UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20849 FORM 10-KSB [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 2005 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF THE EXCHANGE ACT FOR THE TRANSITION PERIOD COMMISSION FILE NUMBER 0-50237 VSB Bancorp, Inc. ---------------------------------------------- (Name of Small Business Issuer in its charter) New York -------------------------------------------------------------- (State or other jurisdiction of incorporation or organization) 11 - 3680128 -------------------------------------- (I. R. S. Employer Identification No.) 3155 Amboy Road, Staten Island, New York 10306 ---------------------------------------------- (Address of principal executive offices) (718) 979-1100 ------------------------- Issuer's telephone number Common Stock ---------------- (Title of Class) 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. [X] Yes [ ] No. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB/A or any amendment to this Form 10-KSB/A. [ ]. Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No Indicate by check mark if accelerated filer. [ ] Yes [X] No. State Issuer's revenues for the most recent fiscal year: $13,402,125. The aggregate market value of the voting stock held by non-affiliates of the registrant at June 30, 2005 was $20,232,755. The registrant had 1,509,822 common shares outstanding as of March 13, 2006. Documents incorporated by reference: Portions of the registrant's definitive proxy statement filed on or about March 27, 2006 into Part III of this Form 10-KSB. Forward-Looking Statements When used in this Form 10-KSB, or in any written or oral statement made by us or our officers, directors or employees, the words and phrases "will result," "expect," "will continue," "anticipate," "estimate," "project," or similar terms are intended to identify "forward-looking statements." A variety of factors could cause our actual results and experiences to differ materially from the anticipated results or other expectations expressed in any forward-looking statements. Some of the risks and uncertainties that may affect our operations, performance, development and results, the interest rate sensitivity of our assets and liabilities, and the adequacy of our loan loss allowance, include, but are not limited to: o deterioration in local, regional, national or global economic conditions which could result in, among other things, an increase in loan delinquencies, a decrease in property values, or a change in the real estate turnover rate; o changes in market interest rates or changes in the speed at which market interest rates change; o changes in laws and regulations affecting the financial service industry; o changes in competition; and o changes in consumer preferences by our customers or the customers of our business borrowers. Please do not place undue reliance on any forward-looking statement, which speaks only as of the date made. There are many factors, including those described above, that could affect our future business activities or financial performance and could cause our actual future results or circumstances to differ materially from those we anticipate or project. We do not undertake any obligation to update any forward-looking statement after it is made. PART I Item 1. Description of Business. Business of VSB Bancorp, Inc. VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company") became the holding company for Victory State Bank (the "Bank"), a New York chartered commercial bank, upon the completion of a reorganization of the Bank into the holding company form of organization. The reorganization was effective in May 2003. All the outstanding stock of Victory State Bank was exchanged for stock of VSB Bancorp, Inc. on a three for two basis so that the stockholders of Victory State Bank became the owners of VSB Bancorp, Inc. and VSB Bancorp, Inc. owns all the stock of Victory State Bank. The common stock we issued in the transaction qualifies as exempt securities under Section 3(a)(12) of the Securities Act of 1933. Our primary business is owning all of the issued and outstanding stock of the Bank. The main office of the Company and the Bank is at 3155 Amboy Road, Staten Island, New York 10306, telephone (718) 979-1100. We maintain an Internet web site at www.victorystatebank.com. We also own all of the common stock of VSB Capital Trust I, a special purpose trust established to issue $5 million of trust preferred securities in August 2003. Under Federal Reserve Regulations, provided that certain conditions are met, up to 25% of our Tier I capital requirement may be satisfied through funds raised by the sale of trust preferred securities. We used the proceeds from the sale of the trust preferred securities to continue to satisfy our regulatory capital requirements. We contributed $4.2 million of the proceeds from the sale of those securities to Victory State Bank as capital, thus providing the Bank with capital to support future growth. Trust preferred securities are long-term debt securities in which interest paid to the owner of the security is tax deductible to the holding company, in contrast to dividends paid by the holding company, which do not provide a tax benefit to the company that pays the dividends. The tax deductibility of the interest payments means that trust preferred securities can be a low-cost source of capital. Victory State Bank Victory State Bank's principal business has been and continues to be attracting commercial deposits from primarily the general public and investing those deposits, together with funds generated from operations and repayments on existing investments, primarily in loans for business purposes and investment securities. The Bank's revenues are derived principally from interest on our commercial loan and investment securities portfolios. The Bank's primary sources of funds are deposits and principal and interest payments on loans and investment securities. Victory State Bank serves its primary market of Staten Island, New York through its four banking offices. The Bank opened its main office in the Oakwood section of Staten Island in November 1997; its first branch was opened in the West Brighton section of Staten Island in June 1999; its second branch in the St. George section of Staten Island in January 2000; and its third branch in the Dongan Hills section of Staten Island in December 2002. In 2006, the Bank anticipates that it will open its fifth branch location in the Rosebank section of Staten Island and a sixth branch location in the Great Kills section of Staten Island. The Bank's deposits are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation up to the maximum amounts permitted by law. Victory State Bank also serves its customers through its website, www.victorystatebank.com. Market Area and Competition Victory State Bank has been, and continues to be, a community-oriented, state-chartered commercial bank offering a variety of traditional financial services to meet the needs of the communities in which it operates. Management considers our reputation for customer service as its major competitive advantage in attracting and retaining customers in its market area. 1 Our primary market area is concentrated in the neighborhoods surrounding our branches in the New York City Borough of Staten Island. Management believes that our branch offices are located in communities that can generally be characterized as stable, residential neighborhoods of predominantly one- to four-family residences and middle income families. From 1990 to 2000, Staten Island's population grew to 443,728 from 378,977, or a 17% increase. There was a modest shift from the 20 to 44 year age group to the 45 to 64 year age group. As a percentage of population, the 45 to 64 year age group increased from 19.8% to 23.4% during the decade. The largest age group continues to be the 20 to 44 age group, currently at 37.0% of total population. Median household income increased to $55,039 from $50,064 during the decade of the 90's. Per capita income in 1999 was $23,905 in Staten Island, slightly higher than $23,389, the per capita income of New York State. One third of the households in Staten Island had household income of more than $75,000 in 1999. These income levels compare favorably with the national household median of $41,994 and the national per capita median of $21,587. The income levels in Staten Island provide satisfactory support for personal home ownership, in turn supporting the home building industry, which is a major industry focus for Victory State Bank. As the population grew, the total number of households increased to 156,341 from 130,519. Total housing units stood at 163,993 in 2000, as compared to 139,726 in 1990. Owner occupied housing units represented 63.8% of total housing units in 2000, which was consistent with the 63.7% level in 1990. This reflects an increase of approximately 15,600 owner-occupied housing units during the decade and demonstrates the importance of the housing market, especially people purchasing homes for their personal use, to the local economy. The New York City metropolitan area has a high density of financial institutions, many of which are significantly larger and have greater financial resources than we have, and all of which are our competitors to varying degrees. Our competition for loans comes principally from commercial banks, savings banks and insurance companies. Our most direct competition for deposits has come from commercial banks and savings banks. In addition, we face increasing competition for deposits from non-bank institutions such as brokerage firms and insurance companies in such areas as short-term money market funds, corporate and government securities funds, mutual funds and annuities. RISK FACTORS Bank lending is an inherently risky business. A substantial portion of our assets are invested in loans, and loans necessarily present many risks. We must first rely on our borrowers to repay their loans, and if they are unable to do so, we must rely on the value of the collateral, if any, for the loan. Changing business conditions, increases in unemployment, personal problems that a borrower may experience, changes in the regulations that apply to a borrower's business, changes in the political climate or in public policy, and many other factors outside our control, could adversely affect the ability of our borrowers to repay their loans or the value of the collateral we have received. Although we seek to reduce these risks through underwriting procedures that we believe are prudent, it is impossible for a bank to completely eliminate the risks which arise from making loans except by eliminating our lending operations. Fluctuations in interest rates could have an adverse affect on our profitability. Our principal source of income is the difference between the interest income we earn on interest-earning assets, such as loans and securities, and our cost of funds, principally interest paid on deposits. These rates of interest change from time to time, depending upon a number of factors, including general market interest rates. However, the frequency of the changes varies among different types of assets and liabilities. For example, for a five-year loan with an interest rate based upon the prime rate, the interest rate may change every time the prime rate changes. In contrast, the rate of interest we pay on a five-year certificate of deposit adjusts only every five years, based upon changes in market interest rates. In general, the interest rates we pay on deposits adjust more slowly than the interest rates we earn on loans because the largest part of our loan portfolio consist of loans with interest rates that fluctuate based upon the prime rate. 2 In contrast, although many of our deposit categories have interest rates that could adjust immediately, such as interest checking accounts and savings accounts, changes in the interest rates on those accounts are at our discretion and tend to occur more slowly. As a result, increases in market interest rates could increase our net interest income because our cost of deposits would probably increase more slowly than the yields on our loans. However, customer preferences and competitive pressures may negate this positive effect because customers may choose to move funds into higher-earning deposit types as higher interest rates make them more attractive, or competitors offer premium rates to attract deposits. We also have a substantial portfolio of investment securities with fixed rates of interest, most of which are mortgage-backed securities with an estimated average life of not more than 5 years. There is no active trading market for our common stock. There is no active trading market for our common stock. Our common stock is not listed on any exchange nor is it quoted on the NASDAQ Stock Market. It is quoted on the OTC Bulletin Board, but does not trade every day. the twelve months ended March 1, 2006, there were trades were reported on only 74 out of 253 trading days, or less than one out of every three trading days. We currently have approximately 200 stockholders of record and we believe based upon reports we have received from broker/dealers, that there are approximately an additional 100 stockholders who own their shares in street name. This relatively small number of stockholders reduces the likelihood that an active trading market for our common stock will develop and makes it difficult for us to have our stock listed or quoted on any but the least active exchanges or quotation systems. The geographic concentration of our loans increases the risk that adverse economic conditions could affect our net income. Substantially all of our loans are mortgage loans on property located in Staten Island, New York, or loans to residents of Staten Island. Staten Island has experienced an economic down turn in recent years. A continued economic slow-down or decline in the local economy could have an adverse effect on us for a number of reasons. Adverse economic conditions could hurt the ability of our borrowers to repay their loans. If real estate values decline, reductions in the value of real estate collateral could make it more difficult for us to recover the full amount due on loans which go into default. Furthermore, economic difficulties can also increase deposit outflows as customers must use savings to pay bills. This could increase our cost of funds because of the need to replace the deposit outflow. All of these factors might combine to reduce significantly our net income. Our loans are concentrated in the residential building trades industry, and thus a downturn in the local housing market could adversely affect our net income. The largest segment of our loan portfolio is represented by loans to home builders and others involved in the home building industry, such as equipment and material suppliers. At December 31, 2005, 39.8% of our loans were construction mortgage loans, primarily for the construction of residential properties. Our non-mortgage commercial loans, totaling an additional 17.0% of our loan portfolio were also concentrated in companies involved in the construction industry and some of our other loans also involved companies in related industries. As a result, a down turn in the housing market in our Staten Island lending area could have a significant negative impact on both our loan portfolio and our level of deposits. Not only could such a down turn adversely affect the ability of our borrowers to repay their loans, but it could also reduce our ability to generate new loans that satisfy our underwriting criteria. Furthermore, businesses in the home building industry are a source of deposits as well as loans, and if their businesses suffer, they are likely to reduce the level of deposits they maintain at with us. Changes in the federal or state regulation of financial institutions could have an adverse effect on future operations. Federal and New York State banking laws and regulations exert substantial control over our operations. Federal and state regulatory authorities have extensive discretion in connection with their supervision of Victory State Bank, such as the right to impose restrictions on operations and the insistence that we increase our allowance for loan losses. Furthermore, federal and state laws affecting banks are constantly being revised, often imposing new restrictions or increasing competitive pressures through de-regulation. Any change in the regulatory structure or statutes or regulations applicable to banks, bank holding companies, or their competitors, whether by the Congress, the FDIC, the Federal Reserve System, the New York State legislature, the New York State Banking Department or any other regulator, could have a material impact on our operations and profitability. 3 We operate in an extremely competitive environment. We operate in one of the most competitive environments for financial products in the world. Many of the world's largest financial institutions have offices in our local communities, and they have far greater financial resources than we have. We seek to distinguish ourselves from those institutions by providing personalized service and providing the same level of care to small community based businesses that only Fortune 500 companies can obtain from the largest banks. The Loss of Key Personnel Could Impair our Future Success. Our future success depends in part on the continued service of our executive officers, other key management, as well as our staff, and our ability to continue to attract, motivate, and retain additional highly qualified employees. The loss of one or more of our key personnel or our inability to timely recruit replacements of such personnel, or otherwise attract, motivate, or retain qualified personnel could have an adverse effect on our business, operating results and financial condition. Lending Activities Loan Portfolio Composition. Our loan portfolio consists primarily of commercial mortgage loans and unsecured commercial loans. At December 31, 2005, we had total unsecured commercial loans outstanding of $11,078,101, or 14.9% of total loans, and commercial real estate loans of $29,794,108, or 40.1% of total loans. There was $29,611,346 of construction loans secured by real estate, $26,623,846 of which were construction loans to businesses for the construction of either commercial property or residential property for sale, representing 35.8% of total loans. Other loans in our portfolio principally included commercial loans secured by assets other than real estate totaling $1,584,484 or 2.1% of total loans at December 31, 2005 and consumer non-mortgage loans of $1,477,366 or 2.0% of total loans. For the year ended December 31, 2005, approximately $62,840,808, or 84.5%, of loans for business purposes had adjustable interest rates based on the prime rate of interest. The following table sets forth the composition of our loan portfolio in dollar amounts and in percentages at the dates indicated At December 31, ----------------------------------------------------------------------------------------------------------- 2005 2004 2003 2002 2001 ------------------- ------------------- ------------------- ------------------- ------------------- % of % of % of % of % of Amount Total Amount Total Amount Total Amount Total Amount Total ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Commercial loans: Commercial secured $ 1,584,484 2.1% $ 1,572,824 2.3% $ 1,896,374 2.8% $ 4,014,494 6.3% $ 4,337,062 8.6% Commercial unsecured 11,078,101 14.9 9,620,243 14.1 8,905,587 13.1 11,322,164 17.7 10,964,539 21.6 ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total commercial loans 12,662,585 17.0 11,193,067 16.4 10,801,961 15.9 15,336,658 24.0 15,301,601 30.2 Real Estate loans: Commercial 29,794,108 40.1 31,741,069 46.5 32,416,537 47.5 31,357,950 49.1 21,553,696 42.5 One-to-four family 298,779 0.4 1,112,032 1.6 1,382,490 2.0 493,504 0.8 376,999 0.7 ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total real estate loans 30,092,887 40.5 32,853,101 48.1 33,799,027 49.5 31,851,454 49.9 21,930,695 43.2 Construction loans: Commercial 26,623,846 35.8 19,893,858 29.1 20,390,849 29.8 13,562,442 21.3 10,477,294 20.7 Owner occupied one-to-four family 2,987,500 4.0 2,960,000 4.3 1,870,000 2.7 1,315,000 2.1 1,803,000 3.6 ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total construction loans 29,611,346 39.8 22,853,858 33.4 22,260,849 32.5 14,877,442 23.4 12,280,294 24.3 Other loans: Consumer loans 1,477,366 2.0 1,048,448 1.5 949,899 1.4 1,179,485 1.9 796,987 1.6 Other loans 486,009 0.7 435,837 0.6 510,617 0.7 509,073 0.8 331,355 0.7 ----------- ----- ----------- ----- ----------- ----- ----------- ----- ----------- ----- Total other loans 1,963,375 2.7 1,484,285 2.1 1,460,516 2.1 1,688,558 2.7 1,128,342 2.3 Total loans 74,330,193 100.0% 68,384,311 100.0% 68,322,353 100.0% 63,754,112 100.0% 50,640,932 100.0% ----------- ===== ----------- ===== ----------- ===== ----------- ===== ----------- ===== Less: Unearned discounts, net and deferred loan fees, net 386,088 337,426 340,892 339,601 216,139 Allowance for loan losses 1,153,298 1,299,520 1,162,776 1,168,358 894,692 ----------- ----------- ----------- ----------- ----------- Loans, net $72,790,807 $66,747,365 $66,818,685 $62,246,153 $49,530,101 =========== =========== =========== =========== =========== The following table sets forth our loan originations and principal repayments for the periods indicated. We did not purchase or sell any loans in 2005, 2004 or 2003. 4 Year Ended Year Ended Year Ended December 31, December 31, December 31, 2005 2004 2003 ------------ ------------ ------------ Commercial Loans (gross): At beginning of period $ 11,193,067 $ 10,801,961 $ 15,336,658 Commercial loans originated: Secured 1,318,810 537,400 1,109,942 Unsecured 39,289,021 23,088,067 24,918,508 ------------ ------------ ------------ Total commercial loans 40,607,831 23,625,467 26,028,450 Principal repayments (39,138,313) (23,234,361) (30,563,147) ------------ ------------ ------------ At end of period $ 12,662,585 $ 11,193,067 $ 10,801,961 ============ ============ ============ Real Estate loans: At beginning of period $ 32,853,101 $ 33,799,027 $ 31,851,454 Real estate loans originated: Commercial 11,228,592 10,373,324 12,104,500 One-to-four family 370,000 325,000 5,862,639 ------------ ------------ ------------ Total real estate loans 11,598,592 10,698,324 17,967,139 Principal repayments (14,358,806) (11,644,250) (16,019,566) ------------ ------------ ------------ At end of period $ 30,092,887 $ 32,853,101 $ 33,799,027 ============ ============ ============ Construction loans At beginning of period $ 22,853,858 $ 22,260,849 $ 14,877,442 Construction loans originated 33,364,808 26,851,000 25,867,500 Principal repayments (26,607,320) (26,257,991) (18,484,093) ------------ ------------ ------------ At end of period $ 29,611,346 $ 22,853,858 $ 22,260,849 ============ ============ ============ Other loans (gross): At beginning of period $ 1,484,285 $ 1,460,516 $ 1,688,558 Other loans originated 1,801,270 1,242,684 771,063 Principal repayments (1,322,180) (1,218,915) (999,105) ------------ ------------ ------------ At end of period $ 1,963,375 $ 1,484,285 $ 1,460,516 ============ ============ ============ Loan Maturity. The following table shows the contractual maturity of our loans at December 31, 2005. At December 31, 2005 --------------------------------------------------------------------------------------- Commercial Commercial Other Unsecured Secured Construction Real Estate Loans (1) Total ------------ ------------ ------------ ------------ ------------ ------------ Amounts due: Within one year (1) $ 6,730,354 $ 441,169 $ 9,205,215 $ 5,365,451 $ 1,337,646 $ 23,079,835 After one year: One to five years 4,347,747 1,143,315 20,406,131 19,627,748 625,729 46,150,670 Total due after five years -- -- -- 5,099,688 -- 5,099,688 ------------ ------------ ------------ ------------ ------------ ------------ Total amount due 11,078,101 1,584,484 29,611,346 30,092,887 1,963,375 74,330,193 Less: Unearned fees -- 925 238,651 146,512 -- 386,088 Allowance for loan losses 360,532 2,349 362,590 370,907 56,920 1,153,298 ------------ ------------ ------------ ------------ ------------ ------------ Loans, net $ 10,717,569 $ 1,581,210 $ 29,010,105 $ 29,575,468 $ 1,906,455 $ 72,790,807 ============ ============ ============ ============ ============ ============ (1) Amount includes overdrawn deposit accounts of $365,275 The following table sets forth at December 31, 2005, the dollar amount of all loans, due after December 31, 2006, and whether such loans have fixed or variable interest rates. 5 Due After December 31, 2006 ------------------------------------------ Fixed Variable Total ------------ ------------ ------------ Commercial Loans: Unsecured $ 260,112 $ 4,087,635 $ 4,347,747 Secured 315,344 827,971 1,143,315 Real Estate Commercial 663,120 23,917,436 24,580,556 One-to-four 146,880 -- 146,880 Construction -- 20,406,131 20,406,131 Other loans 625,729 -- 625,729 ------------ ------------ ------------ Total loans $ 2,011,185 $ 49,239,173 $ 51,250,358 ============ ============ ============ Commercial Business Lending. We originate commercial business loans directly to the professional and business community in our market area. We target small to medium sized business, and professionals such as lawyers, doctors and accountants. Applications for commercial business loans are obtained primarily from the efforts of our directors and senior management, who have extensive contacts in the local business community, or from branch referrals. As of December 31, 2005, commercial loans totaled $12,662,585 or 17.0% of total loans. Commercial business loans we originate generally have terms of five years or less and have adjustable interest rates tied to the Wall Street Journal Prime Rate plus a margin. Such loans may be secured or unsecured. Secured commercial business loans can be collateralized by receivables, inventory and other assets. All these loans are either loans to individuals for which they have personal liability or loans to entities backed by the personal guarantee of principals of the borrower. The loans generally have shorter maturities and higher yields than residential lending. Management has extensive experience in originating commercial business loans within our marketplace. Commercial business loans generally carry the greatest credit risks of the loans in our portfolio because repayment is more dependent on the success of the business operations of the borrower. Some of these loans are unsecured and those that are secured frequently have collateral that rapidly depreciates or is difficult to control in the event of a default. Commercial Real Estate Lending. We originate commercial real estate loans that are generally secured by properties used for business purposes such as retail stores, other mixed-use (business and residential) properties, restaurants, light industrial and small office buildings located in our primary market area. Our commercial real estate loans are generally made in amounts up to 70% of the appraised value of the property. These loans are most commonly made with terms up to five years with interest rates that adjust to 100 or 150 basis points above the floating prime rate. A significant portion of these loans are subject to an interest rate floor ranging between 7.00% to 7.50%. Our underwriting standards consider the collateral of the borrower, the net operating income of the property and the borrower's expertise, credit history and profitability. We require personal guarantees from the borrower or the principals of the borrowing entity. At December 31, 2005, our commercial real estate loans totaled $30,092,887, or 40.5% of total loans. Loans secured by commercial real estate are generally larger and involve greater risks than one-to-four family residential mortgage loans, but generally lesser risks than commercial loans. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy, to a greater extent than other types of loans. We seek to minimize these risks through our lending policies and underwriting standards, which restrict new originations of such loans to our primary lending area and qualify such loans on the basis of the property's income stream, collateral value and debt service ratio. 6 Construction Lending. Our construction loans primarily have been made to builders and developers to finance the construction of one- to four-family residential properties and, to a lesser extent, multi-family residential real estate properties. Our policies provide that construction loans may be made in amounts up to the lesser of 80% of the total hard and soft costs of the project or Victory State bank's loans to-one borrower limitation. We generally require personal guarantees. Construction loans generally are made with prime-based interest rates with terms up to 18 months. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. At December 31, 2005, our construction loans totaled $29,611,346 or 39.8% of total loans. Construction loans generally carry greater credit risks than residential mortgage loans on completed properties because their repayment is more dependent on the borrower's ability to sell or rent units under construction and the general as well as local economic conditions. Because payments on construction loans are often dependent on the successful completion of construction project and the management of the project, repayment of such loans may be subject to adverse conditions in the real estate market or the economy, to a greater extent than other types of loans. Loan Approval Procedures and Authority. All unsecured loans in excess of $200,000 and all secured loans over $400,000, are reviewed and approved by the Loan Committee, which consists of seven directors of Victory State Bank, prior to commitment. Smaller loans may be approved by underwriters designated by the Bank's Chief Executive Officer. Consumer loans not secured by real estate and unsecured consumer loans, depending on the amount of the loan and the loan to value ratio, where applicable, require the approval of the Bank's Chief Lending Officer and/or Chief Executive Officer. Upon receipt of a completed loan application from a prospective borrower, we order a credit report and we verify other information. If necessary, we request additional financial information. An independent appraiser we designate performs an appraisal of the real estate intended to secure the proposed loan. The Board of Victory State Bank annually approves the independent appraisers and approves the Bank's appraisal policy. It is our policy to obtain title insurance on all real estate first mortgage loans. Borrowers must also obtain hazard insurance prior to closing. Some borrowers are required to make monthly escrow deposits which we then use to pay items such as real estate taxes. Delinquencies and Classified Assets Delinquent Loans. Our collection procedures for mortgage loans include sending a past due notice at 15 days and a late notice after payment is 30 days past due. In the event that payment is not received after the late notice, letters are sent or phone calls are made to the borrower. We attempt to obtain full payment or work out a repayment schedule with the borrower to avoid foreclosure. Generally, we authorize foreclosure proceedings when a loan is over 90 days delinquent. We record property acquired in foreclosure as real estate owned at the lower of its appraised value less costs to dispose, or cost. We cease to accrue interest on all loans 90 days past due and reverse all accrued but unpaid interest when the loan becomes non-accrual. We continue to accrue interest on construction loans that are 90 days past contractual maturity date if we expect the loan to be paid in full in the next 60 days and all interest is paid up to date. The collection procedures for other loans generally include telephone calls to the borrower after ten days of the delinquency and late notices at 15 and 25 days past due. Letters and telephone calls generally continue until the matter is referred to a collection attorney or resolved. After the loan is 90 days past due, the loan is referred to counsel and is written-off. Classified Assets. Federal regulations and our Loan Review and Risk Rating Policy provide for the classification of loans and other assets we consider to be of lesser quality as "Substandard", "Doubtful" or "Loss" assets. An asset is considered "Substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the insured institution will sustain "some loss" if the deficiencies are not corrected. Assets classified as "Doubtful" have all of the weaknesses inherent in those classified "Substandard" with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "Loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not 7 currently expose us to sufficient risk to warrant classification but which possess weaknesses are designated "Special Mention" by management. We had twenty (20) loans, in the aggregate amount of $2,390,871, classified as special mention, ten (10) loans, in the aggregate amount of $1,775,228, classified as substandard, one (1) loan, in the aggregate amount of $19,587, classified as doubtful, and no loans classified as loss as of December 31, 2005. When we classify an asset as Substandard or Doubtful, we provide, as part of our general allowance for loan losses, an amount management deems prudent to recognize the risks pertaining to the loans. A general allowance represents loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike a specific allowance, has not been allocated to particular problem assets. When we classify an asset as "Loss," we either establish a specific allowance for losses equal to 100% of the amount of the asset or charge off that amount. Victory State Bank's Loan Review Officer and Board of Directors regularly review problem loans and review all classified assets on a quarterly basis. We believe our policies are consistent with the regulatory requirements regarding classified assets. Our determination as to the classification of our assets and the amount of our valuation allowances is subject to review by the New York State Banking Department and the FDIC, which can order the establishment of additional general or specific loss allowances. The following table sets forth delinquencies in our loan portfolio as of the dates indicated: 8 At December 31, 2005 -------------------------------------------------- 60-89 Days 90 Days or more Number Principal Number Principal ---------- ---------- ---------- ---------- Commercial real estate -- $ -- 6 $1,123,081 Commercial construction -- -- 2 579,000 Commercial unsecured 1 8,420 -- -- ---------- ---------- ---------- ---------- Total 1 $ 8,420 8 $1,702,081 ========== ========== ========== ========== Delinquent loans to total loans 0.01% 2.29% At December 31, 2004 -------------------------------------------------- 60-89 Days 90 Days or more Number Principal Number Principal ---------- ---------- ---------- ---------- Commercial real estate 2 $ 256,137 4 $ 160,310 Commercial unsecured -- -- 1 20,112 Other -- -- 1 2,476 ---------- ---------- ---------- ---------- Total 2 $ 256,137 6 $ 182,898 ========== ========== ========== ========== Delinquent loans to total loans 0.37% 0.27% At December 31, 2003 -------------------------------------------------- 60-89 Days 90 Days or more Number Principal Number Principal ---------- ---------- ---------- ---------- Commercial real estate 2 $ 503,694 4 $ 259,026 Commercial construction -- -- 1 145,000 Commercial unsecured -- -- 1 30,619 Other -- -- 1 4,406 ---------- ---------- ---------- ---------- Total 2 $ 503,694 7 $ 439,051 ========== ========== ========== ========== Delinquent loans to total loans 0.74% 0.64% At December 31, 2002 -------------------------------------------------- 60-89 Days 90 Days or more Number Principal Number Principal ---------- ---------- ---------- ---------- Commercial real estate -- $ -- 7 $ 925,952 Commercial unsecured -- -- 1 14,734 ---------- ---------- ---------- ---------- Total -- $ -- 8 $ 940,686 ========== ========== ========== ========== Delinquent loans to total loans 0.00% 1.48% At December 31, 2001 -------------------------------------------------- 60-89 Days 90 Days or more Number Principal Number Principal ---------- ---------- ---------- ---------- Commercial construction 1 $ 7,376 -- $ -- Other -- -- -- -- ---------- ---------- ---------- ---------- Total 1 $ 7,376 -- $ -- ========== ========== ========== ========== Delinquent loans to total loans 0.01% 0.00% Loans 90 days or more past due represent non-accrual loans and loans that are contractually past due maturity but are still accruing interest. 9 Non-performing Assets. The following table sets forth information about our non-performing assets at December 31, 2005, 2004 and 2003. At December 31, At December 31, At December 31, 2005 2004 2003 -------------- -------------- -------------- Non-performing assets: Commercial loans: Unsecured $ -- $ 20,112 $ 30,619 Commercial real estate 1,022,097 121,810 259,026 Construction 579,000 -- 145,000 Consumer loan -- 2,476 4,406 -------------- -------------- -------------- Total non-performing assets $ 1,601,097 $ 144,398 $ 439,051 ============== ============== ============== Non-performing loans to total loans 2.15% 0.21% 0.64% Non-performing loans to total assets 0.74% 0.06% 0.24% Non-performing assets to total assets 0.74% 0.06% 0.24% The gross interest income that would have been recorded in 2005 if the non-accrual loans had been current in accordance with their original terms was $64,880. The amount of interest income on those loans that was included in net income for 2005 was $18,667. The following table sets forth the aggregate carrying value of our assets classified as Substandard, Doubtful and Loss according to asset type: At December 31, 2005 At December 31, 2005 Substandard Doubtful ----------------------- ----------------------- Number Amount Number Amount ---------- ---------- ---------- ---------- Classification of assets: Commercial Loans: Unsecured 4 $ 150,153 -- $ -- Commercial Real Estate 3 904,217 1 19,587 Construction 3 677,293 -- -- Other 1 43,565 -- -- ---------- ---------- ---------- ---------- Total loans 11 $1,775,228 1 $ 19,587 ========== ========== ========== ========== No assets were classified as Loss at year end 2005. Allowance for Loan Losses Our allowance for loan losses is established through a provision for loan losses based on management's evaluation of the risks inherent in its loan portfolio and the general economy. When analyzing the adequacy of the allowance for loan losses, management first considers performing loans in our loan portfolio that have no material identified weaknesses. Management considers historical experience, the state of the economy, our credit process, the nature of collateral, industry trends, geographic considerations and other factors, when assessing these loans. Management then establishes an amount equal to a fixed percentage of the performing loans in each of our five principal loan categories as appropriate to be included in the allowance to cover inherent weaknesses in the broad category of loans. 10 In addition, management analyzes each loan that has been identified as having specific weaknesses to determine the appropriate level of the allowance for that loan. This analysis considers both the general factors which are considered in assessing performing loans as well as specific facts pertinent to each loan, such as collateral value, borrower's income and ability to repay, payment history, the reasons for and length of the delinquency, and the value of any credit support. Although loans may be analyzed individually or in groups to determine the allowance, the entire allowance is available for any losses that occur. In order to assist in determining the allowance, an independent loan review firm, senior management and the Bank's Board of Directors review the allowance for loan losses quarterly. If they determine that the allowance is inadequate, then management increases the provision for loan losses to bring the allowance up to the level required. As of December 31, 2005, our allowance for loan losses was $1,153,298 or 1.55% of total loans. Based upon all relevant and presently available information, management believes that the allowance for loan losses is appropriate. We continue to monitor and modify the level of the allowance for loan losses in order to maintain the allowance at a level which management considers appropriate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary, based on changes in economic and local market conditions beyond management's control. In addition, federal and state bank regulatory agencies periodically review Victory State Bank's loan loss allowance as part of their periodic safety and soundness examinations of the Bank. They may recommend or seek to compel increases in the allowance if they believe that weaknesses in the loan portfolio are more significant than management's assessment. The following table sets forth the activity in our allowance for loan losses: For the Year Ended December 31, -------------------------------------------------------------------------------- 2005 2004 2003 2002 2001 ------------ ------------ ------------ ------------ ------------ Allowance for Loan Losses: Balance at beginning of period $ 1,299,520 $ 1,162,776 $ 1,168,358 $ 894,692 $ 766,377 Charge-offs: Commercial loans: Unsecured (318,399) (180,125) (315,490) (130,191) (229,337) Other loans (25,302) (4,940) (17,138) (24,421) (15,444) ------------ ------------ ------------ ------------ ------------ Total charge-offs (343,701) (185,065) (332,628) (154,612) (244,781) Recoveries 257,479 171,809 122,046 73,278 68,096 ------------ ------------ ------------ ------------ ------------ Net charge-offs (86,222) (13,256) (210,582) (81,334) (176,685) Provision charged to income (60,000) 150,000 205,000 355,000 305,000 ------------ ------------ ------------ ------------ ------------ Balance at end of period $ 1,153,298 $ 1,299,520 $ 1,162,776 $ 1,168,358 $ 894,692 ============ ============ ============ ============ ============ Ratio of net charge-offs during the period to average loans outstanding during the period 0.12% 0.02% 0.49% 0.27% 0.37% Ratio of allowance for loan losses to total loans at the end of period 1.55% 1.90% 1.70% 1.83% 1.77% Ratio of allowance for loan losses to non-performing loans at the end of the period 72.03% 899.96% 264.84% 356.45% 137.73% Ratio of allowance for loan losses to non-performing assets at the end of the period 72.03% 899.96% 264.84% 356.45% 137.73% The following table sets forth the allocation of our allowance for loan losses among each of the categories listed. 11 At December 31, At December 31, At December 31, 2005 2004 2003 -------------------------- ------------------------- ------------------------- % of Loans % of Loans % of Loans in Category in Category in Category to to to Amount Total Loans Amount Total Loans Amount Total Loans ----------- ----------- ----------- ----------- ----------- ----------- Allowance: Commercial loans: Unsecured $ 360,532 14.9% $ 351,215 14.1% $ 218,871 13.1% Secured 2,349 2.1 17,660 2.3 22,766 2.8 Commercial real estate 363,072 40.1 490,488 46.5 523,209 47.5 Residential real estate 7,835 0.4 11,296 1.6 12,957 2.0 Construction loans 362,590 39.8 358,632 33.4 354,792 32.5 Other loans 56,920 2.7 70,229 2.1 30,181 2.1 ----------- ----------- ----------- ----------- ----------- ----------- Total allowances $ 1,153,298 100.0% $ 1,299,520 100.0% $ 1,162,776 100.0% =========== =========== =========== =========== =========== =========== At December 31, At December 31, 2002 2001 ------------------------- ------------------------- % of Loans % of Loans in Category in Category to to Amount Total Loans Amount Total Loans ----------- ----------- ----------- ----------- Allowance: Commercial loans: Unsecured $ 290,496 17.7% $ 218,772 21.6% Secured 55,186 6.3 290,535 8.6 Commercial real estate 567,390 49.1 279,512 42.5 Residential real estate 8,896 0.8 2,351 0.7 Construction loans 206,920 23.4 79,030 24.3 Other loans 39,470 2.7 24,492 2.3 ----------- ----------- ----------- ----------- Total allowances $ 1,168,358 100.0% $ 894,692 100.0% =========== =========== =========== =========== Investment Activities State-chartered banking institutions have the authority to invest in various types of liquid assets, including United States Treasury Obligations, securities of various federal agencies, certain certificates of deposits of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Additionally, it is appropriate for us to maintain investments for ongoing liquidity needs and we have maintained liquid assets at a level believed to be adequate to meet our normal daily activities. Our investment policy, established by the Board of Directors of Victory State Bank and implemented by its Asset/Liability Committee, attempts to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complement our lending activities. Although we classify most of our securities portfolio as available for sale, it is our practice to retain most of our securities until they mature. Our policies generally limit investments to government and federal agency securities or AAA rated securities, including corporate debt obligations, that are investment grade with weighted average lives of seven years or less. Our policies provide that all investment purchases be ratified by the Bank's Board and may only be initiated by the President or Chief Financial Officer of the Bank. Investment securities consist of collateralized mortgage obligations ("CMO") with an estimated average lives of 4.5 years or less, mortgage-backed securities ("MBS") with maturities of seven years or less and U.S. Agency notes with a maturity of less than 15 years. These CMOs and MBS are backed by federal agencies such as Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC") or are "AAA" rated whole loan securities. At December 31, 2005, we had investment securities with a cost basis of $108,689,698 and a fair value of $106,023,293. Of these, $97,633,137 were either CMO's or MBS's. The entire investment portfolio at December 31, 2005 was classified as available for sale and is accounted on a fair market value basis. The following table sets forth certain information regarding the amortized cost and fair values of the investment securities, available for sale portfolio at the dates indicated: 12 At December 31, --------------------------------------------------------------------------------------- 2005 2004 2003 --------------------------- --------------------------- --------------------------- Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value ------------ ------------ ------------ ------------ ------------ ------------ Investments securities, available for sale US Government Agency $ 8,500,000 $ 8,390,156 $ 8,500,000 $ 8,481,563 $ 2,000,000 $ 2,000,000 FNMA 9,348,861 9,067,796 11,245,666 11,118,275 698,940 743,311 FHLMC 321,113 320,258 517,411 523,766 1,013,649 1,033,838 GNMA 2,718,832 2,627,459 3,296,901 3,263,366 3,782,659 3,732,954 Whole Loan MBS 4,135,883 4,051,823 5,114,582 5,068,462 3,691,027 3,746,108 Collateralized mortgage obligations 83,665,009 81,565,801 100,728,914 100,077,335 72,302,939 71,915,336 ------------ ------------ ------------ ------------ ------------ ------------ $108,689,698 $106,023,293 $129,403,474 $128,532,767 $ 83,489,214 $ 83,171,547 ============ ============ ============ ============ ============ ============ The table below sets forth certain information regarding the amortized cost value, weighted average yields and stated maturities of our investment securities at December 31, 2005 and 2004. At December 31, 2005 ------------------------------------------------------------------------------------------------------------------- Weighted Weighted Weighted Weighted Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average 1 Year Yield Years Yield Years Yield Years Yield Total ---------- ---------- ---------- ---------- ----------- ---------- ------------ ---------- ------------ Investment Securities: US Government Agency $ -- --% $5,500,000 3.00% $ 3,000,000 3.89% $ -- --% $ 8,500,000 FNMA 7 Year Balloon 29,328 5.56 -- -- 2,889,149 4.15 6,430,384 3.90 9,348,861 FHLMC -- -- 321,113 4.95 -- -- -- -- 321,113 GNMA -- -- -- -- -- -- 2,718,832 4.40 2,718,832 Whole Loan MBS -- -- -- -- -- -- 4,135,883 4.74 4,135,883 Collateralized Mortgage Obligations -- -- -- -- 1,935,895 4.57 81,729,114 4.45 83,665,009 ---------- ---------- ----------- ------------ ------------ Total $ 29,328 5.56% $5,821,113 3.11% $ 7,825,044 4.15% $ 95,014,213 4.42% $108,689,698 ========== ========== =========== ============ ============ At December 31, 2004 ------------------------------------------------------------------------------------------------------------------- Weighted Weighted Weighted Weighted Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average 1 Year Yield Years Yield Years Yield Years Yield Total ---------- ---------- ---------- ---------- ----------- ---------- ------------ ---------- ------------ Investment Securities: US Government Agency $ -- --% $3,000,000 2.98% $ 5,500,000 3.54% $ -- --% $ 8,500,000 FNMA 7 Year Balloon -- -- 560,127 5.33 2,976,988 4.36 7,708,551 3.92 11,245,666 FHLMC -- -- 517,411 5.02 -- -- -- -- 517,411 GNMA -- -- -- -- -- -- 3,296,901 4.39 3,296,901 Whole Loan MBS -- -- -- -- -- -- 5,114,582 4.66 5,114,582 Collateralized Mortgage Obligations -- -- -- -- 2,585,812 4.24 98,143,102 4.43 100,728,914 ---------- ---------- ----------- ------------ ------------ Total $ -- --% $4,077,538 3.60% $11,062,800 4.07% $114,263,136 4.40% $129,403,474 ========== ========== =========== ============ ============ Source of Funds General. Deposits are the primary source of our funds for use in lending, investing and for other general purposes. In addition to deposits, we obtain funds from principal repayments and prepayments on loans and securities. Loan and securities repayments are a relatively stable source of funds, while deposit inflows and outflows as well as unscheduled prepayments are influenced by general interest rates and money market conditions. 13 Deposits. We offer a variety of deposit accounts having a range of interest rates and terms. Our deposits consist of non-interest bearing checking accounts, money market accounts, time deposit ("certificate") accounts, statement savings and NOW accounts. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. Our deposits are obtained primarily from the areas in which our offices are located. We do not actively solicit certificate accounts in excess of $100,000, nor do we use brokers to obtain deposits. Management constantly monitors our deposit accounts and, based on historical experience, management believes it will retain a large portion of such accounts upon maturity. Deposit account terms we offer vary according to the minimum balance required, the time periods that the funds must remain on deposit and the interest rates, among other factors. In determining the characteristics of the deposit account programs we offer, we consider potential profitability, matching terms of the deposits with loan products, the attractiveness to the customers and the rates offered by our competitors. Our focus on customer service, primarily for the business and professional community in our marketplace, has facilitated our retention of non-interest bearing checking accounts and low costing NOW and money market accounts, which generally have interest rates substantially less than certificate of deposits. At December 31, 2005, these types of low cost deposit accounts amounted to $110,710,876, or 57.3% of total deposits. The following table presents deposit activity for the periods indicated. Year Ended Year Ended Year Ended December 31, December 31, December 31, 2005 2004 2003 -------------- -------------- -------------- Beginning balance $ 215,423,473 $ 167,103,445 $ 123,702,365 Net (decrease)/ increase before interest credited (23,793,756) 47,520,990 43,211,836 Interest credited on deposits 1,621,442 799,038 788,600 -------------- -------------- -------------- Ending balance $ 193,251,159 $ 215,423,473 $ 167,702,801 ============== ============== ============== The following table provides information regarding the remaining term to maturity of our time deposits over $100,000 at December 31, 2005: Maturity Period Amount ------------------- ------------- Three months or less $ 49,298,102 Over three through six months 6,103,486 Over six through 12 months 1,575,750 Over 12 months -- ------------- Total $ 56,977,338 ============= The following table presents by various rate categories, the amount and the periods to maturity of the certificate accounts outstanding at December 31, 2005. 14 Over Six Mos. Over One Year Over Two Years Six Months Through One Through Two Through Three Over Three And Less Year Years Years Years Total ------------ ------------ ------------ ------------ ------------ ------------ Certificate accounts: 1.00% to 1.99% $ 12,934,695 $ 1,265,963 $ -- $ -- $ -- $ 14,200,658 2.00% to 2.99% 37,907,884 601,759 959,829 164,000 -- 39,633,472 3.00% to 3.99% 10,886,812 1,095,135 443,196 327,000 1,145,000 13,897,143 ------------ ------------ ------------ ------------ ------------ ------------ $ 61,729,391 $ 2,962,857 $ 1,403,025 $ 491,000 $ 1,145,000 $ 67,731,273 ============ ============ ============ ============ ============ ============ Borrowings We do not routinely utilize borrowings, but in connection with the issuance of $5 million in trust preferred securities in August 2003, we issued a $5.2 million subordinated note to VSB Capital Trust I. Therefore, at December 31, 2004 and 2005, we had $5.2 million in subordinated debt. Personnel As of December 31, 2005, we had 51 full-time employees and 20 part-time employees. These employees are not represented by a collective bargaining unit and we consider our relationship with our employees to be good. REGULATION AND SUPERVISION Regulation of VSB Bancorp, Inc. VSB Bancorp, Inc., is a New York corporation and is subject to and governed by the New York Business Corporation Law. It is a bank holding company and thus is subject to regulation, supervision, and examination by the Federal Reserve. Bank Holding Company Regulation. As a bank holding company, we are required to file periodic reports and other information with the Federal Reserve and the Federal Reserve may conduct examinations of us. We are subject to capital adequacy guidelines of the Federal Reserve. The guidelines apply on a consolidated basis and require bank holding companies to maintain a minimum ratio of Tier1 capital to total assets of 4.0%. The minimum ratio is 3.0% for the most highly rated bank holding companies. The Federal Reserve's capital adequacy guidelines also require bank holding companies to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8.0%, and a minimum ratio of Tier1 capital to risk-weighted assets of 4.0%. As of December 31, 2005, the ratio of Tier 1 capital to total assets was 9.54%, the ratio of Tier 1 capital to risk-weighted assets was 20.37%, and the ratio of qualifying total capital to risk-weighted assets was 21.47%. Our ability to pay dividends can be restricted if overall capital falls below levels established by the Federal Reserve's guidelines. Federal Reserve approval is required if we seek to acquire direct or indirect ownership or control of 5% or more of the voting shares of a bank or bank holding company. We must obtain Federal Reserve approval before we acquire all or substantially all the assets of a bank or merge or consolidate with another bank holding company. These provisions also would apply to a bank holding company that sought to acquire 5% or more of the common stock of or to merge or consolidate with us. 15 Bank holding companies like us may not engage in activities other than banking and activities so closely related to banking or managing or controlling banks as to be a proper incident thereto. Federal Reserve regulations contain a list of permissible non-banking activities that are closely related to banking or managing or controlling banks and the Federal Reserve has identified a limited number of additional activities by order. These activities include lending activities, certain data processing activities, and securities brokerage and investment advisory services, trust activities and leasing activities. A bank holding company must file an application or a notice with the Federal Reserve prior to acquiring more than 5% of the voting shares of a company engaged in such activities. A bank holding company that is well capitalized and well managed and meets other conditions may provide notice after making the acquisition. We have the right to elect to be treated as a financial holding company if the Bank is well capitalized and well managed and has at least a satisfactory record of performance under the Community Reinvestment Act. Financial holding companies that meet certain conditions may engage in activities that are financial in nature or incidental to financial activities, or activities that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Federal law identifies certain activities that are deemed to be financial in nature, including non-banking activities currently permissible for bank holding companies to engage in both within and outside the United States, as well as insurance and securities underwriting and merchant banking activities. The Federal Reserve may identify additional activities that are permissible financial activities. No prior notice to the Federal Reserve is required for a financial holding company to acquire a company engaged in these activities or to commence these activities directly or indirectly through a subsidiary. We have not elected to be treated as a financial holding company since we have no current plans to use the authority to engage in expanded activities. However, we may elect to do so in the future. Section 404 of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") implements a broad range of corporate governance and accounting measures for public companies (including VSB Bancorp, Inc.) designed to promote honesty and transparency in corporate America. Among many other requirements, Sarbanes-Oxley includes a requirement, in Section 404, that annual reports include Section 404 of the Act requires each annual report of a public company to include a report by management on the company's internal control over financial reporting. The Securities and Exchange Commission has extended the deadline for non-accelerated filers (such as VSB Bancorp, Inc.) to comply with the filing requirements under Section 404. Under the extension, we are not required to comply with Section 404 until the fiscal year ending December 31, 2007. There have been proposals to amend, repeal or further delay the implementation Section 404 requirements and we cannot determine the ultimate outcome of those proposals. If we are required to implement Section 404 in its current form, we would be required to allocate significant amounts of management and other employee time to compliance and incur significant expense in fees to our independent registered public accountants. Statutory Restrictions on Acquisition of VSB Bancorp, Inc., and Victory State Bank Applicable provisions of the New York Banking Law, the federal Bank Holding Company Act, and other federal statutes, restrict the ability of persons or entities to acquire control of a bank holding company. Under the Change in Bank Control Act, persons who intend to acquire control of a bank holding company, either directly or indirectly or through or in concert with one or more persons must give 60 days' prior written notice to the Federal Reserve. "Control" would exist when an acquiring party directly or indirectly has voting control of at least 25% of our voting securities or the power to direct our management or policies. Under Federal Reserve regulations, a rebuttable presumption of control would arise with respect to an acquisition where, after the transaction, the acquiring party has ownership control, or the power to vote at least 10% (but less than 25%) of our common stock. The New York Banking Law requires prior approval of the New York Banking Board before any action is taken that causes any company to acquire direct or indirect control of a banking institution that is organized in the State of New York. The term "control" is defined generally to mean the power to direct or cause the direction of the management and policies of the banking institution and is presumed to exist if the company owns, controls or holds with power to vote 10% or more of the voting stock of the banking institution. 16 Section 912 of the New York Business Corporation Law, known as the New York Anti-Takeover Law, restricts the ability of interested stockholders to engage in business combinations with a New York corporation. In general terms, Section 912 prohibits any New York corporation covered by the statute from merging with an interested shareholder (i.e., one who owns 20% or more of the outstanding voting stock) for five years following the date on which the interested shareholder first acquired 20% of the stock, unless before that date the Board of Directors of the corporation had approved either the merger or the interested shareholder's stock purchase. Section 912 defines an interested stockholder as the beneficial owner, directly or indirectly, of 20% or more of the outstanding voting stock of a corporation; and certain other entities that have owned 20% or more of a corporation's stock during the past five years. A business combination is defined as a merger, consolidation, sale of 10% or more of the assets, or similar transaction. Unless an interested stockholder waits five years after becoming an interested stockholder to engage in a business combination, the business combination is prohibited unless our Board of Directors has approved either (a) the business combination or (b) the acquisition of stock by the interested stockholder, before the interested stockholder acquired its 20% interest. Even though the interested stockholder waits five years, the business combination is prohibited unless either: (i) the business combination or the acquisition of stock by the interested stockholder was approved by the Board of Directors before the interested stockholder acquired its 20% interest; (ii) the business combination is approved by a majority vote of all outstanding shares of stock not beneficially owned by the interested stockholder or its affiliates or associates at a meeting held at least five years after the interested stockholder becomes an interested stockholder; or (iii) the price paid for common stock acquired in the business combination is, in general terms, at least as much as the greater of (a) highest price paid by the interested stockholder for any stock since the interested stockholder first owned 5% of the stock of the corporation, or (b) the market value of the stock as of the date of announcement of the business combination; and the price paid for stock other than common stock is subject to comparable minimum standards. 17 Regulation of Victory State Bank The Bank is subject to extensive regulation and examination by the New York State Banking Department ("Department"), as its chartering authority, and by the FDIC, as the insurer of its deposits. The federal and state laws and regulations which are applicable to banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans. The Bank must file reports with the Department and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as establishing branches and mergers with, or acquisitions of, other depository institutions. There are periodic examinations by the Department and the FDIC to test the Bank's compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the Department, the FDIC or as a result of the enactment of legislation, could have a material adverse impact on the Bank and its operations. Capital Requirements The FDIC imposes capital adequacy standards on state-chartered banks, which, like the Bank, are not members of the Federal Reserve System. The FDIC's capital regulations establish a minimum 3.0% Tier I leverage capital requirement for the most highly-rated state-chartered, non-member banks, with an additional cushion of at least 100 basis points for all other state-chartered, non-member banks, which effectively will increase the minimum Tier I leverage ratio for such other banks to 4.0%. Under the FDIC's regulation, the highest-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, which are considered a strong banking organization and are rated composite 1 under the Uniform Financial Institutions Rating System. Tier I or core capital is defined as the sum of common stockholders' equity (including retained earnings), non-cumulative perpetual preferred stock and related surplus, and minority interests in consolidated subsidiaries, minus all intangible assets other than certain qualifying supervisory goodwill and certain mortgage servicing rights. The FDIC also requires that banks meet a risk-based capital standard. The risk-based capital standard for banks requires the maintenance of a ratio of total capital (which is defined as Tier I capital and supplementary capital) to risk-weighted assets of 8.0% and Tier I capital to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, plus certain off-balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier I capital are the same as for the leverage capital standard. The components of supplementary capital include certain perpetual preferred stock, certain mandatory convertible securities, certain subordinated debt and intermediate preferred stock and general allowances for loan and lease losses. Allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of core capital. The FDIC has an additional, higher capital level, known as well-capitalized. In order to be classified as well-capitalized, a bank must have a Tier1 leverage ratio of at least 5%, a Tier1 risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10%. At December 31, 2005, the Bank met each of its capital requirements. The following table shows the Bank's actual capital amounts and ratios. 18 To be well-capitalized For capital under prompt corrective Actual adequacy purposes action provisions ---------------------- ---------------------- ---------------------- Amount Ratio Amount Ratio Amount Ratio ------------ ------- ------------ ------- ------------ ------- As of December 31, 2005 Tier 1 Capital (to Average Assets) $ 20,453,000 9.19% $ 8,897,920 4.00% $ 11,122,400 5.00% Tier 1 Capital (to Risk Weighted Assets) 20,453,000 19.66% 4,162,120 4.00% 6,243,180 6.00% Total Capital (to Risk Weighted Assets) 21,606,000 20.76% 8,324,240 8.00% 10,405,300 10.00% Activities and Investments of New York-Chartered Banks. The Bank derives its lending, investment and other authority primarily from the applicable provisions of New York State Banking Law and the regulations of the Department, as limited by FDIC regulations and other federal laws and regulations. See "Activities and Investments of FDIC Insured State-Chartered Banks" below. These New York laws and regulations authorize the Bank to invest in real estate mortgages, consumer and commercial loans, certain types of debt securities, including certain corporate debt securities and obligations of federal, State and local governments and agencies, and certain other assets. A bank's aggregate lending powers are not subject to percentage of asset limitations, although there are limits applicable to single borrowers. A New York-chartered bank may also exercise trust powers upon approval of the Department. The Bank does not have trust powers. The New York Banking Board has the power to adopt regulations that enable state chartered banks to exercise the rights, powers and privileges permitted for a national bank. The Bank has not engaged in material activities authorized by such regulations. With certain limited exceptions, the Bank may not make loans or extend credit for commercial, corporate or business purposes (including lease financing) to a single borrower, the aggregate amount of which would be in excess of 15% of the Bank's net worth, on an unsecured basis, and 25% of the net worth if the loan is collateralized by readily marketable collateral or collateral otherwise having a value equal to the amount by which the loan exceeds 15% of the Bank's net worth. Theses limits do not apply to loans made by VSB Bancorp, Inc. directly at the holding company level. The Bank currently complies with all applicable loans-to-one-borrower limitations and VSB Bancorp, Inc. has not made any loans in its own name. Activities and Investments of FDIC-Insured State-Chartered Banks. The activities and equity investments of FDIC-insured, state-chartered banks are generally limited to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees' and officers' liability insurance coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. In addition, an FDIC-insured state-chartered bank may not directly, or indirectly through a subsidiary, engage as "principal" in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. 19 Regulatory Enforcement Authority Applicable banking laws include substantial enforcement powers available to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities. Under the New York State Banking Law, the Department may issue an order to a New York-chartered banking institution to appear and explain an apparent violation of law, to discontinue unauthorized or unsafe practices and to keep prescribed books and accounts. Upon a finding by the Department that any director, trustee or officer of any banking organization has violated any law, or has continued unauthorized or unsafe practices in conducting the business of the banking organization after having been notified by the Department to discontinue such practices, such director, trustee or officer may be removed from office by the Department after notice and an opportunity to be heard. The Bank does not know of any past or current practice, condition or violation that might lead to any proceeding by the Department against the Bank or any of its directors or officers. The Department also may take possession of a banking organization under specified statutory criteria. Prompt Corrective Action. Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the federal banking regulators with broad power to take "prompt corrective action" to resolve the problems of undercapitalized institutions. The extent of the regulators' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." A bank is deemed to be (i) "well capitalized" if it has total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure, (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized," (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. The regulations also provide that a federal banking regulator may, after notice and an opportunity for a hearing, reclassify a "well capitalized" institution as "adequately capitalized" and may require an "adequately capitalized" institution or an "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. The federal banking regulator may not, however, reclassify a "significantly undercapitalized" institution as "critically undercapitalized." An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with an appropriate federal banking regulator within 45 days of the date that the institution receives notice or is deemed to have notice that it is "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." Immediately upon becoming undercapitalized, an institution becomes subject to statutory provisions, which, among other things, set forth various mandatory and discretionary restrictions on the operations of such an institution. At December 31, 2005, the Company and the Bank had capital levels which qualified it as a "well-capitalized" institution. 20 FDIC Insurance The Bank is a member of the Bank Insurance Fund ("BIF") administered by the FDIC. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. On February 8, 2006, President Bush signed into law the Federal Deposit Insurance Reform Act of 2005. The law increases the amount of deposit insurance available for retirement accounts, indexes the amount of deposit insurance to inflation, merges the two existing deposit insurance funds (one historically for banks and one historically for savings and loan associations) into a single fund and gives the FDIC greater flexibility in determining the amount of future deposit insurance premiums that banks may be required to pay. The law also grants banks that were in existence prior to December 31, 1996 and paid deposit insurance premium prior to that date a credit against future deposit insurance assessments that the FDIC may make. The amount of the credit for each bank is based upon the amount of deposits they had on December 31, 1996. Since the Bank did not open for business until 1997, it is not entitled to any credit. Therefore, if the FDIC decides to reimpose deposit insurance premiums in the future, the Bank may be at a competitive disadvantage when compared to institutions with longer operating histories because those institutions might have lower expenses for deposit insurance premiums. The effect of the credit cannot be determined at this time because that effect would depend upon whether, when and upon what basis the FDIC imposes deposit insurance premiums in the future. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances that would result in termination of the Bank's deposit insurance. Brokered Deposits Under federal law and applicable regulations, (i) a well capitalized bank may solicit and accept, renew or roll over any brokered deposit without restriction, (ii) an adequately capitalized bank may not accept, renew or roll over any brokered deposit unless it has applied for and been granted a waiver of this prohibition by the FDIC and (iii) an undercapitalized bank may not (x) accept, renew or roll over any brokered deposit or (y) solicit deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in such institution's normal market area or in the market area in which such deposits are being solicited. The term "undercapitalized insured depository institution" is defined to mean any insured depository institution that fails to meet the minimum regulatory capital requirement prescribed by its appropriate federal banking agency. The FDIC may, on a case-by-case basis and upon application by an adequately capitalized insured depository institution, waive the restriction on brokered deposits upon a finding that the acceptance of brokered deposits does not constitute an unsafe or unsound practice with respect to such institution. The Bank had no brokered deposits outstanding at December 31, 2005. Community Reinvestment and Consumer Protection Laws In connection with its lending activities, the Bank is subject to a variety of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. Included among these are the Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community Reinvestment Act ("CRA"). 21 The CRA requires FDIC insured banks to define the assessment areas that they serve, identify the credit needs of those assessment areas and take actions that respond to the credit needs of the community. The FDIC must conduct regular CRA examinations of the Bank and assign it a CRA rating of "outstanding," "satisfactory," "needs improvement" or "unsatisfactory." The Bank is also subject to provisions of the New York State Banking Law which impose similar obligations to serve the credit needs of its assessment areas. The New York Banking Department makes a biennial written assessment of a bank's compliance, and makes the assessment available to the public. Federal and New York State laws both require consideration of these ratings when reviewing a bank's application to engage in certain transactions, including mergers, asset purchases and the establishment of branch offices. A negative assessment may serve as a basis for the denial of any such application. The Bank has received "Satisfactory" ratings from both the New York Banking Department and the FDIC. Limitations on Dividends The payment of dividends by the Bank is subject to various regulatory requirements. Under New York State Banking Law, a New York-chartered stock bank may declare and pay dividends out of its net profits, unless there is an impairment of capital, but approval of the Superintendent of Banks is required if the total of all dividends declared in a calendar year would exceed the total of its net profits for that year combined with its retained net profits of the preceding two years, subject to certain adjustments. Miscellaneous The Bank is subject to restrictions on loans to its non-bank subsidiaries, on investments in the stock or securities thereof, on the taking of such stock or securities as collateral for loans to any borrower, and on the issuance of a guarantee or letter of credit on behalf of the Bank or its non-bank subsidiaries. The Bank also is subject to restrictions on most types of transactions with the Bank or its non-bank subsidiaries, requiring that the terms of such transactions be substantially equivalent to terms of similar transactions with non-affiliated firms. Assessments Banking institutions are required to pay assessments to both the FDIC and the NYSBD to fund their operations. The assessments are based upon the amount of the Bank's total assets. The Bank must also pay an examination fee to the NYSBD when they conduct an examination. The Bank paid federal and state assessments and examination fees of $48,705 in 2005. Transactions with Related Parties The Bank's authority to engage in transactions with related parties or "affiliates" (i.e., any entity that controls or is under common control with an institution, including the Bank) or to make loans to certain insiders, is limited by Sections 23A and 23B of the Federal Reserve Act ("FRA"). Section 23A limits the aggregate amount of transactions with any individual affiliate to 10% of the capital and surplus of the institution and also limits the aggregate amount of transactions with all affiliates to 20% of the institution's capital and surplus. Loans to affiliates must be secured by collateral with a value that depends on the nature of the collateral. The purchase of low quality assets from affiliates is generally prohibited. Loans and asset purchases with affiliates, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated companies. In the absence of comparable transactions, such transactions may only occur under terms and circumstances, including credit standards that in good faith would be offered to or would apply to nonaffiliated companies. 22 The Bank's authority to extend credit to executive officers, directors and 10% shareholders, as well as entities controlled by such persons, is currently governed by Regulation O of the Federal Reserve Board. Regulation O generally requires such loans to be made on terms substantially similar to those offered to unaffiliated individuals (except for preferential loans made in accordance with broad based employee benefit plans), places limits on the amount of loans the Bank may make to such persons based, in part, on the Bank's capital position, and requires certain approval procedures to be followed. Standards for Safety and Soundness FDIC regulations require that Victory State Bank adopt procedures and systems designed to foster safe and sound operations in the areas of internal controls, information systems, internal and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings and compensation, fees and benefits. Among other things, theses regulations prohibit compensation and benefits and arrangements that are excessive or that could lead to a material financial loss. If Victory State Bank fails to meet any of these standards, it will be required to submit to the FDIC a plan specifying the steps that will be taken to cure the deficiency. If it fails to submit an acceptable plan or fails to implement the plan, FDIC the will require it or VSB Bancorp, Inc. to correct the deficiency and until corrected, may impose restrictions on them. The FDIC has also adopted regulations that require Victory State Bank to adopt written loan policies and procedures that are consistent with safe and sound operation, are appropriate for the size of the Bank, and must be reviewed by the Bank's Board of Directors annually. Victory State Bank has adopted such policies and procedures, the material provisions of which are discussed above as part of the discussion of our lending operations. Federal Reserve System The Federal Reserve Board regulations require banks to maintain non-interest earning reserves against their transaction accounts (primarily regular checking accounts and interest-bearing checking accounts). The Federal Reserve Board regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for accounts aggregating $48.3 million or less (subject to adjustment by the Federal Reserve Board) the reserve requirement is 3%; for accounts greater than $48.3 million, the reserve requirement is $1.2 million plus 10% (subject to adjustment by the Federal Reserve Board between 8% and 14%) against that portion of total transaction accounts in excess of $40.6 million. The first $7.8 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The Bank is in compliance these requirements. Because required reserves must be maintained in the form of either vault cash or a non-interest-bearing account at a Federal Reserve Bank or a pass-through account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce our interest-earning assets. TAXATION Federal Taxation General We are subject to federal income taxation in the same general manner as other corporations with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to us. Our federal income tax returns have not been audited or closed without audit by the Internal Revenue Service. Method of Accounting We report our income and expenses on the accrual method of accounting and use a tax year ending December 31 for filing our consolidated federal income tax returns. The Company files consolidated tax returns with the Bank and VSB Capital Trust I. 23 Bad Debt Reserves We use the experience method in computing bad debt deductions for federal tax purposes. Minimum Tax The Internal Revenue Code imposes an alternative minimum tax ("AMT") at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The AMT is payable to the extent such AMT is in excess of the Company's regular tax liability. Net operating losses can offset no more than 90% of AMT. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. We have not been subject to the alternative minimum tax and have no such amounts available as credits. State and Local Taxation New York State and New York City Taxation. New York State Franchise Tax on corporations is imposed in an amount equal to the greater of (a) 7.5% of "entire net income" allocable to New York State (b) 3% of "alternative entire net income" allocable to New York State (c) 0.01% of the average value of assets allocable to New York State or (d) a nominal minimum tax. Entire net income is based on federal taxable income, subject to certain modifications. Alternative entire net income is equal to entire net income without certain modifications. The New York City Corporation Tax is imposed using similar alternative taxable income methods and rates. A temporary Metropolitan Transportation Business Tax Surcharge on banking corporations doing business in the Metropolitan District has been applied since 1982. We transact a significant portion of our business within this District and thus we are subject to this surcharge. The current surcharge rate is 17% of the State franchise tax liability. New York City does not impose comparable surcharges. For New York State and City tax purposes, the bad debt deduction may be computed using a specific formula based on our actual loss history ("Experience Method"). Item 2. Description of Property. We conduct our business through four banking offices, with our fifth and sixth offices currently under construction. The main office is also our loan origination center. 24 Original Net Book Value Date Date of of Leasehold Leased or Leased or Lease Improvements at Location Description Owned Acquired Expiration (1) December 31, 2005 -------------- -------------- --------------- --------------- ----------------- 3155 Amboy Road Staten Island, N.Y. 10306 Main Office Leased 1997 12/31/2006 $ 29,591 755 Forest Avenue Staten Island, N.Y. 10310 Branch Leased 1999 11/30/2013 $ 164,416 One Hyatt Street Staten Island, N.Y. 10301 Branch Leased 1999 10/30/2014 $ 75,614 1762 Hylan Boulevard (2) Staten Island, N.Y. 10305 Branch Leased 2001 6/30/2016 $ 715,559 1766 Hylan Boulevard (3) Staten Island, N.Y. 10305 Retail Stores Leased 2001 6/30/2016 $ 205,249 4142 Hylan Boulevard Staten Island, N.Y. 10308 Branch Leased 2005 3/25/2020 (4) 1065 Bay Street Staten Island, N.Y. 10305 Branch Leased 2006 (5) (4) ----------------- Total net book value $1,190,429 ================= (1) All lease agreements with the exception of 3155 Amboy Road are renewable at our option. (2) Hylan Boulevard Branch commenced operations on December 4, 2002. (3) We leased the retail stores at 1766 Hylan Boulevard as a component of the lease for the Hylan branch and we sublease the property to retail tenants. (4) Construction in progress. No recorded book value. (5) This branch is under construction and the lease term will expire 15 years after the date of delivery of the space to the Bank by the landlord after certain construction is complete. Item 3. Legal Proceedings. The Bank is a defendant in an action pending in Supreme Court, Richmond County, commenced by IndyMac Bank, F.S.B. against the Bank, LaMattina & Associates, Inc. ("LAI") and various individuals and entities alleged to be officers, directors or otherwise to have relationships with LAI. LAI was a deposit customer of the Bank engaged in the business of providing real estate settlement services to lenders making residential mortgage loans. The plaintiff alleges that it was such a lender and that it had provided funds to LAI by wiring those funds to an account of LAI at the Bank to use to fund mortgage loans to be made by the plaintiff, only to have LAI not use those funds for their intended purpose. The action was commenced in August 2005. In November 2005, the plaintiff amended its complaint to add the Bank as a defendant and asserted a claim against the Bank for aiding and abetting a breach of a fiduciary duty. After the Bank made a motion to dismiss the claims against it, the plaintiff requested court permission to drop the aiding and abetting a breach of fiduciary duty claim, and to instead assert different claims based upon alleged negligence, misappropriation and deceptive business practices under the New York General Business Law. The proposed amended complaint requests monetary damages against the Bank of $1,817,041 plus recovery of attorneys fees. The Bank anticipates that the court will permit the plaintiff to amend its complaint. The Bank intends to defend aggressively the amended claims and has referred the litigation to its insurance carrier, which has indicated that at least some of the claims in the proposed second amended complaint asserted against the Bank are covered by insurance. 25 VSB Bancorp, Inc., is not involved in any pending legal proceedings. The Bank, from time to time, is involved in routine collection proceedings in the ordinary course of business on loans in default. Management believes that such other routine legal proceedings in the aggregate are immaterial to our financial condition or results of operations. Item 4, Submission of Matters to a Vote of Security Holders. None PART II Item 5. Market for Common Equity and Related Stockholder Matters. Our common stock is quoted on the NASDAQ Over the Counter Market ("OTC") under the symbol "VSBN". The following table reflects the high and low bid price for our common stock during each calendar quarter of the last two fiscal years. Such information is derived from quotations published by Bloomberg LP. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. 2005 ---- First Quarter Second Quarter Third Quarter Fourth Quarter ------------- -------------- ------------- -------------- High Bid.............. $25.50 $27.00 $23.00 $21.60 Low Bid............... $21.55 $21.50 $21.00 $19.40 2004 ---- First Quarter* Second Quarter Third Quarter Fourth Quarter ------------- -------------- ------------- -------------- High Bid.............. $24.00 $23.60 $23.60 $23.50 Low Bid............... $17.25 $22.00 $22.30 $21.75 * All per share prices have been adjusted for the one share for every three shares stock split effected as a stock dividend paid on March 8, 2004. We have approximately 273 stockholders of record. We have not paid any cash dividends. In a transaction consummated on May 30, 2003, we became the holding company for Victory State Bank as the result of what is commonly known as a reverse triangular merger. We issued our common stock to the then existing common stockholders of Victory State Bank in exchange for the outstanding common stock of Victory State Bank in the holding company reorganization. All shares issued were common stock. There was no underwriter in connection with the transaction. The shares issued on a three for two exchange basis. We issued 1,055,998 shares of our common stock upon consummation of the transaction and settled for fractional shares, aggregating two whole shares, in cash. The transaction was exempt from registration under the Securities Act of 1933 pursuant to Section 3(a)(12) as a bank holding company reorganization. VSB Bancorp, Inc. and Victory State Bank filed applications or notices with the New York State Superintendent of Banks, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System and received all required approvals to complete the holding company reorganization from those regulators. 26 Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations General VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company") became the holding company for Victory State Bank (the "Bank"), a New York State chartered commercial bank, upon the completion of a reorganization of the Bank into the holding company form of organization. The reorganization was effective in May 2003. Our primary business is owning all of the issued and outstanding stock of the Bank. Victory State Bank is a New York State chartered commercial bank, founded in November 1997. The Bank is supervised by the New York State Banking Department and the Federal Deposit Insurance Corporation ("FDIC"). The Bank gathers deposits from individuals and businesses primarily in Staten Island and makes loans throughout that community. The Bank invests funds that are not used for lending primarily in government securities, mortgage backed securities and collateralized mortgage obligations. Customer deposits are insured, up to the applicable limit, by the FDIC. VSB Bancorp, Inc. common stock is quoted on the NASDAQ Over the Counter Market ("OTC") under the symbol "VSBN". Since the Bank opened for business in 1997, the Board of Directors and management have pursued a strategy of growth and expansion in order to enhance the long term value of our banking franchise. The Board of Directors and management anticipate that an increase in customer deposits, and the resulting increase in funds we would have available to fund asset growth, will generate an increase in net interest income. We experienced an overall decline in deposits in 2005 due to factors we discuss below. We expect to open two new branches in 2006 and we anticipate that those new branches, as well as our existing branch network, will generate an increase in funds for investment in the future. In order to support branch expansion and asset growth, we have not paid cash dividends since we opened for business. Instead, our Board of Directors has elected to retain earnings to increase our capital base so that we can continue to be classified as well-capitalized for regulatory capital purposes while we grow. We also recognize that, on a short term basis, the development of a branch network generates significant expenses before it generates income from increased business. Our Board of Directors views the adverse effect on net income which occurs immediately after a branch opening as an investment in our future. As we have seen with our existing banking offices, as they mature and their deposits increase, we have increasing funds available for investment. During 2005, we faced a number of challenges, including increases in market interest rates that pushed up our cost of funds, both due to the upward pressure of deposit rates. Furthermore, our customers appear to have elected to move funds into higher rate deposit types such as certificate accounts as our rates on those products were high enough to outweigh the decreased convenience associated with them. However, the increase in the prime rate also allowed us to increase the yields on our existing prime based loans and originate new loans at higher initial interest rates. Also important in 2005 was a shift in our deposit mix as we experienced a decline in non-interest bearing demand deposits. This decline resulted from a number of factors including a reduction in real estate activity, which reduced demand deposits held in connection with pending real estate transactions; our termination of a relationship with a company providing services to residential mortgage lenders that eliminated demand deposit balances held by that company on pending and closed loans; and a shift in customer preferences towards interest bearing accounts as the yields on those accounts increased to the point where they became desirable alternatives. Management intends to exert efforts to continue growing our company in the future. However, both internal and external factors could adversely affect our future growth. The recent down turn in the economy has made it more difficult for us to originate new loans that meet our underwriting standards. Not only does that cause us to invest available funds in lower-yielding securities and 27 deposits with other banks, but it also slows the development of non-loan relationships which sometimes flow from cross-selling to loan customers. A continuation of adverse general economic conditions could make it difficult for us to execute our growth plans. Furthermore, regulatory capital requirements could have a negative effect on our ability to grow if growth outpaces our ability to support that growth with increased capital. Our results of operations are dependent primarily on net interest income, which is the difference between the income earned on our loan and investment portfolios and our costs of funds, consisting primarily of interest paid on our deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities. Critical Accounting Policies We are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change and to management's estimates. Actual results can differ from those estimates and may have an impact on our financial statements. Asset/Liability Management We maintain the interest rate sensitivity of our assets by investing primarily in CMO's and MBS's with short and intermediate average lives to generate cash flows and by originating and retaining primarily loans with interest rates based on the prime rate. As of December 31, 2005, prime based loans totaled $62,840,808, or 84.5% of total loans. Many of these prime based loans are subject to interest rate floors of 7.00% to 8.50%. We anticipate that we will continue to concentrate on originating prime based loans in our principal market areas. We also expect to continue to invest other available funds that we cannot invest in loans in short-term investment grade securities. Cash Flow Sensitivity Analysis. The matching of assets and liabilities may be analyzed by examining our cash flow sensitivity "gap." An asset or liability is said to be cash flow sensitive within a specific time period if it will mature or reprice within that time period. The cash flow sensitivity gap is defined as the difference between the amount of interest-earning assets maturing within a specific time period and the amount of interest-bearing liabilities maturing within that time period. A gap is considered positive when the amount of interest earning assets exceeds the amount of interest bearing liabilities. A gap is considered negative when the amount of interest bearing liabilities exceeds the amount of interest earning assets. During a period of falling interest rates, the net income of an institution with a positive gap can be expected to be adversely affected because the yield on its interest-earning assets should reprice downward faster than the decline in its cost of funds. Conversely, during a period of rising interest rates, the net income of an institution with a positive gap position can be expected to increase as it is able to invest in higher yielding interest-earning assets at a more rapid rate than its interest-earning liabilities reprice. A positive gap may not protect an institution with a large portfolio of adjustable rate based loans or mortgage-backed securities from increases in interest rates for extended time periods if such loans or securities have annual and lifetime interest rate caps. The increase in the cost of funds in a rapidly increasing rate environment could exceed the cap on assets yields, negatively impacting net interest income. However, our prime rate based loans and our securities investments generally do not have any annual or lifetime caps. In the current interest rate environment, we generally have been investing available funds not needed for lending in CMOs and MBSs with estimated average lives of four and one-half years or less. As a result of this strategy, and 28 based upon the assumptions used in the following table at December 31, 2005, our total interest-bearing liabilities maturing within one year exceeded our total interest-earning assets maturing in the same period by $16,989,547, representing a one year cumulative gap ratio of negative 3.57%. We closely monitor our interest rate risk as such risk relates to our operational strategies. The Victory State Bank Board of Directors has established an Asset/Liability Committee, responsible for reviewing our asset/liability policies and interest rate risk position, which generally meets quarterly and reports back to the Board on interest rate risk and trends on a quarterly basis. We are currently attempting to achieve a positive gap position in light of the current interest rate environment. There can be no assurance, however, that we will be able to achieve a positive gap position or that our strategies will not result in maintaining a negative gap position in the future. Although we have not experienced a material runoff in our core deposits, there can be no assurances that such a runoff will not occur in the future if depositors seek higher yielding investments. Our substantial level of non-interest-bearing demand deposits also furthers our goal of maintaining a positive gap because the interest cost of those deposits will not increase as market rates increase. However an increase in market interest rates could cause our customers to shift funds from demand deposits into interest earning deposits if interest rates are high enough to justify maintaining multiple accounts. Furthermore, there have been frequent proposals in Congress to permit the payment of interest on commercial demand deposits. The adoption of such legislation could have a significant effect on our net income by forcing us to pay interest on business demand deposits to maintain parity with our competitors. The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2005 which we estimate, based upon certain assumptions, will mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which mature during a particular period were determined in accordance with the earlier of estimated repayment or runoff or the contractual terms of the asset or liability. Our loan prepayment assumptions are based on peer banks' historical performance and statistics, including a 26.7% prepayment assumption on other loans and a 38.0% prepayment assumption on fixed-rate loans. There can be no assurance that deposits would reprice to peer bank's historical levels if interest rates were to increase. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets may have features which restrict changes in interest rates on a short-term basis and over the life of the asset. For example, if a prime rate loan has a minimum interest rate of 7.5%, an increase in a very low prime rate might not be sufficient to increase the interest rate on the loan to more than the minimum. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their prime rate loans may decrease in the event of an interest rate increase. 29 At December 31, 2005 ----------------------------------------------------------------------------------- Three Four More than months to twelve One year to More than or less months five years five years Total ------------- ------------- ------------- ------------- ------------- Interest-earning assets: Commercial loans (1) $ 68,679,297 $ 36,987 $ 340,707 $ 200,078 $ 69,257,069 Consumer loans (1) 3,335,691 28,352 47,019 66,092 3,477,154 Money market investments 730,758 -- -- -- 730,758 Mortgage-backed securities 5,722,472 17,167,416 77,225,387 -- 100,115,275 Other interest-earning assets 21,394,072 -- -- -- 21,394,072 Investment securities -- -- 5,500,000 3,000,000 8,500,000 ------------- ------------- ------------- ------------- ------------- Total interest-earning assets 99,862,290 17,232,755 83,113,113 3,266,170 203,474,328 Less: Unearned (discount) and deferred fees(2) (92,268) (276,804) 57,408 -- (311,664) ------------- ------------- ------------- ------------- ------------- Net interest-earning assets 99,770,022 16,955,951 83,170,521 3,266,170 203,162,664 Interest-bearing liabilities: Savings accounts 14,809,010 -- -- -- 14,809,010 NOW accounts 23,574,056 -- -- -- 23,574,056 Money market accounts 20,907,998 -- -- -- 20,907,998 Certificate accounts 53,220,153 11,472,095 3,039,025 -- 67,731,273 Subordinated debt -- -- 5,155,000 -- 5,155,000 ------------- ------------- ------------- ------------- ------------- Total interest-bearing liabilities 112,511,217 11,472,095 8,194,025 -- 132,177,337 Interest sensitivity gap $ (12,741,195) $ 5,483,856 $ 74,976,496 $ 3,266,170 $ 70,985,327 ============= ============= ============= ============= ============= Cumulative gap $ (12,741,195) $ (7,257,339) $ 67,719,157 $ 70,985,327 $ 70,985,327 ============= ============= ============= ============= ============= Cumulative gap as a percentage of total interest-earning assets -6.26% -3.57% 33.28% 34.89% 34.89% Cumulative net interest-earning assets as a percentage of total interest- bearing liabilities 88.68% 94.15% 151.23% 153.70% 153.70% (1) For purposes of the gap analysis, mortgage and other loans are reduced for non-performing loans but are not reduced for the allowance for possible loan losses. (2) For purposes of the gap analysis, unearned discount and deferred fees are pro-rated. Analysis of Net Interest Income Our profitability is primarily dependent upon net interest income. Net interest income represents the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities. Net interest income depends primarily upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them. 30 Average Balance Sheet The following table sets forth certain information relating to our consolidated statements of financial condition and the consolidated statements of earnings for the fiscal years ended December 31, 2005, 2004 and 2003 and reflects the average yield on assets and average cost of liabilities for the period indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The average balance of loans receivable does not include loans on which we have discontinued accruing interest. The yields and costs include net fees, which are considered adjustments to yields. No tax equivalent adjustments have been made. Year Ended December 31, Year Ended December 31, Year Ended December 31, 2005 2004 2003 ---------------------------------- ---------------------------------- ----------------------------------- Average Yield/ Average Yield/ Average Yield/ Balance Interest Cost Balance Interest Cost Balance Interest Cost ------------ ------------ ------ ------------ ------------ ------ ------------ ------------ ------ Assets: Interest-earning assets: Loans receivable $ 71,521,353 $ 5,828,338 8.15% $ 68,513,503 $ 5,340,281 7.79% $ 68,232,867 $ 5,120,215 7.50% Other interest earning assets 18,196,007 585,512 3.22 22,406,937 293,464 1.31 22,571,739 210,182 0.93 Investment securities 114,817,580 4,870,635 4.24 95,319,848 4,051,983 4.25 61,624,978 2,242,367 3.64 ------------ ------------ ------------ ------------ ------------ ------------ Total interest- earning assets 204,534,940 11,284,485 5.52 186,240,288 9,685,728 5.20 152,429,584 7,572,764 4.97 Non-interest earning assets 13,044,634 13,260,423 10,413,473 ------------ ------------ ------------ Total assets $217,579,574 $199,500,711 $162,843,057 ============ ============ ============ Liabilities and equity: Interest-bearing liabilities: Savings accounts $ 15,745,514 79,073 0.50 $ 12,596,720 63,130 0.50 $ 9,150,010 57,543 0.63 Time accounts 60,071,303 1,200,566 2.00 41,259,632 433,374 1.05 28,341,812 343,317 1.21 Money market accounts 20,835,285 229,906 1.10 23,219,409 195,269 0.84 25,379,394 264,283 1.04 Now accounts 24,524,078 104,620 0.43 23,988,825 100,941 0.42 25,610,959 123,457 0.48 Subordinated debt 5,155,000 356,159 6.91 5,155,000 356,159 6.91 1,779,534 118,029 6.63 ------------ ------------ ------------ ------------ ------------ ------------ Total interest- bearing liabilities 126,331,180 1,970,324 1.56 106,219,586 1,148,873 1.08 90,261,709 906,629 1.00 Checking accounts 74,654,567 79,654,202 60,842,673 ------------ ------------ ------------ Total 200,985,747 185,873,788 151,104,382 Other liabilities 2,631,982 2,071,349 1,438,827 ------------ ------------ ------------ Total liabilities 203,617,729 187,945,137 152,543,209 Equity 13,961,845 11,555,574 10,299,848 ------------ ------------ ------------ Total liabilities and equity $217,579,574 $199,500,711 $162,843,057 ============ ============ ============ Net interest income/net interest rate spread $ 9,314,161 3.96% $ 8,536,855 4.12% $ 6,666,135 3.97% ============ ====== ============ ====== ============ ======= Net interest earning assets/net interest margin $ 78,203,760 4.55% $ 80,020,702 4.58% $ 62,167,875 4.37% ============ ====== ============ ====== ============ ====== Ratio of interest-earning assets to interest- bearing liabilities 1.62 x 1.75 x 1.69 x ============ ============ ============ Return On Average Assets: 1.18% 1.14% 0.93% ====== ====== ====== Return On Average Equity: 18.39% 19.68% 14.76% ====== ====== ====== Equity To Assets: 6.73% 5.44% 5.77% ====== ====== ====== 31 Rate/Volume Analysis The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. Year Ended December 31, 2005 Year Ended December 31, 2004 Compared to Compared to December 31, 2004 December 31, 2003 Increase/(Decrease) Increase/(Decrease) In Net Interest Income In Net Interest Income ----------------------------------------- ----------------------------------------- Due to Due to -------------------------- -------------------------- Volume Rate Net Volume Rate Net ----------- ----------- ----------- ----------- ----------- ----------- Interest-earning assets: Loans receivable $ 234,312 $ 253,745 $ 488,057 $ 21,048 $ 199,018 $ 220,066 Money market -- -- -- (3,234) 6 (3,228) Other interest-earning assets (55,163) 347,211 292,048 (1,533) 84,815 83,282 Investment securities, afs 828,654 (10,002) 818,652 1,237,333 575,511 1,812,844 ----------- ----------- ----------- ----------- ----------- ----------- Total 1,007,802 590,955 1,598,757 1,253,614 859,350 2,112,964 Interest-bearing liabilities: Savings accounts 15,744 199 15,943 21,714 (16,127) 5,587 Time accounts 197,523 569,669 767,192 156,306 (66,249) 90,057 Money market accounts (20,027) 54,664 34,637 (22,464) (46,550) (69,014) Now accounts 2,248 1,431 3,679 (7,786) (14,730) (22,516) Subordinated debt -- -- -- 238,130 -- 238,130 ----------- ----------- ----------- ----------- ----------- ----------- Total 195,488 625,963 821,451 385,900 (143,656) 242,244 ----------- ----------- ----------- ----------- ----------- ----------- Net change in net interest income $ 812,314 ($ 35,008) $ 777,306 $ 867,715 $ 1,003,005 $ 1,870,720 =========== =========== =========== =========== =========== =========== Year Ended December 31, 2003 Compared to December 31, 2002 Increase/(Decrease) In Net Interest Income ---------------------------------------- Due to ------------------------- Volume Rate Net ----------- ----------- ----------- Interest-earning assets: Loans receivable $ 836,654 ($ 128,127) $ 708,527 Money market 3,975 (4,243) (268) Other interest-earning assets 123,269 (94,497) 28,772 Investment securities, afs 1,264,723 (947,590) 317,133 ----------- ----------- ----------- Total 2,228,621 (1,174,457) 1,054,164 Interest-bearing liabilities: Savings accounts 9,664 (23,900) (14,236) Time accounts 251,003 (294,943) (43,940) Money market accounts 116,130 (114,597) 1,533 Now accounts 39,928 (16,972) 22,956 Subordinated debt 118,029 -- 118,029 ----------- ----------- ----------- Total 534,755 (450,413) 84,342 ----------- ----------- ----------- Net change in net interest income $ 1,693,866 ($ 724,044) $ 969,822 =========== =========== =========== Comparative Results for the Years Ended December 31, 2005 and December 31, 2004 General. We had net income of $2,567,429 for the year ended December 31, 2005, as compared to net income of $2,274,578 for the year ended December 31, 2004. The principal categories which make up the 2005 net income are: o Interest income of $11,284,485 o Reduced by interest expense of $1,970,324 o Increased by a credit provision for loan losses of $60,000 o Increased by non-interest income of $2,117,640 o Reduced by non-interest expense of $6,684,898 o Reduced by $2,239,474 in income tax expense. We discuss each of these categories individually and the reasons for the differences between the years ended December 31, 2005 and 2004 in the following paragraphs. The most significant factors that caused changes in net income from 2004 to 2005 were the increase in short-term interest rates and an increase in the average volume of interest-earning assets and liabilities. The interest rate increase affected both our yields on investments and our cost of funds, while the increase in average volume had a more significant effect on yields earned than on rates paid. Our average yields earned are higher than our cost of funds, and thus an increase in interest-earning assets provides more interest income than the cost of the increase in interest bearing liabilities to fund those assets. Therefore, our proposed new branches in 2006 and other marketing efforts are designed to seek to reverse the decline in assets we experienced during 2005. The implementation of our Employee Stock Ownership Plan ("ESOP") also increases compensation expense as we make contributions to the ESOP. 32 Interest Income. Interest income was $11,284,485 for the year ended December 31, 2005, compared to $9,685,728 for the year ended December 31, 2004, an increase of $1,598,757, or 16.5%. The reasons for this increase include a $19,497,732 increase in the average balance of investment securities, which generated an additional $818,652 of interest income. Toward the end of 2004, we were able to increase the average volume of investment securities by focusing funds we could not deploy in loans into higher-yielding investment securities instead of lower-yielding short term investments such as overnight federal funds sold. Our volume of investment securities was highest at the beginning of 2005 and gradually declined during the year as principal was repaid on those securities, The reported yield on investment securities for the year ended 2005 was flat from the prior year because the purchases made in the portfolio in 2005 were made during the fourth quarter and they did not create a material change in the average yield Also contributing to the increase in interest income was a $3,007,850 or 4.4% increase in the average balance of loans receivable, coupled with a 36 basis point increase in the yield on loans. These increases generated a $488,057 increase in interest earned on loans. The increase in the volume of loans was a result of our efforts to increase our loan portfolio because loans are our highest earning asset category. The average yield on our loans increased because during 2005 the prime rate increased to the point where our prime based loans began to reprice upward from their interest rate floors that had been effective in 2004. Finally, we had a $292,048 increase in income from overnight funds and other interest earning assets, as the yield increased 191 basis points during 2005 due to higher market rates on short term and overnight investments. The volume of these assets declined by $4,210,930 from 2004 as we directed our available funds into investment securities which gain higher yields than overnight investments. Interest Expense. Interest expense was $1,970,324 for the year ended December 31, 2005, compared to $1,148,873 for the year ended December 31, 2004, an increase of 71.5%. More than 90% of the $821,451 increase in interest expense was represented by an increase in the cost of our time deposits. The average balance of time accounts increased by $18,811,671 (or 45.6%) and the average rate on those accounts increased by 95 basis points, which resulted in an increase of $767,192 in interest expense. The increase in rate was due to the increase in market rates, while the volume increase, which represented substantially all of our increase in average deposit balances between the two years, was apparently the result of a shift in customer preferences in favor of time deposit accounts. The rates we paid on those accounts increased to the point where we believe customers perceived a sufficient economic benefit for agreeing to lock up the deposited funds for the term to maturity of the time deposit. Our average cost of funds increased from 1.08% to 1.56% between the periods because of the increase in the cost of time and money market deposits and the shift in favor of time deposits, which are our highest cost deposit category. In addition, average non-interest bearing checking accounts decreased as a percentage of total deposits from 42.9% in 2004 to 37.1% in 2005. This decrease is due to the migration of deposits from non-interest bearing to interest-bearing products as rates increased throughout the year and the decrease in mortgage related checking account balances as the mortgage market cooled in 2005 and the Bank terminated its relationship with a customer that had maintained large balances. Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $9,314,161 for the year ended December 31, 2005, an increase of $777,306, or 9.1% over the $8,536,855 we had for the year ended December 31, 2004. The increase was driven primarily by the increase in the volume of average interest-earning assets, partially offset by the increase in the cost of funds due to the higher market rates and the related customer reallocation of deposits into higher cost products. We benefited from having higher interest earning assets toward the beginning of the year, which resulted in an increase of $19,497,732 in average investment securities. Our interest rate spread declined by 16 basis points from 4.12% at December 31, 2004 to 3.96% at December 31, 2005, principally for the following reasons: 33 o An increase in prevailing interest rates caused a substantial increase in the cost of our money market and time deposits; o Customers appear to have shifted their deposit preferences towards higher cost time deposits as the increase in interest rates made those deposits more attractive; but o These negative effects were partially offset by the increase in the yield and average volume of interest earning assets. Our net interest margin, which takes into account the effect of non-interest bearing funding sources such as checking accounts and capital, declined by only 3 basis points from 2004 to 2005. This decline was less than the decline in spread because, as interest rates rise, zero cost funding sources become more and more valuable. The increase in yields on assets funded by non-interest bearing deposits and capital outweighed the negative effects of a $4,999,655 (or 6.3%) decline in the average balance of checking accounts from $79,654,202 in 2004 to $74,654,567 in 2005. The prime rate, which is the index used to adjust interest rates on many of our loans, was 7.25% at the end of 2005, as compared to 5.25% at the end of 2004. Although these loans primarily have interest rates with a margin of 100 to 150 basis points above the prime rate, many have interest rate floors so that the rates on the loans cannot decline below 7.00% to 7.50%. As a result of the prime rate increase, the index plus the margin exceeded the floors on many of these loans in 2005, so our yields on these loans now adjust with increases in the prime rate. Therefore, we had higher loan yields in 2005 than we had in 2004 when many of the loans had interests rates equal to their floor rates. If the prime rate continues to rise, these loans will continue to re-price upwards along with prime. Conversely, if the prime rate falls, these loans will re-price downward with prime until rates reach the interest rate floors. Provision for Loan Losses. In 2005, we recorded a $60,000 credit to the provision for loan losses, compared to a provision for loan losses of $150,000 for the year ended December 31, 2004. The $210,000 net decrease in the provision was primarily due to a moderate decrease in the rate of unsecured loan delinquencies in the loan portfolio. If we are able to effectuate a material increase in our loan portfolio to increase average asset yields, that would probably also generate an increase in the provision for loan losses. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses reflects probable incurred losses based on management's evaluation of the loan portfolio, and the general economy, local economic conditions and other factors affecting loan repayments. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance. Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.55% of total loans at December 31, 2005, but there can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future. Non-interest Income. Non-interest income was $2,117,640 for the year ended December 31, 2005, compared to $1,889,818 during the same period last year. The $227,822, or 12.1% increase was caused primarily by a $150,151 increase in net rental income, which resulted from a one-time payment of $119,000 from a tenant of the Bank who opted to terminate the sub-lease agreement in which the Bank is lessor. This payment satisfied all conditions of the sub-lease agreement. 34 Service fees on deposit accounts declined from 2004 to 2005 as the volume of deposit account transactions generating fee income declined. Although average deposits increased from year to year, much of this increase was in time deposit accounts that tend not to generate fee income, and by the end of 2005, total deposits were lower than they had been at the beginning of 2005. Most of the decline during 2005 was in the non-interest bearing checking account category, which is the account type that tends to generate the highest level of service fees. Non-interest Expense. Non-interest expense was $6,684,898 for the year ended December 31, 2005, compared to $6,018,691 for the year ended December 31, 2004. an increase of $666,207, or 11.1%. The principal causes of the increase were: o $361,580 in higher salary and benefits costs due to normal salary increases, a slight increase in staffing to support growth, and higher benefit costs. o $38,807 in higher legal expenses incurred in connection with a number of pending lawsuits involving a former customer of the Bank. o $263,820 more of "other expenses," reflecting the effects of branch expansion on other expense categories, increased costs of service providers and a $100,000 expense associated with the establishment of a reserve for an unasserted claim. The reserve involves a transaction between other parties that was processed by the Company. Income Tax Expense. Income tax expense was $2,239,474 for the year ended December 31, 2005, compared to income tax expense of $1,983,404 for the year ended December 31, 2004, due to the $548,921 increase of income before income taxes for the year ended December 31, 2005. Our effective tax rate remained the same for 2005 and 2004 at 46.6%. Changes in Financial Condition Our total assets were $215,775,712 at December 31, 2005, a decrease of $19,908,755, or 8.4%, since December 31, 2004. The decline resulted from a need to fund a decline in deposits, principally demand accounts. We funded the decline in deposits primarily with cash flows from principal paydowns on investment securities. The total decrease in assets can be categorized as follows. o A $4,334,926 decrease in cash and equivalents o A $22,509,474 decrease in investment securities available for sale o Partially offset by a $6,043,442 increase in net loans receivable, as management continued its efforts to increase our loan portfolio in order to increase interest income. In addition, we also experienced changes in other asset categories due to normal fluctuations in operations. Our deposits (including escrow deposits) were $193,251,159 at December 31, 2005, a decrease of $22,172,314, or 10.3%, from December 31, 2004. The decrease in total deposits includes a $34,868,496 decrease in non-interest demand deposits and a $3,211,610 decrease in money market accounts, partially offset by a $2,000,003 increase in NOW accounts, a $649,984 increase in savings and a $13,260,766 increase in time deposits. Total stockholders' equity was $14,531,407 at December 31, 2005, an increase of $1,701,786 from December 31, 2004. The increase reflected net income of $2,567,429 for the year ended December 31, 2005, reduced by an increase of $959,082 in other comprehensive loss due to an increase in the unrealized loss in securities available for sale during 2005. The unrealized loss increased due to the increase in market interest rates, which drove down the market value of the fixed rate bond portfolio. This unrealized loss is excluded from the 35 calculation of regulatory capital. Management does not anticipate selling securities in this portfolio, but changes in market interest rates or in the demand for funds may change management's plans with respect to the securities portfolio. If there is a material increase in interest rates, the market value of the available for sale portfolio may decline further. Management believes that the principal and interest payments on this portfolio, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow. The change in stockholders' equity also included a decrease of $75,640 in additional paid in capital due to reclassification of $158,113 representing the Employee Stock Ownership Plan Repurchase Obligation, partially offset by the increase due to the exercise of options to purchase 4,800 shares of common stock and a decrease in unearned ESOP shares of $169,078 reflecting the effect of the gradual payment of the loan we made to fund the ESOP's purchase of our stock. VSB Bancorp, Inc. satisfied all capital ratio requirements of the Federal Reserve at December 31, 2005, with a Tier I Leverage Capital ratio of 9.54%, a ratio of Tier I Capital to Risk-Weighted Assets ratio of 20.37%, and a Total Capital to Risk-Weighted Assets ratio of 21.47%. In May of 2004, we implemented the stockholder-approved ESOP. We lent the ESOP the money to purchase shares of our stock with the expectation that the ESOP will repay the loan principally from contributions from Victory State Bank as part of its employee compensation program. The loan has a ten year term, with periodic payments due annually sufficient to repay the loan, including interest, in monthly installments over the term of the loan. The interest rate is fixed at 4.00%, the prime rate on the date of the loan. Upon implementation, the ESOP purchased 74,320 shares of our common stock out of our authorized but unissued shares, which initially had no net effect on capital on the purchase date. The purchase price was $22.75 per share, the fair market value at that time, for a total purchase price of $1.7 million. As payments are made to reduce the ESOP loan, stock is released from the security interest for the loan, resulting in an increase in capital equal to the market value of the ESOP stock as it is released. However, under federal law regarding employee stock ownership plans, since our stock is not considered to be "readily tradable on an established market," employees who receive a distribution of stock from the ESOP upon termination of employment have the right to require that we repurchase the stock at fair value. We reflect this contingent repurchase obligation on our balance sheet as a reclassification of additional paid in capital of $284,938 to mezzanine capital, based upon our quoted price on December 31, 2005, but the amount still qualifies as capital for regulatory purposes. Employees are not permitted to make contributions to the ESOP. For financial statement reporting purposes, we record the compensation expense related to the ESOP when shares are to be released from the security interest for the loan. The amount of the compensation expense is based upon the fair market value of the shares at that time, not the original purchase price. The initial sale of shares to the ESOP did not increase our capital by the amount of the purchase price because the purchase price was paid by the loan we made to the ESOP. Instead, capital increases as the shares are allocated or committed to be allocated to employee accounts (i.e., as the ESOP loan is gradually repaid), based upon the fair market value of the shares at that time. When we calculate earnings per share, only shares allocated or committed to be allocated to employee accounts are considered to be outstanding. However, all shares that the ESOP owns are legally outstanding, so they have voting rights and, if we pay dividends, dividends will be paid on all ESOP shares. Liquidity and Capital Resources Our primary sources of funds are increases in deposits and proceeds from the repayment of investment securities. We use these funds principally to purchase new investment securities and to fund increases in our loan portfolio. 36 For the year ended December 31, 2005, we had a net decrease in total deposits of $22,172,314 as a result of a $35,430,119 decline in demand deposit accounts, partially offset by a $13,260,766 increase in time deposits. We received proceeds from repayment of investment securities of $28,371,189, which we used to fund the deposit outflow, net loan growth of $6,043,442 and the purchase of $7,776,706 of investment securities. The decrease in deposits is primarily attributable to a decline in real estate activity in our community, which resulted in a reduction in demand deposits created in connection with pending real estate and mortgage loan transactions, as well as our termination of our relationship with a customer in the real estate settlement business. Demand deposits also tend to decline in a rising rate environment, as customers have a greater incentive to place their funds in interest-bearing accounts. In contrast, for the year ended December 31, 2004, we had a net increase in deposits of $47,720,672 as a result of the continued implementation of our strategy to seek to grow our bank. We also received proceeds from repayment of investment securities of $31,356,409. We used those funds to increase our interest-bearing bank balances by $4,876,006 and to purchase $77,439,652 of investment securities and money market investments. The increase in deposits is primarily attributable to deposit increases at all our branches and a $5 million time deposit from the City of New York, into our St. George branch, under New York City's new Bank Development District deposit program. In 2005, we experienced a net decline of $4,334,926 in cash and equivalents because of our strategy to invest available cash in investments and loans as opposed to lower yielding overnight deposits. Total cash and equivalents at December 31, 2005 were $31,324,147. In contrast, during 2004 funds available to us exceeded the amount of investments we chose to make, so we experienced a $5,471,332 increase in cash and cash equivalents. Total cash and cash equivalents at December 31, 2004 were $35,659,073. The following table sets forth our contractual obligations and commitments for future lease payments, time deposit maturities and loan commitments. Contractual Obligations and Commitments at December 31, 2005 Contractual Obligations Payment due by Period ------------------------------------------------------------------------ Less than One to three Four to five After Total Amounts One Year years years five years committed ------------ ------------ ------------ ------------ ------------ Minimum annual rental payments under non-cancelable operating leases $ 511,869 $ 1,219,592 $ 415,101 $ 2,950,638 $ 5,097,200 Remaining contractual maturities of time deposits 64,692,248 1,894,025 1,145,000 -- 67,731,273 ------------ ------------ ------------ ------------ ------------ Total contractual cash obligations $ 65,204,117 $ 3,113,617 $ 1,560,101 $ 2,950,638 $ 72,828,473 ============ ============ ============ ============ ============ Other commitments Amount of commitment Expiration by Period ------------------------------------------------------------------------ Less than One to three Four to five After Total Amounts One Year years years five years committed ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------ Loan commitments $ 17,093,709 $ 9,326,424 $ 15,000 $ -- $ 26,435,133 ============ ============ ============ ============ ============ Impact of Inflation and Changing Prices The consolidated financial statements and related notes presented herein have been prepared in accordance with accounting principles generally accepted in the United States, which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time and due to inflation. Unlike industrial companies, nearly all of our assets and liabilities are monetary. As 37 a result, interest rates have a greater impact on our performance than do the general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. PART II Item 7. The company's financial statements appear on the following pages: 38 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm ................................................F-1 Consolidated Statements of Financial Condition as of December 31, 2005 and 2004.........................F-2 Consolidated Statements of Earnings for the Years Ended December 31, 2005 and 2004......................F-3 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2005 and 2004..........F-4 Consolidated Statements of Cash Flows for the Years Ended December 31, 2005 and 2004....................F-5 Notes to Consolidated Financial Statements..............................................................F-6 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders VSB Bancorp, Inc. Staten Island, New York We have audited the accompanying consolidated statements of financial condition of VSB Bancorp, Inc. as of December 31, 2005 and 2004 and the related consolidated statement of earnings, stockholders' equity and comprehensive income and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material results, the financial position of VSB Bancorp, Inc. as of December 31, 2005 and 2004 and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Crowe Chizek and Company LLC Livingston, New Jersey February 16, 2006 F-1 VSB BANCORP, INC. CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2005 AND 2004 -------------------------------------------------------------------------------- ASSETS 2005 2004 ------------- ------------- Cash and cash equivalents $ 31,324,147 $ 35,659,073 Investment securities, available for sale 106,023,293 128,532,767 Loans receivable (net of allowance for loan losses of $1,153,298 and $1,299,520, respectively) 72,790,807 66,747,365 Accrued interest receivable 728,627 745,368 Premises and equipment, net 1,441,087 1,817,284 Prepaid and other assets 1,169,556 719,670 Deferred income taxes, net 2,298,195 1,462,940 ------------- ------------- Total assets $ 215,775,712 $ 235,684,467 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Deposits Non-interest bearing $ 66,959,580 $ 101,831,037 Interest bearing 126,291,579 113,592,436 Subordinated Debt 5,155,000 5,155,000 Accounts payable, accrued expenses and other liabilities 2,553,208 2,149,548 ------------- ------------- Total liabilities 200,959,367 222,728,021 ------------- ------------- Employee Stock Ownership Plan Repurchase Obligation 284,938 126,825 STOCKHOLDERS' EQUITY Common stock ($.0001 par value, 3,000,000 shares authorized, 1,509,822 issued and outstanding at December 31, 2005; 1,505,022 issued and outstanding at December 31, 2004) 151 150 Additional paid-in capital 8,742,673 8,818,313 Retained earnings 8,621,693 6,054,264 Unearned Employee Stock Ownership Plan shares (1,408,983) (1,578,061) Accumulated other comprehensive loss, net of taxes of $1,242,278 and $405,662, respectively (1,424,127) (465,045) ------------- ------------- Total stockholders' equity 14,531,407 12,829,621 ------------- ------------- Total liabilities and stockholders' equity $ 215,775,712 $ 235,684,467 ============= ============= See notes to consolidated financial statements. F-2 VSB BANCORP, INC. CONSOLIDATED STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 -------------------------------------------------------------------------------- 2005 2004 ------------ ------------ INTEREST INCOME: Loans receivable $ 5,828,338 $ 5,340,281 Investment securities 4,870,635 4,051,983 Other interest income 585,512 293,464 ------------ ------------ Total interest income 11,284,485 9,685,728 INTEREST EXPENSE: Deposits 1,614,165 792,714 Subordinated Debt 356,159 356,159 ------------ ------------ Total interest expense 1,970,324 1,148,873 Net interest income 9,314,161 8,536,855 PROVISION (CREDIT) FOR LOAN LOSSES (60,000) 150,000 ------------ ------------ Net interest income after provision (credit) for loan losses 9,374,161 8,386,855 ------------ ------------ NON-INTEREST INCOME: Deposit service fees 1,685,198 1,709,787 Other income 432,442 180,031 ------------ ------------ Total non-interest income 2,117,640 1,889,818 ------------ ------------ NON-INTEREST EXPENSES: Salaries and employee benefits 3,780,485 3,418,905 Occupancy and equipment 976,949 947,954 Data processing service fees 241,396 255,350 Legal fees 173,178 134,371 Professional fees 222,000 235,041 Director fees 167,050 123,500 Supplies and service 287,652 201,886 Checkbook charges 156,115 165,267 Other 680,073 536,417 ------------ ------------ Total non-interest expenses 6,684,898 6,018,691 ------------ ------------ INCOME BEFORE INCOME TAXES 4,806,903 4,257,982 ------------ ------------ PROVISION/(BENEFIT) FROM INCOME TAXES: Current 2,238,114 2,253,973 Deferred 1,360 (270,569) ------------ ------------ Total income taxes 2,239,474 1,983,404 ------------ ------------ NET INCOME $ 2,567,429 $ 2,274,578 ============ ============ Basic net income per share of common stock $ 1.78 $ 1.60 ============ ============ Diluted net income per share of common stock $ 1.73 $ 1.54 ============ ============ Comprehensive income $ 1,608,347 $ 1,979,199 ============ ============ See notes to consolidated financial statements. F-3 VSB BANCORP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 -------------------------------------------------------------------------------- Accumulated Number of Additional Unearned Other Total Common Common Paid-in Retained ESOP Comprehensive Stockholders' Shares Stock Capital Earnings Shares Earnings/(Loss) Equity ------------ ------------ ------------ ------------ ------------ ------------ ------------ Balance at December 31, 2003 1,055,998 $ 106 $ 7,076,486 $ 3,779,686 $ -- $ (169,666) $ 10,686,612 Exercise of stock option 22,720 2 177,802 177,804 4 for 3 stock split and the purchase of fractional shares 351,984 35 (368) (333) Purchase of newly issued common stock by ESOP 74,320 7 1,690,773 1,690,780 Issuance of ESOP shares (1,690,780) (1,690,780) Amortization of earned portion of ESOP common stock 112,719 112,719 Amortization of excess fair value of cost - ESOP 445 445 Transfer to ESOP repuchase obligation (126,825) (126,825) Comprehensive income: Net income 2,274,578 2,274,578 Other comprehensive income, net: Unrealized holding loss arising during the year -- -- -- -- -- (295,379) (295,379) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Total comprehensive income 1,979,199 Balance at December 31, 2004 1,505,022 150 8,818,313 6,054,264 (1,578,061) (465,045) 12,829,621 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Exercise of stock option 4,800 1 63,731 63,732 Amortization of earned portion of ESOP common stock 169,078 169,078 Amortization of excess fair value of cost - ESOP 18,742 18,742 Transfer to ESOP repuchase obligation (158,113) (158,113) Comprehensive income: Net income 2,567,429 2,567,429 Other comprehensive income, net: Unrealized holding loss arising during the year -- -- -- -- -- (959,082) (959,082) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Total comprehensive income 1,608,347 Balance at December 31, 2005 1,509,822 $ 151 8,742,673 $ 8,621,693 $ (1,408,983) $ (1,424,127) $ 14,531,407 ============ ============ ============ ============ ============ ============ ============ See notes to consolidated financial statements. F-4 VSB BANCORP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2005 and 2004 -------------------------------------------------------------------------------- 2005 2004 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 2,567,429 $ 2,274,578 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 449,777 496,132 Accretion of discount, net amortization of premium (177,651) (141,627) ESOP compensation expense 187,820 113,164 (Credit) provision for loan losses (60,000) 150,000 (Gain) / loss on the sale of other assets (4,500) 3,188 Other -- -- Changes in operating assets and liabilities: Increase in prepaid and other assets (449,886) (22,125) Decrease / (increase) in accrued interest receivable 16,741 (157,136) Decrease / (increase) in deferred income taxes 1,360 (270,569) Increase in accrued expenses, income tax payable and other liabilities 403,660 563,991 ------------ ------------ Net cash provided by operating activities 2,934,750 3,009,596 ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Net ( increase) / decrease in loans receivable (5,686,497) 231,930 Proceeds from maturities of money market investments -- 599,356 Proceeds from repayments and calls of investment securities, available for sale 28,371,189 31,356,409 Purchase of investment securities, available for sale (7,776,706) (77,439,652) Purchases of premises and equipment, net (69,080) (184,450) ------------ ------------ Net cash provided by (used in) investing activities 14,838,906 (45,436,407) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Net (decrease) / increase in deposits (22,172,314) 47,720,672 Exercise of stock options 63,732 177,804 Proceeds from ESOP loan -- 1,690,780 Purchase of ESOP shares -- (1,690,780) Purchase of fractional shares, 4 for 3 split -- (333) ------------ ------------ Net cash (used in) provided by financing activities (22,108,582) 47,898,143 ------------ ------------ NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (4,334,926) 5,471,332 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 35,659,073 30,187,741 ------------ ------------ CASH AND CASH EQUIVALENTS, END OF YEAR $ 31,324,147 $ 35,659,073 ============ ============ SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 2,176,292 $ 1,220,386 ============ ============ Income taxes $ 2,500,378 $ 2,185,655 ============ ============ See notes to consolidated financial statements. F-5 VSB BANCORP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005 and 2004 -------------------------------------------------------------------------------- 1. GENERAL VSB Bancorp, Inc. ("Bancorp" or "Company") became the holding company for Victory State Bank ("Bank"), a New York State chartered commercial bank on May 30, 2003 as the result of a reorganization of Victory State Bank into the holding company form of organization. Through the Bank, the Company is primarily engaged in the business of commercial banking, and to a lesser extent retail banking, in Staten Island New York. The stockholders of Victory State Bank became the stockholders of VSB Bancorp, Inc. as a result of the reorganization, receiving three shares of VSB Bancorp, Inc. stock for each two shares of Victory State Bank stock. Each stockholder owned the same percentage interest in VSB Bancorp immediately after the reorganization that the stockholder owned in Victory State Bank immediately before the reorganization, subject to immaterial differences due to adjustments for cash in lieu of fractional shares. VSB Bancorp now owns 100% of the capital stock of Victory State Bank. No stockholders of Victory State Bank exercised dissenter's rights to receive cash instead of shares of VSB Bancorp. The transaction between these entities under common control was accounted for at historical cost on an "as if pooled basis". 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The following is a description of the significant accounting and reporting policies followed in preparing and presenting the accompanying consolidated financial statements. These policies conform with accounting principles generally accepted in the United States of America ("GAAP"). Principles of Consolidation - The consolidated financial statements of the Company include the accounts of the Company, including its subsidiary Victory State Bank (the "Bank"). All significant inter-company accounts and transactions between the Company and Bank have been eliminated in consolidation. Use of Estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. Actual results can differ from those estimates. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change. Reclassifications - Some items in the prior year financial statements were reclassified to conform to the current presentation. Cash and Cash Equivalents - Cash and cash equivalents consists of cash on hand, due from banks and interest-bearing deposits. Net cash flows are reported for customer loan and deposit transactions and interest-bearing deposits. Regulation D of the Board of Governors of the Federal Reserve system requires that Victory State Bank maintain non-interest-bearing deposits or cash on hand as reserves against its demand deposits. The amount of reserves which Victory State Bank is required to maintain depends upon its level of transaction accounts. During the fourteen day period from December 22, 2005 through January 4, 2006, Victory State Bank was required to maintain reserves, after deducting vault cash, of $5,960,000. Reserves are required to be maintained on a fourteen day basis, so, from time to time, Victory State Bank may use available cash reserves on a day to day basis, so long as the fourteen day average reserves satisfy Regulation D requirements. Victory State Bank is required to report transaction account levels to the Federal Reserve on a weekly basis. F-6 Interest-bearing bank balances - Interest-bearing bank balances mature overnight and are carried at cost. Investment Securities, Available for Sale - Investment securities, available for sale, are to be held for an unspecified period of time and include securities that management intends to use as part of its asset/liability strategy. These securities may be sold in response to changes in interest rates, prepayments or other factors and are carried at estimated fair value. Gains or losses on the sale of such securities are determined by the specific identification method. Interest income includes amortization of purchase premium and accretion of purchase discount. Premiums and discounts are recognized in interest income using a method that approximates the level yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are estimated. Unrealized holding gains or losses, net of deferred income taxes, are excluded from earnings and reported as other comprehensive income in a separate component of stockholders' equity until realized. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the Company's ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. The Company invests primarily in agency Collateralized Mortgage-Backed Obligations ("CMOs") with estimated average lives primarily under 4.5 years and Mortgage-Backed Securities. These securities are primarily issued by the Federal National Mortgage Association ("FNMA"), the Government National Mortgage Association ("GNMA") or the Federal Home Loan Mortgage Corporation ("FHLMC") and are primarily comprised of mortgage pools guaranteed by FNMA, GNMA or FHLMC. The Company also invests in whole loan CMOs, all of which are AAA rated. These securities expose the Company to risks such as interest rate, prepayment and credit risk and thus pay a higher rate of return than comparable treasury issues. Loans Receivable - Loans receivable, that management has the intent and ability to hold for the foreseeable future or until maturity or payoff, are stated at unpaid principal balances, adjusted for deferred net origination and commitment fees and the allowance for loan losses. Interest income on loans is credited as earned. It is the policy of the Company to provide a valuation allowance for probable incurred losses on loans based on the Company's past loan loss experience, known and inherent risks in the portfolio, adverse situations which may affect the borrower's ability to repay, estimated value of underlying collateral and current economic conditions in the Company's lending area. The allowance is increased by provisions for loan losses charged to earnings and is reduced by charge-offs, net of recoveries. While management uses available information to estimate losses on loans, future additions to the allowance may be necessary based upon the expected growth of the loan portfolio and any changes in economic conditions beyond management's control. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. Management believes, based upon all relevant and available information, that the allowance for loan losses is adequate. The Company has a policy that all loans 90 days past due are placed on non-accrual status. It is the Company's policy to cease the accrual of interest on loans to borrowers past due less than 90 days where a probable loss is estimated and to reverse out of income all interest that is due. The Company applies payments received on non-accrual loans to the outstanding principal balance due. On a limited basis, the Company may apply a payment to interest on a non-accrual loan if there is no impairment or no estimatible loss on this asset. The Company continues to accrue interest on construction loans that are 90 days past contractual maturity date if the loan is expected to be paid in full in the next 60 days and all interest is paid up to date. F-7 Loan origination fees and certain direct loan origination costs are deferred and the net amount recognized over the contractual loan terms using the level-yield method, adjusted for periodic prepayments in certain circumstances. The Company considers a loan to be impaired when, based on current information, it is probable that the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impairment is measured on a loan by loan basis for commercial and construction loans. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral. The fair value of the collateral, as reduced by costs to sell, is utilized if a loan is collateral dependent. Large groups of smaller balance homogeneous loans, such as consumer loans and residential loans, are collectively evaluated for impairment. Long-Lived Assets - The Company periodically evaluates the recoverability of long-lived assets, such as premises and equipment, to ensure the carrying value has not been impaired. In performing the review for recoverability, the Company would estimate the future cash flows expected to result from the use of the asset. If the sum of the expected future cash flows is less than the carrying amount, an impairment will be recognized. The Company reports these assets at the lower of the carrying value or fair value. Subordinated Debt - In August of 2003, the Company formed VSB Capital Trust I (the "Trust"). The Trust is a statutory business trust organized under Delaware law and the Company owns all of its common securities. The Trust issued $5.0 million of Trust Preferred Capital Securities to an independent investor and $155,000 of common securities to the Company. The Company issued a $5.16 million subordinated debenture to the Trust. The subordinated debenture is the sole asset of the Trust. The subordinated debenture and the Trust Preferred Capital Securities pay interest and dividends, respectively, on a quarterly basis, at a rate of 6.909%, for the first five years. They mature thirty years after the issuance of the securities and are non-callable for five years. After the first five years, the Trust Preferred Securities may be called by the Company at any quarterly interest payment date at par and the rate of interest that fluctuates quarterly based upon 300 basis points over the 90 day LIBOR rate. The Trust is not consolidated with the Company. Premises and Equipment - Premises, leasehold improvements, and furniture and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are accumulated by the straight-line method over the estimated useful lives of the respective assets, which range from three to ten years. Leasehold improvements are amortized at the lesser of their useful life or the term of the lease. Federal Home Loan Bank (FHLB) Stock - The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value. Both cash and stock dividends are reported as income. Income Taxes - The Company utilizes the liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined on differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws expected to be in effect when the differences are expected to reverse. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Financial Instruments - In the ordinary course of business, the Company has entered into off-balance sheet financial instruments, primarily consisting of commitments to extend credit. F-8 Basic and Diluted Net Income Per Common Share - Basic net income per share of common stock is based on 1,441,989 and 1,425,909, the weighted average number of common shares outstanding for the years ended December 31, 2005 and 2004, respectively. Diluted net income per share of common stock is based on 1,488,104 and 1,481,258, the weighted average number of common shares and potentially dilutive common shares outstanding for the years ended December 31, 2005 and 2004, respectively. The weighted average number of potentially dilutive common shares excluded in calculating diluted net income per common share due to the anti-dilutive effect is 46,115 and 55,349 shares for the years ended December 31, 2005 and 2004, respectively. Common stock equivalents were calculated using the treasury stock method. The reconciliation of the numerators and the denominators of the basic and diluted per share computations for the years ended December 31, are as follows: 2005 2004 ------------------------------------ ------------------------------------ Weighted Weighted Net Average Per Share Net Average Per Share Income Shares Amount Income Shares Amount ---------- ---------- ---------- ---------- ---------- ---------- Basic earnings per common share -------------------------- Net income available to common stockholders $2,567,429 1,441,989 $ 1.78 $2,274,578 1,425,909 $ 1.60 ========== ========== Effect of dilutive shares -------------------------- Weighted average shares, if converted 46,115 55,349 ---------- ---------- Diluted earnings per common share -------------------------- Net income available to common stockholders $2,567,429 1,488,104 $ 1.73 $2,274,578 1,481,258 $ 1.54 ========== ========== ========== ========== ========== ========== Stock Based Compensation - At December 31, 2005, the Company had stock-based employee compensation plans. The Company accounts for these plans under Accounting Principles Board Opinion, ("APB Opinion") No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation expense has been reflected in net income for stock options as all rights and options to purchase the Company's stock granted under these plans have an exercise price equal to the market value of the underlying stock on the date of grant. In December 2005, the Board authorized the acceleration of the vesting of all outstanding stock options issued to both employees and directors. The decision to accelerate the vesting of these options, which the Company believes is in the best interest of its stockholders, was made primarily to reduce non-cash compensation expense, approximately $169,000 of future compensation expense, net of taxes, that would have been recorded in its income statement in future periods upon the adoption of Financial Accounting Standards Board Statement No. 123R (Share-Based Payment) in January 2006 If compensation cost for the Stock Plan and Director's Stock Plan awards had been measured based on the fair value of the stock options awarded at the grant dates, net income and basic and diluted earnings per common share would have been reduced to the pro-forma amounts on the table below for the years ended December 31, 2005 and 2004, including the effect of accelerating all the outstanding stock options in December 2005. F-9 2005 2004 -------------- -------------- Net Income As reported $ 2,567,429 $ 2,274,578 Less: Total stock-based compensation expense determined under the fair value method for all rewards, net of related tax effects 218,887 53,897 -------------- -------------- Pro-forma $ 2,348,542 $ 2,220,681 ============== ============== 2005 2004 -------------- -------------- Basic earnings per common share As reported $ 1.78 $ 1.60 Less: Total stock-based compensation expense determined under the fair value method for all rewards, net of related tax effects 0.15 0.04 -------------- -------------- Pro-forma $ 1.63 $ 1.56 ============== ============== 2005 2004 -------------- -------------- Diluted earnings per common share As reported $ 1.73 $ 1.54 Less: Total stock-based compensation expense determined under the fair value method for all rewards, net of related tax effects 0.15 0.04 -------------- -------------- Pro-forma $ 1.58 $ 1.50 ============== ============== Employee Stock Ownership Plan - The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders' equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest. As participants may put their ESOP shares back to the Company upon termination, an amount of equity equal to these shares times the current market price is reclassified out of stockholders' equity. Comprehensive Income - Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses, net of taxes, on securities available for sale which are also recognized as separate components of equity. Recently-Issued Accounting Standards - FAS 123, Revised, required companies to record compensation expense for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This will apply to awards granted or modified in fiscal years beginning in 2006. Compensation cost will also be recorded for prior option grants that vest after the date of adoption. The effect of result on operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so cannot currently be predicted. As of December 31, 2005 vesting on all outstanding option grants were accelerated so that they are immediately exercisable. By accelerating the vesting of these options, we estimate that approximately $169,000 of future compensation expense, net of taxes, will be eliminated. Management continuously monitors emerging issues and accounting bulletins, some of which could potentially impact the Company's financial statements F-10 3. INVESTMENT SECURITIES, AVAILABLE FOR SALE The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income/(loss) were as follows at December 31, 2005 and 2004: December 31, 2005 ------------------------------------------- Estimated Gross Gross Fair Unrealized Unrealized Value Gains Losses ------------ ------------ ------------ US Government Agency $ 8,390,156 $ -- $ (109,844) FNMA MBS 9,067,796 169 (281,234) FHLMC MBS 320,258 325 (1,180) GNMA MBS 2,627,459 -- (91,373) Whole Loan MBS 4,051,823 -- (84,060) Collateralized mortgage obligations 81,565,801 29,588 (2,128,796) ------------ ------------ ------------ $106,023,293 $ 30,082 $ (2,696,487) ============ ============ ============ December 31, 2004 ------------------------------------------- Estimated Gross Gross Fair Unrealized Unrealized Value Gains Losses ------------ ------------ ------------ US Government Agency $ 8,481,563 $ -- $ (18,437) FNMA MBS 11,118,275 11,831 (139,222) FHLMC MBS 523,766 6,355 -- GNMA MBS 3,263,366 -- (33,535) Whole Loan MBS 5,068,462 22,372 (68,492) Collateralized mortgage obligations 100,077,335 340,531 (992,110) ------------ ------------ ------------ $128,532,767 $ 381,089 $ (1,251,796) ============ ============ ============ The tax benefits related to these net unrealized gains and losses were $1,242,278 and $405,662 at December 31, 2005 and 2004, respectively. The following table shows the banks investments' gross unrealized losses and estimated fair value aggregated by investment category and length of time that an individual security has been in the continuous unrealized loss position at December 31, 2005 and 2004: F-11 December 31, 2005 Less than 12 months More than 12 months Total ------------------------------- ------------------------------- ------------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Loss Value Loss Value Loss -------------- -------------- -------------- -------------- -------------- -------------- US Government Agency $ -- $ -- $ 8,390,156 $ (109,844) $ 8,390,156 $ (109,844) FHLMC MBS 258,602 (1,180) -- -- 258,602 (1,180) FNMA MBS 501,974 (8,126) 8,536,325 (273,108) 9,038,299 (281,234) GNMA MBS -- -- 2,627,459 (91,373) 2,627,459 (91,373) Whole Loan MBS 3,093,344 (58,415) 958,479 (25,645) 4,051,823 (84,060) Collateralized mortgage obligations 37,031,800 (575,439) 40,740,451 (1,553,357) 77,772,251 (2,128,796) -------------- -------------- -------------- -------------- -------------- -------------- $ 40,885,720 $ (643,160) $ 61,252,870 $ (2,053,327) $ 102,138,590 $ (2,696,487) ============== ============== ============== ============== ============== ============== December 31, 2004 Less than 12 months More than 12 months Total ------------------------------- ------------------------------- ------------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value Loss Value Loss Value Loss -------------- -------------- -------------- -------------- -------------- -------------- US Government Agency $ 8,481,563 $ (18,437) $ -- $ -- $ 8,481,563 $ (18,437) FNMA MBS 10,546,317 (139,222) -- -- 10,546,317 (139,222) GNMA MBS -- -- 3,263,366 (33,535) 3,263,366 (33,535) Whole Loan MBS 3,119,780 (68,492) -- -- 3,119,780 (68,492) Collateralized mortgage obligations 51,235,171 (632,465) 11,309,155 (359,645) 62,544,326 (992,110) -------------- -------------- -------------- -------------- -------------- -------------- $ 73,382,831 $ (858,616) $ 14,572,521 $ (393,180) $ 87,955,352 $ (1,251,796) ============== ============== ============== ============== ============== ============== The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer's financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer's financial condition. At December 31, 2005, the unrealized loss on investment securities was caused by interest rate increases. We expect that these securities, at maturity, will not be settled for less than the amortized cost of the investment. In analyzing an issuer's financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and industry analysts' reports. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these securities until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired. At December 31, 2005 there were seven debt securities with unrealized losses with aggregate depreciation of 5% or more from the Company's amortized cost basis. As the market value decline of these securities is caused by interest rate increases and management has the ability to hold these securities until maturity, or for the foreseeable future, if classified as available for sale, these securities are not deemed to be other-than-temporarily impaired. The maturity schedule of all investment securities available for sale at amortized cost and estimated fair values for December 31, 2005 was as follows: F-12 Estimated Securities, Available for Sale Amortized Fair Expected Maturity Cost Value ------------ ------------ Less than one year $ 29,328 $ 29,496 Due after one year through 5,821,113 5,764,790 five years Due after five years through 7,825,044 7,654,801 ten years Due after ten years 95,014,213 92,574,206 ------------ ------------ $108,689,698 $106,023,293 ============ ============ Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. Securities pledged at year end 2005 and 2004 had a carrying amount of $27,725,000 and $23,739,000, respectively and were pledged to secure public deposits and balances in excess of the deposit insurance limit on certain customer accounts. 4. LOANS RECEIVABLE, NET Loans receivable, net at December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Commercial loans (principally variable rate): Secured $ 1,584,484 $ 1,572,824 Unsecured 11,078,101 9,620,243 ------------ ------------ Total commercial loans 12,662,585 11,193,067 Real estate loans: Commercial 29,794,108 31,741,069 One-to-four family 298,779 1,112,032 ------------ ------------ Total real estate loans 30,092,887 32,853,101 Construction loans (net of undisbursed funds of $10,160,576 and $9,774,166, respectively) 29,611,346 22,853,858 Consumer loans 1,477,366 1,048,448 Other loans 486,009 435,837 ------------ ------------ 1,963,375 1,484,285 ------------ ------------ Total loans receivable 74,330,193 68,384,311 Less: Unearned loans fees, net (386,088) (337,426) Allowance for loan losses (1,153,298) (1,299,520) ------------ ------------ Total $ 72,790,807 $ 66,747,365 ============ ============ The activity in the allowance for loan losses, for the years ended December 31, 2005 and 2004 are summarized as follows: F-13 2005 2004 ------------ ------------ Beginning balance $ 1,299,520 $ 1,162,776 Charge-offs (343,701) (185,065) Recoveries 257,479 171,809 (Credit) Provision (60,000) 150,000 ------------ ------------ Ending balance $ 1,153,298 $ 1,299,520 ============ ============ Nonaccrual loans outstanding at December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Nonaccrual loans: Unsecured commercial loans $ -- $ 20,112 Commercial real estate 1,022,097 121,810 Construction 579,000 -- Consumer loans -- 2,476 ------------ ------------ Total nonaccrual loans $ 1,601,097 $ 144,398 ============ ============ 2005 2004 ------------ ------------ Interest income that would have been recorded during the year on nonaccrual loans outstanding at year-end in accordance with original terms $ 64,880 $ 7,149 ============ ============ The Company's recorded investment in impaired loans at December 31 is as follows: 2005 2004 --------------------------- --------------------------- Related Related Investment Allowance Investment Allowance in Impaired for loan in Impaired for loan Loans losses Loans losses ------------ ------------ ------------ ------------ Impaired loans With a related allowance for loan losses Commercial and financial $ -- $ -- $ 20,112 $ 4,022 Commercial real estate 1,022,097 160,171 121,810 31,165 Construction 579,000 86,850 -- -- Consumer loans -- -- 2,476 495 ------------ ------------ ------------ ------------ $ 1,601,097 $ 247,021 $ 144,398 $ 35,682 ============ ============ ============ ============ The following table sets forth certain information about impaired loans at December 31: F-14 Investment in Impaired Loans ----------------------- 2005 2004 ---------- ---------- Average recorded investment $ 803,971 $ 151,009 ========== ========== Interest income recognized during time period that loans were impaired, using cash-basis method of accounting $ 18,667 $ 1,602 ========== ========== The Company's loan portfolios are primarily comprised of commercial loans made to small businesses and individuals located in the Borough of Staten Island. As of December 31, 2005 and 2004, the Company had no restructured loans. 5. ACCRUED INTEREST RECEIVABLE Accrued interest receivable at December 31, 2005 and 2004 are summarized as follows: 2005 2004 ---------- ---------- Loans receivable $ 300,178 $ 246,796 Investment securities, available for sale 428,449 498,572 ---------- ---------- Total $ 728,627 $ 745,368 ========== ========== 6. PREMISES AND EQUIPMENT Premises and equipment at December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Leasehold improvements $ 1,822,390 $ 1,818,910 Computer equipment and software 383,156 468,981 Furniture, fixtures and equipment 787,949 807,050 Other 26,323 25,987 ------------ ------------ 3,019,818 3,120,928 Less accumulated depreciation and amortization (1,578,731) (1,303,644) ------------ ------------ Total $ 1,441,087 $ 1,817,284 ============ ============ Depreciation and amortization expense amounted to $449,777 and $496,132 for the years ended December 31, 2005 and 2004, respectively. At December 31, 2005, the Company was obligated under six non-cancelable operating leases on property used for banking purposes. Rental expense under these leases was $363,477 and $343,161 for the years ended December 31, 2005 and 2004, respectively. The projected minimum rental payments under the terms of the leases at December 31, 2005 are summarized as follows: F-15 Year Ending December 31, Amount ---------------- ------------- 2006 $ 485,669 2007 390,856 2008 394,092 2009 399,062 2010 404,949 Thereafter 3,046,371 ------------- Total $ 5,120,999 ============= 7. PREPAID AND OTHER ASSETS Prepaid and other assets at December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Accounts receivable and other assets $ 267,158 $ 27,414 Security deposit receivable 57,360 57,360 Prepaid assets 218,706 187,178 Equity securities, primarily FHLB stock 337,600 135,700 Investment in unconsolidated subsidiary 155,000 155,000 Subordinated debt related placement cost 75,763 104,263 Late charges receivable 57,969 52,755 ------------ ------------ $ 1,169,556 $ 719,670 ============ ============ 8. DEPOSITS Deposits are summarized, according to their original terms, at December 31, 2005 and 2004 as follows: F-16 2005 2004 ------------------------------------------- ------------------------------------------- Weighted Weighted Average Average Amount Percent Stated Rate Amount Percent Stated Rate ------------ ------------ ------------ ------------ ------------ ------------ Demand accounts: Checking $ 66,692,436 34.52% --% $101,560,932 47.14% --% Variable-rate money market 20,177,240 10.44 0.81 23,388,850 10.86 0.65 Statement savings 14,809,010 7.66 0.50 14,159,026 6.57 0.50 Interest-bearing checking 23,574,056 12.20 0.33 21,574,053 10.01 0.32 ------------ ------------ ------------ ------------ ------------ ------------ 125,252,742 64.82 0.25 160,682,861 74.58 0.18 Time deposits: Less than six months 39,444,207 20.41 2.51 31,400,968 14.58 1.12 Six months to one year 23,583,453 12.20 3.28 18,369,058 8.53 2.06 More than one year 4,703,613 2.43 3.56 4,700,481 2.18 2.89 ------------ ------------ ------------ ------------ ------------ ------------ 67,731,273 35.04 2.85 54,470,507 25.29 1.59 Other deposits 267,144 0.14 -- 270,105 0.13 -- ------------ ------------ ------------ ------------ ------------ ------------ Total $193,251,159 100.00% 0.54% $215,423,473 100.00% 0.49% ============ ============ ============ ============ ============ ============ The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100,000 was approximately $56,977,338 and $43,944,241 at December 31, 2005 and 2004 respectively. Scheduled maturities of time deposits at December 31, 2005 are as follows: Amount Percent ------------ ------------ Within six months $ 61,729,391 91.14% Six months to one year 2,962,857 4.37 One to five years 3,039,025 4.49 ------------ ------------ Total $ 67,731,273 100.00% ============ ============ 9. INCOME TAXES The Company files consolidated federal, state and local income tax returns on a calendar-year basis. For federal, state and local income tax purposes, the Company uses the specific charge-off method in computing its federal, state and local tax bad debt deduction. The basis for the determination of state and local tax is the greater of a tax on entire net income or a tax computed on taxable assets. Federal, state and city income tax provisions were determined based on the tax computed on net income for the years ended December 31, 2005 and 2004. F-17 The components of the income tax expense/(benefit) for the years ended December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Current: Federal $ 1,380,322 $ 1,392,322 State and local 857,792 861,651 ------------ ------------ 2,238,114 2,253,973 Deferred: Federal 847 (168,489) State and local 513 (102,080) ------------ ------------ 1,360 (270,569) ------------ ------------ $ 2,239,474 $ 1,983,404 ============ ============ The components of the deferred income tax asset, net as of December 31, 2005 and 2004 are summarized as follows: 2005 2004 ------------ ------------ Deferred loan fees $ 215,337 $ 84,063 Excess book allowance for loan losses 482,898 519,086 Unrealized loss/(gain) on investment securities 1,242,278 405,662 Other compensation expense 145,009 167,850 Other 212,673 286,279 ------------ ------------ Deferred tax asset, net $ 2,298,195 $ 1,462,940 ============ ============ Management evaluated the weight of available evidence and concluded that it is more likely than not that the Company will realize the net deferred tax asset in future years. Factors influencing management's judgment include, among other things, changes in the levels of actual and expected future taxable income and anticipated reversals of net deductible temporary differences. The Company's effective tax rate differs from the statutory Federal tax rate for the years ended December 31, 2005 and 2004 and are as follows: 2005 2004 ------------------ ------------------ Federal income tax provision at statutory rates $1,634,347 34.0% $1,447,714 34.0% State and local taxes, net of Federal income tax benefit 591,249 12.3 523,732 12.3 Other 13,878 0.3 11,958 0.3 ---------- ---- ---------- ---- $2,239,474 46.6% $1,983,404 46.6% ========== ==== ========== ==== F-18 10. REGULATORY MATTERS The Bank is a New York State chartered stock form commercial bank. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is subject to certain FDIC capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by the regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet certain specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. As of the latest notification from the FDIC, the Bank was classified as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized," the Bank must maintain Tier 1 Leverage, Tier 1 Risk-Based and minimum Total risk-based ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. Management believes, as of December 31, 2005, that the Bank meets all capital adequacy requirements to which it is subject. The Bank is subject to certain restrictions on the availability of its undistributed earnings for payment of dividends to stockholders, including prior regulatory approval. The following table is the Bank's actual capital amounts and ratios, as well as the minimum required levels for both "capital adequacy purposes" and to be considered "well capitalized". No deductions were made for qualitative judgments by regulators: F-19 To be well-capitalized For capital under prompt corrective Actual adequacy purposes action provisions --------------------- --------------------- --------------------- As of December 31, 2005 Amount Ratio Amount Ratio Amount Ratio ----------------------- --------------------- --------------------- --------------------- Tier 1 Capital (to Average Assets) $ 20,453,000 9.19% $ 8,897,920 4.00% $ 11,122,400 5.00% Tier 1 Capital (to Risk Weighted Assets) 20,453,000 19.66 4,162,120 4.00 6,243,180 6.00 Total Capital (to Risk Weighted Assets) 21,606,000 20.76 8,324,240 8.00 10,405,300 10.00 As of December 31, 2004 ----------------------- Tier 1 Capital (to Average Assets) $ 17,647,000 7.80% $ 9,045,280 4.00% $ 11,306,600 5.00% Tier 1 Capital (to Risk Weighted Assets) 17,647,000 17.28 4,085,000 4.00 6,127,500 6.00 Total Capital (to Risk Weighted Assets) 18,924,000 18.53 8,170,000 8.00 10,212,500 10.00 The Company's consolidated capital ratios as of December 31, 2005 were as follows: Tier 1 Capital to Average Assets of 9.54%; Tier 1 Capital to Risk Weighted Assets of 20.37%; and Total Capital to Risk Weighted Assets of 21.47%, which are not substantially different than the Bank's capital ratios at December 31, 2005 and therefore are not presented separately. 11. EMPLOYEE BENEFITS The Bank does not currently maintain a defined contribution benefit plan but sponsors an incentive savings plan (401(k) plan) which started March 1, 1999. All eligible employees, who have reached the age of 21, have at least one year of service and work a minimum of 1,000 hours per year will be permitted to make tax deferred contributions up to certain limits. The Bank may reduce or cease matching contributions if it is determined that the current or accumulated net earnings or undivided profits of the Bank are insufficient to pay the full contributions in a plan year. The Bank contributed $120,530 to the 401(k) plan in 2005 and $110,204 in 2004. Stock Options Options to buy stock are granted to directors, officers and employees under the VSB Bancorp, Inc. 2000 Incentive Plan, the 1998 Incentive Plan, the 2004 Directors' Plan, the 2000 Directors' Plan and the 1998 Directors' Plan which, in the aggregate, provide for issue up to 195,000 options. Exercise price is the market price at the date of grant, so there is no compensation expense recognized in the income statement. The maximum option term is ten years, and the options vesting period is up to five years. As of December 31, 2005 the Board accelerated the vesting on all outstanding options so that they became immediately exercisable. By accelerating the vesting of these options, we estimate that approximately $169,000 of future compensation expense, net of taxes, will be eliminated. F-20 There were no stock option grants in 2005. Stock Option Grants in 2004 -------------------------------------------------------------------------------------------------- Percent of Total Exercise or Number of Options Granted to Base Price Options employees in Fiscal ($/share) Expiration Granted Year(1) Date -------------------------------------------------------------------------------------------------- 2000 Incentive Plan 19,965(1) 100.00% $19.50 01/19/2014 2004 Directors' Plan 45,000(1) 22.22% $22.00 04/27/2014 (1) Options granted will become exercisable at a rate of 20% per annum after the grant date. As of 12/31/05, all options have been accelerated so that all outstanding options became immediately exercisable. The weighted average fair value of options granted during 2004 was $7.40. There were no option grants in 2005. For purposes of the pro forma calculation under SFAS No. 123, the fair value of the options granted in 2004 is estimated using the Black-Scholes option pricing model with the following weighted average assumptions used for the 2004 options: 2004 ---------- Dividend yield --% Expected volatility 27.13 Risk-free interest rate 4.32 Expected life 10 Years The stock option components of the 2000 Incentive Plan, the 1998 Incentive Plan and the 2004 Directors' Plan, the 2000 Directors' Plan and the 1998 Directors' Plan, as of December 31, 2005 and 2004, and changes during the years ended, consist of the following: 2005 2004 ------------------------ ------------------------ Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price ---------- ---------- ---------- ---------- Options outstanding 151,932 $ 12.85 111,300 $ 6.78 at the beginning of the year Granted -- -- 64,965 21.23 Canceled (1,133) 19.50 (1,613) 17.15 Exercised (4,800) 10.18 (22,720) 6.71 ---------- ---------- Options outstanding at the end of the year 145,999 $ 12.89 151,932 $ 12.85 ========== ========== ========== ========== Options exercisable at the end of the year 145,999 $ 12.89 85,280 $ 6.84 ========== ========== ========== ========== Weighted average remaining contractual life of options outstanding at the end of the year 5.6 Years 6.5 Years Described below is the range of exercise prices for options granted under the following option plans as of December 31, 2005: F-21 Range of Number of Weighted Average Weighted Average Plan Description Exercise Prices Exercisable Shares Exercise Price Contractual Life -------------------------------------- ------------------- ------------------ ---------------- ---------------- 1998 Director Stock Option Plan From $6.13 to $8.00 22,000 $ 7.66 3.11 1998 Incentive Stock Option Plan From $5.94 to $8.00 26,400 7.20 3.04 2000 Director Stock Option Plan $5.94 20,000 5.49 4.40 2000 Incentive Stock Option Plan $5.94 and $19.50 33,599 13.00 6.33 2004 Director Stock Option Plan $22.00 44,000 22.00 8.50 ------------------ ---------------- ---------------- All Plans 145,999 $12.89 5.60 ================== ================ ================ Stock Appreciation Rights The Company issued stock appreciation rights ("SARs") to an officer of the Company to advance the interests of the Company and its shareholders by providing this key officer of the Company and its affiliates, upon whose judgment, initiative and efforts were instrumental upon the formation and development of the Company and its affiliates, with an additional incentive to perform in a superior manner. Pursuant to the terms, 25,000 SARs with an exercise price of $5.00 per SAR, as determined by the Board of Directors, have been issued. There are no SARs available to be granted and those SARs which terminate, or are forfeited without being exercised, can not be recycled into new grants. The term of each SAR is determined by the Committee of the Board of Directors and may not exceed ten years after the date of the grant. The SARs vest and are exercisable for the cash value between the Company's stock price less the exercise price. The SARs vest over five years, 40% two years after the grant date and 20% per year after. In 2005, 6,000 SARs were exercised. As of December 31, 2005, of the remaining 17,000 SARs, all 17,000 were granted and all 17,000 were vested or exercisable. The accounting for these instruments is according to FIN 28: "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans," for which compensation expense was $31,000 and $190,000 for the years ended December 31, 2005 and 2004, respectively. The Company did not issue any SAR grants in 2005 and 2004. 12. COMMITMENTS, CONTINGENCIES AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers. Such financial instruments primarily include commitments to extend credit. A summary of these commitments and contingent liabilities, all of which are variable rate commitments, at December 31: 2005 2004 ------------ ------------ Amount Amount ------------ ------------ Commitments to fund secured construction loans $ 10,160,576 $ 9,774,166 Commitments to fund all other commercial loans 18,638,006 13,960,142 ------------ ------------ $ 28,798,582 $ 23,734,308 ============ ============ F-22 Commitments to extend credit are legally binding agreements to lend to a customer. Commitments are issued following the Company's evaluation of each applicant's creditworthiness on a case-by-case basis. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual notional amount of those instruments. The Bank is a defendant in a lawsuit against a former customer brought by a third party. The Bank intends to defend aggressively the claims made against it. VSB Bancorp, Inc., is not involved in any pending legal proceedings. The Bank, from time to time, is involved in routine collection proceedings in the ordinary course of business on loans in default. Management believes that such other routine legal proceedings in the aggregate are immaterial to our financial condition or results of operations. 13. FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The following methods and assumptions were used by the Company in estimating fair values of financial instruments: Interest-bearing bank balances - Interest-bearing bank balances mature within one year and are carried at cost. Money Market Investments - The fair value of these securities approximates their carrying value due to the relatively short time to maturity Investment Securities, Available For Sale - The estimated fair value of these securities is determined by using available market information and appropriate valuation methodologies. The estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. Loans Receivable - The fair value of commercial and construction loans are approximated by the carrying value as the loans are tied directly to the Prime Rate and are subject to change on a daily basis. The fair value of the remainder of the portfolio is determined by discounting the future cash flows of the loans using the appropriate discount rate and prepayment assumptions. Other Financial Assets - The fair value of these assets, principally accrued interest receivable, approximates their carrying value due to their short maturity. Non-Interest Bearing and Interest Bearing Deposits - The fair value disclosed for non-interest bearing deposits is equal to the amount payable on demand at the reporting date. The fair value of interest bearing deposits is based upon the current rates for instruments of the same remaining maturity. Interest bearing deposits with a maturity of greater than one year are estimated using a discounted cash flow approach that applies interest rates currently being offered. F-23 Subordinated Debt- The fair value of subordinated debt is based upon the current rates for such instruments of the same remaining maturity. Other Liabilities - The estimated fair value of other liabilities, which primarily include accrued interest payable, approximates their carrying amount. The estimated fair values of the Company's financial instruments at December 31, 2005 and 2004 were as follows: 2005 2004 --------------------------- --------------------------- Carrying Fair Carrying Fair Amount Value Amount Value ------------ ------------ ------------ ------------ Financial Assets: Cash and cash equivalents $ 31,324,147 $ 31,324,147 $ 35,659,073 $ 35,659,073 Investment securities 106,023,293 106,023,293 128,532,767 128,532,767 Loans receivable 72,790,807 72,739,105 66,747,365 83,109,864 Other financial assets 728,627 728,627 745,368 745,368 ------------ ------------ ------------ ------------ Total Financial Assets $210,866,874 $210,815,172 $231,684,573 $248,047,072 ============ ============ ============ ============ Financial Liabilities: Non-interest bearing deposits $ 66,959,580 $ 66,959,580 $101,831,037 $101,831,037 Interest bearing deposits 126,291,579 126,313,306 113,592,436 125,132,325 Trust preferred securities 5,155,000 5,107,565 5,155,000 5,268,819 Other liabilities 176,063 176,063 22,628 22,628 ------------ ------------ ------------ ------------ Total Financial Liabilities $198,582,222 $198,556,514 $220,601,101 $232,254,809 ============ ============ ============ ============ 14. INTEREST RATE RISK (UNAUDITED) The Company's principal business of originating loans, issuing term certificates of deposit and other interest-bearing deposit accounts and investing in short-term investment securities inherently includes elements of interest rate risk and requires careful application of interest rate management techniques to manage such risks. Because the Company has a varied array of investment, loan and deposit products, which differ as to maturity, repricing terms and interest rate spreads relative to various rate indices, different interest rate risk management strategies are utilized. The Company funds its assets primarily with deposits. A substantial portion of these, mature or reprice within one year of their origination or last repricing date. In view of the short maturity profile of the Company's funding sources, the Company invests in loans and investments which have a maturity or repricing date designed to match the Company's funding maturities and serve as a natural hedge of the related interest rate risk. Net interest income will fluctuate based on changes in the general level of interest rates, changes in the levels of interest sensitive assets and liabilities, and changes in the relationships between different interest rate indices. In addition, net interest income can also be affected by timing of repricing dates and repayments and changes in estimated prepayments. 15. RELATED PARTIES In the ordinary course of business, the Bank at times has had loans, and other financial transactions, with its executive officers and directors. At December 31, 2005, the aggregate amount of loans outstanding to directors was F-24 $239,838. These loans were all granted upon the same terms and conditions, including interest rates and collateral, as were applicable to loans to unaffiliated persons. There were no loans granted to executive officers. The change in aggregate amount of loans outstanding to directors as of December 31, 2005 and 2004 are as follows: 2005 2004 ------------ ------------ Beginning balance $ 1,468,153 $ 281,187 Originations 314,377 2,630,409 Payments (1,542,692) (1,443,443) ------------ ------------ Ending balance $ 239,838 $ 1,468,153 ============ ============ The interest income that was paid on these loans was $75,530 and $60,919 for 2005 and 2004, respectively. Certain officers and directors own, in the aggregate, 33.2% and 40.7% of the common shares outstanding at December 31, 2005 and 2004, respectively. 16. CONDENSED FINANCIAL STATEMENTS OF THE PARENT COMPANY ONLY VSB BANCORP, INC. STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2005 and 2004 2005 2004 --------------------------------------------------------------- ------------ ------------ ASSETS Cash and cash equivalents $ 321 $ 1,957 Money markets 730,758 530,990 Investment in subsidiaries 19,075,629 17,291,629 Deferred taxes -- 203 Other assets 242,942 350,979 ------------ ------------ Total assets $ 20,049,650 $ 18,175,758 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Subordinated debt $ 5,155,000 $ 5,155,000 Accounts payable, accrued expenses and other liabilities 78,305 64,312 ------------ ------------ Total liabilities 5,233,305 5,219,312 ------------ ------------ COMMITMENTS AND CONTINGENT LIABILITIES STOCKHOLDERS' EQUITY Common stock ($.0001 par value, 3,000,000 shares authorized, 1,509,822 issued and outstanding at December 31, 2005; 1,505,022 issued and outstanding at December 31, 2004) 151 150 Additional paid-in capital 9,027,611 8,945,138 Retained earnings 8,621,693 6,054,264 Unearned Employee Stock Ownership Plan shares (1,408,983) (1,578,061) Accumulated other comprehensive loss, net of taxes of $1,242,278 and $405,662, respectively (1,424,127) (465,045) ------------ ------------ Total stockholders' equity 14,816,345 12,956,446 ------------ ------------ Total liabilities and stockholders' equity $ 20,049,650 $ 18,175,758 ============ ============ F-25 VSB BANCORP, INC. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 -------------------------------------------------------------------------------- 2005 2004 ------------ ------------ INTEREST INCOME: Loans recievable $ 63,104 $ -- Other interest income 7,277 17,033 ------------ ------------ Total interest income 70,381 17,033 INTEREST EXPENSE: Subordinated debt 356,159 356,159 ------------ ------------ Total interest expense 356,159 356,159 ------------ ------------ Net interest loss (285,778) (339,126) ------------ ------------ NON-INTEREST INCOME: Other 10,709 -- ------------ ------------ 10,709 -- NON-INTEREST EXPENSES: Legal fees 48,000 52,664 Other 61,067 61,219 ------------ ------------ Total non-interest expenses 109,067 113,883 ------------ ------------ LOSS BEFORE INCOME TAXES (384,136) (453,009) ------------ ------------ PROVISION/(BENEFIT) FROM INCOME TAXES: Current (209,669) (211,072) Deferred 1,187 (203) ------------ ------------ Total income taxes (208,482) (211,275) ------------ ------------ EQUITY IN UNDISTRIBUTED EARNINGS, NET OF TAXES 2,743,083 2,516,312 ------------ ------------ NET INCOME $ 2,567,429 $ 2,274,578 ============ ============ F-26 VSB BANCORP, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2005 AND 2004 -------------------------------------------------------------------------------- 2005 2004 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 2,567,429 $ 2,274,578 Adjustments to reconcile net income to net cash used in operating activities: Changes in operating assets and liabilities: ESOP compensation expense 18,742 445 Undistributed income of subsidiaries (2,743,083) (2,470,928) Increase in other assets 108,038 (106,346) Increase in deferred income taxes 203 (203) (Decrease)/increase in accrued expenses, income taxes payable and other liabilities 13,993 (54,145) ------------ ------------ Net cash used in operating activities (34,678) (356,599) ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Investments in subsidiaries -- -- Net increase in loan receivable 169,078 (1,578,061) Net decrease/(increase) in money market deposit (199,768) 68,366 ------------ ------------ Net cash used in investing activities (30,690) (1,509,695) ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock -- -- Exercise stock option 63,732 177,804 4 for 3 stock split and the purchase of fractional shares -- (333) Proceeds from ESOP loan -- 1,690,780 Proceeds from the issuance of subordinated debt -- -- ------------ ------------ Net cash provided by financing activities 63,732 1,868,251 ------------ ------------ NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1,636) 1,957 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 1,957 -- ------------ ------------ CASH AND CASH EQUIVALENTS, END OF YEAR $ 321 $ 1,957 ============ ============ SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 345,450 $ 412,621 ============ ============ Income taxes $ -- $ -- ============ ============ 17. EMPLOYEE STOCK OWNERSHIP PLAN Employees participate in an Employee Stock Ownership Plan ("ESOP"). VSB Bancorp, Inc. ESOP Trust was formed on May 1, 2004. The ESOP borrowed from the Company to purchase 74,320 shares of stock at $22.75 per share. The Company makes discretionary contributions to the ESOP, as well as paying dividends on unallocated shares to the ESOP, and the ESOP uses funds it receives to repay the loan. When loan payments are made, ESOP shares are allocated to participants based on relative compensation and expense is recorded. Dividends on allocated shares increase participant accounts. Shares allocated to each participant, to the extent vested, are distributed to the participant upon termination of employment. As required by federal law, a participant may require the Company to repurchase shares so distributed unless the stock is traded on an established market. F-27 The contribution to the ESOP was $169,078 and $112,719 for the years ended December 31, 2005 and 2004, respectively. ESOP expense was $187,820 and $113,165, for the years ended December 31, 2005 and 2004, respectively. Shares held by the ESOP at December 31, 2005 and 2004 were as follows: 2005 2004 ------------ ------------ Shares allocated to particpants 14,071 5,700 Unearned shares 60,249 68,620 ------------ ------------ Total ESOP Shares 74,320 74,320 ============ ============ Fair value of unearned shares $ 1,340,540 $ 1,526,795 ============ ============ Fair value of allocated shares subject to repurchase obligation $ 284,938 $ 126,825 ============ ============ 18. SUBORDINATED DEBENTURES In August of 2003, the Company formed VSB Capital Trust I (the "Trust"). The Trust is a statutory business trust organized under Delaware law and the Company owns all of its common securities. The Trust issued $5.0 million of Trust Preferred Capital Securities to an independent investor and $155,000 of common securities to the Company. The Company issued a $5.16 million subordinated debenture to the Trust. The subordinated debenture is the sole asset of the Trust. The subordinated debenture and the Trust Preferred Capital Securities pay interest and dividends, respectively, on a quarterly basis, at a rate of 6.909%, for the first five years. They mature thirty years after the issuance of the securities and are non-callable for five years. After the first five years, the Trust Preferred Securities may be called by the Company at any quarterly interest payment date at par and the rate of interest that fluctuates quarterly based upon 300 basis points over the 90 day LIBOR rate. The Company reports as liabilities the subordinated debentures issued by the Company and held by the Trust. ***************** F-28 Item 8. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure The information required by this Item is incorporated by reference to page 14 of the Company's Definitive Proxy Statement for its 2006 Annual Meeting of Stockholders dated March 24, 2006, as filed with the Commission on March 27, 2006 (the "Proxy Statement"). Item 8-A. Disclosure As of the end of the period covered by this report, we carried out an evaluation, under the supervision of, and with the participation of, our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as contemplated by Rule 13a-15 under the Securities Exchange Act of 1934 (the "Exchange Act"). Based upon, and as of the date of, that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective, in all material respects, in timely alerting them to material information relating to the Company (and its consolidated subsidiaries) required to be included in the periodic reports the Company is required to file and submit to the Securities and Exchange Commission under the Exchange Act. PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act The information required by this Item is incorporated by reference to pages 7 through 13 of the Proxy Statement. Item 10. Executive Compensation The information required by this Item is incorporated by reference to pages 8 through 9 of the Proxy Statement. Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is incorporated by reference to pages 11 through 12 of the Proxy Statement. Item 12. Certain Relationships and Related Transactions The information required by this Item is incorporated by reference to pages 12 through 13 of the Proxy Statement. 39 Item 13. Exhibits and Reports on Form 8-K. Exhibit No. Title of Exhibit ----------- ---------------- 2.1 Restated Certificate of Incorporation of VSB Bancorp, Inc.* 2.2 Bylaws of VSB Bancorp, Inc.* 6.1 Employment Agreement between Merton Corn and Victory State Bank* 6.2 Victory State Bank 2000 Incentive Stock Option Plan* 6.3 Victory State Bank 2000 Directors Stock Option Plan* 6.4 Victory State Bank 1998 Incentive Stock Option Plan* 6.5 Victory State Bank 1998 Directors Stock Option Plan* 6.6 VSB Bancorp, Inc. Restated 2000 Incentive Stock Option Plan* 6.7 VSB Bancorp, Inc. Restated 2000 Directors Stock Option Plan* 6.8 VSB Bancorp, Inc. Restated 1998 Incentive Stock Option Plan* 6.9 VSB Bancorp, Inc. Restated 1998 Directors Stock Option Plan* 6.10 VSB Bancorp, Inc. 2004 Directors Stock Option Plan** 12.1 Agreement, Plan of Reorganization and Plan of Acquisition among Victory State Bank, VSB Bancorp, Inc. and Victory Interim Bank (in formation)* 21. Subsidiaries of the Registrant 23. Consent of Independent Registered Public Accounting Firm 31.1 Rule 13A-14(a)/15D-14(a) Certification of Chief Executive Officer 31.2 Rule 13A-14(a)/15D-14(a) Certification of Chief Financial Officer 32.1 Certification by CEO pursuant to 18 U.S.C. 1350. 32.2 Certification by CFO pursuant to 18 U.S.C. 1350. * - previously filed as exhibit to the Issuer's Registration Statement on Form 10-SB (File No. 0-50237) as filed with the Securities and Exchange Commission on April 4, 2003. ** - previously filed as an exhibit included in the Issuer's proxy statement for its 2004 Annual Meeting of Stockholders on Form 14A. Item 14. Principal Accountant Fees and Services. The information required by this Item is incorporated by reference to pages 13 through 14 of the Proxy Statement. 40 SIGNATURES Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized. VSB Bancorp, Inc. (Registrant) Date: March 27, 2006 By: /s/ MERTON CORN ---------------------------- Merton Corn, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated below. /s/ MERTON CORN March 27, 2006 --------------------------------------------------- -------------- Merton Corn, President, Chief Executive Officer Date and Director /s/ RAFFAELE M. BRANCA March 27, 2006 --------------------------------------------------- -------------- Raffaele M. Branca, Executive Vice President, Date Chief Financial and Accounting Officer and Director /s/ JOSEPH J. LIBASSI March 27, 2006 --------------------------------------------------- -------------- Joseph J, LiBassi, Chairman of the Board Date /s/ JOAN NERLINO CADDELL March 27, 2006 --------------------------------------------------- -------------- Joan Nerlino Caddell, Director Date /s/ ROBERT S. CUTRONA, SR. March 27, 2006 --------------------------------------------------- -------------- Robert S. Cutrona, Sr., Director Date /s/ CHAIM FARKAS March 27, 2006 --------------------------------------------------- -------------- Chaim Farkas, Director Date /s/ ALFRED C. JOHNSEN March 27, 2006 --------------------------------------------------- -------------- Alfred C. Johnsen, Director Date /s/ CARLOS PEREZ March 27, 2006 --------------------------------------------------- -------------- Carlos Perez, Director Date /s/ BRUNO SAVO March 27, 2006 --------------------------------------------------- -------------- Bruno Savo, Director Date 41