UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

For the transition period from ____________ to ____________

Commission File Number 0-26996

INVESTORS FINANCIAL SERVICES CORP.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:  (617) 937-6700

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.01 Par Value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o  No x  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer   x      Accelerated filer o      Non-accelerated filer   o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o  No x  

The aggregate market value of common stock held by non-affiliates of the registrant was $2,431,820,932 based on the last reported sale price of $37.82 on The Nasdaq National Market on June 30, 2005 as reported by Nasdaq.

As of January 31, 2006, there were 65,332,641 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant will file a definitive Proxy Statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2005. Portions of such Proxy Statement are incorporated by reference in Part III.

PART I

ITEM 1. BUSINESS.

General

Unless otherwise indicated or unless the context requires otherwise, all references in this Report to “Investors Financial,” “we,” “us,” “our,” or similar references mean Investors Financial Services Corp., together with our subsidiaries. “Investors Bank” or the “Bank” means our subsidiary, Investors Bank & Trust Company, alone.

We provide a broad range of services to financial asset managers, such as mutual fund complexes, investment advisors, family offices, banks and insurance companies. We define these services as core services and value-added services. Our core services include middle office outsourcing, global custody, multicurrency accounting and fund administration. Our value-added services include securities lending, foreign exchange, cash management, performance measurement, institutional transfer agency, investment advisory services, lines of credit and brokerage and transition management services. At December 31, 2005, we provided services for approximately $1.8 trillion in net assets, including approximately $0.3 trillion of foreign net assets.

Investors Financial Services Corp. is a bank holding company. We were organized as a Delaware corporation in 1995. Our primary operating subsidiary is Investors Bank & Trust Company® which was founded in 1969 as a banking subsidiary of Eaton Vance Corp., an investment management firm. In 1995, we reorganized as a bank holding company, were spun-off to the stockholders of Eaton Vance and completed our initial public offering. We provide our services from offices in Boston, New York, Sacramento, Toronto, Dublin, London and the Cayman Islands.

Overview of the Asset Servicing Industry

Asset managers invest and manage the financial assets entrusted to them. They do so using a broad range of financial products, including mutual funds, alternative investment vehicles, unit investment trusts, separate accounts, variable annuities and other products that pool together money from multiple investors. Asset servicing companies like ours perform various back and middle office services for asset managers and the pooled financial products they sponsor, allowing asset managers to focus on core competencies such as product development and distribution. In addition, asset servicing companies like ours provide these back office services such as the third-party safekeeping of assets and administrative services to give investors more confidence in the integrity of their investments. The following discussion sets forth our view of the key drivers in today’s asset servicing industry.

Historical Financial Asset Growth.   Despite the stock market declines of 2000 through 2002, over the past ten years growth in financial assets under management has remained strong. Factors driving this growth include an aging population, the privatization of retirement systems and the increased popularity of pooled investment products such as mutual funds. The total amount of U.S. financial assets held in mutual funds, life insurance companies, private pension funds and bank personal trust accounts was $17.3 trillion at December 31, 2004, up from $7.1 trillion in 1994, a compounded annual growth rate of approximately 9%. Mutual funds, one of the primary markets for our services, hold a large portion of the money invested in pooled investment vehicles. The U.S. mutual fund market has grown at a compounded annual growth rate of approximately 13% since 1994, and held approximately $7.8 trillion in assets at December 31, 2004.

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The following table presents U.S. financial assets, including mutual funds (Dollars in billions):

Source: Federal Reserve Bank

Consolidation and Outsourcing Trends.   Another important factor affecting the asset servicing industry is the consolidation of asset servicing providers. Since the early 1990s, a number of small and mid-size asset servicers have consolidated with larger service providers or divested their asset servicing operations to focus their finite resources on their core businesses. Also, numerous service providers have combined their operations with other companies. This ongoing consolidation has concentrated the industry around a smaller number of service providers and presents us with opportunities for growth as clients react to consolidation and review their relationships with existing providers. In addition, as consolidated financial institutions dispose of businesses that do not fit with their core services, we may see opportunities to acquire those business lines at a reasonable price.

The unique operational philosophy of a particular asset management organization determines its view of asset servicing. The majority of asset managers hire third parties to provide custody services. Some use more than one custodian in an attempt to foster cost reduction through competition. Large asset managers may have enough assets to justify the cost of providing in-house facilities to handle accounting, administration and transfer agency services. Other asset managers generally hire third parties to provide accounting, administration and transfer agency services in addition to custody services. Keeping abreast of developments like regulatory changes, Internet data delivery, compressed settlement cycles, and complex investment strategies, structures and instruments has forced significant increases in technology spending across the financial services industry. We believe that this increase in spending requirements has accelerated the pace at which asset managers outsource middle and back office operations to asset servicers.

Technology.   Information technology is a driving force in the financial services industry. Asset managers are able to create innovative investment products using technological tools including:

·       Access to data from world markets as a result of more powerful and affordable information processing power.

·       The ability to send and receive large volumes of information almost instantly through widely dispersed communication networks.

·       Timely on-line access to electronic information on security positions, prices and price shifts that facilitate activities, including on-line currency trading, indexing of assets, real time arbitrage and hedging through the use of derivative securities.

Asset servicers use technology as a competitive tool to deliver precise and functional information to asset managers. Technology also allows asset servicers to offer more value-added services, such as performance measurement. Examples of analytical tools used in performance measurement include reports showing time-weighted return, performance by sector and time-weighted return by sector.

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Complex Investment Products.   Asset managers create different investment structures in an effort to capture efficiencies and appeal to investors with diverse means, risk tolerances, diversification requirements and time horizons. One innovative example of this is exchange traded funds, or ETFs. ETFs are securities that replicate an index and are traded on a national securities exchange, such as the New York Stock Exchange or the American Stock Exchange. Unlike investing in a conventional index mutual fund, investing in an ETF allows investors to buy and sell shares throughout the trading day at market prices. ETFs also offer potential tax efficiencies. According to an industry source, domestic ETF assets increased 31% to approximately $296 billion as of December 31, 2005 from approximately $226 billion as of December 31, 2004.

Alternative investments, including hedge funds, private equity funds, venture capital funds and commodity pools, are another example of complex investment products that have recently experienced dramatic growth. According to an industry source, hedge fund assets in particular have grown at an impressive rate for several years and total approximately $1.3 trillion at the end of 2005. Hedge fund assets have increased due to widening interest from institutional investors such as pension plans and endowments, as well as high net worth individuals. These asset pools often feature increasingly sophisticated trading strategies, financial instruments and product structures such as distressed debt, swaps and asset-backed securities that require more specialized operational support than traditional mutual funds.

In addition, a growing number of mutual funds have been structured as multi-class funds or as multi-manager funds in order to address the differing requirements and preferences of potential investors. Multi-class arrangements allow an investment company to sell interests in a single investment portfolio to separate classes of stockholders. Multi-manager funds have two or more investment managers, who may have different investing styles, managing the assets of one fund. Multi-manager funds offer investors diverse investment styles with a single investment.

Another product innovation is the master-feeder structure. In the master-feeder structure, one or more investment vehicles (the “feeder funds”) with identical investment objectives pool their assets in the common portfolio of a separate investment vehicle (the “master fund”). This structure permits each of the feeder funds to be sold to a separate target market or through a different distribution channel. The feeder fund, if it were a stand-alone fund, might not be large enough to support its operating costs. The feeder funds benefit from the economies of scale available to the larger pool of assets invested in the master fund.

International investing.   Asset managers have also expanded their reach in the global marketplace to capitalize on cross-border and multi-national marketing opportunities. This creates demand for asset servicing around the world and particularly for value-added services like foreign exchange. At December 31, 2005, we provided services for approximately $1.8 trillion in net assets, including approximately $0.3 trillion of foreign net assets.

Our Strategy

We believe that asset servicing companies operate most efficiently when bundling core services such as custody and accounting with value-added services such as securities lending and foreign exchange. We also believe that efficient integration of these services is critical to both service quality and profitability. The following discussion outlines the key components of our growth strategy:

Maintain Our Technological Expertise.   One of our core strategies is to commit the necessary capital and resources to maintain our technological expertise. The asset servicing industry requires the technological capability to support a wide range of global security types, currencies and complex portfolio structures. Asset servicers must also maintain the telecommunications flexibility to support the diversity of global communications standards. Technological change creates opportunities for product differentiation and cost reduction.

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Our Fund Accounting and Custody Tracking System, or FACTS™, is a single integrated technology platform that combines our service offerings into one solution for customers and can accommodate rapid growth in net assets processed. FACTS provides the following functions in a single information system:

·       Middle office outsourcing

·       Custody

·       Securities movement and control

·       Portfolio accounting

·       Multicurrency general ledger accounting

·       Pricing

·       Net asset value calculation

·       Multi-class and multi-manager processing

·       ETF processing

By consolidating these functions, we have eliminated redundancy in data capture and reduced the opportunity for clerical error.

The consolidation of functions available through FACTS allows us to assign a dedicated client team to provide a full suite of services to each account. We believe that this approach helps us to provide high quality service and to maintain better overall relationships with our clients.

The FACTS architecture also enables us to modify the system quickly. Rapid modifications allow us to constantly improve processing quality and efficiency and to implement service innovations for our clients quickly. We believe that the integrated nature of FACTS provides us with a competitive advantage by allowing us to respond quickly to the continuously changing technological demands of the financial services industry. We believe the separate systems used for different tasks by many other asset servicing providers may not provide the same advantages.

Maintain Our Expertise in Complex Products.   Another of our core strategies is to maintain our strength in the rapidly growing area of complex investment products. We have developed expertise in servicing ETFs, various alternative investment structures, master-feeder funds and multi-managed funds. Because the design of FACTS allows us to effect modifications or enhancements quickly, we are able to respond rapidly to the systems requirements of complex structures.

Deliver Superior Service.   We strive to deliver superior and innovative client service. We believe service quality is the key to maintaining and expanding existing client relationships and to attracting new clients. The consolidation of functions available through FACTS allows us to take an integrated approach to client servicing. We believe this approach is different from that employed by many of our competitors. We dedicate a single operations team to handle all tasks for a particular client. In addition, each client is assigned a client manager, independent of the operations team, to anticipate the client’s needs, to coordinate service delivery and to provide consulting support.

Cross-Sell Our Services.   We believe that our strong client relationships provide opportunities to cross-sell value-added services to broaden our customer relationships. Many of our clients manage multiple pools of assets. Once an investment manager becomes a client, we believe that this client is more likely to select us to service more products, provide additional services, or both. If we are engaged to provide services for only certain pools of assets managed by our clients, we strive to expand the relationship to include more asset pools by providing superior client service. Also, some of our clients engage us to provide core services such as global custody and multicurrency accounting, but do not use us

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for value-added services such as foreign exchange or cash management. We target expanding these relationships through increasing the number of services provided for each client.

Service Offerings

We provide a broad range of services to financial asset managers, such as mutual fund complexes, investment advisors, family offices, banks and insurance companies. We think of these services in two groupings: core services and value-added services.

Our value-added services help clients develop and execute their strategies, and evaluate and manage their risks, which we believe provides them with the opportunity to enhance their returns. We strive to maximize the use of our value-added services by our client base.

Fees charged for core services vary from client to client based on the value of assets processed, the number of securities held and the number of portfolio transactions. Generally, fees are billed to our clients monthly in arrears and, upon their approval, charged directly to their account. Fees charged for core services reflect the price sensitivity of the market for such services. Fees charged for value-added services reflect a more favorable pricing environment for us because we can increase activity in these areas without a necessarily proportionate increase in personnel or other resources. We also derive net interest income by investing cash balances that our clients leave on deposit with us. Our share of earnings from these investments is viewed as part of the total compensation that our clients pay us for servicing their assets.

The following is a description of the various services we offer:

Core Services

Middle Office Outsourcing.   Middle office outsourcing services represent the tasks that need to be performed for financial asset managers after they have initiated a particular trade to ensure accurate and timely trade processing and communications to any party affected by the trades. We perform some or all of the following functions for our middle office outsourcing clients: trade operations management, settlements, portfolio and fund accounting, fund administration, cash management, reconciliation, corporate actions, tax reclaims and tax filings, performance measurement, broker performance and vendor data management.

Global Custody.   Global custody entails the safekeeping of securities for clients and settlement of portfolio transactions. Our net assets processed have grown from $22 billion at October 31, 1990 to $1.8 trillion at December 31, 2005. At December 31, 2005, our foreign net assets processed totaled approximately $0.3 trillion.

In order to service our clients worldwide, we have established a network of global subcustodians in almost 100 markets. Since we do not have our own branches in these countries, we are able to operate in the foreign custody arena with minimal fixed costs, while our clients benefit from the ability to use a single custodian, Investors Bank, for all of their international investment needs.

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Multicurrency Accounting.   Multicurrency accounting entails the daily recordkeeping for each account or investment vehicle, including the calculation of net asset value per share. In addition to providing these services to domestic-based accounts and investment vehicles, we also provide fund accounting services to clients in Europe and Canada, which we continue to view as areas of significant business opportunity.

Fund Administration.   Fund administration services include management reporting, regulatory reporting, compliance monitoring, tax accounting and return preparation, partnership administration and chief compliance officer services and support. In addition to these ongoing services, we also provide fund start-up consulting services, which typically include assistance with product definition, service provider selection and fund structuring and registration. We have worked with a number of investment advisors to assist them in the development of new funds and other pooled investment vehicles.

Value-Added Services

Securities Lending.   Securities lending involves the lending of clients’ securities to brokers and other institutions for a fee. Receipt of securities lending fees improves a client’s return on the underlying securities. We act as agent for our clients for both international and domestic securities lending services.

Foreign Exchange.   We provide foreign exchange services to facilitate settlement of international securities transactions for funds and other accounts and to convert income payments denominated in a non-base currency to base dollars. By using us rather than a third-party foreign exchange bank to perform these functions, clients can reduce the amount of time spent coordinating currency delivery and monitoring delivery failures and claims.

Cash Management.   We provide a number of investment options for cash balances held by our clients. Typically, we have a standing arrangement to sweep client balances into one or more investments, including deposit accounts, short-term funds and repurchase agreements. This allows our clients to conveniently maximize their earnings on idle cash balances.

Investment Advisory Services.   The Bank acts as investment advisor to the Merrimac Master Portfolio, an open-end investment management company registered under the Investment Company Act of 1940. The portfolio currently consists of a series of six master funds in a master-feeder structure. The Merrimac Cash Portfolio, the Merrimac Prime Portfolio and the Merrimac U.S. Government Portfolio are subadvised by Lincoln Capital Fixed Income Management Company, LLC. The Merrimac Treasury Portfolio and the Merrimac Treasury Plus Portfolio are subadvised by M&I Investment Management Corp. The Merrimac Municipal Portfolio is subadvised by ABN AMRO Asset Management (USA) LLC. At December 31, 2005, the total net assets of the portfolio approximated $5.2 billion. The portfolio’s master funds serve as investment vehicles for seven domestic feeder funds and two offshore feeder funds whose shares are sold to institutional investors.

Performance Measurement.   Performance measurement services involve the creation of systems and databases that enable asset managers to construct, manage and analyze their portfolios. Services include portfolio profile analysis, portfolio return analysis and customized benchmark construction. Performance measurement uses data already captured by FACTS to calculate statistics and report them to asset managers in a customized format.

Institutional Transfer Agency.   Transfer agency encompasses shareholder recordkeeping and communications. We provide these services only to institutional clients with a small number of shareholder accounts or omnibus positions of retail shareholders.

Lines of Credit.   We offer credit lines to our clients for the purpose of leveraging portfolios, covering overnight cash shortfalls and other borrowing needs. We do not conduct retail banking operations. At December 31, 2005, we had gross loans outstanding to clients of approximately $402 million, which represented approximately 3% of our total assets. The interest rates charged on the Bank’s loans are

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indexed to either the Prime rate or the Federal Funds rate. We have never had a loan loss. All loans are secured, or may be secured, by marketable securities and virtually all loans to individually managed account customers are due on demand.

Brokerage and Transition Management Services.   In 2002, we began offering “introducing broker-dealer” services to clients by accepting customer orders, which we have elected to clear through a clearing broker-dealer. The clearing broker-dealer processes and settles customer transactions and maintains detailed customer records. This arrangement allows us to use the back office processing infrastructure of the clearing broker-dealer while earning a commission on trades executed on behalf of clients. Transition management services are designed to assist the process of moving a portfolio from one asset manager to another in as seamless a manner as possible. Components of these services include planning and customizing a strategy for the transition, conducting performance analysis and executing the transition in an efficient, risk-managed fashion. The brokerage services we offer do not include margin accounts, short selling or market making activities.

Sales, Marketing and Client Support

We employ a direct sales staff that targets potential market opportunities, including investment management companies, insurance companies, family offices, banks and investment advisors. Sales personnel are primarily based at our headquarters in Boston, and are given geographic area sales responsibility. We also have sales personnel located in Dublin, Toronto and London who are responsible for international markets. Included in the sales staff are individuals who are dedicated to marketing services to institutional accounts. Senior managers from all functional areas are directly involved in obtaining new clients, frequently working as a team with a sales professional.

In order to service existing clients, a separate team of client management professionals based in our Boston, New York, Toronto, Dublin and London offices provide dedicated client support. Each client is assigned a client manager responsible for the client’s overall satisfaction. The client manager is usually a senior professional with extensive industry experience who works with the client on designing new products and specific systems requirements, provides consulting support, anticipates the client’s needs and coordinates service delivery.

Financial information regarding our geographic reporting can be found in Note 21 of our Notes to Consolidated Financial Statements included in this Report.

Significant Clients

Barclays Global Investors, N.A. (“BGI”) accounted for approximately 18% of our consolidated net operating revenues for the year ended December 31, 2005, approximately 17% for the year ended December 31, 2004 and approximately 16% for the year ended December 31, 2003. No client other than BGI accounted for more than 10% of our net operating revenues for the years ended December 31, 2005, 2004 and 2003. See “Risk Factors—A material portion of our revenue is derived from our relationship with Barclays Global Investors, N.A. (“BGI”) and related entities.”

Software Systems and Data Center

Our business requires that we provide daily and periodic reports of asset accounting and performance, and provide measurement and analytical data to asset managers on-line on a real-time basis. To help us meet these requirements, our asset servicing operations are supported by sophisticated information technology. We receive vast amounts of information across a worldwide computer network. That information covers a wide range of global security types in various currencies and must be processed before system-wide updating and reporting.

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Our proprietary system, FACTS, is multi-tiered. FACTS uses personal computers linked to mainframe processing by means of local and wide area networks. This configuration combines the best features of each platform. FACTS uses the power and capacity of the mainframe, the data distribution capabilities of the network and the independence of personal computers. The fully functional microcomputer component of FACTS works independently of the mainframe throughout the processing cycle. This minimizes the amount of system-wide delay inherent in data processing. The FACTS configuration also allows for fully distributed processing capabilities within multiple geographic locations in an effective and efficient manner.

The integrated nature of the FACTS architecture allows us to effect modifications and enhancements quickly. Swift modifications and enhancements result in increased processing quality and efficiency for our clients. These modifications and enhancements also help us quickly implement service innovations for our clients. This integrated architecture helps differentiate us from our competitors. Technological enhancements and upgrades are an ongoing part of asset servicing that are necessary for asset administrators to remain competitive and to create information delivery mechanisms that add value to the information available as part of clearing and settling transactions.

Technology also helps us add value to the custody and fund accounting information we gather by processing client assets. We have developed a comprehensive suite of standardized data extracts and reports and created automated interfaces that allow our clients to access the full range of custody and fund accounting data. We have also developed interfaces that allow our clients to connect electronically with our host systems and access data collected from clearance and settlement transactions in multiple currencies. Through these information-sharing tools, we are better equipped to supplement our custody and accounting services with foreign exchange services and asset and transaction reporting and monitoring services. Electronic linkages also position us to respond quickly to client requests.

We use the Internet as a means to communicate with clients and external parties. We also provide secure value-added services to our clients over the Internet. We utilize a secure extranet environment that provides the authentication, access controls, intrusion detection, encryption and firewalls needed to ensure the protection of client information and assets. Internet-based applications provide our clients with secure electronic access to their data as well as flexible ad-hoc data query and reporting tools.

Our mainframe processing and mainframe disaster recovery capability is provided by Electronic Data Systems (“EDS”), located in Plano, Texas. In addition, International Business Machines (“IBM”), located in Armonk, New York, provides support for our network and hardware environments and our help desk services. By outsourcing these infrastructure support functions, we can focus our resources on systems development and minimize our capital investment in large-scale computer equipment. EDS and IBM offer us state-of-the-art computer products and services, access to which we could not otherwise afford, while removing the risk of product obsolescence. Due to their large and diverse customer bases, EDS and IBM can invest in the latest computer technology and spread the related costs over multiple users. We also receive the benefit of the continuing investment by EDS and IBM in their computer hardware. Under both contracts we are billed monthly for services provided by EDS or IBM on an as-used basis in accordance with a predetermined pricing schedule for specific products and services. Our current agreement with EDS is scheduled to expire on December 31, 2008. Our current agreement with IBM is scheduled to expire on June 30, 2011.

Each year we target spending approximately 18-20% of our consolidated net operating revenue on technology. Because of our relationships with EDS and IBM and our system architecture, we are able to devote the majority of our technology investments to development, rather than support or infrastructure.

Our trust processing services are provided by SEI Investments Company (“SEI”), located in Oaks, Pennsylvania. SEI is a global provider of asset management and investment technology solutions. We pay

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SEI certain monthly service fees based upon usage. Our current agreement with SEI is scheduled to expire on December 31, 2009.

Investors Bank maintains a comprehensive Business Continuity Plan (“BCP”). The program has been developed to comply with guidelines issued by various regulatory and industry bodies such as the Federal Financial Institutions Examination Council (“FFIEC”). The planning process begins with a business impact analysis which isolates critical business processes and determines their recoverability under various disruption scenarios. In addition to maintaining regional backup facilities for all offices, our locations are geographically diverse in order to allow recovery of essential functions at another location in the event of a widespread disruption. In 2005, BCP staff conducted over 100 different tests to ensure that our technology infrastructure, facilities and staff could respond and recover in a disaster.

Competition

We operate in a highly competitive environment in all areas of our business. Many of our competitors, including State Street Bank and Trust Company, JP Morgan Chase, The Bank of New York, Citigroup, Mellon and PNC, possess substantially greater financial and marketing resources than we do and process a greater amount of financial assets. Other competitive factors include technological advancement and flexibility, breadth of services provided and quality of service. We believe that we compete favorably in these categories.

Competition in the asset servicing industry, especially over the past decade, has impacted both pricing and margins in core services such as global custody. Partially offsetting this more competitive pricing environment is the development of new services that have higher margins. Our continuous investment in technology has permitted us to offer value-added services to clients, such as middle office outsourcing, performance measurement, securities lending and foreign exchange, on a global basis and at competitive prices. Technological evolution and service innovation have enabled us to generate additional revenue to offset competitive pricing in maturing service lines.

We believe that our size, commitment to technology development and enhancement and responsiveness to client needs provide the asset management industry with a very attractive asset servicing alternative to large money center banks and other asset servicers. As many of our competitors grow larger through acquisition, we believe that our customized and highly responsive service offerings become even more attractive. While consolidation within the investment management and asset servicing industries may adversely affect our ability to retain clients that have been acquired, it also creates opportunity for us as prospective clients review their relationships with existing service providers that are affected by acquisitions. In addition, consolidation among large financial institutions may enable us to acquire, at a reasonable price, asset servicing businesses that do not fit within the core focus of these newly consolidated financial institutions.

Intellectual Property

Our success is dependent upon our software development methodology and other intellectual property rights that we have developed and own, including FACTS. We rely on trade secret, copyright and trademark laws, and confidentiality agreements with employees and third parties to protect our proprietary technology, all of which offer only limited protection. There can be no assurance that the steps we take in this regard will be adequate to deter misappropriation of our proprietary information or that we will be able to detect unauthorized use. Furthermore, our intellectual property rights may be invalidated or our competitors may develop similar technology independently. In addition, effective copyright, trademark, trade secret and other protection may not be available in certain international markets that we service.

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Employees

On December 31, 2005, we had 3,252 employees. We maintain a professional development program for entry level staff. Successful completion of the program is required of most newly hired employees. This training program is supplemented by ongoing education on systems and technological developments and innovations, the financial services industry, the regulatory environment and our client base. This program is administered by experienced full-time trainers that continually enhance existing courses and develop new programs to match an evolving business environment.

None of our employees are covered by collective bargaining agreements and we believe our relations with our employees are good.

Regulation and Supervision

Virtually all aspects of our business and operations are regulated under state and federal law. In addition to the laws governing businesses and employers, we are subject to federal and state laws and regulations applicable to financial institutions and their parent companies. The operations of our securities broker affiliate, Investors Securities Services, LLC, are also subject to federal and state securities laws, as well as the rules of both the Securities and Exchange Commission (“SEC”) and the National Association of Securities Dealers, Inc. (“NASD”). The principal objective of state and federal banking laws is the maintenance of the safety and soundness of financial institutions and the federal deposit insurance system, the protection of consumers or classes of consumers and the furtherance of broad public policy goals, rather than the specific protection of stockholders of a bank or its parent company. Some of the significant statutory and regulatory provisions to which we and our subsidiaries are subject are described below. The description of these statutory and regulatory provisions is not complete and is qualified in its entirety by reference to the particular statutory or regulatory provision. Any change in applicable law or regulation may have a material effect on our business, prospects and operations, as well as those of our subsidiaries.

Investors Financial

General.   As a registered Bank Holding Company (“BHC”), Investors Financial is subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”), and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (“FRB”) and by the Massachusetts Commissioner of Banks (“Commissioner”). We are required to file reports of our operations with, and are subject to examination by, the FRB and the Commissioner. The FRB has the authority to issue orders to BHCs to cease and desist from unsafe or unsound banking practices and violations of conditions imposed by, or violations of agreements with, the FRB. The FRB is also empowered to assess civil money penalties against companies or individuals who violate the BHCA or orders or regulations thereunder, to order termination of nonbanking activities of nonbanking subsidiaries of BHCs and to order termination of ownership and control of a nonbanking subsidiary by a BHC.

BHCA-Activities and Other Limitations.   The BHCA prohibits a BHC from acquiring substantially all the assets of a bank or acquiring direct or indirect ownership or control of more than 5% of any class of the voting shares of any bank, BHC or savings association, or increasing such ownership or control of any bank, BHC or savings association, or merging or consolidating with any BHC without prior approval of the FRB. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal”) permits adequately capitalized and adequately managed BHCs, as determined by the FRB, to acquire banks located in any state, subject to certain concentration limits and other conditions. Subject to certain conditions, Riegle-Neal also generally authorizes the interstate mergers of banks and, to a lesser extent, interstate branching, so long as the law of the host state specifically authorizes such action. Massachusetts law imposes certain approval requirements with respect to acquisitions by a BHC of certain banking institutions and to mergers of BHCs.

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Unless a BHC becomes a financial holding company (“FHC”) under the Gramm-Leach-Bliley Act of 1999 (“GLBA”), the BHCA also prohibits a BHC from acquiring a direct or indirect interest in or control of more than 5% of the voting securities of any company that is not a bank or a BHC and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiary banks, except that it may engage in and may own shares of companies engaged in certain activities the FRB determined to be so closely related to banking or managing and controlling banks as to be a proper incident thereto. Before permitting a BHC to engage in such activities that are closely related to banking or making an investment in a company engaged in such activities, the FRB is required to weigh the expected benefit to the public, such as greater convenience, increased competition or gains in efficiency, against the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interests or unsound banking practices.

The GLBA permits a BHC that qualifies and elects to be treated as a FHC to engage in a significantly broader range of financial activities than BHCs, such as Investors Financial, that have not elected FHC status. “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the FRB, in consultation with the Secretary of the Treasury, determines to be financial in nature or incidental to such financial activities, or that the FRB determines to be complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. To elect to become a FHC, a BHC, such as Investors Financial, must meet certain tests and file an election with the FRB. To qualify, all of a BHC’s subsidiary banks must be well-capitalized and well-managed, as measured by regulatory guidelines. In addition, each of the BHC’s banks must have been rated “satisfactory” or better in its most recent federal Community Reinvestment Act (“CRA”) evaluation. A BHC that elects to be treated as a FHC may face significant consequences if its banks fail to maintain the required capital and management ratings, including entering into an agreement with the FRB which imposes limitations on its operations. Investors Financial has not elected to become a FHC.

Capital Requirements.   The FRB has adopted capital adequacy guidelines applicable to United States banking organizations. The FRB’s capital adequacy guidelines generally require BHCs to maintain total capital equal to 8% of total risk-adjusted assets and off-balance sheet items (the “Total Risk-Based Capital Ratio”), with at least 50% of that amount consisting of Tier 1, or core capital and the remaining amount consisting of Tier 2, or supplementary capital. Tier 1 capital for BHCs generally consists of the sum of common stockholders’ equity and perpetual preferred stock (subject to certain limitations), less goodwill and other nonqualifying intangible assets. Tier 2 capital generally consists of hybrid capital instruments, perpetual debt and mandatory convertible debt securities; perpetual preferred stock, not included as Tier 1 capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan and lease losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics.

In addition to the risk-based capital requirements, the FRB requires BHCs to maintain a minimum leverage capital ratio of Tier 1 capital to its average total consolidated assets (the “Leverage Ratio”) of 3.0%. Total average consolidated assets for this purpose does not include goodwill and any other intangible assets and investments that the FRB determines should be deducted from Tier 1 capital. The FRB has announced that the 3.0% Leverage Ratio requirement is the minimum for the top-rated BHCs. All other BHCs are required to maintain a minimum Leverage Ratio of 4.0%. BHCs with supervisory, financial, operational or managerial weaknesses, as well as BHCs that are anticipating or experiencing significant growth, are expected to maintain capital ratios well above the minimum levels. Because we anticipate significant future growth, we will be required to maintain a Leverage Ratio of 4.0% or higher.

We are currently in compliance with both the Total Risk-Based Capital Ratio and the Leverage Ratio requirements, and management expects these ratios to remain in compliance with the FRB’s capital

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adequacy guidelines. At December 31, 2005, our Total Risk-Based Capital Ratio and Leverage Ratio were 18.50% and 5.95%, respectively.

In June 2004, the Basel Committee on Banking Supervision (“Basel Committee”) released the document “International Convergence of Capital Measurement and Capital Standards: A Revised Framework.”  The Framework, also referred to as Basel II, is designed to secure international convergence on regulations and standards governing the capital adequacy of internationally active banking organizations. In September 2005, the FFIEC (U.S. banking and thrift supervisory agencies) revised guidance on the timing and qualification process for U.S. banks that will become subject to Basel II. The new rules as applied in the U.S. are expected to become effective on January 1, 2009, subject to transitional parallel testing beginning on January 1, 2008. Although we are not required to be compliant with the new rules, we are in the process of developing an implementation program to achieve Basel II compliance. Ultimately, U.S. implementation of Basel II will depend on, and will be subject to, final regulations and related policies promulgated by the FFIEC supervisory agencies. We cannot predict the final form of the rules, nor their impact on our risk-based capital.

Control Acquisitions.   The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a depository institution or a depository institution holding company unless the FRB has been notified and has not objected to the proposal. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting securities of a depository institution or depository institution holding company with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), would, under the circumstances set forth in the presumption, constitute the acquisition of control of the depository institution or a depository institution holding company. In addition, any company, as that term is broadly defined in the statute, would be required to obtain the approval of the FRB under the BHCA before acquiring 25% (5% in the case of an acquirer that is a BHC) or more of any class of voting securities of a bank or BHC or a savings association, or otherwise obtaining control or a controlling influence over such an institution.

Massachusetts Law.   Investors Financial is also considered a BHC for purposes of Massachusetts law. Accordingly, we have registered with the Commissioner and are obligated to make reports to the Commissioner. Under Massachusetts law, any person that proposes to acquire, directly or indirectly, 25% or more of any class of voting securities of a company must give prior notice to the Massachusetts Commissioner of Banks, who may disapprove the transaction. Additionally, any company that is a BHC under Massachusetts law must obtain the approval of the Massachusetts Board of Bank Incorporation (“Massachusetts BBI”) before acquiring more than 5% of the voting stock of a company. As a general matter, however, the Commissioner does not rule upon or regulate the activities in which a BHC or its nonbank subsidiaries engage.

Cash Dividends.   FRB policy provides that a bank or a BHC generally should not maintain its existing rate of cash dividends on common stock unless the organization’s net income available to common shareholders over the past year has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. FRB policy further provides that a BHC should not maintain a level of cash dividends to its shareholders that places undue pressure on the capital of bank subsidiaries, or that can be funded only through additional borrowings or other arrangements that may undermine the BHC’s ability to serve as a source of strength.

Source of Strength.   FRB policy requires BHCs to serve as sources of financial and managerial strength to their subsidiary banks and, if necessary, to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and to maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks in a manner consistent with FRB policy. This support may be required at times when the BHC may not have the resources to provide it. Accordingly, Investors Financial is expected to commit resources to the Bank in circumstances where it might not do so absent such policy.

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Investors Bank

General.   The Bank is subject to extensive regulation and examination by the Commissioner and the Federal Deposit Insurance Corporation (“FDIC”), which insures the Bank’s deposits, and to certain requirements established by the FRB. The federal and state laws and regulations which are applicable to banks regulate among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of certain deposited funds and the nature and amount of and collateral for certain loans.

FDIC Insurance Premiums.   The Bank currently pays deposit insurance premiums to the FDIC based on an assessment rate established by the FDIC for Bank Insurance Fund (“BIF”)-member institutions. The FDIC has established a risk-based premium system under which the FDIC classifies institutions based on their capital ratios and on other relevant information and generally assesses higher rates on those institutions that tend to pose greater risks to the federal deposit insurance funds. The Federal Deposit Insurance Act (“FDIA”) does not require the FDIC to charge all banks deposit insurance premiums when the ratio of deposit insurance reserves to insured deposits is maintained above specified levels. However, as a result of general economic conditions, it is possible that the ratio of deposit insurance reserves to insured deposits could fall below the minimum ratio that FDIA requires, which would result in the FDIC setting deposit insurance assessment rates sufficient to increase deposit insurance reserves to the required ratio. We cannot predict whether the FDIC will be required to increase deposit insurance assessments above their current levels.

In February 2006, Congress enacted the Federal Deposit Insurance Reform Act of 2005 (the “FDIR Act”). As a result of the passage of the FDIR Act, over the course of the next year, among other things: (i) the BIF will be merged with the FDIC’s Savings Association Insurance Fund creating the Deposit Insurance Fund (the “DIF”); (ii) the $100,000 per account insurance level will be indexed to reflect inflation; (iii) deposit insurance coverage for certain retirement accounts will be increased to $250,000; and (iv) a cap will be placed on the level of the DIF and dividends will be paid to banks once the level of the DIF exceeds the specified threshold.

Capital Requirements.   The FDIC has promulgated regulations and adopted a statement of policy regarding the capital adequacy of state-chartered banks, which, like the Bank, are not members of the Federal Reserve System. These requirements are substantially similar to those adopted by the FRB regarding BHCs.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), identifies five capital categories for insured depository institutions (well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital-raising requirements. An “undercapitalized” bank must develop a capital restoration plan, and its parent holding company must guarantee that bank’s compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of 5% of the bank’s assets at the time it became “undercapitalized” or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent’s general unsecured creditors. In addition, FDICIA requires the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation, and permits regulatory action against a financial institution that does not meet such standards.

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The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a “well-capitalized” institution must have a Tier 1 risk-based capital ratio of at least 6%, a total risk-based capital ratio of at least 10% and a leverage ratio of at least 5% and not be subject to a capital directive order. Regulators also must take into consideration (a) concentrations of credit risk; (b) interest rate risk (when the interest rate sensitivity of an institution’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position); and (c) risks from non-traditional activities, as well as an institution’s ability to manage those risks, when determining the adequacy of an institution’s capital. This evaluation will be made as a part of the institution’s regular safety and soundness examination. At December 31, 2005, the Bank was deemed to be a well-capitalized institution.

The Community Reinvestment Act.   The Community Reinvestment Act (“CRA”) requires lenders to identify the communities served by the institution’s offices and other deposit-taking facilities and to make loans and investments and provide services that meet the credit needs of these communities. Regulatory agencies examine each of the banks and rate such institutions’ compliance with CRA as “Outstanding”, “Satisfactory”, “Needs to Improve” or “Substantial Noncompliance”. Failure of an institution to receive at least a “Satisfactory” rating could inhibit such institution or its holding company from undertaking certain activities, including engaging in activities newly permitted as a financial holding company under the GLBA and acquisitions of other financial institutions. The FRB and the FDIC must take into account the record of performance of banks in meeting the credit needs of the entire community served, including low- and moderate-income neighborhoods, before they approve certain bank acquisitions, mergers, branch establishments and other transactions proposed by banking organizations. Massachusetts has also enacted a similar statute that requires the Commissioner to evaluate the Bank’s performance in helping to meet the credit needs of its entire community and to take that record into account in considering certain applications. Management believes the Bank is currently in compliance with all CRA requirements.

Customer Information Security.   The FDIC and other bank regulatory agencies have established standards for safeguarding nonpublic personal information about customers that implement provisions of the GLBA. Specifically, the Information Security Guidelines established by the GLBA require each financial institution, under the supervision and ongoing oversight of its Board of Directors or an appropriate Board committee, to develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, to protect against anticipated threats or hazards to the security or integrity of such information and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer.

Privacy.   The GLBA requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to nonaffiliated third parties. In general, the statute requires financial institutions to explain to consumers their policies and procedures regarding the disclosure of such nonpublic personal information, and, unless otherwise required or permitted by law, financial institutions are prohibited from disclosing such information except as provided in their policies and procedures.

USA Patriot Act.   The USA Patriot Act of 2001 (the “USA Patriot Act”), designed to deny terrorists and others the ability to obtain anonymous access to the U.S. financial system, has significant implications for depository institutions, broker-dealers and other businesses involved in the transfer of money. The USA Patriot Act, together with the implementing regulations of various federal regulatory agencies, require financial institutions, including the Bank, to adopt and implement policies and procedures with respect to, among other things, anti-money laundering compliance, suspicious activity and currency transaction reporting, customer identity verification and customer risk analysis. The statute and its

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underlying regulations also permit information sharing for counter-terrorist purposes between federal law enforcement agencies and financial institutions, as well as among financial institutions, subject to certain conditions, and require federal banking agencies to evaluate the effectiveness of an applicant in combating money laundering activities when considering applications filed under Section 3 of the BHCA or the Bank Merger Act. Management believes that we are currently in compliance with all requirements prescribed by the USA Patriot Act and all applicable regulations.

Dividends.   The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. Under Massachusetts law, the board of directors of a trust company, such as the Bank, may declare from “net profits” cash dividends no more often than quarterly, provided that there is no impairment to the trust company’s capital stock. Moreover, prior Commissioner approval is required if the total of all dividends declared by a trust company in any calendar year would exceed the total of its net profits for that year combined with its retained net profits for the previous two years, less any required transfer to surplus or a fund for the retirement of any preferred stock. These restrictions on the Bank’s ability to declare and to pay dividends may limit Investors Financial’s ability to pay dividends to its stockholders. We cannot predict future dividend payments of the Bank at this time.

Other Securities Law Issues.   The GLBA requires a bank that acts as investment adviser to a registered investment company to register as an investment adviser or to conduct such advisory activities through a separately identifiable department or division of the bank so registered. Accordingly, the Bank furnishes investment advice to registered investment companies through a separately identifiable department or division of the Bank that is registered with the SEC as an investment adviser. Federal and state laws impose onerous obligations on registered investment advisers, including fiduciary duties, recordkeeping requirements and disclosure obligations. Currently, management believes that we are in compliance with these requirements.

Regulation of Investment Companies.   Certain of our mutual fund and unit investment trust clients are regulated as “investment companies” as that term is defined under the Investment Company Act of 1940, as amended (the “ICA”), and are subject to examination and reporting requirements applicable to the services we provide. The provisions of the ICA and the regulations promulgated thereunder prescribe the type of institution which may act as a custodian of investment company assets, as well as the manner in which a custodian administers the assets in its custody. Because we serve as custodian for a number of our investment company clients, these regulations require, among other things, that we maintain certain minimum aggregate capital, surplus, and undivided profits. Additionally, arrangements between us and clearing agencies or other securities depositories must meet ICA requirements for segregation of assets, identification of assets and client approval. Currently, management believes we are in compliance with all minimum capital and securities depository requirements. Investment companies are also subject to extensive recordkeeping and reporting requirements. These requirements dictate the type, volume and duration of the recordkeeping we undertake, either in our role as custodian for an investment company or as a provider of administrative services to an investment company. Further, we must follow specific ICA guidelines when calculating the net asset value of a client mutual fund. Consequently, changes in the statutes or regulations governing recordkeeping and reporting or valuation calculations will affect the manner in which we conduct our operations.

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Availability of Filings

You may access, free of charge, copies of the following documents and related amendments, if any, in the Investor Relations section of our web site at www.ibtco.com:

1)              Our Annual Reports on Form 10-K;

2)              Our Quarterly Reports on Form 10-Q;

3)              Our Current Reports on Form 8-K; and

4)              Our Proxy Statement.

You may also access, free of charge, copies of the following corporate governance documents in the Investor Relations section of our web site at www.ibtco.com:

1)              Our Code of Conduct;

2)              Our Corporate Governance Guidelines;

3)              Our Audit Committee Charter;

4)              Our Nominating and Corporate Governance Committee Charter; and

5)              Our Compensation Committee Charter.

We post these documents on our web site as soon as reasonably practicable after we file or furnish them electronically with or to the Securities and Exchange Commission or, in the case of the corporate governance documents, as soon as reasonably practical after material amendment. The information contained on our web site is not incorporated by reference into this document and should not be considered a part of this Report. Our web site address is included in this document as an inactive textual reference only.

Item 1A. Risk Factors.

Our operating results are subject to fluctuations in interest rates and the securities markets.

A significant portion of our fees is based on the market value of the assets we process. Accordingly, our operating results are subject to fluctuations in interest rates and securities markets as these fluctuations affect the market value of assets processed. Our net interest income is earned by investing depositors’ funds in our investment portfolio and, in small part, by making loans. A rising short-term interest rate environment, such as we are now experiencing, generally causes downward pressure on net interest income. Changes in the relationship between short-term and long-term interest rates, referred to as the yield curve, could also adversely affect the market value of, or the earnings produced by, our investment and loan portfolios, and thus could adversely affect our operating results. The current flat yield curve, where short-term rates have increased while long-term rates have failed to increase, has resulted in a decrease in our net interest margin that will continue to have a material impact on our net interest income.

Volatility in the equity markets can have a material effect on our asset-based fees. While reductions in asset servicing fees may be offset by increases in other sources of revenue, a sustained downward movement of the broad equity markets will likely have an adverse impact on our earnings.

Our growth depends in part on the ability of our clients to generate fund flows by selling their investment products to new and existing investors. Fluctuations in interest rates or the securities markets can lead to investors seeking alternatives to the investment offerings of our clients, which could result in a lesser amount of assets processed and correspondingly lower fees. For example, if the value of equity or fixed income assets held by our clients were to increase or decrease by 10% for a sustained period of time, we

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estimate currently that this market movement, by itself, would cause a corresponding change of less than 5% in our earnings per share.

In addition, we are experiencing narrower investment portfolio reinvestment spreads, which reduces our net interest income. If reinvestments spreads on the security types we purchase remain narrow, or become narrower, our net interest income will continue to be impacted negatively.

A material portion of our revenue is derived from our relationship with Barclays Global Investors, N.A. (“BGI”) and related entities.

As a result of our ongoing relationship with BGI’s iShares and Master Investment Portfolios, our assumption of the operations of the U.S. asset administration unit of BGI in 2001 and our servicing assets for Barclays Global Investors Canada, Ltd., BGI accounted for approximately 18%, 17% and 16% of our net operating revenue for the years ended December 31, 2005, 2004 and 2003, respectively. We recently renewed our U.S. asset administration outsourcing agreement with BGI and we expect that BGI will continue to account for a significant portion of our net operating revenue. We provide services to BGI under long-term contracts that may be terminated before the expiration of the contracts under certain circumstances that we have described in filings with the Securities and Exchange Commission (“SEC”), as described below. While we believe that our relationship with BGI is excellent, the loss of BGI’s business would cause our net operating revenue to decline significantly and would likely have an adverse effect on our quarterly and annual results.

The outsourcing agreement was renewed pursuant to an amendment (the “Amendment”) to the Custodial, Fund Accounting and Services Agreement between the Bank and BGI dated May 1, 2001 (the “Custodial Agreement”). Under the terms of the Amendment, the Custodial Agreement is extended through April 30, 2013. As provided in the Amendment, BGI may terminate the Custodial Agreement upon sixty days prior written notice:  (i) as to any underlying account if BGI fails to receive any consent required by law for the Bank to act as servicing agent for such account; (ii) as to any underlying account if the continued provision of services by the Bank to such account would be inconsistent with BGI’s fiduciary duties under applicable law; or (iii) as to the entire Custodial Agreement in the event a conservator or receiver is appointed for the Bank under applicable federal law. In addition, BGI may terminate the Custodial Agreement prior to April 30, 2013 if the Bank fails to meet a certain number of service level commitments for four consecutive months in any rolling twelve-month period or if the Bank materially breaches a material provision of the Custodial Agreement, in both cases subject to customary notice and opportunity to cure provisions.

Also, under the terms of the Amendment, the parties have agreed to assess the fee schedule and status of each party and of the industry 90 days prior to November 1, 2009 and to negotiate in good faith any appropriate amendments to the fee schedule arising from that assessment. If the parties are unable to agree on an amended fee schedule by November 1, 2009, BGI may terminate the Custodial Agreement. The Amendment also provides that the Bank will continue to service BGI for up to two years, or longer under certain circumstances, after expiration or termination by BGI of the Custodial Agreement.

We may incur losses due to operational errors.

The services that we provide require complex processes and interaction with numerous third parties. While we maintain sophisticated computer systems and a comprehensive system of internal controls, and our operational history has been excellent, from time to time we may make operational errors for which we are responsible to our clients. In addition, even though we maintain appropriate errors and omissions and other insurance policies, an operational error could result in a significant liability to us and may have a material adverse effect on our results of operations.

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We face significant competition from other financial services companies, which could negatively affect our operating results.

We are part of an extremely competitive asset servicing industry. Many of our current and potential competitors have longer operating histories, greater name recognition and substantially greater financial, marketing and other resources than we do. These greater resources could, for example, allow our competitors to develop technology superior to our own. In addition, we face the risk that large mutual fund complexes may build in-house asset servicing capabilities and no longer outsource these services to us. As a result, we may not be able to compete effectively with current or future competitors, which could result in a loss of existing clients or difficulty in gaining new clients.

We may incur significant costs defending legal claims.

We have been named in lawsuits in U.S. District Court in Massachusetts alleging, among other things, violations of securities laws. In addition, we have been named in a lawsuit in Massachusetts state court alleging, among other things, violations of a covenant of good faith and fair dealing in a contract. While we believe these claims are without merit, we cannot be sure that we will prevail in the defense of these claims. We are also party to other litigation and we may become subject to other legal claims in the future. Litigation is costly and could divert the attention of management. For a more detailed discussion of our ongoing lawsuits, please see Item 3. Legal Proceedings, in Part I of this report.

Our future results depend, in part, on successful integration of prior and possible future outsourcing transactions.

Integration of outsourcing transactions is complicated and frequently presents unforeseen difficulties and expenses which can affect whether and when a particular outsourcing transaction will be accretive to our earnings per share. Any future outsourcing transactions will present similar challenges. These outsourcing transactions can also consume a significant amount of management’s time.

The failure to properly manage our growth could adversely affect the quality of our services and result in the loss of clients.

We have experienced a period of rapid growth that has required the dedication of significant management and other resources. Continued growth could place a strain on our management and other resources. To manage future growth effectively, we must continue to invest in our operational, financial and other internal systems, and our human resources, which could affect our profitability.

We must hire and retain skilled personnel in order to succeed.

Qualified personnel, in particular managers and other senior personnel, are in great demand throughout the financial services industry. As a result, we could find it increasingly difficult to continue to attract and retain sufficient numbers of these highly skilled employees, which could affect our ability to attract and retain clients.

We may not be able to protect our proprietary technology.

Our proprietary technology is important to our business. We rely on trade secret, copyright and trademark laws and confidentiality agreements with employees and third parties to protect our proprietary technology, all of which offer only limited protection. These intellectual property rights may be invalidated or our competitors may develop similar technology independently. Legal proceedings to enforce our intellectual property rights may be unsuccessful, and could also be expensive and divert management’s attention.

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Our quarterly and annual operating results may fluctuate.

Our quarterly and annual operating results are difficult to predict and may fluctuate from quarter to quarter and annually for several reasons, including:

·       The timing of commencement or termination of client engagements;

·       Changes in interest rates, the relationship between different interest rates or equity values;

·       The rate of net inflows and outflows of investor funds in the investment vehicles offered by our clients; and

·       The timing and magnitude of share repurchases under our share repurchase plan.

Most of our expenses, such as employee compensation and rent, are relatively fixed. As a result, any shortfall in revenue relative to our expectations could significantly affect our operating results.

We are subject to extensive federal and state regulations that impose complex restraints on our business.

Federal and state laws and regulations applicable to financial institutions and their parent companies apply to us. Our primary regulators are the Federal Reserve Board (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the Massachusetts Commissioner of Banks, the National Association of Securities Dealers, Inc. (“NASD”), and the State of Vermont Department of Banking, Insurance, Securities and Health Care Administration (“BISHCA”). Virtually all aspects of our operations are subject to specific requirements or restrictions and general regulatory oversight including the following:

·       The FRB and the FDIC maintain capital requirements that we must meet. Failure to meet those requirements could lead to severe regulatory action or even receivership. We are currently considered to be “well-capitalized”;

·       Under Massachusetts law, the Bank may be restricted in its ability to pay dividends to Investors Financial Services Corp., which may in turn restrict our ability to pay dividends to our stockholders;

·       The FRB and the FDIC are empowered to assess monetary penalties against, and to order termination of activities by, companies or individuals who violate the law;

·       The NASD maintains certain regulatory requirements that our securities broker affiliate, Investors Securities Services, LLC, must meet. Failure to meet those requirements could lead to severe regulatory action;

·       BISHCA maintains certain regulatory requirements that our insurance captive affiliate, Investors Vermont Insurance Company, must meet. Failure to meet those requirements could lead to regulatory action; and

·       Our international operations are subject to regulatory oversight by regulators in the jurisdictions in which we operate, including the Office of the Superintendent of Financial Institutions in Canada, the Irish Financial Services Regulatory Authority, the Cayman Islands Monetary Authority and the Financial Services Authority (“FSA”) in the United Kingdom. Failure to comply with applicable international regulatory requirements could result in regulatory action and impact our ability to provide services in those jurisdictions.

Banking law restricts our ability to own the stock of certain companies and also makes it more difficult for us to be acquired. Also, we have not elected financial holding company status under the federal Gramm-Leach-Bliley Act of 1999. This may place us at a competitive disadvantage with respect to other organizations.

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ITEM 2.                PROPERTIES.

The following table provides certain summary information with respect to the principal properties that we leased as of December 31, 2005:

*                    Pursuant to the terms of the contract, this lease can be terminated in 2013 by paying six months rent as compensation.

For more information, see Note 16 of the Notes to Consolidated Financial Statements.

ITEM 3.                LEGAL PROCEEDINGS.

On June 27, 2003, we and an individual employee of ours were named in a lawsuit alleging, among other things, that we breached an implied covenant of good faith and fair dealing in a subadvisory contract with Opus Investment Management, Inc. (“Opus”) and that our individual employee engaged in a breach of fiduciary duties and tortious interference with a contract. Opus had been a subadviser to the Merrimac Funds, for which we act as investment adviser. Upon the expiration of Opus’s contract on June 1, 2003, the Merrimac Funds elected not to re-appoint Opus as subadviser. The lawsuit was filed in Superior Court in Worcester, Massachusetts and seeks unspecified damages. The lawsuit is currently in the discovery phase. We believe that the claims are without merit and intend to defend our rights vigorously. However, we cannot predict the outcome of this lawsuit at this time, and we can give no assurance that it will not affect our financial condition or results of operations in a materially adverse way.

In July 2000, two of our Dublin subsidiaries, Investors Trust & Custodial Services (Ireland) Ltd. (“ITC”) and Investors Fund Services (Ireland) Ltd. (“IFS”), received a plenary summons in the High Court, Dublin, Ireland. The summons named ITC and IFS as defendants in an action brought by the FTF ForexConcept Fund Plc (the “Fund”), a former client. The summons also named as defendants FTF Forex Trading and Finance, S.A., the Fund’s investment manager, Ernst & Young, LLP, the Fund’s auditors, and Dresdner Bank-Kleinwort Benson (Suisse) S.A., a trading counterparty to the Fund. The Fund is an investment vehicle organized in Dublin to invest in foreign exchange contracts. A total of approximately $4.7 million had been invested in the Fund. Most of that money was lost prior to the Fund’s closing to subscriptions in June 1999. In January 2001, ITC, IFS and the other defendants named in the plenary summons received a statement of claim by the Fund seeking unspecified damages allegedly arising from breach of contract, misrepresentation and breach of warranty, negligence and breach of duty of care, and breach of fiduciary duty, among others. We have notified our insurers and intend to defend this claim vigorously. Based on our investigation through December 31, 2005, we do not expect this matter to have a material adverse effect on our business, financial condition or results of operations.

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Investors Financial Services Corp. and five of its officers are named as defendants in three purported class action complaints that were filed on or about August 4, 2005, August 15, 2005 and September 30, 2005 in the United States District Court for the District of Massachusetts, Boston, Massachusetts. Among other things, the complaints filed on August 4, 2005 and August 15, 2005 assert that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 during the period October 15, 2003 until July 15, 2005. Among other things, the complaint filed on September 30, 2005 asserts that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 during the period July 16, 2003 until July 15, 2005. The allegations in the complaints predominantly relate to: (1) the Company’s October 2004 restatement of its financial results, and (2) the Company’s July 2005 revision of public guidance regarding its future financial performance. The complaints seek unspecified damages, interest, fees, and costs. We strongly believe that the lawsuits lack merit and we intend to defend against the claims vigorously. However, we cannot predict the outcome of the lawsuits at this time, and we can give no assurance that they will not materially adversely affect our financial condition or results of operations.

Investors Financial Services Corp. and nine of its officers and directors are named as defendants in two shareholder derivative complaints that were filed on or about September 22, 2005 and October 17, 2005 in the United States District Court for the District of Massachusetts, Boston, Massachusetts. Among other things, the complaints assert that the defendants are liable for breach of fiduciary duty, unjust enrichment, abuse of control, mismanagement, misappropriation of information, insider trading, and violation of Section 14(a) of the Securities Exchange Act of 1934. The complaint filed on September 22, 2005 also seeks reimbursement under the Sarbanes-Oxley Act of 2002. The allegations in the complaints predominantly relate to: (1) the Company’s October 2004 restatement of its financial results, and (2) the Company’s July 2005 revision of public guidance regarding its future financial performance. The complaints seek unspecified damages, attorneys’ fees, accountant and expert fees, and costs. We strongly believe that the lawsuits lack merit and we intend to defend against the claims vigorously. However, we cannot predict the outcome of the lawsuits at this time, and we can give no assurance that they will not materially adversely affect our financial condition or results of operations.

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PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, AND ISSUER PURCHASE OF EQUITY SECURITIES AND RELATED STOCKHOLDER MATTERS.

PRICE RANGE OF COMMON STOCK AND DIVIDEND HISTORY AND POLICY

Our common stock is quoted on the Nasdaq National Market under the symbol “IFIN”. The following table sets forth, for the calendar periods indicated, the high and low sale prices for the common stock as reported by Nasdaq and dividends per share paid on the common stock.

As of January 31, 2006, there were approximately 837 stockholders of record.

We currently intend to retain the majority of future earnings to fund the development and growth of our business. Our ability to pay dividends on our common stock may depend on the receipt of dividends from Investors Bank. In addition, we may not pay dividends on our common stock if we are in default under certain agreements that we entered into in connection with the sale of the 9.77% Capital Securities by Investors Capital Trust I. See Note 10 of our Notes to Consolidated Financial Statements included with this Report. Any dividend payments by Investors Bank are subject to certain restrictions imposed by federal law and by the Massachusetts Commissioner of Banks. See “Business—Regulation and Supervision” for additional information. Subject to regulatory requirements, we expect to pay an annual dividend to our stockholders, currently estimated to be in an amount equal to $0.09 per share of outstanding common stock (approximately $5.9 million based upon 65,052,637 shares outstanding as of December 31, 2005). We expect to declare and pay such dividend ratably on a quarterly basis.

The information required under this item regarding securities authorized for issuance under equity compensation plans is incorporated herein by reference to the section entitled “Stock Plans” contained in our definitive proxy statement pursuant to Regulation 14A, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of our fiscal year ended December 31, 2005.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

In July 2005, we announced that our Board of Directors authorized a repurchase plan of up to $150.0 million of our common stock in the open market during the twelve months following the announcement. The repurchase plan expires in June 2006. For the three months ended December 31, 2005, there was no activity under this plan.

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ITEM 6.                SELECTED FINANCIAL DATA.

The following table contains certain of our consolidated financial and statistical information, and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, our Consolidated Financial Statements and Notes to Consolidated Financial Statements, and other financial information appearing elsewhere in this Report. (Dollars in thousands, except per share and employee data):

(1)    Effective July 1, 2003, the Company adopted provisions of SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which resulted in a reclassification of the trust preferred securities from mezzanine financing to liabilities. As such, interest expense associated with the trust preferred securities was reclassified to net interest income.

(2)    All numbers shown in this table have been restated to reflect reclassifications related to Emerging Issues Task Force Issue No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-pocket” Expenses Incurred.

(3)    All numbers shown in this table have been restated to reflect the two-for-one stock split paid June 14, 2002, where applicable.

(4)    Effective October 1, 2003, the Company adopted the provisions of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, which resulted in the deconsolidation of Investors Capital Trust I, the trust that holds the trust preferred securities.

(5)    We intend to retain the majority of future earnings to fund development and growth of our business. We currently expect to pay cash dividends at an annualized rate of $0.09 per share subject to regulatory requirements. Refer to “Liquidity” included in Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information.

(6)    Refer to “Capital Resources” included within Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information.

(7)    Assets processed is the total dollar value of financial assets on the reported date for which we provide one or more of the following services: middle office outsourcing, global custody, multicurrency accounting, fund administration, securities lending, foreign exchange, cash management, performance measurement, institutional transfer agency, investment advisory services, lines of credit and brokerage and transition management services.

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ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

You should read the following discussion together with our Consolidated Financial Statements and related Notes to Consolidated Financial Statements, which are included elsewhere in this Report. The following discussion contains forward-looking statements that reflect plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. See “Certain Factors That May Affect Future Results” herein.

Overview

We provide asset administration services for the financial services industry through our wholly-owned subsidiary, Investors Bank & Trust Company. We provide core services and value-added services to a variety of financial asset managers, including mutual fund complexes, investment advisors, family offices, banks and insurance companies. Core services include middle office outsourcing, global custody, multicurrency accounting and fund administration. Value-added services include securities lending, foreign exchange, cash management, performance measurement, institutional transfer agency, investment advisory services, lines of credit and brokerage and transition management services. We have offices located in the United States, Ireland, Canada, the Cayman Islands and the United Kingdom with a vast global subcustodian network established to accommodate the international needs of our clients. At December 31, 2005, we provided services for approximately $1.8 trillion in net assets, including approximately $0.3 trillion in foreign net assets.

We grow our business by selling our services to new clients and by further penetrating our existing clients. We believe that we service approximately 10% of the assets managed by our existing clients, and we have traditionally achieved significant success in growing client relationships. Our ability to service new clients and expand our relationships with existing clients depends on our provision of superior client service. Our growth is also affected by conditions in the global securities markets, the interest rate environment, the regulatory environment for us and our clients and the success of our clients in marketing their products.

We derive our asset servicing revenue from providing core and value-added services. We derive our net interest income by investing the cash balances our clients leave on deposit with us. Since we price our service offerings on a bundled basis, our share of earnings from these investments is viewed as part of the total compensation that our clients pay us for servicing their assets. In establishing a fee structure for a specific client, we analyze all expected revenue and expenses. We believe net operating revenue (net interest income plus noninterest income) and net income are the most meaningful measures of our financial results.

As an asset administration services company, the amount of net operating revenue that we generate is impacted by overall market conditions, client activity and the prevailing interest rate environment. A significant portion of our core services revenue is based upon the amount of assets we process. As market values of underlying assets fluctuate, so will our revenue. We have managed this volatility by offering a tiered pricing structure for our asset-based fees. As asset values increase, the basis point fee is reduced for the incremental assets. When asset values decrease, revenue is only impacted at the then marginal rate. Many of our value-added services are transactional based, and we receive a fee for each transaction processed. We have continued to experience net interest margin compression during 2005 due to a relatively flat yield curve, lower reinvestment spreads and the liability sensitive nature of our balance sheet. Because we are a liability sensitive institution, as overnight interest rates rise, most of our liabilities reprice but our assets take longer to reprice due to the nature of their reset provisions (i.e., monthly, quarterly and annually). The lower interest rate spreads we experienced in 2005 were also due to the narrowing of market spreads on reinvestment and purchase opportunities for fixed and floating-rate investment assets. In 2006, we expect to see short-term rates continue to rise and a continued very flat yield curve.

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We remain focused on our sales efforts, prudent expense management and increasing our operating efficiency. These goals are complicated by the need to build infrastructure to support our growth, the need to maintain state-of-the-art systems and the need to retain and motivate our workforce.

In 2003, we settled a tax assessment with the Commonwealth of Massachusetts. In March 2003, a retroactive change in the Commonwealth of Massachusetts tax law disallowed a dividends received deduction taken by the Bank on dividends it had received since 1999 from a wholly-owned real estate investment trust. During the second quarter of 2003, we settled this disputed tax assessment with the Massachusetts Department of Revenue, agreeing to pay approximately 50% of the liability. As a result of this change in tax law, we recorded an additional state tax expense of approximately $7.2 million, net of federal income tax benefit, in 2003.

In our 2003 and 2004 earnings releases, we reported non-GAAP operating income and non-GAAP operating earnings per share information that exclude the effect of the state tax assessment settlement discussed above. We believe that non-GAAP operating earnings provide a more meaningful presentation of our 2003 results of operations because they do not include the one-time tax charge which was unrelated to our core operations. The following table presents a reconciliation between net income and earnings per share presented on the face of our Statements of Income and the non-GAAP measure of net operating income referenced in our earnings releases (Dollars in thousands, except per share data):

GAAP Earnings

Non-GAAP Operating Earnings

(1)          Provision for income taxes for the year ended December 31, 2003 excludes a $7.2 million charge, net of federal income tax benefit, that resulted from a retroactive change in the Commonwealth of Massachusetts tax law enacted in the first quarter of 2003 and the Company’s subsequent settlement of the resulting tax assessment with the Massachusetts Department of Revenue. The effect of the exclusions is an increase in basic and diluted earnings per share of $0.11.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions. We have

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identified the following accounting policies that, as a result of the complexities of the underlying accounting standards and operations involved, could result in significant changes to our consolidated financial condition or results of operations under different conditions or using different assumptions. Senior management has discussed these critical accounting policies with the Audit Committee.

Derivative Financial Instruments—Cash flow hedge accounting requires that we measure the changes in fair value of derivatives designated as hedges as compared to changes in expected cash flows of the underlying hedged transactions for each reporting period. This process involves the estimation of the expected future cash flows of hedged transactions. Interest rate swaps are valued using a nationally recognized swap valuation model. The LIBOR (London InterBank Offered Rate) curve in this model serves as the basis for computing the market value of the swap portfolio. If short-term interest rates increase, as they did during 2005, we would expect the swaps to gain in value. Conversely, if short-term interest rates decrease, we would expect there to be a corresponding decline in the market value of the swap portfolio. The measurement of fair value of our derivatives portfolio is based upon market interest rate curve and spreads.

Defined Benefit Pension Assumptions—Each fiscal year, we must assess and select the discount rate, compensation increase percentage and average return on plan assets assumptions in order to determine our net periodic pension cost and to project our benefit obligations under our defined benefit plans. The discount rate is based on the weighted-average yield on high-quality fixed-income investments that are expected to match the plan’s projected cash flows. The compensation increase percentage is based upon management’s current and expected salary increases. The average return on plan assets is based on the expected return on the plan’s current investment portfolio, which can reflect the historical returns of the various asset classes.

For the fiscal year ended December 31, 2005, the discount rate, compensation increase percentage and average return on plan assets used to determine net periodic pension cost for our qualified defined benefit pension plan were 5.80%, 4.00% and 8.50%, respectively. The discount rate was 0.45% lower than the rate at December 31, 2004 due to a retraction of the projected yield curve during the year. The compensation increase assumption at December 31, 2005 was slightly higher by 0.25% than at December 31, 2004 and the rate of return on plan assets of 8.50% has remained consistent with the prior year. Net periodic pension expense for the pension plan for 2005, excluding the effect of curtailment, was $0.8 million, as compared to $0.8 million for the year ended December 31, 2004. We expect the net periodic pension expense to be approximately $0.2 million in fiscal year 2006.

At December 31, 2005, the discount rate assumption used to project the benefit obligation for our nonqualified, unfunded, supplemental retirement plan, which covers certain employees, was 5.75%. The compensation increase percentage assumption ranged from 4.0% to 10.0% at December 31, 2005, which was consistent with the prior year. The net periodic pension expense for 2005 for the supplemental retirement plan, using a 5.80% discount rate and 4.00% compensation increase, was $4.3 million, as compared to $2.5 million for the year ended December 31, 2004. The net periodic pension expense is expected to be approximately $5.3 million in fiscal year 2006.

New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards 123 (revised 2004), Share-Based Payment (“SFAS 123R”). SFAS 123R requires that compensation cost relating to share-based payment transactions be recognized in the financial statements, with measurement based upon the fair value of the equity or liability instruments issued. We currently use the intrinsic-value method to measure compensation cost related to our share-based transactions. SFAS 123R replaces SFAS 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees.

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In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses the views of the SEC regarding the interaction of SFAS 123R and certain SEC regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies.

In April 2005, the SEC issued Release 2005-57, which delayed the effective date for SFAS 123R to reporting periods in the first fiscal year beginning after June 15, 2005. Accordingly, we adopted SFAS 123R on January 1, 2006, effective for financial periods in 2006. There was no impact to our financial condition or results of operations upon adoption.

In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3 (“SFAS 154”). SFAS 154 replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the accounting and reporting requirements for a change in accounting principle. SFAS 154 applies to all voluntary changes in an accounting principle, as well as to changes required by a new accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005 and requires retrospective application to prior periods’ financial statements for most voluntary changes in an accounting principle, unless it is impracticable to do so.  We do not anticipate any material impact to our financial condition or results of operations as a result of the adoption of SFAS 154.

In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Instruments—an amendment of FASB Statements No. 133 and 140 (“SFAS 155”). SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 eliminates the need to bifurcate the derivative from its host, as previously required under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedge Accounting (“SFAS 133”). SFAS 155 also amends SFAS 133 by establishing a requirement to evaluate interests in securitized financial assets to determine whether they are free standing derivatives or whether they contain embedded derivatives that require bifurcation. SFAS 155 is effective for all hybrid financial instruments acquired or issued by the Company on or after January 1, 2007. The Company does not anticipate any material impact to its financial condition or results of operations as a result of the adoption of SFAS 155.

Certain Factors That May Affect Future Results

From time to time, information provided by us, statements made by our employees, or information included in our filings with the SEC (including this Form 10-K) may contain statements which are not historical facts, so-called “forward-looking statements,” which are made under Section 21E of the Securities Exchange Act of 1934 and which involve risks and uncertainties. These statements relate to future events or our future financial performance and are identified by words such as “may,” “could,” “should,” “expect,” “plan,” “intend,” “seek,” “anticipate,” “believe,” “estimate,” “potential,” or “continue” or other comparable terms or the negative of those terms. Forward-looking statements in this Form 10-K include certain statements regarding liquidity, growth rate, annual dividend payments, interest rate conditions, the shape of the yield curve, interest rate sensitivity, compliance with capital adequacy guidelines, loss exposure on lines of credit, the timing and effect on earnings of derivative gains and losses and the reclassification of net after-tax gains on derivative contracts, securities lending revenue, net interest income, operating expenses, including occupancy expenses and needs, transaction processing services expense, professional fee expense, compensation expense, travel and sales expense, investments in technology and compensation expense, pension plan and supplemental pension expense, depreciation expense, effective tax rate, investments in FHLBB capital stock, the effect on earnings of changes in equity values or fixed income, the effects of increased prepayments and reduced investment opportunities for our net interest income, our ability to execute our stock repurchase plan and the effect of certain legal claims against us. Our actual future results may differ significantly from those stated in any forward-looking

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statements. Factors that may cause such differences include, but are not limited to, the factors discussed in Item 1A of this Form 10-K. Each of these factors, and others, are discussed from time to time in our filings with the SEC.

Statements of Income

Comparison of Operating Results for the Years Ended December 31, 2005 and 2004.

Net income for the year ended December 31, 2005 was $159.8 million, up 13% from $142.0 million for the same period in 2004. The principal factors contributing to our net income growth were growth in asset servicing fees of 20% and increased gain on sale of investments. Net income growth was partially offset by a 15% increase in operating expenses (largely due to new business wins, additional headcount and technology requirements) and a 9% decrease in net interest income.

Fees and Other Revenue

The components of fees and other revenue are as follows (Dollars in thousands):

*                    Percentage is not considered meaningful.

The largest components of asset servicing fees are custody, multicurrency accounting and fund administration, which increased 20% to $375.6 million for the year ended December 31, 2005 from $314.3 million for the same period in 2004. Custody, multicurrency accounting and fund administration fees are based in part on the value of assets processed. Assets processed is the total dollar value of financial assets on the reported date for which we provide one or more of the following services: middle office outsourcing, global custody, multicurrency accounting, fund administration, securities lending, foreign exchange, cash management, performance measurement, institutional transfer agency, investment advisory services, lines of credit and brokerage and transition management services.

The change in net assets processed includes the following components (Dollars in billions):

The majority of the increase in assets processed was due to sales to new and existing clients, the ability of our clients to develop and sell product, which generates fund flows that have a direct, positive impact on our business, and slightly higher asset values compared to a year ago. As indicated in the “Overview” section, our core services fees are generated by charging a fee based upon the value of assets processed. As market values or clients’ asset levels fluctuate, so will our revenue. Our tiered pricing structure, coupled with

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minimum and flat fees, allow us to manage this volatility to a certain extent. As asset values increase, the basis point fee typically lowers. When asset values decrease, revenue is only impacted by the asset decline at the then marginal rate.

If the value of equity or fixed income assets held by our clients were to increase or decrease by 10% for a sustained period of time, we estimate currently that this market movement, by itself, would cause a corresponding change of less than 5% in our earnings per share. Earnings per share do not track precisely to the value of the equity and fixed-income markets because conditions present in a market increase or decrease may generate offsetting increases or decreases in other revenue and expense items that are influenced by the value of the assets we administer. For example, increased market volatility often results in higher transaction fee revenue. Also, market value declines may result in increased interest income and sweep fee income as clients move larger amounts of assets into the cash management vehicles that we offer. In addition, our tiered pricing structure reduces the impact of volatility in asset values to a certain extent. However, there can be no assurance that any of these offsetting revenue and expense movements will occur during any future upturn or downturn in the equity or fixed-income markets, or that our tiered pricing structure will reduce the impact on us of a sustained change in asset values.

Transaction-driven income includes our value-added services, such as foreign exchange, cash management, securities lending and investment advisory services.

·       Foreign exchange fees were $62.1 million for the year ended December 31, 2005, up 14% from the same period in 2004. The increase in foreign exchange fees is attributable to new business, increased volume of client activity and volatility in currency markets. Future foreign exchange income is dependent on the volume of new and existing client activity and overall volatility in the currencies traded.

·       Cash management fees, which consist of sweep fees, were $37.6 million for the year ended December 31, 2005, up 42% from the same period in 2004. The increase is primarily due to higher balances placed by our clients in the cash management products we offer. Cash management revenue will continue to depend on the level of client balances maintained in the cash management products we offer. If our clients’ investment products continue to maintain higher cash balances than they did in comparable periods, we expect our cash management revenue to be positively impacted.

·       Securities lending fees were $22.5 million for the year ended December 31, 2005, up 117% from the same period in 2004, primarily due to new business, higher volumes and improved market conditions. Securities lending transaction volume is positively affected by the market value of the securities on loan, merger and acquisition activity, increased IPO activity and a steeper short-end of the yield curve. If the capital markets continue to experience the aforementioned characteristics, it is likely that our securities lending revenue will continue to be positively impacted. If we experience a reduction in our securities lending portfolio, lower market values or compression of the spreads earned on our securities lending activity, our securities lending revenue will likely be negatively impacted.

·       Investment advisory fees were $8.4 million for the year ended December 31, 2005, down 44% from the same period in 2004. The decrease in investment advisory fees is attributable to lower asset values in our proprietary Merrimac money market funds combined with advisory fee waivers on certain of the funds. Future investment advisory fee income is dependent upon the asset levels within the Merrimac money market funds, which are driven by overall market conditions, client activity and transaction volumes. We discontinued advisory fee waivers in the second quarter of 2005.

·       Other service fees for the year ended December 31, 2005 were $2.8 million, up 5% from the same period in 2004. Other service fees include income earned on compliance advisory, brokerage and transition management services. The increase in 2005 was due to an increase in compliance and brokerage services.

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·       Other operating income for the year ended December 31, 2005 was $4.1 million, up 98% from the same period in 2004. The increase is primarily due to an increase in the dividend rate on our holding of FHLBB stock.

During the year ended December 31, 2005 we sold municipal securities and U.S. Treasury securities held in our available for sale portfolio, resulting in the recognition of $12.4 million in gains. We sold these securities as part of a strategy to improve the after-tax yield of our municipal securities portfolio by replacing the sold municipal securities with those that offer a more attractive after-tax yield, as well as to capitalize on strong market conditions.

Net Interest Income

The following table presents the components of net interest income (Dollars in thousands):

Net interest income is affected by the volume and mix of assets and liabilities and the movement and level of interest rates. The decrease in our net interest income was primarily driven by lower interest rate spreads, which was partially offset by growth in our investment portfolio. Lower interest rate spreads were due to increasing short-term interest rates without a concurrent increase in longer-term rates, which resulted in a relatively flat yield curve. Consequently, our interest-bearing liabilities, of which the majority is priced based on overnight floating rates, have repriced at higher rates faster than our interest-earning assets have repriced, resulting in a lower net interest margin. In addition, reinvestment and purchase spreads on fixed and floating-rate assets were lower than expected due to higher market demand, especially for shorter-term and floating-rate fixed income investments. Average investment security balances were up approximately $1.5 billion for the year ended December 31, 2005 compared to the same period in 2004.

The table below presents the changes in net interest income resulting from changes in the volume of interest-earning assets or interest-bearing liabilities and changes in interest rates for the year ended December 31, 2005 compared to the year ended December 31, 2004. Changes attributed to both volume and rate have been allocated based on the proportion of change in each category (Dollars in thousands):

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Amortization and accretion of debt securities purchased at a premium or discount are amortized or accreted into income using a method which approximates the constant effective yield method. We apply Statement of Financial Accounting Standard No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (“SFAS 91”) for the amortization of premiums and accretion of discounts. In calculating the effective yield for securities that represent holdings of large numbers of similar loans for which prepayments are probable and the timing and amount of prepayments can be reasonably estimated, prepayments are anticipated using our actual three-month prepayment experience.

The amount of amortization or accretion to recognize in income is driven by the calculation of the constant effective yield. When calculating this yield, we assume that prepayments will continue from the analysis date to the date of the security’s expected maturity at our most recent three-month prepayment rate. The prepayment rate is updated monthly based on our previous three-month actual prepayment experience.

We utilize three-month prepayment rates to anticipate prepayments because such rates are based on our own actual prepayment experience and because we believe three-month rates are a better estimate of future experience than either one-month or six-month or longer rates. In the opinion of management, a one-month rate does not capture enough experience to predict future prepayment behavior and may create undue volatility in interest income due to one-time fluctuations in prepayment activity. Conversely, in the opinion of management, a six-month or longer rate would not capture enough volatility to predict future prepayment behavior.

If a difference arises between our estimated prepayments and our actual prepayments received, the constant effective yield is recalculated based on our actual payments to date and anticipated future payments. This monthly recalculation results in the carrying value of the security being adjusted to the amount that would have existed had the new effective yield been applied since the purchase date, and a corresponding charge or credit is recognized to interest income.

For securities that do not represent holdings of large numbers of similar loans for which prepayments are probable and the timing and amount of prepayments can be reasonably estimated, the associated premiums and discounts are amortized or accreted over their contractual term using the constant effective yield. Actual prepayment experience for such securities is reviewed monthly and a proportionate amount of premium or discount is recognized in income at that time such that the effective yield on the remaining portion of the securities continues unchanged.

As of and for the years ended December 31, 2005, 2004, and 2003, we anticipated prepayments on our mortgage-backed securities. All other securities, including Federal agency securities, state and political subdivisions, corporate debt, U.S. Treasury securities, and foreign government securities do not meet the SFAS 91 criteria for anticipating prepayments. Accordingly, no prepayments were anticipated for these securities.

In addition to investing in both variable and fixed-rate securities, we use derivative instruments to manage our exposure to interest rate risks. See the “Market Risk” section for more detailed information.

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Operating Expenses

Total operating expenses were $460.1 million in 2005, up 15% from 2004. The increase in total operating expenses was primarily due to increased compensation and benefits, technology and telecommunications, transaction processing services, travel and sales promotion, loss and loss adjustment expenses and other operating expenses, as detailed below. The components of operating expenses were as follows (Dollars in thousands):

*                    Percentage is not considered meaningful

Compensation and benefits increased 22% from 2004 due to higher headcount and annual salary increases. Further increases in compensation expense in 2006 will be primarily dependant upon sales to new and existing clients, the full year impact of staff additions made in 2005 related to the overall growth of our business, annual salary increases and the full year effect of the adoption of SFAS 123R.

Technology and telecommunications expense increased 10% from 2004 as a result of increased infrastructure investments in 2005. The increase is also due to our outsourcing agreement with IBM, which we entered into in July of 2004. A portion of the increase is offset by lower compensation costs due to employees transferring to IBM. Also, increases in our processing volumes drove higher technology and telecommunications expense. Generally, we expect technology reinvestment to equal approximately 18-20% of net operating revenue each year, including related compensation costs.

Transaction processing services expense increased 18% from 2004 as a result of higher global asset values and transactions with our subcustodians. Future transaction processing servicing expense will be dependent on asset levels and the volume of client transaction activity.

Professional fees expense decreased 13% from 2004, primarily due to lower subadvisory expense associated with our Merrimac money market funds, resulting from lower average fund balances. Future professional fees are dependent upon changes in the value of the Merrimac portfolios and upon other business needs for outside professional services.

Travel and sales promotion expense increased 25% from 2004. Travel and sales promotion expense consists of expenses incurred by the sales force, client management staff and other employees in connection with sales calls on potential clients, as well as traveling to existing client sites and our foreign offices. The increases resulted from a higher level of travel to client sites, a higher level of sales calls to potential clients, attendance at industry conferences, and travel related to the establishment of our new European offices. Travel and sales expense may increase in 2006, dependent upon new business leads and other client and business needs.

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The increase in loss and loss adjustment expenses from 2004 to 2005 is due to a processing error identified during the fourth quarter of 2005.

Other operating expense increased 27% from 2004 primarily as a result of higher recruiting and staffing expense. We expect other operating expense to increase in 2006 due to staffing and recruiting costs as a result of the growth of our business.

Income Taxes

Income taxes were $76.0 million for the year ended December 31, 2005, up 4% from the same period in 2004. The increase in income taxes and the effective tax rate (excluding the effect of Accounting Principles Board Opinion No. 23, Accounting for Income Taxes—Special Areas (“APB 23”)) is primarily attributable to increased pretax earnings as well as a decrease in the percentage of tax-exempt income to pretax income. The increase in income taxes was partially offset by the reversal of a deferred income tax liability related to the undistributed earnings of our Irish subsidiaries. During the second quarter of 2005, we recognized the indefinite reversal provision of APB 23, which specifies that U.S. income taxes should not be recorded on the undistributed earnings of a foreign subsidiary if those undistributed earnings have been or will be invested indefinitely in that subsidiary. We have determined that the undistributed earnings of our Irish subsidiaries will be permanently invested in our Irish operations to support continued growth.

In 2006, we expect that our effective tax rate will approximate 34.5% of pretax income.

Comparison of Operating Results for the Years Ended December 31, 2004 and 2003.

Net income for the year ended December 31, 2004 was $142.0 million, up 54% from $92.4 million for the same period in 2003. The principal factors contributing to our net income growth were growth in asset servicing fees of 27% in addition to a 22% increase in net interest income. Net income growth was partially offset by a 16% increase in operating expenses, largely due to new business, additional headcount and technology requirements. Our income statement for the year ended December 31, 2003 reflects the net effect of the first quarter 2003 tax accrual and its later partial reversal resulting from our settlement with the Massachusetts Department of Revenue. Absent the effects of this tax matter, net income for the year ended December 31, 2004 increased 43% from net operating income for the same period in 2003. We provide a full reconciliation of this non-GAAP measure in the Overview of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Fees and Other Revenue

The components of fees and other revenue are as follows (Dollars in thousands):

*                    Percentage is not considered meaningful

The largest components of asset servicing fees are custody, multicurrency accounting and fund administration, which increased 24% to $314.3 million for the year ended December 31, 2004 from $254.2 million for the same period in 2003.

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The change in net assets processed includes the following components (Dollars in billions):

The majority of the increase in assets processed was due to sales to new and existing clients, the ability of our clients to develop and sell product, which generates fund flows that have a direct, positive impact on our business, and higher asset values compared to a year ago.

·       Foreign exchange fees were $54.5 million for the year ended December 31, 2004, up 49% from the same period in 2003. The increase in foreign exchange fees is attributable to new business, increased volume of client activity and volatility in currency markets.

·       Cash management fees were $26.4 million for the year ended December 31, 2004, up 26% from the same period in 2003. The increase is primarily due to higher balances placed by our clients in the cash management products we offer.

·       Investment advisory fees were $15.0 million for the year ended December 31, 2004, up 28% from the same period in 2003. The increase in investment advisory fees is attributable to increased average asset values of the Merrimac money market funds, an investment company for which we act as advisor, and where a portion of excess client cash balances are invested.

·       Securities lending fees were $10.4 million for the year ended December 31, 2004, up 17% from the same period in 2003, primarily due to improved spreads and volumes.

Net Interest Income

The following table presents the components of net interest income (Dollars in thousands):

The improvement in our net interest income was primarily due to balance sheet growth, driven by healthy client funding, partially offset by lower investment spreads.

During 2004 we employed a strategy of prepaying high-rate borrowings and replacing them with lower cost term funding in order to maintain our net interest margin. Prepayment fees incurred during 2004 were $6.8 million, compared to $3.1 million during 2003. This strategy combined with a rising interest rate environment during the second half of 2004 resulted in a 5 basis point increase in the average rate paid on interest-bearing liabilities to 1.39% for the year ended December 31, 2004 from 1.34% for the same period in 2003.

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The table below presents the changes in net interest income resulting from changes in the volume of interest-earning assets or interest-bearing liabilities and changes in interest rates for the year ended December 31, 2004 compared to the year ended December 31, 2003. Changes attributed to both volume and rate have been allocated based on the proportion of change in each category (Dollars in thousands):

Operating Expenses

Total operating expenses were $398.4 million in 2004, up 16% from 2003. The growth in our cost structure was largely driven by the new business that we won during 2004, which required us to invest in headcount and technology. The components of operating expenses were as follows (Dollars in thousands):

Compensation and benefits increased $18.8 million, or 10%, from 2003. Salaries increased due to higher headcount and annual merit raises. These increases were partially offset by employee costs that shifted to technology and telecommunications expense as part of our outsourcing arrangement with IBM that we initiated in the summer of 2004.

Technology and telecommunications expense increased $10.9 million, or 28%, from 2003 as a result of increased infrastructure investments in 2004. As mentioned previously, we entered into an agreement with IBM in the summer of 2004 to outsource certain technical infrastructure services. Service expense under this agreement was $9.5 million during 2004, which included initial start-up costs. The costs of these

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services were partially offset by decreases in other technology and telecommunications expenses, as the services were previously performed internally or by other service providers.

Transaction processing services expense increased 27% from 2003 as a result of higher global asset values and transactions with our subcustodians.

Depreciation and amortization expense increased 15% from 2003. This increase resulted from the completion of capitalized software projects in late 2003 and early 2004 and their placement into service. This increase was partially offset by fully depreciated equipment from our 2001 assumption of BGI’s North American asset administration unit.

Professional fees expense increased 37% from 2003, primarily due to increased fees associated with the Merrimac money market funds. The Merrimac fees are asset based and grew along with the assets of the portfolios during 2004. Also in 2004, we incurred additional technical consulting fees as we hired external consultants to assist with technology initiatives.

Travel and sales promotion expense increased 13% from 2003.

Insurance expense was up 44% from 2003. In May 2003, our five-year fixed-rate insurance policy expired, resulting in increased premiums.

Other operating expense increased 53% from 2003. The primary contributors to the increase included higher regulatory assessments due to higher deposit liabilities, higher recruiting expense due to increased staffing needs, increased advertising expense and increased miscellaneous office expense due to the overall growth of our business.

Income Taxes

Income taxes were $72.8 million for the year ended December 31, 2004, up 38% from the same period in 2003. This increase is attributable to a 48% increase in pretax earnings for the year ended December 31, 2004 from the same period in 2003.

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The following tables present average balances, interest income and expense, and yields earned or paid on the major categories of assets and liabilities for the periods indicated (Dollars in thousands):