SCNB Suffolk Bancorp

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

Suffolk Bancorp (the “Company”) was incorporated in 1985 as a bank holding company. The Company currently owns all of the outstanding capital stock of Suffolk County National Bank (the “Bank”). The Bank was organized under the national banking laws of the United States in 1890. The Bank formed Suffolk Greenway, Inc. (the “REIT”), a real estate investment trust, and owns 100% of an insurance agency and two corporations used to acquire foreclosed real estate. The insurance agency and the two corporations used to acquire foreclosed real estate are immaterial to the Company’s operations. The unaudited interim condensed consolidated financial statements include the accounts of the Company and the Bank and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Unless the context otherwise requires, references herein to the Company include the Company and the Bank and subsidiaries on a consolidated basis.

On June 26, 2016, the Company entered into an Agreement and Plan of Merger (the “merger agreement”) with People’s United Financial, Inc. (“People’s United”) pursuant to which the Company will merge into People’s United (the “merger”). People’s United will be the surviving corporation in the merger. Subject to the terms and conditions of the merger agreement, the Company’s shareholders will have the right to receive 2.225 shares of People’s United common stock in exchange for each share of Company common stock. The merger agreement was adopted by the Company’s shareholders on October 13, 2016. The closing of the merger remains subject to regulatory approvals and other customary conditions.

In the opinion of the Company’s management, the preceding unaudited interim condensed consolidated financial statements contain all adjustments, consisting of normal accruals, necessary for a fair presentation of the Company’s condensed consolidated statement of condition as of September 30, 2016, its condensed consolidated statements of income for the three and nine months ended September 30, 2016 and 2015, its condensed consolidated statements of comprehensive income for the three and nine months ended September 30, 2016 and 2015, its condensed consolidated statements of changes in stockholders’ equity for the nine months ended September 30, 2016 and 2015 and its condensed consolidated statements of cash flows for the nine months ended September 30, 2016 and 2015.

The preceding unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The results of operations for the three and nine months ended September 30, 2016 are not necessarily indicative of the results of operations to be expected for the remainder of the year. For further information, please refer to the audited consolidated financial statements and footnotes thereto included in the Company’s 2015 Annual Report on Form 10-K.

Earnings Per Share - Basic earnings per share is computed based on the weighted average number of common shares and unvested restricted shares outstanding for each period. The Company’s unvested restricted shares are considered participating securities as they contain rights to non-forfeitable dividends and thus they are included in the basic earnings per share computation. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under stock options. In the event a net loss is reported, restricted shares and stock options are excluded from earnings per share computations.

The reconciliation of basic and diluted weighted average number of common shares outstanding for the three and nine months ended September 30, 2016 and 2015 follows.

 

Loans and Loan Interest Income Recognition – Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned discounts, deferred loan fees and costs. Unearned discounts on installment loans are credited to income using methods that result in a level yield. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income over the respective term of the loan without anticipating prepayments.

 

Interest income is accrued on the unpaid loan principal balance. Recognition of interest income is discontinued when reasonable doubt exists as to whether principal or interest due can be collected. Loans of all classes will generally no longer accrue interest when over 90 days past due unless the loan is well-secured and in process of collection. When a loan is placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current-year interest income. Interest received on such loans is applied against principal or interest, according to management’s judgment as to the collectability of the principal, until qualifying for return to accrual status. Loans may start accruing interest again when they become current as to principal and interest for at least six months, and when, after a well-documented analysis by management, it has been determined that the loans can be collected in full.  For all classes of loans, an impaired loan is defined as a loan for which it is probable that the lender will not collect all amounts due under the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties are considered troubled debt restructurings (“TDRs”) and are classified as impaired. Generally, TDRs are initially classified as non-accrual until sufficient time has passed to assess whether the restructured loan will continue to perform. For impaired, accruing loans, interest income is recognized on an accrual basis with cash offsetting the recorded accruals upon receipt.

Allowance for Loan Losses - The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a quarterly analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company’s own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction and residential mortgages loan classes and all TDRs are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics. These classes are commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The allowance for loan losses consists of specific and general components, as well as an unallocated component. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment or liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on the fair market value of collateral and the estimated time required to recover the Company’s investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan’s effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data. These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors include consideration of the following: levels and trends in various risk rating categories; levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures and practices; experience, ability, and depth of lending management and other relevant staff; local, regional and national economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. These adjustments reflect management’s overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

 

Loans Held For Sale – Loans held for sale are carried at the lower of aggregate cost or fair value, based on observable inputs in the secondary market. Changes in fair value of loans held for sale are recognized in earnings.

Other Real Estate Owned (“OREO”) - Property acquired through foreclosure, or OREO, is initially stated at the lower of cost or fair value less estimated selling costs. Losses arising at the time of the acquisition of property are charged against the allowance for loan losses. Any additional write-downs to the carrying value of these assets that may be required, as well as the cost of maintaining and operating these foreclosed properties, are charged to expense. The Company held OREO amounting to $650 thousand at September 30, 2016 resulting from the addition of one residential property during the first quarter of 2016.

Bank-Owned Life Insurance – Bank-owned life insurance is recorded at the lower of the cash surrender value or the amount that can be realized under the insurance policy and is included as an asset in the consolidated statements of condition. Changes in the cash surrender value and insurance benefit payments are recorded in non-interest income in the consolidated statements of income.

Derivatives   - Derivatives are contracts between counterparties that specify conditions under which settlements are to be made. The only derivatives held by the Company are swap contracts with the purchaser of its Visa Class B shares. The Company records its derivatives on the consolidated statements of condition at fair value. The Company’s derivatives do not qualify for hedge accounting. As a result, changes in fair value are recognized in earnings in the period in which they occur. (See also Note 3. Investment Securities contained herein.)

Recent Accounting Guidance – In August 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-15, Statement of Cash Flows (Topic 230), “Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 clarifies whether the following items should be categorized as operating, investing or financing in the statement of cash flows: (i) debt prepayments and extinguishment costs, (ii) settlement of zero-coupon debt, (iii) settlement of contingent consideration, (iv) insurance proceeds, (v) settlement of corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI) policies, (vi) distributions from equity method investees, (vii) beneficial interests in securitization transactions, and (viii) receipts and payments with aspects of more than one class of cash flows. For public business entities that are U.S. Securities and Exchange Commission filers, like the Company, the amendments are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. An entity that elects early adoption must adopt all of the amendments in the same period. The amendments in this ASU should be applied using a retrospective transition method to each period presented. If it is impracticable to apply the amendments retrospectively for some of the issues, the amendments for those issues would be applied prospectively as of the earliest date practicable. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326), “Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 significantly changes the impairment model for most financial assets that are measured at amortized cost and certain other instruments from an incurred loss model to an expected loss model and provides for recording credit losses on available-for-sale debt securities through an allowance account. The ASU also requires certain incremental disclosures. For public business entities, the amendments are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for all entities beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation—Stock Compensation (Topic 718), “Improvements to Employee Share-Based Payment Accounting.” ASU 2016-09 introduces targeted amendments intended to simplify the accounting for stock compensation. Specifically, the ASU requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity also should recognize excess tax benefits, and assess the need for a valuation allowance, regardless of whether the benefit reduces taxes payable in the current period. The ASU also requires excess tax benefits to be classified along with other income tax cash flows as an operating activity in the statement of cash flows. In addition, the ASU elevates the statutory tax withholding threshold to qualify for equity classification up to the maximum statutory tax rates in the applicable jurisdiction(s). The ASU also clarifies that cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. The ASU provides an optional accounting policy election (with limited exceptions), to be applied on an entity-wide basis, to either estimate the number of awards that are expected to vest (consistent with existing U.S. GAAP) or account for forfeitures when they occur. The amendments are effective for public business entities for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The ASU establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10), “Recognition and Measurement of Financial Assets and Financial Liabilities” which requires an entity to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in other comprehensive income the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of available for sale debt securities in combination with other deferred tax assets. This ASU provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes and also requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements. For public entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Generally, early adoption of the amendments in this ASU is not permitted. The Company believes that adoption in 2018 will not have a material effect on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), “Revenue from Contracts with Customers,” which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of the ASU is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. The ASU defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The FASB subsequently issued ASU 2016-08 which updates the new standard by clarifying the principal versus agent implementation guidance, ASU 2016-10 which clarifies identifying performance obligations and the licensing implementation guidance and ASU 2016-12 which clarifies the guidance on assessing collectability, presenting sales taxes, measuring noncash consideration and certain transition matters, but these do not change the core principle of the new standard. The FASB also subsequently issued ASU 2015-14 to defer the effective date of the new standard by one year. As such, it now takes effect for public entities in fiscal years beginning after December 15, 2017, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting the ASU recognized at the date of adoption (which includes additional footnote disclosures). Early adoption is permitted for any entity that chooses to adopt the new standard as of the original effective date. The Company has not yet determined the method by which it will adopt ASU 2014-09 in 2018 and does not believe that the adoption will have a material effect on the Company’s consolidated financial statements.

 

2. ACCUMULATED OTHER COMPREHENSIVE INCOME/LOSS (“AOCI”)

The changes in the Company’s AOCI by component, net of tax, for the three and nine months ended September 30, 2016 and 2015 follow (in thousands).

 

Reclassifications out of AOCI for the three and nine months ended September 30, 2016 and 2015 follow (in thousands).

 

3. INVESTMENT SECURITIES

At the time of purchase of a security, the Company designates the security as either available for sale, trading or held to maturity, depending upon investment objectives, liquidity needs and intent.

In 2014, investment securities with a fair value of $48 million and an unrealized loss of $3.2 million were transferred from available for sale to held to maturity. In accordance with U.S. GAAP, the securities were transferred at fair value, which became the amortized cost. The discount, equal to the unrealized holding losses at the date of transfer, is being accreted to interest income over the remaining life of the securities. The unrealized holding losses at the date of transfer remained in AOCI and are being amortized simultaneously against interest income. Those amounts offset or mitigate each other.

The amortized cost, fair value and gross unrealized gains and losses of the Company’s investment securities available for sale and held to maturity at September 30, 2016 and December 31, 2015 were as follows (in thousands):

At September 30, 2016 and December 31, 2015, investment securities carried at $180 million and $261 million, respectively, were pledged primarily for public funds on deposit and as collateral for the Company’s derivative swap contracts.

 

The amortized cost, contractual maturities and fair value of the Company’s investment securities at September 30, 2016 (in thousands) are presented in the table below. Collateralized mortgage obligations (“CMOs”) and mortgage-backed securities (“MBS”) assume maturity dates pursuant to average lives.

 

The proceeds from sales of securities available for sale and the associated realized gains and losses are shown below (in thousands) for the periods indicated. Realized gains are also inclusive of gains on called securities.

 

Information pertaining to securities with unrealized losses at September 30, 2016 and December 31, 2015, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows (in thousands):

 

The CMOs with unrealized losses for twelve months or longer at September 30, 2016 are issued or guaranteed by U.S. Government agencies or sponsored enterprises. The corporate bonds with unrealized losses for twelve months or longer at September 30, 2016 carry investment grade ratings by all major credit rating agencies including Moody’s and Standard & Poor’s. In all cases, the unrealized losses on these bonds were a result of overall market conditions including the current interest rate environment and general market liquidity. The losses were not related to a deterioration of the quality of the issuer or any company-specific adverse events. The Company does not intend to sell and it is not more likely than not that the Company will be required to sell these securities prior to their recovery to a level equal to or greater than amortized cost. Management has determined that no OTTI was present at September 30, 2016.

The Bank was a member of the Visa USA payment network and was issued Class B shares upon Visa’s initial public offering in March 2008. The Visa Class B shares are transferable only under limited circumstances until they can be converted into shares of the publicly traded class of stock. This conversion cannot happen until the settlement of certain litigation, which is indemnified by Visa members. Since its initial public offering, Visa has funded a litigation reserve based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. At its discretion, Visa may continue to increase the conversion rate in connection with any settlements in excess of amounts then in escrow for that purpose and reduce the conversion rate to the extent that it adds any funds to the escrow in the future. Based on the existing transfer restriction and the uncertainty of the litigation, the Company has recorded its Visa Class B shares on its balance sheet at zero value.

In conjunction with the sale of Visa Class B shares in 2013, the Company entered into derivative swap contracts with the purchaser of these Visa Class B shares which provide for settlements between the purchaser and the Company based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. The Company’s recorded liability representing the fair value of the derivative was $752 thousand at September 30, 2016 and December 31, 2015.

The present value of estimated future fees to be paid to the derivative counterparty, or carrying costs, calculated by reference to the market price of the Visa Class A shares at a fixed rate of interest are expensed as incurred. For the three months ended September 30, 2016 and 2015, $87 thousand and $73 thousand, respectively, in such carrying costs was expensed. For the nine months ended September 30, 2016 and 2015, $243 thousand and $214 thousand, respectively, in such carrying costs was expensed. The Company has pledged mortgage-backed securities of U.S. Government-sponsored enterprises held in its available for sale portfolio, with a market value of approximately $3 million at September 30, 2016, as collateral for the derivative swap contracts. The Company had pledged U.S. Government agency securities held in its available for sale portfolio, with a market value of approximately $3 million at December 31, 2015, as collateral for such contracts.

Subjectivity has been used in estimating the fair value of both the derivative liability and the associated fees, but management believes that these fair value estimates are adequate based on available information. However, future developments in the litigation could require potentially significant changes to these estimates.

At September 30, 2016 and December 31, 2015, the Company still owned 38,638 Visa Class B shares subsequent to the sales described here. Upon termination of the existing transfer restriction and settlement of the litigation, and to the extent that the Company continues to own such Visa Class B shares in the future, the Company expects to record its Visa Class B shares at fair value.

4. LOANS

At September 30, 2016 and December 31, 2015, net loans disaggregated by class consisted of the following (in thousands):

 

 

There were no loans in the process of foreclosure collateralized by residential real estate property at September 30, 2016.

The following summarizes the activity in the allowance for loan losses disaggregated by class for the periods indicated (in thousands).

 

At September 30, 2016 and December 31, 2015, the ending balance in the allowance for loan losses disaggregated by class and impairment methodology is as follows (in thousands). Also in the tables below are total loans at September 30, 2016 and December 31, 2015 disaggregated by class and impairment methodology (in thousands).