,688,558 1,128,342
----------- -----------
Total loans receivable 63,754,112 50,640,932
Less:
Unearned loans fees, net (339,601) (216,139)
Allowance for loan losses (1,168,358) (894,692)
----------- -----------
Total $62,246,153 $49,530,101
=========== ===========
The activity in the allowance for loan losses for the years ended December
31, 2002, 2001 and 2000 are summarized as follows:
2002 2001 2000
---------- --------- ---------
Beginning balance $ 894,692 $ 766,377 $ 263,466
Charge-offs (154,612) (244,782) (154,196)
Recoveries 73,278 68,097 12,107
Provision 355,000 305,000 645,000
---------- --------- ---------
Ending balance $1,168,358 $ 894,692 $ 766,377
---------- --------- ---------
65
Nonaccrual loans outstanding at December 31, 2002 and 2001 are summarized
as follows:
2002 2001
-------- --------
Nonaccrual loans:
Commercial loans:
Unsecured $ 14,734 $ 70,000
Commercial real estate 313,039 579,601
-------- --------
Total nonaccrual loans $327,773 $649,601
-------- --------
2002 2001 2000
------ ------- -------
Interest income that would have been recorded
during the year on nonaccrual loans outstanding
at year-end in accordance with original terms $7,560 $70,307 $70,745
------ ------- -------
Interest income included in net income during the
year on nonaccrual loans outstanding at year-end $ -- $ -- $ --
------ ------- -------
The Bank's recorded investment in impaired loans at December 31 is as
follows:
2002 2001
------------------------- -------------------------
Related Related
Investment in Allowance Investment in Allowance
Impaired for loan Impaired for loan
Loans losses Loans losses
------------- --------- ------------- ---------
Impaired loans
With a related allowance for loan losses
Commercial and financial $ 14,734 $ 2,947 $ 70,000 $10,500
Commercial real estate 313,039 79,556 579,601 86,940
Without a related allowance for loan losses
Commercial and financial -- -- -- --
-------- ------- -------- -------
$327,773 $82,503 $649,601 $97,440
======== ======= ======== =======
The following table sets forth certain information about impaired loans at
December 31:
Investment in
Impaired Loans
-------------------
2002 2001
-------- --------
Average recorded investment $495,476 $718,412
-------- --------
Interest income recognized during time period that loans
were impaired, using cash-basis method of accounting $ -- $ 49,862
-------- --------
66
The Bank's loan portfolios are primarily comprised of commercial loans made
to small businesses and individuals located in the Borough of Staten Island. As
of December 31, 2002 and 2001, the Bank had no restructured loans.
6. ACCRUED INTEREST RECEIVABLE
Accrued interest receivable at December 31, 2002 and 2001 are summarized as
follows:
2002 2001
-------- --------
Loans receivable $233,180 $175,468
Investment securities, available for sale 191,456 190,645
-------- --------
Total $424,636 $366,113
======== ========
7. PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2002 and 2001 are summarized as
follows:
2002 2001
---------- ----------
Leasehold improvements $1,790,256 $ 798,506
Computer equipment and software 581,827 728,841
Furniture, fixtures and equipment 916,114 688,147
Other 24,020 24,115
---------- ----------
3,312,217 2,239,609
Less accumulated depreciation and amortization (913,054) (897,956)
---------- ----------
Total $2,399,163 $1,341,653
========== ==========
Depreciation and amortization expense amounted to $379,245, $354,355 and
$380,803 for the years ended December 31, 2002, 2001 and 2000, respectively.
At December 31, 2002, the Bank was obligated under four non-cancelable
operating leases on property used for banking purposes. Rental expense under
these leases were $343,161, $260,305, and $179,700 for the years ended December
31, 2002, 2001 and 2000, respectively.
The projected minimum rental payments under the terms of the leases at
December 31, 2002 are summarized as follows:
67
Year Ending
December 31, Amount
- ------------ ----------
2003 $ 326,936
2004 329,856
2005 333,630
2006 336,670
2007 216,856
Thereafter 1,841,866
----------
Total $3,385,814
----------
8. PREPAID AND OTHER ASSETS
Prepaid and other assets at December 31, 2002 and 2001 are summarized as
follows:
2002 2001
-------- --------
Accounts receivable $ 97,093 $728,016
Security deposit receivable 64,911 64,715
Deferred Initial Direct Lease Costs 52,568 --
Prepaid assets 104,186 77,852
ACBB common stock 30,000 30,000
Income tax receivable 18,482 --
Late charges receivable 48,082 33,033
-------- --------
$415,322 $933,616
-------- --------
9. DEPOSITS
Deposits are summarized at December 31, 2002 and 2001 as follows:
68
2002 2001
------------------------------------ -----------------------------------
Weighted Weighted
Average Average
Amount Percent Stated Rate Amount Percent Stated Rate
------------ ------- ----------- ----------- ------- -----------
Demand accounts:
Checking $ 45,506,450 36.78% --% $36,907,588 40.51% --%
Variable-rate money market 26,025,830 21.04 1.32 13,391,450 14.69 1.51
Statement savings 7,626,798 6.17 0.75 7,012,409 7.69 1.05
Interest-bearing checking 26,573,121 21.48 0.49 17,720,710 19.44 0.43
------------ ------ ---- ----------- ------ ----
105,732,199 85.47 0.50 75,032,157 82.33 0.47
Time deposits:
Less than six months 7,740,624 6.26 1.36 7,537,616 8.27 1.70
Six months to one year 6,730,304 5.44 1.70 6,852,999 7.52 2.04
More than one year 3,307,103 2.67 2.08 1,608,880 1.77 2.63
------------ ------ ---- ----------- ------ ----
17,778,031 14.37 1.62 15,999,495 17.56 1.94
Other deposits 192,135 0.16 -- 101,164 0.11 --
------------ ------ ---- ----------- ------ ----
Total $123,702,365 100.00% 0.66% $91,132,816 100.00% 0.73%
============ ====== ==== =========== ====== ====
The aggregate amount of jumbo certificates of deposit with a minimum
denomination of $100,000 was approximately $8,463,952 and $8,405,955 at December
31, 2002 and 2001 respectively.
Scheduled maturities of time deposits at December 31, 2002 are as follows:
Amount Percent
----------- -------
Within six months $13,739,459 77.29%
Six months to one year 2,022,178 11.37
One to three years 2,016,394 11.34
----------- ------
Total $17,778,031 100.00%
=========== ======
10. INCOME TAXES
The Bank files federal, state and local income tax returns on a
calendar-year basis. For federal, state and local income tax purposes, the Bank
uses the specific charge-off method in computing its federal, state and local
tax bad debt deduction.
The basis for the determination of state and local tax is the greater of a
tax on entire net income or a tax computed on taxable assets. Federal, state and
city income tax provisions were determined based on
69
the tax computed on net income for the years ended December 31, 2002, 2001 and
2000.
The components of the income tax expense/(benefit) for the years ended
December 31, 2002, 2001, and 2000 are summarized as follows:
2002 2001 2000
---------- ---------- --------
Current:
Federal $ 734,919 $ 609,475 $292,772
State and local 497,592 410,752 291,881
---------- ---------- --------
1,232,511 1,020,227 584,653
Deferred:
Federal (98,651) (117,635) (44,785)
State and local (82,930) (78,966) (30,064)
---------- ---------- --------
(181,581) (196,601) (74,849)
---------- ---------- --------
$1,050,930 $ 823,626 $509,804
========== ========== ========
The components of the deferred income tax asset, net as of December 31,
2002 and 2001 are summarized as follows:
2002 2001
--------- ---------
Organization costs $ -- $ 21,146
Excess book allowance for loan losses 477,298 427,699
Unrealized gain on investment securities (380,372) (126,450)
Other 166,963 83,071
--------- ---------
Deferred tax asset, net $ 263,889 $ 405,466
--------- ---------
The tax effect of FAS 115 was recorded directly to equity and to the
deferred tax asset.
The Bank's effective tax rate differs from the statutory Federal tax rate
for the years ended December 31, 2002, 2001 and 2000 are as follows:
70
2002 2001 2000
----------------- --------------- --------------
Federal income tax provision
at statutory rates $ 758,621 34.0% $594,544 34.0% $366,662 34.0%
State and local taxes, net of
Federal income tax benefit 274,442 12.3 215,085 12.3 133,241 12.3
Other 17,867 0.8 13,997 0.8 9,901 0.9
---------- ---- -------- ---- -------- ----
$1,050,930 47.1% $823,626 47.1% $509,804 47.2%
========== ==== ======== ==== ======== ====
Management evaluated the weight of available evidence and concluded that it
is more likely than not that the Bank will realize the net deferred tax asset in
future years. Factors influencing management's judgment include, among other
things, changes in the levels of actual and expected future taxable income and
anticipated reversals of net deductible temporary differences.
11. REGULATORY MATTERS
The Bank is a New York State chartered stock form commercial bank. The
Bank's deposits are insured by the Federal Deposit Insurance Corporation
("FDIC"). The Bank is subject to certain FDIC capital requirements. Failure to
meet minimum capital requirements can initiate certain mandatory and possibly
discretionary actions by the regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet certain specific capital guidelines that involve quantitative measures
of the Bank's assets, liabilities and certain off-balance sheet items calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings and other factors.
As of the latest notification from the FDIC, the Bank was classified as
"well capitalized" under the regulatory framework for prompt corrective action.
To be categorized as "well capitalized," the Bank must maintain Tier 1 Leverage,
Tier 1 Risk-Based and minimum Total risk-based ratios as set forth in the table
below. There are no conditions or events since that notification that management
believes have changed the Bank's category. Management believes, as of December
31, 2002 that the Bank meets all capital adequacy requirements to which it is
subject.
The Bank was required to maintain a reserve balance with the Federal
Reserve Bank of New York of $2,331,000 as of December 31, 2002. The Bank is
subject to certain restrictions on the availability of its undistributed
earnings for payment of dividends to shareholders, including prior regulatory
approval.
In accordance with the New York State Banking Law and the New York State
Banking Board Regulations, the Bank credits 10% of quarterly net income to
regulatory surplus and is required to do so until such time as shareholders'
equity is equal to 10% of amounts due to depositors.
The following table is the Bank's actual capital amounts and ratios. No
deductions were made for qualitative judgments by regulators:
71
To be well-capitalized
For capital under prompt corrective
Actual adequacy purposes action provisions
------------------- ------------------ -----------------------
Amount Ratio Amount Ratio Amount Ratio
----------- ----- ---------- ----- ---------- -----
As of December 31, 2002:
Tier 1 Capital
(to Average Assets) $ 9,336,000 7.00% $5,333,760 4.00% $6,667,200 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 9,336,000 11.43 3,268,240 4.00 4,902,360 6.00
Total Capital
(to Risk Weighted Assets) 10,359,000 12.68 6,536,480 8.00 8,170,600 10.00
As of December 31, 2001:
Tier 1 Capital
(to Average Assets) $ 8,079,000 8.16% $3,960,560 4.00% $4,950,700 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 8,079,000 12.56 2,572,760 4.00 3,859,140 6.00
Total Capital
(to Risk Weighted Assets) 8,884,000 13.81 5,145,520 8.00 6,431,900 10.00
12. EMPLOYEE BENEFITS
The Bank does not currently maintain a defined contribution benefit plan
but sponsors an incentive savings plan (401(k) plan) which started March 1,
1999. All eligible employees, who have reached the age of 21, have at least one
year of service and work a minimum of 1,000 hours per year will be permitted to
make tax deferred contributions up to certain limits. The Bank may reduce or
cease matching contributions if it is determined that the current or accumulated
net earnings or undivided profits of the Bank are insufficient to pay the full
contributions in a plan year. The Bank contributed $108,323 to the 401(k) plan
in 2002.
The Bank has issued stock appreciation rights to one officer of the Bank
and is accounting for these instruments according to SFAS 123, "Accounting For
Stock-Based Compensation," for which compensation expenses were $85,500, $26,000
and $11,714 for the years ended December 31, 2002, 2001 and 2000, respectively.
Stock Option Plans
The purpose of the Victory State Bank 2000 Incentive Stock Option Plan (the
"2000 Incentive Plan") and the Victory State Bank 1998 Incentive Stock Option
Plan (the "1998 Incentive Plan") is to advance the interests of the Bank and its
shareholders by providing those key employees of the Bank and its affiliates,
upon whose judgment, initiative and efforts the successful conduct of the
business of the Bank and its affiliates largely depends, with additional
incentive to perform in a superior manner. A purpose of the 2000 Incentive Plan
and the 1998 Incentive Plan is also to attract people of experience and ability
to
72
the service of the Bank and its affiliates. Pursuant to the terms of the 2000
Incentive Plan, 21,000 shares of Victory State Bank common stock have been
reserved for issuance under the terms of the Plan. Pursuant to the terms of the
1998 Incentive Plan, 21,000 shares of Victory State Bank common stock have been
reserved for issuance under the terms of the Plan. To the extent that options
are granted under the 2000 Incentive Plan and the 1998 Incentive Plan, the
shares underlying such options are unavailable for any other use including
future grants under the 2000 Incentive Plan and the 1998 Incentive Plan, except
those options which terminate, or are forfeited without being exercised, may be
recycled into new grants. The exercise price is determined by the Committee of
the Board of Directors and may not be less than the fair market value of Victory
State Bank common stock on the date of the grant. The term of each option is
determined by the Committee of the Board of Directors and may not exceed ten
years after the date of the grant. Options vest and are exercisable as
determined by the Board of Directors. As of December 31, 2002, 11,100 options
under the 2000 Incentive Plan were granted and 4,440 were vested or exercisable
and 20,800 options under the 1998 Incentive Plan were granted and 14,360 were
vested or exercisable.
The purpose of the Victory State Bank 2000 Directors Stock Option Plan (the
"2000 Directors' Plan") and the 1998 Directors Stock Option Plan (the "1998
Directors' Plan") is to promote the growth and profitability of the Bank by
providing outside directors of the Bank with an incentive to achieve long-term
objectives of the Bank and to attract and retain non-employee directors of
outstanding competence by providing such outside Directors with an opportunity
to acquire an equity interest in the Bank. Pursuant to the terms of the 2000
Directors' Plan, 14,000 shares of Victory State Bank common stock have been
reserved for issuance under the terms of the 2000 Directors' Plan. Pursuant to
the terms of the 1998 Directors' Plan, 14,000 shares of Victory State Bank
common stock have been reserved for issuance under the terms of the 1998
Directors' Plan. To the extent that options are granted under the 2000
Directors' Plan and the 1998 Directors' Plan, the shares underlying such options
are unavailable for any other use including future grants under the 2000
Directors' Plan the 1998 Directors' Plan, except those options which terminate,
or are forfeited without being exercised, may be recycled into new grants. The
exercise price is determined by the Board of Directors and may not be less than
the fair market value of Victory State Bank common stock on the date of the
grant. The term of each option is determined by the Board of Directors and may
not exceed ten years after the date of the grant. Options vest and are
exercisable as determined by the Board of Directors. All 14,000 options under
the 2000 Directors' Plan were granted and all 14,000 options from the 1998
Directors' Plan were granted. In December 2002, 2,000 options from the 2000
Directors' Plan were exercised and 2,000 options from the 1998 Directors' Plan
were exercised. As of December 31, 2002, the remaining 12,000 options under the
2000 Directors' Plan were vested and were exercisable and the remaining12,000
options under the 1998 Directors' Plan were vested and were exercisable.
2002 Stock Option Grants
There were no stock option grants in 2002.
If compensation cost for the Stock Plan and Director's Stock Plan awards
had been measured based on the fair value of the stock options awarded at the
grant dates, net income and diluted earnings per common share would have been
reduced to the pro-forma amounts on the table below for the years ended December
31, 2002, 2001 and 2000.
73
2002 2001 2000
---------- -------- --------
Net Income
As reported $1,180,308 $925,032 $568,615
Less: Total stock-based compensation
expense determined under the fair value
method for all rewars, net of related
tax effects 22,942 31,281 95,305
---------- -------- --------
Pro-forma $1,157,366 $893,751 $473,310
========== ======== ========
2002 2001 2000
----- ----- -----
Diluted earnings per common share
As reported $1.64 $1.31 $0.81
Less: Total stock-based compensation
expense determined under the fair value
method for all rewars, net of related
tax effects 0.04 0.03 0.13
----- ----- -----
Pro-forma $1.60 $1.28 $0.68
===== ===== =====
The weighted average fair value of options granted during 2002, 2001 and
2000 were $0, $7.30 and $10.57, respectively. For purposes of the pro forma
calculation under SFAS No. 123, the fair value of the options granted is
estimated using the Black-Scholes option pricing model with the following
weighted average assumptions used for the 2002, 2001 and 2000 grants:
Exercise Exercise Exercise
2002 Rate 2001 Rate 2000 Rate
---- -------- -------- -------- ------- --------
Dividend yield --% --% --%
Expected volatility -- 18.86 10.92
Risk-free interest rate -- 5.25 6.12
Expected life n/a 10 years 100% 7 years 20%
The Stock Option components of the 2000 Incentive Plan, the 1998 Incentive
Plan and the 2000 Directors' Plan and the 1998 Directors' Plan, as of December
31, 2002, 2001 and 2000, and changes during the years ended, consist of the
following:
74
2002 2001 2000
----------------- ----------------- -----------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------ -------- ------ -------- ------ --------
Options outstanding
at the beginning of the year 60,200 $ 13.57 60,300 $ 13.68 34,150 $15.08
Granted -- -- 2,000 12.25 26,300 11.88
Canceled 300 13.53 2,100 15.80 150 16.00
Exercised 4,000 13.94 -- -- -- --
------ ------ ------
Options outstanding at the end of the year 55,900 $ 13.54 60,200 $ 13.57 60,300 $13.68
====== ======== ====== ======= ====== ======
Options exercisable at the end of the year 42,800 $ 13.77 40,540 $ 13.84 34,070 $14.08
====== ======== ====== ======= ====== ======
Value of exercisable options 42,800 $523,444 40,540 $47,026 34,070 $ --
======== ======= ======
Value of unexercised options 13,100 $173,182 19,660 $43,325 26,230 $ --
======== ======= ======
Weighted average remaining contractual life of
options outstanding at the end of the year 6.6 Years 7.7 Years 8.4 Years
SAR Grants in 2002
The Bank did not issue any SAR grants in 2002.
Aggregated Options/SAR Exercises in 2002 and 2002 Option/SAR Values
Shares Number of Securities
Acquired on Value Underlying Unexercised Value of Unexercised In-the-
Exercise Realized Options/SAR at FY End Money Options/SAR at FY End
Name (#) ($) Exercisable/Unexercisable(#) Exercisable/Unexercisable ($)
- ------------------ ----------- -------- ---------------------------- -----------------------------
Merton Corn 0 $ -- 15,200/6,800 $219,650/$97,913(1)
Raffaele M. Branca 0 $ -- 5,220/3,480 $ 77,453/$45,704(1)
(1) The value of unexercised, in-the-money options at December 31, 2002 is the
difference between the closing price of the Common Stock on December 31, 2002
($26.00) and the exercise price ($10.00) under such outstanding SARs and the
difference between the closing price of the Common Stock on December 31, 2002
($26.00) and the exercise price ($16.00 for 1998 Grants; $12.75 for 1999 Grants
and $11.875 for 2000 Grants) under such outstanding options.
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13. COMMITMENTS, CONTINGENCIES AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET
RISK
The Bank is a party to financial instruments with off-balance sheet risk in
the normal course of business in order to meet the financing needs of its
customers. Such financial instruments primarily include commitments to extend
credit.
A summary of these commitments and contingent liabilities at December 31,
2002 follows:
Amount
-----------
Commitments to fund secured construction loans $11,531,500
Commitments to fund all other commercial loans 12,949,372
-----------
$24,480,872
===========
Commitments to extend credit are legally binding agreements to lend to a
customer. Commitments are issued following the Bank's evaluation of each
applicant's creditworthiness on a case-by-case basis. The Bank's exposure to
credit loss in the event of nonperformance by the other party to the financial
instrument is represented by the contractual notional amount of those
instruments.
In the normal course of business, the Bank is party to various legal
proceedings, claims, commitments and contingent liabilities. In the opinion of
management, the financial position of the Bank will not be materially affected
by the outcome of any such legal proceedings or claims.
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial
instruments is made in accordance with the requirements of SFAS No. 107,
"Disclosures about Fair Value of Financial Instruments." The estimated fair
value amounts have been determined by the Bank using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required to interpret market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Bank could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
The following methods and assumptions were used by the Bank in estimating
fair values of financial instruments:
Money Market Investments - The fair value of these securities
approximates their carrying value due to the relatively short time to
maturity.
Investment Securities, Available For Sale - The estimated fair value
of these securities is determined by using available market
information and appropriate valuation methodologies. The estimates
presented herein are not necessarily indicative of the amounts that
the Bank could realize in a current market exchange.
Loans Receivable - The fair value of commercial and construction loans
are approximated by the carrying value as the loans are tied directly
to the Prime Rate and are subject to change on a daily
76
basis. The fair value of the remainder of the portfolio is determined
by discounting the future cash flows of the loans using the
appropriate discount rate and prepayment assumptions.
Other Financial Assets - The fair value of these assets, principally
accrued interest receivable, approximates their carrying value due to
their short maturity.
Demand and Time Deposits - The fair value disclosed for demand
accounts is equal to the amount payable on demand at the reporting
date. The fair value of time deposits accounts is based upon the
current rates for instruments of the same remaining maturity. Time
deposits with a maturity of greater than one year are estimated using
a discounted cash flow approach that applies interest rates currently
being offered.
Other Liabilities - The estimated fair value of other liabilities,
which primarily include trade accounts payable, approximates their
carrying amount.
Off-Balance Sheet Instruments - The fair value of lending commitments
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 estimated fair values of the Bank's financial instruments at December
31, 2002 and 2001 were as follows:
Carrying Fair Carrying Fair
Amount Value Amount Value
------------ ------------ ----------- ------------
Financial Assets:
Cash $ 26,095,803 $ 26,095,803 $ 8,511,515 $ 8,511,515
Money market investments -- -- 50,187 50,187
Investment securities 42,999,660 42,999,660 39,286,998 39,286,998
Loans receivable 62,246,153 71,979,956 49,530,101 56,134,863
Other financial assets 424,636 424,636 396,113 396,113
------------ ------------ ----------- ------------
Total Financial Assets $131,766,252 $141,500,055 $97,774,914 $104,379,676
============ ============ =========== ============
Financial Liabilities:
Demand deposits $105,924,334 $105,924,334 $75,133,321 $ 75,133,321
Time deposits 17,778,031 17,406,698 15,999,495 11,461,412
Other liabilities 1,379,144 1,379,144 1,071,807 1,071,807
------------ ------------ ----------- ------------
Total Financial Liabilities $125,081,509 $124,710,176 $92,204,623 $ 87,666,540
============ ============ =========== ============
Off Balance Sheets Investments:
Notional Fair Notional Fair
Amount Value Amount Value
----------- -------- ----------- --------
Commitments to extend credit $24,480,872 $123,480 $14,658,181 $124,410
77
15. INTEREST RATE RISK
The Bank's principal business of originating loans, issuing term
certificates of deposit and other interest-bearing deposit accounts and
investing in short-term investment securities inherently includes elements of
interest rate risk and requires careful application of interest rate management
techniques to manage such risks.
Because the Bank has a varied array of investment, loan and deposit
products, which differ as to maturity, repricing terms and interest rate spreads
relative to various rate indices, different interest rate risk management
strategies are utilized.
The Bank funds its assets primarily with deposits. A substantial portion of
these, mature or reprice within one year of their origination or last repricing
date.
In view of the short maturity profile of the Bank's funding sources, the
Bank invests in loans and investments which have a maturity or repricing date
designed to match the Bank's funding maturities and serve as a natural hedge of
the related interest rate risk.
Net interest income will fluctuate based on changes in the general level of
interest rates, changes in the levels of interest sensitive assets and
liabilities, and changes in the relationships between different interest rate
indices. In addition, net interest income can also be affected by timing of
repricing dates and repayments and changes in estimated prepayments.
16. RELATED PARTIES
In the ordinary course of business, the Bank at times has had loans, and
other financial transactions, with its officers, employees and directors. Such
transactions are generally made on substantially the same terms as those
prevailing at the time for comparable transactions with others and do not
involve more than a normal risk of collectibility. At December 31, 2002, the
aggregate amount of loans outstanding to directors was $42,209.
The change in aggregate amount of loans outstanding to directors as of
December 31, 2002 and 2001 are as follows:
2002 2001
----------- ---------
Beginning balance $ 562,325 $ 110,793
Originations 1,381,122 740,963
Payments (1,901,238) (289,431)
----------- ---------
Ending balance $ 42,209 $ 562,325
=========== =========
Certain officers and directors own, in the aggregate, 38.4% of the common
shares outstanding.
78
17. SUBSEQUENT EVENTS
On January 29, 2003,Victory State Bank filed applications with state and
federal regulatory authorities to reorganize into the holding company form of
organization. The reorganization into a holding company requires stockholder
approval, once preliminary regulatory approval has been received. May of 2003 is
targeted for final regulatory and shareholder approval. When the holding company
reorganization is completed, each the stockholders of Victory State Bank will
get three shares VSB Bancorp, Inc. stock for each two shares of Victory State
Bank stock that they own. The new holding company will be known as VSB Bancorp,
Inc., which was formed as a New York corporation.
*****************
79
PART III
Item 1. Index to Exhibits.
Exhibit No. Title of Exhibit
- ----------- ----------------
2.1 Restated Certificate of Incorporation of VSB Bancorp, Inc.
2.2 Bylaws of VSB Bancorp, Inc.
6.1 Employment Agreement between Merton Corn and Victory State Bank
6.2 Victory State Bank 2000 Incentive Stock Option Plan
6.3 Victory State Bank 2000 Directors Stock Option Plan
6.4 Victory State Bank 1998 Incentive Stock Option Plan
6.5 Victory State Bank 1998 Directors Stock Option Plan
6.6 VSB Bancorp, Inc. Restated 2000 Incentive Stock Option Plan
6.7 VSB Bancorp, Inc. Restated 2000 Directors Stock Option Plan
6.8 VSB Bancorp, Inc. Restated 1998 Incentive Stock Option Plan
6.9 VSB Bancorp, Inc. Restated 1998 Directors Stock Option Plan
12.1 Agreement, Plan of Reorganization and Plan of Acquisition among
Victory State Bank, VSB Bancorp, Inc. and Victory Interim Bank
(in formation)
Item 2. Description of Exhibits.
The Exhibits are as described in their titles. Exhibits 6.6, 6.7, 6.8 and
6.9 (the "VSB Option Plans") correspond directly with Exhibits 6.2, 6.3, 6.4 and
6.5 (the "Bank Option Plans"). The outstanding options described in Part One
were issued pursuant to the Bank Option Plans. In connection with the holding
company reorganization, the Bank Option Plans are assumed by VSB Bancorp, Inc.,
and restated in the form of the VSB Option Plans, with the number of shares
covered by the restated plans being adjusted to reflect the three-for-two
exchange ratio in the reorganization. All outstanding options issued under the
Bank Option Plans will likewise be adjusted for the number of shares covered
thereby and the exercise price to reflect the exchange ratio.
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of
1934, the registrant has duly caused this registration statement to be signed on
its behalf by the undersigned, thereunto duly authorized.
VSB Bancorp, Inc.
(Registrant)
Date: April 4, 2003
By:/s/ MERTON CORN
---------------------------
Merton Corn, President
80