U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-KSB ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 30, 2003 Commission File No.: 01-13465 FALMOUTH BANCORP, INC. (Name of small business issuer in its charter) Delaware 04-3337685 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 20 Davis Straits, Falmouth, Massachusetts 02540 (Address of principal executive offices) (508) 548-3500 (Issuer's Telephone Number) Securities registered pursuant to section 12(g) of the Exchange Act: Name of Each Exchange Title of each class on Which Registered: ------------------- --------------------- Common Stock, par value $0.01 per share American Stock Exchange Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] The revenues for the issuer's fiscal year ended September 30, 2003 were $7,862,818. State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was sold, as of a specified date within the last 60 days. On December 1, 2003: $21,767,972. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. The Company had 914,827 shares outstanding as of December 1, 2003. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive proxy statement pursuant to Regulation 14A, which was delivered to the Commission for filing on December 17, 2003, and the 2003 Annual Report to Stockholders for the fiscal year ended September 30, 2003, are incorporated by reference into Part II and III of this report. Transitional Small Business Disclosure Format (check one): Yes No X ----- ----- TABLE OF CONTENTS Page ---- FORWARD LOOKING STATEMENTS i PART I ITEM 1. DESCRIPTION OF BUSINESS 1 ITEM 2. DESCRIPTION OF PROPERTY 36 ITEM 3. LEGAL PROCEEDINGS 36 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 36 PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS 36 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 37 ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS 37 ITEM 8. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 37 PART III ITEM 9. DIRECTORS AND PRINCIPAL OFFICERS OF THE COMPANY 37 ITEM 10. EXECUTIVE COMPENSATION 38 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 38 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 38 ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K 39 ITEM 14. CONDITIONS AND PROCEDURES 40 SIGNATURES 41 EXHIBITS 42 FORWARD LOOKING STATEMENTS This Form 10-KSB contains certain forward-looking statements consisting of estimates with respect to the financial condition, results of operations and business of the Company and the Bank that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to: general and local economic conditions; changes in interest rates, deposit flows, demand for mortgages and other loans, real estate values, and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services. Any or all of our forward-looking statements in this Form 10-KSB and in any other public statements we make may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Consequently, no forward-looking statement can be guaranteed. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. i PART I ITEM 1. DESCRIPTION OF BUSINESS General Falmouth Bancorp, Inc. (the "Company" or "Bancorp"), a Delaware corporation, is the holding company for Falmouth Co-operative Bank (the "Bank"), a Massachusetts-chartered stock co-operative bank. At September 30, 2003, there were 913,727 shares outstanding. The Company's sole business activity is ownership of the Bank. The Company also makes investments in long and short-term marketable securities and other liquid investments. The Company's common stock trades on the American Stock Exchange under the symbol "FCB." Unless otherwise disclosed, the information presented in this Report on Form 10-KSB represents the consolidated activity of Falmouth Bancorp, Inc. and subsidiaries. The Company had total assets of $166.1 million as of September 30, 2003. The Bank conducts its business through an office located in Falmouth, Massachusetts, where it was originally founded in 1925 as a Massachusetts chartered mutual co-operative Bank, and branches located in East Falmouth and North Falmouth, Massachusetts. The Bank opened a new branch office in Bourne, Massachusetts in November 2003. The Bank's deposits are currently insured up to applicable limits by the Bank Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC") and the Share Insurance Fund of the Co-operative Central Bank of Massachusetts. The Bank's principal business consists of attracting deposits from the general public and uses these funds to originate mortgage loans secured by one- to four-family residences located primarily in Falmouth, Massachusetts and surrounding areas and to invest in United States Government and Agency securities. Business Strategy The Bank's business strategy is to operate as a profitable and independent community bank dedicated primarily to financing home ownership and consumer needs in its market area and to provide quality service to its customers. The Bank has implemented this strategy by: (i) closely monitoring the needs of customers and providing quality service; (ii) emphasizing consumer-oriented banking by originating residential mortgage loans and consumer loans, and by offering checking accounts and other financial services and products; (iii) focusing on expanding lending activities to produce moderate increases in loan originations; (iv) maintaining asset quality; (v) maintaining capital in excess of regulatory requirements; and (vi) producing stable earnings. The Bank serves its primary market area, the Massachusetts communities of Falmouth and Mashpee located in the Cape Cod region of Massachusetts, through its offices in Falmouth, North Falmouth and East Falmouth. The Bank expanded its market area in November 2003 opening a branch office in the Massachusetts community of Bourne. The Bank continues to offer 1 traditional retail and commercial banking services as well as electronic services such as its toll free Voice Response System "ON CALL," which enables its customers to access current balance information and transfer funds between accounts by telephone, its new Internet Banking and Bill Paying product on its web site at www.FalmouthBank.com, and three on-site, as well as three off-site ATMs. The Bank competes with fifteen branches of financial institutions (including national banks, savings banks, savings and loans and credit unions), which are headquartered outside its market area. The Bank is the only independent financial institution headquartered in Falmouth. To a lesser extent, the Bank also makes commercial real estate loans, commercial and industrial, and consumer loans, including passbook loans, automobile, home equity and other consumer loans. The Bank originates both fixed-rate and adjustable-rate loans and emphasizes the origination of residential real estate mortgage loans with adjustable interest rates, and makes other investments which allow the Bank to more closely match the interest rate and maturities of its assets and liabilities. Market Area The Bank considers its primary market area to be the communities of Falmouth and Mashpee in Barnstable County, which is located in the Cape Cod region of Massachusetts, approximately 72 miles south of Boston. The year- round population of Barnstable County is over 200,000. The majority of the Bank's lending has been in Falmouth and Mashpee. The Cape Cod region is a major recreational resort/retirement community, with seasonal tourism being the most significant economic activity. Falmouth's year-round population of 32,660 (2000 census) increases to a summer population of approximately 75,000. Falmouth is the second most populous and second largest town on the Cape. Visitors find accommodations in the many motels, hotels and inns in the area. Falmouth has approximately 44 miles of ocean and lake shoreline. There are nine harbors and inlets, some with docking and most with mooring facilities. Two major harbors offer access, via ferry, to the island of Martha's Vineyard with service to the island of Nantucket during the summer months from Woods Hole. In addition to swimming, boating, fishing and other forms of water recreation, Falmouth also has four public and two private golf courses. The major employers in the Falmouth area are the Woods Hole Oceanographic Institute, with approximately 800 employees, Falmouth Hospital, with 750 employees and Woods Hole, Martha's Vineyard and Nantucket Steamship Authority, with 500 employees. Other major employers include Marine Biological Laboratories. 2 Employees At September 30, 2003, the Bank employed 33 full-time and 6 part-time employees. The Bank's employees are not represented by a collective bargaining agreement, and the Bank considers its relationship with its employees to be good. Lending Activities General. The principal lending activity of the Bank is the origination of conventional mortgage loans for the purpose of purchasing or refinancing owner-occupied, one- to four-family residential properties in its designated community reinvestment area of the Massachusetts towns of Falmouth and Mashpee. To a lesser extent, the Bank also originates consumer loans including home equity and passbook loans and commercial loans. The Bank also originates and retains in its loan portfolio adjustable-rate loans and fixed-rate loans with maturities of up to 30 years. Traditionally, fixed-rate loans with terms of up to 30 years are originated and sold in the secondary market. Loan originations for the year ended September 30, 2003, achieved the level of $111.2 million and were primarily single-family residential loans. During this period, the Bank was ranked by Banker and Tradesman as one of the largest producers of residential mortgage loans in the Falmouth market. The mortgage market in the Falmouth area was vigorous in both the purchase money and refinance categories during fiscal 2003. The Bank is a qualified seller/servicer for the Federal National Mortgage Association ("FNMA") and was servicing $68.1 million in loans for FNMA and $1.9 million for other investors at September 30, 2003. 3 Loan Portfolio. The following table presents selected data relating to the composition of the Bank's loan portfolio by type of loan on the dates indicated. At September 30, ------------------------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ----------------- ----------------- ----------------- ----------------- ----------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in thousands) Residential mortgage loans $50,525 58.06% $ 69,694 69.40% $ 94,084 79.63% $ 88,647 79.50% $ 67,709 81.02% Commercial real estate loans 15,702 18.04 11,845 11.80 10,406 8.81 11,865 10.64 8,488 10.16 Consumer loans 403 .46 439 .44 546 .46 527 .47 577 .69 Home equity loans 15,451 17.75 13,251 13.20 8,486 7.18 7,143 6.41 4,621 5.53 Commercial loans 4,943 5.69 5,179 5.16 4,634 3.92 3,331 2.98 2,175 2.60 ------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Gross loans 87,024 100.00% 100,408 100.00% 118,156 100.00% 111,513 100.00% 83,570 100.00% ------- ====== -------- ====== -------- ====== -------- ====== -------- ====== Less: Deferred loan (cost), net of origination fees (257) (297) (362) (190) (19) Unadvanced principal 3,201 4,756 5,019 5,216 2,533 Allowance for loan losses 761 939 945 755 569 ------- -------- -------- -------- -------- Loans, net $83,319 $ 95,010 $112,554 $105,732 $ 80,487 ======= ======== ======== ======== ======== 4 One- to Four-Family Residential Real Estate Lending. The primary emphasis of the Bank's lending activity is the origination of conventional mortgage loans secured by one- to four-family residential dwellings located in the Bank's primary market area. As of September 30, 2003, loans on one- to four-family residential properties accounted for 58.1% of the Bank's loan portfolio and totaled $50.5 million. The Bank's mortgage loan originations are for terms of up to 30 years, amortized on a monthly basis with interest and principal due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms allow as borrowers may refinance or prepay loans at their option, without penalty. Conventional residential mortgage loans granted by the Bank customarily contain "due-on- sale" clauses that permit the Bank to accelerate the indebtedness of the loan upon transfer of ownership of the mortgaged property. The Bank makes conventional mortgage loans and it uses standard FNMA documents to allow for the sale of loans in the secondary mortgage market. The Bank's lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or purchase price of the property, with the condition that private mortgage insurance is required on loans with a loan-to-value ratio in excess of 80%. The Bank also offers adjustable-rate mortgage loans with terms of up to 30 years. Adjustable-rate loans offered by the Bank include loans which reprice every one, three, five and seven years and provide for an interest rate which is based on the interest rate paid on United States Treasury securities of a corresponding term, plus a margin of 2.75%. The Bank currently offers adjustable-rate loans with initial rates below those that would prevail under the foregoing computations, based upon the Bank's determination of market factors and competitive rates for adjustable-rate loans in its market area. For adjustable-rate loans, borrowers are qualified at the initial rate plus an anticipated upward adjustment of 200 basis points. The Bank retains substantially all of the adjustable-rate mortgages it originates. The Bank's adjustable-rate mortgages include caps on increases or decreases of 2% per year, and 6% over the life of the loan (2% per yearly adjustment, and 5% over the life of the loan for five-year adjustable-rate loans). The retention of adjustable-rate mortgage loans in the Bank's loan portfolio helps reduce the Bank's exposure to increases in interest rates. However, there are unquantifiable credit risks resulting from potential increased costs to the borrower as a result of repricing of adjustable-rate mortgage loans. It is possible that during periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower. During the year ended September 30, 2003, the Bank originated $8.6 million in adjustable-rate mortgage loans and $78.1 million in fixed-rate mortgage loans for its portfolio. Approximately 57.1% of all loan originations during fiscal 2003 were the refinancing of loans already in the Bank's loan portfolio. At September 30, 2003, the Bank's loan portfolio included $29.0 million in adjustable-rate one- to four-family residential mortgage loans, or 34.5% of the Bank's total loan portfolio, and $33.3 million in fixed-rate one- to four-family residential mortgage loans, or 39.6% of the Bank's total loan portfolio. 5 The Bank engages in a limited amount of construction lending generally for the construction of single-family residences. Most are construction/permanent loans structured to become permanent loans upon the completion of construction. All construction loans are secured by first liens on the property. Loan proceeds are disbursed as construction progresses and inspections warrant. Loans involving construction financing present a greater risk than loans for the purchase of existing homes, since collateral values and construction costs can only be estimated at the time the loan is approved. Due to the small amount of construction loans in the Bank's portfolio, the risk in this area is limited. Commercial Real Estate Loans. At September 30, 2003, the Bank's commercial real estate loan portfolio totaled $15.7 million, or 18.7% of total loans. The Bank's largest loan is a commercial loan with an outstanding commitment of $1.5 million at September 30, 2003 secured by a lumber company located in Falmouth, Massachusetts. Commercial real estate lending entails additional risks compared with one- to four-family residential lending. For example, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers and the payment experience on such loans is typically dependent on the successful operation of a real estate project and/or the collateral value of the commercial real estate securing the loan. At September 30, 2003, all of the Bank's commercial real estate loans were performing. Home Equity Loans. The Bank also originates home equity loans, which are loans, secured by available equity based on the appraised value of one- to four-family residential property. Home equity loans will be made for up to 80% of the tax assessed or appraised value of the property (less the amount of the first mortgage). Home equity loans have an adjustable interest rate which ranges from 0% to 1% above the prime rate as reported in The Wall Street Journal and have terms of twenty years or less. At September 30, 2003, the Bank had $33.7 million in home equity loans with unused credit available to existing borrowers of $18.2 million. Consumer Loans. The Bank's consumer loans consist of passbook loans, and other consumer loans, including automobile loans. At September 30, 2003, the consumer loan portfolio totaled $403,000 or .48% of total loans. Consumer loans generally are offered for terms of up to five years at fixed interest rates. Consumer loans do not exceed $15,000 individually. Management expects to continue to promote consumer loans as part of its strategy to provide a wide range of personal financial services to its customers and as a means to increase the yield on the Bank's diversified loan portfolio. The Bank makes loans up to 90% of the amount of the depositor's savings account balance. The interest rate on the loan is 4.0% higher than the rate being paid on regular savings accounts and 3% higher than the rate being paid on certificates of deposit. The Bank also makes other consumer loans, which may or may not be secured. The terms of such loans usually depend on the collateral. At September 30, 2003, the total amount of passbook and other consumer loans, including overdraft lines of credit, was $201,000. The Bank makes loans for automobiles, both new and used, directly to the borrowers. The loans are generally limited to 80% of the purchase price or the retail value listed by the National Automobile Dealers Book. The terms of the loans are determined by the age and condition of the 6 collateral. Collision insurance policies are required on all these loans. At September 30, 2003, the total amount of automobile loans was $202,000. Consumer loans generally are originated at higher interest rates than residential mortgage loans but also tend to have a higher credit risk than residential loans due to the loan being unsecured or secured by rapidly depreciable assets. Despite this risk, the Bank's level of consumer loan delinquencies generally has been low. No assurance can be given, however, that the Bank's delinquency rate on consumer loans will continue to remain low in the future, or that the Bank will not incur future losses on these activities. Commercial Loans. The Bank employs a commercial loan officer with over 20 years of experience in commercial lending in the Falmouth market. The Bank is pursuing, on a selective basis, the origination of commercial loans to meet the working capital and short-term financing needs of established local businesses. Unless otherwise structured as a mortgage on commercial real estate, such loans are generally being limited to terms of five years or less. Substantially all such commercial loans have variable interest rates tied to the prime rate as reported in The Wall Street Journal. Whenever possible, the Bank collateralizes these loans with a lien on commercial real estate, or alternatively, with a lien on business assets and equipment and the personal guarantees from principals of the borrower. Commercial loans do not presently comprise a significant portion of the Bank's loan portfolio. At September 30, 2003 the Bank's non-real estate commercial loan portfolio totaled $4.9 million or 5.9% of the Bank's loan portfolio. Commercial business loans generally are considered to involve a higher degree of risk than residential mortgage loans because the collateral may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial loans also may involve relatively large loan balances to single borrowers or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation and income stream of the borrower. Such risks can be affected significantly by economic conditions. In addition, commercial business lending generally requires substantially greater oversight efforts compared to residential real estate lending. Loan Commitments. The Bank makes a 60-day loan commitment to borrowers. At September 30, 2003, the Bank had $3.2 million in loan commitments outstanding for the origination of one- to four-family residential real estate loans. Loan Solicitation Origination and Loan Fees. The Bank originates loans through its main office located in Falmouth, Massachusetts and branch offices located in East Falmouth, North Falmouth and Bourne. Loan originations are derived from a number of sources, including the Bank's existing customers, referrals, realtors, advertising and "walk-in" customers at the Bank's offices. The Bank has one full-time residential loan originator who is compensated with commission. The originator meets with applicants at their convenience and location and is in regular contact with real estate brokers, attorneys, accountants, building contractors, developers and others in the Bank's local market area. The Bank increased its advertising in locally distributed newspapers and has utilized local radio advertising to increase its market share of residential loan originations. 7 Upon receipt of a loan application from a prospective borrower, a credit report and verifications are ordered to verify specific information relating to the loan applicant's employment, income and credit standing. For all mortgage loans, an appraisal of real estate intended to secure the proposed loan is obtained from an independent fee appraiser who has been approved by the Bank's Board of Directors. Fire, casualty and sometimes flood insurance are required on all loans secured by improved real estate. Insurance on other collateral is required, unless waived by the loan committee. The Board of Directors of the Bank has the responsibility and authority for the general supervision over the loan policies of the Bank. The Board has established written lending policies for the Bank. All applications for residential and commercial real estate mortgages and commercial business loans must be ratified by the Bank's Board of Directors. In addition, certain designated officers of the Bank have limited authority to approve consumer loans. Interest rates charged by the Bank on all loans are primarily determined by competitive loan rates offered in its market area and the Bank generally charges an origination fee on new mortgage loans. The origination fees, net of direct origination costs, are deferred and amortized into income over the life of the loan. Loan Maturities. The following table sets forth certain information at September 30, 2003 regarding the dollar amount of loans maturing in the Bank's portfolio based on their contractual terms to maturity, including scheduled repayments of principal. Demand loans, loans having no stated schedule of repayments and any stated maturity, and overdrafts are reported as due in one year or less. 8 At September 30, 2003(1) ------------------------------- Real Consumer Total Estate and Other Loans ------------------------------- (In thousands) Total loans scheduled to mature: In one year or less $ 6,410 $1,924 $ 8,334 After one year through five years 12,756 945 13,701 Beyond five years 59,245 2,800 62,045 ------- ------ ------- Total $78,411 $5,669 $84,080 ======= ====== ======= Loan balance by type scheduled to mature after one year: Fixed $41,819 $1,238 $43,057 Adjustable $30,182 $2,507 $32,689-------------------- Originations and Sales of Loans. The following table sets forth information with respect to originations and sales of loans during the periods indicated. In recent years, the Bank has been retaining more of its fixed-rate residential loans in excess of 15-year term with the intent of selling such loans service retained. Years Ended September 30, ------------------------------------------------------------ 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- (In thousands) Beginning balance(1) $ 95,949 $113,499 $106,487 $ 81,056 $ 78,182 -------- -------- -------- -------- -------- Mortgage loan originations(2) 96,411 65,782 44,141 39,853 28,279 Consumer loan originations 12,130 12,573 8,999 5,318 4,323 Commercial loan originations 2,644 3,914 1,519 1,619 2,249 Less: Amortization and payoffs(3) (58,324) (62,992) (38,734) (21,299) (24,193) Transfers to other real estate owned (OREO) - - - - - -------- -------- -------- -------- -------- Net loans originated 52,861 19,277 15,925 25,491 10,658 -------- -------- -------- -------- -------- Total loans sold (64,730) (36,827) (8,913) (60) (7,784) -------- -------- -------- -------- -------- Ending balance(1) $ 84,080 $ 95,949 $113,499 $106,487 $ 81,056 ======== ======== ======== ======== ========Net of unearned income and unadvanced principal. -------------------- Non-Performing Assets, Asset Classification and Allowances for Losses. Loans are reviewed on a regular basis and are placed on a non-accrual status when, in the opinion of management, the collection of principal and interest is doubtful. The level established for the provision for loan losses is determined by management in its effort to maintain an allowance for loan losses that is adequate for the size and composition of its loan portfolio and reflects the Bank's historical record of loan losses. Loans with deviations in their quality are monitored on 9 the Bank's "watch list" and are assigned specific reserve allocations, such as commercial loans and construction loans, which are weighted heavier than owner occupied 1-4 family residential loans and warrant increased provisions on an on-going basis. The Bank's non-real estate commercial loans totaled $4.9 million at September 30, 2003, as compared to $5.2 million at September 30, 2002. Management routinely reviews the risk weighting applied to each loan type. These are estimates that can increase or decrease the provision depending on the current risk assessment. Several risk weightings were increased slightly during the twelve-month period ended September 30, 2003. On September 30, 2003 the Bank had one delinquent residential real estate loan, two delinquent consumer loans, and no non-performing loans. Real estate acquired by the Bank as a result of foreclosure is classified as real estate owned until such time as it is sold. When such property is acquired, it is recorded at the lower of the unpaid principal balance or its fair value. Any required write-down of the loan to its fair value is charged to the allowance for loan losses. At September 30, ------------------------------------ 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- (Dollars in thousands) Loans 30-89 days past due (not included in non- performing loans) $ 81 $100 $ - $ - $ 57 Loans 30-89 days past due as a percent of total loans .10% .10% -% -% .07% Non-performing loans: (90 days past due) $ - $ - $ - $ - $ - OREO $ - $ - $ - $ - $ - Total non-performing assets $ - $ - $ - $ - $ - Non-performing loans as a percent of total loans -% -% -% -% -% Non-performing assets as a percent of total assets -% -% -% -% -% During the year ended September 30, 2003, no gross interest income would have been recorded on loans accounted for on a non-accrual basis if the loans had been current throughout the period. No interest on such loans was included in income during the respective periods. At September 30, 2003, management was not aware of any loans not currently classified as non-accrual, 90 days past due or restructured but which may be so classified in the near future because of concerns over the borrower's ability to comply with repayment terms. Federal and state regulations require each banking institution to classify its asset quality on a regular basis. In addition, in connection with examinations of such banking institutions, federal and state examiners have authority to identify problem assets and, if appropriate, classify them. An asset is classified substandard if it is determined to be inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. As a 10 general rule, the Bank will classify a loan as substandard if the Bank can no longer rely on the borrower's income as the primary source for repayment of the indebtedness and must look to secondary sources such as guarantors or collateral. An asset is classified as doubtful if full collection is highly questionable or improbable. An asset is classified as loss if it is considered uncollectible, even if a partial recovery could be expected in the future. The regulations also provide for a special mention designation, described as assets which do not currently expose a banking institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management's close attention. Assets classified as substandard or doubtful require a banking institution to establish general allowances for loan losses. If an asset or portion thereof is classified loss, a banking institution must either establish specific allowances for loan losses in the amount of the portion of the asset-classified loss, or charge off such amount. Examiners may disagree with a banking institution's classifications and amounts reserved. If a banking institution does not agree with an examiner's classification of an asset, it may appeal this determination to the FDIC Regional Director. At September 30, 2003, the Bank had no assets classified as special mention or doubtful, no assets designated as substandard, and none classified as loss. In originating loans, the Bank recognizes that credit losses will occur and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. It is management's policy to maintain an adequate general allowance for loan losses based on, among other things, the Bank's and the industry's historical loan loss experience, evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Further, after properties are acquired following loan defaults, additional losses may occur with respect to such properties while the Bank is holding them for sale. The Bank increases its allowances for loan losses and losses on real estate owned by charging provisions for losses against the Bank's income. Specific reserves also are recognized against specific assets when warranted. Results of recent examinations by bank regulators indicate that these regulators may be applying more conservative criteria in evaluating real estate market values, requiring significantly increased provisions for potential loan losses. While Falmouth believes it has established its existing allowances for loan losses in accordance with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase its allowance for loan losses, thereby negatively affecting the Bank's financial condition and earnings. The bank regulatory agencies, including the FDIC, have a policy statement regarding maintenance of an adequate allowance for loan and lease losses and an effective loan review system. This policy includes an arithmetic formula for checking the reasonableness of an institution's allowance for loan loss estimate compared to the average loss experience of the industry as a whole. Examiners will review an institution's allowance for loan losses and compare it against the sum of (i) 50% of the portfolio that is classified doubtful; (ii) 15% of the portfolio that is classified as substandard; and (iii) for the portions of the portfolio that have not been classified (including those loans designated as special mention), estimated credit losses over the upcoming twelve months given the facts and circumstances as of the evaluation date. This amount is considered neither a "floor" nor a "safe harbor" of the level of allowance for loan 11 losses an institution should maintain, but examiners will view a shortfall relative to the amount as an indication that they should review management's policy on allocating these allowances to determine whether it is reasonable based on all relevant factors. The following table analyzes activity of the Bank's allowance for loan losses for the periods indicated. Year Ended September 30, ---------------------------------------------------------- 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- (Dollars in thousands) Average loans, net $85,333 $106,785 $111,573 $ 94,315 $77,657 ------- -------- -------- -------- ------- Period-end total loans(1) $84,080 $ 95,949 $113,499 $106,487 $81,056 ------- -------- -------- -------- ------- Allowance for loan losses at beginning of period $ 939 $ 945 $ 755 $ 569 $ 527 Loans charged-off - 6 - 4 - Recoveries 2 - - 1 - Provision charged to operations (180) - 190 189 42 ------- -------- -------- -------- ------- Allowance for loan losses at end of period $ 761 $ 939 $ 945 $ 755 $ 569 ======= ======== ======== ======== ======= Ratios: Allowance for loan losses as a percentage of period end total loans .91% .98% .83% .71% .70% Allowance for loan losses as a percentage of non-performing loans - - - - - Net charge-offs to average loans, net - .01% - - - Net charge-offs to allowance for loan losses - .64% - .40% -Net of unearned income and unadvanced principal. Includes residential and commercial real estate loans. Includes unadvanced principal. -------------------- 12 The following table sets forth a breakdown of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. These allocations are not necessarily indicative of future losses and do not restrict the use of the allowance to absorb losses in any loan category. At September 30, ----------------------------------------------------------------------------------------------------------- 2003 2002 2001 2000 1999 ------------------- ------------------- ------------------- ------------------- ------------------- Percent of Percent of Percent of Percent of Percent of Loans in Loans in Loans in Loans in Loans in Each Each Each Each Each Category to Category to Category to Category to Category to Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans ------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ ----------- (Dollars in Thousands) Real estate mortgage: Residential $211 55.57% $330 65.56% $532 78.79% $436 78.53% $282 80.42% Commercial 330 19.64 310 14.78 201 9.17 181 11.14 171 10.47 Commercial loans, other 99 5.90 162 5.39 119 4.08 76 3.13 62 2.70 Consumer, including home equity loans 121 18.89 137 14.27 93 7.96 62 7.20 54 6.41 ---- ------ ---- ------ ---- ------ ---- ------ ---- ------ Total allowance for loan losses $761 100.00% $939 100.00% $945 100.00% $755 100.00% $569 100.00% ==== ====== ==== ====== ==== ====== ==== ====== ==== ====== 13 Investment Activities General. The Bank is required to maintain an amount of liquid assets appropriate for its level of net withdrawals from savings accounts and current borrowings. Generally, it has been the Bank's policy to maintain a liquidity portfolio in excess of regulatory requirements. At September 30, 2003, the Bank's liquidity ratio was 53.1%. Liquidity levels may be increased or decreased depending upon the yields on investment alternatives, management's judgment as to the attractiveness of the yields then available in relation to other opportunities, management's expectations of the level of yield that will be available in the future and management's projections as to the short-term demand for funds to be used in Falmouth's loan origination and other activities. Interest income from investments in various types of liquid assets provides a significant source of revenue for the Bank. In the late 1980s, the Bank maintained its conservative underwriting standards in an effort to avoid asset quality problems and chose instead to invest excess liquidity in its investment portfolio. The Bank's short-term investments include United States Treasury securities and United States Agency securities, commercial paper, equity securities, short-term corporate debt securities and overnight federal funds. The balance of the securities investments maintained by the Bank in excess of regulatory requirements reflects management's historical objective of maintaining liquidity at a level that assures the availability of adequate funds, taking into account anticipated cash flows and available sources of credit, for meeting withdrawal requests and loan commitments and making other investments. The Bank purchases securities through a primary dealer of United States Government obligations or such other securities dealers authorized by the Board of Directors and requires that the securities be delivered to the safekeeping agent (Investors Bank & Trust Company) before the funds are transferred to the broker or dealer. The Bank purchases investment securities pursuant to an investment policy established by the Board of Directors. All securities and investments are recorded on the books of the Bank in accordance with accounting principles generally accepted in the United States of America (GAAP). The Bank does not purchase securities and investments for trading. Available-for-sale securities are reported at fair value with unrealized gains or losses reported as a separate component of net worth. All purchases of securities and investments conform to the Bank's interest rate risk policy. 14 The following table sets forth the scheduled maturities, average yields, amortized cost and market value for the Bank's investment securities at September 30, 2003. September 30, 2003 ------------------------------------------------------------------------------------------------------------ One Year or Less One to Five Years Five to Ten Years More than Ten Years Total Investment Portfolio ------------------ ------------------ ------------------ ------------------- ---------------------------- Amortized Average Amortized Average Amortized Average Amortized Average Amortized Average Market Cost Yield Cost Yield Cost Yield Cost Yield Cost Yield Value --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- ------- (Dollars in thousands) U.S. Government Obligations $ 5,436 0.94% $ - -% $ - -% $ - -% $ 5,536 .94% $ 5,534 Mortgage-backed Securities - - 32 7.74 352 7.49 118 7.27 502 7.45 531 Corporate Notes and Bonds 53,094 1.99% 8,993 1.99 - - - - 62,088 1.99 62,045 ------- ------ ---- ---- ------- -------- Total $58,630 3.22% $9,025 3.77% $352 7.49% $118 7.27% 68,126 1.94 68,110 ======= ====== ==== ==== Marketable Equity Securities 1,703 1.47 1,626 FHLB Stock 878 3.81 878 ------- -------- Total Invest- ment Portfolio $70,707 1.96% $70,614 ======= ======= 15 The following tables set forth information regarding the investment portfolio at the dates indicated. September 30, 2003 -------------------------------------------------------------------------------------------- Available-for-Sale Held-to-Maturity -------------------------------------------- -------------------------------------------- Amortized Cost Market Value Percent(1) Amortized Cost Market Value Percent(2) -------------- ------------ ---------- -------------- ------------ ---------- (Dollars in thousands) Investment securities(3): U.S. government obligations $ 5,536 $ 5,534 14.9% $ - $ - -% Other bonds and obligations 29,688 29,643 79.7 32,400 32,401 99.5 Marketable equity securities 1,703 1,626 4.4 - - - Mortgage-backed securities(4) 352 376 1.0 150 155 .5 ------- ------- ----- ------- ------- ----- Total Investment Portfolio $37,279 $37,179 100.0% $35,550 $32,556 100.0% ======= ======= ===== ======= ======= ===== September 30, ----------------------------------------------------------------- 2003 2002 2001 ------------------- ------------------- ------------------- Carrying Carrying Carrying Amount Percent Amount Percent Amount Percent -------- ------- -------- ------- -------- ------- (Dollars in thousands) Investment securities at carrying amount(3): U.S. government obligations $ 5,534 7.9% $14,506 31.0% $ 4,581 23.7% Other bonds and obligations 62,043 89.0 29,447 63.0 10,722 55.5 Marketable equity securities 1,626 2.3 1,984 4.2 2,630 13.6 Mortgage-backed securities(4) 526 0.8 836 1.8 1,398 7.2 ------- ----- ------- ----- ------- ----- Total Investment Portfolio $69,729 100.0% $46,773 100.0% $19,331 100.0% ======= ===== ======= ===== ======= =====Net of unearned income and unadvanced principal. -------------------- 16 Deposit Activity and Other Sources of Funds General. Deposits are the primary source of the Bank's funds for lending and other investment purposes. In addition to deposits, the Bank derives funds from principal repayments and interest payments on loans and investments as well as other sources arising from operations in the production of net earnings. Loan repayments and interest payments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources, or on a longer- term basis for general business purposes. Deposits. Deposits are attracted principally from within the Bank's primary market area through the offering of a broad selection of deposit instruments, including passbook savings, NOW accounts, demand deposits, money market accounts and certificates of deposit. Deposit account terms vary, with the principal differences being the minimum balance required, the time periods the funds must remain on deposit and the interest rate. The Bank's policies are designed primarily to attract deposits from local residents and businesses rather than to solicit deposits from areas outside its primary market. The Bank does not accept deposits from brokers due to the volatility and rate sensitivity of such deposits. Interest rates paid, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations. 17 The following table sets forth the various types of deposit accounts at the Bank and the balances in these accounts at the dates indicated. At September 30, ------------------------------------------------------------------------------------------------------ 2003 2002 2001 2000 1999 ------------------ ------------------ ------------------ ------------------ ------------------ Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in thousands) Savings deposits $ 25,406 17.5% $ 21,463 16.3% $ 18,683 15.3% $ 19,380 17.2% $17,782 19.1% NOW accounts 14,863 10.2 9,540 7.2 9,637 7.9 10,095 9.0 9,389 10.1 Money market deposits 31,386 21.6 26,049 19.8 19,413 15.9 16,462 14.7 14,188 15.3 -------- ----- -------- ----- -------- ----- -------- ----- ------- ----- Total 71,655 49.3 57,052 43.3 47,733 39.1 45,937 40.9 41,359 44.5 Demand deposits 20,426 14.0 17,552 13.3 16,147 13.2 14,243 12.6 8,091 8.7 Certificates of deposit 53,454 36.7 57,113 43.4 58,296 47.7 52,194 46.5 43,436 46.8 -------- ----- -------- ----- -------- ----- -------- ----- ------- ----- Total deposits $145,535 100.0% $131,717 100.0% $122,176 100.0% $112,374 100.0% $92,886 100.0% ======== ===== ======== ===== ======== ===== ======== ===== ======= ===== 18 For more information on the Bank's deposit accounts, see Note 6 of the Notes to Consolidated Financial Statements. The following table indicates the amount of the Bank's certificates of deposit of $100,000 or more by time remaining until maturity at September 30, 2003. Certificates of Maturity Period Deposit ---------------- --------------- (In thousands) Within three months $ 2,638 After three but within six months 3,272 After six but within twelve months 3,712 After twelve months 3,461 ------- Total $13,083 ======= The following table sets forth the deposit activity of the Bank for the periods indicated. Years Ended September 30, -------------------------------------------------------- 2003 2002 2001 2000 1999 ---- ---- ---- ---- ---- (In thousands) Deposits $809,151 $675,994 $551,960 $448,303 $344,310 Withdrawals 797,522 669,546 546,278 432,244 335,933 -------- -------- -------- -------- -------- Net increase (decrease) before interest credited 11,629 6,448 5,682 16,059 8,377 Interest credited 2,189 3,093 4,120 3,429 2,990 -------- -------- -------- -------- -------- Net increase in deposits $ 13,818 $ 9,541 $ 9,802 $ 19,488 $ 11,367 ======== ======== ======== ======== ======== Borrowings. Savings deposits historically have been the primary source of funds for the Bank's lending and investment activities and for its general business activities. The Bank is authorized, however, to use advances from the FHLB of Boston to supplement its supply of lend able funds and to meet deposit withdrawal requirements. Advances from the FHLB are secured by the Bank's stock in the FHLB and a portion of the Bank's mortgage loans. The Bank had $2.6 million of FHLB advances outstanding at September 30, 2003. The FHLB of Boston functions as a central reserve bank providing credit for savings institutions and certain other financial institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of its home mortgages and other assets (principally, securities which are obligations of, or guaranteed by the United States) provided certain standards related to creditworthiness have been met. Competition The Bank experiences substantial competition both in attracting and retaining savings deposits and in the making of mortgage and other loans. Direct competition for savings deposits primarily comes from larger commercial banks and other savings institutions located in or near the Bank's primary market area that generally have significantly greater financial and 19 technological resources than the Bank. Additional significant competition for savings deposits comes from credit unions, money market funds and brokerage firms. The primary factors in competing for loans are interest rates and loan origination fees and the range of services offered by the various financial institutions. Competition for origination of real estate loans normally comes from commercial banks, other thrift institutions, mortgage bankers, mortgage brokers and insurance companies. Management considers the Bank's competitors in its market area to consist of 15 branches of financial institutions headquartered outside of its market area. The Bank is the only independent financial institution headquartered in Falmouth. FEDERAL AND STATE TAXATION Federal Taxation General. The following is intended only as a discussion of material federal income tax matters and does not purport to be a comprehensive description of the federal income tax rules applicable to the Bank or the Company. The Bank's federal income tax return was last audited for the tax year ended September 30, 1975. For federal income tax purposes, the Company and the Bank, as members of the same affiliated group, file consolidated income tax returns on a September 30 fiscal year basis using the accrual method of accounting and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's tax reserve for bad debts, discussed below. Bad Debt Reserves. The Bank, as a "small bank" (one with assets having an adjusted tax basis of $500 million or less) is permitted to maintain a reserve for bad debts with respect to "qualifying loans," which, in general, are loans secured by certain interests in real property, and to make, within specified formula limits, annual additions to the reserve which are deductible for purposes of computing the Bank's taxable income. Pursuant to the Small Business Job Protection Act of 1996, the Bank is now recapturing (taking into income) over a multi-year period a portion of the balance of its bad debt reserve as of September 30, 1996. See Note 9 to the consolidated financial statements. Distributions. To the extent that the Bank makes "non-dividend distributions" to the Company, such distributions will be considered to have been made from the Bank's "base year reserve," i.e., its reserve as of September 30, 1988, and then from the Bank's supplemental reserve for losses on loans, to the extent thereof, and an amount based on the amount distributed (but not in excess of the amount of such reserves) will be included in the Bank's income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of the Bank's current or accumulated earnings and profits will not be so included in the Bank's income. The amount of additional taxable income created from a non-dividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if the Bank makes a non-dividend distribution to the Company, approximately one and one-half times the amount of such distribution (but not in excess of the amount of such reserves) would be includible in income, assuming a 34% federal corporate income tax rate. The 20 Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves. Corporate Alternative Minimum Tax. The Code imposes a tax ("AMT") on alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset by net operating loss carryovers of which the Bank currently has none. AMTI is also adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. The Bank does not expect to be subject to the AMT. Elimination of Dividends; Dividends Received Deduction. The Company may exclude from its income 100% of dividends received from the Bank as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Bank will not file a consolidated tax return, except that if the Company or the Bank owns more than 20% of the stock of a corporation distributing a dividend, then 80% of any dividends received may be deducted. State Taxation Massachusetts Taxation. The Bank currently files a separate Massachusetts excise tax return, based on net income. Under state laws, Massachusetts-based financial institutions may apportion income earned in other states. However, the Massachusetts bank excise (income) tax applies to non-bank entities and out-of-state financial institutions as well as Massachusetts-based financial institutions. The Massachusetts excise tax rate for co-operative banks is currently 10.50% of federal taxable income, adjusted for certain items. Taxable income includes gross income as defined under the Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less deductions, but not the credits, allowable under the provisions of the Code. Carry forwards and carry backs of net operating losses are not allowed. In March of 2003, tax legislation enacted by the Commonwealth of Massachusetts, effective retroactively to 1999, eliminated the 95% income tax dividend exclusion on dividends the Bank received from its real estate investment trust subsidiary. For additional information regarding taxation, see Note 9 of the Notes to Financial Statements. Delaware Taxation. As a Delaware holding company not earning income in Delaware, the Company is exempt from Delaware corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware. 21 REGULATION AND SUPERVISION General As a co-operative bank chartered by the Commonwealth of Massachusetts, whose deposits are insured by the Bank Insurance Fund of the FDIC, the Bank is subject to extensive regulation under state law with respect to many aspects of its banking activities; this state regulation is administered by the Commissioner of the Massachusetts Division of Banks (the "Division"). In addition, the FDIC levies assessments or deposit insurance premiums on the Bank and is vested with authority to supervise the Bank and to exercise a broad range of enforcement powers. Finally, the Bank is required to maintain reserves against deposits according to a schedule established by the Federal Reserve System. These laws and regulations have been established primarily for the protection of depositors and the deposit insurance fund, not the Company's stockholders. The Company, as the bank holding company controlling Falmouth Co- operative Bank, is subject to the Bank Holding Company Act of 1956, as amended, and its rules and regulations promulgated by the Federal Reserve Board. The Company is also subject to certain Massachusetts banking laws applicable to bank holding companies. The following references to the laws and regulations under which the Company and the Bank are regulated are brief summaries thereof, do not purport to be complete and are qualified in their entirety by reference to such laws and regulations. Financial Services Modernization Legislation On November 12, 1999, President Clinton signed into law the Gramm- Leach-Bliley Financial Services Modernization Act of 1999 ("GLB Act"). This federal legislation was intended to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Bank holding companies are now permitted to engage in a wider variety of financial activities than permitted under prior law, particularly with respect to insurance and securities activities if such companies elect to be regulated as a financial holding company. In addition, in a change from prior law, bank holding companies will be in a position to be owned, controlled or acquired by any company engaged in financially related activities. Federal Banking Regulations Capital Requirements. FDIC regulations require BIF-insured banks, such as the Bank, to maintain minimum levels of capital. The FDIC regulations define two tiers, or classes, of capital- Tier 1 Capital and Tier 2 Capital. 22 Overall, the amount of Tier 2 Capital that may be included in total capital cannot exceed 100% of Tier 1 Capital. The FDIC regulations establish a minimum leverage capital requirement for banks in the strongest financial and managerial condition, with a rating of 1 (the highest examination rating of the FDIC for banks) under the Uniform Financial Institutions Rating System, of not less than a ratio of 3.0% of Tier 1 capital to total assets. For all other banks, the minimum leverage capital requirement is 4.0%, unless a higher leverage capital ratio is warranted by the particular circumstances or risk profile of the depository institution. The FDIC regulations also require that co-operative banks meet a risk- based capital standard. The risk-based capital standard requires the maintenance of a ratio of total capital (which is defined as the sum of Tier 1 capital and Tier 2 capital) to risk-weighted assets of at least 8% and a ratio of Tier 1 capital to risk-weighted assets of at least 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, 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 federal banking agencies, including the FDIC, have also adopted regulations to require an assessment of an institution's exposure to declines in the economic value of a bank's capital due to changes in interest rates when assessing the bank's capital adequacy. Under such a risk assessment, examiners will evaluate a bank's capital for interest rate risk on a case-by-case basis, with consideration of both quantitative and qualitative factors. 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 also 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 connection with capital adequacy. The following table shows the Company's and the Bank's leverage capital ratio, their Tier 1 risk-based capital ratio, and their total risk- based capital ratio, at September 30, 2003: 23 At September 30, 2003 -------------------------------------------------- Capital Percent of Capital Percent of Amount Assets(1) Requirement Assets(1) ------- ---------- ----------- ---------- (Dollars in thousands) Falmouth Bancorp, Inc Tier 1 leverage capital $17,696 10.74% $ 6,590 > or =4.0% Tier 1 risk-based capital $17,696 13.36% $ 5,297 > or =4.0% Total risk-based capital $18,457 13.94% $10,594 > or =8.0% Falmouth Cooperative Bank Tier 1 leverage capital $16,443 9.96% $ 6,602 > or =4.0% Tier 1 risk-based capital $16,443 12.48% $ 5,269 > or =4.0% Total risk-based capital $17,204 13.06% $10,538 > or =8.0%As a percentage of total market value. As a percentage of total amortized cost. Does not include federal funds sold of $4 million or Federal Home Loan Bank Stock of $878,000. Consists of GNMA, FHLMC and FNMA certificates. -------------------- As the table shows, the Bank and the Company exceeded the minimum capital adequacy requirements at September 30, 2003. Enforcement The FDIC has extensive enforcement authority over insured co-operative banks, including the Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices. The FDIC has authority under federal law to appoint a conservator or receiver for an insured bank under certain circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state bank if that bank is "critically undercapitalized." For this purpose, "critically undercapitalized" means having a ratio of tangible capital to total assets of less than 2%. The FDIC may also appoint a conservator or receiver for a state bank on the basis of the institution's financial condition or upon the occurrence of certain events, including: (i) insolvency (whereby the assets of the bank are less than its liabilities to depositors and others); (ii) substantial dissipation of assets or earnings through violations of law or unsafe and unsound practices; (iii) existence of an unsafe or unsound condition to transact business; (iv) likelihood that the bank will be unable to meet the demands of its depositors or to pay its obligations in the normal course of business; and (v) insufficient capital, or the incurring or likely incurring of losses that will deplete substantially all of the institution's capital with no reasonable prospect of replenishment of capital without federal assistance. Deposit Insurance The FDIC has adopted a risk-based deposit insurance assessment system. The FDIC assigns an institution to one of three capital categories based on the institution's financial information, as of the reporting period ending seven months before the assessment period, 24 consisting of (1) well capitalized, (2) adequately capitalized or (3) undercapitalized, and one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution's primary federal regulator and information that the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance funds. An institution's assessment rate depends on the capital category and supervisory category to which it is assigned. Assessment rates for BIF deposits currently range from 0 basis points to 27 basis points. The Bank's assessment rate is currently 0 basis points. The FDIC is authorized to raise the assessment rates in certain circumstances, including maintaining or achieving the designated reserve ratio of 1.25%, which requirement the BIF currently meets. The FDIC has exercised its authority to raise rates in the past and may raise insurance premiums in the future. If the FDIC takes such action, it could have an adverse effect on the earnings of the Bank. In addition, legislation requires BIF-insured institutions like the Bank to assist in the payment of FICO bonds. Under the Federal Deposit Insurance Act (the "FDI Act"), insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the Division. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance. Transactions with Affiliates and Insiders Transactions between state non-member banks and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. Currently, a subsidiary of a bank that is not also a depository institution is not treated as an affiliate of the bank for purposes of Sections 23A and 23B. Generally, Section 23A: * limits the extent to which the bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such bank's capital and surplus, and contains an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital and surplus; and * requires that all such transactions be on terms that are consistent with safe and sound banking practices. The term "covered transaction" includes the making of loans, purchase of assets, issuance of guarantees and similar other types of transactions. In addition, most extensions of credit by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100% to 130% of the loan amounts, depending on the type of collateral. Section 23B requires that any covered transaction, and certain other transactions, including the bank's sale of assets and purchase of services from an affiliate must be on terms that are substantially the same, or at least as favorable, to the institution as those that would prevail in a comparable transaction with a non-affiliate. 25 Effective April 1, 2003, the Federal Reserve Board, or FRB, rescinded its interpretations of Sections 23A and 23B of the Federal Reserve Act and replaced these interpretations with Regulation W. In addition, Regulation W made various changes to existing law regarding Sections 23A and 23B, including expanding the definition of what constitutes an affiliate subject to Sections 23A and 23B and exempting certain subsidiaries of state- chartered banks from the restrictions of Sections 23A and 23B. Under Regulation W, all transactions entered into on or before December 12, 2002, which either became subject to Section 23A and 23B solely because of Regulation W, and all transactions covered by Sections 23A and 23B, the treatment of which changed solely because of Regulation W on July 1, 2003. All other covered affiliate transactions became subject to Regulation W on April 1, 2003. The Federal Reserve Board expects each depository institution that is subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W. We do not expect that the changes made by Regulation W will have a material adverse effect on our business. Banks are also subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the FRB's Regulation O, there under on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer or a holder of more than 10% of the shares of a bank, as well as certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the loans-to-one-borrower limit applicable to national banks (generally 15% of an institution's unimpaired capital and surplus) and all loans to all such persons in the aggregate may not exceed an institution's unimpaired capital and unimpaired surplus. Regulation O also prohibits the making of loans in an amount greater than the lesser of $25,000 or 5% of capital and surplus but in any event over $500,000, to a director, executive officer and greater than 10% stockholder of a bank, and the respective affiliates of such a person, unless such loans are approved in advance by a majority of the board of directors of the bank, with any "interested" director not participating in the voting. Further, the FRB pursuant to Regulation O requires that loans to directors, executive officers and principal stockholders (a) be made on terms substantially the same as those that are offered in comparable transactions to persons not affiliated with the bank and (b) follow credit underwriting procedures not less stringent than those prevailing for comparable transactions with persons not affiliated with the bank. Regulation O also prohibits a depository institution from paying, with certain exceptions, an overdraft of any of the executive officers or directors of the institution or any of its affiliates unless the overdraft is paid pursuant to written pre-authorized extension of interest-bearing extension of credit or transfer of funds from another account at the bank. Section 402 of the Sarbanes-Oxley Act of 2002, of Sarbanes-Oxley, prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to the insider lending restrictions of Section 22(h) of the FRA. State chartered non-member banks are further subject to the requirements and restrictions of 12 U.S.C. section 1972 against certain tying arrangements and on extensions of credit involving correspondent banks. Specifically, a depository institution is prohibited from 26 extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution, subject to certain exceptions. In addition, a depository institution with a correspondent banking relationship with another depository institution is prohibited from extending credit to the executive officers, directors, and holders of more than 10% of the stock of the other depository institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features. Real Estate Lending Policies Under FDIC regulations, state-chartered non-member banks must adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens or interest in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards, prudent underwriting standards, including loan- to-value limits that are clear and measurable, loan administration procedures and documentation, approval and reporting requirements. The real estate lending policies must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies (the "Interagency Guidelines") that have been adopted by the federal bank regulators. Community Reinvestment Act Under the Community Reinvestment Act (the "CRA"), any insured depository institution, including the Bank, has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the FDIC, in connection with its examination of a bank to assess the depository institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution, including applications for additional branches and acquisitions. CRA regulations rate an institution based on its actual performance in meeting community needs. In particular, the evaluation system focuses on three tests: * a lending test, to evaluate the institution's record of making loans in its service areas; * an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and * a service test, to evaluate the institution's delivery of services through its branches, ATMs and other offices. The CRA requires the FDIC to provide a written evaluation of an institution's CRA performance utilizing a four-tiered descriptive rating system and requires public disclosure of an 27 institution's CRA rating. The Bank received a "satisfactory" rating in its CRA examination conducted by the FDIC on January 17, 1999. Standards for Safety and Soundness Pursuant to the requirements of the Federal Deposit Insurance Corporation Improvement Act ("FDICIA"), as amended by the Riegle Community Development and Regulatory Improvement Act of 1994, each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder. In addition, the FDIC adopted regulations to require a bank that is given notice by the FDIC that it is not satisfying any of such safety and soundness standards to submit compliance plan to the FDIC. If, after being so notified, a bank fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the FDIC may issue an order directing corrective and other actions of the types to which a significantly undercapitalized institution is subject under the "prompt corrective action" provisions of FDICIA. If a bank fails to comply with such an order, the FDIC may seek to enforce such an order in judicial proceedings and to impose civil monetary penalties. Prompt Corrective Action FDICIA also established a system of prompt corrective action to resolve the problems of undercapitalized institutions. The FDIC, as well as the other federal banking regulators, adopted regulations governing the supervisory actions that may be taken against undercapitalized institutions. The regulations establish five categories, consisting of "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." At September 30, 2003, the Bank was categorized as "well capitalized." The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as bank's capital deteriorates within the three undercapitalized categories. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized. Federal Home Loan Bank System The Bank is member of the FHLB System, which consists of 12 regional Federal Home Loan Banks subject to supervision and regulation by the Federal Housing finance Board ("FHFB"). The Federal Home Loan Banks provide a central credit facility primarily for member institutions. As a member of the FHLB, the Bank is required to acquire and hold shares of capital stock in the FHLB in an amount equal to 1% of the aggregate unpaid principal of its home mortgage loans, home purchase contracts, and similar obligations, but not less than $500. The 28 Bank was in compliance with this requirement with an investment in FHLB stock at September 30, 2003, of $878,000. The FHLB serves as a reserve of central bank for its member institutions within its assigned region. It is funded primarily from the proceeds derived from the sale of consolidated obligations of the FHFB System. It offers advances to members in accordance with policies and procedures established by the FHLB and the Board of Directors of the FHLB. Title 6 of the GLB Act, entitled the Federal Home Loan Bank System Modernization Act of 1999 ("FHLB Modernization Act"), has amended the FHLB Act by allowing for voluntary membership in, and the modernizing of the capital structure and governance of, the FHLB system. The new capital structure established under the FHLB Modernization Act sets forth new leverage and risk-based capital requirements based on permanence of capital. It also requires some minimum investment in FHLB stock of all member entities. Capital will include retained earnings and two forms of stock: Class A stock redeemable within six months, written notice and Class B stock redeemable within five years, written notice. The FHLB Modernization Act provides a transition period top the new capital regime, which will not be effective until the FHLB enacts implementing regulations. The FHLB Modernization Act also reduces the period of time in which a member exiting the FHLB system must stay out of the system. Pursuant to regulations promulgated by the FHFB, as required by the GLB Act, the FHLB of Boston has adopted, and the FHFB has approved, a capital plan that changes the foregoing minimum stock ownership requirements for FHLB of Boston stock. Under the new capital plan, each member of the FHLB of Boston must maintain a minimum investment in FHLB of Boston capital stock in an amount equal to the sum of (i) .35% of member eligible collateral (subject to a minimum of $10,000 and a maximum of $25,000,000, per member), and (ii) 4.50% of the member's activity-based assets. Federal Reserve System Under FRB regulations, the Bank is required to maintain no interest- earning reserves against its transaction accounts (primarily NOW and regular checking accounts). The FRB regulations generally require that reserves of 3% must be maintained against aggregate transaction accounts of $42.1 million or less (subject to adjustment by the FRB) and an initial reserve of $1.2 million plus 10% (subject to adjustment by the FRB between 8% and 14%) against that portion of total transaction accounts in excess of $42.1 million. The first $6 million of otherwise reservable balances (subject to adjustments by the FRB) are exempted from the reserve requirements. As of September 30, 2003, the Bank met its reserve requirements. 29 Massachusetts Banking Laws and Supervision Massachusetts's co-operative banks such as the Bank are also regulated and supervised by the Division of Banks. The Division of Banks is required to regularly examine each state-chartered bank. The approval of the Division of Banks is required to establish or close branches, to merge with another bank, to form a bank holding company, to issue stock or to undertake many other activities. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Division of Banks is subject to sanctions. The Division of Banks may under certain circumstances suspend or remove directors or officers of a bank who have violated the law, conducted a bank's business in a manner which is unsafe, unsound or contrary to the depositors' interests, or been negligent in the performance of their duties. All Massachusetts-chartered co-operative banks are required to be members of the Co-operative Central Bank and are subject to its assessments. The Co-operative Central Bank maintains the Share Insurance Fund, a private deposit insurer, which insures all deposits in member banks in excess of FDIC deposit insurance limits. In addition, the Co-operative Central Bank acts as a source of liquidity to its members in supplying them with low-cost funds, and purchasing certain qualifying obligations from them. Lending Activities. A Massachusetts-chartered co-operative bank may make a wide variety of mortgage loans. Fixed-rate loans, adjustable-rate loans, variable-rate loans, participation loans, graduated payment loans, construction loans, condominium and co-operative loans, second mortgage loans and other types of loans may be made in accordance with applicable regulations. Mortgage loans may be made on real estate in Massachusetts or in another New England state if the bank making the loan has an office there or under certain other circumstances. In addition, certain mortgage loans may be made on improved real estate located anywhere in the United States. Commercial loans may be made to corporations and other commercial enterprises with or without security. With certain exceptions, such loans may be made without geographic limitations. Consumer and personal loans may be made with or without security and without geographic limitations. Loans to individual borrowers generally will be limited to 20% of the total of the Bank's capital accounts and stockholders' equity. Investments Authorized. Massachusetts-chartered co-operative banks have broad investment powers under Massachusetts's law, including so-called "leeway" authority for investments that are not otherwise specifically authorized. Federal law to permit only investments of the kinds that would be permitted for national banks restricts the investment powers authorized under Massachusetts's law. The Bank has authority to invest in all of the classes of loans and investments that are permitted by its existing loan and investment policies. Payment of Dividends. A Massachusetts-chartered co-operative bank may only pay dividends on its capital stock from net profits and no dividends may be declared, credited or paid so long as there is any impairment of the capital stock. Prior approval by the Division is required if the Bank intends to declare dividends on its common stock for any period other than for which dividends are declared upon the preferred stock. The approval of the Division is also required for a co-operative bank to declare a dividend if the total of all dividends declared by the Bank in any calendar year exceeds the total of its net profits for that year combined with its retained net 30 profits of the preceding two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. Branches. With the approval of the Division of Banks, bank branches may be established in any city or town in Massachusetts. In addition, co- operative banks may operate automated teller machines at any of their offices or, with the approval of the Division of Banks, anywhere in Massachusetts. Sharing of ATMs or "networking" is also permitted with the approval of the Division of Banks. Massachusetts-chartered co-operative banks may also operate ATMs outside of Massachusetts if permitted to do so by the law of the jurisdiction in which the ATM is located. Interstate Banking. An out-of-state bank may (subject to various regulatory approvals and to reciprocity in its home state) establish and maintain bank branches in Massachusetts by: * merging with a Massachusetts bank that has been in existence for at least three years; * acquiring a branch or branches of a Massachusetts bank without acquiring the entire bank; or * opening such branches de novo. Massachusetts banks' ability to exercise similar interstate banking powers in other states depends upon the laws of the other states. For example, according to the law of the bordering state of New Hampshire, out-of-state banks may acquire New Hampshire banks by merger, but may not establish de novo branches in New Hampshire. Community Reinvestment Act. The Bank is also subject to provisions of the Massachusetts banking laws that, like the provisions of the federal Community Reinvestment Act, impose continuing and affirmative obligations upon a banking institution organized in Massachusetts to serve the credit needs of its local communities. The obligations of the Massachusetts Community Reinvestment Act are similar to those imposed by the federal Community Reinvestment Act with the exception of the assigned exam ratings. Massachusetts banking law provides for an additional exam rating of "high satisfactory" in addition to the federal Community Reinvestment Act ratings of "outstanding," "satisfactory," "needs to improve" and "substantial noncompliance." The Division has adopted regulations to implement the Massachusetts Community Reinvestment Act that are based on the federal Community Reinvestment Act. The Division is required to consider a bank's Massachusetts Community Reinvestment Act rating when reviewing the 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 Massachusetts Community Reinvestment Act requires the Division to assess a bank's compliance with the Massachusetts Community Reinvestment Act and to make such assessment available to the public. The Bank received a "high satisfactory" rating in its Community Reinvestment Act examination conducted by the Commonwealth of Massachusetts on June 18, 2003. Other Powers. Massachusetts-chartered co-operative banks may also lease machinery and equipment, act as trustee or custodian for tax qualified retirement plans, establish trust 31 departments and act as professional trustee or fiduciary, provide payroll services for their customers, issue or participate with others in the issuance of mortgage-backed securities and establish mortgage banking companies and discount securities brokerage operations. Some of these activities require the prior approval of the Division of Banks. Loans to Bank's Insiders. The Massachusetts banking laws prohibit any officer, director or trustee from borrowing, otherwise becoming indebted, or becoming liable for a loan or other extension of credit by such bank to any other person, except for any of the following loans or extensions of credit: * loan or extension of credit, secured or unsecured, to an officer of the bank in an amount not exceeding $20,000; * loan or extension of credit intended or secured for educational purposes to an officer of the bank in an amount not exceeding $75,000; * loan or extension of credit secured by a mortgage on residential real estate to be occupied in whole or in part by the officer to whom the loan or extension of credit is made, in an amount not exceeding $275,000; or * loan or extension of credit to a director or trustee of the bank who is not also an officer of the bank in an amount permissible under the bank's loan-to-one borrower limit. The loans listed above require approval of the majority of the members of the Bank's executive committee, excluding any member involved in the loan or extension of credit. No such loan or extension of credit may be granted with an interest rate or other terms that are preferential in comparison to loans granted to persons not affiliated with the Bank. Regulation of Holding Company Federal Regulation. The Company is subject to examination, regulation and periodic reporting under the BHCA, as administered by the FRB. The FRB has adopted capital adequacy guidelines for bank holding companies on a consolidated basis substantially similar to those of the FDIC for the Bank. The Company is required to obtain the prior approval of the FRB and the Massachusetts Board of Bank Incorporation ("BBI") to acquire all, or substantially all, of the assets or any bank of bank holding company. Prior FRB and BBI approval would be required for the Company to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than 5% of any class of voting shares of such bank or bank holding company. The Company is required to give the FRB prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Company's consolidated net worth. The FRB may disapprove such a purchase or redemption if it determines 32 that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB. Such notice and approval is not required for a bank holding company that would be treated as "well capitalized" under applicable regulations of the FRB, both before and after the redemption that is well managed, and that is not the subject of any unresolved supervisory issues. The status of the Company as a registered bank holding company under the BHCA does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws. In addition, a bank holding company which does not qualify as a financial holding company under the GLB Act, is generally prohibited from engaging in, or acquiring 5% or more of any class of voting securities of any company engaged in, non-banking activities. One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Bank holding companies that qualify as a financial holding company may engage in activities that are financial in nature or incident to activities that are financial in nature. To date, the Company has not elected to become regulated as a financial holding company. Under the Federal Deposit Insurance Act, depository institutions are liable to the FDIC for losses suffered or anticipated by the FDIC in connection with the default of a commonly controlled depository institution or any assistance provided by the FDIC to such an institution in danger of default. This law would have potential applicability if the Company ever acquired as a separate subsidiary a depository institution in addition to the Bank. USA PATRIOT Act In response to the events of September 11th, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions: * Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program. 33 * Pursuant to Section 326, on May 9, 2003 the Secretary of the Department of Treasury, in conjunction with other bank regulators, issued a Joint Final Rule that provides for minimum standards with respect to customer identification and verification. The Bank was required to comply with this rule by October 1, 2003. * Section 312 requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. * Effective December 26, 2001, financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and are subject to certain record-keeping obligations with respect to correspondent accounts of foreign banks. * Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications. Although we anticipate that we will incur additional expense in complying with the provisions of the USA PATRIOT ACT and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition. The Sarbanes-Oxley Act On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate wrongdoing that occurred in Enron, WorldCom and similar companies. The Sarbanes-Oxley Act's principal legislation includes: * the creation of an independent accounting oversight board; * Auditor independence provisions which restrict non-audit services that accountants may provide to their audit clients; * additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements; * the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve 34 month period following initial publication of any financial statements that later require restatement; * an increase the oversight of, and enhancement of certain requirements relating to audit committees of public companies and how they interact with the company's independent auditors; * requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer; * requirement that companies disclose whether at least one member of the committee is a "financial expert" (as such term will be defined by the Securities and Exchange Commission) and if not, why not; * expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods; * a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions; * disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; * mandatory disclosure by analysts of potential conflicts of interest; and * a range of enhanced penalties for fraud and other violations. The SEC has been delegated the task of enacting rules to implement various provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Securities Exchange Act. To date, the SEC has implemented some of the provisions of the Sarbanes-Oxley Act. However, the SEC continues to issue final rules, reports, and press releases. As the SEC provides new requirements, we review those rules and comply as required. Although we anticipate that we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition. Federal Securities Laws The Company's common stock is registered with the SEC under Section 12(b) of the Securities Exchange Act of 1934 (the "Exchange Act"). The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act. 35 ITEM 2. DESCRIPTION OF PROPERTY The following table sets forth certain information at September 30, 2003 regarding Falmouth office facilities, and certain other information relating to the properties at that date. Year Completed Square Net Book Value or Acquired Footage at September 30, 2003 -------------- ------- --------------------- Main Office: 20 Davis Straits Falmouth, MA 02540 1978 10,696 $276,369 Branch Offices: North Falmouth, MA 78 County Rd. N. Falmouth, MA 02556 1998 1,706 $ 525,520 East Falmouth, MA 397 E. Falmouth Hwy E. Falmouth, MA 02536 1998 2,380 $718,308 Bourne, MA 172 Clay Pond Road Bourne, MA Under Construction 2,000 $ 60,995 At September 30, 2003, the net book value of Falmouth's computer equipment and other furniture, fixtures and equipment at its offices totaled $330,702. For more information, see Note 5 of the Notes to Consolidated Financial Statements. ITEM 3. LEGAL PROCEEDINGS Although the Bank and the Company, from time to time, are involved in various legal proceedings in the normal course of business, there are no material legal proceedings to which the Bank or the Company, its directors or its officers is a party or to which any of its property is subject as of the date of this Form 10-KSB. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the quarter ended September 30, 2003. PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Certain of the above-captioned information is included in the Falmouth Bancorp, Inc. 2003 Annual Report to Stockholders (the "Annual Report") and is incorporated herein by reference. See "Market for the Company's Common Stock" on page 18 of the Annual Report and which is attached to this 10-KSB as Exhibit 13.1. 36 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The above-captioned information is included in the Annual Report and is incorporated herein by reference. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Financial Highlights" on pages 5 through 17 of the Annual Report. ITEM 7. CONSOLIDATED FINANCIAL STATEMENTS The following information included in the Annual Report is incorporated herein by reference. See "Consolidated Financial Statements and Notes to Consolidated Financial Statements" on pages 19 through 51 of the Annual Report. ITEM 8. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company has not filed any current report on Form 8-K within 24 months prior to the date of the most recent financial statements reporting a change of accountants and/or reporting disagreements of any matter of accounting principle or financial statement disclosure. ITEM 8A. CONTROLS AND PROCEDURES Management, including the Company's President and Chief Executive Officer and Senior Vice President, Treasurer and Clerk, has evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based upon that evaluation, the President and Chief Executive Officer and Senior Vice President, Treasurer and Clerk, concluded that the disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required. There have been no changes in the Company's internal control over financial reporting identified in connection with the evaluation that occurred during the Company's last fiscal quarter that has materially affected, or that is reasonably likely to materially affect, the Company's internal control over financial reporting. PART III ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The above-captioned information is included in the Company's 2003 Proxy Statement for the 2004 Annual Meeting of Stockholders filed with the SEC on December 18, 2003 ("Proxy Statement") and is incorporated herein by reference. See "Election of Directors," "Nominees and Continuing Directors," "Executive Officers," and "Section 16(a) Beneficial Ownership Reporting Compliance." 37 ITEM 10. EXECUTIVE COMPENSATION The above-captioned information is included in the Proxy Statement and is incorporated herein by reference. See "Proposal 1 - Election of Directors - Director Compensation," "- Compensation Table," "-Employment Agreements," " -Stock Option Plan," "-Recognition and Retention Plan," and "- Transactions with Certain Related Persons." ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Certain of the above-captioned information are included in the Proxy Statement and are incorporated herein by reference. See "Stock Ownership of Management" and "Security Ownership of Certain Beneficial Owners." The following table sets forth the aggregate information of the Company's equity compensation plans in effect as of September 30, 2003. Number of securities Number of securities remaining available for to be issued Weighted-average future issuance under equity upon exercise of exercise price of compensation plans outstanding options, outstanding options, (excluding securities Plan category warrants and rights warrants and rights reflected in column (a)) ------------- -------------------- -------------------- ---------------------------- (a) (b) (c) Equity compensation plans approved by security holders 83,260 $14.494 23,778 ------- ------- ------ Equity compensation plans not approved by security holders 23,778 $16.112 0 ------- ------- ------ Total 107,038 $14.854 23,778 ======= ======= ====== ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The above-captioned information is included in the Proxy Statement and is incorporated herein by reference. See "Transactions with Certain Related Persons." 38 ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) The following financial statements included in the 2003 Annual Report are incorporated herein by reference: Balance Sheets - At September 30, 2003 and 2002; Statements of Income - Years Ended September 30, 2003, 2002 and 2001; Statements of Changes in Stockholders' Equity - Years Ended September 30, 2003, 2002 and 2001; Statements of Cash Flows - Years Ended September 30, 2003, 2002 and 2001; and Notes to Financial Statements - Years Ended September 30, 2003, 2002 and 2001 (b) Exhibits. The following exhibits are either filed as part of this report or are incorporated herein by reference: 3.1 Certificate of Incorporation of Falmouth Bancorp, Inc. (1) 3.2 By-laws of Falmouth Bancorp, Inc.(1) 4.1 Specimen Stock Certificate of Falmouth Bancorp, Inc. (1) 10.1 1997 Stock Option Plan for Outside Directors, Officers and Employees of Falmouth Bancorp, Inc. (1) 10.2 Amendments to 1997 Stock Option Plan for Outside Directors, Officers and Employees of Falmouth Bancorp, Inc. (2) 10.3 1997 Recognition and Retention Plan for Outside Directors, Officers and Employees of Falmouth Bancorp, Inc. (1) 10.4 Agreement and Plan of Reorganization by and between Falmouth Co-operative Bank and Falmouth Bancorp, Inc., dated November 25, 1997 (1) 10.5 Employment Agreement by and between Falmouth Co- operative Bank and Santo P. Pasqualucci. (2) 10.6 Change of Control Agreement by and among Falmouth Co- operative Bank, Falmouth Bancorp, Inc., and George E. Young III 10.7 Falmouth Co-operative Bank Employee Stock Ownership Plan. (1) 10.7(a) Amendment No. 5 to Falmouth Co-operative Bank Employee Stock Ownership Plan. 10.8 Falmouth Bancorp, Inc. Employee Stock Ownership Trust. (1) 13.1 Annual Report to Stockholders for the Year Ended September 30, 2003. 14.1 Code of Ethics 21.1 Subsidiaries of the Registrant. 23.1 Consent of Shatswell, MacLeod & Company, P.C. 31.1 Certifications Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002. 32.1 Certifications Pursuant to Section 906 of the Sarbanes- Oxley Act of 2002. 39For purposes of calculating the Tier 1 leverage capital ratio, assets include adjusted total average assets. In calculating Tier 1 risk- based capital and total risk-based capital ratio, assets include total risk-weighted assets. -------------------- (c) The Company filed a report or form 8-K with the SEC on July 25, 2003 reporting its earnings for the period ended June 30, 2003. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The above - captioned information is included in the Proxy Statement and is incorporated herein by reference. See "Audit Fees" and "Audit Committee Report." 40 SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FALMOUTH BANCORP, INC. By: /s/ Santo P. Pasqualucci ------------------------ Santo P. Pasqualucci President and Chief Executive Officer In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Name Title Date ---- ----- ---- /s/ Santo P. Pasqualucci Director, President and December 29, 2003 ------------------------- Chief Executive Officer Santo P. Pasqualucci (Principal executive officer) /s/ George E. Young, III Senior Vice President and Chief December 29, 2003 ------------------------- Financial Officer (Principal George E. Young, III financial officer) /s/ Peter A. Frizzell, DMD Director December 29, 2003 ------------------------- Peter A. Frizzell, DMD /s/ Wayne C. Lamson Director December 29, 2003 ------------------------- Wayne C. Lamson /s/ Gardner L. Lewis Director December 29, 2003 ------------------------- Gardner L. Lewis /s/ John J. Lynch, Jr. Chairman of the Board December 29, 2003 ------------------------- John J. Lynch, Jr. /s/ Eileen C. Miskell Director December 29, 2003 ------------------------- Eileen C. Miskell /s/ Robert H. Moore Director December 29, 2003 ------------------------- Robert H. Moore /s/ Henry D. Newman, III Director December 29, 2003 ------------------------- Henry D. Newman, III /s/ William E. Newton Director December 29, 2003 ------------------------- William E. Newton 41Incorporated herein by reference to the Registration Statement on Form S-4 (Registration No. 333-16931), as filed with the Securities and Exchange Commission on November 27, 1996. Incorporated herein by reference to the Annual Report on Form 10-KSB for the year ended September 30, 2001, as filed with the Securities and Exchange Commission on December 22, 2001.