UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

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

 

For the fiscal year ended December 31, 2005

 

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

 

For the transition period from                                      to                                                   

 

Commission File Number: 000-25081

 

VAIL BANKS, INC.

(Exact name of registrant as specified in its charter)

 

 

0015 Benchmark Road, Suite 300, P.O. Box 6580, Avon, Colorado 81620

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:  (970) 476-2002

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act: Common shares, $1.00 par value per share.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

o Yes            ý No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

o Yes            ý No

 

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.

ý Yes             o No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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.

 

o Large accelerated filer                                                             o Accelerated Filer                                                                                       ý Non-accelerated filer

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

o Yes            ý No

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter:  As of June 30, 2005, 3,284,834 common shares, $1.00 par value, were issued and outstanding with an aggregate value of $48,089,970 held by non-affiliates (based on market value of $14.64 per share) (computed by reference to the price at which the common shares were sold.)

 

Indicate the number of shares outstanding of each of the registrant’s classes of common shares, as of the latest practicable date: As of March 27, 2006, there were issued and outstanding 5,606,235 common shares.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held May 15, 2006, are incorporated by reference into Part III.

 

 

VAIL BANKS, INC.

 

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2005

 

TABLE OF CONTENTS

 

PART I
ITEM 1.	BUSINESS
General
Community Banking Philosophy
Key Strategies
Segment Information
Products and Services
Competition
Administration of WestStar
Technology
Associates
Supervision and Regulation
Executive Officers and Non-Executive Chairman of Vail Banks
ITEM 1A.	RISK FACTORS
ITEM 1B.	UNRESOLVED STAFF COMMENTS
ITEM 2.	PROPERTIES
ITEM 3.	LEGAL PROCEEDINGS
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
PART II
ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Holders
Dividends
ITEM 6.	SELECTED FINANCIAL DATA
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Introduction
Critical Accounting Policies and Estimates
Certain Factors Affecting Forward-Looking Statements
Financial Overview
Results of Operations
Financial Condition
Related Party Transactions
Liquidity and Interest Rate Sensitivity
Capital Resources
Impact of New Financial Accounting Standards
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Quantitative Disclosures About Market Risk
Qualitative Disclosures About Market Risk

 

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ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
ITEM 9A.	CONTROLS AND PROCEDURES
ITEM 9B.	OTHER INFORMATION
PART III
ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11.	EXECUTIVE COMPENSATION
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES
ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES
FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
Report of Independent Certified Public Accounting Firm
Consolidated Balance Sheet
Consolidated Statement of Income
Consolidated Statement of Shareholders’ Equity and Comprehensive Income
Consolidated Statement of Cash Flows
SIGNATURES

 

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PART I

 

ITEM 1. BUSINESS.

 

General

 

Vail Banks, Inc. (Vail Banks) is a bank holding company headquartered in Avon, Colorado with consolidated assets of $686.3 million at December 31, 2005. The accompanying consolidated financial statements include the accounts of Vail Banks and its wholly-owned subsidiary, WestStar Bank (WestStar). WestStar and Vail Banks own a combined 54.04% interest in Avon 56 Limited and 74.94% of Glenwood/Rose L.P. Both Avon 56 Limited and Glenwood/Rose L.P. are real estate partnerships. All entities are collectively referred to as the Company. All significant intercompany balances and transactions have been eliminated in consolidation. The Company’s two trusts that had been previously consolidated with the Company are reported separately.

 

WestStar is a Colorado state bank with 24 retail offices located primarily in the “Western Slope” and “Front Range” regions of Colorado. It was formed in 1977 as a community bank to serve the local residents and businesses of Vail. In 1993, Vail Banks was formed as a bank holding company for WestStar. Since that time, Vail Banks has grown through a combination of organic growth, de novo establishment of retail offices and external growth, including the acquisition of community banks. Vail Banks has maintained WestStar’s position as an institution offering a relatively broad range of convenient banking services delivered with personalized customer service.

 

The “Western Slope,” includes Summit County (which includes the Breckenridge, Keystone and Copper Mountain ski resorts), Grand County (which includes the Winter Park ski resort), Eagle County (which includes the Vail and Beaver Creek ski resorts), Delta County, Garfield County, Pitkin County (which includes the Aspen and Snowmass ski resorts), Mesa County, Montrose County, and San Miguel County (which includes the ski resort of Telluride). The “Front Range” includes Denver and Estes Park. These areas of Colorado are home to a variety of commercial, recreational, entertainment, and cultural enterprises.

 

The Western Slope has experienced growth in past years, primarily as a result of an expanding market for first and second homes, and summer and winter tourism. As the year-round population of this region has grown, local businesses have prospered by servicing this growth. Consequently, a large portion of Vail Banks’ business is in construction lending and providing banking services for small-to-medium size businesses in its markets.

 

Vail Banks’ growth has been designed to maintain customer loyalty through continuity of operations and associates. Historically, shareholders of entities merged into Vail Banks, who are typically members of the local community, have elected to hold ownership stakes in Vail Banks after the merger. The additions of Bank of Telluride (founded in 1969), Western Colorado Bank (founded in 1950), Glenwood Independent Bank (founded in 1955) and United Valley Bank (founded in 1908) expanded Vail Banks’ presence in the Western Slope and Front Range markets, as these were well-established community banks that had significant local sponsorship. Several directors of the Company, as well as both its Non-Executive Chairman and Vice Chairman, have been associated with WestStar for more than fifteen years.

 

On January 1, 2000, the Company acquired a retail mortgage lending company, First Western Mortgage Services, Inc. (First Western), as a wholly-owned subsidiary. On December 1, 2000 the Company acquired the assets of East West Mortgage, Inc. and contributed those assets to First Western. On August 1, 2004, First Western was merged into WestStar. The merger did not have an impact on the consolidated financial condition or results of operations of the Company as First Western was previously owned 100% by WestStar and was included in the consolidated financial statements of the Company. The mortgage operation offers an array of mortgage products and earns revenues through the origination and processing of mortgages prior to selling them to investors.

 

In 2005, the Company opened a new branch in Fruita, just west of Grand Junction, to further expand its presence in this growing market.

 

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Community Banking Philosophy

 

WestStar provides a broad range of banking products and services to consumers and businesses in all of its retail offices. Retail offices are operated with the goal of offering individualized customer service and providing a complete range of financial services. Many administrative operations, such as data processing, loan administration, account reconciliation and maintenance, accounting, retail operations, internal audit, compliance and broad policy decisions are centralized to ensure consistency, accuracy and efficiency and to allow our associates to concentrate on serving our customers. The managers and associates of each retail office focus on day-to-day service excellence, business development, selling, loan origination and portfolio management. Management of Vail Banks believes that this organizational structure allows retail offices to offer the individualized customer service of a community bank while maximizing the benefits of technological expertise, operating synergies and other administrative cost savings and efficiencies.

 

Management is committed to investing in its communities. Executive officers and regional presidents live in the communities served by their retail offices, and Vail Banks encourages board members and Company associates to be actively involved in civic and public service activities in their communities.

 

Key Strategies

 

Vail Banks intends to enhance and solidify its position as a major provider of banking services for individuals and small-to-medium size businesses on the Western Slope and the Front Range. The Company intends to grow in the future primarily through expansion of its existing market share and de novo establishment of retail offices. From December 1995 to December 2005, Vail Banks completed eight mergers and acquisitions.

 

Expansion of Existing Market Share.  Vail Banks intends to increase its overall market share in its markets by solidifying relationships with current customers and attracting new customers who desire a local banking relationship. Management believes that this can be accomplished by (1) evaluating the needs of its existing and potential customers to determine ways to enhance services and products, (2) increasing the focus on sales training and customer retention, (3) providing personalized customer service, and (4) further implementing technological advances to make banking more efficient and convenient.

 

De Novo Establishment of Retail Offices.  Vail Banks intends to continue to expand by opening new retail offices. Management believes that initially establishing a small presence in growing communities positions Vail Banks to expand with the community, thereby fostering a local identity with existing businesses and consumers in these communities, as well as offering new customers a local alternative.  Management has committed to establishing additional banking locations to expand its presence in the Front Range and Telluride markets. Such offices will be opened as market opportunities and availability of banking talent permit.

 

Mergers and Acquisitions.  Vail Banks’ merger and acquisition strategy will be a secondary approach for growth opportunities. In assessing future mergers, Vail Banks will focus primarily on credit quality, financial performance, market share, management, location, community demographics, strength of the local economy, potential merger synergies and the terms of the transaction. Management believes that merging with established banks and then methodically integrating their operations into Vail Banks allows the Company to offer its broad range of products and services while maintaining the merged bank’s reputation and community ties. Vail Banks’ strategy is to streamline operations judiciously to optimize the balance between cost savings and minimizing the interruption of community-based services of the acquired bank.

 

Segment Information

 

Segment information is presented in accordance with Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information. This standard is based on a management approach that requires segmentation based on the Company’s internal organization and internal monitoring of operations. During 2004 and 2003, the Company had two reportable segments, banking and mortgage origination. Commencing in August 2004, management directed a reorganization of the mortgage activities of the Company. This resulted in such activities no longer being an operating segment of the Company. See Notes 2 and 25 of “Notes to Consolidated Financial Statements” contained in Item 15 of this Annual Report on Form 10-K for additional information.

 

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Products and Services

 

WestStar serves the banking needs of its business and consumer customers by providing a broad range of commercial and consumer banking products and services in all of its communities. These products and services include short-term and medium-term loans, revolving credit facilities, accounts receivable financing, equipment financing, short-term commercial mortgage lending and mortgage broker services, installment loans, home equity loans, home improvement loans, short-term loans for the purchase or refinancing of principal residences or second homes, personal banking through internet and telephone access, safe deposit box services and various savings accounts, money market accounts, time certificates of deposit and checking accounts, automated teller machines, depository services, corporate cash management services and repurchase agreements. WestStar also originates mortgage loans and sells them to investors in the secondary market.

 

Lending.  WestStar offers loans for business and consumer purposes and focuses its lending activities on individuals and small-to-medium size businesses. Lending activities are funded primarily from deposits gathered in the local communities. Loan products are concentrated in relatively short-term, variable rate loans, with 44% of the loans at December 31, 2005 having remaining terms of less than one year. Collateral for loans is concentrated in real estate and operating business assets. WestStar also offers an array of residential mortgage products.

 

Deposits.  WestStar offers a broad range of depository products including checking, savings and money market accounts, and certificates of deposit. Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to statutory limits. Within ranges set by policies determined by WestStar’s executive management, regional presidents have local authority to determine the type, mix and pricing of the depository products offered to best compete in a retail office’s particular marketplace.

 

Other Services.  WestStar offers its customers the flexibility of monitoring their loan and deposit account activity and conducting some banking transactions, including on-line bill pay and the receipt of electronic statements 24 hours a day from their homes or businesses via www.weststarbank.com on the Internet. Additionally, telephone access allows customers to receive current account balances, deposit status, checks paid, withdrawals made, loan status, loan amounts due and other specifics relating to services provided by WestStar.

 

As of March 7, 2006, WestStar had 22 automated teller machines, 17 that were located at WestStar’s retail offices and 5 at other locations.

 

Competition

 

WestStar is in a highly competitive industry and faces strong competition from larger financial institutions. See “Item 1A Risk Factors — Risks Related to Our Business” for additional information on WestStar’s competition.

 

Administration of WestStar

 

The retail offices are customer-focused. Regional presidents operate with significant customer service-oriented local autonomy within policies established by WestStar’s Board of Directors in providing financial services, making lending decisions, selling products and presenting a favorable impression of WestStar to the community in order to attract new customers and retain existing ones.

 

Administrative services, oversight and support to the retail offices, including data processing, accounting services, investments, credit policy formulation, loan administration, a customer service center, Internet banking support, other customer service assistance, and audit and compliance review are centralized at the Vail Banks’ administrative center in Gypsum, Colorado. Also, our proof and balancing services are centrally located at our Broadway branch in Denver to better capture float efficiency with our correspondent banks.

 

Management believes that by standardizing products, services and systems, and providing appropriate centralized support, retail office associates can concentrate on customer service and community relations. Management also believes that continued centralization of services benefits the individual retail offices by lowering expenses of administration and data processing services, streamlining credit administration and supervision, and facilitating compliance with the requirements of complex banking regulations. Vail Banks believes that autonomy at the retail office level allows its banking subsidiary to better serve customers in their respective communities, and thus enhances business opportunities and operations.

 

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Technology

 

Vail Banks’ use of advanced technology enables it to offer customers fast, efficient services and connects all of WestStar’s associates with on-line access to information concerning customer account data. Vail Banks offers its customers a choice of truncated, imaged or electronic statements. The Company also utilizes current technology to eliminate paper flow by capturing customer signatures electronically and imaging new account documentation instantaneously. Customers are able to access account information and initiate transactions via the Internet or by phone using advanced on-line and voice response unit systems. Additionally, the Company’s enhanced imaging system allows, via a data network, instant access at all retail offices to customer statements, transactions, customer signature cards, loan files and other data. The Company continually researches the most recent hardware and software applications available and ensures Vail Banks’ technology is among the most advanced for banks of its size in Colorado and provides it with the resources to continue to offer leading-edge services to customers.

 

Associates

 

As of February 28, 2006, the Company employed 260 persons, 258 on a full-time basis and 2 on a part-time basis. The Company is not a party to any collective bargaining agreement, and believes that its employee relations are good.

 

Supervision and Regulation

 

The following discussion of statutes and regulations affecting bank holding companies and banks is a summary thereof and is qualified in its entirety by reference to such statutes and regulations. This explanation does not purport to describe state, federal or NASDAQ National Market supervision and regulation of general business corporations or NASDAQ listed companies.

 

General. Vail Banks is a registered bank holding company subject to regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the Act). Vail Banks is required to file financial information with the Federal Reserve periodically and is subject to periodic examination by the Federal Reserve.

 

The Act requires every bank holding company to obtain the Federal Reserve’s prior approval before (1) it may acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank that it does not already control; (2) it or any of its non-bank subsidiaries may acquire all or substantially all of the assets of a bank; and (3) it may merge or consolidate with any other bank holding company. In addition, a bank holding company is generally prohibited from engaging in, or acquiring, direct or indirect control of the voting shares of any company engaged in non-banking activities. This prohibition does not apply to activities listed in the Act or found by the Federal Reserve, by order or regulation, to be closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the activities that the Federal Reserve has determined by regulation or order to be closely related to banking include:

 

•                  making or servicing loans and certain types of leases;

•                  performing certain data processing services;

•                  acting as fiduciary or investment or financial advisor;

•                  providing brokerage services;

•                  underwriting bank eligible securities;

•                  underwriting debt and equity securities on a limited basis through separately capitalized subsidiaries; and

•                  making investments in corporations or projects designed primarily to promote community welfare.

 

Although the activities of bank holding companies have traditionally been limited to the business of banking and activities closely related or incidental to banking, the Gramm-Leach-Bliley Act (the GLB Act) relaxed the previous limitations, permitting bank holding companies to engage in a broader range of financial activities. Specifically, bank holding companies may now elect to become financial holding companies that may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Among the activities that are deemed “financial in nature” are:

 

•                  lending, exchanging, transferring, investing for others or safeguarding money or securities;

•                  insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker with respect thereto;

 

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•                  providing financial, investment, or economic advisory services, including advising an investment company;

•                  issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly; and

•                  underwriting, dealing in or making a market in securities.

 

A bank holding company may become a financial holding company under this statute only if each of its subsidiary banks is well capitalized, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. A bank holding company that falls out of compliance with such requirements may be required to cease engaging in certain activities. Any bank holding company that does not elect to become a financial holding company remains subject to the current restrictions of the Act.

 

Under the GLB Act, the Federal Reserve Board serves as the primary “umbrella” regulator of financial holding companies with supervisory authority over each parent company and limited authority over its subsidiaries. The primary regulator of each subsidiary of a financial holding company will depend on the type of activity conducted by the subsidiary. For example, broker-dealer subsidiaries will be regulated largely by securities regulators and insurance subsidiaries will be regulated largely by insurance authorities.

 

Vail Banks has no immediate plans to become a financial holding company.

 

The Sarbanes-Oxley Act of 2002 was adopted to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to securities laws. The Sarbanes-Oxley Act includes additional disclosure requirements and new corporate governance rules, requires the Securities and Exchange Commission (SEC) and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between the board of directors and committees. The SEC extended the compliance deadline for non-accelerated filers to the first fiscal year ending on or after July 15, 2007. This is a two-year extension from the previously established July 15, 2005, compliance date for non-accelerated filers.

 

On October 28, 2004, President Bush signed into law the Check Clearing for the 21^st Century Act (Check 21). Check 21 is intended to improve the efficiency and security of the nation’s payment system. Financial institutions will have the option of processing images of checks rather than transporting the original check. WestStar has been utilizing check images for years and is currently evaluating further implementation of Check 21.

 

Vail Banks must also register with the Colorado Division of Banking (CDB) and file periodic information with the CDB. As part of such registration, the CDB requires information with respect to, among other matters, the financial condition, operations, management and intercompany relationships of Vail Banks and its subsidiary. The CDB may also require such other information as is necessary to ascertain whether the provisions of Colorado law and the regulations and orders issued thereunder by the CDB have been complied with, and the CDB may examine Vail Banks and its subsidiary.

 

Vail Banks is an “affiliate” of its banking subsidiary under the Federal Reserve Act, which imposes certain restrictions on (1) loans by WestStar to Vail Banks, (2) investments in the stock or securities of Vail Banks by its banking subsidiary, (3) its banking subsidiary’s taking the stock or securities of an “affiliate” as collateral for loans by it to a borrower, and (4) the purchase of assets from Vail Banks by its banking subsidiary. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

 

WestStar is a member of the Federal Reserve System and is subject to the supervision of and is regularly examined by the Federal Reserve. Furthermore, WestStar, as a state banking association organized under Colorado law, is subject to the supervision of, and is regularly examined by, the CDB. Both the Federal Reserve and the CDB must grant prior approval of any merger, consolidation or other corporate reorganization involving WestStar. A bank can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of a commonly controlled institution.

 

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Payment of Dividends. Vail Banks is a legal entity separate and distinct from WestStar. Most of the revenues of Vail Banks result from dividends paid to it by WestStar. There are statutory and regulatory requirements applicable to the payment of dividends by WestStar, as well as by Vail Banks to its shareholders.

 

Under the regulations of the CDB and the Federal Reserve, approval of the regulators will be required if the total of all dividends declared by WestStar in any calendar year exceed the total of its net profits of that year combined with its retained net profits of the preceding two years, less any required transfers to surplus or fund for the retirement of any preferred stock.

 

The payment of dividends by Vail Banks and WestStar may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. In addition, if, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending upon the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. Capital adequacy considerations could further limit the availability of dividends. Due to the volume of dividends paid relative to earnings in earlier years, any dividend payments from WestStar to Vail Banks required prior regulatory approval through December 31, 2005. On September 9, 2005, approval was obtained from the Federal Reserve Bank of Kansas City and on September 20, 2005 from the State of Colorado, for a $4.0 million dividend to be paid from WestStar to Vail Banks. On October 18, 2005, a $2.0 million dividend payment was made to Vail Banks from WestStar. Commencing January 1, 2006, WestStar no longer requires regulatory approval for a dividend payment from WestStar to Vail Banks.

 

Monetary Policy. The results of operations of WestStar are affected by credit policies of monetary authorities, particularly the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of Vail Banks’ banking subsidiary.

 

Capital Adequacy. The Federal Reserve and the FDIC have implemented substantially identical risk-based rules for assessing bank and bank holding company capital adequacy. These regulations establish minimum capital standards in relation to assets and off-balance sheet exposures as adjusted for credit risk. Banks and bank holding companies are required to have (1) a minimum level of total capital (as defined) to risk-weighted assets of 8%; (2) a minimum Tier 1 capital (as defined below) to risk-weighted assets of 4%; and (3) a minimum shareholders’ equity to risk-weighted assets of 4%. In addition, the Federal Reserve and the FDIC have established a minimum 4% leverage ratio (Tier 1 capital to average assets) for all but the most highly rated banks and bank holding companies. “Tier 1 capital” generally consists of common equity not including unrecognized gains and losses on securities, minority interests in equity accounts of consolidated subsidiaries and certain perpetual preferred stock, less certain intangibles. The Federal Reserve and the FDIC use the leverage ratio in tandem with the risk-based ratio to assess the capital adequacy of banks and bank holding companies. The FDIC’s and the Federal Reserve’s capital adequacy standards also provide for the consideration of interest rate risk in the overall determination of a bank’s capital ratio, requiring banks with greater interest rate risk to maintain greater capital for the risk.

 

In addition, the FDIC regulations and Federal Reserve “prompt corrective action” provisions, designed to efficiently resolve failing financial institutions, set forth five regulatory zones in which all banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s capital leverage ratio reaches 2%. Better-capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser capital ratios.

 

The FDIC and the Federal Reserve regulations requiring implementation of “prompt corrective action” place financial institutions in the following five categories based on capitalization ratios (1) a “well capitalized” institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a leverage ratio of at least 5%; (2) an “adequately capitalized” institution has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a leverage ratio of at least 4%; (3) an “undercapitalized” institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based capital ratio of under 3% or a leverage ratio of under 3%; and (5) a “critically undercapitalized” institution has a leverage ratio of 2% or less. Institutions in any of the three undercapitalized categories are prohibited from declaring dividends or making capital distributions without regulatory

 

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approval. The Federal Reserve regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital.

 

Under the Federal Reserve’s regulations, both Vail Banks and WestStar met all capital adequacy requirements to which they were subject at December 31, 2005. Vail Banks had Tier 1 and total risk-based capital ratios of 9.58% and 10.91%, respectively, and a leverage ratio of 8.05%. WestStar was deemed to be “well capitalized” with Tier 1 and total risk-based capital ratios of 9.61% and 10.44%, respectively, and a leverage ratio of 8.06%. For further information, see “Notes to Consolidated Financial Statements—Note 20” contained in Item 15 of this Annual Report on Form 10-K.

 

Loans. Inter-agency guidelines adopted by federal bank regulators mandate that financial institutions establish real estate lending policies with maximum allowable real estate loan-to-value limits, subject to an allowable amount of non-conforming loans as a percentage of capital. WestStar adopted the federal guidelines as its maximum allowable limits; however, policy exceptions are permitted, with justification, for real estate loan customers.

 

Transactions with Affiliates. Under federal law, all transactions between and among Federal Reserve member banks and its affiliates, which include holding companies, are subject to Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder. Generally, these requirements limit these transactions to a percentage of the bank’s capital and require all of them to be on terms at least as favorable to the bank as transactions with non-affiliates. In addition, a bank may not lend to any affiliate engaged in non-banking activities not permissible for a bank holding company or acquire shares of any affiliate that is not a subsidiary. The Federal Reserve may impose additional restrictions on transactions with affiliates if necessary to protect the safety and soundness of a bank. The regulations also set forth various reporting requirements relating to transactions with affiliates.

 

Financial Privacy. In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

 

Anti-Money Laundering Initiatives and the USA Patriot Act. A major focus of governmental policy on financial institutions in recent years has been aimed at combating terrorist financing. This has generally been accomplished by amending existing anti-money laundering laws and regulations. The USA Patriot Act of 2001 (the USA Patriot Act) imposed significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued a number of implementing regulations that apply the requirements of the USA Patriot Act to the Company. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution. Compliance with the USA Patriot Act requires WestStar to engage in additional record keeping and reporting, to obtain identification of account owners and to restrict or prohibit certain correspondent accounts.

 

Executive Officers and Non-Executive Chairman of Vail Banks

 

Certain information regarding the executive officers and Non-Executive Chairman of the Company is set forth in the following table and paragraphs.

 

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Name		Age		Position
E.B. Chester, Jr.		63		Non-Executive Chairman of the Board
Lisa M. Dillon		52		Vice Chairman of the Board
Gary S. Judd		65		President and Chief Executive Officer
Raymond E. Verlinde		43		Senior Executive Vice President and Chief Administrative Officer
Dan E. Godec		50		President and Chief Executive Officer of WestStar
Paul M. Ferguson		52		Senior Executive Vice President and Chief Credit Officer of WestStar
Brady T. Burt		33		Executive Vice President and Chief Financial Officer

 

Mr. Chester has served as Chairman of the Board of Directors of Vail Banks since 1993 and the Chairman of the Board of Directors of WestStar since 1989. From May 2003 to January 2004, Mr. Chester served as Interim Chief Executive Officer of the Company. Mr. Chester became the Non-Executive Chairman in December 2004.

 

Ms. Dillon has served as Vice Chairman of Vail Banks since July 2000. Ms. Dillon began working with WestStar in 1979, served as President of Vail Banks from 1993 until January 2004, President of WestStar from 1989 to 1999 and has served as a director of WestStar since 1989.

 

Mr. Judd became a director of Vail Banks in May 2003. He was elected as President and Chief Executive Officer of Vail Banks in January 2004, and previously served as a Division President and President, Regional Operations, of WestStar since May 2003. Mr. Judd co-founded Vectra Bank in Colorado in 1989 and served as its President until January 2000. From 2000 to 2002, Mr. Judd was President and Chief Executive Officer of Metyor, Inc. Mr. Judd also spent 16 years with Citibank, N.A. in management positions in the United States and overseas.

 

Mr. Verlinde has served as the Senior Executive Vice President and Chief Administrative Officer of WestStar Bank since August of 2004 and Senior Executive Vice President and Chief Administrative Officer of Vail Banks since June 2005. Mr. Verlinde was the acting Principal Financial and Accounting Officer for Vail Banks from August 2004 to June 2005. Mr. Verlinde initially joined WestStar Bank in March 2002 as the Executive Vice President, Director of Internal Auditing and Compliance. Mr. Verlinde left WestStar Bank in August 2003 to join Fidelity Investments as Vice President of Internal Audit. Mr. Verlinde also spent 6 years with KPMG and 11 years with Bank One in management positions.

 

Mr. Godec became a Director of Vail Banks in July 2000. Mr. Godec has served as the President and a director of WestStar since 1999 and as Chief Executive Officer of WestStar since 2000. Prior to becoming President of WestStar, Mr. Godec served as Senior Executive Vice President of WestStar from January to April 1999 and served as the Senior Vice President of WestStar from January 1996 to January 1999.

 

Mr. Ferguson joined WestStar Bank as Chief Credit Officer in July of 2001. He previously served as President and Chief Executive Officer of Pemi-National Bank in New Hampshire. Mr. Ferguson has over twenty years experience in commercial lending.

 

Mr. Burt has served as the Executive Vice President and Chief Financial Officer of Vail Banks and WestStar Bank since June of 2005. From September 2003 to February 2005, Mr. Burt served as the Senior Vice President and Director of Internal Audit and Compliance of WestStar Bank. Prior to joining WestStar Bank in April 2002, Mr. Burt spent seven years with PricewaterhouseCoopers, the last four in London, England.

 

ITEM 1A. RISK FACTORS.

 

An investment in our common shares involves risks. Before making an investment decision, investors should carefully consider the risks described below in conjunction with the other information in this report, including our consolidated financial statements and related notes. If any of the following risks or other risks, which have not been identified or which we

 

11

 

may believe are immaterial or unlikely, actually occur, our business, financial condition and results of operations could be adversely affected. In such a case, the trading price of our common shares could decline, and investors may lose all or part of their investment.

 

Risks Related to Our Business

 

If the value of real estate in our primary market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

 

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2005, approximately 89.4% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings could be adversely affected.

 

We are subject to the local economies where we operate, and unfavorable economic conditions in these areas could have a material adverse effect on our financial condition and results of operations.

 

Our growth depends upon the growth in population, income levels and deposits in our primary market areas. If the communities in which we operate do not grow, or if prevailing economic conditions locally or nationally are unfavorable, our business may not grow. Unpredictable economic conditions may have an adverse effect on the quality of our loan portfolio and our financial performance. Economic recession over a prolonged period or other economic problems in our market areas could have a material adverse impact on the quality of our loan portfolio and the demand for our products and services. Future adverse changes in the economies in our market areas may have a material adverse effect on our financial condition, results of operations or cash flows. Further, the banking industry in our primary market areas is affected by general economic conditions such as inflation, recession, unemployment and other factors beyond our control. As a community bank, we are less able to spread the risk of unfavorable local economic conditions than larger or more regional banks. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas even if they do occur. See “Item 1 Business.”

 

Further, because of our geographic concentrations, a decline in the local economic conditions of any of our primary market areas may have a greater effect on our earnings than on the earnings larger financial institutions whose real estate loan portfolios are more geographically diverse.

 

Our recent results may not be indicative of our future results.

 

We may not be able to sustain our historical rate of growth or may not even be able to grow our business at all. Various factors, such as poor economic conditions, changes in interest rates, regulatory and legislative considerations and competition may also impede or prohibit our ability to expand our market presence. If we experience a significant decrease in our rate of growth, our results of operations and financial condition may be adversely affected.

 

We face strong competition from larger, more established competitors.

 

The banking business is highly competitive, and we experience strong competition from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other financial institutions, which operate in our primary market areas and elsewhere. We compete with these institutions both in attracting deposits and in making loans. In addition, we must expand our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established and much larger financial institutions, and we may face a competitive disadvantage as a result of our smaller size and lack of geographic diversification. Many of these competitors have substantially greater resources, lending limits and operating histories than we do and may offer services that we do not or cannot provide. We believe we have the ability to compete effectively with our competitors by emphasizing customer service, and local decision-making, to establish long-term customer relationships and build customer loyalty with products and services designed to address the specific needs of our customers.

 

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The factors affecting competition include banking and financial services provided, customer service and responsiveness, customer convenience and office location. We believe that we will continue to compete successfully in the communities in which we operate and that our competitive strengths include our reputation for developing and retaining banking relationships, responsiveness to customer needs and individualized customer service, and skilled, knowledgeable associates. Our customers and potential customers choose to bank with WestStar to take advantage of this individualized attention while also receiving products and services at competitive prices. Further, we believe that the community commitment and involvement of our associates and our commitment to providing quality financial services are factors that should allow us to continue to maintain and improve our competitive position.

 

Our business could be harmed if we lose the services of any of our senior management team and are unable to recruit or retain a suitable replacement.

 

We believe that our success to date and our prospects for future success depend significantly on the efforts of our management team. We do not have employment agreements with these officers or with any of our employees. Therefore, they are free to terminate their employment with us at any time, and we could have difficulty replacing these officers with equally competent persons who are experienced in the specialized aspects of our business. The loss of the services of any of these persons could have an adverse effect on our business.

 

We face risks with respect to future expansion and acquisitions or mergers.

 

We may seek to acquire other financial institutions or parts of those institutions and may continue to engage in de novo branch expansion in the future. Acquisitions and mergers involve a number of risks, including:

 

 

•                  the time and costs associated with identifying and evaluating potential acquisitions and merger partners may negatively affect our business;

•                  the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution may not be accurate;

•                  the time and costs of evaluating new markets, hiring experienced local management and opening new offices and the delays between these activities and the generation of sufficient assets and deposits to support the costs of the expansion may negatively affect our business;

•                  we may not be able to finance an acquisition without diluting our existing shareholders;

•                  the diversion of our management’s attention to the negotiation of a transaction may detract from their business productivity;

•                  we may enter into new markets where we lack experience;

•                  we may introduce new products and services into our business with which we have no prior experience; and

•                  we may incur an impairment of goodwill associated with an acquisition and experience adverse, short-term effects on our results of operations.

 

In addition, no assurance can be given that we will be able to integrate operations after an acquisition without encountering difficulties including, without limitation:

 

•             the loss of key employees and customers; and

 

•             the disruption of our respective ongoing businesses or possible inconsistencies in standards, controls, procedures and policies.

 

Successful integration of our operations with another entity’s will depend primarily on our ability to consolidate operations, systems and procedures and to eliminate redundancies and costs. If we have difficulties with an integration, we might not achieve the economic benefits we expect to result from any particular acquisition or merger. In addition, we may experience greater than expected costs or difficulties relating to such integration.

 

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Our business strategy includes the continuation of growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

 

We intend to continue pursuing a growth strategy for our business. Our ability to grow successfully will depend on a variety of factors, including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development. We may not be able to expand our market presence in our existing markets or enter new markets successfully, and such expansion could adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy. Also, if our growth occurs more slowly than anticipated or declines, our operating results could be materially adversely affected.

 

Our expansion plans may require us to raise additional capital in the future, but that capital may not be available when it is needed or may be available only on unfavorable terms that could have a material adverse effect on our financial condition and results of operations.

 

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. As a result, we may from time to time need to raise additional capital to support our continued growth. Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired. Alternatively, we may be able to raise capital only by issuing debt on unfavorable terms to us that could have a material adverse effect on our financial condition and results of operations.

 

Improper functioning of our information technology systems could have an adverse impact on our operations.

 

We rely heavily on our information technology systems, including the systems of outside service providers. If our internal systems or external technological sources were to fail or there is a breach of security, our ability to maintain accurate financial records may be impaired, which could materially affect our reputation and results of operations and financial condition.

 

Risks Related to Our Industry

 

Changes in the interest rate environment could reduce our profitability.

 

Our profitability depends substantially upon our net interest income. Net interest income is the difference between the interest earned on assets, such as loans and investment securities, and the interest paid for liabilities, such as money market accounts, savings and time deposits. Market interest rates for loans, investments and deposits are highly sensitive to many factors beyond our control. In addition, we cannot predict whether interest rates will continue to remain at present levels. Changes in interest rates may cause significant changes, up or down, in our net interest income. Even if rates remain constant, a decrease in the percentage of our deposit base consisting of non-interest-bearing deposits could adversely affect our net interest income. Depending on our portfolio of loans and investments, our results of operations may be adversely affected by changes in interest rates. In addition, any significant increase in prevailing interest rates could adversely affect our mortgage banking business because higher interest rates could cause customers to request fewer refinancings and purchase money mortgage originations.

 

We could suffer loan losses from a decline in credit quality.

 

We could sustain losses if borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. Our underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, may not prevent unexpected losses that could materially adversely affect our results of operations.

 

14

 

If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.

 

Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. We may experience significant loan losses, which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses that may occur. In determining the size of the allowance for loan losses, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions and other pertinent information. If we expand into new markets, our determination of the size of the allowance for loan losses could be inaccurate due to our lack of familiarity with market-specific factors.

 

If our assumptions are wrong, our current allowance for loan losses may not be sufficient to cover our loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance for loan losses would materially decrease our net income. Our allowance for loan losses was $4.5 million, or 0.92% of total loans, as of December 31, 2005.

 

In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize future loan charge-offs based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results.

 

We are subject to extensive regulation that could limit or restrict our activities and impose financial requirements or limitations on the conduct of our business.

 

As a bank holding company, we are primarily regulated by the Board of Governors of the Federal Reserve System. Our bank subsidiary, WestStar, is primarily regulated by the Federal Reserve Bank of Kansas City. Our compliance with Federal Reserve regulations is costly and may limit our growth and restrict certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to capital requirements of our regulators. The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.

 

The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Securities and Exchange Commission and the NASDAQ National Market that apply to us have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. As a result, we may experience greater compliance costs.

 

Changes in monetary policies may have an adverse effect on our business.

 

Our results of operations are affected by the policies of monetary authorities, particularly the Federal Reserve. Actions by monetary and fiscal authorities, including the Federal Reserve, could have an adverse effect on our deposit levels, loan demand or business and earnings. See “Item 1 Business—Supervision and Regulation.”

 

Risks Related to Our Common Shares

 

The trading volume in our common shares has been low, and the sale of a substantial number of shares in the public market could depress the price of our common shares and make it difficult for you to sell your shares.

 

Our common shares are listed to trade on the NASDAQ National Market, but are thinly traded. Thinly traded shares can be more volatile than stock trading in an active public market. We cannot predict the extent to which an active public market for our common shares will develop or be sustained. In recent years, the stock market has experienced a high-level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to operating performance.

 

15

 

We cannot predict what effect future sales of our common shares in the market, or the availability of our common shares for sale in the market, will have on the market price of our common shares. Accordingly, we cannot provide any assurance that sales of substantial amounts of our common shares in the market, or the potential for large amounts of market sales, would not cause the price of our common shares to decline or impair our ability to raise capital.

 

Our directors and executive officers own a significant portion of our common shares and can influence shareholder decisions.

 

Our directors and executive officers, as a group, beneficially owned approximately 47% of our outstanding common shares as of February 28, 2006. As a result of their ownership, the directors and executive officers will have the ability, by voting their shares in concert, to influence the outcome of any matter submitted to our shareholders for approval, including the election of directors.

 

Our ability to pay dividends depends primarily on dividends from our banking subsidiary, WestStar, which is subject to regulatory limits.

 

We are a bank holding company and our operations are conducted by our banking subsidiary, WestStar. Our ability to pay dividends depends on our receipt of dividends from our banking subsidiary. Dividend payments from our banking subsidiary are subject to legal and regulatory limitations, generally based on net income and retained earnings, imposed by the various banking regulatory agencies. The ability of our banking subsidiary to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. There is no assurance that our banking subsidiary will be able to pay dividends in the future or that we will generate adequate cash flow to pay dividends in the future. Our failure to pay dividends on our common shares could have a material adverse effect on the market price of our common shares.

 

Certain provisions of our articles of incorporation may be deemed to have the effect of making an acquisition of control of our company more difficult when attempted in a transaction not approved by our Board of Directors.

 

Our articles of incorporation authorize the issuance of preferred stock with such designations, rights and preferences as may be determined from time to time by the Board of Directors. Accordingly, the Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights that could adversely affect the voting power or other rights of the holders of common stock. The issuance of such stock could also be used, under certain circumstances, as a method to discourage, delay or prevent a change in control of the Company. Although we do not currently intend to issue any shares of preferred stock, we may issue such shares in the future.

 

Our articles of incorporation also provide that the Board of Directors will be divided into three classes serving staggered three-year terms and that a director may only be removed by the shareholders prior to the expiration of a term for cause. These provisions could enable a minority of our shareholders to prevent the removal of a director sought to be removed by a majority of the shareholders and may tend to enhance management’s ability to retain control over our affairs and to preserve the director’s present position on the board.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS.

 

Not applicable to non-accelerated filers.

 

ITEM 2. PROPERTIES.

 

As of March 6, 2006, Vail Banks had 24 operating offices and an administrative center. Of these 25 properties, 12 were leased and 13 were owned. Vail Banks broke ground on the Fruita retail office building in March of 2006. Vail Banks currently leases space in Fruita. Vail Banks completed significant remodeling of its retail offices in Vail and Estes Park in 2005. Vail Banks plans to commence operation in leased facilities in Southwest Denver and the Mountain Village near Telluride during 2006. On January 16, 2006, the Board made a strategic decision to close the Stapleton retail office during the spring of 2006. None of the properties owned by Vail Banks are encumbered. The aggregate annual lease payments for properties in 2005 were $1.5 million. Leases for the facilities expire at various periods through 2014 with options to renew through 2039. Vail Banks considers its properties adequate for its current needs.

 

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ITEM 3. LEGAL PROCEEDINGS.

 

Vail Banks and its banking subsidiary periodically are parties to or otherwise involved in legal proceedings arising in the normal course of business, such as claims to enforce liens, claims involving the making and servicing of real property loans and other issues incident to their business. Management does not believe that there is any pending or threatened proceeding against Vail Banks or its banking subsidiary which, if determined adversely, would have a material effect on the business, results of operations, or financial position of Vail Banks or its banking subsidiary.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

No matters were submitted to security holders during the fourth quarter of fiscal year 2005.

 

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PART II

 

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

 

Market Information

 

Vail Banks’ common shares trade on The NASDAQ National Market under the symbol “VAIL.”  The following table sets forth, for the periods indicated, the high and low bid prices of the common shares on The NASDAQ National Market.

 

 

Holders

 

As of February 28, 2006, Vail Banks had 102 record holders of its common shares. Investors who beneficially own common shares that are held in street name by brokerage firms or similar holders are not included in this number. Vail Banks believes there are approximately 2,000 beneficial holders of its common shares.

 

Dividends

 

Cash dividends paid per share were as follows:

 

 

Additionally, a cash dividend of $0.07 per share was declared on January 16, 2006 and paid on February 10, 2006 to shareholders of record on January 27, 2006.

 

Holders of common shares are entitled to receive dividends when, as and if declared by Vail Banks’ Board of Directors out of funds legally available therefore. The final determination of the timing, amount and payment of dividends on the common shares are at the discretion of the Board of Directors. The declaration of dividends will depend on conditions then existing, including Vail Banks’ profitability, financial condition, capital requirements, future growth plans and other relevant factors. The principal source of Vail Banks’ income is dividends received from WestStar. The payment of these dividends by WestStar is subject to certain restrictions imposed by the federal and state banking laws and regulations.

 

Vail Banks’ ability to pay cash dividends on its common shares is also subject to statutory restrictions, including banking regulations, and restrictions arising under the terms of securities or indebtedness which may be issued or incurred in the future. The terms of such securities or indebtedness may restrict payment of dividends on common shares until required payments and distributions are made on such securities or indebtedness. See “Supervision and Regulation” in Item 1.

 

ITEM 6. SELECTED FINANCIAL DATA.

 

The selected historical financial data set forth below should be read in conjunction with the “General,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Financial Statements and

 

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Notes to Consolidated Financial Statements” sections, as well other financial data contained elsewhere in this Annual Report on Form 10-K.

 

Net income for 2003 has been increased by $150,000 from amounts previously reported as a result of the prior period adjustment made to the results of operation and statement of financial position for 2003. Adjustments have also been made to 2002 and 2001 to reflect the impact of the prior period adjustment made to 2003 (see footnote 8, below, for additional information). See Note 1 of the Notes to Consolidated Financial Statements contained in this Annual Report on Form 10-K for further information.

 

(dollars in thousands, except for share data)
EARNINGS (1)		2005			2004			2003			2002			2001
								(Restated)			(Restated)			(Restated)
Net interest income		$	29,141		$	22,769		$	21,498		$	25,408		$	28,835
Provision for loan losses		529			704			578			382			800
Non-interest income		6,838			9,766			10,964			12,024			11,397
Non-interest expense		28,894			27,364			30,860			28,440			29,044
Net income (8)		4,489			2,956			864			5,613			6,065
PER SHARE DATA (1)
Basic earnings (8)		$	0.87		$	0.58		$	0.17		$	0.99		$	1.02
Diluted earnings (8)		0.83			0.55			0.15			0.95			0.99
Book value per common share at year end		11.37			11.25			10.95			11.62			11.00
Tangible book value per common share at year end		4.93			4.46			3.96			5.20			4.60
Closing market price		15.00			13.18			11.94			12.00			10.90
AT YEAR END
Total assets		$	686,319		$	634,595		$	575,610		$	554,263		$	555,331
Earning assets		584,797			539,983			476,864			452,943			454,076
Loans		485,984			406,353			311,774			331,003			391,725
Allowance for loan losses		4,473			3,895			3,503			3,747			4,375
Non-interest bearing deposits		133,250			120,127			101,305			97,383			103,730
Total deposits		552,508			500,444			448,515			428,698			442,350
Shareholders’ equity		63,733			59,902			57,859			66,622			63,306
Shares outstanding		5,606,235			5,326,504			5,283,264			5,734,303			5,754,152
AVERAGE BALANCES
Total assets		$	665,479		$	604,921		$	589,664		$	561,496		$	559,570
Earning assets		571,264			511,793			494,134			465,750			460,807
Loans		423,558			350,535			324,086			356,703			410,613
Non-interest bearing deposits		123,924			103,008			94,512			98,122			98,439
Total deposits		530,769			478,490			456,810			439,884			465,194
Shareholders’ equity		61,752			58,736			62,457			65,000			63,734
Weighted average common shares outstanding-Basic		5,172,811			5,060,627			5,220,221			5,651,737			5,965,374
Weighted average common shares outstanding-Diluted		5,395,914			5,417,562			5,617,720			5,914,891			6,111,103
PERFORMANCE (1)
Return on assets		0.67		%	0.49		%	0.15		%	1.00		%	1.08		%
Return on equity		7.27			5.03			1.38			8.62			9.50
Dividend payout ratio		34			51			165			23			18
Cash dividends paid per share		$	0.28		$	0.28		$	0.26		$	0.22		$	0.18
Net interest margin (2)		5.18		%	4.55		%	4.46		%	5.49		%	6.26		%
Efficiency ratio		80			84			95			76			72
Loan to deposit ratio (at year end)		88			81			70			77			89
ASSET QUALITY (at year end)
Net (recoveries) charge-offs to average loans		(0.01		)%	0.09		%	0.25		%	0.28		%	0.21		%
Allowance for loan losses to loans		0.92			0.96			1.12			1.13			1.12
Allowance for loan losses to non-performing loans (3)		10,909.76			1,657.45			200.52			100.35			214.25
Non-performing assets to loan-related assets (4) (5)		0.13			0.25			0.68			1.20			0.58
Risk assets to loan-related assets (5) (6)		0.14			0.25			0.73			1.20			0.73
CAPITAL (at year end)
Equity to assets		9.29		%	9.44		%	10.05		%	12.02		%	11.40		%
Tangible equity to assets		4.03			3.75			3.63			5.38			4.76
Leverage ratio (7)		8.05			8.01			7.45			10.24			9.40
Tier 1 risk based capital Ratio (7)		9.58			10.37			11.50			14.11			11.69
Total risk based capital Ratio (7)		10.91			12.05			13.72			15.57			13.38

 

(1) During 2002, the Company implemented SFAS No. 142, Goodwill and Other Intangible Assets, which eliminated goodwill amortization expense beginning January 1, 2002. The Company continued to amortize its core deposit intangibles. For further information, see Note 7 of the Notes to Consolidated Financial Statements contained in Item 15 of this Annual Report on Form 10-K.

(2) Net interest margin is reported on a fully taxable equivalent basis.

(3) Non-performing loans consist of non-accrual and restructured loans.

(4) Non-performing assets consist of non-performing loans and foreclosed properties.

(5) Loan related assets consist of total loans and foreclosed properties.

(6) Risk assets consist of non-performing assets and loans 90 days or more past due but continuing to accrue interest.

(7) For further information, see Note 20 of the Notes to Consolidated Financial Statements contained in Item 15 of this Annual Report on Form 10-K.

(8) The amounts of net income for 2003 and 2001 have been restated from amounts previously reported to reflect amortization expense on goodwill for periods prior to 2002 that was inadvertently recorded as income tax expense during 2003. These retroactive adjustments increased net income for 2003 by $150,000 ($0.03 per basic share and $0.02 per diluted share) and decreased net income for 2001 by $38,000 ($0.00 per share and $0.01 per diluted share).

 

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

 

Introduction

 

The following section presents management’s review of the financial condition and operating results of Vail Banks and its subsidiary, WestStar. It is intended to assist readers in evaluating Vail Banks’ performance. Certain reclassifications have been made to previous periods’ information to conform to the 2005 presentation. The following analysis should be read in conjunction with the Consolidated Financial Statements and accompanying notes as well as the selected financial information included elsewhere in this Annual Report on Form 10-K.

 

Critical Accounting Policies and Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated balance sheet and the reported amounts of revenues and expenses during the reporting period.  The SEC has defined a company’s most critical accounting policies as those that are most important to the portrayal of its financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on these criteria, management has identified the following critical accounting policies and judgments. Although management believes its estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions or conditions.

 

Allowance for Loan Losses

 

The allowance for loan losses calculation process has two components. The first component represents the allowance for loan losses for impaired loans computed in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114 Component), as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan — Income Recognition and Disclosures an amendment of FASB Statement No. 114. To determine the SFAS 114 Component, collateral dependent impaired loans are evaluated using internal analyses as well as third-party information, such as appraisals. If an impaired loan is unsecured, it is evaluated using a discounted cash flow of the payments expected over the life of the loan giving consideration to currently existing factors that would impact the amount or timing of the cash flows. The second component is the allowance for loan losses calculated under SFAS No. 5, Accounting for Contingencies (SFAS 5 Component), and represents the estimated probable but undetected losses inherent within the portfolio due to uncertainties in economic conditions, delays in obtaining information about a borrower’s financial condition, delinquent loans that have not been determined to be impaired, trends in speculative construction real estate lending, results of internal and external loan reviews, and other factors. This component of the allowance for loan losses is calculated by assigning a certain risk weighting, within a predetermined range, to each identified risk factor. Management has an internal goal to maintain the allowance for loan losses between 0.75% and 1.50% of average gross loans.   The recorded allowance for loan losses is the aggregate of the SFAS 114 Component and SFAS 5 Component.

 

At December 31, 2005, the Company had a $4.5 million allowance for loan losses. Management believes that this allowance for loan losses is adequate to cover probable losses based on all currently available evidence. Future additions to the allowance for loan losses may be required based on management’s continuing evaluation of the inherent risks in the portfolio. Additional provisions for loan losses may need to be recorded if the economy declines, asset quality deteriorates, or historical loss experience changes. Also, state or federal regulators, when reviewing Vail Banks’ loan portfolio in the future, may require Vail Banks to increase the allowance for loan losses. Any increase in the allowance for loan losses would adversely affect Vail Banks’ earnings.  An analysis of the allowance for loan losses for loan losses as well as its allocation among certain categories of the loan portfolio can be found in the “Financial Condition” section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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Accounting for Goodwill and Core Deposit Intangible

 

In assessing the recoverability of goodwill and core deposit intangible, management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, management may be required to record impairment charges not previously recorded. The Company assesses goodwill and intangible assets for impairment at least annually, using a two-step process that begins with an estimation of the fair value of the reporting unit. The first step is a screen for impairment, and the second step measures the amount of any impairment.

 

The Company performed its annual goodwill impairment test during the fourth quarter of 2005 and determined that goodwill was not impaired. The Company also performed an annual impairment test of its core deposit intangible, comprised of core deposit premiums, during the fourth quarter of 2005 and determined that the core deposit intangible was not impaired.

 

Compensation Plans/Share-Based Payments

 

The Company accounts for its stock options in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, while disclosing pro forma net income and pro forma earnings per share for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123, Accounting for Stock Based Compensation, had been applied. Accordingly, no stock-based compensation cost for employee stock option grants has been recognized in the consolidated financial statements (other than as described in Footnote 16), as options granted under the Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Commencing January 1, 2006, the Company will adopt SFAS 123(R), Share-Based Payment, and will discontinue the use of APB Opinion No. 25. The fair value of stock options granted was estimated at the measurement date, which is generally the date of grant, using the Black-Scholes option-pricing model.

 

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, a revision of SFAS 123. This standard eliminates the ability to account for share-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on the fair values on the date of grant.  This standard is effective for the Company on January 1, 2006.  See Note 2 of the Notes to Consolidated Financial Statements contained in Item 15 of this Annual Report on Form 10-K for further information.

 

Restricted stock awards are expensed over their vesting period. Restricted stock awards vest ratably over the service period; however, vesting may also be based upon attainment of certain performance measures. Unearned compensation on restricted stock awards is a reduction of “additional paid in capital” included in shareholders’ equity on the consolidated balance sheet.

 

Impairment of Investment Securities

 

Investment securities are evaluated for impairment on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value below amortized cost is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the issues for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

 

Certain Factors Affecting Forward-Looking Statements

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. When used in this report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the results discussed in these forward-looking statements as a result of the risk factors discussed in Item 1A. of this Annual Report on Form 10-K.  Vail Banks does not intend to update any forward-looking statements whether written or oral, relating to matters discussed in this Annual Report on Form 10-K.

 

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Financial Overview

 

Net income was $4.5 million in 2005, an increase of approximately $1.5 million from the $3.0 million earned in 2004. The growth was due primarily to an increase in net interest income of $6.4 million, or 28%, from $22.8 million in 2004 to $29.1 million in 2005. Net interest income increased due to an increase in loan volumes and rising interest rates. Net loans increased $79.0 million, or 20%, from $402.5 million in 2004 to $481.5 million in 2005. In conjunction with the increase in loan volumes, the Federal Reserve increased the Federal Funds interest rate 200 basis points, or 2.0%, during 2005 from 2.25% in December 2004 to 4.25% in December 2005. These increases were partially offset by a $2.6 million decrease in non-interest income primarily due to a $1.1 million decrease in mortgage-broker fee income and a $1.7 million decrease related to the gain recognized in 2004 on the sale of the Company’s Vail bank building. These results are not necessarily indicative of the results that may be expected for future years.

 

The return on average assets was 0.67% for the year ended December 31, 2005 compared to 0.49% for the year ended December 31, 2004 and 0.15% for the year ended December 31, 2003.

 

The return on average equity was 7.27% for the year ended December 31, 2005 compared to 5.03% for the year ended December 31, 2004 and 1.38% for the year ended December 31, 2003.

 

Assets increased by $51.7 million, or 8%, to $686.3 million during 2005. This increase was due to growth in loans of $79.0 million, partially offset by decreases in investment securities of $16.6 million and cash equivalents of $4.3 million. Assets increased by $59.0 million, or 10%, to $634.6 million during 2004. This increase was primarily due to growth in loans and investment securities of $121.8 million, partially offset by a decrease in cash equivalents of $65.3 million.

 

Results of Operations

 

Net Interest Income

 

Net interest income continues to be Vail Banks’ principal source of income, representing the difference between interest and fees earned on loans and investments and interest paid on deposits and borrowings. In this discussion, Net Interest Income on a fully tax-equivalent basis (FTE) includes tax-exempt income, such as interest on securities of states and municipalities, increased to an amount that would have been earned had such income been taxable. This adjustment places taxable and nontaxable income on a common basis and permits comparisons of rates and yields.

 

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The following table sets forth the average balances, interest income and expense, and average yields and rates for Vail Banks’ earning assets and interest bearing liabilities for the periods indicated on a fully tax-equivalent basis.

 

Average Balance Sheet and Net Interest Income Analysis

 

(dollars in thousands on a fully taxable equivalent (FTE) basis)		2005								2004								2003
		Average Balance			Interest			Average Yield/Rate		Average Balance			Interest			Average Yield/Rate		Average Balance			Interest			Average Yield/Rate
ASSETS
Federal funds sold and other short-term investments		$	36,337		$	1,183		3.26	%	$	32,010		$	335		1.05	%	$	68,244		$	690		1.01	%
Investment securities
Taxable		82,362			2,681			3.26		101,157			2,710			2.68		71,987			2,222			3.09
Tax-exempt (1)		25,130			1,859			7.40		24,337			1,828			7.51		22,485			1,717			7.64
Investment in Trust I and Trust II		743			76			10.23		743			76			10.23		—			—			—
Loans (2) (3)		426,755			35,101			8.23		353,546			26,585			7.52		331,418			26,098			7.87
TOTAL EARNING ASSETS		571,327			40,900			7.16		511,793			31,534			6.16		494,134			30,727			6.22
Non-earning assets		94,152								93,128								95,530
TOTAL ASSETS		$	665,479							$	604,921							$	589,664
LIABILITIES
Interest bearing deposits
Interest bearing transaction accounts		$	297,065		$	4,555		1.53	%	$	253,484		$	1,719		0.68	%	$	225,623		$