United States
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly period ended September 30, 2006

or

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition period from               to             

0-26996
(Commission File Number)

INVESTORS FINANCIAL SERVICES CORP.

(Exact name of registrant as specified in its charter)

 

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

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

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. (Check one):

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

As of October 31, 2006 there were 66,058,042 shares of common stock outstanding.

INVESTORS FINANCIAL SERVICES CORP.

INDEX

				Page
PART I.		FINANCIAL INFORMATION
Item 1.		Unaudited Consolidated Financial Statements
		Unaudited Consolidated Balance Sheets September 30, 2006 and December 31, 2005		3
		Unaudited Consolidated Statements of Income and Comprehensive Income Nine months ended September 30, 2006 and 2005		4
		Unaudited Consolidated Statements of Income and Comprehensive Income Three months ended September 30, 2006 and 2005		5
		Unaudited Consolidated Statements of Stockholders’ Equity Nine months ended September 30, 2006 and 2005		6
		Unaudited Consolidated Statements of Cash Flows Nine months ended September 30, 2006 and 2005		7
		Notes to Unaudited Consolidated Financial Statements		8
		Report of Independent Registered Public Accounting Firm		24
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 3.		Quantitative and Qualitative Disclosures about Market Risk		39
Item 4.		Controls and Procedures		39
PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings		40
Item 1A.		Risk Factors		40
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		43
Item 6.		Exhibits		44
SIGNATURES				44

 

2

PART I.  FINANCIAL INFORMATION

Item 1.  Unaudited Consolidated Financial Statements

Investors Financial Services Corp.

Unaudited Consolidated Balance Sheets

September 30, 2006 and December 31, 2005 (Dollars in thousands, except share data)

		September 30,			December 31,
		2006			2005
Assets
Cash and due from banks		$	59,229		$	79,637
Federal Funds sold		250,000			—
Other short-term investments		9,468			—
Securities held to maturity (including securities pledged of $4,498,296 and $4,529,421 at September 30, 2006 and December 31, 2005, respectively) (approximate fair value of $5,807,100 and $6,725,729 at September 30, 2006 and December 31, 2005, respectively) (Note 3)		5,830,022			6,761,930
Securities available for sale (including securities pledged of $3,054,836 and $2,997,958 at September 30, 2006 and December 31, 2005, respectively) (Note 3)		4,623,393			4,369,720
Nonmarketable equity securities		33,250			50,000
Loans, less allowance for loan losses of $100 at September 30, 2006 and December 31, 2005 (Note 4)		286,378			402,370
Accrued interest and fees receivable		136,031			119,583
Equipment and leasehold improvements, less accumulated depreciation of $58,497 and $59,156 at September 30, 2006 and December 31, 2005, respectively		96,677			69,401
Goodwill, net		79,969			79,969
Other assets		168,164			163,783
Total Assets		$	11,572,581		$	12,096,393
Liabilities and Stockholders’ Equity
Liabilities:
Deposits (Note 5):
Demand		$	830,810		$	537,558
Savings		5,020,126			4,224,908
Time		352,142			230,124
Total deposits		6,203,078			4,992,590
Securities sold under repurchase agreements (Note 6)		4,128,598			4,797,868
Short-term and other borrowings (Note 7)		44,685			1,356,649
Due to brokers for open trades payable		72,920			21,293
Junior subordinated deferrable interest debentures		24,774			24,774
Accrued taxes and other expenses		70,821			45,077
Other liabilities		93,864			85,284
Total liabilities		10,638,740			11,323,535
Commitments and contingencies (Note 12)		—			—
Stockholders’ Equity:
Preferred stock, par value $0.01 (shares authorized: 1,000,000; issued: none at September 30, 2006 and December 31, 2005)		—			—
Common stock, par value $0.01 (shares authorized: 175,000,000; issued: 68,274,003 and 67,177,306 at September 30, 2006 and December 31, 2005, respectively)		683			672
Surplus		326,724			286,265
Deferred compensation		—			(311		)
Retained earnings		686,201			572,549
Accumulated other comprehensive loss, net		(6,805		)	(13,369		)
Treasury stock, at cost (2,124,987 shares and 2,124,669 shares at September 30, 2006 and December 31, 2005, respectively)		(72,962		)	(72,948		)
Total stockholders’ equity		933,841			772,858
Total Liabilities and Stockholders’ Equity		$	11,572,581		$	12,096,393

See Notes to Unaudited Consolidated Financial Statements.

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Investors Financial Services Corp.

Unaudited Consolidated Statements of Income and Comprehensive Income

Nine Months ended September 30, 2006 and 2005 (Dollars in thousands, except per share data)

		September 30,			September 30,
		2006			2005
Fees and Other Revenue:
Asset servicing fees:
Core service fees		$	331,249		$	274,150
Value-added service fees		135,643			92,370
Total asset servicing fees		466,892			366,520
Other operating income		4,054			2,424
Gain on sale of investments		2,523			11,123
Total fees and other revenue		473,469			380,067
Interest income		412,696			320,670
Interest expense		291,820			192,970
Net interest income		120,876			127,700
Net operating revenue		594,345			507,767
Operating Expenses:
Compensation and benefits		238,846			185,779
Technology and telecommunications		54,750			39,901
Transaction processing services		45,487			35,252
Occupancy		24,163			19,409
Depreciation and amortization		23,513			23,724
Professional fees		9,881			9,253
Travel and sales promotion		6,451			4,823
Recruitment		3,388			1,928
Insurance		2,944			3,284
Other operating expenses		14,340			10,806
Total operating expenses		423,763			334,159
Income Before Income Taxes		170,582			173,608
Provision for income taxes		52,497			53,301
Net Income		$	118,085		$	120,307
Basic Earnings Per Share		$	1.80		$	1.81
Diluted Earnings Per Share		$	1.75		$	1.77
Comprehensive Income:
Net income		$	118,085		$	120,307
Other comprehensive income (loss):
Net unrealized investment gain (loss)		9,436			(31,095		)
Net unrealized derivative instrument (loss) gain		(4,435		)	9,462
Cumulative translation adjustment		1,563			348
Other comprehensive income (loss)		6,564			(21,285		)
Comprehensive income		$	124,649		$	99,022

 

See Notes to Unaudited Consolidated Financial Statements.

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Investors Financial Services Corp.

Unaudited Consolidated Statements of Income and Comprehensive Income

Three Months Ended September 30, 2006 and 2005 (Dollars in thousands, except per share data)

		September 30,			September 30,
		2006			2005
Fees and Other Revenue:
Asset servicing fees:
Core service fees		$	111,247		$	95,447
Value-added service fees		41,207			33,372
Total asset servicing fees		152,454			128,819
Other operating income		2,420			1,013
Gain on sale of investments		—			1,383
Total fees and other revenue		154,874			131,215
Interest income		140,338			114,512
Interest expense		101,348			76,471
Net interest income		38,990			38,041
Net operating revenue		193,864			169,256
Operating Expenses:
Compensation and benefits		74,639			65,428
Technology and telecommunications		19,625			13,988
Transaction processing services		16,018			12,476
Occupancy		8,600			6,569
Depreciation and amortization		7,971			7,740
Professional fees		4,477			2,874
Travel and sales promotion		2,374			1,649
Recruitment		1,568			873
Insurance		977			1,009
Other operating expenses		2,905			3,524
Total operating expenses		139,154			116,130
Income Before Income Taxes		54,710			53,126
Provision for income taxes		18,327			17,894
Net Income		$	36,383		$	35,232
Basic Earnings Per Share		$	0.55		$	0.54
Diluted Earnings Per Share		$	0.54		$	0.53
Comprehensive Income:
Net income		$	36,383		$	35,232
Other comprehensive income (loss):
Net unrealized investment gain (loss)		30,266			(18,401		)
Net unrealized derivative instrument (loss) gain		(7,833		)	6,770
Cumulative translation adjustment		464			572
Other comprehensive income (loss)		22,897			(11,059		)
Comprehensive income		$	59,280		$	24,173

 

See Notes to Unaudited Consolidated Financial Statements.

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Investors Financial Services Corp.

Unaudited Consolidated Statements of Stockholders’ Equity

Nine Months ended September 30, 2006 and 2005 (Dollars in thousands, except share data)

		September 30,			September 30,
		2006			2005
Common shares
Balance, beginning of period		67,177,306			66,668,584
Exercise of stock options		1,028,194			356,238
Common stock issuance		68,503			54,862
Balance, end of period		68,274,003			67,079,684
Treasury shares
Balance, beginning of period		2,124,669			73,235
Common stock repurchased		318			2,051,434
Balance, end of period		2,124,987			2,124,669
Common stock
Balance, beginning of period		$	672		$	667
Exercise of stock options		11			4
Balance, end of period		683			671
Surplus
Balance, beginning of period		286,265			272,536
Share-based awards and exercise of stock options		32,947			6,896
Tax benefit from exercise of stock options		5,216			2,525
Common stock issuance		2,296			1,878
Transfer of deferred compensation to surplus		(311		)	—
Amortization of deferred compensation		311			—
Balance, end of period		326,724			283,835
Deferred compensation
Balance, beginning of period		(311		)	(572		)
Transfer of deferred compensation to surplus		311			—
Amortization of deferred compensation		—			327
Balance, end of period		—			(245		)
Retained earnings
Balance, beginning of period		572,549			418,034
Net income		118,085			120,307
Cash dividend, $0.0675 and $0.0600 per share in the nine-month periods ending September 30, 2006 and 2005, respectively		(4,433		)	(4,003		)
Balance, end of period		686,201			534,338
Accumulated other comprehensive (loss) income, net
Balance, beginning of period		(13,369		)	23,888
Net unrealized investment gain (loss)		9,436			(31,095		)
Net unrealized derivative instrument (loss) gain		(3,285		)	10,607
Amortization of terminated interest rate swap agreements		(1,150		)	(1,145		)
Cumulative translation adjustment		1,563			348
Balance, end of period		(6,805		)	2,603
Treasury stock
Balance, beginning of period		(72,948		)	(2,291		)
Common stock repurchased		(14		)	(70,657		)
Balance, end of period		(72,962		)	(72,948		)
Total Stockholders’ Equity		$	933,841		$	748,254

 

See Notes to Unaudited Consolidated Financial Statements.

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Investors Financial Services Corp.

Unaudited Consolidated Statements of Cash Flows

Nine Months ended September 30, 2006 and 2005 (Dollars in thousands)

		September 30,			September 30,
		2006			2005
Cash Flows From Operating Activities:
Net income		$	118,085		$	120,307
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed loss of unconsolidated subsidiary		21			21
Depreciation and amortization		23,513			23,724
Share-based compensation		3,093			—
Amortization of deferred compensation		—			327
Amortization of premiums on securities, net of accretion of discounts		41,817			38,844
Gain on sale of investments		(2,523		)	(11,123		)
Excess tax benefit related to share-based compensation		(5,736		)	—
Changes in assets and liabilities:
Accrued interest and fees receivable		(16,448		)	(19,714		)
Other assets		(4,390		)	(89,147		)
Accrued taxes and other expenses		25,744			7,556
Other liabilities		8,696			109,148
Net cash provided by operating activities		191,872			179,943
Cash Flows From Investing Activities:
Proceeds from maturities and paydowns of securities available for sale		827,928			1,047,624
Proceeds from maturities and paydowns of securities held to maturity		954,428			1,199,301
Proceeds from sale of securities available for sale		134,131			293,488
Proceeds from sale of non-marketable equity securities		16,750			—
Purchases of securities available for sale		(1,203,305		)	(1,183,603		)
Purchases of securities held to maturity		(62,088		)	(2,160,300		)
Net increase in due to brokers for open trades payable		51,627			51,741
Net increase in Federal Funds sold		(250,000		)	(1,000,000		)
Net increase in other short-term investments		(9,468		)	—
Net decrease (increase) in loans		115,992			(209,009		)
Purchases of equipment, software and leasehold improvements		(50,768		)	(20,502		)
Net cash provided by (used for) investing activities		525,227			(1,981,260		)
Cash Flows From Financing Activities:
Net increase (decrease) in demand deposits		293,252			(306,607		)
Net increase in time and savings deposits		917,236			1,123,747
Net (decrease) increase in securities sold under repurchase agreements		(669,270		)	1,017,909
Net (decrease) increase in short-term and other borrowings		(1,311,964		)	50,351
Proceeds from exercise of stock options		30,015			6,900
Proceeds from issuance of common stock		2,296			1,878
Common stock repurchase		(14		)	(70,657		)
Excess tax benefit related to share-based compensation		5,736			—
Dividends paid to stockholders		(4,433		)	(4,003		)
Net cash (used for) provided by financing activities		(737,146		)	1,819,518
Effect of exchange rates on cash		(361		)	(14		)
Net (Decrease) Increase in Cash and Due From Banks		(20,408		)	18,187
Cash and Due From Banks, Beginning of Period		79,637			49,059
Cash and Due From Banks, End of Period		$	59,229		$	67,246

See Notes to Unaudited Consolidated Financial Statements.

7

Investors Financial Services Corp.
Notes to Unaudited Consolidated Financial Statements

1.     Description of Business

Investors Financial Services Corp. (‘IFSC’) provides asset administration services for the financial services industry through its wholly-owned subsidiary, Investors Bank & Trust Company (‘the Bank’).  As used herein, the defined term “the Company” shall mean IFSC together with the Bank and its domestic and foreign subsidiaries.  The Company provides core services and value-added services to a variety of financial asset managers, including mutual fund complexes, investment advisors, family offices, hedge funds, 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.  The Company is subject to regulation by the Federal Reserve Board of Governors (‘FRB’), the Federal Deposit Insurance Corporation (‘FDIC’), the Office of the Commissioner of Banks of the Commonwealth of Massachusetts (‘Commissioner’), the Securities and Exchange Commission (‘SEC’), the National Association of Securities Dealers, Inc. (‘NASD’), the State of Vermont Department of Banking, Insurance, Securities & Health Care Administration (‘BISHCA’), the Office of the Superintendent of Financial Institutions in Canada (‘OSFI’), the Irish Financial Services Regulatory Authority (‘IFSRA’), the Cayman Islands Monetary Authority (‘CIMA’), the Financial Services Authority in the United Kingdom (‘FSA’) and the Commission de Surveillance du Secteur Financier in Luxembourg (‘CSSF’). 

2.     Interim Financial Statements

The unaudited consolidated interim financial statements of the Company as of September 30, 2006 and December 31, 2005, and for the nine-month and three-month periods ended September 30, 2006 and 2005 have been prepared by the Company pursuant to the rules and regulations of the SEC.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America (‘GAAP’) have been omitted as permitted by such rules and regulations.  All adjustments, consisting of normal recurring adjustments, necessary for their fair presentation in conformity with GAAP are included.  All significant intercompany accounts and transactions have been eliminated.  The Company’s management believes that the disclosures are adequate to present fairly the financial position, results of operations and cash flows at the dates and for the periods presented.  The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results may differ from those estimates.  It is suggested that these interim financial statements be read in conjunction with the financial statements and the notes thereto included in the Company’s latest annual report on Form 10-K.  Results for interim periods are not necessarily indicative of those to be expected for the full fiscal year. Certain amounts in prior financial statements have been reclassified to conform to the current presentation.

Securities – The Company classifies all equity securities that have readily determinable fair values and all investments in debt securities into one of three categories.  Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost.  Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and carried at fair value, with unrealized gains and losses included in earnings.  All other debt and equity securities not classified as either held to maturity or trading are classified as available for sale and carried at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Nonmarketable securities consist of stock of the Federal Home Loan Bank of Boston (‘FHLBB’) and are carried at cost and redeemable at par value.  The Company is required to hold this stock under its borrowing arrangement with the FHLBB.

An investment is considered impaired if the fair value of the investment is less than its cost.  The Company recognizes an impairment charge if, based on the facts and circumstances, management determines the impairment to be other than temporary.  For example, the Company will record an other than temporary impairment charge on a debt security if it is determined that it is probable that the Company will be unable to recover all amounts due under the contractual obligations of the security.

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.  The Company applies Statement of Financial Accounting Standards 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

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prepayments can be reasonably estimated, prepayments are anticipated using the Company’s 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, the Company assumes that prepayments will continue from the analysis date to the date of the security’s expected maturity at its most recent three-month prepayment rate.  The prepayment rate is updated monthly based on the Company’s previous three-month actual prepayment experience.

The Company utilizes three-month prepayment rates to anticipate prepayments because such rates are based on its own actual prepayment experience and because the Company believes 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 the Company’s estimated prepayments and its actual prepayments received, the constant effective yield is recalculated based on the Company’s 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 periods ended September 30, 2006, December 31, 2005 and September 30, 2005, the Company anticipated prepayments on its residential mortgage-backed securities.  All other securities do not meet the SFAS 91 criteria for anticipating prepayments.  Accordingly, no prepayments were anticipated for these securities.

Income Taxes – Income tax expense is based on estimated taxes payable or refundable on a tax return basis for the current year and the changes in deferred tax assets and liabilities during the year.  Deferred tax assets and liabilities are established for temporary differences between the accounting bases and the tax bases of the Company’s assets and liabilities at enacted tax rates expected to be in effect when the amounts related to such temporary differences are realized or settled.  If the Company determines that it is “more likely than not” that some portion or all of a deferred tax asset will not be realized, the Company records a valuation allowance in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (‘SFAS 109’).

Share-Based Compensation - On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 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.  The Company adopted SFAS 123R using the modified prospective application method.  Under that method, compensation cost for equity awards granted after January 1, 2006 is recognized over the service period based on the grant date fair value.  In addition, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of January 1, 2006 is recognized prospectively as the requisite service is rendered.  The compensation cost for that portion of awards is based on the grant date fair value of those awards as calculated under the pro forma disclosures of Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (‘SFAS 123’).  In accordance with the modified prospective application method, the financial statements of interim periods prior to the adoption of SFAS 123R have not been restated.

The following table sets forth share-based compensation cost and the related tax benefit recognized in the income statement for all of the Company’s share-based compensation plans (Dollars in thousands):

 

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Certain of the Company’s share-based awards contain terms that provide for a graded vesting schedule whereby portions of the award vest in increments over the requisite service period.  As provided for under SFAS 123R, the Company has elected to recognize compensation cost for awards granted on or after January 1, 2006 with graded vesting schedules on a straight-line basis over the requisite service period for the entire award.

Prior to adopting SFAS 123R, the Company measured compensation cost for share-based compensation plans using the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (‘APB 25’), and made pro forma disclosures of the fair value method under SFAS 123.  The intrinsic value method measures compensation cost as the amount by which the fair market value of the Company’s common stock exceeds the option exercise price on the measurement date, which is typically the date of grant.  Generally, options granted had an exercise price equivalent to the fair market value at the measurement date.  Accordingly, no compensation cost was recorded.  If share-based compensation cost were recognized using the fair value method, stock options would be valued at grant date using the Black-Scholes valuation model and the resulting compensation cost would have decreased net income as indicated below (Dollars in thousands, except per share data):

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes valuation model with the following weighted average assumptions for the nine months ended September 30, 2005:  an average assumed risk-free interest rate of 4.03%, an expected term of four years, an average expected volatility of 42.32%, and an average dividend yield of 0.20%.

For the three months ended September 30, 2005, the following assumptions were used in the Black-Scholes valuation model:  an average assumed risk-free interest rate of 4.23%, an expected term of four years, an average expected volatility of 41.21%, and an average dividend yield of 0.24%.

The amount of share-based compensation cost (net of tax) included in net income as reported for the nine months and three months ended September 30, 2005 was $0.2 million and $0.1 million, respectively.

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The following table represents the effect of changing from the intrinsic value method under APB 25 to the fair value method under SFAS 123R for the nine months and three months ended September 30, 2006, respectively (Dollars in thousands, except per share data):

 

The fair value of each option grant under the Director Plan, the Stock Plan, and the 2005 Plan (each as described further in Note 8) was estimated on the grant date using the Black-Scholes valuation model with the following weighted average assumptions for the nine months ended September 30, 2006:  an average assumed risk-free interest rate of 4.78%, an expected term of five years, an average expected volatility of 42.19%, and an average dividend yield of 0.20%.  For the three months ended September 30, 2006, the following assumptions were used in the Black-Scholes valuation model:  an average assumed risk-free interest rate of 4.83%, an expected term of five years, an average expected volatility of 41.30%, and an average dividend yield of 0.21%.

The Company bases its estimate of expected term on the historical exercise and post-vesting employment termination behavior for similar grants.  The Company’s volatility assumption is based on the historical volatility of the Company’s stock over a period equating to the expected term of the employee share option, using weekly price observations and looking backward from the date of grant.

The fair value of the option feature of grants under the 1997 Employee Stock Purchase Plan (‘ESPP’) (as described further in Note 8) was estimated on the grant date using the Black-Scholes valuation model with the following weighted average assumptions for the nine months ended September 30, 2006:  an average assumed risk-free rate of 4.79 %, an expected term of 0.5 years, an average volatility of 37.54%, and an average dividend yield of 0.23%.  For the three months ended September 30, 2006, the following assumptions were used for the fair value of the option grants under the ESPP:  an average assumed risk-free interest rate of 5.17%, an expected term of 0.5 years, an average expected volatility of 38.12%, and an average dividend yield of 0.20%.

The expected term for the ESPP is equal to the six-month payment period.  The Company estimates expected volatility for the ESPP in the same manner as for employee stock options, except that daily volatility is used instead of weekly volatility.  The Company uses daily volatility for the ESPP because weekly volatility over six months does not result in a statistically significant number of data points upon which to base the volatility calculation.

SFAS 123R also requires that any deferred compensation related to share-based awards granted prior to January 1, 2006 must be eliminated against the appropriate equity accounts.  In connection with the Company’s adoption of SFAS 123R, the presentation in the consolidated statement of stockholders’ equity for the nine months ended September 30, 2006 was revised to reflect the transfer of balances previously reported in deferred compensation to surplus.

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Earnings Per Share – Basic earnings per share (‘EPS’) were computed by dividing net income by the weighted-average number of common shares outstanding during the quarter.  Diluted EPS reflects the potential dilution that could occur if contracts to issue common stock were exercised into common stock that then shared in the earnings of the Company.  The reconciliation from Basic to Diluted EPS is as follows (Dollars in thousands, except per share data):

		For the Nine Months						For the Three Months
		Ended September 30,						Ended September 30,
		2006			2005			2006			2005
Income available to common stockholders		$	118,085		$	120,307		$	36,383		$	35,232
Basic weighted-average shares outstanding		65,727,040			66,530,636			66,067,400			66,076,656
Dilutive effect of stock options		1,859,103			1,435,857			1,750,187			934,232
Diluted weighted-average shares outstanding		67,586,143			67,966,493			67,817,587			67,010,888
Earnings per share:
Basic		$	1.80		$	1.81		$	0.55		$	0.54
Diluted		$	1.75		$	1.77		$	0.54		$	0.53

 

There were 101,313 and 79,493 options which were not considered dilutive for purposes of EPS calculations for the nine-month periods ended September 30, 2006 and 2005, respectively.  For the three-month periods ended September 30, 2006 and 2005, there were 102,533 and 1,121,058 options, respectively, which were not considered dilutive for purposes of EPS calculations.

Recently Issued Accounting Pronouncements - In June 2006, the Financial Accounting Standards Board (‘FASB’) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (‘FIN 48’).  FIN 48 establishes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Pursuant to FIN 48, the effects of a tax position are recognized in the financial statements when it is more likely than not, based on the technical merits, that the position will be sustained upon examination by the taxing authority.  Conversely, previously recognized tax positions are derecognized when it is no longer more likely than not that the tax position would be sustained upon examination.  FIN 48 also requires certain disclosures regarding unrecognized tax benefits and the amounts and classification of the related interest and penalties.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  The Company does not anticipate any material impact to its financial condition or results of operations as a result of the adoption of FIN 48.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (‘SFAS 157’).  SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands upon existing disclosures about fair value measurements.  SFAS 157 does not require any new fair value measurements.  Rather, the guidance contained in SFAS 157 applies to assets, liabilities, and certain equity instruments that are already measured at fair value under existing accounting pronouncements.  SFAS 157 is effective for fiscal years beginning after November 15, 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 157.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132R (‘SFAS 158’).  SFAS 158 changes current practice by requiring employers to recognize the overfunded or underfunded positions of defined benefit postretirement plans, including pension plans, on the balance sheet.  The funded status is defined as the difference between the projected benefit obligation and the fair value of plan assets.  SFAS 158 also requires employers to recognize the change in funded status in other comprehensive income (a component of shareholders’ equity).  SFAS 158 does not change the requirements for the measurement and recognition of pension expense in the statement of income.  SFAS 158 is effective for fiscal years ending after December 15, 2006.  The Company does not anticipate any material impact to its financial condition or results of operations as a result of the adoption of SFAS 158.

In September 2006, the SEC issued Staff Accounting Bulletin 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (‘SAB 108’).  SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year financial statement misstatements should be considered in quantifying a current year misstatement.  SAB 108 is effective for financial statements covering the first fiscal year ending after November 15, 2006.  The Company does not anticipate any material impact to its financial condition or results of operations as a result of the adoption of SAB 108.

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3.     Securities

Amortized cost amounts and fair values of securities are summarized as follows as of September 30, 2006 (Dollars in thousands):

		Amortized			Unrealized			Unrealized			Fair
Held to Maturity		Cost			Gains			(Losses)			Value
Mortgage-backed securities		$	3,889,455		$	8,402		$	(25,728	)	$	3,872,129
Federal agency securities		1,833,915			3,072			(13,113		)	1,823,874
State and political subdivisions		106,652			4,531			(86		)	111,097
Total		$	5,830,022		$	16,005		$	(38,927	)	$	5,807,100

 

		Amortized			Unrealized			Unrealized			Fair
Available for Sale		Cost			Gains			(Losses)			Value
Mortgage-backed securities		$	4,116,606		$	7,913		$	(41,121	)	$	4,083,398
State and political subdivisions		343,562			4,423			(125		)	347,860
Corporate debt		181,955			340			(1,158		)	181,137
Foreign government securities		11,021			—			(23		)	10,998
Total		$	4,653,144		$	12,676		$	(42,427	)	$	4,623,393

 

Amortized cost amounts and fair values of securities are summarized as follows as of December 31, 2005 (Dollars in thousands):

		Amortized			Unrealized			Unrealized
Held to Maturity		Cost			Gains			(Losses)			Fair Value
Mortgage-backed securities		$	4,342,254		$	11,420		$	(29,818	)	$	4,323,856
Federal agency securities		2,305,331			1,560			(23,914		)	2,282,977
State and political subdivisions		114,345			4,646			(95		)	118,896
Total		$	6,761,930		$	17,626		$	(53,827	)	$	6,725,729

 

		Amortized			Unrealized			Unrealized
Available for Sale		Cost			Gains			(Losses)			Fair Value
Mortgage-backed securities		$	3,810,797		$	3,882		$	(48,578	)	$	3,766,101
State and political subdivisions		388,789			5,515			(1,913		)	392,391
Corporate debt		201,499			736			(1,543		)	200,692
Foreign government securities		10,539			—			(3		)	10,536
Total		$	4,411,624		$	10,133		$	(52,037	)	$	4,369,720

 

During the nine-month period ended September 30, 2006, the Company sold forty-two securities classified as available for sale totaling $134.1 million using the specific identification method.  The book value of the securities was $131.6 million and resulted in a gross realized gain of $2.5 million for the nine-month period ended September 30, 2006.  The Company had no sales of securities during the three-month period ended September 30, 2006.

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During the nine-month period ended September 30, 2005, the Company sold fifty-six securities classified as available for sale totaling $293.5 million using the specific identification method.  The book value of the securities was $282.4 million resulting in a gross realized gain of $11.1 million.  During the three-month period ended September 30, 2005, the Company sold seventeen securities classified as available for sale totaling $45.1 million using the specific identification method.  The book value of the securities was $43.7 million resulting in a gross realized gain of $1.4 million.

The carrying value of securities pledged amounted to approximately $7.6 billion and $7.5 billion at September 30, 2006 and December 31, 2005, respectively.  Securities are pledged primarily to secure clearings with other depository institutions, to secure repurchase agreements and to secure outstanding FHLBB borrowings.

On a quarterly basis the Company reviews its investment portfolio on a security by security basis for any investment that may be other-than-temporarily impaired.  In its evaluation, the Company considers the length of time the security has been impaired, the severity of the impairment, the financial condition and future prospects of the issuer, and the Company’s ability and intent to hold the security to maturity or until it recovers in value.  At September 30, 2006, no securities were considered to be other-than-temporarily impaired.

4.     Loans

Loans consist of demand loans to custody clients of the Company, including individuals, not-for-profit institutions and mutual fund clients.  The loans to mutual funds and other pooled product clients include lines of credit and advances pursuant to the terms of the custody agreements between the Company and those clients to facilitate securities transactions and redemptions. Almost all of the Company’s commitments to fund loans are at variable rates.  The credit risk associated with these loans is considered low since the loans are, or may be, in the event of default, collateralized with marketable securities held by the Company as custodian.  There were no impaired loans, nonperforming loans or loans on nonaccrual status at September 30, 2006 or December 31, 2005.  In addition, there were no loan charge-offs or recoveries during the nine months ended September 30, 2006 or 2005.  Loans are summarized as follows (Dollars in thousands):

 

5.     Deposits

The following is a summary of deposit balances by type (Dollars in thousands):

 

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Time deposits with balances greater than $100,000 totaled $352.1 million and $230.1 million at September 30, 2006 and December 31, 2005, respectively.  All time deposits had a maturity of less than three months at September 30, 2006 and December 31, 2005.  The aggregate amounts of overdraft deposits that have been reclassified as loan balances were $92.6 million and $162.2 million at September 30, 2006 and December 31, 2005, respectively.

6.     Securities Sold Under Repurchase Agreements

The components of securities sold under repurchase agreements are as follows (Dollars in thousands):

 

Approximately $4.2 billion and $4.9 billion of securities were pledged to collateralize repurchase agreements as of September 30, 2006 and December 31, 2005, respectively.

7.     Short-term and Other Borrowings

The components of short-term and other borrowings are as follows (Dollars in thousands):

 

The Company has borrowing arrangements with the FHLBB and the Federal Reserve Discount Window, which have been utilized on an overnight and short-term basis to satisfy funding requirements.  Approximately $1.0 billion of securities were pledged to collateralize FHLBB advances as of both September 30, 2006 and December 31, 2005, and approximately $2.1 billion and $1.4 billion of securities were pledged to collateralize Federal Reserve Discount Window borrowings as of September 30, 2006 and December 31, 2005, respectively.

8.     Stockholders’ Equity

As of September 30, 2006, the Company’s capital stock consisted of 1,000,000 authorized shares of preferred stock, of which no shares were issued, and 175,000,000 authorized shares of common stock, of which 68,274,003 shares were issued.  All shares have a par value of $0.01 per share.

The Company has four equity incentive plans:  the Amended and Restated 1995 Stock Plan (‘Stock Plan’), the Amended and Restated 1995 Non-Employee Director Stock Option Plan (‘Director Plan’), the 1997 Employee Stock Purchase Plan (‘ESPP’) and the 2005 Equity Incentive Plan (the ‘2005 Plan’).  The 2005 Plan supersedes both the Stock Plan and the Director Plan, both of which continue in effect only with regard to options outstanding under those plans.  Options awarded under the Stock Plan, the Director Plan and the 2005 Plan generally vest over zero to four years of continuous service and generally have ten-year contractual terms.  The exercise prices of these awards are generally equal to the fair market value of the Company’s common stock on the date the awards are granted.  There were no amendments to any plans during the nine months ended September 30, 2006.

Cash received from options exercised under all share-based payment arrangements for the nine months and three months ended September 30, 2006 was $30.0 million and $5.6 million, respectively.  The actual tax benefit realized for the tax deductions related to these exercises amounted to $5.9 million and $0.7 million for the nine months and three months ended September 30, 2006, respectively.

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In June 2006, the Company announced that its Board of Directors authorized a repurchase plan of up to $150.0 million of the Company’s common stock over the twelve months following the announcement.  The plan expires in June 2007.

The Stock Plan, the Director Plan, and the 2005 Plan

Effective with the start of the 2005 Plan, 45,703 shares of the Director Plan and 3,439,197 shares of the Stock Plan were transferred to the 2005 Plan.  On April 14, 2005, the shareholders authorized an additional 2,000,000 shares of common stock for issuance under the 2005 Plan.

A summary of option activity under the Director Plan, the Stock Plan and the 2005 Plan for the nine months ended September 30, 2006, is as follows:

 

The weighted-average grant-date fair values per option of options granted during the nine months ended September 30, 2006 and 2005 were $20.13 and $15.87, respectively.  The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 were $17.8 million and $7.9 million, respectively.

As of September 30, 2006, there was $1.7 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Stock Plan, the Director Plan and the 2005 Plan.  That cost is expected to be recognized over a weighted-average period of 1 year.

A summary of the status of the Company’s nonvested shares for the nine months ended September 30, 2006 is presented below:

 

The total fair values of shares vested during the nine months ended September 30, 2006 and 2005 were $34 thousand and $0, respectively.

ESPP

Under the terms of the ESPP, the Company may issue up to 1,620,000 shares of common stock pursuant to the exercise of nontransferable options granted to participating employees.  The ESPP permits eligible employees to purchase up to 8,000 shares of common stock per payment period, subject to limitations provided by Section 423(b) of the Internal Revenue Code, through accumulated payroll deductions.  The purchases are made twice a year at a price equal to the lesser of (i) 90% of the market value of the Company’s common stock on the first business day of the payment period or (ii) 90% of the market value of the Company’s common stock on the last business day of the payment period.  The payment periods consist of two six-month periods, January 1 through June 30, and July 1 through December 31.  The NASDAQ Stock Market became a registered national securities exchange with the SEC in August 2006.  In accordance with the terms of the plan, because the Company is now traded on a national securities exchange, the Company will calculate the market value on a measurement day to be the average of the high and low prices of the Company’s common stock on that day.  This calculation method will apply to all purchases made during and after the six-month period ended December 31, 2006.

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For the six-month period ended June 30, 2006, the purchase price of stock was $33.52, or 90% of the market value of the Company’s common stock on the first business day of the payment period ending June 30, 2006.

During the year ended December 31, 2005, the purchase prices of the stock were $34.25 and $33.25, or 90% of the market value of the Company’s common stock on the last business day of the payment periods ending June 30, 2005 and December 31, 2005, respectively.

A summary of activity under the ESPP is as follows:

 

Prior to the adoption of SFAS 123R, the ESPP was considered a non-compensatory plan and, therefore, no compensation cost was recognized.  However, pursuant to SFAS 123R, the ESPP is considered a compensatory plan, effective January 1, 2006.  Accordingly, compensation cost is computed as the sum of:  (a) 10% of the fair market value of the Company’s common stock on the first day of the purchase period and (b) the fair value of the option feature, calculated using the Black-Scholes valuation model.  Compensation cost is recognized ratably over the payment period based on the components of fair value in the preceding sentence and the number of shares that could be purchased at grant date based on the estimated total withholdings and the discounted market price of the stock on grant date.  The weighted-average grant-date fair value of awards granted under the ESPP was $7.86 per share for the payment period from January 1, 2006 through June 30, 2006 and $9.86 per share during the first half of the payment period from July 1, 2006 through December 31, 2006.

Compensation cost related to the ESPP was $0.9 million and $0.3 million for the nine months and three months ended September 30, 2006, respectively.  Compensation cost related to the ESPP was $0 for both the nine months and three months ended September 30, 2005.  As of September 30, 2006, there was $0.3 million of total unrecognized compensation cost related to the nonvested awards granted under the ESPP.

9.     Employee Benefit Plans

Pension Plan - The Company has a trusteed, noncontributory, qualified defined benefit pension plan (‘Pension Plan’) covering substantially all of its employees who were hired before January 1, 1997.  The benefits are based on years of service and the employee’s compensation during employment.  Generally, the Company’s funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes.  Contributions are intended to provide not only for benefits attributed to service to date, but also for benefits expected to be earned in the future.  The plan document was amended in December 2001 and December 2004 to freeze benefit accruals for certain highly compensated participants.  Effective January 1, 2006, no further Pension Plan benefit will accrue on behalf of any Pension Plan participant, and effective December 31, 2005, all Pension Plan participant’s accounts were frozen.  The Company uses a December 31 measurement date for this plan.

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Net periodic pension cost for the Company’s Pension Plan included the following components (Dollars in thousands):

 

The Company does not expect to contribute to its Pension Plan during 2006, and no contributions were made during the nine-month period ended September 30, 2006.

Supplemental Retirement Plan - The Company also has a nonqualified, unfunded, supplemental retirement plan (‘SERP’) which was established in 1994 and covers certain employees and pays benefits that supplement any benefits paid under the Pension Plan.  Benefits under the SERP are generally based on compensation not includable in the calculation of benefits to be paid under the Pension Plan.  The plan document was amended in April 2000 to eliminate the compensation cap and include bonuses and commissions of certain employees.  The Company uses a December 31 measurement date for this plan.

Net periodic pension cost for the Company’s SERP included the following components (Dollars in thousands):

 

As of September 30, 2006, the Company has contributed $0.5 million to the SERP, and the SERP has distributed $0.5 million to its plan participants.  The Company does not anticipate making any contributions during the remainder of 2006.

10.  Off-Balance Sheet Financial Instruments

Lines of Credit - At September 30, 2006, the Company had commitments to mutual funds, individuals and others under collateralized open lines of credit totaling $1.2 billion, against which $193.8 million in loans were drawn.  The credit risk involved in issuing lines of credit is essentially the same as that involved in extending demand loans.  The Company does not anticipate any loss as a result of these lines of credit.

Securities Lending - On behalf of its clients, the Company lends securities to creditworthy broker-dealers.  In certain circumstances, the Company may indemnify its clients for the fair market value of those securities against a failure of the borrower to return such securities.  The Company requires the borrowers to provide collateral in an amount equal to, or in excess of, 102% of the fair market value of U.S. dollar-denominated securities borrowed and 105% of the fair market value of non-U.S. dollar-denominated securities borrowed.  The borrowed securities are revalued daily to determine whether additional collateral is necessary.  As guarantor, the Company is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee.  The Company measures the fair value of its indemnification obligation by marking its securities lending portfolio to market on a daily basis and comparing the value of the portfolio to the collateral holdings position.  The fair value of the indemnification obligation to be recorded would be the deficiency of collateral as compared to the value of the securities out on loan.

With respect to the indemnified securities lending portfolio, the cash and U.S. government securities held by the Company as collateral at September 30, 2006 totaled $9.3 billion, while the fair value of the indemnified securities lending portfolio totaled approximately $8.9 billion.  Given that the collateral held was in excess of the value of the securities that the Company would be required to replace if the borrower defaulted and failed to return such securities, the Company’s indemnification obligation was zero and no liability was recorded.

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All securities loans are categorized as overnight loans.  The maximum potential amount of future payments that the Company could be required to make would be equal to the market value of the securities borrowed.  Since the securities loans are over collateralized by 2% (for U.S. dollar-denominated securities) to 5% (for non-U.S. dollar-denominated securities) of the fair market value of the loan made, the collateral held by the Company would be used to satisfy the obligation.  In addition, each borrowing agreement includes “set-off” language that allows the Company to use any excess collateral on other loans to that borrower to cover any collateral shortfall of that borrower.  However, there is a potential risk that the collateral would not be sufficient to cover such an obligation if the security on loan increased in value between the time the borrower defaulted and the time the security is “bought-in”.  In those instances, the Company would “buy-in” the security using all available collateral and a loss would result from the difference between the value of the security “bought-in” and the value of the collateral held.  The Company has never experienced a broker default.

11.  Derivative Financial Instruments

Interest Rate Contracts - Interest rate contracts involve an agreement with a counterparty to exchange cash flows based on an underlying interest rate index.  A swap agreement involves the exchange of a series of interest payments, either at a fixed or variable-rate, based upon the notional amount without the exchange of the underlying principal amount.  The Company’s exposure from these interest rate contracts results from the possibility that one party may default on its contractual obligation when the contracts are in a gain position.  The Company has experienced no terminations by counterparties of interest rate swaps.  Credit risk is limited to the positive fair value of the derivative financial instrument, which is significantly less than the notional value.  As of September 30, 2006, the positive fair value related to the Company’s interest rate contracts was approximately $17.9 million, which is included in other assets on the Company’s consolidated balance sheet.

The Company enters into pay-fixed/receive-floating interest rate swap agreements.  These instruments have been designated as cash flow hedges of variable-rate liabilities and a forecasted series of fixed-rate overnight liabilities incurred at different daily fixed rates (thereby resulting in a variable interest expense pattern).  The contractual or notional amounts of the interest rate swap agreements held by the Company were approximately $1.7 billion at September 30, 2006 and $1.9 billion at December 31, 2005.  These contracts had net fair values of approximately $17.6 million and $24.2 million at September 30, 2006 and December 31, 2005, respectively.  These fair values are included in the respective other assets and other liabilities categories on the Company’s consolidated balance sheets.

For the nine months and three months ended September 30, 2006, the Company recognized net pre-tax losses of $0.8 million and $0.7 million, respectively, which represented the total ineffectiveness for all cash flow hedges.  For the nine months and three months ended September 30, 2005, total ineffectiveness related to cash flow hedges resulted in net pre-tax gains of $3.3 million and $0.4 million, respectively.

As of September 30, 2006, the Company expects that approximately $7.4 million of deferred net after-tax gains on derivative contracts included in other comprehensive income will be reclassified to net interest income within the next twelve months. This expectation is based on the net discounted cash flows from existing cash flow hedging derivatives, as well as the amortization of gains from the terminated cash flow hedging derivatives.

Foreign Exchange Contracts - Foreign exchange contracts involve an agreement to exchange the currency of one country for the currency of another country at an agreed-upon rate and settlement date.  Foreign exchange contracts consist of spot, forward and swap contracts.  Spot contracts call for the exchange of one currency for another and usually settle in two business days.  Forward contracts call for the exchange of one currency for another at a date beyond spot.  In a currency swap, the holder of a currency transacts simultaneously both a spot and a forward transaction in that currency for an equivalent amount of another currency to get temporary liquidity in the currency owned.  The Company’s risk from foreign exchange contracts results from the possibility that one party may default on its contractual obligation or from movements in exchange rates. Credit risk is limited to the positive market value of the derivative financial instrument, which is significantly less than the notional value.  The notional value of the Company’s foreign exchange contracts at September 30, 2006 and December 31, 2005 was $10.2 billion and $6.3 billion, respectively.  Unrealized gains or losses resulting from purchases and sales of foreign exchange contracts are included within the respective other assets and other liabilities categories on the Company’s consolidated balance sheets.  Unrealized gains in other assets were $15.4 million and $20.8 million at September 30, 2006 and December 31, 2005, respectively.  Unrealized losses in other liabilities were $13.9 million and $19.7 million at September 30, 2006 and December 31, 2005, respectively.  Foreign exchange contracts with the same counterparty are netted in the Company’s consolidated balance sheets when a master netting agreement exists.  These contracts have not been designated as hedging instruments; therefore, all changes in fair value are included in asset servicing fees.

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Other - The Company also enters into fixed price purchase contracts that are designed to hedge the variability of the consideration to be paid for the purchase of investment securities.  By entering into these contracts, the Company is fixing the price to be paid at a future date for certain investment securities.  At September 30, 2006, the Company had no fixed price purchase contracts outstanding to purchase investment securities.  At December 31, 2005, the Company had $97.5 million of fixed price purchase contracts outstanding to purchase investment securities.  Changes in fair value of these cash flow hedges are included as a component of other comprehensive income.

12.  Commitments and Contingencies

Restrictions on Cash Balances - The Company is required to maintain certain average cash reserve balances.  The average required reserve balance with the FRB for the two-week period including September 30, 2006 was approximately $29.0 million.  In addition, the Company’s consolidated balance sheet includes deposits totaling $46.0 million, which were pledged to secure clearings with depository institutions as of September 30, 2006.

Contingencies - Assets held by the Company in a fiduciary capacity are not included in the consolidated balance sheets since these items are not assets of the Company.  Management conducts regular reviews of its fiduciary responsibilities and considers the results in preparing its consolidated financial statements.  In the opinion of management, there were no contingent liabilities related to its fiduciary capacity at September 30, 2006 that were material to the consolidated financial position or consolidated results of operations of the Company.

On June 27, 2003, the Company and an individual employee of the Company were named in a lawsuit alleging, among other things, that the Company breached an implied covenant of good faith and fair dealing in a subadvisory contract with Opus Investment Management, Inc. and that the individual employee of the Company engaged in a breach of fiduciary duties and tortuous interference with a contract.  The lawsuit was filed in the Superior Court of Worcester, Massachusetts and sought unspecified damages.  In October 2006, the parties settled the lawsuit.  Included in other liabilities in the Company’s consolidated balance sheet at September 30, 2006 and in other operating expenses in the Company’s consolidated statement of income for the nine months ended September 30, 2006 is approximately $1.8 million for settlement costs, legal fees and administrative costs related to the settlement.

13.  Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.  The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined).  Management believes, as of September 30, 2006, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

Our most recent notification from the Federal Deposit Insurance Corporation categorized the Company and the Bank as well-capitalized under the regulatory framework for prompt corrective action.  To be categorized as well-capitalized, the Company and the Bank must maintain minimum Total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table.  There are no conditions or events since that notification that management believes have changed the Company’s or the Bank’s category.

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