FINANCIAL INSTITUTIONS INC (Form: 10-Q, Received: 11/06/2020 16:11:16)

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Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2020

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

For the transition period from ________ to ________

Commission File Number: 000-26481

Financial Institutions, Inc.

(Exact name of registrant as specified in its charter)

New York		16-0816610
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

220 LIBERTY STREET, WARSAW, New York		14569
(Address of principal executive offices)		(Zip Code)

(585) 786-1100

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:


Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common stock, par value $0.01 per share	FISI	Nasdaq Global Select Market

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑ No ☐

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

Large accelerated filer	☐	Accelerated filer	☑

Non-accelerated filer	☐	Smaller reporting company	☐

		Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

The registrant had 16,038,220 shares of Common Stock, $0.01 par value, outstanding as of October 31, 2020.

Table of Contents

FINANCIAL INSTITUTIONS, INC.

Form 10-Q

For the Quarterly Period Ended September 30, 2020

TABLE OF CONTENTS

		PAGE
PART I.	FINANCIAL INFORMATION

ITEM 1.	Financial Statements

	Consolidated Statements of Financial Condition (Unaudited) - at September 30, 2020 and December 31, 2019	3

	Consolidated Statements of Income (Unaudited) - Three and nine months ended September 30, 2020 and 2019	4

	Consolidated Statements of Comprehensive Income (Unaudited) - Three and nine months ended September 30, 2020 and 2019	5

	Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) - Three and nine months ended September 30, 2020 and 2019	6

	Consolidated Statements of Cash Flows (Unaudited) - Nine months ended September 30, 2020 and 2019	8

	Notes to Consolidated Financial Statements (Unaudited)	9

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	42

ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	63

ITEM 4.	Controls and Procedures	64

PART II.	OTHER INFORMATION

ITEM 1.	Legal Proceedings	65

ITEM 1A.	Risk Factors	65

ITEM 6.	Exhibits	67

	Signatures	68

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Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition (Unaudited)

(Dollars in thousands, except share and per share data)	September 30, 2020			December 31, 2019
ASSETS
Cash and due from banks	$	282,070		$	112,947
Securities available for sale, at fair value		515,971			417,917
Securities held to maturity, at amortized cost (net of allowance for credit losses of $8 and $0, respectively) (fair value of $301,878 and $363,259, respectively)		290,946			359,000
Loans held for sale		7,076			4,224
Loans (net of allowance for credit losses of $49,395 and $30,482, respectively)		3,519,144			3,190,505
Company owned life insurance		70,347			68,942
Premises and equipment, net		40,568			41,424
Goodwill and other intangible assets, net		74,062			74,923
Other assets		159,017			114,296
Total assets	$	4,959,201		$	4,384,178
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand	$	1,013,176		$	707,752
Interest-bearing demand		786,059			627,842
Savings and money market		1,724,463			1,039,892
Time deposits		841,230			1,180,189
Total deposits		4,364,928			3,555,675
Short-term borrowings		5,300			275,500
Long-term borrowings, net of issuance costs of $742 and $727, respectively		39,258			39,273
Other liabilities		93,354			74,783
Total liabilities		4,502,840			3,945,231
Shareholders’ equity:
Series A 3% preferred stock, $100 par value; 1,533 shares authorized; 1,435 shares issued		143			143
Series B-1 8.48% preferred stock, $100 par value; 200,000 shares authorized; 171,847 shares issued		17,185			17,185
Total preferred equity		17,328			17,328
Common stock, $0.01 par value; 50,000,000 shares authorized; 16,099,556 shares issued		161			161
Additional paid-in capital		124,812			124,582
Retained earnings		315,585			313,364
Accumulated other comprehensive loss		(209	)		(14,513	)
Treasury stock, at cost – 61,971 and 96,657 shares, respectively		(1,316	)		(1,975	)
Total shareholders’ equity		456,361			438,947
Total liabilities and shareholders’ equity	$	4,959,201		$	4,384,178

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

(In thousands, except per share amounts)	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Interest income:
Interest and fees on loans	$	35,602		$	37,904		$	107,659		$	112,177
Interest and dividends on investment securities		4,086			4,449			13,206			14,147
Other interest income		31			106			266			297
Total interest income		39,719			42,459			121,131			126,621
Interest expense:
Deposits		3,370			7,277			15,066			21,454
Short-term borrowings		232			2,081			1,408			6,575
Long-term borrowings		618			618			1,853			1,853
Total interest expense		4,220			9,976			18,327			29,882
Net interest income		35,499			32,483			102,804			96,739
Provision for credit losses		4,028			1,844			21,689			5,391
Net interest income after provision for credit losses		31,471			30,639			81,115			91,348
Noninterest income:
Service charges on deposits		1,254			1,925			3,321			5,361
Insurance income		1,357			1,439			3,525			3,689
ATM and debit card		1,943			1,801			5,321			4,983
Investment advisory		2,443			2,269			6,940			6,812
Company owned life insurance		470			459			1,397			1,293
Investments in limited partnerships		(105	)		116			(136	)		492
Loan servicing		49			102			106			316
Income from derivative instruments, net		1,931			890			4,617			1,013
Net gain on sale of loans held for sale		1,581			439			2,616			1,028
Net gain on investment securities		554			1,608			1,449			1,721
Net (loss) gain on other assets		(55	)		(2	)		8			56
Loss on tax credit investments		(40	)		—			(120	)		—
Other		1,019			1,315			3,151			3,950
Total noninterest income		12,401			12,361			32,195			30,714
Noninterest expense:
Salaries and employee benefits		15,085			14,411			45,173			41,661
Occupancy and equipment		3,263			4,650			10,407			10,106
Professional services		1,242			1,528			4,974			3,618
Computer and data processing		3,250			1,378			8,622			7,407
Supplies and postage		463			522			1,533			1,554
FDIC assessments		594			7			1,505			1,005
Advertising and promotions		955			745			2,055			2,351
Amortization of intangibles		280			309			861			948
Restructuring charges		1,362			—			1,362			—
Other		2,165			2,336			6,583			7,410
Total noninterest expense		28,659			25,886			83,075			76,060
Income before income taxes		15,213			17,114			30,235			46,002
Income tax expense		2,940			4,281			5,703			10,247
Net income	$	12,273		$	12,833		$	24,532		$	35,755
Preferred stock dividends		365			365			1,096			1,096
Net income available to common shareholders	$	11,908		$	12,468		$	23,436		$	34,659
Earnings per common share (Note 3):
Basic	$	0.74		$	0.78		$	1.46		$	2.17
Diluted	$	0.74		$	0.78		$	1.46		$	2.16
Cash dividends declared per common share	$	0.26		$	0.25		$	0.78		$	0.75

See accompanying notes to the consolidated financial statements.

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Unaudited)

(Dollars in thousands)	Three months ended September 30,					Nine months ended September 30,
	2020			2019		2020			2019
Net income	$	12,273		$	12,833	$	24,532		$	35,755
Other comprehensive income (loss), net of tax:
Securities available for sale and transferred securities		(69	)		1,121		13,778			11,863
Hedging derivative instruments		123			43		(174	)		(317	)
Pension and post-retirement obligations		233			262		700			784
Total other comprehensive income, net of tax		287			1,426		14,304			12,330
Comprehensive income	$	12,560		$	14,259	$	38,836		$	48,085

See accompanying notes to the consolidated financial statements.

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

Three and nine months ended September 30, 2020 and 2019

(Dollars in thousands, except per share data)	Preferred Equity		Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Loss			Treasury Stock			Total Shareholders’ Equity
Balance at December 31, 2019	$	17,328	$	161	$	124,582		$	313,364		$	(14,513	)	$	(1,975	)	$	438,947
Cumulative-effect adjustment		—		—		—			(8,719	)		—			—			(8,719	)
Balance at January 1, 2020	$	17,328	$	161	$	124,582		$	304,645		$	(14,513	)	$	(1,975	)	$	430,228
Comprehensive income:
Net income		—		—		—			1,127			—			—			1,127
Other comprehensive income, net of tax		—		—		—			—			12,431			—			12,431
Purchases of common stock for treasury		—		—		—			—			—			(196	)		(196	)
Share-based compensation plans:
Share-based compensation		—		—		332			—			—			—			332
Restricted stock units released		—		—		(469	)		—			—			469			—
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(364	)		—			—			(364	)
Common-$0.26 per share		—		—		—			(4,164	)		—			—			(4,164	)
Balance at March 31, 2020	$	17,328	$	161	$	124,445		$	301,243		$	(2,082	)	$	(1,702	)	$	439,393
Comprehensive income:
Net income		—		—		—			11,132			—			—			11,132
Other comprehensive income, net of tax		—		—		—			—			1,586			—			1,586
Share-based compensation plans:
Share-based compensation		—		—		369			—			—			—			369
Restricted stock awards issued		—		—		(272	)		—			—			272			—
Stock awards		—		—		(19	)		—			—			114			95
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(365	)		—			—			(365	)
Common-$0.26 per share		—		—		—			(4,164	)		—			—			(4,164	)
Balance at June 30, 2020	$	17,328	$	161	$	124,523		$	307,845		$	(496	)	$	(1,316	)	$	448,045
Comprehensive income:
Net income		—		—		—			12,273			—			—			12,273
Other comprehensive income, net of tax		—		—		—			—			287			—			287
Share-based compensation plans:
Share-based compensation		—		—		289			—			—			—			289
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(364	)		—			—			(364	)
Common-$0.26 per share		—		—		—			(4,168	)		—			—			(4,168	)
Balance at September 30, 2020	$	17,328	$	161	$	124,812		$	315,585		$	(209	)	$	(1,316	)	$	456,361

Continued on next page

See accompanying notes to the consolidated financial statements.

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) (Continued)

Three and nine months ended September 30, 2020 and 2019

(Dollars in thousands, except per share data)	Preferred Equity		Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Loss			Treasury Stock			Total Shareholders’ Equity
Balance at December 31, 2018	$	17,328	$	161	$	122,704		$	279,867		$	(21,281	)	$	(2,486	)	$	396,293
Cumulative-effect adjustment		—		—		—			(710	)		—			—			(710	)
Balance at January 1, 2019	$	17,328	$	161	$	122,704		$	279,157		$	(21,281	)	$	(2,486	)	$	395,583
Comprehensive income:
Net income		—		—		—			11,521			—			—			11,521
Other comprehensive income, net of tax		—		—		—			—			5,510			—			5,510
Reclassification of income tax effects		—		—		—			2,783			(2,783	)		—			—
Purchases of common stock for treasury		—		—		—			—			—			(193	)		(193	)
Share-based compensation plans:
Share-based compensation		—		—		182			—			—			—			182
Restricted stock units released		—		—		(362	)		—			—			362			—
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(364	)		—			—			(364	)
Common-$0.25 per share		—		—		—			(3,985	)		—			—			(3,985	)
Balance at March 31, 2019	$	17,328	$	161	$	122,524		$	289,111		$	(18,554	)	$	(2,317	)	$	408,253
Comprehensive income:
Net income		—		—		—			11,401			—			—			11,401
Other comprehensive income, net of tax		—		—		—			—			5,394			—			5,394
Common stock issued		—		—		1,151			—			—			—			1,151
Share-based compensation plans:
Share-based compensation		—		—		453			—			—			—			453
Restricted stock awards issued		—		—		(165	)		—			—			165			—
Stock awards		—		—		17			—			—			46			63
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(365	)		—			—			(365	)
Common-$0.25 per share		—		—		—			(3,995	)		—			—			(3,995	)
Balance at June 30, 2019	$	17,328	$	161	$	123,980		$	296,151		$	(13,160	)	$	(2,106	)	$	422,354
Comprehensive income:
Net income		—		—		—			12,833			—			—			12,833
Other comprehensive income, net of tax		—		—		—			—			1,426			—			1,426
Purchases of common stock for treasury		—		—		—			—			—			(27	)		(27	)
Share-based compensation plans:
Share-based compensation		—		—		393			—			—			—			393
Restricted stock awards issued		—		—		(51	)		—			—			51			—
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per share		—		—		—			(364	)		—			—			(364	)
Common-$0.25 per share		—		—		—			(3,997	)		—			—			(3,997	)
Balance at September 30, 2019	$	17,328	$	161	$	124,322		$	304,622		$	(11,734	)	$	(2,082	)	$	432,617

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

(Dollars in thousands)	Nine months ended September 30,
	2020			2019
Cash flows from operating activities:
Net income	$	24,532		$	35,755
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,924			6,221
Net amortization of premiums on securities		2,313			1,253
Provision for credit losses		21,689			5,391
Share-based compensation		990			1,028
Deferred income tax (benefit) expense		(2,692	)		1,268
Proceeds from sale of loans held for sale		63,995			28,106
Originations of loans held for sale		(64,231	)		(30,751	)
Income on company owned life insurance		(1,397	)		(1,293	)
Net gain on sale of loans held for sale		(2,616	)		(1,028	)
Net gain on investment securities		(1,449	)		(1,721	)
Net gain on other assets		(8	)		(56	)
Increase in other assets		(42,243	)		(6,768	)
Increase in other liabilities		15,491			3,757
Net cash provided by operating activities		20,298			41,162
Cash flows from investing activities:
Purchases of available for sale securities		(215,433	)		(103,627	)
Purchases of held to maturity securities		(6,008	)		(9,596	)
Proceeds from principal payments, maturities and calls on available for sale securities		65,244			58,283
Proceeds from principal payments, maturities and calls on held to maturity securities		73,114			69,090
Proceeds from sales of securities available for sale		70,729			110,042
Proceeds from sales of securities held to maturity		6			—
Net loan originations		(361,935	)		(98,430	)
Loans sold to others		—			21,077
Purchases of company owned life insurance, net of proceeds received		(8	)		(24	)
Proceeds from sales of other assets		482			360
Purchases of premises and equipment		(2,800	)		(2,367	)
Net cash (used in) provided by investing activities		(376,609	)		44,808
Cash flows from financing activities:
Net increase in deposits		809,253			219,307
Net decrease in short-term borrowings		(270,200	)		(258,100	)
Purchases of common stock for treasury		(196	)		(220	)
Cash dividends paid to common and preferred shareholders		(13,423	)		(12,897	)
Net cash provided by (used in) financing activities		525,434			(51,910	)
Net increase in cash and cash equivalents		169,123			34,060
Cash and cash equivalents, beginning of period		112,947			102,755
Cash and cash equivalents, end of period	$	282,070		$	136,815

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.)	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Financial Institutions, Inc. (the “Company”) is a financial holding company organized in 1931 under the laws of New York State (“New York”). The Company provides diversified financial services through its subsidiaries, Five Star Bank, SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York chartered banking subsidiary, Five Star Bank (the “Bank”). The Bank also has indirect lending network relationships with franchised automobile dealers in the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation of the consolidated statements of financial condition, income, comprehensive income, changes in shareholders’ equity and cash flows for the periods indicated and contain adequate disclosure to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the Company’s 2019 Annual Report on Form 10-K for the year ended December 31, 2019. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.

Allowance for Credit Losses

On January 1, 2020, the Company adopted Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments. ASU 2016-13 amends guidance on reporting credit losses for financial assets held at amortized cost basis and available for sale debt securities. Topic 326 eliminates the probable initial recognition threshold in current GAAP and instead, requires an entity to reflect its current estimate of all expected credit losses based on historical experience, current conditions and reasonable and supportable forecasts. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the reserve for credit losses. In addition, entities need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. The Company adopted ASU 2016-13 using the modified retrospective approach. Results for the periods beginning after January 1, 2020 are presented under Accounting Standards Codification (“ASC”) 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net reduction of retained earnings of $8.7 million upon adoption. The transition adjustment includes an increase in credit-related reserves of $9.6 million, $14 thousand, and $2.1 million for loans, held to maturity investment securities and unfunded commitments, respectively, net of the corresponding increase in deferred tax assets of $3.0 million.

The allowance for credit losses is evaluated on a regular basis and established through charges to earnings in the form of a provision for credit losses. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

Portfolio Segmentation (“Pooled Loans”)

Portfolio segmentation is defined as the pooling of loans based upon similar risk characteristics such that quantitative methodologies and qualitative adjustment factors for estimating the allowance for credit losses is constructed for each segment. The Company has identified six portfolio segments of loans including Commercial Loans/Lines, Commercial Mortgage, Indirect Loans, Direct Loans, Residential Lines of Credit, and Residential Loans.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.)	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Individually Evaluated Loans

The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, troubled debt restructurings (“TDRs”), and other loans deemed appropriate by management.

Held to Maturity (“HTM”) Debt Securities

The Company’s HTM debt securities are also required to utilize the current expected credit losses approach to estimate expected credit losses. The Company’s HTM debt securities included securities that are issued by U.S. government or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. The Company also carries a portfolio of HTM municipal bonds. The Company measures its allowance for credit losses on HTM debt securities on a collective basis by major security type. The estimate is based on historical credit losses, if any, adjusted for current conditions and reasonable and supportable forecasts. The Company considers the nature of the collateral, potential future changes in collateral values and available loss information.

Available for Sale (“AFS”) Debt Securities

For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security's amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met.

Accrued Interest Receivable

Upon adoption of ASU 2016-13 and its related amendments on January 1, 2020, the Company made the following elections regarding accrued interest receivable:

•

Presenting accrued interest receivable balances separately within another line item on the statement of financial condition.

•

Excluding accrued interest receivable that is included in the amortized cost of financing receivables and debt securities from related disclosure requirements.

•

Continuing our policy to write off accrued interest receivable by reversing interest income. For commercial loans, the write off typically occurs upon becoming 90 days past due. For consumer loans, the write off typically occurs upon becoming 120 days past due. Historically, the Company has not experienced uncollectible accrued interest receivable on its investment securities. However, the Company would generally write off accrued interest receivable by reversing interest income if the Company does not reasonably expect to receive payments. Due to the timely manner in which accrued interest receivables are written off, the amounts of such write offs are immaterial.

•

Not measuring an allowance for credit losses for accrued interest receivable due to the Company’s policy of writing off uncollectible accrued interest receivable balances in a timely manner, as described above.

Reserve for Unfunded Commitments

The reserve for unfunded commitments (the “Unfunded Reserve”) represents the expected credit losses on off-balance sheet commitments such as unfunded commitments to extend credit and standby letters of credit. However, a liability is not recognized for commitments unconditionally cancellable by the Company. The Unfunded Reserve is recognized as a liability (other liabilities in the consolidated statements of financial condition), with adjustments to the reserve recognized as a provision for credit loss expense in the consolidated statements of income. The Unfunded Reserve is determined by estimating expected future fundings, under each segment, and applying the expected loss rates. Expected future fundings are based on historical averages of funding rates (i.e., the likelihood of draws taken). To estimate future fundings on unfunded balances, current funding rates are compared to historical funding rates.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.)	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Operating, Accounting and Reporting Considerations related to COVID-19

The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provides an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:

•

Accounting for Loan Modifications - The CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.

•

Paycheck Protection Program - The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s (“SBA”) 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administered directly by the SBA.

•

Mortgage Forbearance - Under the CARES Act, through the earlier of December 31, 2020, or the termination date of the COVID-19 national emergency, a borrower with a federally backed mortgage loan that is experiencing financial hardship due to COVID-19 may request a forbearance.

Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:

•

Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.

•

Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.

•

Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.

Effective March 23, 2020 through July 9, 2020, for consumer customers, the Bank waived early CD penalty fees for withdrawals up to $20,000 (limited to one penalty-free withdrawal per CD account); eliminated all insufficient funds (overdrafts) and returned item fees; eliminated all Pay by Phone fees; waived all late fees; offered the opportunity for monthly mortgage, home equity loan or home equity line payment relief; offered the opportunity to defer unsecured consumer loans or lines of credit and secured consumer loans and lines of credit payments; and offered unsecured personal loans up to $5,000, up to 60 months at 2.95% APR subject to credit approval (additional terms and conditions may apply). In addition, ATM access fees were reinitiated on September 19, 2020.

Reclassifications

Certain reclassifications of previously reported amounts have been made to conform to the current year presentation. Such reclassifications did not impact net income or shareholders’ equity as previously reported.

Subsequent Events

Subordinated Note Issuance

On October 7, 2020, the Company completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due 2030 (the “Notes”) to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month secured overnight financing rate (“SOFR”) plus 4.265%, payable quarterly until maturity.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.)	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and to redeem the Notes in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.

In connection with the issuance and sale of the Notes, the Company entered into a registration rights agreement with the purchasers of the Notes pursuant to which the Company has agreed to take certain actions to provide for the exchange of the Notes for subordinated notes that are registered under the Securities Act of 1933, as amended, with substantially the same terms as the Notes.

Enterprise Standardization Program

In October 2020, the Company announced the planned closure of one additional branch in January 2021. This location was not included in the branch consolidations announced in July, as alternative options were being considered and consolidation was not possible given its significant distance from other Five Star Bank branches. This closure is expected to result in one-time expenses related to severance costs and real estate related charges of approximately $130 thousand in the fourth quarter of 2020. Expected expense savings are anticipated at $340 thousand on an annualized basis.

Stock Repurchase Program

In November 2020, the Company announced that its Board of Directors approved a stock repurchase program for up to 801,879 shares of its common stock, or approximately 5% of the Company’s outstanding common shares. The repurchase program permits shares to be repurchased in open market transactions and pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934. The timing and number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements, market conditions, and other corporate liquidity requirements and priorities. The repurchase program does not obligate the Company to purchase any shares and it may be extended, modified or discontinued at any time.

Use of Estimates

The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for credit losses, the carrying value of goodwill and deferred tax assets, and assumptions used in the defined benefit pension plan accounting.

Cash Flow Reporting

Supplemental cash flow information is summarized as follows for the nine months ended September 30 (in thousands):

	2020		2019
Supplemental information:
Cash paid for interest	$	23,533	$	28,672
Cash paid for income taxes		5,656		8,666
Noncash investing and financing activities:
Real estate and other assets acquired in settlement of loans		2,966		159
Accrued and declared unpaid dividends		4,534		4,363
Increase in net unsettled security purchases		—		(2,650	)
Common stock issued for Courier Capital contingent earn-out		—		1,151

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.)	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements

In April 2019, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. With respect to Topic 815, Derivatives and Hedging, ASU 2019-04 clarifies that the reclassification of a debt security from Held to Maturity (“HTM”) to Available for Sale (“AFS”) under the transition guidance in ASU No. 2017-12, Derivatives and Hedging (Topic 815) – Targeted Improvements to Accounting for Hedging Activities, would not (1) call into question the classification of other HTM securities, (2) be required to actually designate any reclassified security in a last-of-layer hedge, or (3) be restricted from selling any reclassified security. As part of the transition of ASU 2019-04, entities may reclassify securities that would qualify for designation as the hedged item in a last-of-layer hedging relationship from HTM to AFS; however, entities that already made such a reclassification upon their adoption of ASU 2017-12 are precluded from reclassifying additional securities. The Company did not reclassify any securities from HTM to AFS upon adoption of ASU 2017-12. The Company elected to early adopt the amendments to Topic 815 in December 2019, resulting in the reclassification of $26.2 million of qualified investment securities from HTM to AFS. With respect to Topic 326, Financial Instruments - Credit Losses, ASU 2019-04 clarifies the scope of the credit losses standard and addresses issues related to accrued interest receivable balances, recoveries, variable interest rates and prepayments, among other things. With respect to Topic 825, Financial Instruments, on recognizing and measuring financial instruments, ASU 2019-04 addresses the scope of the guidance, the requirement for remeasurement under ASC 820 (Fair Value Measurement) when using the measurement alternative, certain disclosure requirements and which equity securities have to be remeasured at historical exchange rates. The amendments to Topic 326 and the amendments to Topic 825, under ASU 2019-04, were adopted as of January 1, 2020 and did not have a significant impact on the Company’s financial statements.

In March 2020, the FASB issued ASU No. 2020-04, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” This ASU provides temporary optional expedients and exceptions to GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative rates, such as SOFR. For instance, entities can elect not to apply certain modification accounting requirements to contracts affected by reference rate reform, if certain criteria are met. An entity that makes this election would not have to remeasure the contracts at the modification date or reassess a previous accounting determination. Entities can also elect various optional expedients that would allow them to continue applying hedge accounting for hedging relationships affected by reference rate reform, if certain criteria are met. Finally, entities can make a one-time election to sell and/or reclassify HTM debt securities that reference an interest rate affected by reference rate reform. ASU 2020-04 is effective March 12, 2020, through December 31, 2022. The Company is in the process of determining which optional expedients to elect, if any, as well as the timing and application of those elections. At this time, the Company does not expect any elections to have a significant impact on its financial statements.

(2.)	RESTRUCTURING CHARGES

On July 17, 2020, the Bank announced management’s decision to adapt to a full-service branch model to streamline retail branches to better align with shifting customer needs and preferences. The transformation resulted in six branch closures and a reduction in staffing. The announcement was the result of a nine-month comprehensive assessment of all lines of business and functional areas, conducted in partnership with a leading process improvement organization. The data-driven analysis identified, among other things, overlapping service areas, automation opportunities and streamlining of processes and operations that would enhance customer experiences and facilitate the long-term sustainability of current and future branches. The announced consolidations represented about ten percent of the branch network and impacted approximately six percent of the total Company workforce. Where possible, those impacted were offered alternative roles or the opportunity to apply for open positions in other areas of the Company. Separated associates received a comprehensive severance package based on tenure. The Company expects to complete a substantial majority of these actions by December 31, 2020.

The Company incurred total pre-tax expense related to the branch closures of approximately $1.6 million, including approximately $0.2 million in employee severance, $0.5 million in lease termination costs and $0.9 million in valuation adjustments on branch facilities. The Company expects $0.7 million of total costs will result in future cash expenditures. The Company recognized all of these expenses during the third quarter of 2020. The Company anticipates annual expense savings of approximately $2.6 million as a result of these branch closures.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(2.)	RESTRUCTURING CHARGES (continued)

The following table represents the consolidated statements of income classification of the Company’s restructuring charges (in thousands):

		Three months ended September 30,				Nine months ended September 30,
	Income Statement Location	2020		2019		2020		2019

Severance costs	Salaries and employee benefits	$	224	$	—	$	224	$	—
Lease termination costs	Restructuring charges		454		—		454		—
Valuation adjustments	Restructuring charges		908		—		908		—
Total		$	1,586	$	—	$	1,586	$	—

The following table represents the changes in the restructuring reserve (in thousands):

	Three months ended September 30,					Nine months ended September 30,
	2020			2019		2020			2019

Beginning balance	$	—		$	—	$	—		$	—
Restructuring charges		1,586			—		1,586			—
Cash payments		(249	)		—		(249	)		—
Ending balance	$	1,337		$	—	$	1,337		$	—

(3.)	EARNINGS PER COMMON SHARE (“EPS”)

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS (in thousands, except per share amounts).

	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Net income available to common shareholders	$	11,908		$	12,468		$	23,436		$	34,659
Weighted average common shares outstanding:
Total shares issued		16,100			16,100			16,100			16,081
Unvested restricted stock awards		(7	)		(4	)		(5	)		(4	)
Treasury shares		(62	)		(105	)		(77	)		(113	)
Total basic weighted average common shares outstanding		16,031			15,991			16,018			15,964
Incremental shares from assumed:
Exercise of stock options		—			—			—			—
Vesting of restricted stock awards		27			65			40			53
Total diluted weighted average common shares outstanding		16,058			16,056			16,058			16,017
Basic earnings per common share	$	0.74		$	0.78		$	1.46		$	2.17
Diluted earnings per common share	$	0.74		$	0.78		$	1.46		$	2.16

For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:

Stock options	—	—	—	—
Restricted stock awards	71	—	49	5
Total	71	—	49	5

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.)	INVESTMENT SECURITIES

The amortized cost and fair value of investment securities are summarized below (in thousands):

	Amortized			Unrealized		Unrealized		Fair
	Cost			Gains		Losses		Value
September 30, 2020
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	6,234		$	421	$	—	$	6,655
Mortgage-backed securities:
Federal National Mortgage Association		303,740			15,923		66		319,597
Federal Home Loan Mortgage Corporation		139,875			2,684		140		142,419
Government National Mortgage Association		23,300			851		—		24,151
Collateralized mortgage obligations:
Federal National Mortgage Association		18,104			229		—		18,333
Federal Home Loan Mortgage Corporation		4,365			16		—		4,381
Privately issued		—			435		—		435
Total mortgage-backed securities		489,384			20,138		206		509,316
Total available for sale securities	$	495,618		$	20,559	$	206	$	515,971
Securities held to maturity:
State and political subdivisions	$	151,611		$	5,052	$	—	$	156,663
Mortgage-backed securities:
Federal National Mortgage Association		11,576			725		—		12,301
Federal Home Loan Mortgage Corporation		6,183			365		—		6,548
Government National Mortgage Association		39,631			1,402		—		41,033
Collateralized mortgage obligations:
Federal National Mortgage Association		33,396			1,236		—		34,632
Federal Home Loan Mortgage Corporation		39,905			1,835		—		41,740
Government National Mortgage Association		8,652			309		—		8,961
Total mortgage-backed securities		139,343			5,872		—		145,215
Total held to maturity securities		290,954		$	10,924	$	—	$	301,878
Allowance for credit losses - securities		(8	)
Total held to maturity securities, net	$	290,946
December 31, 2019
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	26,440		$	437	$	—	$	26,877
Mortgage-backed securities:
Federal National Mortgage Association		293,873			2,263		1,380		294,756
Federal Home Loan Mortgage Corporation		52,733			318		172		52,879
Government National Mortgage Association		14,065			60		4		14,121
Collateralized mortgage obligations:
Federal National Mortgage Association		23,834			—		57		23,777
Federal Home Loan Mortgage Corporation		4,907			—		18		4,889
Privately issued		—			618		—		618
Total mortgage-backed securities		389,412			3,259		1,631		391,040
Total available for sale securities	$	415,852		$	3,696	$	1,631	$	417,917

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.)	INVESTMENT SECURITIES (Continued)

	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
December 31, 2019 (continued)
Securities held to maturity:
State and political subdivisions	$	192,215	$	3,803	$	—	$	196,018
Mortgage-backed securities:
Federal National Mortgage Association		12,049		227		6		12,270
Federal Home Loan Mortgage Corporation		6,995		77		47		7,025
Government National Mortgage Association		45,758		306		128		45,936
Collateralized mortgage obligations:
Federal National Mortgage Association		41,561		150		256		41,455
Federal Home Loan Mortgage Corporation		49,389		307		103		49,593
Government National Mortgage Association		11,033		12		83		10,962
Total mortgage-backed securities		166,785		1,079		623		167,241
Total held to maturity securities	$	359,000	$	4,882	$	623	$	363,259

The Company elected to exclude accrued interest receivable (“AIR”) from the amortized cost basis of debt securities disclosed throughout this footnote. For AFS debt securities, AIR totaled $1.0 million as of September 30, 2020 and December 31, 2019. For HTM debt securities, AIR totaled $1.4 million and $1.2 million as of September 30, 2020 and December 31, 2019, respectively. AIR is included in other assets on the Company’s consolidated statements of financial condition.

For each of the three months ended September 30, 2020 and 2019, credit loss expense (credit) for HTM investment securities was $0. For the nine months ended September 30, 2020 and 2019, credit loss expense (credit) for HTM investment securities was $(6) thousand and $0, respectively.

Investment securities with a total fair value of $634.4 million and $676.9 million at September 30, 2020 and December 31, 2019, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.

Sales of securities available for sale were as follows (in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Proceeds from sales	$	20,576	$	65,427	$	70,729	$	110,042
Gross realized gains		554		1,608		1,458		1,811
Gross realized losses		—		—		9		90

The scheduled maturities of securities available for sale and securities held to maturity at September 30, 2020 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

	Amortized		Fair
	Cost		Value
Debt securities available for sale:
Due in one year or less	$	1	$	1
Due from one to five years		36,525		38,323
Due after five years through ten years		162,953		175,586
Due after ten years		296,139		302,061
Total available for sale securities	$	495,618	$	515,971
Debt securities held to maturity:
Due in one year or less	$	48,688	$	49,234
Due from one to five years		102,292		106,631
Due after five years through ten years		19,076		20,008
Due after ten years		120,898		126,005
Total held to maturity securities	$	290,954	$	301,878

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.)	INVESTMENT SECURITIES (Continued)

Unrealized losses on investment securities for which an allowance for credit losses has not been recorded and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

	Less than 12 months				12 months or longer				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
September 30, 2020
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities:
Federal National Mortgage Association		40,103		66		—		—		40,103		66
Federal Home Loan Mortgage Corporation		43,075		140		—		—		43,075		140
Government National Mortgage Association		—		—		—		—		—		—
Collateralized mortgage obligations:
Federal National Mortgage Association		—		—		8		—		8		—
Federal Home Loan Mortgage Corporation		—		—		—		—		—		—
Total mortgage-backed securities		83,178		206		8		—		83,186		206
Total available for sale securities		83,178		206		8		—		83,186		206
Total temporarily impaired securities	$	83,178	$	206	$	8	$	—	$	83,186	$	206
December 31, 2019
Securities available for sale:
U.S. Government agencies and government sponsored enterprises	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities:
Federal National Mortgage Association		104,634		1,277		7,196		103		111,830		1,380
Federal Home Loan Mortgage Corporation		10,347		11		9,409		161		19,756		172
Government National Mortgage Association		533		4		—		—		533		4
Collateralized mortgage obligations:
Federal National Mortgage Association		8,803		57		8		—		8,811		57
Federal Home Loan Mortgage Corporation		4,889		18		—		—		4,889		18
Total mortgage-backed securities		129,206		1,367		16,613		264		145,819		1,631
Total available for sale securities		129,206		1,367		16,613		264		145,819		1,631
Securities held to maturity:
State and political subdivisions		—		—		—		—		—		—
Mortgage-backed securities:
Federal National Mortgage Association		2,388		6		—		—		2,388		6
Federal Home Loan Mortgage Corporation		2,967		19		2,598		28		5,565		47
Government National Mortgage Association		11,155		61		5,625		67		16,780		128
Collateralized mortgage obligations:
Federal National Mortgage Association		9,120		40		13,486		216		22,606		256
Federal Home Loan Mortgage Corporation		15,127		30		7,988		73		23,115		103
Government National Mortgage Association		8,760		72		892		11		9,652		83
Total mortgage-backed securities		49,517		228		30,589		395		80,106		623
Total held to maturity securities		49,517		228		30,589		395		80,106		623
Total temporarily impaired securities	$	178,723	$	1,595	$	47,202	$	659	$	225,925	$	2,254

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.)	INVESTMENT SECURITIES (Continued)

The total number of securities positions in the investment portfolio in an unrealized loss position at September 30, 2020 was 16 compared to 91 at December 31, 2019. At September 30, 2020, the Company had a position in one investment security with a fair value of $8 thousand and a total unrealized loss of less than $1 thousand that has been in a continuous unrealized loss position for more than 12 months. At September 30, 2020, there were a total of 15 securities positions in the Company’s investment portfolio with a fair value of $83.2 million and a total unrealized loss of $206 thousand that had been in a continuous unrealized loss position for less than 12 months. At December 31, 2019, the Company had positions in 34 investment securities with a fair value of $47.2 million and a total unrealized loss of $659 thousand that had been in a continuous unrealized loss position for more than 12 months. At December 31, 2019, there were a total of 57 securities positions in the Company’s investment portfolio with a fair value of $178.7 million and a total unrealized loss of $1.6 million that had been in a continuous unrealized loss position for less than 12 months. The unrealized loss on investment securities was predominantly caused by changes in market interest rates subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.

Securities Available for Sale

As of September 30, 2020, no allowance for credit losses has been recognized on available for sale securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality. This is based upon our analysis of the underlying risk characteristics, including credit ratings, and other qualitative factors related to our available for sale securities and in consideration of our historical credit loss experience and internal forecasts. The issuers of these securities continue to make timely principal and interest payments under the contractual terms of the securities. Furthermore, management does not have the intent to sell any of the securities classified as available for sale in the table above and believes that it is more likely than not that we will not have to sell any such securities before a recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline.

Securities Held to Maturity

The Company’s HTM investment securities include debt securities that are issued by U.S. government agencies or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss. In addition, the Company’s HTM investment securities include debt securities that are issued by state and local government agencies, or municipal bonds.

The Company monitors the credit quality of our municipal bonds through the use of a credit rating agency or by ratings that are derived by an internal scoring model. The scoring methodology for the internally derived ratings is based on a series of financial ratios for the municipality being reviewed as compared to typical industry figures. This information is used to determine the financial strengths and weaknesses of the municipality, which is indicated with a numeric rating. This number is then converted into a letter rating to better match the system used by the credit rating agencies. As of September 30, 2020, $151.6 million of our municipal bonds were rated as an equivalent to Standard & Poor’s A/AA/AAA, with $8.5 million internally rated to be the equivalent of Standard & Poor’s A/AA/AAA rating. Additionally, one municipal bond is rated below investment grade, with a BB+ Standard & Poor’s equivalent rating. The below investment grade bond was recently upgraded from a Standard & Poor’s equivalent rating of BB-, represents exposure of $279 thousand, or 0.18% of the municipal bond portfolio and is closely monitored for repayment.

As of September 30, 2020, the Company had no past due or nonaccrual held to maturity investment securities.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)

LOANS

The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):

	Principal Amount Outstanding		Net Deferred Loan (Fees) Costs			Loans, Net
September 30, 2020
Commercial business	$	823,611	$	(5,476	)	$	818,135
Commercial mortgage		1,204,353		(2,307	)		1,202,046
Residential real estate loans		583,963		12,939			596,902
Residential real estate lines		90,899		3,118			94,017
Consumer indirect		813,345		27,234			840,579
Other consumer		16,703		157			16,860
Total	$	3,532,874	$	35,665			3,568,539
Allowance for credit losses - loans							(49,395	)
Total loans, net						$	3,519,144
December 31, 2019
Commercial business	$	571,222	$	818		$	572,040
Commercial mortgage		1,108,315		(2,032	)		1,106,283
Residential real estate loans		560,717		11,633			572,350
Residential real estate lines		101,048		3,070			104,118
Consumer indirect		822,179		27,873			850,052
Other consumer		15,984		160			16,144
Total	$	3,179,465	$	41,522			3,220,987
Allowance for credit losses - loans							(30,482	)
Total loans, net						$	3,190,505

Loans held for sale (not included above) were comprised entirely of residential real estate mortgages and totaled $7.1 million and $4.2 million as of September 30, 2020 and December 31, 2019, respectively.

The CARES Act was passed by Congress and signed into law on March 27, 2020. The CARES Act established the PPP, an expansion of the SBA’s 7(a) loan program and the EIDL, administered directly by the SBA. The Company had $270.5 million of PPP loans (included in Commercial business above) as of September 30, 2020. In addition, the CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes. Accordingly, the Company had $526.7 million of loans with modifications related to COVID-19 as of September 30, 2020.

The Company elected to exclude AIR from the amortized cost basis of loans disclosed throughout this footnote. As of September 30, 2020 and December 31, 2019, AIR for loans totaled $13.7 million and $9.1 million, respectively, and is included in other assets on the Company’s consolidated statements of financial condition.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)	LOANS (Continued)

Past Due Loans Aging

The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Nonaccrual		Current		Total Loans		Nonaccrual with no allowance
September 30, 2020
Commercial business	$	139	$	2	$	—	$	141	$	2,628	$	820,842	$	823,611	$	894
Commercial mortgage		—		—		—		—		3,372		1,200,981		1,204,353		3,175
Residential real estate loans		389		35		—		424		3,305		580,234		583,963		3,305
Residential real estate lines		288		—		—		288		207		90,404		90,899		207
Consumer indirect		3,520		566		—		4,086		1,244		808,015		813,345		1,244
Other consumer		126		20		141		287		6		16,410		16,703		6
Total loans, gross	$	4,462	$	623	$	141	$	5,226	$	10,762	$	3,516,886	$	3,532,874	$	8,831
December 31, 2019
Commercial business	$	361	$	—	$	—	$	361	$	1,177	$	569,684	$	571,222
Commercial mortgage		531		—		—		531		3,146		1,104,638		1,108,315
Residential real estate loans		929		114		—		1,043		2,484		557,190		560,717
Residential real estate lines		231		37		—		268		102		100,678		101,048
Consumer indirect		3,729		1,019		—		4,748		1,725		815,706		822,179
Other consumer		116		8		6		130		—		15,854		15,984
Total loans, gross	$	5,897	$	1,178	$	6	$	7,081	$	8,634	$	3,163,750	$	3,179,465

There were no loans past due greater than 90 days and still accruing interest as of September 30, 2020 and December 31, 2019. There were $141 thousand and $6 thousand in consumer overdrafts which were past due greater than 90 days as of September 30, 2020 and December 31, 2019, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.

The Company recognized no interest income on nonaccrual loans during the nine months ended September 30, 2020 and 2019.

Troubled Debt Restructurings

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, collateral concessions, forgiveness of principal, forbearance agreements, or substituting or adding a new borrower or guarantor.

There were no loans modified as a TDR during the nine months ended September 30, 2020 and 2019. During the third quarter of 2020, the Company discovered that the previously reported 2020 TDR was reported in error. This correction had no impact to any other section within our consolidated financial statements and the Company does not consider this correction to be material to any previously issued consolidated financial statement. There were no loans modified as a TDR within the previous 12 months that defaulted during the nine months ended September 30, 2020 and 2019. For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower becomes 90 days past due.

Collateral Dependent Loans

Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring where repayment is expected to be provided substantially through the operation or sale of the collateral to be collateral dependent loans. The following table presents the amortized cost basis of collateral dependent loans by collateral type as of September 30, 2020 (in thousands):

	Collateral type
	Business assets		Real property		Total
September 30, 2020
Commercial business	$	4,287	$	77	$	4,364
Commercial mortgage		—		14,465		14,465
Total	$	4,287	$	14,542	$	18,829

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)	LOANS (Continued)

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans that do not meet the criteria above that are analyzed individually as part of the process described above are considered “uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):

	Term Loans Amortized Cost Basis by Origination Year
	2020		2019		2018		2017		2016		Prior		Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
September 30, 2020
Commercial Business
Uncriticized	$	356,882	$	111,373	$	90,038	$	32,169	$	12,489	$	19,063	$	183,654	$	—	$	805,668
Special mention		709		108		3		802		40		3		2,088		—		3,753
Substandard		223		486		1,321		757		239		929		4,759		—		8,714
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	357,814	$	111,967	$	91,362	$	33,728	$	12,768	$	19,995	$	190,501	$	—	$	818,135
Commercial Mortgage
Uncriticized	$	213,341	$	278,617	$	186,224	$	189,627	$	96,571	$	199,397	$	430	$	—	$	1,164,207
Special mention		—		2,091		17,133		454		329		1,449		—		—		21,456
Substandard		189		2,448		1,910		1,615		3		10,019		199		—		16,383
Doubtful		—		—		—		—		—		—		—		—		—
Total	$	213,530	$	283,156	$	205,267	$	191,696	$	96,903	$	210,865	$	629	$	—	$	1,202,046

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)	LOANS (Continued)

The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by performance status, as of the dates indicated (in thousands):

	Term Loans Amortized Cost Basis by Origination Year
	2020		2019		2018		2017		2016		Prior			Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
September 30, 2020
Residential Real Estate Loans
Performing	$	106,889	$	100,498	$	93,116	$	73,143	$	71,269	$	148,682		$	—	$	—	$	593,597
Nonperforming		—		200		1,209		790		312		794			—		—		3,305
Total	$	106,889	$	100,698	$	94,325	$	73,933	$	71,581	$	149,476		$	—	$	—	$	596,902
Residential Real Estate Lines
Performing	$	—	$	—	$	—	$	—	$	—	$	—		$	83,746	$	10,064	$	93,810
Nonperforming		—		—		—		—		—		—			46		161		207
Total	$	—	$	—	$	—	$	—	$	—	$	—		$	83,792	$	10,225	$	94,017
Consumer Indirect
Performing	$	223,417	$	220,615	$	186,913	$	128,567	$	57,873	$	21,950		$	—	$	—	$	839,335
Nonperforming		97		241		475		273		165		(7	)		—		—		1,244
Total	$	223,514	$	220,856	$	187,388	$	128,840	$	58,038	$	21,943		$	—	$	—	$	840,579
Other Consumer
Performing	$	5,950	$	3,684	$	2,073	$	1,083	$	466	$	688		$	2,910	$	—	$	16,854
Nonperforming		—		—		—		5		—		—			1		—		6
Total	$	5,950	$	3,684	$	2,073	$	1,088	$	466	$	688		$	2,911	$	—	$	16,860

Allowance for Credit Losses - Loans

The following table sets forth the changes in the allowance for credit losses - loans for the three- and nine-month periods ended September 30, 2020 (in thousands):

	Commercial Business			Commercial Mortgage			Residential Real Estate Loans			Residential Real Estate Lines			Consumer Indirect			Other Consumer			Total
Three months ended September 30, 2020
Beginning balance	$	12,399		$	15,666		$	5,769		$	939		$	11,222		$	321		$	46,316
Charge-offs		(15	)		(640	)		—			—			(1,388	)		(160	)		(2,203	)
Recoveries		103			37			7			—			1,503			65			1,715
Provision (credit)		507			1,417			(1,224	)		(121	)		2,833			155			3,567
Ending balance	$	12,994		$	16,480		$	4,552		$	818		$	14,170		$	381		$	49,395
Nine months ended September 30, 2020
Beginning balance, prior to adoption of ASC 326	$	11,358		$	5,681		$	1,059		$	118		$	11,852		$	414		$	30,482
Impact of adopting ASC 326		(246	)		7,310			3,290			607			(1,234	)		(133	)		9,594
Beginning balance, after adoption of ASC 326		11,112			12,991			4,349			725			10,618			281			40,076
Charge-offs		(8,281	)		(1,712	)		(100	)		—			(7,366	)		(499	)		(17,958	)
Recoveries		1,644			37			25			3			4,550			282			6,541
Provision		8,519			5,164			278			90			6,368			317			20,736
Ending balance	$	12,994		$	16,480		$	4,552		$	818		$	14,170		$	381		$	49,395

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)	LOANS (Continued)

The following table sets forth the changes in the allowance for credit losses - loans for the three- and nine-month periods ended September 30, 2019 (in thousands):

	Commercial Business			Commercial Mortgage			Residential Real Estate Loans			Residential Real Estate Lines			Consumer Indirect			Other Consumer			Total
Three months ended September 30, 2019
Beginning balance	$	11,717		$	8,790		$	1,217		$	145		$	12,157		$	408		$	34,434
Charge-offs		(112	)		(2,994	)		(54	)		(8	)		(2,420	)		(315	)		(5,903	)
Recoveries		102			—			14			1			1,103			73			1,293
Provision		448			126			6			8			1,002			254			1,844
Ending balance	$	12,155		$	5,922		$	1,183		$	146		$	11,842		$	420		$	31,668
Nine months ended September 30, 2019
Beginning balance	$	14,312		$	5,219		$	1,112		$	210		$	12,572		$	489		$	33,914
Charge-offs		(380	)		(2,997	)		(172	)		(10	)		(8,102	)		(867	)		(12,528	)
Recoveries		333			17			31			6			4,205			299			4,891
Provision (credit)		(2,110	)		3,683			212			(60	)		3,167			499			5,391
Ending balance	$	12,155		$	5,922		$	1,183		$	146		$	11,842		$	420		$	31,668

Loans and the related allowance for credit losses - loans are presented below as of the dates indicated (in thousands):

	Commercial Business		Commercial Mortgage		Residential Real Estate Loans		Residential Real Estate Lines		Consumer Indirect		Other Consumer		Total
September 30, 2019
Loans:
Ending balance	$	573,610	$	1,037,304	$	547,839	$	104,545	$	834,968	$	16,467	$	3,114,733
Evaluated for impairment:
Individually	$	3,010	$	3,290	$	—	$	—	$	—	$	—	$	6,300
Collectively	$	570,600	$	1,034,014	$	547,839	$	104,545	$	834,968	$	16,467	$	3,108,433
Allowance for loan losses:
Ending balance	$	12,155	$	5,922	$	1,183	$	146	$	11,842	$	420	$	31,668
Evaluated for impairment:
Individually	$	1,563	$	1	$	—	$	—	$	—	$	—	$	1,564
Collectively	$	10,592	$	5,921	$	1,183	$	146	$	11,842	$	420	$	30,104

Risk Characteristics

Commercial business loans primarily consist of loans to small to mid-sized businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions, including the impact of the COVID-19 pandemic on small to mid-sized business in our market area, and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, potentially resulting in higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events, including the impact of the COVID-19 pandemic on the ability of the tenants to pay rent at these properties, or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.)	LOANS (Continued)

Residential real estate loans (comprised of conventional mortgages and home equity loans) and residential real estate lines (comprised of home equity lines) are generally made based on the borrower’s ability to make repayment from his or her employment and other income but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, including the impact of the COVID-19 pandemic on the employment income of these borrowers, the characteristics of individual borrowers, and the nature of the loan collateral.

Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy, including the heightened risk that such circumstances may arise as a result of the COVID-19 pandemic. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

(6.)

LEASES

ASC 842, Leases (“ASC 842”), establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. The Company is obligated under a number of non-cancellable operating lease agreements for land, buildings and equipment with terms, including renewal options reasonably certain to be exercised, extending through 2047. One building lease is subleased for terms extending through 2021.

The following table represents the consolidated statements of financial condition classification of the Company’s right of use assets and lease liabilities:

		September 30,			December 31,
	Balance Sheet Location	2020			2019
Operating Lease Right of Use Assets:
Gross carrying amount	Other assets	$	23,690		$	23,224
Accumulated amortization	Other assets		(3,266	)		(1,861	)
Net book value		$	20,424		$	21,363

Operating Lease Liabilities:
Right of use lease obligations	Other liabilities	$	21,947		$	22,800

The weighted average remaining lease term for operating leases was 21.5 years at September 30, 2020 and the weighted-average discount rate used in the measurement of operating lease liabilities was 3.80%. The Company utilizes its incremental borrowing rate at lease inception, on a collateralized basis, over a similar term for the discount rate.

The following table represents lease costs and other lease information:

	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Lease costs:
Operating lease costs	$	663		$	706		$	2,018		$	2,096
Variable lease costs ⁽¹⁾		111			112			313			321
Sublease income		(12	)		(12	)		(35	)		(35	)
Net lease costs	$	762		$	806		$	2,296		$	2,382

Other information:
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases							$	1,947		$	1,332
Initial recognition of operating lease right of use assets							$	—		$	23,275
Initial recognition of operating lease liabilities							$	—		$	23,985
Right of use assets obtained in exchange for new operating lease liabilities							$	470		$	346

⁽¹⁾	Variable lease costs primarily represent variable payments such as common area maintenance, insurance, taxes and utilities.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.)	LEASES (Continued)

Future minimum payments under non-cancellable operating leases with initial or remaining terms of one year or more, are as follows at September 30, 2020 (in thousands):

Twelve months ended September 30,
2021	$	2,570
2022		2,039
2023		1,731
2024		1,332
2025		1,208
Thereafter		25,085
Total future minimum operating lease payments		33,965
Amounts representing interest		(12,018	)
Present value of net future minimum operating lease payments	$	21,947

(7.)	GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill

The carrying amount of goodwill totaled $66.1 million as of both September 30, 2020 and December 31, 2019. The Company performs a goodwill impairment test on an annual basis as of October 1st or more frequently if events and circumstances warrant.

	Banking		Non-Banking		Total
Balance, December 31, 2019	$	48,536	$	17,526	$	66,062
No activity during the period		—		—		—
Balance, September 30, 2020	$	48,536	$	17,526	$	66,062

Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, and more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Based on the volatility in the capital markets in 2020 and overall economic conditions as a result of the COVID-19 pandemic accompanied by a decline in the Company’s stock price, a quantitative assessment was performed for the Banking segment in the third quarter of 2020. Based on this quantitative assessment, the Company concluded that goodwill was not impaired for the Banking segment. Based on its qualitative assessment for each of the SDN, Courier Capital and HNP Capital reporting units, the Company concluded that it was more likely than not that goodwill was not impaired as of September 30, 2020. Therefore, no quantitative assessment was deemed necessary as of September 30, 2020.

Other Intangible Assets

The Company has other intangible assets that are amortized, consisting of core deposit intangibles and other intangibles (primarily related to customer relationships). Gross carrying amount, accumulated amortization and net book value, were as follows (in thousands):

	September 30,			December 31,
	2020			2019
Other intangibles assets:
Gross carrying amount	$	15,925		$	15,925
Accumulated amortization		(7,925	)		(7,064	)
Net book value	$	8,000		$	8,861

Amortization expense for total other intangible assets was $280 thousand and $861 thousand for the three and nine months ended September 30, 2020, respectively, and $309 thousand and $948 thousand for the three and nine months ended September 30, 2019, respectively. As of September 30, 2020, the estimated amortization expense of other intangible assets for the remainder of 2020 and each of the next five years is as follows (in thousands):

2020 (remainder of year)	$	273
2021		1,014
2022		923
2023		852
2024		783
2025		714

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(8.)	DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities, and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate caps and interest rate swaps as part of its interest rate risk management strategy. Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium. During the first nine months of 2020 and in 2019, such derivatives were used to hedge the variable cash flows associated with short-term borrowings. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over a period of approximately 60 months. As of September 30, 2020, the Company had one outstanding forward starting interest rate derivative with a notional value of $50.0 million that was designated as a cash flow hedge of interest rate risk. The derivative becomes effective in April 2022.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in accumulated other comprehensive income (loss) and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income (loss) related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s borrowings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company’s cash flow hedge derivatives did not have any hedge ineffectiveness recognized in earnings during the nine months ended September 30, 2020 and 2019. During the next twelve months, the Company estimates that $283 thousand will be reclassified as an increase to interest expense.

Interest Rate Swaps

The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. These interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.

Credit-risk-related Contingent Features

The Company has agreements with certain of its derivative counterparties that contain one or more of the following provisions: (a) if the Company defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, the Company could also be declared in default on its derivative obligations, and (b) if the Company fails to maintain its status as a well-capitalized institution, the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.

Mortgage Banking Derivatives

The Company extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements when the Company intends to sell the related loan, once originated, as well as closed residential mortgage loans held for sale, the Company enters into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(8.)	DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES (Continued)

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the notional amounts, respective fair values of the Company’s derivative financial instruments, as well as their classification on the balance sheet as of September 30, 2020 and December 31, 2019 (in thousands):

					Asset derivatives					Liability derivatives
	Gross notional amount				Balance	Fair value				Balance	Fair value
	Sept. 30, 2020		Dec. 31, 2019		sheet line item	Sept. 30, 2020		Dec. 31, 2019		sheet line item	Sept. 30, 2020		Dec. 31, 2019
Derivatives designated as hedging instruments
Cash flow hedges	$	50,000	$	100,000	Other assets	$	—	$	—	Other liabilities	$	647	$	—
Total derivatives	$	50,000	$	100,000		$	—	$	—		$	647	$	—
Derivatives not designated as hedging instruments
Cash flow hedges	$	100,000	$	—	Other assets	$	—	$	—	Other liabilities	$	—	$	—
Interest rate swaps ⁽¹⁾		575,707		272,962	Other assets		23,079		6,419	Other liabilities		23,498		6,720
Credit contracts		87,393		68,324	Other assets		29		13	Other liabilities		47		18
Mortgage banking		40,752		11,859	Other assets		891		119	Other liabilities		13		7
Total derivatives	$	803,852	$	353,145		$	23,999	$	6,551		$	23,558	$	6,745

⁽¹⁾	The Company secured its obligations under these contracts with $24.6 million and $6.7 million in cash at September 30, 2020 and December 31, 2019, respectively.

Effect of Derivative Instruments on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three and nine months ended September 30, 2020 and 2019 (in thousands):

		Gain (loss) recognized in income					Gain (loss) recognized in income
	Line item of gain (loss)	Three months ended September 30,					Nine months ended September 30,
Undesignated derivatives	recognized in income	2020		2019			2020		2019
Cash flow hedges	Income from derivative instruments, net	$	—	$	—		$	—	$	—
Interest rate swaps	Income from derivative instruments, net		1,310		854			3,715		838
Credit contracts	Income from derivative instruments, net		13		48			136		54
Mortgage banking	Income from derivative instruments, net		608		(12	)		766		121
Total undesignated		$	1,931	$	890		$	4,617	$	1,013

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(9.)	SHAREHOLDERS’ EQUITY

Common Stock

The changes in shares of common stock were as follows for the three and nine months ended September 30, 2020 and 2019:

	Outstanding			Treasury			Issued
2020
Shares at December 31, 2019		16,002,899			96,657			16,099,556
Restricted stock units released		22,921			(22,921	)		—
Treasury stock purchases		(6,436	)		6,436			—
Shares at March 31, 2020		16,019,384			80,172			16,099,556
Restricted stock awards issued		12,798			(12,798	)		—
Stock awards		5,403			(5,403	)		—
Shares at June 30, 2020		16,037,585			61,971			16,099,556
No activity during the period		—			—			—
Shares at September 30, 2020		16,037,585			61,971			16,099,556
2019
Shares at December 31, 2018		15,928,598			127,580			16,056,178
Restricted stock units released		18,580			(18,580	)		—
Treasury stock purchases		(6,368	)		6,368			—
Shares at March 31, 2019		15,940,810			115,368			16,056,178
Common stock issued for Courier Capital contingent earn-out		43,378			—			43,378
Restricted stock awards issued		8,226			(8,226	)		—
Stock awards		2,283			(2,283	)		—
Shares at June 30, 2019		15,994,697			104,859			16,099,556
Restricted stock units released		2,500			(2,500	)		—
Treasury stock purchases		(839	)		839			—
Shares at September 30, 2019		15,996,358			103,198			16,099,556

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.)

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following tables present the components of other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019 (in thousands):

	Pre-tax Amount			Tax Effect			Net-of-tax Amount
Three months ended September 30, 2020
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	374		$	96		$	278
Reclassification adjustment for net gains included in net income ⁽¹⁾		(467	)		(120	)		(347	)
Total securities available for sale and transferred securities		(93	)		(24	)		(69	)
Hedging derivative instruments:
Change in unrealized gain/loss during the period		165			42			123
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(8	)		(2	)		(6	)
Amortization of net actuarial loss included in income		321			82			239
Total pension and post-retirement obligations		313			80			233
Other comprehensive income	$	385		$	98		$	287
Nine months ended September 30, 2020
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	19,737		$	5,057		$	14,680
Reclassification adjustment for net gains included in net income ⁽¹⁾		(1,213	)		(311	)		(902	)
Total securities available for sale and transferred securities		18,524			4,746			13,778
Hedging derivative instruments:
Change in unrealized gain/loss during the period		(234	)		(60	)		(174	)
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(26	)		(7	)		(19	)
Amortization of net actuarial loss included in income		967			248			719
Total pension and post-retirement obligations		941			241			700
Other comprehensive loss	$	19,231		$	4,927		$	14,304

⁽¹⁾

Includes amounts related to the amortization/accretion of unrealized net gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. The unrealized net gains/losses will be amortized/accreted over the remaining life of the investment securities as an adjustment of yield.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.)

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

	Pre-tax Amount			Tax Effect			Net-of-tax Amount
Three months ended September 30, 2019
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	2,992		$	755		$	2,237
Reclassification adjustment for net gains included in net income ⁽¹⁾		(1,492	)		(376	)		(1,116	)
Total securities available for sale and transferred securities		1,500			379			1,121
Hedging derivative instruments:
Change in unrealized gain/loss during the period		57			14			43
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(16	)		(4	)		(12	)
Amortization of net actuarial loss included in income		366			92			274
Total pension and post-retirement obligations		350			88			262
Other comprehensive income	$	1,907		$	481		$	1,426
Nine months ended September 30, 2019
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	17,222		$	4,342		$	12,880
Reclassification adjustment for net gains included in net income ⁽¹⁾		(1,360	)		(343	)		(1,017	)
Total securities available for sale and transferred securities		15,862			3,999			11,863
Hedging derivative instruments:
Change in unrealized gain/loss during the period		(424	)		(107	)		(317	)
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(49	)		(12	)		(37	)
Amortization of net actuarial loss included in income		1,098			277			821
Total pension and post-retirement obligations		1,049			265			784
Other comprehensive income	$	16,487		$	4,157		$	12,330

⁽¹⁾

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Notes to Consolidated Financial Statements (Unaudited)

(10.)

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

Activity in accumulated other comprehensive income (loss), net of tax, for the three and nine months ended September 30, 2020 and 2019 was as follows (in thousands):

	Hedging Derivative Instruments			Securities Available for Sale and Transferred Securities			Pension and Post- retirement Obligations			Accumulated Other Comprehensive Income (Loss)
Three months ended September 30, 2020
Balance at beginning of period	$	(815	)	$	14,720		$	(14,401	)	$	(496	)
Other comprehensive income before reclassifications		123			278			—			401
Amounts reclassified from accumulated other comprehensive (loss) income		—			(347	)		233			(114	)
Net current period other comprehensive income (loss)		123			(69	)		233			287
Balance at end of period	$	(692	)	$	14,651		$	(14,168	)	$	(209	)
Nine months ended September 30, 2020
Balance at beginning of period	$	(518	)	$	873		$	(14,868	)	$	(14,513	)
Other comprehensive (loss) income before reclassifications		(174	)		14,680			—			14,506
Amounts reclassified from accumulated other comprehensive (loss) income		—			(902	)		700			(202	)
Net current period other comprehensive income (loss)		(174	)		13,778			700			14,304
Balance at end of period	$	(692	)	$	14,651		$	(14,168	)	$	(209	)

Three months ended September 30, 2019
Balance at beginning of period	$	(636	)	$	2,292		$	(14,816	)	$	(13,160	)
Other comprehensive income before reclassifications		43			2,237			—			2,280
Amounts reclassified from accumulated other comprehensive (loss) income		—			(1,116	)		262			(854	)
Net current period other comprehensive income		43			1,121			262			1,426
Balance at end of period	$	(593	)	$	3,413		$	(14,554	)	$	(11,734	)
Nine months ended September 30, 2019
Balance at beginning of period	$	(276	)	$	(7,769	)	$	(13,236	)		(21,281	)
Reclassification of income tax effects to retained earnings		—			(681	)		(2,102	)		(2,783	)
Other comprehensive (loss) income before reclassifications		(317	)		12,880			—			12,563
Amounts reclassified from accumulated other comprehensive income (loss)		—			(1,017	)		784			(233	)
Net current period other comprehensive (loss) income		(317	)		11,863			784			12,330
Balance at end of period	$	(593	)	$	3,413		$	(14,554	)	$	(11,734	)

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.)

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019 (in thousands):

Details About Accumulated Other Comprehensive Income (Loss) Components	Amount Reclassified from Accumulated Other Comprehensive Income (Loss)						Affected Line Item in the Consolidated Statement of Income
	Three months ended
	September 30,
	2020			2019
Realized gain on sale of investment securities	$	554		$	1,608		Net gain on investment securities
Amortization of unrealized holding losses on investment securities transferred from available for sale to held to maturity		(87	)		(116	)	Interest income
		467			1,492		Total before tax
		(120	)		(376	)	Income tax expense
		347			1,116		Net of tax
Amortization of pension and post-retirement items:
Prior service credit ⁽¹⁾		8			16		Salaries and employee benefits
Net actuarial losses ⁽¹⁾		(321	)		(366	)	Salaries and employee benefits
		(313	)		(350	)	Total before tax
		80			88		Income tax benefit
		(233	)		(262	)	Net of tax
Total reclassified for the period	$	114		$	854

	Nine months ended
	September 30,
	2020			2019
Realized gain on sale of investment securities	$	1,449		$	1,721		Net gain on investment securities
Amortization of unrealized holding losses on investment securities transferred from available for sale to held to maturity		(236	)		(361	)	Interest income
		1,213			1,360		Total before tax
		(311	)		(343	)	Income tax (expense) benefit
		902			1,017		Net of tax
Amortization of pension and post-retirement items:
Prior service credit ⁽¹⁾		26			49		Salaries and employee benefits
Net actuarial losses ⁽¹⁾		(967	)		(1,098	)	Salaries and employee benefits
		(941	)		(1,049	)	Total before tax
		241			265		Income tax benefit
		(700	)		(784	)	Net of tax
Total reclassified for the period	$	202		$	233

⁽¹⁾	These items are included in the computation of net periodic pension expense. See Note 12 – Employee Benefit Plans for additional information.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(11.)

SHARE-BASED COMPENSATION PLANS

The Company maintains certain share-based compensation plans, approved by the Company’s shareholders, that are administered by the Management Development and Compensation Committee (the “MD&C Committee”) of the Board. The share-based compensation plans were established to allow for the grant of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the long-term growth and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.

The MD&C Committee approved the grant of restricted stock units (“RSUs”) and performance share units (“PSUs”) shown in the table below to certain members of management during the nine months ended September 30, 2020.

Number of

Underlying

Weighted

Average

Per Share

Grant Date

Fair Value

RSUs

57,306

25.67

PSUs

23,302

25.63

The grant-date fair value for the RSUs granted during the nine months ended September 30, 2020 is equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.

Fifty percent of the PSUs that ultimately vest is contingent on achieving specified return on average equity (“ROAE”) targets relative to the SNL Small Cap Bank & Thrift Index, a market index the MD&C Committee has selected as a peer group for this purpose. These shares will be earned based on the Company’s achievement of a relative ROAE performance requirement, on a percentile basis, compared to the SNL Small Cap Bank & Thrift Index over a three-year performance period ended December 31, 2022. The shares earned based on the achievement of the ROAE performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company. The remaining fifty percent of the PSUs that ultimately vest is contingent upon achievement of an average return on average assets (“ROAA”) performance requirement over a three-year performance period ended December 31, 2022. The shares earned based on the achievement of the ROAA performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company.

The grant-date fair values for both the ROAE and the ROAA portions of PSUs granted during the nine months ended September 30, 2020 are equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.

During the nine months ended September 30, 2020, the Company issued a total of 5,403 shares of common stock in-lieu of cash for the annual retainer of four non-employee directors and granted a total of 12,798 restricted shares of common stock to non-employee directors, of which 6,399 shares vested immediately and 6,399 shares will vest after completion of a one-year service requirement. The market value of the stock and restricted stock at the close of the Nasdaq Global Select Market on the date of grant was $17.57.

The following is a summary of restricted stock awards and restricted stock units activity for the nine months ended September 30, 2020:

	Number of Shares			Weighted Average Market Price at Grant Date
Outstanding at beginning of year		151,808		$	27.80
Granted		93,406			24.55
Vested		(33,433	)		28.88
Forfeited		(39,406	)		27.99
Outstanding at end of period		172,375		$	25.78

At September 30, 2020, there was $2.5 million of unrecognized compensation expense related to unvested restricted stock awards and restricted stock units that is expected to be recognized over a weighted average period of 1.96 years.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(11.)

SHARE-BASED COMPENSATION PLANS (Continued)

The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. There were no stock options awarded during the first nine months of 2020 or 2019. There was no unrecognized compensation expense related to unvested stock options as of September 30, 2020. There was no stock option activity for the nine months ended September 30, 2020.

The Company amortizes the expense related to share-based compensation awards over the vesting period. Share-based compensation expense is recorded as a component of salaries and employee benefits in the consolidated statements of income for awards granted to management and as a component of other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income, is as follows (in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Salaries and employee benefits	$	261	$	364	$	793	$	825
Other noninterest expense		28		29		197		203
Total share-based compensation expense	$	289	$	393	$	990	$	1,028

(12.)

EMPLOYEE BENEFIT PLANS

The components of the Company’s net periodic benefit expense for its pension and post-retirement obligations were as follows (in thousands):

	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Service cost	$	924		$	801		$	2,770		$	2,405
Interest cost on projected benefit obligation		635			696			1,905			2,086
Expected return on plan assets		(1,284	)		(1,184	)		(3,852	)		(3,552	)
Amortization of unrecognized prior service credit		(8	)		(16	)		(26	)		(49	)
Amortization of unrecognized net actuarial loss		321			366			967			1,098
Net periodic benefit expense	$	588		$	663		$	1,764		$	1,988

The net periodic benefit expense is recorded as a component of salaries and employee benefits in the consolidated statements of income. The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of the Internal Revenue Code. The Company has no minimum required contribution for the 2020 fiscal year.

(13.)

COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.

Off-balance sheet commitments consist of the following (in thousands):

September 30,

2020

December 31,

2019

Commitments to extend credit

973,129

820,282

Standby letters of credit

22,652

21,911

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(13.)

COMMITMENTS AND CONTINGENCIES (Continued)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses which may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.

Unfunded Commitments

At September 30, 2020 and December 31, 2019, the allowance for credit losses for unfunded commitments totaled $3.1 million and $0, respectively, and was included in other liabilities on the Company's consolidated statements of financial condition. For the three months ended September 30, 2020 and 2019, credit loss expense for unfunded commitments was $461 thousand and $0, respectively. For the nine months ended September 30, 2020 and 2019, credit loss expense for unfunded commitments was $959 thousand and $0, respectively.

Contingent Liabilities and Litigation

In the ordinary course of business, there are various threatened and pending legal proceedings against the Company. Management believes that the aggregate liability, if any, arising from such litigation, except for the matter described below, would not have a material adverse effect on the Company’s consolidated financial statements.

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the SEC on March 4, 2020 and as disclosed in Part II, Item 1 of this Quarterly Report on Form 10-Q, we are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania. The plaintiffs seek to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania and are seeking statutory damages, interest and declaratory relief. The Company is pursuing insurance coverage for these claims, including reimbursement for defense costs. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves. If we are unsuccessful in defending ourselves from these claims or if we elect to settle these claims and if our insurer does not insure us against legal costs we incur in excess of our deductible, the result may materially adversely affect our business, results of operations and financial condition.

(14.)

FAIR VALUE MEASUREMENTS

Determination of Fair Value – Assets Measured at Fair Value on a Recurring and Nonrecurring Basis

Valuation Hierarchy

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. There have been no changes in the valuation techniques used during the current period. The fair value hierarchy is as follows:

•

Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

•

Level 2 - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

•

Level 3 - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Transfers between levels of the fair value hierarchy are recorded as of the end of the reporting period.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(14.)

FAIR VALUE MEASUREMENTS (Continued)

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Securities available for sale: Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Derivative instruments: The fair value of derivative instruments is determined using quoted secondary market prices for similar financial instruments and are classified as Level 2 in the fair value hierarchy.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.

Collateral dependent loans: Fair value of collateral dependent loans with specific allocations of the allowance for credit losses – loans is measured based on the value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. Collateral dependent loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Loan servicing rights: Loan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of loan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. The significant unobservable inputs used in the fair value measurement of the Company’s loan servicing rights are the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

Other real estate owned (foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Commitments to extend credit and letters of credit: Commitments to extend credit and fund letters of credit are principally at current interest rates, and, therefore, the carrying amount approximates fair value. The fair value of commitments is not material.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(14.)

FAIR VALUE MEASUREMENTS (Continued)

Assets Measured at Fair Value

The following tables present for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of the dates indicated (in thousands).

	Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
September 30, 2020
Measured on a recurring basis:
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	—	$	6,655		$	—	$	6,655
Mortgage-backed securities		—		509,316			—		509,316
Other liabilities:
Hedging derivative instruments		—		(647	)		—		(647	)
Fair value adjusted through comprehensive income	$	—	$	515,324		$	—	$	515,324
Other assets:
Derivative instruments - cash flow hedges	$	—	$	—		$	—	$	—
Derivative instruments - interest rate swaps		—		23,079			—		23,079
Derivative instruments - credit contracts		—		29			—		29
Derivative instruments - mortgage banking		—		891			—		891
Other liabilities:
Derivative instruments - interest rate swaps		—		(23,498	)		—		(23,498	)
Derivative instruments - credit contracts		—		(47	)		—		(47	)
Derivative instruments - mortgage banking		—		(13	)		—		(13	)
Fair value adjusted through net income	$	—	$	441		$	—	$	441
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	7,076		$	—	$	7,076
Collateral dependent loans		—		—			17,913		17,913
Other assets:
Loan servicing rights		—		—			1,175		1,175
Other real estate owned		—		—			2,999		2,999
Total	$	—	$	7,076		$	22,087	$	29,163

There were no transfers between Levels 1 and 2 during the nine months ended September 30, 2020. There were no liabilities measured at fair value on a nonrecurring basis during the nine months ended September 30, 2020.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(14.)

FAIR VALUE MEASUREMENTS (Continued)

	Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
December 31, 2019
Measured on a recurring basis:
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	—	$	26,877		$	—	$	26,877
Mortgage-backed securities		—		391,040			—		391,040
Other assets:
Hedging derivative instruments		—		—			—		—
Fair value adjusted through comprehensive income	$	—	$	417,917		$	—	$	417,917
Other assets:
Derivative instruments - interest rate swaps	$	—	$	6,419		$	—	$	6,419
Derivative instruments - credit contracts		—		13			—		13
Derivative instruments - mortgage banking		—		119			—		119
Other liabilities:
Derivative instruments - interest rate swaps		—		(6,720	)		—		(6,720	)
Derivative instruments - credit contracts		—		(18	)		—		(18	)
Derivative instruments - mortgage banking		—		(7	)		—		(7	)
Fair value adjusted through net income	$	—	$	(194	)	$	—	$	(194	)
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	4,224		$	—	$	4,224
Collateral dependent impaired loans		—		—			3,630		3,630
Other assets:
Loan servicing rights		—		—			1,129		1,129
Other real estate owned		—		—			468		468
Total	$	—	$	4,224		$	5,227	$	9,451

There were no transfers between Levels 1 and 2 during the nine months ended September 30, 2019. There were no liabilities measured at fair value on a nonrecurring basis during the nine months ended September 30, 2019.

The following table presents additional quantitative information about assets measured at fair value on a recurring and nonrecurring basis for which the Company has utilized Level 3 inputs to determine fair value as of September 30, 2020 (dollars in thousands).

Asset	Fair Value		Valuation Technique	Unobservable Input	Unobservable Input Value or Range
Collateral dependent loans	$	17,913	Appraisal of collateral ⁽¹⁾	Appraisal adjustments ⁽²⁾	10.0% ⁽³⁾
Loan servicing rights		1,175	Discounted cash flow	Discount rate	10.2% ⁽³⁾
				Constant prepayment rate	18.4% ⁽³⁾
Other real estate owned		2,999	Appraisal of collateral ⁽¹⁾	Appraisal adjustments ⁽²⁾	23.3% ⁽³⁾

⁽¹⁾	Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.

⁽²⁾	Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.

⁽³⁾	Weighted averages.

Changes in Level 3 Fair Value Measurements

There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of or during the nine months ended September 30, 2020 and 2019.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(14.)

FAIR VALUE MEASUREMENTS (Continued)

Disclosures about Fair Value of Financial Instruments

The assumptions used below are expected to approximate those that market participants would use in valuing these financial instruments.

Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument. Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.

The estimated fair value approximates carrying value for cash and cash equivalents, Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock, accrued interest receivable, non-maturity deposits, short-term borrowings and accrued interest payable.

The following presents (in thousands) the carrying amount, estimated fair value, and placement in the fair value measurement hierarchy of the Company’s financial instruments as of the dates indicated.

	Level in	September 30, 2020				December 31, 2019
	Fair Value			Estimated				Estimated
	Measurement	Carrying		Fair		Carrying		Fair
	Hierarchy	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	Level 1	$	282,070	$	282,070	$	112,947	$	112,947
Securities available for sale	Level 2		515,971		515,971		417,917		417,917
Securities held to maturity, net	Level 2		290,946		301,878		359,000		363,259
Loans held for sale	Level 2		7,076		7,076		4,224		4,224
Loans	Level 2		3,501,231		3,536,646		3,186,875		3,201,814
Loans ⁽¹⁾	Level 3		17,913		17,913		3,630		3,630
Accrued interest receivable	Level 1		16,230		16,230		11,308		11,308
FHLB and FRB stock	Level 2		8,619		8,619		20,637		20,637
Derivative instruments – cash flow hedges	Level 2		—		—		—		—
Derivative instruments – interest rate products	Level 2		23,079		23,079		6,419		6,419
Derivative instruments – credit contracts	Level 2		29		29		13		13
Derivative instruments – mortgage banking	Level 2		891		891		119		119
Financial liabilities:
Non-maturity deposits	Level 1		3,523,698		3,523,698		2,375,486		2,375,486
Time deposits	Level 2		841,230		843,191		1,180,189		1,179,991
Short-term borrowings	Level 1		5,300		5,300		275,500		275,500
Long-term borrowings	Level 2		39,258		45,224		39,273		41,083
Accrued interest payable	Level 1		5,737		5,737		10,942		10,942
Derivative instruments – cash flow hedges	Level 2		647		647		—		—
Derivative instruments – interest rate products	Level 2		23,498		23,498		6,720		6,720
Derivative instruments – credit contracts	Level 2		47		47		18		18
Derivative instruments – mortgage banking	Level 2		13		13		7		7

⁽¹⁾	Comprised of collateral dependent loans.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(15.)

SEGMENT REPORTING

The Company has two reportable segments: Banking and Non-Banking. These reportable segments have been identified and organized based on the nature of the underlying products and services applicable to each segment, the type of customers to whom those products and services are offered and the distribution channel through which those products and services are made available.

The Banking segment includes all of the Company’s retail and commercial banking operations. The Non-Banking segment includes the activities of SDN, a full-service insurance agency that provides a broad range of insurance services to both personal and business clients, and Courier Capital and HNP Capital, our investment advisor and wealth management firms that provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans. Holding company amounts are the primary differences between segment amounts and consolidated totals and are reflected in the Holding Company and Other column below, along with amounts to eliminate balances and transactions between segments.

The following tables present information regarding our business segments as of and for the periods indicated (in thousands).

	Banking		Non- Banking		Holding Company and Other			Consolidated Totals
September 30, 2020
Goodwill	$	48,536	$	17,526	$	—		$	66,062
Other intangible assets, net		41		7,959		—			8,000
Total assets		4,922,251		37,420		(470	)		4,959,201
December 31, 2019
Goodwill	$	48,536	$	17,526	$	—		$	66,062
Other intangible assets, net		98		8,763		—			8,861
Total assets		4,346,615		36,733		830			4,384,178

	Banking			Non- Banking			Holding Company and Other			Consolidated Totals
Three months ended September 30, 2020
Net interest income (expense)	$	36,117		$	—		$	(618	)	$	35,499
Provision for credit losses		(4,028	)		—			—			(4,028	)
Noninterest income		9,101			3,489			(189	)		12,401
Noninterest expense		(24,504	)		(3,571	)		(584	)		(28,659	)
Income (loss) before income taxes		16,686			(82	)		(1,391	)		15,213
Income tax (expense) benefit		(3,598	)		18			640			(2,940	)
Net income (loss)	$	13,088		$	(64	)	$	(751	)	$	12,273
Nine months ended September 30, 2020
Net interest income (expense)	$	104,657		$	—		$	(1,853	)	$	102,804
Provision for credit losses		(21,689	)		—			—			(21,689	)
Noninterest income		23,169			9,543			(517	)		32,195
Noninterest expense		(72,008	)		(9,349	)		(1,718	)		(83,075	)
Income (loss) before income taxes		34,129			194			(4,088	)		30,235
Income tax (expense) benefit		(6,317	)		(56	)		670			(5,703	)
Net income (loss)	$	27,812		$	138		$	(3,418	)	$	24,532

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(15.)

SEGMENT REPORTING (Continued)

	Banking			Non- Banking			Holding Company and Other			Consolidated Totals
Three months ended September 30, 2019
Net interest income (expense)	$	33,101		$	—		$	(618	)	$	32,483
Provision for loan losses		(1,844	)		—			—			(1,844	)
Noninterest income		9,398			3,149			(186	)		12,361
Noninterest expense		(22,153	)		(3,225	)		(508	)		(25,886	)
Income (loss) before income taxes		18,502			(76	)		(1,312	)		17,114
Income tax (expense) benefit		(4,034	)		16			(263	)		(4,281	)
Net income (loss)	$	14,468		$	(60	)	$	(1,575	)	$	12,833
Nine months ended September 30, 2019
Net interest income (expense)	$	98,592		$	—		$	(1,853	)	$	96,739
Provision for loan losses		(5,391	)		—			—			(5,391	)
Noninterest income		22,452			8,809			(547	)		30,714
Noninterest expense		(65,256	)		(9,097	)		(1,707	)		(76,060	)
Income (loss) before income taxes		50,397			(288	)		(4,107	)		46,002
Income tax (expense) benefit		(10,693	)		59			387			(10,247	)
Net income (loss)	$	39,704		$	(229	)	$	(3,720	)	$	35,755

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2019. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.

FORWARD LOOKING INFORMATION

Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

•

statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the “Parent”) and its subsidiaries (collectively, the “Company,” “we,” “our” or “us”); and

•

statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2019 (the “Form 10-K”), including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to:

•

The ongoing novel coronavirus (“COVID-19”) pandemic, and governmental and individual efforts to contain the pandemic, have had a significant negative impact on the U.S. and New York State economy which will adversely affect our customers and have an adverse effect on our business, financial condition and results of operations;

•

If we experience greater credit losses than anticipated, earnings may be adversely impacted;

•

Geographic concentration may unfavorably impact our operations;

•

Our commercial business and mortgage loans increase our exposure to credit risks;

•

Our indirect and consumer lending involves risk elements in addition to normal credit risk;

•

Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future;

•

We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason;

•

We depend on the accuracy and completeness of information about or from customers and counterparties;

•

We are subject to environmental liability risk associated with our lending activities;

•

We operate in a highly competitive industry and market area;

•

Changes to and replacement of the LIBOR Benchmark Interest Rate may adversely affect our business, financial condition, and results of operations;

•

Our insurance brokerage subsidiary is subject to risk related to the insurance industry;

•

Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility;

•

Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios;

•

We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact our results of operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect;

•

We may be unable to successfully implement our growth strategies, including the integration and successful management of newly-acquired businesses;

•

Acquisitions may disrupt our business and dilute shareholder value;

•

The value of our goodwill and other intangible assets may decline in the future;

•

We use financial models for business planning purposes that may not adequately predict future results;

•

Liquidity is essential to our businesses;

•

We rely on dividends from our subsidiaries for most of our revenue;

•

We may not be able to attract and retain skilled people;

•

Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business;

•

If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses;

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•

We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands;

•

We rely on other companies to provide key components of our business infrastructure;

•

A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image;

•

Any future FDIC insurance premium increases may adversely affect our earnings;

•

We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage;

•

Legal and regulatory proceedings and related matters could adversely affect us and the banking industry in general;

•

The policies of the Federal Reserve have a significant impact on our earnings;

•

We are subject to interest rate risk, and a rising rate environment may reduce our income and result in higher defaults on our loans, whereas a falling rate environment may result in earlier loan prepayments than we expect, which may reduce our income;

•

The soundness of other financial institutions could adversely affect us;

•

Our business may be adversely affected by conditions in the financial markets and economic conditions generally;

•

We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;

•

We may not pay or may reduce the dividends on our common stock;

•

We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could dilute our current shareholders or negatively affect the value of our common stock;

•

Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect; and

•

The market price of our common stock may fluctuate significantly in response to a number of factors.

We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Form 10-K and Item 1A, Risk Factors, below for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

GENERAL

The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its subsidiaries, Five Star Bank (the “Bank”), SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York-chartered banking subsidiary, the Bank. Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the local communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking, insurance and wealth management relationships with a community bank that combines high quality, competitively-priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.

A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, insurance and wealth management

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products typically found at larger banks, our highly experienced management team and our strategically located banking centers. We have evolved to meet changing customer needs by opening what we refer to as financial solution center branches. These financial solution center branches have a smaller footprint than our traditional branches, focus on technology to provide solutions that fit our customer preferences for transacting business with us, and are staffed by certified personal bankers who are trained to meet a broad array of customer needs. In recent years, we have opened four financial solution centers in the Rochester and Buffalo markets. We believe that the foregoing factors all help to grow our core deposits, which supports a central element of our business strategy - the growth of a diversified and high-quality loan portfolio.

EXECUTIVE OVERVIEW

Summary of 2020 Third Quarter Results

Net income decreased $560 thousand, or 4%, to $12.3 million for the third quarter of 2020 compared to $12.8 million for the third quarter of 2019. Net income available to common shareholders for the third quarter of 2020 was $11.9 million, or $0.74 per diluted share, compared with $12.5 million, or $0.78 per diluted share, for the third quarter of last year. Return on average common equity was 10.72% and return on average assets was 1.02% for the third quarter of 2020 compared to 12.00% and 1.19%, respectively, for the third quarter of 2019.

Third quarter results were negatively impacted by a higher provision for credit losses of $4.0 million, as compared to $1.8 million in the third quarter of 2019. The higher provision was driven by the adoption of the current expected credit loss (“CECL”) standard and uncertainty around the long-term impact of the COVID-19 pandemic on the economic environment.

Net interest income totaled $35.5 million in the third quarter of 2020, up from $32.5 million in the third quarter of 2019. This increase was primarily the result of a change in the interest-earning asset mix as loans became a larger percentage of the portfolio. Average loans were up $368.2 million in the third quarter of 2020 compared to the same quarter in 2019.

The provision for credit losses - loans was $3.6 million in the third quarter of 2020 compared to $1.8 million in the third quarter of 2019. Net charge-offs during the recent quarter were $488 thousand, down from $4.6 million in the third quarter of 2019. Net charge-offs expressed as an annualized percentage of average loans outstanding were 0.06% during the third quarter of 2020 compared with 0.58% in the third quarter of 2019. See the “Allowance for Credit Losses - Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion regarding the increase in the provision for credit losses - loans and the decrease in net charge-offs.

Noninterest income was relatively flat at $12.4 million in both the third quarter of 2020 and the third quarter of 2019. Changes in noninterest income for the third quarter were primarily attributed to increases in net gain on sale of loans held for sale and income from derivative instruments, net, partially offset by decreases in net gain on investment securities and service charges on deposits. Net gain on sale of loans held for sale of $1.6 million was recognized in the third quarter of 2020 due to increased residential real estate loans for sale volume and an increase in margin on these transactions. Income from derivative instruments of $1.9 million was recognized in the third quarter of 2020 driven primarily by an increase in the number and value of interest rate swap transactions executed and reflects growth and maturity of the Company’s commercial loan business. The Company sold investment securities during the third quarter of 2020 generating a net gain of $554 thousand as compared to a net gain of $1.6 million in the third quarter of 2019. The Company recognized $1.3 million in service charges on deposits in the third quarter of 2020 as compared to $1.9 million in the third quarter of 2019 primarily due to the Company’s COVID-19 relief initiatives of waiving or eliminating fees, implemented from March 23, 2020 through July 9, 2020, and the Company not re-initiating ATM access fees until September 19, 2020.

Noninterest expense in the third quarter of 2020 totaled $28.7 million compared with $25.9 million in the third quarter of 2019. The increase in noninterest expense was primarily the result of restructuring charges incurred in the third quarter of 2020 and increases in salaries and employee benefits, computer and data processing and FDIC assessments. Restructuring charges of $1.4 million represent non-recurring real estate related charges related to the previously described branch closings and staff reduction announced in July 2020. The increase in salaries and employee benefits includes $224 thousand of non-recurring severance costs incurred in connection with the previously described branch closings and staff reduction announced in July 2020. The increase in computer and data processing expense was primarily due to costs related to the Bank’s new online and mobile platform, Five Star Bank Digital Banking, launched in the second quarter of 2020. FDIC assessments were $594 thousand in the third quarter of 2020 compared to $7 thousand in the third quarter of 2019. The FDIC minimum reserve ratio was exceeded in 2018, resulting in credits used to offset expense in 2019 and the first quarter of 2020.

The regulatory Common Equity Tier 1 Ratio and Total Risk-Based Capital Ratio were 10.19%, and 12.74%, respectively, at September 30, 2020. See the “Liquidity and Capital Management” section of this Management’s Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules.

Enterprise Standardization Program

The Company’s enterprise standardization program is focused on improving operational efficiency and enhancing future profitability. On July 17, 2020, in connection with the program, Five Star Bank announced changes to adapt to a full-service branch model to streamline retail branches to better align with shifting customer needs and preferences.

The announcement was the result of a nine-month comprehensive assessment of all lines of business and functional areas, conducted in partnership with a leading process improvement organization. The data-driven analysis identified, among other things, overlapping service

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areas, automation opportunities and streamlining of processes and operations that would enhance customer experiences and facilitate the long-term sustainability of current and future branches.

The July announcement included the consolidation of eleven branches into five, resulting in six branch closings and a reduction in staffing. The consolidations represent about ten percent of the branch network and impacted approximately six percent of the Company’s total workforce. These actions resulted in one-time expenses related to severance and real estate related charges of approximately $1.6 million in the third quarter of 2020. Expense savings of $2.6 million are anticipated on an annualized basis.

The enterprise standardization program is not yet complete as we continue to evaluate activities and functions across the organization, focusing on ways to improve operational efficiency while enhancing the employee and customer experience.

Subordinated Note Issuance

On October 7, 2020, the Company completed a private placement of $35.0 million of fixed-to-floating rate subordinated notes due 2030 (the “Notes”) to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month secured overnight financing rate (“SOFR”) plus 4.265% basis points, payable quarterly until maturity.

The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.

Stock Repurchase Program

Operational, Accounting and Reporting Impacts Related to COVID-19

•

Accounting for Loan Modifications - The CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.

•

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•

Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.

Business customers are being faced with challenging and unique circumstances. The Bank’s relationship bankers are highly skilled in providing tailored financial solutions designed to meet the specific, individual needs of each business and they are actively reaching out to each business customer to understand how the Bank can help, given each unique business circumstance.

As of October 23, 2020, we have helped more than 1,700 customers obtain more than $270 million in loans through the PPP. Additionally, approximately 3% of our commercial loan and mortgage customers, 1% of our residential real estate loans and lines customers and less than 1% of our indirect loans customers have active payment deferrals.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

Net interest income is our primary source of revenue, comprising 76% of revenue during the nine months ended September 30, 2020. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis (dollars in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Interest income per consolidated statements of income	$	39,719	$	42,459	$	121,131	$	126,621
Adjustment to fully taxable equivalent basis		201		258		680		849
Interest income adjusted to a fully taxable equivalent basis		39,920		42,717		121,811		127,470
Interest expense per consolidated statements of income		4,220		9,976		18,327		29,882
Net interest income on a taxable equivalent basis	$	35,700	$	32,741	$	103,484	$	97,588

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Analysis of Net Interest Income for the Three Months Ended September 30, 2020 and 2019

Net interest income on a taxable equivalent basis for the three months ended September 30, 2020, was $35.7 million, an increase of $3.0 million versus the comparable quarter last year of $32.7 million. The increase in net interest income was due primarily to an increase in average loans of $368.2 million, or 12%, compared to the third quarter of 2019, partially offset by a decrease in investment securities of $15.9 million, or 2%, compared to the third quarter of 2019. The decrease in investment securities is primarily the result of the redeployment of assets from investment securities into loans, resulting in loans comprising a higher percentage of total interest-earning assets.

Our net interest margin for the third quarter of 2020 was 3.22%, seven-basis points lower than 3.29% for the same period in 2019. This comparable period decrease was a function of a 16-basis point lower contribution from net free funds, partially offset by a nine-basis point increase in the interest rate spread. The higher interest rate spread was a result of a 69-basis point decrease in the yield on average interest-earning assets and a 78-basis point decrease in the cost of average interest-bearing liabilities.

For the third quarter of 2020, the yield on average interest earning assets of 3.60% was 69-basis points lower than the third quarter of 2019 of 4.29%. Loan yields decreased 75 basis points during the third quarter of 2020 to 4.02% from 4.77%. The yield on investment securities decreased 17-basis points during the third quarter of 2020 to 2.23% from 2.40%. Overall, the earning asset rate changes decreased interest income by $6.8 million during the third quarter of 2020 and a favorable volume variance increased interest income by $4.0 million, which collectively drove a $2.8 million decrease in interest income.

Average interest-earning assets were $4.41 billion for the third quarter of 2020 compared to $3.96 billion for the third quarter of 2019, an increase of $454.9 million, or 12%, from the comparable quarter last year, with average loans up $368.2 million from $3.15 billion to $3.52 billion and average securities down $15.9 million from $785.6 million to $769.7 million. The growth in average loans reflected increases in the commercial loans, residential real estate loans and other consumer loans categories. Commercial loans, in particular, were up $381.1 million from $1.61 billion to $1.99 billion, or 24%, from the third quarter of 2019. The increase in commercial loans was primarily driven by the PPP loans. Residential real estate loans were up $37.1 million, partially offset by a decrease of $12.0 million in residential real estate lines. Consumer indirect loans decreased by $38.3 million and other consumer loans increased by $304 thousand. Loans comprised 79.8% of average interest-earning assets during the third quarter of 2020 compared to 79.7% during the third quarter of 2019. Loans generally have significantly higher yields compared to securities and federal funds sold and interest-bearing deposits and, as such, have a more positive effect on the net interest margin. The yield on average loans was 4.02% for the third quarter of 2020, a decrease of 75-basis points compared to 4.77% for the comparable quarter in 2019. An unfavorable rate variance resulted in a $6.3 million decrease in interest income, partially offset by an increase of $4.0 million due to the increase in the volume of average loans. Securities represented 17.4% of average interest-earning assets during the third quarter of 2020 compared to 19.8% during the third quarter of 2019. The decrease in the volume of average securities resulted in a $110 thousand decrease in interest income, in addition to a $310 thousand decrease due to the unfavorable rate variance.

The cost of average interest-bearing liabilities of 0.52% in the third quarter of 2020 compared to 1.30% in the third quarter of 2019, was 78-basis points lower. The cost of average interest-bearing deposits decreased 64-basis points from 1.07% to 0.43% and the cost of short-term borrowings decreased 91-basis points from 2.51% to 1.60% in the third quarter of 2020 compared to the same quarter of 2019. The decrease in the cost of short-term borrowings was a result of decreases in the federal funds rate. The cost of long-term borrowings for the third quarter of 2020 increased one-basis point from 6.30% to 6.31% compared to the same quarter of 2019. Overall, interest-bearing liability rate and volume decreases resulted in $5.8 million of lower interest expense.

Average interest-bearing liabilities of $3.24 billion in the third quarter of 2020 were $186.9 million, or 6%, higher than the third quarter of 2019. On average, interest-bearing deposits grew $457.9 million from $2.69 billion to $3.15 billion, and noninterest-bearing demand deposits (a principal component of net free funds) were up $270.4 million from $717.5 million to $987.9 million. The increase in average deposits was driven by PPP loan proceeds, successful business development efforts in retail banking, an increase in reciprocal deposit programs, and higher utilization of brokered deposits as a funding source. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities - Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate and volume changes resulted in a $3.9 million decrease in interest expense during the third quarter of 2020. Average borrowings decreased $271.0 million from $368.2 million to $97.2 million compared to the third quarter of 2019. Overall, short and long-term borrowing rate and volume changes resulted in $1.8 million of lower interest expense during the third quarter of 2020.

Analysis of Net Interest Income for the Nine Months Ended September 30, 2020 and 2019

Net interest income on a taxable equivalent basis for the nine months ended September 30, 2020, was $103.5 million, an increase of $5.9 million versus the comparable period last year of $97.6 million. The increase in net interest income was due primarily to an increase in average earning assets of $260.1 million or 7% compared to the first nine months of 2019.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The net interest margin for the first nine months of 2020 was 3.25%, two-basis point lower than 3.27% for the same period in 2019. This comparable period decrease was a function of an eight-basis point increase in interest rate spread, partially offset by a ten-basis point lower contribution from net free funds. The higher interest rate spread was a result of a 52-basis point decrease in the cost of average interest-bearing liabilities and a 44-basis point decrease in the yield on average interest-earning assets.

For the first nine months of 2020, the yield on average earning assets of 3.83% was 44-basis points lower than the first nine months of 2019 of 4.27%. Loan yields decreased 54-basis points during the first nine months of 2020 to 4.25% from 4.79%. The yield on investment securities increased two-basis points during the first nine months of 2020 to 2.40% from 2.38%. Overall, the earning asset rate changes decreased interest income by $13.5 million during the first nine months of 2020 and a favorable volume variance increased interest income by $7.8 million, which collectively drove a $5.7 million decrease in interest income.

Average interest-earning assets were $4.25 billion for the first nine months of 2020 compared to $3.99 billion for the first nine months of 2019, an increase of $260.1 million, or 7%, from the comparable period last year, with average loans up $254.3 million from $3.13 billion to $3.38 billion and average securities down $66.9 million from $839.0 million to $772.1 million. The growth in average loans reflected increases in the commercial loans and residential real estate loans categories. Commercial loans, in particular, were up $277.1 million from $1.57 billion to $1.85 billion, or 18%, from the first nine months of 2019. Loans represented 79.7% of average interest-earning assets during the first nine months of 2020 compared to 78.5% during the first nine months of 2019. Loans generally have significantly higher yields compared to securities and federal funds sold and interest-bearing deposits and, as such, have a more positive effect on the net interest margin. The yield on average loans was 4.25% for the first nine months of 2020, a decrease of 54-basis points compared to 4.79% for first nine months of 2019. An unfavorable rate variance resulted in a $13.2 million decrease in interest income, partially offset by an increase of $8.7 million due to the increase in the volume of average loans. Securities represented 18.2% of average interest-earning assets during first nine months of 2020 compared to 21.0% during the first nine months of 2019. The decrease in the volume of average securities resulted in a $1.2 million decrease in interest income, partially offset by a $109 thousand increase due to the favorable rate variance.

The cost of average interest-bearing liabilities of 0.77% in the first nine months of 2020 compared to 1.29% in the first nine months of 2019 was 52-basis points lower than the first nine months of 2019. The cost of average interest-bearing deposits decreased 40-basis points from 1.06% to 0.66% and the cost of short-term borrowings decreased 97-basis points from 2.64% to 1.67% in the first nine months of 2020 compared to the same period of 2019. The decrease in the cost of short-term borrowings was a result of decreases in the federal funds rate. The cost of long-term borrowings for the first nine months of 2020 remained relatively flat at 6.30% compared to the same period of 2019. Overall, interest-bearing liability rate and volume decreases resulted in $11.6 million of lower interest expense.

Average interest-bearing liabilities of $3.19 billion in the first nine months of 2020 were $95.9 million, or 3%, higher than the first nine months of 2019. On average, interest-bearing deposits grew $316.3 million from $2.72 billion to $3.03 billion, and noninterest-bearing demand deposits (a principal component of net free funds) were up $154.8 million from $719.6 million to $874.5 million. The increase in average deposits was driven by PPP loans, successful business development efforts in retail banking, an increase in reciprocal deposit programs, and higher utilization of brokered deposits as a funding source. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities - Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate and volume changes resulted in $6.4 million of lower interest expense during the first nine months of 2020. Average borrowings decreased $220.4 million from $372.1 million to $151.7 million compared to the first nine months of 2019. Overall, short and long-term borrowing rate and volume changes resulted in $5.2 million of lower interest expense during the first nine months of 2020.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following tables sets forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (in thousands).

	Three months ended September 30,
	2020								2019
	Average Balance			Interest		Average Rate			Average Balance			Interest		Average Rate
Interest-earning assets:
Federal funds sold and interest-earning deposits	$	121,929		$	31		0.10	%	$	19,370		$	106		2.17	%
Investment securities ⁽¹⁾:
Taxable		614,465			3,330		2.17			587,069			3,478		2.37
Tax-exempt ⁽²⁾		155,208			957		2.47			198,526			1,229		2.48
Total investment securities		769,673			4,287		2.23			785,595			4,707		2.40
Loans:
Commercial business		808,582			6,792		3.34			586,293			7,620		5.16
Commercial mortgage		1,180,747			12,160		4.10			1,021,931			13,244		5.14
Residential real estate loans		590,483			5,314		3.60			553,382			5,326		3.85
Residential real estate lines		95,288			874		3.65			107,290			1,397		5.17
Consumer indirect		830,647			10,039		4.81			868,927			9,813		4.48
Other consumer		16,445			423		10.23			16,141			504		12.40
Total loans		3,522,192			35,602		4.02			3,153,964			37,904		4.77
Total interest-earning assets		4,413,794			39,920		3.60			3,958,929			42,717		4.29
Less: Allowance for credit losses		(47,447	)							(35,271	)
Other noninterest-earning assets		408,986								337,152
Total assets	$	4,775,333							$	4,260,810
Interest-bearing liabilities:
Deposits:
Interest-bearing demand	$	704,550		$	254		0.14	%	$	632,540			348		0.22	%
Savings and money market		1,574,068			1,102		0.28			956,410			1,060		0.44
Time deposits		867,479			2,014		0.92			1,099,212			5,869		2.12
Total interest-bearing deposits		3,146,097			3,370		0.43			2,688,162			7,277		1.07
Short-term borrowings		57,856			232		1.60			328,952			2,081		2.51
Long-term borrowings		39,314			618		6.31			39,244			618		6.30
Total borrowings		97,170			850		3.50			368,196			2,699		2.91
Total interest-bearing liabilities		3,243,267			4,220		0.52			3,056,358			9,976		1.30
Noninterest-bearing demand deposits		987,908								717,473
Other noninterest-bearing liabilities		88,882								57,578
Shareholders’ equity		455,276								429,401
Total liabilities and shareholders’ equity	$	4,775,333							$	4,260,810
Net interest income (tax-equivalent)				$	35,700							$	32,741
Interest rate spread							3.08	%							2.99	%
Net earning assets	$	1,170,527							$	902,571
Net interest margin (tax-equivalent)							3.22	%							3.29	%
Ratio of average interest-earning assets to average interest-bearing liabilities							136.09	%							129.53	%

⁽¹⁾	Investment securities are shown at amortized cost.

⁽²⁾	The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21% for each of the three-month periods ended September 30, 2020 and 2019.

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	Nine months ended September 30,
	2020								2019
	Average Balance			Interest		Average Rate			Average Balance			Interest		Average Rate
Interest-earning assets:
Federal funds sold and interest-earning deposits	$	91,263		$	266		0.39	%	$	18,495		$	297		2.15	%
Investment securities ⁽¹⁾:
Taxable		596,604			10,649		2.38			620,607			10,949		2.35
Tax-exempt ⁽²⁾		175,455			3,237		2.46			218,388			4,047		2.47
Total investment securities		772,059			13,886		2.40			838,995			14,996		2.38
Loans:
Commercial business		712,703			19,843		3.72			570,596			22,627		5.30
Commercial mortgage		1,138,568			37,659		4.42			1,003,593			38,994		5.19
Residential real estate loans		583,540			16,095		3.68			541,185			15,649		3.86
Residential real estate lines		99,156			2,979		4.01			108,207			4,247		5.25
Consumer indirect		834,810			29,757		4.76			890,560			29,174		4.38
Other consumer		15,691			1,326		11.29			16,029			1,486		12.40
Total loans		3,384,468			107,659		4.25			3,130,170			112,177		4.79
Total interest-earning assets		4,247,790			121,811		3.83			3,987,660			127,470		4.27
Less: Allowance for loan losses		(44,228	)							(34,759	)
Other noninterest-earning assets		389,047								328,369
Total assets	$	4,592,609							$	4,281,270
Interest-bearing liabilities:
Deposits:
Interest-bearing demand	$	694,830		$	840		0.16	%	$	653,780		$	1,030		0.21	%
Savings and money market		1,349,931			3,724		0.37			973,005			3,143		0.43
Time deposits		989,236			10,502		1.42			1,090,896			17,281		2.12
Total interest-bearing deposits		3,033,997			15,066		0.66			2,717,681			21,454		1.06
Short-term borrowings		112,451			1,408		1.67			332,922			6,575		2.64
Long-term borrowings		39,297			1,853		6.30			39,227			1,853		6.30
Total borrowings		151,748			3,261		2.87			372,149			8,428		3.03
Total interest-bearing liabilities		3,185,745			18,327		0.77			3,089,830			29,882		1.29
Noninterest-bearing demand deposits		874,456								719,630
Other noninterest-bearing liabilities		85,069								56,449
Shareholders’ equity		447,339								415,361
Total liabilities and shareholders’ equity	$	4,592,609							$	4,281,270
Net interest income (tax-equivalent)				$	103,484							$	97,588
Interest rate spread							3.06	%							2.98	%
Net earning assets	$	1,062,045							$	897,830
Net interest margin (tax-equivalent)							3.25	%							3.27	%
Ratio of average interest-earning assets to average interest-bearing liabilities							133.34	%							129.06	%

⁽¹⁾	Investment securities are shown at amortized cost.

⁽²⁾	The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21% for each of the nine-month periods ended September 30, 2020 and 2019.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):

	Three months ended September 30, 2020 vs. 2019									Nine months ended September 30, 2020 vs. 2019
Increase (decrease) in:	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Federal funds sold and interest-earning deposits	$	108		$	(183	)	$	(75	)	$	377		$	(408	)	$	(31	)
Investment securities:
Taxable		157			(305	)		(148	)		(427	)		127			(300	)
Tax-exempt		(267	)		(5	)		(272	)		(792	)		(18	)		(810	)
Total investment securities		(110	)		(310	)		(420	)		(1,219	)		109			(1,110	)
Loans:
Commercial business		2,360			(3,188	)		(828	)		4,871			(7,655	)		(2,784	)
Commercial mortgage		1,876			(2,960	)		(1,084	)		4,874			(6,209	)		(1,335	)
Residential real estate loans		345			(357	)		(12	)		1,189			(743	)		446
Residential real estate lines		(143	)		(380	)		(523	)		(333	)		(935	)		(1,268	)
Consumer indirect		(444	)		670			226			(1,893	)		2,476			583
Other consumer		9			(90	)		(81	)		(31	)		(129	)		(160	)
Total loans		4,003			(6,305	)		(2,302	)		8,677			(13,195	)		(4,518	)
Total interest income		4,001			(6,798	)		(2,797	)		7,835			(13,494	)		(5,659	)
Interest expense:
Deposits:
Interest-bearing demand		36			(130	)		(94	)		62			(252	)		(190	)
Savings and money market		524			(482	)		42			1,089			(508	)		581
Time deposits		(1,047	)		(2,808	)		(3,855	)		(1,493	)		(5,286	)		(6,779	)
Total interest-bearing deposits		(487	)		(3,420	)		(3,907	)		(342	)		(6,046	)		(6,388	)
Short-term borrowings		(1,280	)		(569	)		(1,849	)		(3,328	)		(1,839	)		(5,167	)
Long-term borrowings		1			(1	)		—			3			(3	)		—
Total borrowings		(1,279	)		(570	)		(1,849	)		(3,325	)		(1,842	)		(5,167	)
Total interest expense		(1,766	)		(3,990	)		(5,756	)		(3,667	)		(7,888	)		(11,555	)
Net interest income	$	5,767		$	(2,808	)	$	2,959		$	11,502		$	(5,606	)	$	5,896

Provision for Credit Losses

The provision for credit losses for the three and nine months ended September 30, 2020 was $4.0 million and $21.7 million, respectively, compared to $1.8 million and $5.4 million for the corresponding periods in 2019. The increase was driven by the adoption of the CECL standard, higher net charge-offs in the first quarter of 2020 and deterioration in the economic environment as a result of the COVID-19 pandemic, which adversely impacted our unemployment forecast, the designated loss driver for our CECL model. Although the unemployment forecast improved in the latest quarter, qualitative factors were increased to more than offset the improved unemployment forecast due to uncertainty around the long-term impact of the pandemic on the economy. The increase in net charge-offs in the first nine months of 2020 is primarily attributable to one commercial credit that was downgraded and partially charged-off during the first quarter of 2020. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic. The provision for credit losses - loans varies based primarily on forecasted unemployment rates, loan growth, net charge-offs, collateral values associated with collateral dependent loans and qualitative factors.

See the “Allowance for Credit Losses - Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion.

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Noninterest Income

The following table details the major categories of noninterest income for the periods presented (in thousands):

	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Service charges on deposits	$	1,254		$	1,925		$	3,321		$	5,361
Insurance income		1,357			1,439			3,525			3,689
ATM and debit card		1,943			1,801			5,321			4,983
Investment advisory		2,443			2,269			6,940			6,812
Company owned life insurance		470			459			1,397			1,293
Investments in limited partnerships		(105	)		116			(136	)		492
Loan servicing		49			102			106			316
Income from derivative instruments, net		1,931			890			4,617			1,013
Net gain on sale of loans held for sale		1,581			439			2,616			1,028
Net gain (loss) on investment securities		554			1,608			1,449			1,721
Net gain (loss) on other assets		(55	)		(2	)		8			56
Net loss on tax credit investments		(40	)		—			(120	)		—
Other		1,019			1,315			3,151			3,950
Total noninterest income	$	12,401		$	12,361		$	32,195		$	30,714

Service charges on deposits decreased $671 thousand, or 35%, to $1.3 million for the third quarter of 2020 compared to $1.9 million for the third quarter of 2019. For the first nine months of 2020, service charges on deposits decreased $2.0 million, or 38%, to $3.3 million compared to $5.4 million for the first nine months of 2019. The decreases were primarily due to our COVID-19 relief initiatives implemented between March 23, 2020 to July 9, 2020, including waiving or eliminating certain fees. In addition, insufficient fund fees in the remainder of the quarter were lower than historic levels, potentially due to the positive impact of stimulus programs on consumer account balances. ATM access fees were not re-initiated until September 19th.

Income (loss) from investments in limited partnerships decreased $221 thousand, to a loss of $105 thousand for the third quarter of 2020 compared to income of $116 thousand for the third quarter of 2019. For the first nine months of 2020, income (loss) from investments in limited partnerships decreased $628 thousand, to a loss of $136 thousand compared to income of $492 thousand for the first nine months of 2019. We have investments in limited partnerships, primarily small business investment companies, and account for these investments under the equity method. The income from these equity method investments fluctuates based on the maturity and performance of the underlying investments.

Income from derivative instruments, net increased $1.0 million to $1.9 million for the third quarter of 2020 compared to $890 thousand for the third quarter of 2019. For the first nine months of 2020, income from derivative instruments, net increased $3.6 million to $4.6 million compared to $1.0 million for the first nine months of 2019. The increases were primarily the result of an increase in the number and value of interest rate swap transactions executed and reflects growth and maturity of our commercial loan business.

Net gain on sale of loans held for sale was $1.6 million for the third quarter of 2020 compared to $439 thousand for the third quarter of 2019. For the first nine months of 2020, net gain on sale of loans held for sale was $2.6 million compared to $1.0 million for the first nine months of 2019. The increases were primarily due to increased residential real estate loans for sale volume and an increase in margin on these transactions. The low interest rate environment has resulted in a significant increase in mortgage refinancing activity.

Net gain on investment securities was $554 thousand for the third quarter of 2020 compared to $1.6 million for the third quarter of 2019. For the first nine months of 2020, net gain on investment securities was $1.4 million compared to $1.7 million for the first nine months of 2019. The net gain in the current quarter is attributable to the management of premium risk, largely achieved through the sale of $20.0 million of fixed rate mortgage backed securities with higher expected prepayment speeds. Proceeds were reinvested in current coupon bonds, with lower anticipated prepayment behavior.

Other noninterest income decreased $296 thousand, or 23%, to $1.0 million for the third quarter of 2020 compared to $1.3 million for the third quarter of 2019. The decrease was due to the impact of stay-at-home orders for COVID-19 that reduced certain volume-based fees like merchant revenue and correspondent credit card fees. Our FHLB dividends have also declined year-over-year due to the lower level of FHLB borrowings in 2020 versus 2019. For the first nine months of 2020, other noninterest income decreased $799 thousand, or 20%, to $3.2 million compared to $4.0 million for the first nine months of 2019. The decrease was due to lower pay-by-phone fees associated with our COVID-19 consumer relief initiatives, coupled with the impact of stay-at-home orders that reduced certain volume-based fees like merchant revenue and correspondent credit card fees. Our FHLB dividends have also declined year-over-year due to the lower level of FHLB borrowings in 2020 versus 2019.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Noninterest Expense

The following table details the major categories of noninterest expense for the periods presented (in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Salaries and employee benefits	$	15,085	$	14,411	$	45,173	$	41,661
Occupancy and equipment		3,263		4,650		10,407		13,562
Professional services		1,242		1,528		4,974		3,618
Computer and data processing		3,250		1,378		8,622		3,951
Supplies and postage		463		522		1,533		1,554
FDIC assessments		594		7		1,505		1,005
Advertising and promotions		955		745		2,055		2,351
Amortization of intangibles		280		309		861		948
Restructuring charges		1,362		-		1,362		-
Other		2,165		2,336		6,583		7,410
Total noninterest expense	$	28,659	$	25,886	$	83,075	$	76,060

Salaries and employee benefits expense increased by $674 thousand, or 5%, to $15.1 million for the third quarter of 2020 compared to $14.4 million for the third quarter of 2019. The increase in the current quarter includes $224 thousand of non-recurring severance costs incurred in connection with the previously described branch closings and staff reduction announced in July 2020. For the first nine months of 2020, salaries and employee benefits expense increased by $3.5 million, or 8%, to $45.2 compared to $41.7 million for the first nine months of 2019. The increase in the first nine months of 2020 was primarily the result of incentive compensation (including producer incentives and commissions), annual merit increases, COVID-19-related incremental pay to front-line retail associates, expense related to the departure of a senior officer on June 26, 2020 and higher medical expense.

Professional services expense decreased $286 thousand, or 19%, to $1.2 million for the third quarter of 2020 compared to $1.5 million for the third quarter of 2019. For the first nine months of 2020, professional services expense increased $1.4 million, or 37%, to $5.0 million compared to $3.6 million for the first nine months of 2019. The decrease in the third quarter of 2020 and increase in the first nine months of 2020 were primarily due to the timing of fees for consulting and advisory projects, including the Company’s improvement initiatives. Expenses related to improvement initiatives totaled $56 thousand and $1.0 million for the three- and nine-month periods ended September 30, 2020, respectively, and $298 thousand and $511 thousand for the three- and nine-month periods ended September 30, 2019, respectively.

Computer and data processing expense increased $603 thousand, or 23%, to $3.3 million for the third quarter of 2020 compared to $2.6 million for the third quarter of 2019. For the first nine months of 2020, computer and data processing expense increased $1.2 million, or 16%, to $8.6 million compared to $7.4 million for the first nine months of 2019. The increases in computer and data processing expense were primarily due to costs related to the Bank’s new online and mobile platform, Five Star Bank Digital Banking, launched in the second quarter of 2020.

FDIC assessments increased $587 thousand to $594 thousand for the third quarter of 2020 compared to $7 thousand for the third quarter of 2019. For the first nine months of 2020, FDIC assessments increased $500 thousand, or 50%, to $1.5 million compared to $1.0 million for the first nine months of 2019. In 2018, the FDIC minimum reserve ratio was exceeded, resulting in credits used to offset expense in 2019 and the first quarter of 2020.

Advertising and promotions expense increased $210 thousand, or 28%, to $955 thousand for the third quarter of 2020 compared to $745 thousand for the third quarter of 2019. For the first nine months of 2020, advertising and promotions expense decreased $296 thousand, or 13%, to $2.1 million compared to $2.4 million for the first nine months of 2019. Advertising and promotions expense was reduced in March 2020 when the COVID-19 pandemic impacted operations in Western New York. Higher expense in the third quarter of 2020 is attributable to promotional costs for Five Star Bank Digital Banking. The advertising campaign started after the last wave of customers was transitioned to the new platform in mid-June and ended in late August.

Restructuring charges of $1.4 million for the third quarter of 2020 represents non-recurring real estate related charges related to the previously described branch closings and staff reduction announced in July 2020.

Our efficiency ratio for the first nine months of 2020 was 61.89% compared with 60.09% for the first nine months of 2019. The higher efficiency ratio is a result of the higher noninterest expenses associated with our improvement initiatives and COVID-related impacts on noninterest income and noninterest expenses. The efficiency ratio is calculated by dividing total noninterest expense by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease indicates a more efficient allocation of resources. The efficiency ratio, a banking industry financial measure, is not required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Income Taxes

For the nine months ended September 30, 2020, we recorded income tax expense of $5.7 million, versus $10.2 million for the same period in the prior year. In the first nine months of 2020, the Company recognized tax credit investments resulting in a $606 thousand reduction in income tax expense and a $120 thousand net loss recorded in noninterest income. For the three months ended September 30, 2020, we recorded income tax expense of $2.9 million, versus $4.3 million for the same period in the prior year. As a result of the Tax Cuts and Jobs Act, the Company estimated tax benefits and recorded a provisional amount in and for the year ended December 31, 2017. In the third quarter of 2019 an adjustment was made to the provisional amount resulting in incremental expense of approximately $600 thousand.

The effective tax rates for the first nine months of 2020 and 2019 were 18.9% and 22.3%, respectively. The effective tax rates for the third quarter of 2020 and 2019 were 19.3% and 25.0%, respectively. Effective tax rates are typically impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities, earnings on Company owned life insurance and the impact of tax credit investments. In addition, our effective tax rate for 2020 and 2019 reflects the New York State tax benefit generated by our real estate investment trust.

ANALYSIS OF FINANCIAL CONDITION

INVESTING ACTIVITIES

Investment Securities

The following table summarizes the composition of our investment securities portfolio as of the dates indicated (in thousands):

	Investment Securities Portfolio Composition
	September 30, 2020					December 31, 2019
	Amortized			Fair		Amortized		Fair
	Cost			Value		Cost		Value
Securities available for sale:
U.S. Government agency and government-sponsored enterprise securities	$	6,234		$	6,655	$	26,440	$	26,877
Mortgage-backed securities:
Agency mortgage-backed securities		489,384			508,881		389,412		390,422
Non-Agency mortgage-backed securities		—			435		—		618
Total available for sale securities		495,618			515,971		415,852		417,917
Securities held to maturity:
State and political subdivisions		151,611			156,663		192,215		196,018
Mortgage-backed securities		139,343			145,215		166,785		167,241
Total held to maturity securities		290,954			301,878		359,000		363,259
Allowance for credit losses - securities		(8	)
Total held to maturity securities, net		290,946
Total investment securities	$	786,564		$	817,849	$	774,852	$	781,176

The available for sale (“AFS”) investment securities portfolio increased $98.1 million from $417.9 million at December 31, 2019 to $516.0 million at September 30, 2020. The AFS portfolio had net unrealized gains of $20.4 million and $2.1 million at September 30, 2020 and December 31, 2019, respectively. The fair value of most of the investment securities in the AFS portfolio fluctuates as market interest rates change.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Security Yields and Maturities Schedule

The following table sets forth certain information regarding the amortized cost (“Cost”), weighted average yields (“Yield”) and contractual maturities of our debt securities portfolio as of September 30, 2020. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. No tax-equivalent adjustments were made to the weighted average yields (dollars in thousands).

	Due in one year or less					Due from one to five years					Due after five years through ten years					Due after ten years					Total
	Cost		Yield			Cost		Yield			Cost		Yield			Cost		Yield			Cost		Yield
Available for sale debt securities:
U.S. Government agencies and government-sponsored enterprises	$	—		—	%	$	6,234		2.43	%	$	—		—	%	$	—		—	%	$	6,234		2.43	%
Mortgage-backed securities		1		6.04			30,291		2.45			162,953		2.36			296,139		1.76			489,384		2.00
		1		—			36,525		2.45			162,953		2.36			296,139		1.76			495,618		2.01
Held to maturity debt securities:
State and political subdivisions		48,688		2.27			99,947		1.93			2,976		2.02			—		—			151,611		2.04
Mortgage-backed securities		—		—			2,345		2.30			16,100		2.14			120,898		2.40			139,343		2.37
		48,688		2.27			102,292		1.94			19,076		2.12			120,898		2.40			290,954		2.20
Total investment securities	$	48,689		2.27	%	$	138,817		2.07	%	$	182,029		2.33	%	$	417,037		1.94	%	$	786,572		2.08	%

Impairment Assessment

LENDING ACTIVITIES

The following table summarizes the composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, as of the dates indicated (in thousands).

	Loan Portfolio Composition
	September 30, 2020					December 31, 2019
	Amount		% of Total			Amount		% of Total
Commercial business	$	818,135		22.9	%	$	572,040		17.8	%
Commercial mortgage		1,202,046		33.7			1,106,283		34.3
Total commercial		2,020,181		56.6			1,678,323		52.1
Residential real estate loans		596,902		16.7			572,350		17.8
Residential real estate lines		94,017		2.6			104,118		3.2
Consumer indirect		840,579		23.6			850,052		26.4
Other consumer		16,860		0.5			16,144		0.5
Total consumer		1,548,358		43.4			1,542,664		47.9
Total loans		3,568,539		100.0	%		3,220,987		100.0	%
Less: Allowance for credit losses		49,395					30,482
Total loans, net	$	3,519,144				$	3,190,505

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Total loans increased $347.6 million to $3.57 billion at September 30, 2020 from $3.22 billion at December 31, 2019. The increase in loans was primarily attributable to PPP loans in our commercial business portfolio. PPP loans of approximately $2 million and $269 million were funded in the third and second quarters of 2020, respectively. The loans carry a 1% interest rate and the Company recorded net PPP loan origination fees of approximately $7.4 million that are amortized over a 24-month period.

Commercial loans increased $341.9 million during the nine months ended September 30, 2020 and represented 56.6% of total loans as of September 30, 2020. The increase in commercial loans was primarily attributable to PPP loans. At September 30, 2020, the PPP loan balance was $264.1 million, net of deferred fees.

The consumer indirect portfolio totaled $840.6 million and represented 23.6% of total loans as of September 30, 2020. During the first nine months of 2020, we originated $230.0 million in indirect auto loans with a mix of approximately 32% new auto and 68% used auto. During the first nine months of 2019, we originated $234.6 million in indirect auto loans with a mix of approximately 34% new auto and 66% used auto. Our origination volumes and mix of new and used vehicles financed fluctuate depending on general market conditions.

Loans Held for Sale and Loan Servicing Rights

Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate loans and totaled $7.1 million and $4.2 million as of September 30, 2020 and December 31, 2019, respectively.

We sell certain qualifying newly originated or refinanced residential real estate loans on the secondary market. Residential real estate loans serviced for others, which are not included in the consolidated statements of financial condition, amounted to $220.7 million and $189.8 million as of September 30, 2020 and December 31, 2019, respectively.

Allowance for Credit Losses - Loans

The following table summarizes the activity in the allowance for credit losses - loans for the periods indicated (in thousands).

	Loan Loss Analysis
	Three months ended September 30,						Nine months ended September 30,
	2020			2019			2020			2019
Allowance for credit losses - loans, beginning of period, prior to adoption of ASC 326							$	30,482		$	33,914
Impact of adopting ASC 326								9,594			—
Allowance for credit losses - loans, beginning of period, after adoption of ASC 326		46,316			34,434			40,076			33,914
Charge-offs:
Commercial business		15			112			8,281			380
Commercial mortgage		640			2,994			1,712			2,997
Residential real estate loans		—			54			100			172
Residential real estate lines		—			8			—			10
Consumer indirect		1,388			2,420			7,366			8,102
Other consumer		160			315			499			867
Total charge-offs		2,203			5,903			17,958			12,528
Recoveries:
Commercial business		103			102			1,644			333
Commercial mortgage		37			—			37			17
Residential real estate loans		7			14			25			31
Residential real estate lines		—			1			3			6
Consumer indirect		1,503			1,103			4,550			4,205
Other consumer		65			73			282			299
Total recoveries		1,715			1,293			6,541			4,891
Net charge-offs		488			4,610			11,417			7,637
Provision for credit losses - loans		3,567			1,844			20,736			5,391
Allowance for credit losses - loans, end of period	$	49,395		$	31,668		$	49,395		$	31,668

Net loan charge-offs to average loans (annualized)		0.06	%		0.58	%		0.45	%		0.33	%
Allowance for credit losses - loans to total loans		1.38	%		1.00	%		1.38	%		1.00	%
Allowance for credit losses - loans to non-performing loans		453	%		324	%		453	%		324	%

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The Company adopted CECL effective January 1, 2020, which resulted in an increase to the allowance for credit losses - loans of $9.6 million and established a reserve for unfunded commitments of $2.1 million, for a total pre-tax cumulative effect adjustment of $11.7 million.

The allowance for credit losses for Pooled Loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in: underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s Loan Review function. The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, troubled debt restructurings (“TDRs”), and other loans deemed appropriate by management.

Assessing the adequacy of the allowance for credit losses - loans involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk profile of our loan products and customers.

The adequacy of the allowance for credit losses - loans is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for credit losses - loans, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for credit losses - loans. Such agencies may require the financial institution to increase the allowance based on their judgments about information available to them at the time of their examination.

Net charge-offs of $488 thousand in the third quarter of 2020 represented 0.06% of average loans on an annualized basis compared to $4.6 million, or 0.58%, in the third quarter of 2019. The decrease from the prior year period is primarily attributable to the third quarter 2019 $3.0 million partial charge-off of a $5.6 million loan that had been classified as non-performing in the second quarter of 2019. For the nine months ended September 30, 2020, net charge-offs of $11.4 million represented 0.45% of average loans, compared to $7.6 million or 0.33% of average loans for the same period in 2019. The increase in net charge-offs in the nine months ended September 30, 2020 was primarily due to an $8.2 million partial charge-off of an $11.9 million commercial loan downgraded in the first quarter of 2020. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic. The allowance for credit losses - loans was $49.4 million at September 30, 2020, compared with $30.5 million at December 31, 2019. The ratio of the allowance for credit losses -loans to total loans was 1.33% and 0.95% at September 30, 2020 and December 31, 2019, respectively. The ratio of allowance for credit losses - loans to non-performing loans was 453% at September 30, 2020, compared with 353% at December 31, 2019.

Non-Performing Assets and Potential Problem Loans

The table below summarizes our non-performing assets at the dates indicated (in thousands).

	Non-Performing Assets
	September 30, 2020			December 31, 2019
Nonaccrual loans:
Commercial business	$	2,628		$	1,177
Commercial mortgage		3,372			3,146
Residential real estate loans		3,305			2,484
Residential real estate lines		207			102
Consumer indirect		1,244			1,725
Other consumer		6			—
Total nonaccrual loans		10,762			8,634
Accruing loans 90 days or more delinquent		141			6
Total non-performing loans		10,903			8,640
Foreclosed assets		2,999			468
Total non-performing assets	$	13,902		$	9,108
Non-performing loans to total loans		0.31	%		0.27	%
Non-performing assets to total assets		0.28	%		0.21	%

Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at September 30, 2020 were $13.9 million, an increase of $4.8 million from the $9.1 million balance at December 31, 2019. The primary component of non-performing assets is non-performing loans, which were $10.9 million or 0.31% of total loans at September 30, 2020, compared with $8.6 million or 0.27% of total loans at December 31, 2019. The increase in non-performing assets in the nine months ended September 30, 2020 is primarily due to an $11.9 million commercial loan downgraded, with $8.2 million charged-off, in the first quarter of 2020. In the third quarter of 2020, this commercial loan was recategorized as a foreclosed asset. The borrower’s business was related to the hospitality industry and the downgrade and charge-off were precipitated by the impact of the COVID-19 pandemic.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Approximately $1.8 million, or 16.6%, of the $10.9 million in non-performing loans as of September 30, 2020 were current with respect to payment of principal and interest but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. Included in nonaccrual loans are TDRs of $254 thousand and $297 thousand at September 30, 2020 and December 31, 2019, respectively. There were no TDRs accruing interest as of September 30, 2020 and one TDR of $550 thousand was accruing interest as of December 31, 2019.

Foreclosed assets consist of real property formerly pledged as collateral for loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Foreclosed asset holdings represented three properties totaling $3.0 million at September 30, 2020 and three properties totaling $468 thousand at December 31, 2019. The increase in foreclosed assets in the nine months ended September 30, 2020 is primarily due to one commercial credit that was partially charged off during the first quarter of 2020 and foreclosure occurred in the third quarter.

Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes us to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. We consider loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $19.1 million and $14.6 million in loans that continued to accrue interest which were classified as substandard as of September 30, 2020 and December 31, 2019, respectively.

FUNDING ACTIVITIES

Deposits

The following table summarizes the composition of our deposits at the dates indicated (dollars in thousands):

	Deposit Composition
	September 30, 2020					December 31, 2019
	Amount		% of Total			Amount		% of Total
Noninterest-bearing demand	$	1,013,176		25.3	%	$	707,752		19.9	%
Interest-bearing demand		786,059		18.2			627,842		17.7
Savings and money market		1,724,463		34.3			1,039,892		29.2
Time deposits < $250,000		660,300		17.6			893,177		25.1
Time deposits of $250,000 or more		180,930		4.6			287,012		8.1
Total deposits	$	4,364,928		100.0	%	$	3,555,675		100.0	%

We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At September 30, 2020, total deposits were $4.36 billion, representing an increase of $809.3 million from December 31, 2019. The increase was driven by growth in nonpublic deposits and the reciprocal and brokered deposits portfolios. Time deposits were approximately 19% and 33% of total deposits at September 30, 2020 and December 31, 2019, respectively.

Nonpublic deposits, the largest component of our funding sources, totaled $2.50 billion and $2.16 billion at September 30, 2020 and December 31, 2019, respectively, and represented 57% and 61% of total deposits as of the end of each period, respectively. The increase in nonpublic deposits was in part attributable to PPP loan proceeds received by customers. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high cost deposit account.

As an additional source of funding, we offer a variety of public (municipal) deposit products to the towns, villages, counties and school districts within our market. Public deposits generally range from 20% to 30% of our total deposits. There is a high degree of seasonality in this component of funding, because the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquid assets to accommodate the seasonality associated with public deposits. Total public deposits were $989.4 million and $860.7 million at September 30, 2020 and December 31, 2019, respectively, and represented 23% and 24% of total deposits as of the end of each period, respectively. The increase in public deposits during 2020 was due largely to seasonality.

We also participate in reciprocal deposit programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Prior to the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”) enacted on May 14, 2018, all reciprocal deposits were considered brokered deposits for regulatory reporting purposes. With the enactment of EGRRCPA, reciprocal deposits, subject to certain restrictions, are no longer required to be reported as brokered deposits. Reciprocal deposits totaled $243.9 million and $337.2 million, respectively, at September 30, 2020, compared to $157.9 million and $172.0 million, respectively, at December 31, 2019. Reciprocal deposits represented 13% and 9% of total deposits as of the end of each period, respectively.

Brokered deposits totaled $294.9 million and $208.8 million at September 30, 2020 and December 31, 2019, respectively, and represented 7% and 6% of total deposits as of the end of each period, respectively.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Borrowings

The Company classifies borrowings as short-term or long-term in accordance with the original terms of the applicable agreement. Outstanding borrowings consisted of the following as of the dates indicated (in thousands):

	September 30,		December 31,
	2020		2019
Short-term borrowings - FHLB	$	5,300	$	275,500
Long-term borrowings - Subordinated notes, net		39,258		39,273
Total borrowings	$	44,558	$	314,773

Short-term Borrowings

Short-term Federal Home Loan Bank (“FHLB”) borrowings have original maturities of less than one year and include overnight borrowings which we typically utilize to address short term funding needs as they arise. Short-term FHLB borrowings at September 30, 2020 consisted of $5.3 million in short-term borrowings. The maximum amount of short-term FHLB borrowings outstanding at any month-end during the nine months ended September 30, 2020 was $198.9 million. Short-term FHLB borrowings at December 31, 2019 consisted of $10.0 million in overnight borrowings and $265.5 million in short-term borrowings. The lower level of short-term borrowings at September 30, 2020, is attributable to growth in brokered deposits, which were utilized as a cost-effective alternative to FHLB borrowings. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits, which reached a seasonal high point during the third quarter.

We have credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $218.6 million of immediate credit capacity with the FHLB as of September 30, 2020. We had approximately $538.8 million in secured borrowing capacity at the Federal Reserve Bank (“FRB”) discount window, none of which was outstanding at September 30, 2020. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had approximately $145.0 million of credit available under unsecured federal funds purchased lines with various banks as of September 30, 2020 and December 31, 2019. Additionally, we had approximately $174.6 million of unencumbered liquid securities available for pledging.

The Parent has a revolving line of credit with a commercial bank allowing borrowings up to $20.0 million in total as an additional source of working capital. At September 30, 2020, no amounts have been drawn on the line of credit.

Long-term Borrowings

On April 15, 2015, we issued $40.0 million of Subordinated Notes in a registered public offering. The Subordinated Notes bear interest at a fixed rate of 6.0% per year, payable semi-annually, for the first 10 years. From April 15, 2025 to the April 15, 2030 maturity date, the interest rate will reset quarterly to an annual interest rate equal to the then-current three-month London Interbank Offered Rate (LIBOR) plus 3.944%, payable quarterly. After the discontinuance of LIBOR, the interest rate will be determined by an alternate method as reasonably selected by the Company. The Subordinated Notes are redeemable by us at any quarterly interest payment date beginning on April 15, 2025 to maturity at par, plus accrued and unpaid interest. Proceeds, net of debt issuance costs of $1.1 million, were $38.9 million. The Subordinated Notes qualify as Tier 2 capital for regulatory purposes.

On October 7, 2020, the Company completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes due 2030 to qualified institutional buyers and accredited institutional investors. The Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month SOFR plus 4.265% basis points, payable quarterly until maturity. The Company is entitled to redeem the Notes, in whole or in part, on any interest payment date on or after October 15, 2025, and to redeem the Notes in whole at any time upon certain other specified events. The Company intends to use the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank.

LIQUIDITY AND CAPITAL MANAGEMENT

Liquidity

We continue to actively monitor our liquidity profile and funding concentrations in accordance with our Board approved Liquidity Policy. While funding pressures have not occurred, management is actively monitoring customer activity by way of commercial and consumer line of credit utilization, as well as deposit flows. As of September 30, 2020, all structural liquidity ratios and early warning indicators remain in compliance, with what we believe are ample funding sources available in the event of a stress scenario.

The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of both core customer funds and maturing short-term assets; we also rely on our ability to sell or pledge securities and lines-of-credit and our overall ability to access to the financial and capital markets.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with other banking institutions, the FHLB and the FRB. The primary source of our non-deposit short-term borrowings is FHLB advances, of which we had $5.3 million outstanding at September 30, 2020. In addition to this amount, we have additional collateralized wholesale borrowing capacity of approximately $902.4 million from various funding sources which include the FHLB, the FRB, and commercial banks that we can use to fund lending activities, liquidity needs, and/or to adjust and manage our asset and liability position.

The Parent’s funding requirements consist primarily of dividends to shareholders, debt service, income taxes, operating expenses, funding of non-bank subsidiaries, repurchases of our stock, and acquisitions. The Parent obtains funding to meet obligations from dividends received from the Bank, net taxes collected from subsidiaries included in the federal consolidated tax return, and the issuance of debt and equity securities. In addition, the Parent maintains a revolving line of credit with a commercial bank for an aggregate amount of up to $20.0 million, all of which was available at September 30, 2020. The line of credit has a one-year term and matures in May 2021. Funds drawn would be used for general corporate purposes and backup liquidity.

Cash and cash equivalents were $282.1 million as of September 30, 2020, up $169.1 million from $112.9 million as of December 31, 2019. Net cash provided by operating activities totaled $20.3 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash used in investing activities totaled $376.6 million, which included outflows of $361.9 million for net loan originations, and $12.3 million from net investment securities transactions. Net cash provided by financing activities of $525.4 million was attributed to a $809.3 million increase in deposits, partially offset by a $270.2 million decrease in short-term borrowings and by $13.4 million in dividend payments.

Capital Management

We actively manage capital, commensurate with our risk profile, to enhance shareholder value. We also seek to maintain capital levels for the Company and the Bank at amounts in excess of the regulatory “well-capitalized” thresholds. Periodically, we may respond to market conditions by implementing changes to our overall balance sheet positioning to manage our capital position.

Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material impact on our consolidated financial statements. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Shareholders’ equity was $456.4 million at September 30, 2020, an increase of $17.5 million from $438.9 million at December 31, 2019. Net income for the nine months ended September 30, 2020 increased shareholders’ equity by $24.5 million, offset by an $8.7 million cumulative effect adjustment from the adoption of ASC 326 and common and preferred stock dividends declared of $13.6 million. Accumulated other comprehensive loss included in shareholders’ equity decreased $14.3 million during the first nine months of 2020 due primarily to higher net unrealized gains on securities available for sale.

The FRB and FDIC have adopted a system using risk-based capital guidelines to evaluate the capital adequacy of banks and bank holding companies. The final rules implementing the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks became effective for the Company on January 1, 2015 and was fully phased-in on January 1, 2019. As of September 30, 2020, the Company’s capital levels remained characterized as “well-capitalized” under the new rules.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following table reflects the ratios and their components (dollars in thousands):

	September 30,			December 31,
	2020			2019
Common shareholders’ equity	$	439,033		$	421,619
Add: CECL transitional amount		11,286			—
Less: Goodwill and other intangible assets		71,135			71,987
Net unrealized gain (loss) on investment securities ⁽¹⁾		14,651			873
Hedging derivative instruments		(692	)		(518	)
Net periodic pension and postretirement benefits plan adjustments		(14,168	)		(14,868	)
Other		—			—
Common Equity Tier 1 (“CET1”) Capital		379,393			364,145
Plus: Preferred stock		17,328			17,328
Less: Other		—			—
Tier 1 Capital		396,721			381,473
Plus: Qualifying allowance for credit losses		38,186			30,482
Subordinated Notes		39,258			39,273
Total regulatory capital	$	474,165		$	451,228
Adjusted average total assets (for leverage capital purposes)	$	4,713,549		$	4,237,596
Total risk-weighted assets	$	3,723,091		$	3,533,281
Regulatory Capital Ratios
Tier 1 Leverage (Tier 1 capital to adjusted average assets)		8.42	%		9.00	%
CET1 Capital (CET1 capital to total risk-weighted assets)		10.19			10.31
Tier 1 Capital (Tier 1 capital to total risk-weighted assets)		10.66			10.80
Total Risk-Based Capital (Total regulatory capital to total risk-weighted assets)		12.74			12.77

⁽¹⁾	Includes unrealized gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category.

We have elected to apply the 2020 CECL transition provision related to the impact of the CECL accounting standard on regulatory capital, as provided by the US banking agencies’ March 2020 interim final rule. Under the 2020 CECL transition provision, the regulatory capital impact of the Day 1 adjustment to the allowance for credit losses (after-tax) upon the January 1, 2020 CECL adoption date has been deferred, and will phase in to regulatory capital at 25% per year commencing January 1, 2022. For the ongoing impact of CECL, we are allowed to defer the regulatory capital impact of the allowance for credit losses in an amount equal to 25% of the change in the allowance for credit losses (pre-tax) recognized through earnings for each period between January 1, 2020, and December 31, 2021. The cumulative adjustment to the allowance for credit losses between January 1, 2020, and December 31, 2021, will also phase in to regulatory capital at 25% per year commencing January 1, 2022.

BCBS Capital Rules

The BCBS Capital Rules include a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, increase the minimum Tier 1 capital to risk-weighted assets ratio from 4.0% to 6.0%, require a minimum total capital to risk-weighted assets ratio of 8.0%, and require a minimum Tier 1 leverage ratio of 4.0%. A new capital conservation buffer is also established above the regulatory minimum capital requirements, effectively increasing the minimum required risk-weighted asset ratios. This capital conservation buffer was fully phased-in as of January 1, 2019 at 2.5% of risk-weighted assets. Banking institutions with a capital conservation buffer below the minimum level will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The BCBS Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to the Company or the Bank. Strict eligibility criteria for regulatory capital instruments were also implemented under the final rules. The final rules also revised the definition and calculation of Tier 1 capital, total capital, and risk-weighted assets.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following table presents actual and required capital ratios as of September 30, 2020 and December 31, 2019 for the Company and the Bank under the BCBS Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of those dates based on the phase-in provisions of the BCBS Capital Rules and the minimum required capital levels as of January 1, 2019 when the BCBS Capital Rules have been fully phased-in. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the BCBS Capital Rules (in thousands):

											Required to be
						Minimum Capital					Considered Well
	Actual					Required – Basel III					Capitalized
	Amount		Ratio			Amount		Ratio			Amount		Ratio
September 30, 2020
Tier 1 leverage:
Company	$	396,721		8.42	%	$	188,542		4.00	%	$	235,677		5.00	%
Bank		422,605		8.98			188,265		4.00			235,332		5.00
CET1 capital:
Company		379,393		10.19			260,616		7.00			242,001		6.50
Bank		422,605		11.38			259,959		7.00			241,391		6.50
Tier 1 capital:
Company		396,721		10.66			316,463		8.50			297,847		8.00
Bank		422,605		11.38			315,665		8.50			297,096		8.00
Total capital:
Company		474,165		12.74			390,925		10.50			372,309		10.00
Bank		460,791		12.41			389,939		10.50			371,370		10.00
December 31, 2019
Tier 1 leverage:
Company	$	381,473		9.00	%	$	169,504		4.00	%	$	211,880		5.00	%
Bank		409,031		9.67			169,189		4.00			211,486		5.00
CET1 capital:
Company		364,145		10.31			247,330		7.00			229,663		6.50
Bank		409,031		11.61			246,674		7.00			229,055		6.50
Tier 1 capital:
Company		381,473		10.80			300,329		8.50			282,663		8.00
Bank		409,031		11.61			299,533		8.50			281,914		8.00
Total capital:
Company		451,228		12.77			370,995		10.50			353,328		10.00
Bank		439,514		12.47			370,011		10.50			352,392		10.00

Dividend Restrictions

In the ordinary course of business, the Company is dependent upon dividends from the Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years.

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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk refers to the potential impact on earnings or capital arising from movements in interest rates. The Bank’s market risk management framework has been developed to control both short-term and long-term exposure within Board approved policy limits and is monitored by the Asset-Liability Management Committee and Board of Directors. Quantitative and qualitative disclosures about market risk were presented at December 31, 2019 in Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, as filed with the Securities and Exchange Commission on March 4, 2020. The following is an update of the discussion provided therein.

Portfolio Composition

There was no material change in the composition of assets, deposit liabilities or borrowings from December 31, 2019 to September 30, 2020, aside from asset growth due to the PPP program, remixing of the wholesale funding base and an increase Federal Reserve Bank excess cash position resulting from deposit growth. See the section titled “Analysis of Financial Condition” in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of asset, deposit and borrowing activity during the period.

Net Interest Income at Risk

A primary tool used to manage interest rate risk is “rate shock” simulation to measure the rate sensitivity. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income as well as economic value of equity.

Net interest income at risk is measured by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. The following table sets forth the estimated changes to net interest income over the 12-month period ending September 30, 2021 assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):

	Changes in Interest Rate
	-100 bp			+100 bp			+200 bp			+300 bp
Estimated change in net interest income	$	921		$	1,788		$	4,077		$	6,756
% Change		0.66	%		1.28	%		2.92	%		4.84	%

In the rising rate environments, the model results indicate increases in net interest income compared to the flat rate scenario over a one-year timeframe. This is a result of assumed commercial loan products repricing at a higher frequency than underlying borrowing and deposit costs. As intermediate and longer-term assets continue to mature and are replaced at higher yields, net interest income improves over longer term timeframes. Model results in the declining rate environments also indicate increases in net interest income due to floating rate loans, tied to Prime, no longer repricing downwards due to Prime rate being floored, while interest rate sensitive liabilities still have slight sensitivity to downward movement in rates.

In addition to the changes in interest rate scenarios listed above, other scenarios are typically modeled to measure interest rate risk. These scenarios vary depending on the economic and interest rate environment.

The simulation referenced above is based on our assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of future results, does not measure the effect of changing interest rates on noninterest income and is based on many assumptions that, if changed, could cause a different outcome.

Economic Value of Equity At Risk

The economic (or “fair”) value of financial instruments on our balance sheet will also vary under the interest rate scenarios previously discussed. This variance is measured by simulating changes in our economic value of equity (“EVE”), which is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while fair values of non-financial assets and liabilities are assumed to equal book value and do not vary with interest rate fluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the characteristics of our balance sheet evolve and as interest rate and yield curve assumptions are updated.

The amount of change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical data (back-testing).

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The analysis that follows presents the estimated EVE resulting from market interest rates prevailing at a given quarter-end (“Pre-Shock Scenario”), and under other interest rate scenarios (each a “Rate Shock Scenario”) represented by immediate, permanent, parallel shifts in interest rates from those observed at September 30, 2020 and December 31, 2019 (dollars in thousands). The analysis additionally presents a measurement of the interest rate sensitivity at September 30, 2020 and December 31, 2019. EVE amounts are computed under each respective Pre-Shock Scenario and Rate Shock Scenario. An increase in the EVE amount is considered favorable, while a decline is considered unfavorable. The following table sets forth the estimated changes to EVE assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):

	September 30, 2020							December 31, 2019
Rate Shock Scenario:	EVE		Change		Percentage Change			EVE		Change			Percentage Change
Pre-Shock Scenario	$	545,804						$	632,832
- 100 Basis Points		549,695	$	3,891		0.71	%		676,362	$	43,530			6.88	%
+100 Basis Points		565,710		19,906		3.65			627,409		(5,423	)		(0.86	)
+ 200 Basis Points		587,022		41,218		7.55			614,927		(17,905	)		(2.83	)
+ 300 Basis Points		604,760		58,956		10.80			600,636		(32,196	)		(5.09	)

The decrease in the Pre-Shock Scenario EVE at September 30, 2020 compared to December 31, 2019 is a result of a 15% increase in non-public deposits. The decrease in the -100 basis point Rate Shock Scenario EVE is reflective of the assumption that deposit pricing is nearly floored and has the inability to reprice to a lower level. This is compounded by the assumption that the discount curve on the fixed rate portfolio is nearly floored, resulting in less premium on the portfolio in a falling rate environment. The overall level of change is in line with expectations due to the Federal Open Market Committee action to reduce the Federal Funds target rate by 150 basis points within the period and programs introduced to help small businesses with loans.

ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of September 30, 2020, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the SEC under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

From time to time we are a party to or otherwise involved in legal proceedings arising out of the normal course of business. Regardless of the outcome, litigation can have an adverse impact on us because of prosecution, defense and settlement costs, unfavorable awards, diversion of management resources and other factors.

We are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania. Plaintiffs seek class certification to represent classes of consumers in New York and Pennsylvania along with statutory damages, interest and declaratory relief. The plaintiffs seek to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves.

In February 2020, we agreed to engage in mediation with the plaintiffs but mediation has not yet commenced. On October 19, 2020, the Court granted plaintiffs’ motion for judgment on the pleadings dismissing our affirmative defense against one named New York plaintiff that his claim was time-barred under New York law, applying a six-year statute of limitations rather than the three years limitation period we had argued. Under the current scheduling order, briefing on any class certification request is scheduled to occur in November 2020.

If we settle these claims or the action is not resolved in our favor, we may suffer reputational damage and incur legal costs, settlements or judgments that exceed the amounts covered by our existing insurance policies. We can provide no assurances that our insurer will insure the legal costs, settlements or judgements we incur in excess of our deductible. If we are unsuccessful in defending ourselves from these claims or if our insurer does not insure us against legal costs we incur in excess of our deductible, the result may materially adversely affect our business, results of operations and financial condition.

ITEM 1A. Risk Factors

Except as stated below, there have been no material changes from the risk factors previously disclosed in Part I – Item 1A of the Company’s Form 10-K for the year ended December 31, 2019.

The ongoing novel coronavirus (“COVID-19”) pandemic, and governmental and individual efforts to contain the pandemic, have had a significant negative impact on the U.S. and global economy which has and will continue to adversely affect our business, financial condition and results of operations.

In response to the COVID-19 pandemic and resulting economic downturn, the Federal Reserve reduced the target federal funds rate to a range of 0.00% to 0.25% and has stated that it intends to keep the rate near 0.00% until signs of higher inflation and a tighter labor market emerge. This lower rate reduces the rate of interest we earn on loans and pay on borrowings and interest-bearing deposits, and can affect the value of financial instruments we hold. In an environment with lower interest rates, we will not be able to earn as much on our interest-earning assets, which will likely reduce net interest margin. In addition, our ability to earn interest and receive dividend income from investment securities will be reduced. If interest rates remain low for an extended period of time, our results of operations could be materially adversely affected.

The U.S. economy generally and our customers and employees in particular have been directly impacted by governmental orders reducing travel and in-person interactions. Executive orders from the Governor of the State of New York may impact our ability to keep our bank branch locations open. We expect we and our customers will continue to be impacted by social distancing efforts for the duration of the COVID-19 pandemic. A significant proportion of our employees are working remotely, which may slow response times to customers’ inquiries or preclude providing the level of service our employees are typically able to offer in person. Our reputation and results of operations may be impacted if our competitors are better able to adjust to the restrictions on in-person interactions and remote work. Furthermore, as our employees continue to work from home, our operational risk, including data security risk, is higher than it would otherwise be, as cybercriminal activity has increased in an attempt to profit from the disruption to typical operations. The cybersecurity-related risks we face include more phishing, malware, and other cybersecurity attacks, vulnerability to disruptions of our information technology infrastructure and telecommunications systems for remote operations, and unauthorized dissemination, misuse or destruction of confidential or valuable information.

While we have experienced higher loan origination volume due to the Paycheck Protection Program (“PPP”) under the CARES Act, there can be no assurance that the borrowers under the CARES Act programs will be able to pay the interest, and principal payments, if applicable, when they are due. If the borrower of a PPP loan fails to qualify for loan forgiveness under the program, we will have to hold the loan at an unfavorable interest rate as compared to a loan we may otherwise have extended to our customer. Even though those loans are guaranteed by the U.S. Small Business Association (the “SBA”), we may not be able to collect from the SBA as quickly as those payments come due, and our cash flow and earnings may be reduced accordingly. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which we originated, funded or serviced the PPP loan, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already made payment under the guaranty, seek recovery of any loss related to the deficiency from us. Originations for consumer indirect lending, which currently constitutes 23.6% of our total loans, have declined since the outbreak of the COVID-19 pandemic. If this trend continues, our financial condition and results of operations could be materially adversely affected.

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Our loan customers will likely be impacted by the overall decline in the U.S. economy, which may cause them to make late or reduced payments on their loans or default on their loans with us. In particular, our commercial mortgage customers may be experiencing higher rates of tenants not paying rent due to the COVID-19 pandemic. As a lender, we are exposed to the risk that customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. The collateral securing our indirect loan portfolio in particular may not be sufficient to cover the full value of an outstanding loan because the collateral, namely automobiles, are depreciating assets. Our credit risk has increased since the start of the COVID-19 pandemic and related decline in the U.S. economy. In the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from taking certain remediation actions, including foreclosure. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral, and we provide an allowance for estimated loan losses based on a number of factors. We believe that the allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, the allowance for loan losses may not be sufficient to cover the actual credit losses. We may have to increase the allowance in the future in response to the COVID-19 pandemic and resulting changes to the U.S. economy. The actual amount of future provisions for credit losses may vary from the amount of past provisions. The longer the economic results of the COVID-19 pandemic negatively impact our customers, the more likely our credit quality is to decline and the more likely our customers will be to default on their loans with us. Continued economic disruption and fear of the spread of COVID-19 could result in business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and commercial property vacancy rates and reduced profitability and ability for property owners to make mortgage payments. If a significant proportion of our customers are unable to repay their loans and the collateral securing repayment is insufficient to cover our losses, we may have to increase our allowance for credit losses - loans, the quality of our loan portfolio will decline, our net income will decrease and our results of operations will be materially adversely impacted. In addition, our capital and leverage ratios may be adversely impacted.

At September 30, 2020, we held $151.6 million in debt securities that are issued by state and local government agencies, or municipal bonds, that are backed by the credit and taxing power of the issuing jurisdiction. As these state and local governments experience the impacts of the pandemic and stay at home orders, they are earning less sales tax revenue while incurring higher than expected costs as a result of the COVID-19 pandemic. The impact of the COVID-19 pandemic may cause the credit rating of the municipal bonds we hold to be downgraded, which could in turn cause us to incur credit losses. If these bond issuers are unable to repay us when the bonds mature, we could lose our investment and our results of operations and cash flows could be materially adversely impacted.

The market volatility related to the COVID-19 pandemic has driven market values of publicly traded securities downward. Because the majority of our investment advisory revenue is from fees based on a percentage of assets under management, our investment advisory revenues and profitability have fallen and will continue to fluctuate with the overall market conditions.

The spread of COVID-19 has led to an economic recession and continues to cause severe disruptions in the U.S. economy. Should the COVID-19 pandemic continue for an extended period of time, our business, financial condition, results of operations and cash flows may likewise be materially adversely impacted for an extended period of time.

The value of our goodwill and other intangible assets may decline in the future.

As of September 30, 2020, we had $66.1 million of goodwill and $8.0 million of other intangible assets. Although we did not record any impairment to our goodwill for the first nine months of 2020, significant and sustained declines in our stock price and market capitalization, significant declines in our expected future cash flows, significant adverse changes in the business climate and slower growth rates, any or all of which could be materially impacted by the ongoing COVID-19 pandemic, may necessitate our taking charges in the future related to the impairment of our goodwill. If the recent capital markets downturn resulting from the COVID-19 pandemic continues for an extended period of time, or the capital markets continue to experience increased volatility, we may record an impairment to our goodwill in subsequent fiscal periods. Future regulatory actions could also have a material impact on assessments of goodwill for impairment. If the fair value of our net assets improves at a faster rate than the market value of our reporting units, or if we were to experience increases in book values of a reporting unit in excess of the increase in fair value of equity, we may also have to take charges related to the impairment of our goodwill. If we were to conclude that a future write-down of our goodwill is necessary, we would record the appropriate charge, which could have a material adverse effect on our results of operations.

Identifiable intangible assets other than goodwill consist of core deposit intangibles and other intangible assets (primarily customer relationships). Adverse events or circumstances could impact the recoverability of these intangible assets including loss of core deposits, significant losses of customer accounts and/or balances, increased competition or adverse changes in the economy, such as those related to the ongoing COVID-19 pandemic. To the extent these intangible assets are deemed unrecoverable, a non-cash impairment charge would be recorded which could have a material adverse effect on our results of operations.

For further discussion, see Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements (Unaudited) included in Item 1 of this Quarterly Report on Form 10-Q.

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ITEM 6. Exhibits

(a)	The following is a list of all exhibits filed or incorporated by reference as part of this Report:

Exhibit Number	Description	Location

4.1	Subordinated Indenture, dated as of October 7, 2020, between Financial Institutions, Inc. and Wilmington Trust, National Association, as Trustee	Incorporated by reference to Exhibit 4.1 of the Form 8-K, dated October 7, 2020

4.2	Form of 4.375% Fixed-to-Floating Rate Subordinated Note due October 15, 2030 (included in Exhibit 4.1)	Incorporated by reference to Exhibit 4.2 of the Form 8-K, dated October 7, 2020

10.1	Subordinated Note Purchase Agreement, dated as of October 7, 2020, by and among Financial Institutions, Inc. and the Purchasers*	Filed Herewith

10.2	Registration Rights Agreement, dated as of October 7, 2020, by and among Financial Institutions, Inc. and the Purchasers	Filed Herewith

31.1	Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Principal Executive Officer	Filed Herewith

31.2	Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Principal Financial Officer	Filed Herewith

32	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	Filed Herewith

101.INS	Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.

101.SCH	Inline XBRL Taxonomy Extension Schema Document

101.CAL	Inline XBRL Taxonomy Extension Calculation Linkbase Document

101.LAB	Inline XBRL Taxonomy Extension Label Linkbase Document

101.PRE	Inline XBRL Taxonomy Extension Presentation Linkbase Document

101.DEF	Inline XBRL Taxonomy Extension Definition Linkbase Document

104	Cover Page Interactive Data File (embedded within the Inline XBRL document)

* Schedules and similar attachments have been omitted pursuant to Item 601(a)(5) of Regulation S-K. The registrant will furnish a copy of any omitted schedule or similar attachment to the Securities and Exchange Commission upon request.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

FINANCIAL INSTITUTIONS, INC.

/s/ Martin K. Birmingham		, November 6, 2020
Martin K. Birmingham
President and Chief Executive Officer
(Principal Executive Officer)

/s/ Justin K. Bigham		, November 6, 2020
Justin K. Bigham
Executive Vice President and Chief Financial Officer
(Principal Financial Officer)

/s/ Sonia M. Dumbleton		, November 6, 2020
Sonia M. Dumbleton
Senior Vice President and Controller
(Principal Accounting Officer)

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Exhibit 10.1

SUBORDINATED NOTE PURCHASE AGREEMENT

This SUBORDINATED NOTE PURCHASE AGREEMENT (this “Agreement”) is dated as of October 7, 2020, and is made by and among Financial Institutions, Inc., a New York corporation (the “Company”), and the several purchasers of the Subordinated Notes (as defined herein) identified on the signature pages hereto (each a “Purchaser” and collectively, the “Purchasers”).

RECITALS

WHEREAS, the Company has requested that the Purchasers purchase from the Company up to $35.0 million in aggregate principal amount of Subordinated Notes, which aggregate amount is intended to qualify as Tier 2 Capital (as defined herein).

WHEREAS, the Company has engaged Piper Sandler & Co., as its exclusive placement agent (“Placement Agent”) for the offering of the Subordinated Notes.

WHEREAS, each of the Purchasers is an institutional accredited investor as such term is defined in Rule 501(a)(1), (2), (3) or (7) of Regulation D (“Regulation D”) promulgated under the Securities Act of 1933, as amended (the “Securities Act”) or a QIB as such term is defined in Rule 144A(a)(1) promulgated under the Securities Act (“QIB”).

WHEREAS, the offer and sale of the Subordinated Notes by the Company is being made in reliance upon the exemptions from registration available under Section 4(a)(2) of the Securities Act and Rule 506(b) of Regulation D promulgated under the Securities Act.

WHEREAS, each Purchaser is willing to purchase from the Company a Subordinated Note in the principal amount set forth on such Purchaser’s respective signature page hereto (the “Subordinated Note Amount”) in accordance with the terms, subject to the conditions and in reliance on, the recitals, representations, warranties, covenants and agreements set forth herein and in the Subordinated Notes.

WHEREAS, at Closing, the Company and the Purchasers shall execute and deliver a Registration Rights Agreement, substantially in the form attached hereto as Exhibit B (the “Registration Rights Agreement”), pursuant to which, among other things, the Company will agree to provide certain registration rights with respect to the Securities under the Securities Act and the rules and regulations promulgated thereunder and applicable state securities laws.

NOW, THEREFORE, in consideration of the mutual covenants, conditions and agreements herein contained and other good and valuable consideration, the receipt of which is hereby acknowledged, the parties hereto hereby agree as follows:

AGREEMENT

1.DEFINITIONS.

1.1Defined Terms. The following capitalized terms used in this Agreement and in the Subordinated Notes have the meanings defined or referenced below. Certain other capitalized terms used only in specific sections of this Agreement may be defined in such sections. Terms used herein and not defined below shall have the meaning set forth in the Indenture.

“Affiliate(s)” means, with respect to any Person, such Person’s immediate family members, partners, members or parent and subsidiary corporations, and any other Person directly or indirectly controlling, controlled by, or under common control with said Person and their respective Affiliates.

“Agreement” has the meaning set forth in the preamble hereto.

“Bank” means Five Star Bank, a New York chartered bank, and wholly owned subsidiary of the Company.

“Business Day” means any day other than a Saturday, Sunday or any other day on which banking institutions in the State of New York are permitted or required by any applicable law or executive order to close; provided that banking institutions shall not be deemed to be authorized or obligated to be closed due to a “shelter in place,” “non-essential employee” or similar closure of physical branch locations at the direction of any governmental authority if such banking institutions’ electronic funds transfer systems (including for wire transfers) are open for use by customers on such day.

“Bylaws” means the Bylaws of the Company, as in effect on the Closing Date.

“Charter” means the Certificate of Incorporation of the Company, as in effect on the Closing Date.

“Closing” has the meaning set forth in Section 2.5.

“Closing Date” means October 7, 2020

“Company” has the meaning set forth in the preamble hereto and shall include any successors to the Company.

“Company Covered Person” has the meaning set forth in Section 4.2.4.

“Company’s Reports” means (i) the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 as filed with the SEC, including the audited financial statements contained therein; (ii) the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2020, as filed with the SEC, including the unaudited financial statements contained therein, and (iii) the Company’s public reports for the year ended December 31, 2019 and the period ended June 30, 2020, as filed with the FRB as required by regulations of the FRB.

“Disbursement” has the meaning set forth in Section 3.1.

“Disqualification Event” has the meaning set forth in Section 4.2.4.

“DTC” has the meaning set forth in Section 3.1.

“Equity Interest” means any and all shares, interests, participations or other equivalents (however designated) of capital stock of a corporation, any and all equivalent ownership interests in a Person which is not a corporation, and any and all warrants, options or other rights to purchase any of the foregoing.

“Event of Default” has the meaning set forth in the Subordinated Notes.

“Exchange Act” means the Securities Exchange Act of 1934, as amended.

“FDIC” means the Federal Deposit Insurance Corporation.

“FRB” means the Board of Governors of the Federal Reserve System.

“GAAP” means generally accepted accounting principles in effect from time to time in the United States of America.

“Global Note” has the meaning set forth in Section 3.1.

“Governmental Agency(ies)” means, individually or collectively, any federal, state, county or local governmental department, commission, board, regulatory authority or agency (including, without limitation, each applicable Regulatory Agency) with jurisdiction over the Company or a Subsidiary of the Company.

“Governmental Licenses” has the meaning set forth in Section 4.3.

“Hazardous Materials” means flammable explosives, asbestos, urea formaldehyde insulation, polychlorinated biphenyls, radioactive materials, hazardous wastes, toxic or contaminated substances or similar materials, including, without limitation, any substances which are “hazardous substances,” “hazardous wastes,” “hazardous materials” or “toxic substances” under the Hazardous Materials Laws and/or other applicable environmental laws, ordinances or regulations.

“Hazardous Materials Laws” mean any laws, regulations, permits, licenses or requirements pertaining to the protection, preservation, conservation or regulation of the environment which relates to real property, including: the Clean Air Act, as amended, 42 U.S.C. Section 7401 et seq.; the Federal Water Pollution Control Act, as amended, 33 U.S.C. Section 1251 et seq.; the Resource Conservation and Recovery Act of 1976, as amended, 42 U.S.C. Section 6901 et seq.; the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (including the Superfund Amendments and Reauthorization Act of 1986), 42 U.S.C. Section 9601 et seq.; the Toxic Substances Control Act, as amended, 15 U.S.C. Section 2601 et seq.; the Occupational Safety and Health Act, as amended, 29 U.S.C. Section 651, the Emergency Planning and Community Right-to-Know Act of 1986, 42 U.S.C. Section 11001 et seq.; the Mine Safety and Health Act of 1977, as amended, 30 U.S.C. Section 801 et seq.; the Safe Drinking Water Act, 42 U.S.C. Section 300f et seq.; and all comparable state and local laws, laws of other jurisdictions or orders and regulations.

“Indebtedness” means: (i) all items arising from the borrowing of money that, according to GAAP as in effect from time to time, would be included in determining total liabilities as shown on the consolidated balance sheet of the Company; and (ii) all obligations secured by any lien in property owned by the Company or any Subsidiary whether or not such obligations shall have been assumed; provided, however, Indebtedness shall not include deposits or other indebtedness created, incurred or maintained in the ordinary course of the Company’s or the Bank’s business (including, without limitation, federal funds purchased, advances from any Federal Home Loan Bank, secured deposits of municipalities, letters of credit issued by the Company or the Bank and repurchase arrangements) and consistent with customary banking practices and applicable laws and regulations.

“Indenture” means the indenture, dated as of the date hereof, by and between the Company and Wilmington Trust, N.A., as trustee, substantially in the form attached hereto as Exhibit A, as the same may be amended or supplemented from time to time in accordance with the terms thereof.

“Leases” means all leases, licenses or other documents providing for the use or occupancy of any portion of any Property, including all amendments, extensions, renewals, supplements, modifications, sublets and assignments thereof and all separate letters or separate agreements relating thereto.

“Material Adverse Effect” means, with respect to any Person, any change or effect that (i) is or would be reasonably likely to be material and adverse to the financial condition, results of operations or business of such Person and its Affiliates, or (ii) would materially impair the ability of such Person to perform its respective obligations under any of the Transaction Documents, or otherwise materially impede the consummation of the transactions contemplated hereby; provided, however, that “Material Adverse Effect” shall not be deemed to include the impact of (1) changes in banking and similar laws, rules or regulations of general applicability or interpretations thereof by Governmental Agencies, (2) changes in GAAP or regulatory accounting requirements applicable to financial institutions and their holding companies generally, (3) changes in general economic or capital market conditions affecting financial institutions or their market prices generally and not specifically related to the Company, the Bank or the Purchasers, (4) the effects of the COVID-19 pandemic that do not disproportionately affect the operations or business of the Company in comparison to other banking institutions with similar operations, (5) direct effects of compliance with this Agreement on the operating performance of the Company, the Bank or the Purchasers, including expenses incurred by the Company, the Bank or the Purchasers in consummating the transactions contemplated by this Agreement, and (6) the effects of any action or omission taken by the Company with the prior written consent of the Purchasers, and vice versa, or as otherwise contemplated by this Agreement and the Subordinated Notes.

“Maturity Date” means October 15, 2030.

“Person” means an individual, a corporation (whether or not for profit), a partnership, a limited liability company, a joint venture, an association, a trust, an unincorporated organization, a government or any department or agency thereof (including a Governmental Agency) or any other entity or organization.

“Placement Agent” has the meaning set forth in the Recitals.

“Property” means any real property owned or leased by the Company or any Affiliate or Subsidiary of the Company.

“Purchaser” or “Purchasers” has the meaning set forth in the preamble hereto.

“QIB” has the meaning set forth in the Recitals.

“Registration Rights Agreement” has the meaning set forth in the Recitals.

“Regulation D” has the meaning set forth in the Recitals.

“Regulatory Agency” means any federal or state agency charged with the supervision or regulation of depository institutions or holding companies of depository institutions, or engaged in the insurance of depository institution deposits, or any court, administrative agency or commission or other authority, body or agency having supervisory or regulatory authority with respect to the Company, the Bank or any of their Subsidiaries.

“SEC” means the Securities and Exchange Commission.

“Secondary Market Transaction” has the meaning set forth in Section 5.5.

“Securities Act” has the meaning set forth in the Recitals.

“Subordinated Note” means the Subordinated Note (or collectively, the “Subordinated Notes”) in the form attached as an exhibit to the Indenture, as amended, restated, supplemented or modified from time to time, and each Subordinated Note delivered in substitution or exchange for such Subordinated Note.

“Subordinated Note Amount” has the meaning set forth in the Recitals.

“Subsidiary” means with respect to any Person, any corporation or entity (other than a trust) in which a majority of the outstanding Equity Interest is directly or indirectly owned by such Person.

“Tier 2 Capital” has the meaning given to the term “Tier 2 capital” in 12 C.F.R. Part 217, as amended, modified and supplemented and in effect from time to time or any replacement thereof.

“Tier 2 Capital Event” has the meaning set forth in the Indenture.

“Transaction Documents” has the meaning set forth in Section 3.2.1.1.

“Trustee” means the trustee or successor in accordance with the applicable provisions of the Indenture.

1.2Interpretations. The foregoing definitions are equally applicable to both the singular and plural forms of the terms defined. The words “hereof”, “herein” and “hereunder” and words of like import when used in this Agreement shall refer to this Agreement as a whole and not to any particular provision of this Agreement. The word “including” when used in this Agreement without the phrase “without limitation,” shall mean “including, without limitation.” All references to time of day herein are references to Eastern Time unless otherwise specifically provided. All references to this Agreement, the Subordinated Notes and the Indenture shall be deemed to be to such documents as amended, modified or restated from time to time. With respect to any reference in this Agreement to any defined term, (i) if such defined term refers to a Person, then it shall also mean all heirs, legal representatives and permitted successors and assigns of such Person, and (ii) if such defined term refers to a document, instrument or agreement, then it shall also include any amendment, replacement, extension or other modification thereof.

1.3Exhibits Incorporated. All Exhibits attached hereto are hereby incorporated into this Agreement.

2.SUBORDINATED DEBT.

2.1Certain Terms. Subject to the terms and conditions herein contained, the Company proposes to issue and sell to the Purchasers, severally and not jointly, Subordinated Notes, which will be issued pursuant to the Indenture, in an aggregate principal amount equal to the aggregate of the Subordinated Note Amounts. The Purchasers, severally and not jointly, each agree to purchase the Subordinated Notes, which will be issued pursuant to the Indenture, from the Company on the Closing Date in accordance with the terms of, and subject to the conditions and provisions set forth in, this Agreement, the Subordinated Notes and the Indenture. The Subordinated Note Amounts shall be disbursed in accordance with Section 3.1.

2.2Subordination. The Subordinated Notes shall be subordinated in accordance with the subordination provisions set forth therein.

2.3Maturity Date. On the Maturity Date, all sums due and owing under this Agreement and the Subordinated Notes shall be repaid in full. The Company acknowledges and agrees that the Purchasers have not made any commitments, either express or implied, to extend the terms of the Subordinated Notes

past their Maturity Date, and shall not extend such terms beyond the Maturity Date unless the Company and the Purchasers hereafter specifically otherwise agree in writing.

2.4Unsecured Obligations. The obligations of the Company to the Purchasers under the Subordinated Notes shall be unsecured.

2.5The Closing. The execution and delivery of the Transaction Documents (the “Closing”) shall occur on the Closing Date at such place or time or on such other date as the parties hereto may agree.

2.6Payments. The Company agrees that matters concerning payments and application of payments shall be as set forth in this Agreement, the Indenture and the Subordinated Notes.

2.7No Right of Offset. Each Purchaser hereby expressly waives any right of offset it may have against the Company or any of its Subsidiaries.

2.8Use of Proceeds. The Company shall use the net proceeds from the sale of Subordinated Notes for general corporate purposes, organic growth and to support the Bank’s regulatory capital ratios.

3.DISBURSEMENT.

3.1Disbursement. On the Closing Date, assuming all of the terms and conditions set forth in Section 3.2 have been satisfied by the Company and the Company has executed and delivered to each of the Purchasers this Agreement and any other related documents in form and substance reasonably satisfactory to the Purchasers, each Purchaser shall disburse to the Company in immediately available funds the Subordinated Note Amount set forth on each Purchaser’s respective signature page hereto to the Company in exchange for an electronic securities entitlement through the facilities of the Depository Trust Company (“DTC”) with a principal amount equal to such Subordinated Note Amount (the “Disbursement”). The Company will deliver to the Trustee a global certificate (the “Global Note”) representing the Subordinated Notes, registered in the name of Cede & Co. as nominee for DTC.

3.2Conditions Precedent to Disbursement.

3.2.1Conditions to the Purchasers’ Obligation. The obligation of each Purchaser to consummate the purchase of the Subordinated Notes to be purchased by such Purchaser at Closing and to effect the Disbursement is subject to delivery by or at the direction of the Company to such Purchaser (or, with respect to the Indenture, the Trustee) each of the following (or written waiver of delivery by such Persons prior to the Closing):

3.2.1.1Transaction Documents. This Agreement, the Indenture, the Global Note and the Registration Rights Agreement (collectively, the “Transaction Documents”), each duly authorized and executed by the Company, and the delivery of written instruction to the Trustee (with respect to the Indenture).

3.2.1.2Authority Documents.

(a)A copy, certified by the Secretary or Assistant Secretary of the Company, of the Charter of the Company;

(b)A certificate of good standing of the Company issued by the Secretary of State of the State of New York; and a certificate of good standing of the Bank issued by the New York State Department of Financial Services;

(c)A copy, certified by the Secretary or Assistant Secretary, of the Bylaws of the Company;

(d)A copy, certified by the Secretary or Assistant Secretary of the Company, of the resolutions of the board of directors of the Company, and any committee thereof, authorizing the issuance of the Subordinated Note and the execution, delivery and performance of the Transaction Documents;

(e)An incumbency certificate of the Secretary or Assistant Secretary of the Company certifying the names of the officer or officers of the Company authorized to sign the Transaction Documents and the other documents provided for in this Agreement; and

(f)The opinion of Harter Secrest & Emery LLP, counsel to the Company, dated as of the Closing Date, substantially in the form set forth at Exhibit C attached hereto addressed to the Purchasers and Placement Agent.

3.2.1.3Other Documents and Information. Such other certificates, affidavits, schedules, resolutions, notes and/or other documents which are provided for hereunder or as a Purchaser may reasonably request.

3.2.1.4Aggregate Investments. Prior to, or contemporaneously with the Closing, each Purchaser shall have actually subscribed for the Subordinated Note Amount set forth on such Purchaser’s signature page to this Agreement.

3.2.2Conditions to the Company’s Obligation. With respect to a given Purchaser, the obligation of the Company to consummate the sale of the Subordinated Notes and to effect the Closing is subject to delivery by or at the direction of such Purchaser to the Company of this Agreement and the Registration Rights Agreement, duly authorized and executed by such Purchaser.

4.REPRESENTATIONS AND WARRANTIES OF THE COMPANY.

The Company hereby represents and warrants to each Purchaser as follows:

4.1Organization and Authority.

4.1.1Organization Matters of the Company and Its Subsidiaries.

4.1.1.1The Company is a duly organized corporation, is validly existing and in good standing under the laws of the State of New York and has all requisite corporate power and authority to conduct its business and activities as presently conducted, to own its properties, and to perform its obligations under the Transaction Documents. The Company is duly qualified as a foreign corporation to transact business and is in good standing in each other jurisdiction in which such qualification is required, whether by reason of the ownership or leasing of property or the conduct of business, except where the failure to so qualify or to be in good standing would not result in a Material Adverse Effect. The Company is duly registered as a financial holding company under the Bank Holding Company Act of 1956, as amended.

4.1.1.2Schedule 4.1.1.2 sets forth the only direct or indirect Subsidiaries of the Company. Each Subsidiary of the Company, other than the Bank, either has been duly organized and is validly existing as a corporation or limited liability company, or, in the case of the Bank, has been duly chartered and is validly existing as a commercial bank, in each case in good standing under the laws

of the jurisdiction of its incorporation, has corporate, trust or limited liability company power, as applicable, and authority to own, lease and operate its properties and to conduct its business and is duly qualified as a foreign corporation to transact business and is in good standing in each jurisdiction in which such qualification is required, whether by reason of the ownership or leasing of property or the conduct of business, except where the failure to so qualify or to be in good standing would not reasonably be expected to result in a Material Adverse Effect. All of the issued and outstanding shares of capital stock or other equity interests in each Subsidiary of the Company have been duly authorized and validly issued, are fully paid and non-assessable (to the extent such concepts apply to entities other than corporations) and are owned by the Company, directly or through Subsidiaries of the Company, free and clear of any security interest, mortgage, pledge, lien, encumbrance or claim; none of the outstanding shares of capital stock of, or other Equity Interests in, any Subsidiary of the Company were issued in violation of the preemptive or similar rights of any security holder of such Subsidiary of the Company or any other entity.

4.1.1.3The deposit accounts of the Bank are insured by the FDIC up to applicable limits. The Bank has not received any notice or other information indicating that the Bank is not an “insured depository institution” as defined in 12 U.S.C. Section 1813, nor has any event occurred which could reasonably be expected to adversely affect the status of the Bank as an FDIC-insured institution.

4.1.2Capital Stock and Related Matters. The Charter of the Company authorizes the Company to issue: (i) 50,000,000 shares of common stock, par value $0.01 per share, and (ii) 210,000 shares of preferred stock, par value $100 per share, (a) 10,000 of which are designated as Class A Preferred Stock, with 1,533 designated as Series A 3% Preferred Stock and 7,503 designated as Fixed Rate Cumulative Perpetual Preferred Stock, Series A and (b) 200,000 of which are designated as Series B-1 8.48% Preferred Stock. As of the date of this Agreement, 16,038,220 shares of the Company’s common stock, 1,435 shares of Series A 3% Preferred Stock and 171,847 shares of the Series B-1 8.48% Preferred Stock are issued and outstanding. All of the outstanding capital stock of the Company has been duly authorized and validly issued and is fully paid and non-assessable. There are, as of the date hereof, no outstanding options, rights, warrants or other agreements or instruments obligating the Company to issue, deliver or sell, or cause to be issued, delivered or sold, additional shares of the capital stock of the Company or obligating the Company to grant, extend or enter into any such agreement or commitment to any Person, other than in the ordinary course of business, consistent with past practice, pursuant to the Company’s equity compensation programs duly adopted by the Company’s Board of Directors.

4.2No Impediment to Transactions.

4.2.1Transaction is Legal and Authorized. The issuance of the Subordinated Notes pursuant to the Indenture, the borrowing of the aggregate of the Subordinated Note Amount, the execution of the Transaction Documents, and the compliance by the Company with all of the provisions of the Transaction Documents are within the corporate and other powers of the Company.

4.2.2Agreement, Indenture, and Registration Rights Agreement. This Agreement, the Indenture, and the Registration Rights Agreement have been duly authorized, executed and delivered by the Company, and, assuming due authorization, execution and delivery by the other parties hereto, including the Trustee for purposes of the Indenture, constitute the legal, valid and binding obligations of the Company, enforceable against the Company in accordance with their terms, except as enforcement thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to or affecting creditors’ rights generally or by general equitable principles.

4.2.3Subordinated Notes. The Subordinated Notes have been duly authorized by the Company and when executed by the Company and completed and authenticated by the Trustee in accordance with, and in the forms contemplated by, the Indenture and issued to, delivered to and paid for

by the Purchasers in accordance with the terms of the Agreement, will have been duly executed, authenticated, issued and delivered, under the Indenture and will constitute legal, valid and binding obligations of the Company, entitled to the benefits of the Indenture, and enforceable in accordance with their terms, except as enforcement thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to or affecting creditors’ rights generally or by general equitable principles. When executed and delivered, the Subordinated Notes will be substantially in the forms attached as exhibits to the Indenture.

4.2.4Exemption from Registration; No Disqualification Event. Neither the Company, nor any of its Subsidiaries or Affiliates, nor, to the Company’s knowledge, any Person acting on its or their behalf, has engaged in any form of general solicitation or general advertising (within the meaning of Regulation D) in connection with the offer or sale of the Subordinated Notes. Assuming the accuracy of the representations and warranties of each Purchaser set forth in this Agreement, the Subordinated Notes will be issued in a transaction exempt from the registration requirements of the Securities Act. No “bad actor” disqualifying event described in Rule 506(d)(1)(i)-(viii) of the Securities Act (a “Disqualification Event”) is applicable to the Company or, to the Company’s knowledge, any Person described in Rule 506(d)(1) (each, a “Company Covered Person”). The Company has exercised reasonable care to determine whether any Company Covered Person is subject to a Disqualification Event. The Company has complied, to the extent applicable, with its disclosure obligations under Rule 506(e).

4.2.5No Defaults or Restrictions. Neither the execution and delivery of the Transaction Documents by the Company nor compliance by the Company with their respective terms and conditions will (whether with or without the giving of notice or lapse of time or both) (i) violate, conflict with or result in a breach of, or constitute a default under: (1) the Charter or Bylaws of the Company; (2) any of the terms, obligations, covenants, conditions or provisions of any corporate restriction or of any contract, agreement, indenture, mortgage, deed of trust, pledge, bank loan or credit agreement, or any other agreement or instrument to which the Company or the Bank, as applicable, is now a party or by which it or any of its properties may be bound or affected; (3) any judgment, order, writ, injunction, decree or demand of any court, arbitrator, grand jury, or Governmental Agency applicable to the Company or the Bank; or (4) any statute, rule or regulation applicable to the Company, except, in the case of items (2), (3) or (4), for such violations, conflicts, breaches or defaults that would not reasonably be expected to have, singularly or in the aggregate, a Material Adverse Effect on the Company and its Subsidiaries taken as a whole, or (ii) result in the creation or imposition of any lien, charge or encumbrance of any nature whatsoever upon any property or asset of the Company. Neither the Company nor the Bank is in default in the performance, observance or fulfillment of any of the terms, obligations, covenants, conditions or provisions contained in any indenture or other agreement creating, evidencing or securing Indebtedness of any kind or pursuant to which any such Indebtedness is issued, or any other agreement or instrument to which the Company or the Bank, as applicable, is a party or by which the Company or the Bank, as applicable, or any of its properties may be bound or affected, except, in each case, only such defaults that would not reasonably be expected to have, singularly or in the aggregate, a Material Adverse Effect on the Company.

4.2.6Governmental Consent. No governmental orders, permissions, consents, approvals or authorizations are required to be obtained by the Company that have not been obtained, and no registrations or declarations are required to be filed by the Company that have not been filed in connection with, or, in contemplation of, the execution and delivery of, and performance under, the Transaction Documents, except for applicable requirements, if any, of the Securities Act, the Exchange Act or state securities laws or “blue sky” laws of the various states and any applicable federal or state banking laws and regulations.

4.3Possession of Licenses and Permits. The Company and its Subsidiaries possess such permits, licenses, approvals, consents and other authorizations (collectively, “Governmental Licenses”)

issued by the appropriate Governmental Agencies necessary to conduct the business now operated by them except where the failure to possess such Governmental Licenses would not, singularly or in the aggregate, have a Material Adverse Effect on the Company or such applicable Subsidiary; the Company and each Subsidiary of the Company is in compliance with the terms and conditions of all such Governmental Licenses, except where the failure to so comply would not, individually or in the aggregate, have a Material Adverse Effect on the Company or such applicable Subsidiary of the Company; all of the Governmental Licenses are valid and in full force and effect, except where the invalidity of such Governmental Licenses or the failure of such Governmental Licenses to be in full force and effect would not have a Material Adverse Effect on the Company or such applicable Subsidiary of the Company. Neither the Company nor any Subsidiary of the Company has received any notice of proceedings relating to the revocation or modification of any such Governmental Licenses since December 31, 2015.

4.4Financial Condition.

4.4.1Company Financial Statements. The financial statements of the Company included in the Company’s Reports (including the related notes, where applicable), which have been made available to the Purchasers (i) have been prepared from, and are in accordance with, the books and records of the Company; (ii) fairly present in all material respects the results of operations, cash flows, changes in stockholders’ equity and financial position of the Company and its consolidated Subsidiaries, for the respective fiscal periods or as of the respective dates therein set forth (subject in the case of unaudited statements to recurring year-end audit adjustments normal in nature and amount), as applicable; (iii) complied as to form, as of their respective dates of filing in all material respects with applicable accounting and banking requirements as applicable, with respect thereto; and (iv) have been prepared in accordance with GAAP consistently applied during the periods involved, except, in each case, (x) as indicated in such statements or in the notes thereto, (y) for any statement therein or omission therefrom that was corrected, amended, or supplemented or otherwise disclosed or updated in a subsequent Company’s Report, and (z) to the extent that any unaudited interim financial statements do not contain the footnotes required by GAAP, and were or are subject to normal and recurring year-end adjustments, which were not or are not expected to be material in amount, either individually or in the aggregate. The books and records of the Company have been, and are being, maintained in all material respects in accordance with GAAP and any other applicable legal and accounting requirements. The Company does not have any material liability of any nature whatsoever (whether absolute, accrued, contingent or otherwise and whether due or to become due) required to be reflected on or reserved against in a balance sheet in accordance with GAAP, except for those liabilities that are reflected or reserved against on the consolidated balance sheet of the Company contained in the Company’s Reports for the Company’s most recently completed quarterly or annual fiscal period, as applicable, and for liabilities incurred in the ordinary course of business consistent with past practice or in connection with this Agreement and the transactions contemplated hereby.

4.4.2Absence of Default. Since December 31, 2019, no event has occurred which either of itself or with the lapse of time or the giving of notice or both, would give any creditor of the Company the right to accelerate the maturity of any material Indebtedness of the Company. The Company is not in default under any Lease, agreement or instrument, or any law, rule, regulation, order, writ, injunction, decree, determination or award, non-compliance with which could reasonably be expected to result in a Material Adverse Effect on the Company.

4.4.3Solvency. After giving effect to the consummation of the transactions contemplated by this Agreement, the Company has capital sufficient to carry on its business and transactions and is solvent and able to pay its debts as they mature. No transfer of property is being made and no Indebtedness is being incurred in connection with the transactions contemplated by this Agreement with the intent to hinder, delay or defraud either present or future creditors of the Company or any Subsidiary of the Company.

4.4.4Ownership of Property. The Company and each of its Subsidiaries has good and marketable title as to all real property owned by it and good title to all assets and properties owned by the Company and such Subsidiary in the conduct of its businesses, whether such assets and properties are real or personal, tangible or intangible, including assets and property reflected in the most recent balance sheet contained in the Company’s Reports or acquired subsequent thereto (except to the extent that such assets and properties have been disposed of in the ordinary course of business, since the date of such balance sheet), subject to no encumbrances, liens, mortgages, security interests or pledges, except (i) those items which secure liabilities for public or statutory obligations or any discount with, borrowing from or other obligations to the Federal Home Loan Bank, inter-bank credit facilities, reverse repurchase agreements or any transaction by the Bank acting in a fiduciary capacity, (ii) statutory liens for amounts not yet delinquent or which are being contested in good faith, (iii) such as would not be expected, individually or in the aggregate, to result in a Material Adverse Effect on the Company, and (iv) as disclosed in the Company’s Reports. The Company and each of its Subsidiaries, as lessee, has the right under valid and existing Leases of real and personal properties that are material to the Company or such Subsidiary, as applicable, in the conduct of its business to occupy or use all such properties as presently occupied and used by it.

4.5No Material Adverse Effect. Except as set forth in the Company’s Reports, since December 31, 2019, there has been no development or event which has had or could reasonably be expected to have a Material Adverse Effect on the Company or any of its Subsidiaries.

4.6Legal Matters.

4.6.1Compliance with Law. The Company and each of its Subsidiaries (i) has complied with and, (ii) is not under investigation with respect to, and, to the Company’s knowledge, has not been threatened to be charged with or given any notice of any material violation of any applicable statutes, rules, regulations, orders and restrictions of any domestic or foreign government, or any instrumentality or agency thereof, having jurisdiction over the conduct of its business or the ownership of its properties, except where any such failure to comply or violation would not reasonably be expected to have a Material Adverse Effect on the Company and its Subsidiaries taken as a whole. The Company and each of its Subsidiaries is in compliance with, and has been in compliance with, (x) all statutes, rules, regulations, orders and restrictions of any domestic or foreign government, or any Governmental Agency, applicable to it, and (y) its own privacy policies and written commitments to customers, consumers and employees, concerning data protection, the privacy and security of personal data, and the nonpublic personal information of its customers, consumers and employees, in each case except where any such failure to comply, would not result, either individually or in the aggregate, in a Material Adverse Effect. At no time during the two years prior to the date hereof has the Company or any of its Subsidiaries received any written notice asserting any violations of any of the foregoing.

4.6.2Regulatory Enforcement Actions. The Company, the Bank and its other Subsidiaries are in compliance in all material respects with all laws administered by and regulations of any Governmental Agency applicable to it or to them, except where the failure to comply would not have a Material Adverse Effect. None of the Company, the Bank, the Company’s or the Bank’s Subsidiaries nor any of their officers or directors is now operating under any restrictions, agreements, memoranda, commitment letter, supervisory letter or similar regulatory correspondence, or other commitments (other than restrictions of general application) imposed by any Governmental Agency, nor are, to the Company’s knowledge, (a) any such restrictions threatened, (b) any agreements, memoranda or commitments being sought by any Governmental Agency, or (c) any legal or regulatory violations previously identified by, or penalties or other remedial action previously imposed by, any Governmental Agency remains unresolved.

4.6.3Pending Litigation. Except as set forth in the Company’s Reports, there are no actions, suits, proceedings or written agreements pending, or, to the Company’s knowledge, threatened or

proposed, against the Company or any of its Subsidiaries at law or in equity or before or by any federal, state, municipal, or other governmental department, commission, board, or other administrative agency, domestic or foreign, that, either separately or in the aggregate, would reasonably be expected to have a Material Adverse Effect on the Company and any of its Subsidiaries, taken as a whole, or affect issuance or payment of the Subordinated Notes; and neither the Company nor any of its Subsidiaries is a party to or named as subject to the provisions of any order, writ, injunction, or decree of, or any written agreement with, any court, commission, board or agency, domestic or foreign, that either separately or in the aggregate, would reasonably be expected to have a Material Adverse Effect on the Company and any of its Subsidiaries, taken as a whole.

4.6.4Environmental. No Property is or, to the Company’s knowledge, has been a site for the use, generation, manufacture, storage, treatment, release, threatened release, discharge, disposal, transportation or presence of any Hazardous Materials and neither the Company nor any of its Subsidiaries has engaged in such activities. There are no claims or actions pending or, to the Company’s knowledge, threatened against the Company or any of its Subsidiaries by any Governmental Agency or by any other Person relating to any Hazardous Materials or pursuant to any Hazardous Materials Law.

4.6.5Brokerage Commissions. Except for commissions paid to the Placement Agent, neither the Company nor any Affiliate of the Company is obligated to pay any brokerage commission or finder’s fee to any Person in connection with the transactions contemplated by this Agreement.

4.6.6Investment Company Act. Neither the Company nor any of its Subsidiaries is an “investment company” or a company “controlled” by an “investment company,” within the meaning of the Investment Company Act of 1940, as amended.

4.7No Misstatement or Omission. As of the date of this Agreement, none of the representations, warranties, covenants and agreements contained in this Agreement or in any certificate or other document delivered to the Purchasers by or on behalf of the Company pursuant to, or in connection with, this Agreement contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements contained therein not misleading in light of the circumstances when made or furnished to Purchasers.

4.8Internal Accounting Controls and Disclosure Controls. The Company, the Bank and each other Subsidiary has established and maintains a system of internal control over financial reporting that pertains to the maintenance of records that accurately and fairly reflect the transactions and dispositions of the Company’s assets (on a consolidated basis), provides reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s and the Bank’s receipts and expenditures and receipts and expenditures of each of the Company’s other Subsidiaries are being made only in accordance with authorizations of the Company management and Board of Directors, and provides reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets of the Company on a consolidated basis that could have a Material Adverse Effect. Such internal control over financial reporting is effective to provide reasonable assurance regarding the reliability of the Company’s financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with GAAP. Since the conclusion of the Company’s last completed fiscal year there has not been and there currently is not (i) any significant deficiency or material weakness in the design or operation of its internal control over financial reporting which is reasonably likely to adversely affect its ability to record, process, summarize and report financial information, or (ii) any fraud, whether or not material, that involves management or other employees who have a role in the Company’s or the Bank’s internal control over financial reporting. The Company (A) has implemented and maintains disclosure controls and procedures reasonably designed and maintained to ensure that material information relating to the Company is made known to the Chief

Executive Officer and the Chief Financial Officer of the Company by others within the Company and (B) has disclosed, based on its most recent evaluation prior to the date hereof, to the Company’s outside auditors and the audit committee of the Company’s Board of Directors any significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the Company’s internal controls over financial reporting. Such disclosure controls and procedures are effective for the purposes for which they were established.

4.9Tax Matters. The Company, the Bank and each Subsidiary of the Company have (i) filed all material foreign, U.S. federal, state and local tax returns, information returns and similar reports that are required to be filed, and all such tax returns are true, correct and complete in all material respects, and (ii) paid all material taxes required to be paid by it and any other material assessment, fine or penalty levied against it other than taxes (x) currently payable without penalty or interest, or (y) being contested in good faith by appropriate proceedings.

4.10Exempt Offering. Assuming the accuracy of the Purchasers’ representations and warranties set forth in this Agreement, no registration under the Securities Act is required for the offer and sale of the Subordinated Notes by the Company to the Purchasers.

4.11Representations and Warranties Generally. The representations and warranties of Company set forth in this Agreement and in any certificate or other document delivered to the Purchasers by or on behalf of Company, Bank or any of their Subsidiaries pursuant to or in connection with this Agreement that do not contain a “Material Adverse Effect” qualification or other express materiality or similar qualification are true and correct as of the date hereof and as of the Closing Date, except where the failure of such representations and warranties to be so true and correct does not have a Material Adverse Effect; provided, however, that any such representations and warranties made as of a specified date need only be true and correct as of such date. The representations and warranties of Company set forth in this Agreement and in any certificate or other document delivered to Purchaser by or on behalf of Company, Bank or any of their Subsidiaries pursuant to or in connection with this Agreement that contain a “Material Adverse Effect” qualification or any other express materiality or similar qualification are true and correct as of the date hereof and as of the Closing Date; provided, however, that any such representations and warranties made as of a specified date need only be true and correct as of such date.

5.GENERAL COVENANTS, CONDITIONS AND AGREEMENTS.

The Company hereby further covenants and agrees with each Purchaser as follows:

5.1Compliance with Transaction Documents. The Company shall comply with, observe and timely perform each and every one of the covenants, agreements and obligations of the Company under the Transaction Documents.

5.2Affiliate Transactions. The Company shall not itself, nor shall it cause, permit or allow any of its Subsidiaries to enter into any material transaction, including, the purchase, sale or exchange of property or the rendering of any service, with any Affiliate of the Company except upon terms consistent with applicable laws and regulations and reasonably found by the appropriate board(s) of directors to be fair and reasonable and, except for those transactions set forth in Schedule 5.2, no less favorable to the Company or such Affiliate than would be obtained in a comparable arm’s length transaction with a Person not an Affiliate.

5.3Compliance with Laws.

5.3.1Generally. The Company shall comply and cause the Bank and each of its other Subsidiaries to comply in all material respects with all applicable statutes, rules, regulations, orders and restrictions in respect of the conduct of its business and the ownership of its properties, except, in each case, where such noncompliance would not reasonably be expected to have a Material Adverse Effect on the Company.

5.3.2Regulated Activities. The Company shall not itself, nor shall it cause, permit or allow the Bank or any other of its Subsidiaries to (i) engage in any business or activity not permitted by all applicable laws and regulations, except where such business or activity would not reasonably be expected to have a Material Adverse Effect on the Company, the Bank and/or its other Subsidiaries or (ii) make any loan or advance secured by the capital stock of another bank or depository institution, or acquire the capital stock, assets or obligations of or any interest in another bank or depository institution, in each case other than in accordance with applicable laws and regulations and safe and sound banking practices.

5.3.3Taxes. The Company shall and shall cause the Bank and any other of its Subsidiaries to promptly pay and discharge all taxes, assessments and other governmental charges imposed upon the Company, the Bank or any other of its Subsidiaries or upon the income, profits, or property of the Company or any Subsidiary and all claims for labor, material or supplies which, if unpaid, might by law become a lien or charge upon the property of the Company, the Bank or any other of its Subsidiaries, except as would not be reasonably expected to have a Material Adverse Effect on the Company. Notwithstanding the foregoing, none of the Company, the Bank or any other of its Subsidiaries shall be required to pay any such tax, assessment, charge or claim, so long as the validity thereof shall be contested in good faith by appropriate proceedings, and appropriate reserves therefor shall be maintained on the books of the Company, the Bank and such other Subsidiary.

5.3.4Corporate Existence. The Company shall do or cause to be done all things reasonably necessary to maintain, preserve and renew its corporate existence and that of the Bank and the other Subsidiaries and its and their rights and franchises, and comply in all material respects with all related laws applicable to the Company, the Bank or the other Subsidiaries.

5.3.5Dividends, Payments, and Guarantees During Event of Default. Upon the occurrence of an Event of Default (as defined under the Indenture), until such Event of Default is cured by the Company or waived by the Holders in accordance with the terms of the Indenture and except as required by any federal or state Governmental Agency, the Company shall not (a) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of its capital stock; (b) make any payment of principal of, or interest or premium, if any, on, or repay, repurchase or redeem any of the Company’s Indebtedness that ranks equal with or junior to the Subordinated Notes; or (c) make any payments under any guarantee that ranks equal with or junior to the Subordinated Notes, other than (i) any dividends or distributions in shares of, or options, warrants or rights to subscribe for or purchase shares of, any class of the Company’s common stock; (ii) any declaration of a non-cash dividend in connection with the implementation of a shareholders’ rights plan, or the issuance of stock under any such plan in the future, or the redemption or repurchase of any such rights pursuant thereto; (iii) as a result of a reclassification of the Company’s capital stock or the exchange or conversion of one class or series of the Company’s capital stock for another class or series of the Company’s capital stock; (iv) the purchase of fractional interests in shares of the Company’s capital stock pursuant to the conversion or exchange provisions of such capital stock or the security being converted or exchanged; or (v) purchases of any class of the Company’s common stock related to the issuance of common stock or rights under any benefit plans for the Company’s directors, officers or employees or any of the Company’s dividend reinvestment plans.

5.3.6Tier 2 Capital. If all or any portion of the Subordinated Notes ceases to be deemed to be Tier 2 Capital, other than due to the limitation imposed on the capital treatment of subordinated debt during the five (5) years immediately preceding the Maturity Date of the Subordinated Notes, the Company will immediately notify the Holder, and thereafter, subject to the terms of the Indenture, the Company and the Holder will work together in good faith to execute and deliver all agreements as reasonably necessary in order to restructure the applicable portions of the obligations evidenced by the Subordinated Notes to qualify as Tier 2 Capital; provided, however, that nothing contained in this Agreement shall limit the Company’s right to redeem the Subordinated Notes upon the occurrence of a Tier 2 Capital Event as described in the Subordinated Notes and the Indenture.

5.4Absence of Control. It is the intent of the parties to this Agreement that in no event shall the Purchasers, by reason of any of the Transaction Documents, be deemed to control, directly or indirectly, the Company, and the Purchasers shall not exercise, or be deemed to exercise, directly or indirectly, a controlling influence over the management or policies of the Company.

5.5Secondary Market Transactions. Each Purchaser shall have the right at any time and from time to time to securitize its Subordinated Notes or any portion thereof in a single asset securitization or a pooled loan securitization of rated single or multi-class securities secured by or evidencing ownership interests in the Subordinated Notes (each such securitization is referred to herein as a “Secondary Market Transaction”). In connection with any such Secondary Market Transaction, the Company, at the Company’s expense, shall cooperate with the Purchasers and otherwise reasonably assist the Purchasers in satisfying the market standards to which Purchasers customarily adhere or which may be reasonably required in the marketplace or by applicable rating agencies in connection with any such Secondary Market Transaction, but in no event shall the Company be required to incur any costs or expenses in excess of $10,000 in connection therewith. Subject to any written confidentiality obligation, all information regarding the Company may be furnished, without liability except in the case of gross negligence or willful misconduct, to any the Purchaser and to any Person reasonably deemed necessary by Purchaser in connection with participation in such Secondary Market Transaction. The Purchaser shall cause any Person to whom the Purchaser wishes to deliver confidential Company information related to the Secondary Market Transaction (which shall not include the Transaction Documents) to execute and deliver to the Company a non-disclosure agreement reasonably acceptable to the Company unless such Person is a party to a commercially reasonable confidentiality agreement to which the Company is a third party beneficiary. All documents, financial statements, appraisals and other data relevant to the Company or the Subordinated Notes may be retained by any such Person, subject to the terms of any applicable confidentiality agreements.

5.6Bloomberg. The Company shall use commercially reasonable efforts to cause the Subordinated Notes to be quoted on Bloomberg.

5.7Rule 144A Information. While any Subordinated Notes remain “restricted securities” within the meaning of the Securities Act, the Company will make available, upon request of any Purchaser or subsequent holder of any Subordinated Notes the information specified in Rule 144A(d)(4) under the Securities Act, unless the Company is then subject to Section 13 or 15(d) of the Exchange Act.

5.8NRSRO Rating. The Company will use commercially reasonable efforts to maintain a rating by a nationally recognized statistical rating organization (“NRSRO”) while any Subordinated Notes remain outstanding.

5.9Resale Registration Statement. Subject to the terms and conditions of this Agreement, the Company will provide to the Purchasers the resale registration rights described in the Registration Rights Agreement.

6.REPRESENTATIONS, WARRANTIES AND COVENANTS OF THE PURCHASERS.

Each Purchaser hereby represents and warrants to the Company, and covenants with the Company, severally and not jointly, as follows:

6.1Legal Power and Authority. The Purchaser has all necessary power and authority to execute, deliver and perform its obligations under this Agreement and to consummate the transactions contemplated hereby. It is an entity duly organized, validly existing and in good standing under the laws of its jurisdiction of organization.

6.2Authorization and Execution. The execution, delivery and performance of this Agreement and the Registration Rights Agreement have been duly authorized by all necessary action on the part of such Purchaser, and, assuming due authorization, execution and delivery by the other parties thereto, this Agreement and the Registration Rights Agreement are each a legal, valid and binding obligation of such Purchaser, enforceable against such Purchaser in accordance with its terms, except as enforcement thereof may be limited by bankruptcy, insolvency, reorganization, moratorium or other similar laws relating to or affecting creditors’ rights generally or by general equitable principles.

6.3No Conflicts. Neither the execution, delivery of or performance under the Transaction Documents nor the consummation of any of the transactions contemplated thereby will conflict with, violate, or constitute a breach of or a default under (whether with or without the giving of notice or lapse of time or both) (i) the Purchaser’s organizational documents, (ii) any agreement to which the Purchaser is party, (iii) any law applicable to Purchaser or (iv) any order, writ, judgment, injunction, decree, determination or award binding upon or affecting the Purchaser.

6.4Purchase for Investment. The Purchaser is purchasing the Subordinated Note for its own account and not with a view to distribution and with no present intention of reselling, distributing or otherwise disposing of the same. The Purchaser has no present or contemplated agreement, undertaking, arrangement, obligation, Indebtedness or commitment providing for, or which is likely to compel, a disposition of the Subordinated Notes in any manner.

6.5Institutional Accredited Investor. The Purchaser is and will be on the Closing Date either (i) an institutional “accredited investor” as such term is defined in Rule 501(a) of Regulation D and as contemplated by subsections (1), (2), (3) and (7) of Rule 501(a) of Regulation D, and has no less than $5,000,000 in total assets, or (ii) a QIB.

6.6Financial and Business Sophistication. The Purchaser has such knowledge and experience in financial and business matters that it is capable of evaluating the merits and risks of the prospective investment in the Subordinated Notes. The Purchaser has relied solely upon its own knowledge of, and/or the advice of its own legal, financial or other advisors with regard to, the legal, financial, tax and other considerations involved in deciding to invest in the Subordinated Notes.

6.7Ability to Bear Economic Risk of Investment. The Purchaser recognizes that an investment in the Subordinated Notes involves substantial risk. The Purchaser has the ability to bear the economic risk of the prospective investment in the Subordinated Notes, including the ability to hold the Subordinated Notes indefinitely, and further including the ability to bear a complete loss of all of the Purchaser’s investment in the Company.

6.8Information. The Purchaser acknowledges that (i) it is not being provided with the disclosures that would be required if the offer and sale of the Subordinated Notes were registered under the Securities Act, nor is it being provided with any offering circular or prospectus prepared in connection with

the offer and sale of the Subordinated Notes; (ii) it has conducted its own examination of the Company and the terms of the Indenture and the Subordinated Notes to the extent it deems necessary to make its decision to invest in the Subordinated Notes; and (iii) it has availed itself of publicly available financial and other information concerning the Company to the extent it deems necessary to make its decision to purchase the Subordinated Notes. The Purchaser has reviewed the information set forth in the Company’s Reports, the exhibits hereto and the information contained in the data room established by the Company in connection with the transactions contemplated by this Agreement.

6.9Access to Information. The Purchaser acknowledges that it and its advisors have been furnished with all materials relating to the business, finances and operations of the Company that have been requested by it or its advisors and have been given the opportunity to ask questions of, and to receive answers from, persons acting on behalf of the Company concerning the terms and conditions of the transactions contemplated by this Agreement in order to make an informed and voluntary decision to enter into this Agreement.

6.10Investment Decision. The Purchaser has made its own investment decision based upon its own judgment, due diligence and advice from such advisors as it has deemed necessary and not upon any view expressed by any other Person or entity, including the Placement Agent (or with respect to the Indenture, the Trustee). Neither any inquiries nor any other due diligence investigations conducted by the Purchaser or its advisors or representatives, if any, shall modify, amend or affect its right to rely on the Company’s representations and warranties contained herein. The Purchaser is not relying upon, and has not relied upon, any advice, statement, representation or warranty made by any Person by or on behalf of the Company, including, without limitation, the Placement Agent (or with respect to the Indenture, the Trustee), except for the express statements, representations and warranties of the Company made or contained in this Agreement. Furthermore, the Purchaser acknowledges that (i) the Placement Agent has not performed any due diligence review on behalf of it and (ii) nothing in this Agreement or any other materials presented by or on behalf of the Company to the Purchaser in connection with the purchase of the Subordinated Notes constitutes legal, tax, accounting or investment advice.

6.11Private Placement; No Registration; Restricted Legends. The Purchaser understands and acknowledges that the Subordinated Notes are being sold by the Company without registration under the Securities Act in reliance on the exemption from federal and state registration set forth in, respectively, Rule 506(b) of Regulation D promulgated under Section 4(a)(2) of the Securities Act and Section 18 of the Securities Act, or any state securities laws, and accordingly, may be resold, pledged or otherwise transferred only if exemptions from the Securities Act and applicable state securities laws are available to it. It is not subscribing for the Subordinated Notes as a result of or subsequent to any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television, radio, the Internet or social media, or presented at any seminar or meeting. The Purchaser further acknowledges and agrees that all certificates or other instruments representing the Subordinated Notes will bear the restrictive legend set forth in the form of Subordinated Note, which are attached to the Indenture. The Purchaser further acknowledges its primary responsibilities under the Securities Act and, accordingly, will not sell or otherwise transfer the Subordinated Notes or any interest therein without complying with the requirements of the Securities Act and the rules and regulations promulgated thereunder and the requirements set forth in this Agreement.

6.12Placement Agent. The Purchaser will purchase the Subordinated Note(s) directly from the Company and not from the Placement Agent and understands that neither the Placement Agent nor any other broker or dealer has any obligation to make a market in the Subordinated Notes.

6.13Tier 2 Capital. If the Company provides notice as contemplated in Section 5.3.6 of the occurrence of the event contemplated in such section, thereafter the Company and the Purchasers will work

together in good faith to execute and deliver all agreements as reasonably necessary in order to restructure the applicable portions of the obligations evidenced by the Subordinated Notes so that the Subordinated Notes qualify as Tier 2 Capital; provided, however, that nothing contained in this Agreement shall limit the Company’s right to redeem the Subordinated Notes upon the occurrence of a Tier 2 Capital Event as described in the Subordinated Notes.

6.14Accuracy of Representations. The Purchaser understands that each of the Placement Agent and the Company are relying upon the truth and accuracy of the foregoing representations, acknowledgements and agreements in connection with the transactions contemplated by this Agreement, and agrees that if any of the representations or acknowledgements made by it are no longer accurate as of the Closing Date, or if any of the agreements made by it are breached on or prior to the Closing Date, it shall promptly notify the Company.

6.15Representations and Warranties Generally. The representations and warranties of the Purchaser set forth in this Agreement are true and correct as of the date hereof and will be true and correct as of the Closing Date and as otherwise specifically provided herein. Any certificate signed by a duly authorized representative of the Purchaser and delivered to the Company or to counsel for the Company shall be deemed to be a representation and warranty by the Purchaser to the Company as to the matters set forth therein.

7.MISCELLANEOUS.

7.1Prohibition on Assignment by the Company. Except as described in Article VII of the Indenture, the Company may not assign, transfer or delegate any of its rights or obligations under this Agreement or the Subordinated Notes without the prior written consent of all the Purchasers.

7.2Time of the Essence. Time is of the essence for this Agreement.

7.3Waiver or Amendment. No waiver or amendment of any term, provision, condition, covenant or agreement herein shall be effective unless in writing and signed by all of the parties hereto. No failure to exercise or delay in exercising, by a Purchaser or any Holder of the Subordinated Notes, of any right, power or privilege hereunder shall operate as a waiver thereof, nor shall any single or partial exercise of any right, power or privilege preclude any other or further exercise thereof, or the exercise of any other right or remedy provided by law. The rights and remedies provided in this Agreement are cumulative and not exclusive of any right or remedy provided by law or equity.

7.4Severability. Any provision of this Agreement which is unenforceable or invalid or contrary to law, or the inclusion of which would adversely affect the validity, legality or enforcement of this Agreement, shall be of no effect and, in such case, all the remaining terms and provisions of this Agreement shall subsist and be fully effective according to the tenor of this Agreement the same as though any such invalid portion had never been included herein. Notwithstanding any of the foregoing to the contrary, if any provisions of this Agreement or the application thereof are held invalid or unenforceable only as to particular Persons or situations, the remainder of this Agreement, and the application of such provision to Persons or situations other than those to which it shall have been held invalid or unenforceable, shall not be affected thereby, but shall continue valid and enforceable to the fullest extent permitted by law.

7.5Notices. Any notice which any party hereto may be required or may desire to give hereunder shall be deemed to have been given if in writing and if delivered personally, or if mailed, postage prepaid, by United States registered or certified mail, return receipt requested, or if delivered by a responsible overnight commercial courier promising next Business Day delivery, addressed:


if to the Company:	Financial Institutions, Inc. 220 Liberty Street Warsaw, NY 14569 Attention: General Counsel
with a copy to:	Harter Secrest & Emery LLP 1600 Bausch & Lomb Place Rochester, NY 14604-2711 Attention: Alexander R. McClean
if to the Purchasers:	To the address indicated on such Purchaser’s signature page.

or to such other address or addresses as the party to be given notice may have furnished in writing to the party seeking or desiring to give notice, as a place for the giving of notice; provided that no change in address shall be effective until five (5) Business Days after being given to the other party in the manner provided for above. Any notice given in accordance with the foregoing shall be deemed given when delivered personally or, if mailed, three (3) Business Days after it shall have been deposited in the United States mail as aforesaid or, if sent by overnight courier, the Business Day following the date of delivery to such courier (provided next Business Day delivery was requested).

7.6Successors and Assigns. This Agreement shall inure to the benefit of the parties hereto and their respective heirs, legal representatives, successors and assigns; except that, unless a Purchaser consents in writing, no assignment made by the Company in violation of this Agreement shall be effective or confer any rights on any purported assignee of the Company. The term “successors and assigns” will not include a purchaser of any of the Subordinated Notes from any Purchaser merely because of such purchase.

7.7No Joint Venture. Nothing contained herein or in any document executed pursuant hereto and no action or inaction whatsoever on the part of a Purchaser, shall be deemed to make a Purchaser a partner or joint venturer with the Company.

7.8Documentation. All documents and other matters required by any of the provisions of this Agreement to be submitted or furnished to a Purchaser shall be in form and substance satisfactory to such Purchaser.

7.9Entire Agreement. This Agreement, the Indenture, the Registration Rights Agreement and the Subordinated Notes, along with any exhibits thereto, constitute the entire agreement between the parties hereto with respect to the subject matter hereof and may not be modified or amended in any manner other than by supplemental written agreement executed by the parties hereto. No party, in entering into this Agreement, has relied upon any representation, warranty, covenant, condition or other term that is not set forth in this Agreement, the Indenture, the Registration Rights Agreement or the Subordinated Notes.

7.10Choice of Law. This Agreement shall be governed by and construed in accordance with the laws of the State of New York without giving effect to its laws or principles of conflict of laws. Nothing herein shall be deemed to limit any rights, powers or privileges which a Purchaser may have pursuant to

any law of the United States of America or any rule, regulation or order of any department or agency thereof and nothing herein shall be deemed to make unlawful any transaction or conduct by a Purchaser which is lawful pursuant to, or which is permitted by, any of the foregoing.

7.11No Third Party Beneficiary. This Agreement is made for the sole benefit of the Company and the Purchasers, and no other Person shall be deemed to have any privity of contract hereunder nor any right to rely hereon to any extent or for any purpose whatsoever, nor shall any other Person have any right of action of any kind hereon or be deemed to be a third party beneficiary hereunder; provided, that the Placement Agent may rely on the representations and warranties contained herein to the same extent as if it were a party to this Agreement.

7.12Legal Tender of United States. All payments hereunder shall be made in coin or currency which at the time of payment is legal tender in the United States of America for public and private debts.

7.13Captions; Counterparts. Captions contained in this Agreement in no way define, limit or extend the scope or intent of their respective provisions. This Agreement may be executed in any number of counterparts and by different parties hereto in separate counterparts, each of which when so executed and delivered shall be deemed to be an original and all of which taken together shall constitute but one and the same instrument. In the event that any signature is delivered by facsimile transmission, or by e-mail delivery of a “.pdf” format data file, such signature shall create a valid and binding obligation of the party executing (or on whose behalf such signature is executed) with the same force and effect as if such facsimile signature page were an original thereof.

7.14Knowledge; Discretion. All references herein to a Purchaser’s or the Company’s knowledge shall be deemed to mean the knowledge of such party based on the actual knowledge of such party’s Chief Executive Officer and Chief Financial Officer or such other persons holding equivalent offices. Unless specified to the contrary herein, all references herein to an exercise of discretion or judgment by a Purchaser, to the making of a determination or designation by a Purchaser, to the application of a Purchaser’s discretion or opinion, to the granting or withholding of a Purchaser’s consent or approval, to the consideration of whether a matter or thing is satisfactory or acceptable to a Purchaser, or otherwise involving the decision making of a Purchaser, shall be deemed to mean that such Purchaser shall decide using the reasonable discretion or judgment of a prudent lender.

7.15Waiver of Right to Jury Trial. TO THE EXTENT PERMITTED UNDER APPLICABLE LAW, THE PARTIES HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVE ANY RIGHT THAT THEY MAY HAVE TO A TRIAL BY JURY IN ANY LITIGATION ARISING IN ANY WAY IN CONNECTION WITH ANY OF THE TRANSACTION DOCUMENTS, OR ANY OTHER STATEMENTS OR ACTIONS OF THE COMPANY OR THE PURCHASERS. THE PARTIES HERETO ACKNOWLEDGE THAT THEY HAVE BEEN REPRESENTED IN THE SIGNING OF THIS AGREEMENT AND IN THE MAKING OF THIS WAIVER BY INDEPENDENT LEGAL COUNSEL SELECTED OF THEIR OWN FREE WILL. THE PARTIES FURTHER HERETO ACKNOWLEDGE THAT (I) THEY HAVE READ AND UNDERSTAND THE MEANING AND RAMIFICATIONS OF THIS WAIVER, (II) THIS WAIVER HAS BEEN REVIEWED BY THE PARTIES HERETO AND THEIR COUNSEL AND IS A MATERIAL INDUCEMENT FOR ENTRY INTO THIS AGREEMENT AND THE REGISTRATION RIGHTS AGREEMENT AND (III) THIS WAIVER SHALL BE EFFECTIVE AS TO EACH OF SUCH TRANSACTION DOCUMENTS AS IF FULLY INCORPORATED THEREIN.

7.16Expenses. Except as otherwise provided in this Agreement, each of the parties hereto will bear and pay all costs and expenses incurred by it or on its behalf in connection with the transactions contemplated by this Agreement.

7.17Survival. Each of the representations and warranties set forth in this Agreement shall survive the Closing for a period of one year after the date hereof. Except as otherwise provided herein, all covenants and agreements contained herein shall survive until, by their respective terms, they are no longer operative, other than those which by their terms are to be performed in whole or in part prior to or on the Closing Date, which shall terminate as of the Closing Date.

[Signature Pages Follow]

IN WITNESS WHEREOF, the Company has caused this Subordinated Note Purchase Agreement to be executed by its duly authorized representative as of the date first above written.


COMPANY:

FINANCIAL INSTITUTIONS, INC.


By:	/s/ Justin K. Bigham
	Name:	Justin K. Bigham
	Title:	Executive Vice President and Chief Financial Officer

[Company Signature Page to Subordinated Note Purchase Agreement]

IN WITNESS WHEREOF, the Purchaser has caused this Subordinated Note Purchase Agreement to be executed by its duly authorized representative as of the date first above written.


PURCHASER:

[INSERT PURCHASER’S NAME]


By:
	Name:	[●]
	Title:	[●]

Address of Purchaser:

[●]

Principal Amount of Purchased Subordinated Note:

$[●]

SCHEDULE 4.1.1.2

Subsidiaries

SCHEDULE 5.2

Affiliate Transactions

EXHIBIT A

FORM OF INDENTURE (INCLUDING FORM OF SUBORDINATED NOTE)

EXHIBIT B

REGISTRATION RIGHTS AGREEMENT

EXHIBIT C

OPINION OF COUNSEL

Exhibit 10.2

REGISTRATION RIGHTS AGREEMENT

This REGISTRATION RIGHTS AGREEMENT (the “Agreement”) is dated as of October 7, 2020 and is made by and among Financial Institutions, Inc. a New York corporation (the “Company”), and the several purchasers of the Subordinated Notes (as defined below) identified on the signature pages to the Purchase Agreement (as defined below) (collectively, the “Purchasers”).

This Agreement is made pursuant to the Subordinated Note Purchase Agreement dated October 7, 2020 by and among the Company and each of the Purchasers (the “Purchase Agreement”), which provides for the sale by the Company to the Purchasers of $35.0 million in aggregate principal amount of the Company’s 4.375% Fixed-to-Floating Rate Subordinated Notes due 2030, which were issued on October 7, 2020 (the “Subordinated Notes”). In order to induce the each of the Purchasers to enter into the Purchase Agreement and in satisfaction of a condition to the Purchasers’ obligations thereunder, the Company has agreed to provide to the Purchasers and their respective direct and indirect transferees and assigns the registration rights set forth in this Agreement. The execution and delivery of this Agreement is a condition to the closing under the Purchase Agreement.

In consideration of the foregoing, the parties hereto agree as follows:

1.Definitions. As used in this Agreement, the following capitalized defined terms shall have the following meanings:

“1933 Act” shall mean the Securities Act of 1933, as amended from time to time, and the rules and regulations of the SEC promulgated thereunder.

“1934 Act” shall mean the Securities Exchange Act of 1934, as amended from time to time, and the rules and regulations of the SEC promulgated thereunder.

“Additional Interest” shall have the meaning set forth in Section 2(e) hereof.

“Agreement” shall have the meaning set forth in the preamble to this Agreement.

“Closing Date” shall mean October 7, 2020.

“Company” shall have the meaning set forth in the preamble to this Agreement and also includes the Company’s successors.

“Depositary” shall mean The Depository Trust Company, or any other depositary appointed by the Company, including any agent thereof; provided, however, that any such depositary must at all times have an address in the Borough of Manhattan, The City of New York.

“Event Date” shall have the meaning set forth in Section 2(e).

“Exchange Offer” shall mean the exchange offer by the Company of Exchange Securities for Registrable Securities pursuant to Section 2(a) hereof.

“Exchange Offer Registration” shall mean a registration under the 1933 Act effected pursuant to Section 2(a) hereof.

“Exchange Offer Registration Statement” shall mean an exchange offer registration statement on Form S-4 (or, if applicable, on another appropriate form) covering the Registrable Securities, and all

amendments and supplements to such registration statement, in each case including the Prospectus contained therein, all exhibits thereto and all material incorporated or deemed to be incorporated by reference therein.

“Exchange Securities” shall mean the 4.375% Fixed-to-Floating Rate Subordinated Notes due 2030 issued by the Company under the Indenture containing terms substantially identical to the Subordinated Notes (except that (i) interest thereon shall accrue from the last date to which interest has been paid or duly provided for on the Subordinated Notes or, if no such interest has been paid or duly provided for, from the Interest Accrual Date, (ii) provisions relating to an increase in the stated rate of interest thereon upon the occurrence of a Registration Default shall be eliminated, (iii) the transfer restrictions and legends relating to restrictions on ownership and transfer thereof as a result of the issuance of the Subordinated Notes without registration under the 1933 Act shall be eliminated, (iv) the minimum denominations thereof shall be $100,000 and integral multiples of $1,000 and (v) all of the Exchange Securities will be represented by one or more global Exchange Securities in book-entry form unless exchanged for Exchange Securities in definitive certificated form under the circumstances provided in the Indenture) to be offered to Holders of Registrable Securities in exchange for Registrable Securities pursuant to the Exchange Offer.

“FINRA” shall mean the Financial Industry Regulatory Authority, Inc.

“Holders” shall mean (i) the Purchasers, for so long as they own any Registrable Securities, and each of their respective successors, assigns and direct and indirect transferees who become registered owners of Registrable Securities under the Indenture and (ii) each Participating Broker-Dealer that holds Exchange Securities for so long as such Participating Broker-Dealer is required to deliver a prospectus meeting the requirements of the 1933 Act in connection with any resale of such Exchange Securities.

“Indenture” shall mean the indenture, dated as of October 7, 2020 by and between the Company and Wilmington Trust, National Association, as trustee, as the same may be amended or supplemented from time to time in accordance with the terms thereof.

“Interest Accrual Date” means October 7, 2020.

“Majority Holders” shall mean the Holders of a majority of the aggregate principal amount of Registrable Securities outstanding, excluding Exchange Securities referred to in clause (ii) of the definition of “Holders” above; provided that whenever the consent or approval of Holders of a specified percentage of Registrable Securities or Exchange Securities is required hereunder, Registrable Securities and Exchange Securities held by the Company or any of its affiliates (as such term is defined in Rule 405 under the 1933 Act) shall be disregarded in determining whether such consent or approval was given by the Holders of such required percentage.

“Notifying Broker-Dealer” shall have the meaning set forth in Section 3(f).

“Participating Broker-Dealer” shall have the meaning set forth in Section 3(f).

“Person” shall mean an individual, partnership, joint venture, limited liability company, corporation, trust or unincorporated organization, or a government or agency or political subdivision thereof.

“Prospectus” shall mean the prospectus included in a Registration Statement, including any preliminary prospectus, and any such prospectus as amended or supplemented by any prospectus supplement, including a prospectus supplement with respect to the terms of the offering of any portion of the Registrable Securities covered by a Shelf Registration Statement, and by all other amendments and

supplements to a prospectus, including post-effective amendments, and in each case including all material incorporated or deemed to be incorporated by reference therein.

“Purchase Agreement” shall have the meaning set forth in the preamble to this Agreement.

“Purchasers” shall have the meaning set forth in the preamble of this Agreement.

“Registrable Securities” shall mean the Subordinated Notes; provided, however, that any Subordinated Notes shall cease to be Registrable Securities when (i) a Registration Statement with respect to such Subordinated Notes shall have been declared effective under the 1933 Act, (ii) such Subordinated Notes shall have been sold to the public pursuant to Rule 144 (or any similar provision then in force, but not Rule 144A) under the 1933 Act, or are eligible to be resold pursuant to Rule 144 without regard to the public information requirements thereunder, (iii) such Subordinated Notes shall have ceased to be outstanding, or (iv) such Subordinated Notes have been exchanged for Exchange Securities which have been registered pursuant to the Exchange Offer Registration Statement upon consummation of the Exchange Offer unless, in the case of any Exchange Securities referred to in this clause (v), such Exchange Securities are held by Participating Broker-Dealers or otherwise are not freely tradable by such Participating Broker-Dealers without any limitations or restrictions under the 1933 Act (in which case such Exchange Securities will be deemed to be Registrable Securities until such time as such Exchange Securities are sold to a purchaser in whose hands such Exchange Securities are freely tradeable without any limitations or restrictions under the 1933 Act).

“Registration Default” shall have the meaning set forth in Section 2(e).

“Registration Expenses” shall mean any and all reasonable expenses incident to performance of or compliance by the Company with this Agreement, including without limitation: (i) all SEC, stock exchange, or FINRA registration and filing fees, (ii) all fees and expenses incurred in connection with compliance with state or other securities or blue sky laws and compliance with the rules of FINRA (including reasonable fees and disbursements of one counsel for any Holders in connection with qualification of any of the Exchange Securities or Registrable Securities under state or other securities or blue sky laws and any filing with and review by FINRA), (iii) all expenses of any Persons in preparing, printing and distributing any Registration Statement, any Prospectus, any amendments or supplements thereto, securities sales agreements, certificates representing the Subordinated Notes or Exchange Securities and other documents relating to the performance of and compliance with this Agreement, (iv) all rating agency fees, (v) all fees and expenses incurred in connection with the listing, if any, of any of the Subordinated Notes or Exchange Securities on any securities exchange or exchanges or on any quotation system, (vi) all fees and disbursements relating to the qualification of the Indenture under applicable securities laws, (vii) the fees and disbursements of counsel for the Company and the fees and expenses of independent public accountants for the Company or for any other Person, business or assets whose financial statements are included in any Registration Statement or Prospectus, including the expenses of any special audits or “cold comfort” letters required by or incident to such performance and compliance, and (viii) the fees and expenses of the Trustee, any registrar, any depositary, any paying agent, any escrow agent or any custodian, in each case including fees and disbursements of their respective counsel.

“Registration Statement” shall mean any registration statement of the Company relating to any offering of the Exchange Securities or Registrable Securities pursuant to the provisions of this Agreement (including, without limitation, any Exchange Offer Registration Statement and any Shelf Registration Statement), and all amendments and supplements to any such registration statement, including post-effective amendments, in each case including the Prospectus contained therein, all exhibits thereto and all material incorporated or deemed to be incorporated by reference therein.

“SEC” shall mean the Securities and Exchange Commission or any successor thereto.

“Shelf Registration” shall mean a registration effected pursuant to Section 2(b) hereof.

“Shelf Registration Statement” shall mean a “shelf” registration statement of the Company pursuant to the provisions of Section 2(b) of this Agreement which covers all of the Registrable Securities, as the case may be, on an appropriate form under Rule 415 under the 1933 Act, or any similar rule that may be adopted by the SEC, and all amendments and supplements to such registration statement, including post-effective amendments, in each case including the Prospectus contained therein, all exhibits thereto and all material incorporated or deemed to be incorporated by reference therein.

“Subordinated Notes” shall have the meaning set forth in the preamble to this Agreement.

“TIA” shall mean the Trust Indenture Act of 1939, as amended from time to time, and the rules and regulations of the SEC promulgated thereunder.

“Trustee” shall mean the trustee with respect to the Subordinated Notes and the Exchange Securities under the Indenture.

For purposes of this Agreement, (i) all references in this Agreement to any Registration Statement or Prospectus or any amendment or supplement to any of the foregoing shall be deemed to include the copy filed with the SEC pursuant to its Electronic Data Gathering, Analysis and Retrieval system; (ii) all references in this Agreement to financial statements and schedules and other information which is “contained,” “included” or “stated” in any Registration Statement or Prospectus (or other references of like import) shall be deemed to mean and include all such financial statements and schedules and other information which is incorporated or deemed to be incorporated by reference in such Registration Statement or Prospectus, as the case may be; (iii) all references in this Agreement to amendments or supplements to any Registration Statement or Prospectus shall be deemed to mean and include the filing of any document under the 1934 Act which is incorporated or deemed to be incorporated by reference in such Registration Statement or Prospectus, as the case may be; (iv) all references in this Agreement to Rule 144, Rule 144A, Rule 405 or Rule 415 under the 1933 Act, and all references to any sections or subsections thereof or terms defined therein, shall in each case include any successor provisions thereto; and (v) all references in this Agreement to days (but not to business days) shall mean calendar days.

2.Registration Under the 1933 Act.

(a)Exchange Offer Registration. The Company shall (A) use its commercially reasonable efforts to file with the SEC on or prior to the 60^th day after the Closing Date an Exchange Offer Registration Statement covering the offer by the Company to the Holders to exchange all of the Registrable Securities for a like aggregate principal amount of Exchange Securities, (B) use its commercially reasonable efforts to cause such Exchange Offer Registration Statement to be declared effective by the SEC no later than the 120^th day after the Closing Date, (C) use its commercially reasonable efforts to cause such Registration Statement to remain effective until the closing of the Exchange Offer and (D) use its commercially reasonable efforts to consummate the Exchange Offer no later than 45 days after the effective date of the Exchange Offer Registration Statement. Upon the effectiveness of the Exchange Offer Registration Statement, the Company shall promptly commence the Exchange Offer, it being the objective of such Exchange Offer to enable each Holder eligible and electing to exchange Registrable Securities for Exchange Securities (assuming that such Holder is not an affiliate of the Company within the meaning of Rule 405 under the 1933 Act, acquires the Exchange Securities in the ordinary course of such Holder’s business and has no arrangements or understandings with any Person to participate in the Exchange Offer for the purpose of distributing such Exchange Securities) to trade such Exchange Securities from and after their receipt

without any limitations or restrictions under the 1933 Act or under the securities or blue sky laws of the states of the United States.

In connection with the Exchange Offer, the Company shall:

(i)promptly mail or otherwise transmit, in compliance with the applicable procedures of the Depositary for such Registrable Securities, to each Holder a copy of the Prospectus forming part of the Exchange Offer Registration Statement, together with an appropriate letter of transmittal and related documents;

(ii)keep the Exchange Offer open for not less than 20 business days (or longer if required by applicable law) after the date notice thereof is mailed to the Holders and, during the Exchange Offer, offer to all Holders who are legally eligible to participate in the Exchange Offer the opportunity to exchange their Registrable Securities for Exchange Securities;

(iii)use the services of the Depositary for the Exchange Offer;

(iv)permit Holders to withdraw tendered Registrable Securities at any time prior to the close of business, Eastern time, on the last business day on which the Exchange Offer shall remain open, by sending to the institution and at the address specified in the Prospectus or the related letter of transmittal or related documents an electronic or facsimile transmission or letter setting forth the name of such Holder, the principal amount of Registrable Securities delivered for exchange, and a statement that such Holder is withdrawing its election to have such Subordinated Notes exchanged;

(v)notify each Holder that any Registrable Security not tendered will remain outstanding and continue to accrue interest, but will not retain any rights under this Agreement (except in the case of Participating Broker-Dealers as provided herein); and

(vi)otherwise comply in all material respects with all applicable laws relating to the Exchange Offer.

The Exchange Securities shall be issued under the Indenture, which shall be qualified under the TIA. The Indenture shall provide that the Exchange Securities and the Subordinated Notes shall vote and consent together on all matters as a single class and shall constitute a single series of debt securities issued under the Indenture.

As soon as reasonably practicable after the close of the Exchange Offer, the Company shall:

(i)accept for exchange all Registrable Securities duly tendered and not validly withdrawn pursuant to the Exchange Offer in accordance with the terms of the Exchange Offer Registration Statement and the letter of transmittal which is an exhibit thereto;

(ii)deliver, or cause to be delivered, to the Trustee for cancellation all Registrable Securities so accepted for exchange by the Company; and

(iii)cause the Trustee promptly to authenticate and deliver Exchange Securities to each Holder of Registrable Securities so accepted for exchange equal in principal amount to the principal amount of the Registrable Securities of such Holder so accepted for exchange.

Interest on each Exchange Security will accrue from the last date on which interest was paid or duly provided for on the Subordinated Notes surrendered in exchange therefor or, if no interest has been

paid or duly provided for on such Subordinated Notes, from the Interest Accrual Date. The Exchange Offer shall not be subject to any conditions, other than (i) that the Exchange Offer, or the making of any exchange by a Holder, does not violate any applicable law or any applicable interpretation of the staff of the SEC, (ii) that no action or proceeding shall have been instituted or threatened in any court or by or before any governmental agency with respect to the Exchange Offer which, in the Company’s judgment, would reasonably be expected to impair the ability of the Company to proceed with the Exchange Offer, and (iii) that the Holders tender the Registrable Securities to the Company in accordance with the Exchange Offer. Each Holder of Registrable Securities (other than Participating Broker-Dealers) who wishes to exchange such Registrable Securities for Exchange Securities in the Exchange Offer will be required to represent that (i) it is not an affiliate (as defined in Rule 405 under the 1933 Act) of the Company, (ii) any Exchange Securities to be received by it will be acquired in the ordinary course of business, (iii) it has no arrangement with any Person to participate in the distribution (within the meaning of the 1933 Act) of the Exchange Securities, and (iv) it is not acting on behalf of any Person who could not truthfully make the statements set forth in clauses (i), (ii) and (iii) immediately above, and shall be required to make such other representations as may be reasonably necessary under applicable SEC rules, regulations or interpretations to render the use of Form S-4 or another appropriate form under the 1933 Act available.

(b)Shelf Registration. (i) If, because of any change in law or applicable interpretations thereof by the staff of the SEC, the Company is not permitted to effect the Exchange Offer as contemplated by Section 2(a) hereof, or (ii) if for any other reason (A) the Exchange Offer Registration Statement is not declared effective within 120 days following the Closing Date or (B) the Exchange Offer is not consummated within 45 days after effectiveness of the Exchange Offer Registration Statement (provided that if the Exchange Offer Registration Statement shall be declared effective after such 120-day period or if the Exchange Offer shall be consummated after such 45-day period, then the Company’s obligations under this clause (ii) arising from the failure of the Exchange Offer Registration Statement to be declared effective within such 120-day period or the failure of the Exchange Offer to be consummated within such 45-day period, respectively, shall terminate), or (iii) if any Holder is not eligible to participate in the Exchange Offer or elects to participate in the Exchange Offer but does not receive Exchange Securities which are freely tradeable without any limitations or restrictions under the 1933 Act, the Company shall, at its cost:

(A)use its commercially reasonable efforts to file with the SEC on or prior to (a) the 180th day after the Closing Date or (b) the 60th day after any such filing obligation arises, whichever is later, a Shelf Registration Statement relating to the offer and sale of the Registrable Securities by the Holders from time to time in accordance with the methods of distribution elected by the Majority Holders of such Registrable Securities and set forth in such Shelf Registration Statement;

(B)use its commercially reasonable efforts to cause such Shelf Registration Statement to be declared effective by the SEC as promptly as practicable, but in no event later than (a) the 225^th day after the Closing Date or (b) the 105^th day after an obligation to file with the SEC a Shelf Registration Statement arises, whichever is later. In the event that the Company is required to file a Shelf Registration Statement pursuant to clause (iii) above, the Company shall file and use its commercially reasonable efforts to have declared effective by the SEC both an Exchange Offer Registration Statement pursuant to Section 2(a) with respect to all Registrable Securities and a Shelf Registration Statement (which may be a combined Registration Statement with the Exchange Offer Registration Statement) with respect to offers and sales of Registrable Securities held by such Holder described in clause (iii) above;

(C)use its commercially reasonable efforts to keep the Shelf Registration Statement continuously effective, supplemented and amended as required, in order to permit the Prospectus

forming part thereof to be usable by Holders for a period of one year after the latest date on which any Subordinated Notes are originally issued by the Company (subject to extension pursuant to the last paragraph of Section 3) or, if earlier, when all of the Registrable Securities covered by such Shelf Registration Statement (i) have been sold pursuant to the Shelf Registration Statement in accordance with the intended method of distribution thereunder, or (ii) cease to be Registrable Securities; and

(D)notwithstanding any other provisions hereof, use its commercially reasonable efforts to ensure that (i) any Shelf Registration Statement and any amendment thereto and any Prospectus forming a part thereof and any supplements thereto comply in all material respects with the 1933 Act, (ii) any Shelf Registration Statement and any amendment thereto does not, when it becomes effective, contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading and (iii) any Prospectus forming part of any Shelf Registration Statement and any amendment or supplement to such Prospectus does not include an untrue statement of a material fact or omit to state a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading; provided, however, clauses (ii) and (iii) shall not apply to any statement in or omission from a Shelf Registration Statement or a Prospectus made in reliance upon and conformity with information relating to any Holder or Participating Broker-Dealer of Registrable Securities furnished to the Company in writing by such Holder or Participating Broker-Dealer, respectively, expressly for use in such Shelf Registration Statement or Prospectus.

The Company further agrees, if necessary, to supplement or amend the Shelf Registration Statement if reasonably requested by the Majority Holders with respect to information relating to the Holders and otherwise as required by Section 3(b) below, to use its commercially reasonable efforts to cause any such amendment to become effective and such Shelf Registration Statement to become usable as soon as reasonably practicable thereafter and to furnish to the Holders of Registrable Securities copies of any such supplement or amendment promptly after its being used or filed with the SEC.

(c)Expenses. The Company shall pay all Registration Expenses in connection with the registration pursuant to Section 2(a) and 2(b) and, in the case of any Shelf Registration Statement, will reimburse the Holders for the reasonable fees and disbursements of one counsel (in addition to any local counsel) designated in writing by the Majority Holders to act as counsel for the Holders of the Registrable Securities in connection therewith; provided, however, that the Company shall not be responsible for reimbursement for the fees and disbursements of such counsel in an aggregate amount in excess of $10,000. Each Holder shall pay all fees and disbursements of its counsel other than as set forth in the preceding sentence or in the definition of Registration Expenses and all underwriting discounts and commissions and transfer taxes, if any, relating to the sale or disposition of such Holder’s Registrable Securities pursuant to a Shelf Registration Statement.

(d)Effective Registration Statement.

(i)The Company shall be deemed not to have used its commercially reasonable efforts to cause the Exchange Offer Registration Statement or any Shelf Registration Statement, as the case may be, to become, or to remain, effective during the requisite periods set forth herein if the Company voluntarily takes any action that could reasonably be expected to result in any such Registration Statement not being declared effective or remaining effective or in the Holders of Registrable Securities (including, under the circumstances contemplated by Section 3(f) hereof, Exchange Securities) covered thereby not being able to exchange or offer and sell such Registrable Securities during that period unless (A) such action is required by applicable law or (B) such action is taken by the Company in good faith and for valid business reasons (but not including avoidance

of the Company’s obligations hereunder), including, but not limited to, the acquisition or divestiture of assets or a material corporate transaction or event, or if the Company determines in good faith that effecting or maintaining the availability of the registration would materially and adversely affect an offering of securities of the Company or if the Company is in possession of material non-public information the disclosure of which would not be in the best interests of the Company, in each case so long as the Company promptly complies with the notification requirements of Section 3(k) hereof, if applicable. Nothing in this paragraph shall prevent the accrual of Additional Interest on any Registrable Securities or Exchange Securities.

(ii)An Exchange Offer Registration Statement pursuant to Section 2(a) hereof or a Shelf Registration Statement pursuant to Section 2(b) hereof shall not be deemed to have become effective unless it has been declared effective by the SEC; provided, however, that if, after such Registration Statement has been declared effective, the offering of Registrable Securities pursuant to a Registration Statement is interfered with by any stop order, injunction or other order or requirement of the SEC or any other governmental agency or court, such Registration Statement shall be deemed not to have been effective during the period of such interference until the offering of Registrable Securities pursuant to such Registration Statement may legally resume.

(iii)During any 365-day period, the Company may, by notice as described in Section 3(e), suspend the availability of a Shelf Registration Statement (and, if the Exchange Offer Registration Statement is being used in connection with the resale of Exchange Securities by Participating Broker-Dealers as contemplated by Section 3(f), the Exchange Offer Registration Statement) and the use of the related Prospectus for up to two periods of up to 60 consecutive days each (except for the consecutive 60-day period immediately prior to final maturity of the Subordinated Notes), but no more than an aggregate of 120 days during any 365-day period, upon (a) the happening of any event or the discovery of any fact referred to in Section 3(e)(vi), or (b) if the Company determines in good faith that effecting or maintaining the availability of the registration would materially and adversely affect an offering of securities of the Company or if the Company is in possession of material non-public information the disclosure of which would not be in the best interests of the Company, in each case subject to compliance by the Company with its obligations under the last paragraph of Section 3.

(e)Increase in Interest Rate. In the event that:

(i)the Exchange Offer Registration Statement is not filed with the SEC on or prior to the 60^th day following the Closing Date, or

(ii)the Exchange Offer Registration Statement is not declared effective by the SEC on or prior to the 120^th day following the Closing Date, or

(iii)the Exchange Offer is not consummated on or prior to the 45^th day following the effective date of the Exchange Offer Registration Statement, or

(iv)if required, a Shelf Registration Statement is not filed with the SEC on or prior to (A) the 180^th day following the Closing Date or (B) the 60^th day after the obligation to file with the SEC a Shelf Registration Statement arises, whichever is later, or

(v)if required, a Shelf Registration Statement is not declared effective on or prior to (a) the 225^th day following the Closing Date or (b) the 105^th day after an obligation to file with the SEC a Shelf Registration Statement arises, whichever is later, or

(vi)a Shelf Registration Statement is declared effective by the SEC but such Shelf Registration Statement ceases to be effective or such Shelf Registration Statement or the Prospectus included therein ceases to be usable in connection with resales of Registrable Securities for any reason and (A) the aggregate number of days in any consecutive 365-day period for which the Shelf Registration Statement or such Prospectus shall not be effective or usable exceeds 120 days, (B) the Shelf Registration Statement or such Prospectus shall not be effective or usable for more than two periods (regardless of duration) in any consecutive 365-day period or (C) the Shelf Registration Statement or such Prospectus shall not be effective or usable for a period of more than 90 consecutive days, or

(vii)the Exchange Offer Registration Statement is declared effective by the SEC but, if the Exchange Offer Registration Statement is being used in connection with the resale of Exchange Securities as contemplated by Section 3(f) of this Agreement, the Exchange Offer Registration Statement ceases to be effective or the Exchange Offer Registration Statement or the Prospectus included therein ceases to be usable in connection with resales of Exchange Securities for any reason during the 180-day period referred to in Section 3(f)(B) of this Agreement (as such period may be extended pursuant to the last paragraph of Section 3 of this Agreement) and (A) the aggregate number of days in any consecutive 365-day period for which the Exchange Offer Registration Statement or such Prospectus shall not be effective or usable exceeds 120 days, (B) the Exchange Offer Registration Statement or such Prospectus shall not be effective or usable for more than two periods (regardless of duration) in any consecutive 365-day period or (C) the Exchange Offer Registration Statement or the Prospectus shall not be effective or usable for a period of more than 90 consecutive days,

(each of the events referred to in clauses (i) through (vii) above being hereinafter called a “Registration Default”), the per annum interest rate borne by the Registrable Securities shall be increased (“Additional Interest”) by one-quarter of one percent (0.25%) per annum immediately following such 60-day period in the case of clause (i) above, immediately following such 120-day period in the case of clause (ii) above, immediately following such 45-day period in the case of clause (iii) above, immediately following any such 180-day period or 60-day period, whichever ends later, in the case of clause (iv) above, immediately following any such 225-day period or 105-day period, as applicable, in the case of clause (v) above, immediately following the 120^th day in any consecutive 365-day period, as of the first day of the third period in any consecutive 365-day period or immediately following the 90th consecutive day, whichever occurs first, that a Shelf Registration Statement shall not be effective or a Shelf Registration Statement or the Prospectus included therein shall not be usable as contemplated by clause (vi) above, or immediately following the 120^th day in any consecutive 365-day period, as of the first day of the third period in any consecutive 365-day period or immediately following the 90^th consecutive day, whichever occurs first, that the Exchange Offer Registration Statement shall not be effective or the Exchange Offer Registration Statement or the Prospectus included therein shall not be usable as contemplated by clause (vii) above, which rate will be increased by an additional one-quarter of one percent (0.25%) per annum immediately following each 90-day period that any Additional Interest continues to accrue under any circumstances; provided that, if at any time more than one Registration Default has occurred and is continuing, then, until the next date that there is no Registration Default, the increase in interest rate provided for by this paragraph shall apply as if there occurred a single Registration Default that begins on the date that the earliest such Registration Default occurred and ends on such date that there is no Registration Default; provided further, that the aggregate increase in such annual interest rate may in no event exceed one-half of one percent (0.50%) per annum. Upon the filing of the Exchange Offer Registration Statement after the 60-day period described in clause (i) above, the effectiveness of the Exchange Offer Registration Statement after the 120-day period described in clause (ii) above, the consummation of the Exchange Offer after the 45-day period described in clause (iii) above, the filing of the Shelf Registration Statement after the 180-day period or 60-day period, as the case may be, described in clause (iv) above, the effectiveness of a Shelf Registration

Statement after the 225-day period or 105-day period, as applicable, described in clause (v) above, or the Shelf Registration Statement once again being effective or the Shelf Registration Statement and the Prospectus included therein becoming usable in connection with resales of Registrable Securities, as the case may be, in the case of clause (vi) above, or the Exchange Offer Registration Statement once again becoming effective or the Exchange Offer Registration Statement and the Prospectus included therein becoming usable in connection with resales of Exchange Securities, as the case may be, in the case of clause (vii) thereof, the interest rate borne by the Subordinated Notes from the date of such filing, effectiveness, consummation or resumption of effectiveness or usability, as the case may be, shall be reduced to the original interest rate so long as no other Registration Default shall have occurred and shall be continuing at such time and the Company is otherwise in compliance with this paragraph; provided, however, that, if after any such reduction in interest rate, one or more Registration Defaults shall again occur, the interest rate shall again be increased pursuant to the foregoing provisions (as if it were the original Registration Default). Notwithstanding anything in this Agreement to the contrary, the Company will not be obligated to pay any Additional Interest in the case of a Shelf Registration Statement with respect to any Holder of Registrable Securities who fails to timely provide all information with respect to the Holder that is reasonably requested by the Company to enable it to timely comply with its obligations under Section 2(b).

The Company shall notify the Trustee within three business days after each and every date on which an event occurs in respect of which Additional Interest is required to be paid (an “Event Date”). Additional Interest shall be paid by depositing with the Trustee, in trust, for the benefit of the Holders of Registrable Securities, on or before the applicable interest payment date, immediately available funds in sums sufficient to pay the Additional Interest then due. The Additional Interest due shall be payable on each interest payment date to the record Holder of Registrable Securities entitled to receive the interest payment to be paid on such date as set forth in the Indenture. Each obligation to pay Additional Interest shall be deemed to accrue from and including the day following the applicable Event Date.

Anything herein to the contrary notwithstanding, any Holder who was, at the time the Exchange Offer was pending and consummated, eligible to exchange, and did not validly tender, its Subordinated Notes for Exchange Securities in the Exchange Offer will not be entitled to receive any Additional Interest.

(f)Specific Enforcement. Without limiting the remedies available to the Holders or any Participating Broker-Dealer, the Company acknowledges that any failure by the Company to comply with its obligations under Sections 2(a) and 2(b) hereof may result in material irreparable injury to the Holders or the Participating Broker-Dealers for which there is no adequate remedy at law, that it will not be possible to measure damages for such injuries precisely and that, in the event of any such failure, any Holder and any Participating Broker-Dealer may obtain such relief as may be required to specifically enforce the Company’s obligations under Sections 2(a) and 2(b).

3.Registration Procedures.

In connection with the obligations of the Company with respect to the Registration Statements pursuant to Sections 2(a) and 2(b) hereof, the Company shall:

(a)prepare and file with the SEC a Registration Statement or, if required, Registration Statements, within the time periods specified in Section 2, on the appropriate form under the 1933 Act, which form (i) shall be selected by the Company, (ii) shall, in the case of a Shelf Registration Statement, be available for the sale of the Registrable Securities by the selling Holders thereof and (iii) shall comply as to form in all material respects with the requirements of the applicable form and include or incorporate by reference all financial statements required by the SEC to be filed therewith or incorporated by reference therein, and use its commercially reasonable efforts to cause such Registration Statement to become effective and remain effective for the applicable period in accordance with Section 2 hereof;

(b)prepare and file with the SEC such amendments and post-effective amendments to each Registration Statement as may be necessary under applicable law to keep such Registration Statement effective for the applicable period in accordance with Section 2 hereof; cause each Prospectus to be supplemented by any required prospectus supplement, and as so supplemented to be filed pursuant to Rule 424 under the 1933 Act; and comply with the provisions of the 1933 Act and the 1934 Act with respect to the disposition of all Registrable Securities covered by each Registration Statement during the applicable period in accordance with the intended method or methods of distribution by the selling Holders thereof;

(c)in the case of a Shelf Registration, (i) notify each Holder of Registrable Securities, at least five business days prior to filing, that a Shelf Registration Statement with respect to the Registrable Securities is being filed and advising such Holders that the distribution of Registrable Securities will be made in accordance with the method elected by the Majority Holders; (ii) furnish to each Holder of Registrable Securities and counsel for the Holders, without charge, as many copies of each Prospectus and any amendment or supplement thereto and such other documents as such Holder or counsel may reasonably request, including financial statements and schedules and, if such Holder or counsel so requests, all exhibits (including those incorporated by reference) in order to facilitate the public sale or other disposition of the Registrable Securities; and (iii) subject to the penultimate paragraph of this Section 3, the Company hereby consents to the use of the Prospectus or any amendment or supplement thereto by each of the Holders of Registrable Securities in accordance with applicable law in connection with the offering and sale of the Registrable Securities covered by and in the manner described in any Prospectus or any amendment or supplement thereto;

(d)use its commercially reasonable efforts to register or qualify the Registrable Securities under all applicable state securities or “blue sky” laws of such jurisdictions as any Holder of Registrable Securities covered by a Registration Statement shall reasonably request, to cooperate with the Holders of any Registrable Securities in connection with any filings required to be made with FINRA, to keep each such registration or qualification effective during the period such Registration Statement is required to be effective and do any and all other acts and things which may be reasonably necessary or advisable to enable such Holder to consummate the disposition in each such jurisdiction of such Registrable Securities owned by such Holder; provided, however, that the Company shall not be required to (i) qualify as a foreign corporation or entity or as a dealer in securities in any jurisdiction where it would not otherwise be required to qualify but for this Section 3(d) or (ii) take any action which would subject it to general service of process or taxation in any such jurisdiction if it is not then so subject;

(e)in the case of a Shelf Registration, notify each Holder of Registrable Securities and counsel for such Holders promptly and, if requested by such Holder or counsel, confirm such advice in writing promptly

(i)when a Registration Statement has become effective and when any post-effective amendments and supplements thereto become effective,

(ii)of any request by the SEC or any state securities authority for post-effective amendments or supplements to a Registration Statement or Prospectus or for additional information after a Registration Statement has become effective (other than comments to 1934 Act reports incorporated therein by reference),

(iii)of the issuance by the SEC or any state securities authority of any stop order suspending the effectiveness of a Registration Statement or the initiation of any proceedings for that purpose,

(iv)[reserved],

(v)of the receipt by the Company of any notification with respect to the suspension of the qualification of the Registrable Securities for sale in any jurisdiction or the initiation or threatening of any proceeding for such purpose,

(vi)of the happening of any event or the discovery of any facts during the period a Shelf Registration Statement is effective which is contemplated in Section 2(d)(i) or which makes any statement made in such Shelf Registration Statement or the related Prospectus untrue in any material respect or which constitutes an omission to state a material fact in such Shelf Registration Statement or Prospectus, and

(vii)of any determination by the Company that a post-effective amendment to a Registration Statement would be appropriate.

Without limitation to any other provisions of this Agreement, the Company agrees that this Section 3(e) shall also be applicable, mutatis mutandis, with respect to the Exchange Offer Registration Statement and the Prospectus included therein to the extent that such Prospectus is being used by Participating Broker-Dealers as contemplated by Section 3(f);

(f)(A) in the case of an Exchange Offer, (i) include in the Exchange Offer Registration Statement (1) a “Plan of Distribution” section covering the use of the Prospectus included in the Exchange Offer Registration Statement by broker-dealers who have exchanged their Registrable Securities for Exchange Securities for the resale of such Exchange Securities and (2) a statement to the effect that any such broker-dealers who wish to use the related Prospectus in connection with the resale of Exchange Securities acquired as a result of market-making or other trading activities will be required to notify the Company to that effect, together with instructions for giving such notice (which instructions shall include a provision for giving such notice by checking a box or making another appropriate notation on the related letter of transmittal) (each such broker-dealer who gives notice to the Company as aforesaid being hereinafter called a “Notifying Broker-Dealer”), (ii) furnish to each Notifying Broker-Dealer who desires to participate in the Exchange Offer, without charge, as many copies of each Prospectus included in the Exchange Offer Registration Statement and any amendment or supplement thereto, as such broker-dealer may reasonably request, (iii) include in the Exchange Offer Registration Statement a statement that any broker-dealer who holds Registrable Securities acquired for its own account as a result of market-making activities or other trading activities (a “Participating Broker-Dealer”), and who receives Exchange Securities for Registrable Securities pursuant to the Exchange Offer, may be a statutory underwriter and must deliver a prospectus meeting the requirements of the 1933 Act in connection with any resale of such Exchange Securities, (iv) subject to the penultimate paragraph of this Section 3, the Company hereby consents to the use of the Prospectus forming part of the Exchange Offer Registration Statement or any amendment or supplement thereto by any Notifying Broker-Dealer in accordance with applicable law in connection with the sale or transfer of Exchange Securities, and (v) include in the transmittal letter or similar documentation to be executed by an exchange offeree in order to participate in the Exchange Offer the following provision:

“If the undersigned is not a broker-dealer, the undersigned represents that it is not engaged in, and does not intend to engage in, a distribution of Exchange Securities. If the undersigned is a broker-dealer that will receive Exchange Securities for its own account in exchange for Registrable Securities, it represents that the Registrable Securities to be exchanged for Exchange Securities were acquired by it as a result of market-making activities or other trading activities and acknowledges that it will deliver a prospectus meeting the requirements of the 1933 Act in connection with any resale of such Exchange Securities pursuant to the Exchange Offer; however, by so acknowledging and by

delivering a prospectus, the undersigned will not be deemed to admit that it is an “underwriter” within the meaning of the 1933 Act;”

(B)to the extent any Notifying Broker-Dealer participates in the Exchange Offer, (i) the Company shall use its commercially reasonable efforts to maintain the effectiveness of the Exchange Offer Registration Statement for a period of 180 days (subject to extension pursuant to the last paragraph of this Section 3) following the last date on which exchanges are accepted pursuant to the Exchange Offer, and (ii) the Company will comply, insofar as relates to the Exchange Offer Registration Statement, the Prospectus included therein and the offering and sale of Exchange Securities pursuant thereto, with its obligations under Section 2(b)(iii)(D), the last paragraph of Section 2(b), Section 3(c), 3(d), 3(e), 3(g), 3(i), 3(j), 3(k), 3(o), 3(p), 3(q), 3(r) and 3(s), and the last three paragraphs of this Section 3 as if all references therein to a Shelf Registration Statement, the Prospectus included therein and the Holders of Registrable Securities referred, mutatis mutandis, to the Exchange Offer Registration Statement, the Prospectus included therein and the applicable Notifying Broker-Dealers and, for purposes of this Section 3(f), all references in any such paragraphs or sections to the “Majority Holders” shall be deemed to mean, solely insofar as relates to this Section 3(f), the Notifying Broker-Dealers who are the Holders of the majority in aggregate principal amount of the Exchange Securities which are Registrable Securities; and

(C)the Company shall not be required to amend or supplement the Prospectus contained in the Exchange Offer Registration Statement as would otherwise be contemplated by Section 3(b) or 3(k) hereof, or take any other action as a result of this Section 3(f), for a period exceeding 180 days (subject to extension pursuant to the last paragraph of this Section 3) after the last date on which exchanges are accepted pursuant to the Exchange Offer and Notifying Broker-Dealers shall not be authorized by the Company to, and shall not, deliver such Prospectus after such period in connection with resales contemplated by this Section 3;

(g)in the case of a Shelf Registration, furnish counsel for the Holders of Registrable Securities copies of any request by the SEC or any state securities authority for amendments or supplements to a Registration Statement or Prospectus or for additional information (other than comments to 1934 Act reports incorporated therein by reference);

(h)use its commercially reasonable efforts to obtain the withdrawal of any order suspending the effectiveness of a Registration Statement as soon as practicable and provide immediate notice to each Holder of the withdrawal of any such order;

(i)in the case of a Shelf Registration, upon request furnish to each Holder of Registrable Securities, without charge, at least one conformed copy of each Registration Statement and any post-effective amendments thereto (without documents incorporated or deemed to be incorporated therein by reference or exhibits thereto, unless requested);

(j)in the case of a Shelf Registration, cooperate with the selling Holders of Registrable Securities to facilitate the timely preparation and delivery of certificates representing Registrable Securities to be sold and not bearing any restrictive legends; and cause such Registrable Securities to be in such denominations (consistent with the provisions of the Indenture) and in a form eligible for deposit with the Depositary and registered in such names as the selling Holders may reasonably request in writing at least two business days prior to the closing of any sale of Registrable Securities;

(k)in the case of a Shelf Registration, upon the occurrence of any event or the discovery of any facts as contemplated by Section 3(e)(vi) hereof, use its commercially reasonable efforts to prepare a supplement or post-effective amendment to a Registration Statement or the related Prospectus or any document incorporated or deemed to be incorporated therein by reference or file any other required document so that, as thereafter delivered to the purchasers of the Registrable Securities, such Prospectus will not contain at the time of such delivery any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. The Company agrees to notify each Holder to suspend use of the Prospectus as promptly as practicable after the occurrence of such an event, and each Holder hereby agrees to suspend use of the Prospectus until the Company has amended or supplemented the Prospectus to correct such misstatement or omission. At such time as such public disclosure is otherwise made or the Company determines that such disclosure is not necessary, in each case to correct any misstatement of a material fact or to include any omitted material fact, the Company agrees promptly to notify each Holder of such determination and to furnish each Holder such number of copies of the Prospectus, as amended or supplemented, as such Holder may reasonably request;

(l)obtain CUSIP and ISIN numbers for all Exchange Securities or Registrable Securities, as the case may be, not later than the effective date of a Registration Statement, and provide the Trustee with printed or word-processed certificates for the Exchange Securities or Registrable Securities, as the case may be, in a form eligible for deposit with the Depositary;

(m)(i) cause the Indenture to be qualified under the TIA in connection with the registration of the Exchange Securities or Registrable Securities, as the case may be, (ii) cooperate with the Trustee and the Holders to effect such changes, if any, to the Indenture as may be required for the Indenture to be so qualified in accordance with the terms of the TIA and (iii) execute, and use its commercially reasonable efforts to cause the Trustee to execute, all documents as may be required to effect such changes, if any, and all other forms and documents required to be filed with the SEC to enable the Indenture to be so qualified in a timely manner;

(n)in the case of a Shelf Registration, upon request make available for inspection by representatives of the Holders of the Registrable Securities participating in any disposition pursuant to a Shelf Registration Statement and any one counsel or accountant retained by such Holders (with such inspection to occur at such time as mutually agreed between the Company and such Persons), all financial statements and other records, documents and properties of the Company reasonably requested by any such Persons, and cause the respective officers, directors, employees, and any other agents of the Company to supply all information reasonably requested by any such Persons in connection with a Shelf Registration Statement; provided, that any such Persons shall be required to execute a customary confidentiality agreement;

(o)in the case of a Shelf Registration, a reasonable time prior to filing any Shelf Registration Statement, any Prospectus forming a part thereof, any amendment to such Shelf Registration Statement or amendment or supplement to such Prospectus, provide copies of such document to the Holders of Registrable Securities and to counsel for any such Holders, and make such changes in any such document prior to the filing thereof as the Holders of Registrable Securities, or any of their counsel may reasonably request, and cause the representatives of the Company to be available for discussion of such documents as shall be reasonably requested by the Holders of Registrable Securities and shall not at any time make any filing of any such document of which such Holders or their counsel shall not have previously been advised and furnished a copy or to which such Holders or their counsel shall reasonably object within a reasonable time period;

(p)in the case of a Shelf Registration, use its commercially reasonable efforts to cause all Registrable Securities to be listed on any securities exchange on which similar debt securities issued by the Company are then listed if requested by the Majority Holders;

(q)in the case of a Shelf Registration, use its commercially reasonable efforts to cause the Registrable Securities to be rated by the same rating agency that initially rated the Subordinated Notes, if so requested by the Majority Holders of Registrable Securities, unless the Registrable Securities are already so rated;

(r)otherwise use its commercially reasonable efforts to comply with all applicable rules and regulations of the SEC and, with respect to each Registration Statement and each post-effective amendment, if any, thereto and each filing by the Company of an Annual Report on Form 10-K, make available to its security holders, as soon as reasonably practicable, an earnings statement covering at least twelve months which shall satisfy the provisions of Section 11(a) of the 1933 Act and Rule 158 thereunder; and

(s)cooperate and assist in any filings required to be made with FINRA.

In the case of a Shelf Registration Statement, the Company may (as a condition to such Holder’s participation in the Shelf Registration) require each Holder of Registrable Securities to furnish to the Company such information regarding such Holder and the proposed distribution by such Holder of such Registrable Securities as the Company may from time to time reasonably request in writing and require such Holder to agree in writing to be bound by all provisions of this Agreement applicable to such Holder.

In the case of a Shelf Registration Statement, each Holder agrees and, in the event that any Participating Broker-Dealer is using the Prospectus included in the Exchange Offer Registration Statement in connection with the sale of Exchange Securities pursuant to Section 3(f), each such Participating Broker-Dealer agrees that, upon receipt of any notice from the Company of the happening of any event or the discovery of any facts of the kind described in Section 3(e)(ii), 3(e)(iii) or 3(e)(v) through 3(e)(vii) hereof, such Holder or Participating Broker-Dealer, as the case may be, will forthwith discontinue disposition of Registrable Securities pursuant to a Registration Statement until receipt by such Holder or Participating Broker-Dealer, as the case may be, of (i) the copies of the supplemented or amended Prospectus contemplated by Section 3(k) hereof or (ii) written notice from the Company that the Shelf Registration Statement or the Exchange Offer Registration Statement, respectively, are once again effective or that no supplement or amendment is required. If so directed by the Company, such Holder or Participating Broker-Dealer, as the case may be, will deliver to the Company (at the Company’s expense) all copies in its possession, other than permanent file copies then in its possession, of the Prospectus covering such Registrable Securities current at the time of receipt of such notice. Nothing in this paragraph shall prevent the accrual of Additional Interest on any Registrable Securities.

If the Company shall give any such notice to suspend the disposition of Registrable Securities pursuant to the immediately preceding paragraph, the Company shall be deemed to have used its commercially reasonable efforts to keep the Shelf Registration Statement or, in the case of Section 3(f), the Exchange Offer Registration Statement, as the case may be, effective during such period of suspension; provided that (i) such period of suspension shall not exceed the time periods provided in Section 2(d)(iii) hereof and (ii) the Company shall use its commercially reasonable efforts to file and have declared effective (if an amendment) as soon as practicable thereafter an amendment or supplement to the Shelf Registration Statement or the Exchange Offer Registration Statement or both, as the case may be, or the Prospectus included therein and shall extend the period during which the Shelf Registration Statement or the Exchange Offer Registration Statement or both, as the case may be, shall be maintained effective pursuant to this Agreement (and, if applicable, the period during which Participating Broker-Dealers may use the Prospectus included in the Exchange Offer Registration Statement pursuant to Section 3(f) hereof) by the

number of days during the period from and including the date of the giving of such notice to and including the earlier of the date when the Holders or Participating Broker-Dealers, respectively, shall have received copies of the supplemented or amended Prospectus necessary to resume such dispositions and the effective date of written notice from the Company to the Holders or Participating Broker-Dealers, respectively, that the Shelf Registration Statement or the Exchange Offer Registration Statement, respectively, are once again effective or that no supplement or amendment is required.

4.Indemnification and Contribution.

(a)The Company agrees to indemnify and hold harmless each Holder, each Participating Broker-Dealer and each Person, if any, who controls any Holder or Participating Broker-Dealer within the meaning of either Section 15 of the 1933 Act or Section 20 of the 1934 Act, as follows:

(i)against any and all loss, liability, claim, damage and expense whatsoever, as incurred, arising out of any untrue statement or alleged untrue statement of a material fact contained in any Registration Statement (or any amendment thereto) pursuant to which Exchange Securities or Registrable Securities were registered under the 1933 Act, including all documents incorporated therein by reference, or any omission or alleged omission therefrom of a material fact required to be stated therein or necessary to make the statements therein not misleading, or arising out of any untrue statement or alleged untrue statement of a material fact contained in any Prospectus (or any amendment or supplement thereto) or any omission or alleged omission therefrom of a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading;

(ii)against any and all loss, liability, claim, damage and expense whatsoever, as incurred, to the extent of the aggregate amount paid in settlement of any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or of any claim whatsoever based upon any such untrue statement or omission, or any such alleged untrue statement or omission described in subparagraph (i) above; provided that any such settlement is effected with the prior written consent of the Company; and

(iii)against any and all expense whatsoever, as incurred (including, subject to Section 4(c) below, the fees and disbursements of counsel chosen by any indemnified party), reasonably incurred in investigating, preparing or defending against any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or any claim whatsoever based upon any such untrue statement or omission, or any such alleged untrue statement or omission described in subparagraph (i) above, to the extent that any such expense is not paid under subparagraph (i) or (ii) above;

provided, however, that this indemnity agreement shall not apply to any loss, liability, claim, damage or expense to the extent arising out of any untrue statement or omission or alleged untrue statement or omission made in reliance upon and in conformity with written information furnished to the Company by any Holder or Participating Broker-Dealer with respect to such Holder, Participating Broker-Dealer, as the case may be, expressly for use in the Registration Statement (or any amendment thereto) or the Prospectus (or any amendment or supplement thereto).

(b)Each Holder, severally but not jointly, agrees to indemnify and hold harmless the Company, each director of the Company, each officer of the Company who signed the Registration Statement, each Participating Broker-Dealer and each other selling Holder and each Person, if any, who controls the Company, any Participating Broker-Dealer or any other selling Holder within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act against any and all loss, liability, claim, damage

and expense described in the indemnity contained in Section 4(a) hereof, as incurred, but only with respect to untrue statements or omissions, or alleged untrue statements or omissions, made in the Shelf Registration Statement (or any amendment thereto) or any Prospectus included therein (or any amendment or supplement thereto) in reliance upon and in conformity with written information with respect to such Holder furnished to the Company by such Holder expressly for use in the Shelf Registration Statement (or any amendment thereto) or such Prospectus (or any amendment or supplement thereto); provided, however, that no such Holder shall be liable for any claims hereunder in excess of the amount of net proceeds received by such Holder from the sale of Registrable Securities pursuant to such Shelf Registration Statement.

(c)Each indemnified party shall give notice as promptly as reasonably practicable to each indemnifying party of any action commenced against it in respect of which indemnity may be sought hereunder, but failure so to notify an indemnifying party shall not relieve such indemnifying party from any liability hereunder to the extent it is not materially prejudiced as a result thereof and in any event shall not relieve it from any liability which it may have otherwise than on account of this indemnity agreement. Counsel to the respective indemnified parties shall be selected as follows: (i) counsel to the Company, its directors, each of its officers who signed the Registration Statement and all Persons, if any, who control the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall be selected by the Company; (ii) counsel to the Holders (other than Participating Broker-Dealers) and all Persons, if any, who control any Holders (other than any Participating Broker-Dealers) within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall be selected by the Holders who held or hold, as the case may be, a majority in aggregate principal amount of the Registrable Securities held by all such Holders; and (iii) counsel to the Participating Broker-Dealers and all Persons, if any, who control any such Participating Broker-Dealer within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall be selected by the Participating Broker-Dealers who held or hold, as the case may be, a majority in aggregate principal amount of the Exchange Securities referred to in Section 3(f) hereof held by all such Participating Broker-Dealers. In no event shall the indemnifying party or parties be liable for (A) the fees and expenses of more than one counsel (in addition to any local counsel) separate from the indemnifying parties’ own counsel for the Company and all other Persons referred to in clause (i) of this paragraph, (B) the fees and expenses of more than one counsel (in addition to any local counsel) separate from the indemnifying parties’ own counsel for all Holders (other than Participating Broker-Dealers) and all other Persons referred to in clause (ii) of this paragraph, and (C) the fees and expenses of more than one counsel (in addition to any local counsel) separate from the indemnifying parties’ own counsel for all Participating Broker-Dealers and all other Persons referred to in clause (iii) of this paragraph, in each case in connection with any one action or separate but similar or related actions in the same jurisdiction arising out of the same general allegations or circumstances. The indemnifying party shall be entitled to participate therein and, to the extent that it shall elect, jointly with any other indemnifying party similarly notified, to assume the defense thereof, with counsel reasonably satisfactory to such indemnified party, provided, however, if the defendants in any such action include both the indemnified party and the indemnifying party and the indemnified party shall have reasonably concluded that a conflict may arise between the positions of the indemnifying party and the indemnified party in conducting the defense of any such action or that there may be legal defenses available to it and/or other indemnified parties which are different from or additional to those available to the indemnifying party, the indemnified party or parties shall have the right to select separate counsel to assume such legal defenses and to otherwise participate in the defense of such action on behalf of such indemnified party or parties. After notice from the indemnifying party to such indemnified party of its election so to assume the defense thereof, the indemnifying party shall not be liable to such indemnified party under such subsection for any legal expenses of other counsel or any other expenses, in each case subsequently incurred by such indemnified party, in connection with the defense thereof other than reasonable costs of investigation unless (A) the indemnified party shall have employed separate counsel in accordance with the proviso to the preceding sentence (it being understood, however, that the indemnifying party shall not be liable for the expenses of more than one separate counsel, approved by the indemnifying party) or (B) the indemnifying party shall not have employed counsel reasonably satisfactory

to the indemnified party within a reasonable time after notice of commencement of the action, in each of which cases the fees and expenses of counsel shall be at the expense of the indemnifying party. No indemnifying party shall, without the prior written consent of the indemnified parties, settle or compromise or consent to the entry of any judgment with respect to any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or any claim whatsoever in respect of which indemnification or contribution could be sought under this Section 4 (whether or not the indemnified parties are actual or potential parties thereto), unless such settlement, compromise or consent (i) includes an unconditional release of each indemnified party from all liability arising out of such litigation, investigation, proceeding or claim and (ii) does not include a statement as to or an admission of fault, culpability or a failure to act by or on behalf of any indemnified party.

(d)If the indemnification provided for in this Section 4 is for any reason unavailable to or insufficient to hold harmless an indemnified party in respect of any losses, liabilities, claims, damages or expenses referred to therein, then each indemnifying party shall contribute to the aggregate amount of such losses, liabilities, claims, damages and expenses incurred by such indemnified party, as incurred, in such proportion as is appropriate to reflect the relative fault of the indemnifying party or parties on the one hand and of the indemnified party or parties on the other hand in connection with the statements or omissions that resulted in such losses, liabilities, claims, damages or expenses, as well as any other relevant equitable considerations. The relative fault of such indemnifying party or parties on the one hand and the indemnified party or parties on the other hand shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or omission or alleged omission to state a material fact relates to information supplied by such indemnifying party or parties or such indemnified party or parties, and the parties’ relative intent, knowledge, access to information and opportunity to correct or prevent such statement or omission.

(e)The Company and the Holders agree that it would not be just or equitable if contribution pursuant to this Section 4 were determined by pro rata allocation or by any other method of allocation that does not take account of the equitable considerations referred to in paragraph (d) above. The aggregate amount of losses, liabilities, claims, damages and expenses incurred by an indemnified party and referred to above in this Section 4 shall be deemed to include any legal or other expenses reasonably incurred by such indemnified party in investigating, preparing or defending against any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or any claim whatsoever based upon any such untrue or alleged untrue statement or omission or alleged omission.

Notwithstanding the provisions of this Section 4, other than in the case of intentional misrepresentation or omission of a material fact, no Holder or Participating Broker-Dealer shall be required to contribute any amount in excess of the amount by which the total price at which Registrable Securities sold by it were offered exceeds the amount of any damages that such Holder or Participating Broker-Dealer has otherwise been required to pay by reason of any such untrue or alleged untrue statement or omission or alleged omission.

No Person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the 1933 Act) shall be entitled to contribution from any Person who was not guilty of such fraudulent misrepresentation.

For purposes of this Section 4, each Person, if any, who controls a Holder or Participating Broker-Dealer within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall have the same rights to contribution as such Holder or Participating Broker-Dealer, as the case may be, and each director of the Company, each officer of the Company who signed the Registration Statement and each Person, if any, who controls the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall have the same rights to contribution as the Company.

The respective obligations of the Holders and Participating Broker-Dealers to contribute pursuant to this Section 4 are several in proportion to the principal amount of Subordinated Notes purchased by them and not joint.

The indemnity and contribution provisions contained in this Section 4 shall remain operative and in full force and effect regardless of (i) any termination of this Agreement, (ii) any investigation made by or on behalf of any Holder or Participating Broker-Dealer or any Person controlling any Holder or Participating Broker-Dealer, or by or on behalf of the Company, its officers or directors or any Person controlling the Company, (iii) acceptance of any of the Exchange Securities and (iv) any sale of Registrable Securities or Exchange Securities pursuant to a Shelf Registration Statement.

5.Miscellaneous.

(a)Rule 144 and Rule 144A. For so long as the Company is subject to the reporting requirements of Section 13 or 15 of the 1934 Act, the Company covenants that it will file all reports required to be filed by it under Section 13(a) or 15(d) of the 1934 Act and the rules and regulations adopted by the SEC thereunder, that if it ceases to be so required to file such reports, it will upon the request of any Holder or beneficial owner of Registrable Securities (i) make publicly available such information (including, without limitation, the information specified in Rule 144(c)(2) under the 1933 Act) as is necessary to permit sales pursuant to Rule 144 under the 1933 Act, (ii) deliver or cause to be delivered, promptly following a request by any Holder or beneficial owner of Registrable Securities or any prospective purchaser or transferee designated by such Holder or beneficial owner, such information (including, without limitation, the information specified in Rule 144A(d)(4) under the 1933 Act) as is necessary to permit sales pursuant to Rule 144A under the 1933 Act, and (iii) take such further action that is reasonable in the circumstances, in each case to the extent required from time to time to enable such Holder to sell its Registrable Securities without registration under the 1933 Act within the limitation of the exemptions provided by (x) Rule 144 under the 1933 Act, as such Rule may be amended from time to time, (y) Rule 144A under the 1933 Act, as such Rule may be amended from time to time, or (z) any similar rules or regulations hereafter adopted by the SEC. Upon the request of any Holder or beneficial owner of Registrable Securities, the Company will deliver to such Holder a written statement as to whether it has complied with such requirements.

(b)No Inconsistent Agreements. The Company has not entered into nor will the Company on or after the date of this Agreement enter into any agreement which is inconsistent with the rights granted to the Holders of Registrable Securities in this Agreement or otherwise conflicts with the provisions hereof; provided that the Company will not be precluded from entering into any agreement after the date hereof which may or does result, directly or indirectly, in the payment of Additional Interest. The rights granted to the Holders hereunder do not and will not in any way conflict in any material respects with and are not and will not be inconsistent in any material respects with the rights granted to the holders of any of the Company’s other issued and outstanding securities under any other agreements entered into by the Company or any of its subsidiaries.

(c)Amendments and Waivers. The provisions of this Agreement, including the provisions of this sentence, may not be amended, modified or supplemented, and waivers or consents to departures from the provisions hereof may not be given, unless the Company has obtained the written consent of Holders of at least a majority in aggregate principal amount of the outstanding Registrable Securities affected by such amendment, modification, supplement, waiver or departure.

(d)Notices. All notices and other communications provided for or permitted hereunder shall be made in writing by hand-delivery, registered first-class mail, electronic mail, or any courier guaranteeing overnight delivery (i) if to a Holder or Participating Broker-Dealer at the most current address set forth on the records of the registrar under the Indenture, and (ii) if to the Company, initially at the address set forth

in the Purchase Agreement and thereafter at such other address, notice of which is given in accordance with the provisions of this Section 5(d).

All such notices and communications shall be deemed to have been duly given: at the time delivered by hand, if personally delivered; five business days after being deposited in the mail, postage prepaid, if mailed; when receipt is acknowledged, if sent via electronic mail; and on the next business day if timely delivered to an air courier guaranteeing overnight delivery.

Copies of all such notices, demands or other communications shall be concurrently delivered by the Person giving the same to the Trustee, at the address specified in the Indenture.

(e)Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the successors, assigns and transferees of each of the parties, including, without limitation and without the need for an express assignment, subsequent Holders; provided that nothing herein shall be deemed to permit any assignment, transfer or other disposition of Registrable Securities in violation of the terms hereof or of the Purchase Agreement or the Indenture. If any transferee of any Holder shall acquire Registrable Securities, in any manner, whether by operation of law or otherwise, such Registrable Securities shall be held subject to all of the terms of this Agreement, and by taking and holding such Registrable Securities, such Person shall be conclusively deemed to have agreed to be bound by and to perform all of the terms and provisions of this Agreement, including the restrictions on resale set forth in this Agreement and, if applicable, the Purchase Agreement, and such Person shall be entitled to receive the benefits hereof.

(f)Third Party Beneficiary. Each Holder and Participating Broker-Dealer shall be a third party beneficiary of the agreements made hereunder and shall have the right to enforce such agreements directly to the extent it deems such enforcement necessary or advisable to protect its rights or the rights of other Holders hereunder. Each Holder, by its acquisition of Subordinated Notes, shall be deemed to have agreed to the provisions of Section 4 hereof.

(g)Counterparts; Electronic Transmission. This Agreement may be executed in any number of counterparts and by the parties hereto in separate counterparts, each of which when so executed shall be deemed to be an original and all of which taken together shall constitute one and the same agreement. Any facsimile or electronically transmitted copies hereof or signature hereon will, for all purposes, be deemed originals. Unless otherwise provided herein or in any other related document, the words “execute”, “execution”, “signed”, and “signature” and words of similar import used in this Agreement shall be deemed to include electronic signatures and the keeping of records in electronic form, each of which shall be of the same legal effect, validity or enforceability as a manually executed signature in ink or the use of a paper-based recordkeeping system, as applicable, to the fullest extent and as provided for in any applicable law, including the Federal Electronic Signatures in Global and National Commerce Act, the New York State Electronic Signatures and Records Act, and any other similar state laws based on the Uniform Electronic Transactions Act, provided that, notwithstanding anything herein to the contrary, the Company is not under any obligation to agree to accept electronic signatures in any form or in any format unless expressly agreed to by the Company pursuant to procedures approved by the Company.

(h)Headings. The headings in this Agreement are for convenience of reference only and shall not limit or otherwise affect the meaning hereof.

(i)Restriction on Resales. If the Company or any of its subsidiaries or affiliates (as defined in Rule 144 under the 1933 Act) shall redeem, purchase or otherwise acquire any Registrable Security or any Exchange Security which is a “restricted security” within the meaning of Rule 144 under the 1933 Act, the Company will deliver or cause to be delivered such Registrable Security or Exchange Security, as the case may be, to the Trustee for cancellation and neither the Company nor any of its subsidiaries or affiliates will

hold or resell such Registrable Security or Exchange Security or issue any new Registrable Security or Exchange Security to replace the same.

(j)GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK, WITHOUT GIVING EFFECT TO ITS LAWS OR PRINCIPLES OF CONFLICT OF LAWS.

(k)Entire Agreement; Severability. This Agreement contains the entire agreement between the parties relating to the subject matter hereof and supersedes all oral statements and prior writings with respect hereto. In the event that any one or more of the provisions contained herein, or the application thereof in any circumstance, is held invalid, illegal or unenforceable, the validity, legality and enforceability of any such provision in every other respect and of the remaining provisions contained herein shall not be affected or impaired thereby.

[SIGNATURE PAGES FOLLOW]

IN WITNESS WHEREOF, the Company has caused this Registration Rights Agreement to be executed by its duly authorized representative as of the date first above written.

COMPANY:

financial institutions, inc.

By:	/s/ W. Jack Plants, II
	Name:	W. Jack Plants, II
	Title:	Senior Vice President and Corporate Treasurer

IN WITNESS WHEREOF, the Purchaser has caused this Registration Rights Agreement to be executed by its duly authorized representative as of the date first above written.

	PURCHASER:

	By:
			Name:
			Title:

Exhibit 31.1

Certification of Principal Executive Officer

Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Martin K. Birmingham, certify that:

I have reviewed this quarterly report on Form 10-Q of Financial Institutions, Inc.;

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

Based on my knowledge, the financial statements and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)

Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)

Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 6, 2020		/s/ Martin K. Birmingham
		Martin K. Birmingham
		President and Chief Executive Officer

Exhibit 31.2

Certification of Principal Financial Officer

Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Justin K. Bigham, certify that:

I have reviewed this quarterly report on Form 10-Q of Financial Institutions, Inc.;

(a)

(b)

(c)

(d)

(a)

(b)

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: November 6, 2020		/s/ Justin K. Bigham
		Justin K. Bigham
		Chief Financial Officer

Exhibit 32

Certification pursuant to

18 U.S.C. Section 1350,

as adopted pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

Martin K. Birmingham, President and Chief Executive Officer, and Justin K. Bigham, Chief Financial Officer of Financial Institutions, Inc. (the “Company”), each certify in his capacity as an officer of the Company that he has reviewed the Quarterly Report of the Company on Form 10-Q for the period ended Setember 30, 2020 and that:

The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: November 6, 2020				/s/ Martin K. Birmingham
				Martin K. Birmingham
				President and Chief Executive Officer
				(Principal Executive Officer)

Date: November 6, 2020				/s/ Justin K. Bigham
				Justin K. Bigham
				Chief Financial Officer
				(Principal Financial Officer)

The purpose of this statement is solely to comply with Title 18, Chapter 63, Section 1350 of the United States Code, as amended by Section 906 of the Sarbanes-Oxley Act of 2002. A signed original of this written statement required by Section 906 has been provided to Financial Institutions, Inc. and will be retained by Financial Institutions, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.