First Tennessee National Corporation
Table of Contents

SCHEDULE 14A
(Rule 14a-101)

INFORMATION REQUIRED IN PROXY STATEMENT

SCHEDULE 14A INFORMATION

Proxy Statement Pursuant to Section 14(a) of the Securities

Exchange Act of 1934 (Amendment No.      )

Filed by the Registrant  x

Filed by a Party other than the Registrant  o

Check the appropriate box:

     
o  Preliminary Proxy Statement  
o  Confidential, for Use of the Commission Only (as permitted by Rule 14a-6(e)(2))
x  Definitive Proxy Statement
o  Definitive Additional Materials
o  Soliciting Material under Rule 14a-12

FIRST TENNESSEE NATIONAL CORPORATION


(Name of Registrant as Specified In Its Charter)


(Name of Person(s) Filing Proxy Statement, if other than the Registrant)

Payment of Filing Fee (Check the appropriate box):

x No fee required.
 
o Fee computed on table below per Exchange Act Rules 14a-6(i)(1) and 0-11.

     (1) Title of each class of securities to which transaction applies:


     (2) Aggregate number of securities to which transaction applies:


     (3) Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined):


     (4) Proposed maximum aggregate value of transaction:


     (5) Total fee paid:


o Fee paid previously with preliminary materials.
 
o Check box if any part of the fee is offset as provided by Exchange Act Rule  0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the Form or Schedule and the date of its filing.

     (1) Amount Previously Paid:


     (2) Form, Schedule or Registration Statement No.:


     (3) Filing Party:


     (4) Date Filed:



Table of Contents

First Tennessee cover page


Table of Contents

All Things Finance cover page


Table of Contents

(FIRST TENNESSEE LOGO)

March 18, 2003

Dear Shareholders:

     You are cordially invited to attend First Tennessee National Corporation’s 2003 annual meeting of shareholders. We will hold the meeting on April 15, 2003, in the Auditorium, First Tennessee Building, 165 Madison Avenue, Memphis, Tennessee, at 10:00 a.m. We have attached the formal notice of the annual meeting, our 2003 proxy statement, and a form of proxy.

     At the meeting, we will ask you to elect four Class I directors, approve the 2003 Equity Compensation Plan, and ratify the appointment of KPMG LLP as our independent auditors for 2003. The attached proxy statement contains information about these matters.

     An appendix to this proxy statement contains detailed financial information relating to our activities and operating performance during 2002. We have also enclosed our 2002 Summary Report.

     Our registered shareholders that have access to the Internet have the opportunity to receive proxy statements electronically. If you have not already done so for this year, we encourage you to elect this method of receiving the proxy statement next year. Not only will you have access to the document as soon as it is available, but you will be helping our company to save expense dollars. If you vote electronically, you will have the opportunity to give your consent at the conclusion of the voting process.

     Your vote is important. You may vote by telephone or over the Internet or by mail, or if you attend the meeting and want to vote your shares, then prior to the balloting you should request that your form of proxy be withheld from voting. We request that you vote by telephone or over the Internet or return your proxy card in the postage-paid envelope as soon as possible.

     
    Sincerely yours,
     
    (-s- RALPH HORN)
    Ralph Horn
Chairman of the Board

 


Table of Contents

FIRST TENNESSEE NATIONAL CORPORATION

165 Madison Avenue
Memphis, Tennessee 38103

NOTICE OF ANNUAL SHAREHOLDERS’ MEETING
April 15, 2003

     The annual meeting of shareholders of First Tennessee National Corporation will be held on April 15, 2003, at 10:00 a.m., CDT, in the Auditorium, First Tennessee Building, 165 Madison Avenue, Memphis, Tennessee.

     The items of business are:

  1.   Election of four Class I directors to serve until the 2006 annual meeting of shareholders, or until their successors are duly elected and qualified.

  2.   Approval of the 2003 Equity Compensation Plan.

  3.   Ratification of the appointment of auditors.

     These items are described more fully in the following pages, which are made a part of this notice. The close of business February 21, 2003, is the record date for the meeting. All shareholders of record at that time are entitled to vote at the meeting.

     Management requests that you vote by telephone or over the Internet (following the instructions on the enclosed form of proxy) or that you sign and return the form of proxy promptly, so that if you are unable to attend the meeting your shares can nevertheless be voted. You may revoke a proxy at any time before it is exercised at the annual meeting in the manner described on page 1 of the proxy statement.

     
    (-s- CLYDE A. BILLINGS, JR.)
     
    Clyde A. Billings, Jr.
Assistant Corporate Secretary
Memphis, Tennessee
March 18, 2003

 
IMPORTANT NOTICE
 
  PLEASE (1) VOTE BY TELEPHONE OR (2) VOTE OVER THE
   INTERNET OR (3) MARK, DATE, SIGN AND PROMPTLY MAIL THE
   ENCLOSED FORM OF PROXY IN THE ENCLOSED ENVELOPE SO
   THAT YOUR SHARES WILL BE REPRESENTED AT THE MEETING.

 


TABLE OF CONTENTS

GENERAL MATTERS
STOCK OWNERSHIP INFORMATION
Stock Ownership Table
VOTE ITEM NO. 1 — ELECTION OF DIRECTORS
NOMINEES FOR DIRECTOR
CONTINUING DIRECTORS
The Board of Directors and its Committees
Audit Committee Report
VOTE ITEM NO. 2 — APPROVAL OF 2003 EQUITY COMPENSATION PLAN
Equity Compensation Plan Information Table
VOTE ITEM NO. 3 — RATIFICATION OF APPOINTMENT OF AUDITORS
Appointment of Auditors for 2003
Change in Auditors During 2002
2002 Fees
Audit Fees
Financial Information Systems Design and Implementation Fees
All Other Fees
OTHER MATTERS
SHAREHOLDER PROPOSAL DEADLINES
EXECUTIVE COMPENSATION
Summary Compensation Table
Option/SAR Grants in Last Fiscal Year Table
Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values Table
Pension Plan Table
Employment Contracts and Termination of Employment and Change-in-Control Arrangements
Compensation Committee Interlocks and Insider Participation
Certain Relationships and Related Transactions
Board Compensation Committee Report on Executive Compensation
Total Shareholder Return Performance Graph
Compensation of Directors
Section 16(a) Beneficial Ownership Reporting Compliance
AVAILABILITY OF ANNUAL REPORT ON FORM 10-K
APPENDIX A - 2003 Equity Compensation Plan
APPENDIX F - Financial Information and Discussion
SELECTED FINANCIAL AND OPERATING DATA
MANAGEMENT’S DISCUSSION AND ANALYSIS
General Information
Forward-Looking Statements
Financial Summary
Critical Accounting Policies
Income Statements Analysis (2002 compared to 2001)
Cumulative Effect of Changes in Accounting Principles
Business Line Review
Income Statement Analysis (2001 compared to 2000)
Balance Sheet Review
Risk Management
Other
Accounting Changes
GLOSSARY
CONSOLIDATED STATEMENTS OF CONDITION
CONSOLIDATED STATEMENTS OF INCOME
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS REPORT
CONSOLIDATED AVERAGE BALANCE SHEETS AND RELATED YIELDS AND RATES
CONSOLIDATED HISTORICAL STATEMENTS OF INCOME


Table of Contents

PROXY STATEMENT
FIRST TENNESSEE NATIONAL CORPORATION

TABLE OF CONTENTS

             
        Page
       
GENERAL MATTERS
    1  
STOCK OWNERSHIP INFORMATION
    1  
Stock Ownership Table
    2  
VOTE ITEM NO. 1 - ELECTION OF DIRECTORS
    3  
Nominees for Director
    3  
Continuing Directors
    4  
The Board of Directors and its Committees
    4  
Audit Committee Report
    5  
VOTE ITEM NO. 2 - APPROVAL OF 2003 EQUITY COMPENSATION PLAN
    6  
Equity Compensation Plan Information Table
    11  
VOTE ITEM NO. 3 - RATIFICATION OF APPOINTMENT OF AUDITORS
    12  
Appointment of Auditors for 2003
    12  
Change in Auditors during 2002
    12  
2002 Fees
    13  
Audit Fees
    13  
Financial Information Systems Design and Implementation Fees
    13  
All Other Fees
    13  
OTHER MATTERS
    13  
SHAREHOLDER PROPOSAL DEADLINES
    14  
EXECUTIVE COMPENSATION
    14  
Summary Compensation Table
    15  
Option/SAR Grants in Last Fiscal Year Table
    18  
Aggregated Option/SAR Exercises in Last Fiscal Year and
       
   
Fiscal Year-End Option/SAR Values Table
    20  
Pension Plan Table
    21  
Employment Contracts and Termination of Employment and
       
 
Change-in-Control Arrangements
    22  
Compensation Committee Interlocks and Insider Participation
    23  
Certain Relationships and Related Transactions
    23  
Board Compensation Committee Report on Executive Compensation
    23  
Total Shareholder Return Performance Graph
    28  
Compensation of Directors
    29  
Section 16(a) Beneficial Ownership Reporting Compliance
    30  
AVAILABILITY OF ANNUAL REPORT OF FORM 10-K
    30  
 
       
APPENDIX A - 2003 Equity Compensation Plan
    A-1  
 
       
APPENDIX F- Financial Information and Discussion
    F-1  

 


Table of Contents

PROXY STATEMENT
FIRST TENNESSEE NATIONAL CORPORATION
165 Madison Avenue
Memphis, Tennessee 38103

     GENERAL MATTERS

     The following proxy statement is being mailed to shareholders beginning on or about March 18, 2003. The Board of Directors is soliciting proxies to be used at our annual meeting of the shareholders to be held on April 15, 2003, at 10:00 a.m., CDT, in the Auditorium, First Tennessee Building, 165 Madison Avenue, Memphis, Tennessee, and at any adjournment or adjournments thereof.

     The accompanying form of proxy is for use at the meeting if you will be unable to attend in person. You may revoke your proxy at any time before it is exercised by writing to the Corporate Secretary, by timely delivering a properly executed, later-dated proxy (including a telephone or Internet vote) or by voting by ballot at the meeting. All shares represented by valid proxies received pursuant to this solicitation, and not revoked before they are exercised, will be voted in the manner specified therein. If no specification is made, the proxies will be voted in favor of all items below:

  1.   Election of four Class I directors to serve until the 2006 annual meeting of shareholders, or until their successors are duly elected and qualified.

  2.   Approval of the 2003 Equity Compensation Plan.

  3.   Ratification of the appointment of auditors.

     We will bear the entire cost of soliciting the proxies. In following up the original solicitation of the proxies by mail, we may request brokers and others to send proxies and proxy material to the beneficial owners of the shares and may reimburse them for their expenses in so doing. If necessary, we may also use several of our regular employees to solicit proxies from the shareholders, either personally or by telephone or by special letter, for which they will receive no compensation in addition to their normal compensation. We have hired Innisfree M&A Incorporated to aid us in the solicitation of proxies for a fee of $12,000 plus out-of-pocket expenses.

     Our common stock is the only class of voting securities. There were 125,710,620 shares of common stock outstanding and entitled to vote as of February 21, 2003, the record date for the annual shareholders’ meeting. Each share is entitled to one vote. A quorum of the shares must be represented at the meeting to take action on any matter at the meeting. A majority of the votes entitled to be cast constitutes a quorum for purposes of the annual meeting. A plurality of the votes cast is required to elect the nominees as directors. A majority of the votes cast is required to approve the Equity Compensation Plan and ratify the appointment of auditors. Both “abstentions” and broker “non-votes” will be considered present for quorum purposes, but will not otherwise have any effect on any of the vote items.

     STOCK OWNERSHIP INFORMATION

     We know of no person who owned beneficially, as that term is defined by Rule 13d-3 of the Securities Exchange Act of 1934, more than five percent (5%) of our common stock on December 31, 2002.

     The following table sets forth certain information as of December 31, 2002, concerning beneficial ownership of our common stock by each director and nominee, each executive officer named in the Summary Compensation Table, and directors and executive officers as a group:


Table of Contents

Stock Ownership Table

                         
Name of   Shares Beneficially   Stock Units in   Total and Percent
Beneficial Owner   Owned(1)   Deferral Accounts(2)   of Class(3)

Robert C. Blattberg
    34,184 (4)           34,184  
Charles G. Burkett
    92,659 (5)           92,659  
George E. Cates
    66,810 (4)           66,810  
J. Kenneth Glass
    619,875 (5)     84,943       704,818  
John H. Hamilton
    105,956 (5)     14,615       120,571  
James A. Haslam, III
    57,039 (4)           57,039  
Ralph Horn
    1,487,183 (5)     309,520       1,796,703 (1.4%)
Larry B. Martin
    138,252 (5)     19,535       157,787  
R. Brad Martin
    76,207 (4)           76,207  
Sarah L. Meyerrose
    113,271 (5)           113,271  
Joseph Orgill, III
    262,397 (4)           262,397  
Vicki R. Palmer
    71,695 (4)           71,695  
Michael D. Rose
    99,704 (4)           99,704  
William B. Sansom
    95,844 (4)           95,844  
Elbert L. Thomas, Jr.
    268,371 (5)     34,309       302,680  
Jonathan P. Ward
                 
Luke Yancy III
    11,142 (4)           11,142  
Directors and Executive
                       
Officers as a Group (20 persons)     4,295,174 (4)     524,645       4,819,819 (3.8%)

  (1)   The respective directors, nominees and officers have sole voting and investment powers with respect to all of such shares except as specified in notes (4) and (5). Amounts in the second column do not include stock units in the third column.

  (2)   Our stock option program permits participants to defer receipt of shares upon the exercise of options and our restricted stock incentive plan permitted participants to defer receipt of shares prior to the lapsing of restrictions imposed on restricted stock awards. Amounts in the third column reflect the number of shares deferred that a participant has the right to receive on a future date. These shares are not currently issued and are not considered to be beneficially owned for purposes of Rule 13d-3, but are reflected in a deferral account on our books as phantom stock units or restricted stock units.

  (3)   No individual director, nominee or executive officer, except for Mr. Horn, beneficially owns more than one (1%) percent of our common stock that is outstanding. Mr. Horn beneficially owns 1.4% including stock units (or 1.2% excluding stock units). The percentage of common stock outstanding owned by the director and executive officer group (3.8%) includes stock units. The percentage would be 3.4% with stock units excluded.

  (4)   Includes the following shares of restricted stock with respect to which the nonemployee director possesses sole voting power, but no investment power: Mr. Cates — 2,400; Mr. Haslam — 2,400; Mr. Martin — 1,200; Mrs. Palmer — 1,200; and Mr. Yancy — 5,400. Includes the following shares as to which the named nonemployee directors have the right to acquire beneficial ownership through the exercise of stock options granted under our director plans, all of which are 100% vested: Dr. Blattberg — 27,824; Mr. Cates — 51,748; Mr. Haslam — 40,977; Mr. Martin — 37,052; Mr. Orgill — 72,467; Mrs. Palmer — 65,587; Mr. Rose — 61,325; Mr. Sansom — 81,314; and Mr. Yancy — 3,583.

2


Table of Contents

  (5)   Includes the following shares of restricted stock with respect to which the named person or group has sole voting power but no investment power: Mr. Burkett — 23,742; Mr. Glass — 43,175; Mr. Hamilton -17,978; Mr. Horn — 59,225; Mr. Martin — 23,742; Ms. Meyerrose — 17,951; Mr. Thomas — 22,146 and the director and executive officer group — 275,923. Includes the following shares as to which the named person or group has the right to acquire beneficial ownership within 60 days through the exercise of stock options granted under our stock option plans: Mr. Burkett — 26,966; Mr. Glass — 307,381; Mr. Hamilton — 69,026; Mr. Horn — 610,528; Mr. Martin — 68,965; Ms. Meyerrose — 57,780; Mr. Thomas — 170,708 and the director and executive officer group — 1,578,834. Also includes shares held at December 31, 2002 for 401 (k) Savings Plan accounts.

VOTE ITEM NO. 1 — ELECTION OF DIRECTORS

     The Board of Directors is divided into three Classes. The term of office of each Class expires in successive years. The term of Class I directors expires at this annual meeting. The terms of Class II and Class III directors expire at the 2004 and 2005 annual meetings, respectively. The Board of Directors proposes the election of four Class I directors, three incumbent directors and one new nominee. Mr. Ward has not previously served on our Board. Each director elected at the meeting will hold office until the 2006 annual meeting of shareholders and until his or her successor is elected and qualified.

     If any nominee proposed by the Board of Directors is unable to accept election, which the Board of Directors has no reason to anticipate, the persons named in the enclosed form of proxy will vote for the election of such other persons as management may recommend, unless the Board decides to reduce the number of directors pursuant to the Bylaws.

     We have provided below certain information about the nominees and directors (including age, current principal occupation which has continued for at least five years unless otherwise indicated, name and principal business of the organization in which his or her occupation is carried on, directorships in other reporting companies, and year first elected to our Board). All of our directors are also directors of First Tennessee Bank National Association (the “Bank” or “FTB”). The Bank is our principal operating subsidiary.

NOMINEES FOR DIRECTOR
Class I
For a Three Year Term Expiring at 2006 Annual Meeting

     R. BRAD MARTIN (51) is Chairman of the Board and Chief Executive Officer of Saks Incorporated, Birmingham, Alabama, a retail merchandising company. Mr. Martin is a director of two other public companies, Saks Incorporated and Harrah’s Entertainment, Inc. He has been a director since 1994 and is Chairman of the Human Resources Committee.

     VICKI R. PALMER (49) is Corporate Senior Vice President, Treasurer, and Special Assistant to the CEO of Coca-Cola Enterprises Inc., Atlanta, Georgia, a bottler of soft drink products. Prior to December 1999, Mrs. Palmer was Corporate Vice President and Treasurer of Coca-Cola Enterprises, Inc. Mrs. Palmer has been a director since 1993 and is a member of the Human Resources Committee.

     WILLIAM B. SANSOM (61) is Chairman of the Board and Chief Executive Officer of The H. T. Hackney Co., Knoxville, Tennessee, a diversified wholesale distribution firm serving the food, gas, oil and industrial markets in the Southeast. He is a director of two other public companies, Martin Marietta Materials, Inc. and Astec Industries, Inc. Mr. Sansom has been a director since 1984 and is Chairman of the Audit Committee.

     JONATHAN P. WARD (48) is Chairman and Chief Executive Officer of The ServiceMaster Company (“ServiceMaster”), Downers Grove, Illinois, a company that provides consumer services and supportive management services. Prior to April 2002, Mr. Ward was President and Chief Executive Officer of ServiceMaster, and prior to January 2001, he was President and Chief Operating Officer of R. R. Donnelly & Sons Company. Mr. Ward is a director of two other public companies, ServiceMaster and J. Jill Group, Inc. Mr. Ward has not previously served on our Board.

3


Table of Contents

CONTINUING DIRECTORS
Class II
Term Expiring at 2004 Annual Meeting

     ROBERT C. BLATTBERG (60) is the Polk Brothers Distinguished Professor of Retailing, J. L. Kellogg Graduate School of Management, Northwestern University, Evanston, Illinois. Dr. Blattberg has been a director since 1984.

     J. KENNETH GLASS (56) is President and Chief Executive Officer of First Tennessee and the Bank. From July 2001 through July 2002, Mr. Glass was President and Chief Operating Officer of First Tennessee and the Bank. From April 1999 through July 2001, he was President-Retail Financial Services of the Bank and from April 2000 through July 2001, President — Retail Financial Services of First Tennessee. Prior to April 1999, he was President — Tennessee Banking Group of the Bank and prior to April 2000, he was Executive Vice President of First Tennessee. Mr. Glass has been a director since 1996.

     MICHAEL D. ROSE (61) is Chairman of Gaylord Entertainment Company, Nashville, Tennessee, a diversified hospitality and entertainment company. Prior to April 2001, Mr. Rose was a private investor. Mr. Rose is director of four other public companies, Gaylord Entertainment Company, Darden Restaurants, Inc., FelCor Lodging Trust, Inc., and Stein Mart, Inc. Mr. Rose has been a director since 1984.

     LUKE YANCY III (53) is President and Chief Executive Officer of Mid-South Minority Business Council, Memphis, Tennessee, a nonprofit organization that promotes minority and women business enterprises. Prior to June 2000, Mr. Yancy was President, West Region, of AmSouth Bank and, prior to its acquisition by AmSouth in 1999, First American Bank. Mr. Yancy has been a director since October 2001 and is a member of the Audit Committee.

Class III
Term Expiring at 2005 Annual Meeting

     GEORGE E. CATES (65) is the retired Chairman of the Board of Mid-America Apartment Communities, Inc., (“Mid-America”) Memphis, Tennessee, a real estate investment trust. Mr. Cates retired as Chairman in September 2002. Prior to October 2001, he was also Chief Executive Officer of Mid-America. Mr. Cates is a director of one other public company, Mid-America. Mr. Cates has been a director of the Corporation since 1996.

     JAMES A. HASLAM, III (48) is Chief Executive Officer of Pilot Travel Centers, LLC, Knoxville, Tennessee, a national operator of travel centers, and he remains CEO of Pilot Corporation. Mr. Haslam is a director of one other public company, Ruby Tuesday, Inc. Mr. Haslam has been a director since 1996 and is a member of the Human Resources Committee.

     RALPH HORN (60) is Chairman of the Board of First Tennessee and the Bank. Mr. Horn served as Chief Executive Officer from 1994 through July 2002 and has been Chairman of the Board since 1996. From 1991 through July 2001, he also served as President of First Tennessee. Mr. Horn is a director of three other public companies, Harrah’s Entertainment, Inc., Mid-America Apartment Communities, Inc. and Gaylord Entertainment Company. Mr. Horn has been a director since 1991.

The Board of Directors and its Committees

     During 2002, the Board of Directors held four meetings. The average attendance at Board and committee meetings exceeded 97 percent. No director attended fewer than 75 percent of the meetings of the Board and the committees of the Board on which he or she served.

     The Board has several standing committees, including the Audit Committee and the Human Resources Committee. The Human Resources Committee serves as both a nominating committee and a compensation

4


Table of Contents

committee. The Audit Committee and the Human Resources Committee are each composed of directors who are “independent,” as defined below. Currently, Messrs. Orgill (who is scheduled to retire in April 2003), Sansom, and Yancy serve on the Audit Committee and Messrs. Martin and Haslam and Mrs. Palmer serve on the Human Resources Committee.

     The Audit Committee was established by our Board of Directors and operates pursuant to a written charter that was last amended and restated on July 17, 2001. Subject to the limitations and provisions of its charter, the Committee assists our Board in its oversight of our accounting and financial reporting principles and policies, internal audit controls and procedures, and financial statements and the independent audit of the financial statements. The Committee provides advice to the Board concerning the selection and replacement of the independent auditor and evaluates the independent auditor and its independence. The members of the Committee are themselves “independent,” as that term is defined in the listing standards of the New York Stock Exchange, on which our common stock is listed, as interpreted and determined by the Board in the exercise of its business judgment. During 2002 the Audit Committee held ten meetings. The Audit Committee’s Report is included below.

     As a nominating committee, the Human Resources Committee primarily considers recommendations for nominees to the Board of Directors, reviews the performance of incumbent directors and senior officers in determining whether to recommend them to the Board of Directors for reappointment, reviews succession plans, and between annual meetings of the Board has authority to appoint persons to offices except the offices of Chairman, CEO, President, Auditor and any office in which the incumbent has been designated by the Board as an Executive Officer. As a compensation committee, the Human Resources Committee’s primary functions include recommending to the Board major policies concerning compensation, periodically reviewing corporate compensation and management of human resources, fixing the compensation of executive officers, reviewing remuneration structures for non-executive officers, and making recommendations to the Board concerning compensation arrangements for directors and adoption or amendment of employee benefit and management compensation plans. The members of the Human Resources Committee are all “non employee directors” as the term is defined in SEC Rule 16b-3 who meet the eligibility requirements of Section 162(m) of the Tax Code. During 2002 the Human Resources Committee held five meetings.

     It is our practice to encourage communication between management and shareholders. Management in turn communicates appropriate information to the Board. The Human Resources Committee, as a committee of the Board, follows this procedure in considering nominations for directorships and does not receive nominations directly from shareholders.

     Notwithstanding anything to the contrary set forth in any of our previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate future filings by reference, including this proxy statement, in whole or in part, the following Audit Committee Report and the statements regarding the independence of the members of the Committee shall not be incorporated by reference into any such filings.

Audit Committee Report

     The role of the Audit Committee (Committee) is to assist our Board of Directors in its oversight of our financial reporting process. The Committee operates pursuant to a charter that was last amended and restated by the Board on July 17, 2001. As set forth in the Committee’s charter, management of First Tennessee is responsible for the preparation, presentation and integrity of our financial statements, and maintaining appropriate accounting and financial reporting principles and policies and internal controls and procedures designed to assure compliance with accounting standards and applicable laws and regulations. The independent auditors are responsible for auditing our financial statements and expressing an opinion as to their conformity with generally accepted accounting principles.

     In the performance of its oversight function, the Committee has considered and discussed the audited financial statements with management and the independent auditors. The Committee has also discussed with

5


Table of Contents

our Chief Executive Officer and Chief Financial Officer their respective certifications that will be included in our Annual Report on Form 10-K for the year ended December 31, 2002. The Committee has also discussed with the independent auditors the matters required to be discussed by Statement on Auditing Standards No. 61, Communication with Audit Committees, as currently in effect. Finally, the Committee has received the written disclosures and the letter from the independent auditors required by Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees, as currently in effect, has considered whether the provision of non-audit services by the independent auditors to First Tennessee is compatible with maintaining the auditor’s independence and has discussed with the auditors the auditors’ independence.

     The members of the Committee are not professionally engaged in the practice of auditing or accounting and are not experts in the fields of accounting or auditing, including in respect of auditor independence. Members of the Committee rely without independent verification on the information provided to them and on the representations made by management and the independent auditors. Accordingly, the Committee’s oversight does not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles or appropriate internal controls and procedures designed to assure compliance with the accounting standards and applicable laws and regulations. Furthermore, the Committee’s considerations and discussions referred to above do not assure that the audit of our financial statements has been carried out in accordance with generally accepted auditing standards, that the financial statements are presented in accordance with generally accepted accounting principles or that our auditors are in fact “independent.”

     Based upon the reports and discussions described in this report, and subject to the limitations on the role and responsibilities of the Committee referred to above and in the Committee’s charter, the Committee recommended to the Board of Directors that the audited financial statements be included in our Annual Report on Form 10-K for the year ended December 31, 2002, to be filed with the Securities and Exchange Commission.

     Submitted by the Audit Committee of our Board of Directors.

  Audit Committee

  William B. Sansom, Chairman
Joseph Orgill, III
Luke Yancy III

 

VOTE ITEM NO. 2 — APPROVAL OF 2003 EQUITY COMPENSATION PLAN

General

     We retained a nationally recognized benefits and consulting firm to conduct a review of our existing compensation programs and to make appropriate recommendations. As a result of this review and the recommendations received, the Human Resources Committee and our Board of Directors (the “Board”) adopted the 2003 Equity Compensation Plan (the “Plan”), subject to the approval of our shareholders.

     The purpose of the Plan is to promote the interests of the Company by attracting, retaining and motivating officers, employees and non-employee directors of the Company and its subsidiaries by means of performance-related incentives designed to achieve long-range performance goals, and linking their compensation to the long-term interests of shareholders. All officers, employees and non-employee directors of the Company and its subsidiaries, and all “regional board members” (as defined under the Plan), will be eligible to receive awards (“Awards”) under the Plan, which may consist of grants of options, restricted stock, restricted stock units, and performance awards, or any combination thereof. As of February 24, 2003, the Company and its subsidiaries

6


Table of Contents

had approximately 1,699 officers, 9,410 employees and 9 non-employee directors, and there were approximately 131 regional board members. The following is a summary of the material features of the Plan, and is qualified in its entirety by reference to the complete text of the Plan set forth in Appendix A to this Proxy Statement.

Administration

     The Plan will be administered by a committee (the “Committee”) of the Board to be composed solely of not less than two non-employee directors, all of whom (i) satisfy the requirements of Rule 16b-3(b)(3) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), (ii) are “outside directors” within the meaning of Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), and (iii) meet any independence requirements promulgated by any stock exchange on which the Company’s common stock, par value $0.625 per share (the “Common Stock”), is listed. The members of the Committee may be removed by the Board at its discretion. The Board, in its discretion, may also administer the Plan and, in such a case, has all of the rights, powers and authority of the Committee.

     Subject to certain limitations, the Committee has the power and authority in its discretion to, among other things, (i) select the persons to whom Awards will be made, (ii) determine the type, timing, terms and conditions of any Awards, including the number of shares of Common Stock subject to any Award, (iii) interpret and administer the Plan and any instrument or agreement relating to the Plan or any Awards granted pursuant to the Plan, and (iv) establish, amend, suspend or waive such rules and regulations as it shall deem appropriate for the proper administration of the Plan.

     Notwithstanding the immediately preceding paragraph, only the Board has the power and authority to make Awards to non-employee directors, and to determine the type, timing, terms and conditions of those Awards.

Amendment

     The Board may amend, alter, modify, suspend, discontinue or terminate the Plan at any time, except that the Board may not amend the Plan in violation of any law. However, no such action may materially prejudice the rights of any holder of an Award which was granted prior to the date of such action, without the consent of such holder.

Maximum Number of Shares Available

     Subject to adjustment as described below, the maximum number of shares of Common Stock which may be issued with respect to Awards is 3,000,000, of which no more than 300,000 may be issued with respect to Awards other than options, and no participant may, in any calendar year, receive options with respect to more than 500,000 shares of Common Stock.

     The maximum number of shares of Common Stock available for Awards under the Plan, the number of shares of Common Stock covered by each outstanding Award, the number of shares of Common Stock that may be subject to Awards to any one participant and the price per share of Common Stock covered by each outstanding Award shall be proportionately adjusted for any increase or decrease in the number of issued shares of Common Stock resulting from a stock split, reverse stock split, stock dividend, recapitalization, combination or reclassification of the Common Stock, and may be proportionately adjusted, as determined by the Board in its sole discretion, for any other increase or decrease in the number of issued shares of Common Stock effected without receipt of consideration by the Company or to reflect any distributions to holders of shares of Common Stock other than regular cash dividends.

     If any shares of Common Stock covered by an Award are forfeited, or if such Award is settled for cash or otherwise terminates, expires unexercised or is cancelled without delivery of such shares, such shares of Common Stock (or portion thereof) will again be available for issuance under the Plan. If any option or other Award granted under the Plan is exercised through the delivery of shares of Common Stock by a participant or if withholding tax liabilities arising from such Award are satisfied by the withholding of shares of Common Stock by the Company from the total number of shares that would otherwise have been delivered to the participant, the number of shares of Common Stock available for Awards under the Plan shall be increased by the number of shares so surrendered or withheld.

7


Table of Contents

     Because the granting of Awards under the Plan will be entirely within the discretion of the Committee or the Board, it is not possible to determine those persons to whom Awards will be granted under the Plan or the number of shares of Common Stock that will be subject to Awards that are granted under the Plan, nor is it possible to determine those persons to whom Awards would have been granted or the number of shares of Common Stock that would have been subject to such Awards for the last completed fiscal year if the Plan had been in effect.

     On February 28, 2003, the closing price of the Common Stock on the New York Stock Exchange was $38.19 per share.

Types of Awards

     Options. The Committee may grant options to purchase a specified number of shares of Common Stock. Options granted under the Plan will not qualify as “incentive stock options” under Section 422 of the Code. The number of shares of Common Stock subject to any grant of options, the exercise price and all other conditions and limitations applicable to the exercise of any options will be determined by the Committee. Notwithstanding the preceding sentence, except in limited circumstances described in the Plan, the exercise price of an option may not be less than 100% of the fair market value of the shares of Common Stock with respect to which the option is granted on the date of such grant. No option shall be exercisable after the expiration of ten years from the date such option was granted.

     Restricted Stock and Restricted Stock Units. Awards of restricted stock and restricted stock units are grants of Common Stock or stock units that are subject to a risk of forfeiture or other restrictions that lapse upon the occurrence of certain events and the satisfaction of certain conditions, as determined by the Committee in its discretion. The value of a restricted stock unit must equal the fair market value of one share of Common Stock on the date of the grant. Any awards of restricted stock or restricted stock units will be subject to such conditions, restrictions and contingencies as the Committee determines. Restricted stock units are payable, at the Committee’s discretion, in cash, shares of Common Stock, other securities or other property.

     Performance Awards. The Committee may, in its discretion, grant a performance award consisting of a right that is denominated in cash and/or shares of Common Stock, valued in accordance with the achievement of certain performance goals during certain performance periods as determined by the Committee, and payable at such time and in such form as the Committee shall determine. In determining the performance goals applicable to any performance award, the Committee must select one or a combination of the following financial performance measures of the Company, its subsidiaries, or any operating unit, division, line of business, department, team or business unit thereof: stock price; dividends; total shareholder return; earnings per share; price/earnings ratio; market capitalization; book value; revenues; expenses; loans; deposits; non-interest income; net interest income; fee income; operating income before or after taxes; net income before or after taxes; net income before securities transactions; net or operating income excluding non-recurring charges; return on assets; return on equity; return on capital; cash flow; credit quality; service quality; market share; customer retention; efficiency ratio; strategic business objectives, consisting of one or more objectives based on meeting specified cost targets, business expansion goals and goals relating to acquisitions or divestitures; and except in the case of a “covered officer” (as defined under the Plan), any other performance criteria established by the Committee. Each goal may be expressed on an absolute and/or relative basis, may be based on or otherwise employ comparisons based on internal targets, the past performance of the Company (consolidated or unconsolidated) and/or the past or current performance of other companies, the performance of other companies over one or more years or an index of the performance of other companies, markets or economic metrics over one or more years, and in the case of earnings-based measures, may use or employ comparisons relating to capital, shareholders’ equity and/or shares of Common Stock outstanding, or to assets or net assets.

     The Committee may also grant restricted stock and restricted stock units to “covered officers” (as defined under the Plan) which vest or become exercisable upon the achievement of certain performance goals specified by the Committee, subject to the limitations described in the immediately preceding paragraph.

8


Table of Contents

     The maximum annual number of shares of Common Stock in respect of which all performance-based Awards (whether restricted stock, restricted stock units or performance awards) may be granted to a participant under the Plan is 100,000 and the maximum annual amount of any Awards settled in cash to a participant under the Plan is $4,000,000.

Change in Control

     Upon a “change in control” (as defined under the Plan) of the Company, all Awards outstanding under the Plan will vest, become immediately exercisable or payable or have all restrictions lifted, as the case may be.

Effect of Termination of Employment

     The Committee has discretion to determine the terms and conditions that will apply to any outstanding Award upon the “termination of employment” (as defined under the Plan) of a participant, and such terms and conditions will be set forth in an Award agreement.

Federal Income Tax Consequences

     The following is a summary of the current federal income tax treatment related to grants of Awards under the Plan. This summary is not intended to, and does not, provide or supplement tax advice to participants. Participants in the Plan are advised to consult with their own independent tax advisors with respect to the specific tax consequences that, in light of their particular circumstances, might arise in connection with their receipt of any Awards under the Plan, including any state or local tax consequences and the effect, if any, of gift, estate and inheritance taxes.

     Options. No taxable income is realized by a participant upon the grant of an option under the Plan. Upon exercise of an option granted under the Plan, the participant would include in ordinary income an amount equal to the excess, if any, of the fair market value of the shares of Common Stock issued to the participant pursuant to such exercise (the “Option Shares”) at the time of exercise over the purchase price. The Company would be entitled to a deduction on exercise of the option for the amount includible in the participant’s income.

     Restricted Stock. No taxable income is realized by a participant upon the award of restricted Common Stock. Prior to the lapse of restrictions on such shares, any dividends received on such shares will be treated as ordinary compensation income. Upon the lapse of restrictions, the participant would include in ordinary income the amount of the fair market value of the shares of Common Stock at the time the restrictions lapse.

     Any participant may, however, make an election under Section 83(b) of the Code (an “83(b) election”) within 30 days after receipt of restricted Common Stock to take into income in the year the restricted Common Stock is transferred by the Company to such participant an amount equal to the fair market value of the restricted Common Stock on the date of such transfer (as if the restricted stock were unrestricted). If such election is made, the participant (i) will have no taxable income at the time the restrictions actually lapse, (ii) will have a capital gains holding period beginning on the transfer date and (iii) will have dividend income with respect to any dividends received on such shares. If the restricted Common Stock subject to the 83(b) election is subsequently forfeited, however, the participant is not entitled to a deduction or tax refund.

     Any appreciation or depreciation in such shares from the time the restrictions lapse (or the 83(b) election is made) to their subsequent disposition should be taxed as a short-term or long-term gain or loss, as the case may be.

     The Company would be entitled to a federal income tax deduction for the year in which the participant realizes ordinary income with respect to the restricted Common Stock in an amount equal to such income.

     Restricted Stock Units. No taxable income will be realized by a participant upon the grant of restricted stock units and no taxable income will be realized at the times the restricted stock units vest. At the time payment is made with respect to restricted stock units granted under the Plan, the participant will realize ordinary income in an amount equal to the cash received or the fair market value of the shares of Common Stock received. The Company would be entitled to a deduction at the time of payment in an amount equal to such income.

9


Table of Contents

The Board of Directors unanimously recommends that the shareholders vote for Item No. 2.

Equity Compensation Plan Information

     The following table provides information as of December 31, 2002 with respect to shares of First Tennessee common stock that may be issued under our existing equity compensation plans, including the 1990 Stock Option Plan (the “1990 Plan”), the 1995 Employee Stock Option Plan (the “1995 Plan”), the 1997 Employee Stock Option Plan (the “1997 Plan”), the 2000 Employee Stock Option Plan (the “Executive Plan”), the 2000 Non-employee Directors’ Deferred Compensation Stock Option Plan (the “Directors’ Plan”), the 1995 Non-employee Directors’ Deferred Compensation Stock Option Plan (the “1995 Directors’ Plan”), the 1991, 1997 and 2002 Bank Director and Advisory Board Member Deferral Plans (the “Advisory Board Plans”) and the First Tennessee National Corporation 2002 Management Incentive Plan (the “MIP”).

     The table includes information with respect to shares subject to outstanding options granted under equity compensation plans that are no longer in effect. Footnotes (4) and (5) to the table set forth the total number of shares of First Tennessee common stock issuable upon the exercise of options under the expired plans as of December 31, 2002. No additional options may be granted under those expired plans. The table does not include information about the proposed First Tennessee National Corporation 2003 Equity Compensation Plan, which has been submitted for shareholder approval as Vote Item No. 2 in this proxy statement.

10


Table of Contents

Equity Compensation Plan Information Table

                         
            (c)
            Number of Securities
    (a)   (b)   Remaining Available for
    Number of Securities to be   Weighted Average   Future Issuance Under
    Issued Upon Exercise of   Exercise Price of   Equity Compensation Plans
    Outstanding Options,   Outstanding Options,   (excluding securities reflected
Plan Category   Warrants and Rights   Warrants and Rights   in column (a))

Equity compensation plans approved by shareholders(1)
    4,865,315 (4)   $ 22.04       1,145,527 (2)
Equity compensation plans not approved by shareholders(3)
    17,433,428 (5)   $ 28.72       3,619,143  
Total
    23,213,959 (6)   $ 27.26       4,959,085 (7)

  (1)   Consists of the Executive Plan, Directors’ Plan, 1995 Directors’ Plan, 1995 Plan, 1990 Plan and the MIP.

  (2)   Includes shares available for future issuance under the MIP As of December 31, 2002, an aggregate of 200,000 shares of First Tennessee common stock were available for issuance under the MIP.

  (3)   Consists of the 1997 Plan and the Advisory Board Plans.

  (4)   Includes information for equity compensation plans that have expired. The Directors’ Plan and the 1990 Plan were approved by shareholders in 1995 and 1990, respectively. The plans expired June 1999 and April 2000. As of December 31, 2002, a total of 1,467,458 shares of First Tennessee common stock were issuable upon the exercise of outstanding options under these expired plans. No additional options may be granted under these expired plans.

  (5)   Includes information for equity compensation plans that have expired. The 1997 First Tennessee National Corporation Bank Director and Advisory Board Member Deferral Plan and the 1991 First Tennessee National Corporation Bank Director and Advisory Board Member Deferral Plan expired in January 2002 and January 1997, respectively. As of December 31, 2002, a total of 127,113 shares of First Tennessee common stock were issuable upon the exercise of outstanding options under the expired plans. No additional options may be granted under those expired plans.

  (6)   Includes 915,216 shares of First Tennessee common stock to be issued at the end of specified deferral periods set forth in individual deferral agreements.

  (7)   Includes 194,415 shares of First Tennessee common stock underlying restricted stock units granted under the 1992 Restricted Stock Plan.

Description of Equity Compensation Plans Not Approved by Shareholders

     The 1997 Plan. The 1997 Plan was adopted by the Board of Directors on April 16, 1996 and will expire in April 2006. The 1997 Plan provides for granting of nonqualified stock options.

     Options granted under the 1997 Plan have been granted to all employees of the Company under our FirstShare and Management Option programs. The FirstShare program is a broad based employee plan, where all employees of the Company receive a stock option award annually, except for management level employees who receive annual stock option awards under the Management Option program. The FirstShare options vest

11


Table of Contents

100% after three years and have a term of 10 years. The Management Options vest 50% after 3 years and 50% after 4 years, unless a specified stock price is achieved within the 3 year period. The Management Options have a term of 7 years. In addition to the above, certain employees may elect to defer a portion of their annual compensation into stock options. These options vest after 6 months and have a term of 20 years. The options vest on an accelerated basis in the event of a change in control of the Company. All options granted under the 1997 Plan have an exercise price equal to the fair market value on the date of grant. Notwithstanding the above, the option price per share may be less than 100% of the fair market value of the share at the time the option is granted if the employee has entered into an agreement with the Company to receive a stock option grant in lieu of compensation and that the amount of compensation foregone when added to the cash exercise price of the options equals at least the fair market value of the shares on the date of grant.

     As of December 31, 2002, options covering 17,301,136 shares of First Tennessee common stock were outstanding under the 1997 Plan, 3,424,362 shares remained available for future option grants, and options covering 2,109,684 shares had been exercised during the year. Of the options outstanding, approximately 62% were issued in connection with employee cash deferral elections. The Company received approximately $59,645,000 in cash deferrals to offset a portion of the exercise price. Of the 3,424,362 shares remaining available for future option grants, approximately 70% of options to be granted will have an option term of 10 years or less.

     The 1997 Plan is included as Exhibit 10(c) in our Form 10-Q for the quarter ended September 30, 2002, filed with the Securities and Exchange Commission.

     The Advisory Board Plans. The Advisory Board Plans were adopted by the Board of Directors in October 2001, January 1997 and January 1991. The 2002 Advisory Board Plan will expire on January 1, 2007 and the 1997 and 1991 plans expired in 2002 and 1997, respectively. The Advisory Board Plan provides granting of nonqualified stock options to bank regional and advisory board members, who choose to forego board fees and retainers, in exchange for stock options on shares of First Tennessee common stock.

     Options granted under the Advisory Board Plan have been granted only to regional and advisory board members who are non-employees of the bank. The options are granted in lieu of the participants receiving retainers or attendance fees for bank board meetings. The number of shares subject to grant will be the amount of fees/retainers earned divided by one half of the fair market value on the date of option grant. The exercise price plus the amount of fees foregone will equal the fair market value of the stock on the date of the grant. The options vest after 6 months and have a term of 20 years.

     As of December 31, 2002, options covering 132,292 shares of First Tennessee common stock were outstanding under the Advisory Board Plan. 194,781 shares remained available for future option grants, and options covering 6,319 shares had been exercised during the year.

VOTE ITEM NO. 3 — RATIFICATION OF APPOINTMENT OF AUDITORS

Appointment of Auditors for 2003

     KPMG LLP audited our annual financial statements for the year 2002. The Board of Directors has appointed, based on the recommendation of the Audit Committee, KPMG LLP to be our auditors for the year 2003. Although not required by law, regulation or the rules of the New York Stock Exchange, the Board has determined, as a matter of good corporate governance and consistent with past practice, to submit to the shareholders as Vote Item No. 3 the ratification of KPMG LLP’s appointment as our auditors for the year 2003, and the Board unanimously recommends that the shareholders vote for Item No. 3. Representatives of KPMG LLP are expected to be present at the annual meeting of shareholders with the opportunity to make a statement and to respond to appropriate questions.

Change in Auditors During 2002

     On May 15, 2002, we dismissed our independent public accountants, Arthur Andersen LLP (“Arthur Andersen”), and engaged KPMG LLP to serve as our independent public accountants for fiscal year 2002. The decision was approved by our Board of Directors upon the recommendation of the Audit Committee of the Board of Directors.

12


Table of Contents

     Arthur Andersen’s reports on the consolidated financial statements of First Tennessee as of and for the years ended December 31, 2001 and 2000 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

     During the two fiscal years of First Tennessee ended December 31, 2001 and the subsequent interim period through May 15, 2002, there were no disagreements with Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Arthur Andersen, would have caused Arthur Andersen to make reference to the subject matter of the disagreement in connection with its reports.

     None of the reportable events described in Item 304(a)(1)(v) of Regulation S-K occurred within the two fiscal years of First Tennessee ended December 31, 2001 or within the subsequent interim period through May 15, 2002.

     We provided Arthur Andersen with a copy of the foregoing disclosures and attached a copy of Arthur Andersen’s letter, dated May 15, 2002, stating its agreement with such statements as an exhibit to the Form 8-K that we filed on May 16, 2002.

     During the two fiscal years of First Tennessee ended December 31, 2001, and the subsequent interim period through May 15, 2002, we did not consult with KPMG LLP regarding any of the matters or events set forth in Item 304(a)(2)(i) or (ii) of Regulation S-K.

2002 Fees

     Fees billed by KPMG LLP for the year 2002 are described below. The Audit Committee of our Board of Directors has considered whether the provision of services other than professional services rendered for the audit of our financial statements and the quarterly review of the financial statements included in our Form 10-Q’s is compatible with maintaining KPMG LLP’s independence.

Audit Fees

     The aggregate fees billed to us by KPMG LLP for professional services rendered for the audit of our financial statements for the year 2002 and for the reviews of the financial statements in our Form 10-Q’s for the year 2002 were $751,500.

Financial Information Systems Design and
Implementation Fees

     No fees were billed to us by KPMG LLP for professional services for the year 2002 for designing or implementing hardware or software systems that aggregate service data underlying our financial statements or generate information that is significant to our financial statements taken as a whole.

All Other Fees

     The aggregate fees billed to us by KPMG LLP for services rendered for the year 2002 and not included in the fees disclosed in either of the two preceding subsections were $1,408,270. Included in this amount is $1 million for tax planning services rendered prior to KPMG LLP’s engagement as our auditor. The balance of this amount was provided in connection with the following audit-related services ($328,500): ERISA audits, audits for subsidiaries, compliance attestation, and other procedures and in connection with non-audit services, primarily tax compliance ($79,770).

OTHER MATTERS

     The Board of Directors, at the time of the preparation and printing of this proxy statement, knew of no other business to be brought before the meeting other than the matters described in this proxy statement. If any other business properly comes before the meeting, the persons named in the enclosed proxy will have discretionary authority to vote all proxies in accordance with their best judgment.

13


Table of Contents

SHAREHOLDER PROPOSAL DEADLINES

     If you intend to present a shareholder proposal at the 2004 annual meeting, it must be received by the Corporate Secretary, First Tennessee National Corporation, P. O. Box 84, Memphis, Tennessee, 38101, not later than November 19, 2003, for inclusion in the proxy statement and form of proxy relating to that meeting.

     In addition, Sections 2.8 and 3.6 of our Bylaws provide that a shareholder who wishes to nominate a person for election to the Board or submit a proposal at a shareholder meeting must comply with certain procedures whether or not the matter is included in our proxy statement. These procedures require written notification to us, generally not less than 90 nor more than 120 days prior to the date of the shareholder meeting. If, however, we give fewer than 100 days’ notice or public disclosure of the shareholder meeting date to shareholders, then we must receive the shareholder notification not later than 10 days after the earlier of the date notice of the shareholder meeting was mailed or publicly disclosed. The shareholder must disclose certain information about the nominee or item proposed, the shareholder and any other shareholders known to support the nominee or proposal. Section 2.4 of our Bylaws provides that the date and time of the annual meeting will be the third Tuesday in April (or, if that day is a legal holiday, on the next succeeding business day that is not a legal holiday) at 10:00 a.m. Memphis time or such other date and/or such other time as our Board may fix by resolution. The meeting date for 2004, determined according to the Bylaws, is April 20, 2004. Thus, shareholder proposals submitted outside the process that permits them to be included in our proxy statement must be submitted to the Corporate Secretary between December 22, 2003 and January 21, 2004, or the proposals will be considered untimely. Untimely proposals may be excluded by the Chairman or our proxies may exercise their discretion and vote on these matters in a manner they determine to be appropriate.

EXECUTIVE COMPENSATION

     The Summary Compensation Table provides information for the last three years about Mr. Horn and Mr. Glass, each of whom served during a portion of 2002 as Chief Executive Officer (“CEO”), our other four most highly compensated executive officers at year end 2002, and Mr. Thomas, who due to disability leave was not serving as an executive officer at year end 2002 but for whom disclosure is required. All of the named officers are officers of both First Tennessee and the Bank. The amounts include all compensation earned during each year, including amounts deferred (which, if deferred into options, are disclosed only in the notes to the table and in column (g)), by the named officers for all services rendered in all capacities to us and our subsidiaries. Information is provided for each entire year in which an individual served during any portion of the year as an executive officer. Additional information is provided in tabular form below about option grants and exercises in 2002, year-end option values, and pension benefits, along with a report of the Board’s Human Resources Committee on executive compensation and certain other information concerning compensation of executive officers and directors.

14


Table of Contents

                                                             
Summary Compensation Table

    Annual Compensation   Long-Term Compensation
   
 
                                Award(s)   Payouts
                               
 
(a)   (b)   (c)   (d)   (e)   (f)   (g)   (h)   (i)
                        Securities        
Name               Other   Restricted   Underlying        
And               Annual   Stock   Options/   LTIP   All Other
Principal       Salary   Bonus   Compensation   Award(s)   SARs   Payouts   Compensation
Position (3)   Year   ($)   ($)   ($)(7)   ($)(1)   (#)(2)   $   ($)(11)

Ralph Horn   2002   $
912,411

  $
1,305,033

  $
11,913

  $
1,380,686

 
162,438

 


  $
376,286  
Chairman   2001  
861,122

 
1,076,403

 
11,544

 


 
76,416

 


    383,335  
of the Board   2000  
814,346

 


 
11,554

 


 
205,547

 


    355,997  
 
J. Kenneth Glass   2002  
683,923
(4)
 
1,014,420

 
11,913

 
1,065,269

 
237,353
(4)
 

 
    193,229  
President & CEO   2001  
556,235
(4)
 
454,676
(4)
 
9,505

 


 
65,569
(4)
 


    189,136  
    2000  
475,385
(4)
 


 
7,068

 


 
110,921
(4)
 


    183,282  
 
Charles G. Burkett   2002  
381,615
(5)
 
432,692

 
6,376

 
600,016

 
14,390
(5)
 


    47,005  
President–Retail Fin Svs/   2001  
246,923
(5)
 
155,952
(5)
 
6,376

 


 
19,194
(5)
 


    33,812  
Memphis Fin Svs                                                        
 
Larry B. Martin   2002  
384,615

 
384,615
(8)
 
6,376

 
600,016

 
14,229

 


    51,176  
President–Business Fin   2001  
267,641

 
160,260

 
6,376

 


 
7,101

 


    38,167  
Svs/Tennessee Fin Svs                                                        
 
John H. Hamilton   2002  
262,692

 
253,738
(9)
 
5,478

 
397,469

 
15,122
(9)
 


    36,583  
Exec. Vice Pres.–Product                                                        
Mgmt & Delivery Svs                                                        
 
Sarah L. Meyerrose   2002  
278,846

 
320,673

 
5,478

 
397,469

 
12,541

 


    27,188  
Exec. Vice Pres.–   2001  
219,336

 
145,012
(10)
 
5,478

 


 
14,917
(10)
 


    28,516  
Corporate & Emp Svs   2000  
183,885

 


 


         
10,121

 


    17,648  
 
Elbert L. Thomas, Jr.   2002  
336,447

 
420,559

         
529,630

 
12,561

 


    32,759  
Exec. Vice Pres.   2001  
317,098

 
267,098
(6)
 


 


 
22,275
(6)
 


    35,247  
    2000  
288,962

 


 


 


 
19,086

 


    27,620  

(1)   Restricted stock awards are valued on the basis of the fair market value of a share of stock on the date of the award: $35.14 (2-26-02). On 12-31-02, the named officers held the following shares of restricted stock (including RSU’s described in the following sentence) with market values as indicated: Mr. Horn – 159,192 shares ($5,695,094); Mr. Glass – 85,961 shares ($3,075,255); Mr. Burkett – 23,742 shares ($849,370); Mr. Martin – 23,742 shares ($849,730); Mr Hamilton – 17,978 shares ($643,163); Ms. Meyerrose – 17,951 shares ($642,197), and Mr. Thomas – 43,822 shares ($1,567,732). The number of shares disclosed in the preceding sentence includes restricted stock units (“RSU’s”), described in note (2) to the Stock Ownership Table, with respect to which restrictions had not lapsed at 12-31-02, as follows: Mr. Horn – 99,967 RSU’s; Mr. Glass – 42,786 RSU’s; Mr. Thomas – 21,676 RSU’s; Messrs. Burkett, Martin and Hamilton and Ms. Meyerrose 0 RSU’s. Dividends are paid on restricted stock (and dividend equivalents are paid on RSU’s) at the same rate as all other shares of our common stock. Deferred dividend equivalents on RSU’s accrue interest at a 10-year Treasury rate and are settled only in cash.

15

 


Table of Contents

(2)   All amounts represent shares subject to option. No stock appreciation rights (SAR’s) were awarded.
 
(3)   Mr. Horn served as CEO until Mr. Glass’s appointment by the Board as CEO on July 16, 2002. Mr. Thomas went on disability leave December 1, 2002. Prior to that date he served as Chief Financial Officer. Messrs. Burkett and Martin were designated by the Board as Executive Officers on July 17, 2001. Thus, no compensation is required to be provided for them for the 2000 fiscal year. Mr. Hamilton was designated by the Board as an Executive Officer on October 15, 2002. No compensation is required to be provided for him for the 2001 or 2000 fiscal years.
 
(4)   In 2001, 2000, and 1999 Mr. Glass elected to receive a deferred compensation stock option in lieu of $50,000, $50,000 and $50,000 of his salary earned for the following year. The amounts in column (c) do not include these amounts, in lieu of which options for 1,368 shares, 1,315 shares 3,482 shares, 3,546 shares, 4,441 shares, and 7,022 shares (included in the amounts in column (g)) were granted on 1-2-03, 7-1-02, 1-2-02, 7-2-01, 1-02-01 and 7-03-00, respectively. In 2001 Mr. Glass elected to receive a deferred compensation stock option in lieu of $151,559 of his 2001 annual bonus. The amount in column (d) for 2001 does not include this amount, in lieu of which options for 21,565 shares (included in the amount in column (g)) were granted on 2-26-02.
 
(5)   In 2001 and 2000 Mr. Burkett elected to receive a deferred compensation stock option in lieu of $3,000 and $3,000 of his salary earned for the following year. The amount in column (c) does not include this amount, in lieu of which options for 82, 79, 209 and 213 shares (included in the amount in column (g)) were granted on 1-2-03, 7-1-02, 1-2-02 and 7-2-01, respectively. In 2000 Mr. Burkett elected to receive a deferred compensation stock option in lieu of $47,001 of his annual bonus for the following year. The amount in column (d) for 2001 does not include this amount, in lieu of which an option for 6,686 shares was granted on 2-26-02. In 2001, Mr. Burkett received a deferred compensation stock option in lieu of $39,317 of his annual bonus for 2001. The amount in column (d) for 2001 does not include this amount, in lieu of which an option for 5,594 shares (included in the amount in column (g)) was granted on 2-26-02.
 
(6)   In 2000 Mr. Thomas elected to receive a deferred compensation stock option in lieu of a portion of his annual bonus for the following year. The amount in column (d) for 2001 does not include a bonus of $50,000, in lieu of which options for 7,112 shares (included in the amounts in column (g)) were granted on 2-26-02.
 
(7)   The amounts in column (e) for all years represent automobile allowance tax gross-up payments.
 
(8)   In 2002, Mr. Martin elected to defer $288,461 of his annual bonus for the following year into a deferral account that accrues interest at a 10-year U.S. Treasury rate. This amount is included in column (d) for the year 2002.
 
(9)   In 2002, Mr. Hamilton elected to receive a deferred compensation stock option in lieu of $50,000 of his annual bonus for 2002. The amount in column (d) for 2002 does not include this amount, in lieu of which an option for 2,581 shares (included in the amount in column (g)) was granted on 3-3-03. In addition, Mr. Hamilton elected to defer $177,804 of his annual bonus for 2002 into a deferral account that accrues interest at a 10-year U.S. Treasury rate. This amount is included in column (d) for the year 2002.
 
(10)   In 2000, Ms. Meyerrose elected to receive a deferred compensation stock option in lieu of $48,337 of her annual bonus for 2001. The amount in column (d) does not include this amount, in lieu of which an option for 6,876 shares (included in the amount in column (g)) was granted on 2-26-02.
 
(11)   Elements of “All Other Compensation” for 2002 consist of the following:

16

 


Table of Contents

                                                 
    Above Mkt Rate   SurBen/SERP   Flex $   401(k) Match   Auto Allowance   Total

Mr. Horn
  $ 112,130     $ 236,466     $ 6,040     $ 5,500     $ 16,150     $ 376,286  
Mr. Glass
    73,927       91,612       6,040       5,500       16,150       193,229  
Mr. Burkett
    -       24,822       6,040       5,493       10,650       47,005  
Mr. Martin
    418       28,882       6,040       5,186       10,650       51,176  
Mr. Hamilton     -       15,893       6,040       5,500       9,150       36,583  
Ms. Meyerrose     984       5,802       6,040       5,212       9,150       27,188  
Mr. Thomas
    -       21,830       6,040       4,889       -       32,759  

     “Above Mkt Rate” represents above-market interest accrued on deferred compensation.

     “Sur Ben/SERP” represents insurance premiums with respect to our supplemental life insurance and excess pension plans. Under our Survivor Benefits Plan a benefit of 2.5 times final annual base salary is paid upon the participant’s death prior to retirement (or 2 times final salary upon death after retirement).

     “Flex $” represents First Tennessee’s contribution to the Flexible Benefits Plan, based on salary, service and corporate performance.

     “401 (k) Match” represents First Tennessee’s 50% matching contribution to the 401 (k) Savings Plan, which is based on the amount of voluntary contributions by the participant to the FTNC stock fund, up to 6% of compensation.

17

 


Table of Contents

     The following table provides information about stock options granted during 2002 to the officers named in the Summary Compensation Table. No stock appreciation rights (SAR’s) were granted during 2002.

                                         
Option/SAR Grants in Last Fiscal Year Table

Individual Grants                

               
    (b) Number   (c)% of Total           (h) Alternatives to
    of Securities   Options/SARs           (f) and (g)
    Underlying   Granted to   (d) Exercise or   (e)   Grant Date Value.
    Options/SAR's   Employees in   Base Price(2)   Expiration   Grant Date Present
(a) Name   Granted(#)(1)   Fiscal Year   ($ per share)(1)   Date   Value($)(4)

Mr. Horn
    52,386       1.09 %   $ 35.14       2/26/09     $ 458,378  
 
    110,052       2.29 %     35.14       2/26/09       962,955  
 
                                       
Mr. Glass
    3,482 (2)     0.07 %     28.70       1/2/22       40,008  
 
    35,369       0.74 %     35.14       2/26/09       309,479  
 
    74,301       1.55 %     35.14       2/26/09       650,134  
 
    21,565       0.45 %     35.14       2/26/12       136,506  
 
    125,000       2.60 %     36.35       7/16/09       1,107,500  
 
    1,315 (2)     0.03 %     19.01       7/1/22       25,103  
 
                                       
Mr. Burkett
    209 (2)     0.00 %     28.70       1/2/22       2,401  
 
    14,229       0.30 %     35.14       2/26/09       124,504  
 
    5,594       0.12 %     35.14       2/26/12       35,410  
 
    6,686 (2)     0.14 %     28.11       2/26/22       74,148  
 
    79 (2)     0.00 %     19.01       7/1/22       1,508  
 
                                       
Mr. Martin
    14,229       0.30 %     35.14       2/26/09       124,504  
 
                                       
Mr. Hamilton
    2,437 (2)     0.05 %     28.70       1/2/22       28,001  
 
    7,541       0.16 %     35.14       2/26/09       65,984  
 
    5,000       0.10 %     35.14       2/26/12       43,750  
 
    2,134 (2)     0.04 %     28.11       2/26/22       23,666  
 
                                       
Ms. Meyerrose
    7,541       0.16 %     35.14       2/26/09       65,984  
 
    5,000       0.10 %     35.14       2/26/12       43,750  
 
    6,876 (2)     0.14 %     28.11       2/26/22       76,255  
 
                                       
Mr. Thomas
    16,081 (3)     0.33 %     35.14       3/1/20       148,588  
 
    12,561       0.26 %     35.14       2/26/09       109,909  
 
    7,112 (2)     0.15 %     28.11       2/26/22       78,872  
 
    6,900 (3)     0.14 %     38.44       1/2/17       67,275  
 
    8,924 (3)     0.19 %     38.44       3/1/10       87,009  

(1)   All options except those marked with footnote (2) or (3) were granted 2-26-02 and 7-16-02 and vest 50% after three years from the date of grant and 100% after four years, with accelerated vesting if certain performance criteria (for 2-26-02 grant, our stock price equals or exceeds $48.06 on 2-26-05 or on 5 consecutive days before 2-26-05 and for 7-16-02 grant, our stock price equals or exceeds $49.72 on 7-16-05 or on 5 consecutive days before 7-16-05) are met. No SAR’s were granted. The exercise price per share equals the fair market value of one share of our common stock on the date of grant. Under the terms of all options, including those marked with footnote (2) and (3), participants are permitted to pay

18

 


Table of Contents

    the exercise price of the options with our stock; participants are permitted to defer receipt of shares upon an exercise and thereby defer gain; options exercised more than one year prior to the end of their term are eligible for a reload option grant when the exercise price is paid with our stock, with the reload option grant for the number of shares surrendered and having an exercise price equal to fair market value at the time of the first exercise and a term equal to the remainder of the first option’s term; the option plan provides for tax withholding rights upon approval of the plan committee; and upon a Change in Control (as defined in the subsection entitled “Employment Contracts and Termination of Employment and Change-in-Control Arrangements”), all options vest.
 
(2)   Options indicated by footnote (2) that were granted during 2002 were granted in lieu of compensation earned during 2001 and 2002. Mr. Glass was granted options for 3,482 shares on 1-2-02 in lieu of $25,000 of his 2001 salary and 1,315 shares on 7-1-02 in lieu of $25,000 of his 2002 salary. Mr. Burkett was granted an option for 209 shares on 1-2-02 in lieu of $1,500 of his 2001 salary and 79 shares on 7-1-02 in lieu of $1,502 of his 2002 salary. Mr. Burkett was granted 6,686 shares and 5,594 shares on 2-26-02 in lieu of $47,001 and $39,317, respectively, of his bonus for 2001. Mr. Thomas was granted 7,112 shares on 2-26-02 in lieu of $50,000 of his bonus for 2001. Ms. Meyerrose was granted 6,876 shares on 2-26-02 in lieu of $48,338 of her bonus for 2001. Mr. Hamilton was granted 2,437 shares on 1-2-02 in lieu of $17,498 of his 2001 salary. Mr. Hamilton was granted 2,134 shares on 2-26-02 in lieu of $15,000 of bonus for 2001. The exercise price per share equals 80% of the fair market value (“FMV”) of one share of our common stock on the 1-2-02 and 2-26-02 grant dates and equals 50% of FMV on the 7-1-02 grant date. The options vest 100% six months after the grant date. No SAR’s were granted. FMV on grant dates were $35.88, $35.14, and $38.02 on 1-2-02, 2-26-02 and 7-1-02, respectively.
 
(3)   Options indicated by footnote (3) were reload options, as described in footnote (1). Mr. Thomas was granted options for 16,081 shares 2-26-02 and 6,900 shares and 8,924 shares on 8-14-02. FMV on the grant date was $35.14 on 2/26/02 and $38.44 on 8-14-02.
 
(4)   A variation of the Black-Scholes option pricing model has been used. The following assumptions were made for purposes of calculating the Grant Date Value of the options granted 1-2-02 (options in lieu of compensation), 2-26-02 (options in lieu of bonus), 2-26-02 (management grants), 2-26-02 (options in lieu of bonus), 7-1-02 (options in lieu of compensation), 7-16-02 (management grant), and three reloads dated 2-26-02, 8-14-02 and 8-14-02, respectively: an exercise price of $28.70, $28.11, $35.14, $35.14, $19.01, $36.35, $35.14, $38.44 and $38.44; an option term of 20 years, 20 years, 7 or 10 years, 10 years, 20 years, 7 years, 18.02 years, 14.4 years and 7.55 years; an interest rate of 4.28%, 4.07%, 4.39%, 3.04%, 3.77%, 3.92%, 4.80%, 3.93%, and 3.93%; volatility of 31.07%, 31.07%, 29.42%, 33.83%, 31.07%, 29.42%, 26.04%, 26.04% and 26.04%; a dividend yield of 2.79%, 2.85%, 2.85%, 2.85%, 2.63%, 2.75%, 2.85%, 2.60% and 2.60%; a reduction of 4%, 2%, 3%, 0%, 1%, 0%, 0%, 0% and 0% to reflect the probability of forfeiture due to termination prior to vesting; and an expected life of 4, 4, 5, 2, 4, 5, 7, 7 and 7 years to reflect the probability of a shortened option term due to exercise prior to the option expiration date. The actual value if any, realized by a participant upon the exercise of an option may differ and will depend on the future market value of our common stock.

19

 


Table of Contents

     The following table provides information about stock options and SAR’s held at December 31, 2002, and exercises during 2002 by the officers named in the Summary Compensation Table. The values in column (c) represent the difference between the fair market value of the shares on the exercise date and the exercise price of the option. The values in column (e) reflect the spread between the market value at December 31, 2002, of the shares underlying the option and the exercise price of the option.

                                                 
Aggregated Option/SAR Exercises in Last Fiscal Year and
Fiscal Year-End Option/SAR Values Table

(a)   (b)   (c)   (d)   (e)
            Number of Securities    
            Underlying Unexercised   Value of Unexercised
            Options/SARs at   In-the-Money Options/SARs
            Fiscal Year-End (1)   at Fiscal Year-End (1)
           
 
    Shares            
    Acquired   Value        
Name   On Exercise   Realized   Exercisable   Unexercisable   Exercisable   Unexercisable
        ($)   (#)   (#)   ($)   ($)

Mr. Horn
    40,824 (2)   $ 1,147,563 (2)     610,528       301,670     $ 10,271,243     $ 529,423  
 
                                               
Mr. Glass
    11,664 (2)     327,875 (2)     306,066       299,735       4,559,234       294,710  
 
                                               
Mr. Burkett
    -       -       26,887       28,018       182,711       47,036  
 
                                               
Mr. Martin
    6,128 (2)     171,737 (2)     68,965       29,226       1,115,838       49,152  
 
                                               
Mr. Hamilton
    5,832 (2)     163,938 (2)     69,026       26,861       972,189       32,895  
 
                                               
Ms. Meyerrose
    5,248       136,789       57,780       27,781       876,556       52,105  
 
                                               
Mr. Thomas
    133,813 (2)     2,888,386 (2)     170,708       41,216       1,187,335       91,140  

(1)   No SAR’s are attached to any of the options in the table. Option values are based on $35.775 per share, the average of the high and low sales price on 12-31-02.
 
(2)   Messrs. Horn, Glass, Martin, and Hamilton did not realize this value in cash at the time of exercise, and Mr. Thomas did not realize any value in cash at the time of exercise with respect to 5,832 shares. They exercised options that were about to expire, deferred receipt of shares and will receive 31,277 shares, 8,936 shares, 4,691 shares, 4,468 shares and 4,423 shares, respectively, at the termination of the deferral period. The actual value ultimately received will depend on the future market value of our shares at the termination of the deferral period.

20

 


Table of Contents

     The following table provides information about estimated combined benefits under both our Pension Plan and our Pension Restoration Plan.

Pension Plan Table

                                                   

Covered                   Years of Service*        
Compensation    
       
    15 Yrs.   20 Yrs.   25 Yrs.   30 Yrs.   35 Yrs.   40 Yrs.

$
150,000
  $ 62,019     $ 75,488     $ 88,957     $ 95,025     $ 101,094     $ 107,162  
 
200,000
    76,821       95,224       113,627       122,162       130,698       139,233  
 
250,000
    91,623       114,960       138,297       149,299       160,302       171,304  
 
300,000
    106,425       134,696       162,967       176,436       189,906       203,375  
 
350,000
    121,227       154,432       187,637       203,573       219,510       235,446  
 
400,000
    136,029       174,168       212,307       230,710       249,114       267,517  
 
450,000
    150,831       193,904       236,977       257,847       278,718       299,588  
 
500,000
    165,633       213,640       261,647       284,984       308,322       331,659  
 
550,000
    180,435       233,376       286,317       312,121       337,926       363,730  
 
600,000
    195,237       253,112       310,987       339,258       367,530       395,801  
 
650,000
    210,039       272,848       335,657       366,395       397,134       427,872  
 
700,000
    224,841       292,584       360,327       393,532       426,738       459,943  
 
750,000
    239,643       312,320       384,997       420,669       456,342       492,014  
 
800,000
    254,445       332,056       409,667       447,806       485,946       524,085  
 
850,000
    269,247       351,792       434,337       474,943       515,550       556,156  
 
900,000
    284,049       371,528       459,007       502,080       545,154       588,227  
 
950,000
    298,851       391,264       483,677       529,217       574,758       620,298  

  *   Benefit shown is subject to limitations fixed by the Secretary of the Treasury pursuant to Section 415 of the Internal Revenue Code of 1986, as amended. The limitation is $160,000 for 2002 or 100% of the employee’s average income in his three highest paid years, whichever is less.

     Our Pension Plan is integrated with social security under an “offset” formula, applicable to all participants. Retirement benefits are based upon a participant’s average base salary for the highest 60 consecutive months of the last 120 months of service (“Covered Compensation”), service, and social security benefits. Benefits are normally payable in monthly installments after age 65. The normal form of benefit payment for a married participant is a qualified joint and survivor annuity with the surviving spouse receiving for life 50 percent of the monthly amount the participant received. The normal form of benefit payment for an unmarried participant is an annuity payable for life and 10 years certain. For purposes of the plan, “compensation” is defined as the total cash remuneration reportable on the employee’s IRS form W-2, plus pre-tax contributions under the Savings Plan and employee contributions under the Flexible Benefits Plan, excluding bonuses, commissions, and incentive and contingent compensation. Our Pension Restoration Plan is an unfunded plan covering employees in the highest salary grades, including all executive officers, whose benefits under the Pension Plan have been limited under Tax Code Section 415, as described in the note to the Pension Table, and Tax Code Section 401 (a)(17), which limits compensation to $200,000 for purposes of certain benefit calculations. “Compensation” is defined in the same manner as it is for purposes of the Pension Plan. Under the Pension Restoration Plan participants receive the difference between the monthly pension payable, if tax code limitations did not apply, and the actual pension payable. The amounts shown in the table are annual benefits payable (including any social security payments) in the event of retirement on December 31, 2002, at age 65 of a participant with a spouse who is age 65, assuming receipt of a qualified joint and 50% survivor annuity. The estimated credited years of service and the compensation covered by the plans for each of the individuals named in the Summary Compensation Table are as follows: Mr. Horn, 39 ($788,537); Mr. Glass, 29 ($473,931); Mr. Burkett, 33 ($232,568); Mr. Martin, 33 ($224,403); Mr. Hamilton, 31, ($192,277); Ms. Meyerrose, 21, ($194,214) and Mr. Thomas, 13, ($217,319).

21

 


Table of Contents

Employment Contracts and Termination of Employment and Change-in-Control Arrangements

     We have contracts with approximately 70 officers, including each of the named executive officers, which may be terminated upon three years’ prior notice. These contracts provide generally for a payment (which, for the named executive officers, is equal to three times annual base salary plus annual target bonus) in the event of a termination of the officer’s employment by us other than “for cause” or by the employee for “good reason” (as such terms are defined in the contracts) within 36 months after a “Change-in-Control” or the officer’s termination of employment for any reason (other than “cause”) during the 30-day period commencing one year after a Change-in-Control. The contracts provide generally for an excise tax gross-up with respect to any taxes incurred under Internal Revenue Code Section 4999 following a Change-in-Control and for 3 years continued welfare benefits. The term “Change-in-Control” is defined to include:

    a merger or other business combination, unless (i) more than 50 percent of the voting power of the corporation resulting from the business combination is represented by our voting securities outstanding immediately prior thereto, (ii) no person or other entity beneficially owns 20 percent or more of the resulting corporation, and (iii) at least a majority of the members of the board of directors of the resulting corporation were our directors at the time of board approval of the business combination (solely for purposes of the severance contracts, but not for purposes of their 30-day termination period, the “50 percent” test in clause (i) is changed to “60 percent” and the “majority of the board” test in clause (iii) is changed to “two-thirds of the board”),

    the acquisition by a person or other entity of 20 percent or more of our outstanding voting stock,

    a change in a majority of the Board of Directors, or

    shareholder approval of a plan of complete liquidation or a sale of substantially all of our assets.

     A Change-in-Control has the following effect on certain benefit plans in which the named executive officers participate:

    Target annual bonuses are prorated through the date of the Change-in-Control and paid.

    Restricted stock, restricted stock units, phantom stock units and unvested stock options vest.

    Under our Pension Restoration Plan, a lump sum payout is made to participants of the present value, using a discount rate of 4.2 percent, of the participant’s scheduled projected benefits, assuming periodic distributions of the participant’s accrued benefit in the normal form under the plan, actuarially adjusted according to a formula for the participant’s age at the time of the Change-in-Control.

    Excess funding in the Pension Plan is allocated, according to a formula, to participants and retirees.

    Deferred compensation under individual deferral agreements which accrue interest based on the 10-year Treasury rate and certain other benefits are paid over to previously established rabbi trusts. Funds in such trusts will remain available for the benefit of our general creditors prior to distribution.

    Our Survivor Benefits Plan generally cannot be amended to reduce benefits.

    Under the Directors and Executives Deferred Compensation Plan under which new deferrals have not been permitted since 1995, a lump sum payout is made to participating employees and certain terminated employees of the present value, using a discount rate of 4.2 percent, of the participant’s scheduled projected distributions, assuming employment through normal retirement date and continued interest accruals at above-market rates, described in the “Compensation of Directors” section below.

22

 


Table of Contents

Compensation Committee Interlocks
and Insider Participation

     Messrs. Haslam and Martin and Mrs. Palmer, all of whom are non-employee directors, served as members of the Board of Director’s Human Resources Committee (“Committee”), which is our compensation committee, during all or a portion of 2002. No interlocking relationships existed with respect to any of the members of the Committee. Mr. Horn was, however, during 2002, Chairman of the compensation committee of Mid-America Apartment Communities, Inc., of which Mr. Gates was Chairman through September 2002, and Mr. Horn served on the compensation committee of Gaylord Entertainment Company, of which Mr. Rose is Chairman.

Certain Relationships and Related Transactions

     Our banking subsidiaries have had banking transactions in the ordinary course of business with our executive officers, directors, nominees, and their associates which are reported in a note to our financial statements, and they expect to have such transactions in the future. Such transactions, which at December 31, 2002, amounted to 4.25 percent of our shareholders’ equity, have been on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable transactions with others and have not involved more than normal risk of collectibility or presented other unfavorable features.

     During 2002, the FTN Financial Capital Markets division of the Bank participated, in the ordinary course of business, in securities transactions with the clients of an independent investment adviser in which Darrell Horn, the son of Ralph Horn, has an equity interest and of which he is an officer. The aggregate dollar value of the securities involved in these transactions was approximately $40.6 million, less than .0025% of the division’s transactions during 2002. Our gross revenues from these transactions were approximately $87,000, and we paid the entity affiliated with Darrell Horn finders fees totaling $20,000, both amounts that were comparable to those that were involved in transactions with other unrelated third parties.

     During 2002, we paid Cook Systems International (“CSI”) $557,416 in the ordinary course of business for contract employees (computer personnel). Corey Glass, the son of J. Kenneth Glass, is employed by CSI and received from CSI, as part of his compensation, commissions totaling $15,673 in connection with $304,606 of the payments we made to CSI. The amounts paid to CSI were comparable to amounts we paid to unrelated third parties for similar services. Corey Glass is no longer compensated based on transactions between CSI and First Tennessee.

     During 2002, the Bank made lease payments on one of its branches to Lacy Mosby & Sons, Inc. (“LMSI”). Marlin L. Mosby, Jr., who is the owner and president of LMSI, is the father of Marlin L. Mosby, III, who was designated as an executive officer of First Tennessee in October 2002. The lease, which was an arm’s length transaction at market rates, commenced in 1997, has a 30 year term, provides for monthly payments of $3,000, increasing in increments to $7,000 per month in 2017, and has renewal options. The Bank has leased this location or an adjacent property from LMSI for over 30 years.

     Notwithstanding anything to the contrary set forth in any of our previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate future filings by reference, including this proxy statement, in whole or in part, the following Board Compensation Committee Report on Executive Compensation and the Total Shareholder Return Performance Graph shall not be incorporated by reference into any such filings.

Board Compensation Committee Report on Executive Compensation

     Our Bylaws require the Board of Directors or a Board committee to determine the compensation of executive officers. The Board has designated the Human Resources Committee (Committee) to perform this function. The Committee is composed entirely of independent, nonemployee directors who have no interlocking relationships with us. The Committee has set forth below its report on the compensation policies applicable to executive officers and the basis for the compensation of the Chief Executive Officer (CEO) during 2002.

23

 


Table of Contents

     Our executive compensation programs are designed to align the interests of the executive officers with our performance and the interests of our shareholders. Approximately 60 to 70 percent of the executive officers’ annual compensation potential is at risk based on corporate performance and total shareholder return (defined below). Compensation programs have been designed to reward executive officers in both cash and our stock based on performance that also rewards shareholders. When corporate performance does not meet criteria established by the Committee, incentive compensation is reduced accordingly. In addition, the executive compensation program has been designed to attract and retain qualified executive officers. Executive compensation consists generally of the following components:

    base salary
    annual incentive bonus
    long-term incentive awards
    deferral of compensation through stock option grants or at market interest rates (or for compensation deferred before 1996 at above-market rates)
    customary employee and other benefits typically offered to similarly situated executives

     Base salary and annual bonus are based on an evaluation of the individual’s position and responsibilities based on independent criteria and external market data and personal and corporate performance. The Committee does not assign a specific weight to any of the factors but places greater emphasis on corporate and personal performance in the overall mix.

     Long-term incentive awards consist of restricted stock awards containing provisions for acceleration of vesting upon achievement of corporate performance criteria and stock options. It is not our practice to “reprice” stock options or to price them at less than fair market value on the date of grant. Although deferred compensation options have an exercise price of 50 percent (80 percent for options granted for 2001 and 2000 and 85% for options granted for years prior to the year 2000) of fair market value on the grant date, to receive the option the participant must forego the right to receive cash compensation. Under our deferral option plans the amount of the foregone cash compensation plus the option exercise price must equal or exceed 100% of fair market value. In the past, we have offered deferred compensation at above-market rates and deferrals through the use of stock options. Deferrals since 1995 have been limited to stock options or a 10-year Treasury rate of interest. Executive officers may also defer the receipt of shares upon the exercise of stock options and defer the receipt of restricted stock prior to the lapse of restrictions. Except for our stock fund (ESOP) within our 401(k) plan, other benefits provided to the executive officers are not tied to corporate performance.

     The Committee reviewed external market data provided by an independent consulting firm that included some of the highest-performing companies in the American Banker Top 50, a peer group of banking organizations against which we measure our strategic performance, as well as other independent compensation surveys. We selected the highest-performing companies based generally on the following one and five-year return measures: earnings per share growth rate, historical earnings consistency, return on equity, and to a lesser degree return on assets, percentage of fee income versus total revenue, and net loan charge offs.

     The purpose of the review was to determine compensation levels of similar positions at these companies. The compensation peer group used by the independent consulting firm did not include all of the banking organizations listed in the Total Shareholder Return Performance Graph (“TSR graph”) for the 2002 peer group. The median asset size of the compensation high-performing peer group was $39.7 billion. In actual practice, the compensation of executive officers approximates the 75th percentile of the compensation of the high-performing peer group when performance goals that place First Tennessee among the top performing peers are met. We do not, however, have a specific policy that mandates how compensation will be determined relative to external market data.

     All compensation paid to executive officers during 2002 is fully deductible on our corporate federal income tax return. Section 162(m) of the Tax Code generally disallows a tax deduction to public companies, including us, for compensation exceeding $1 million paid during the year to the CEO and the four other highest paid executive

24

 


Table of Contents

officers at year end. Certain performance-based compensation is not, however, subject to the deduction limit. Under Tax Code regulations the salary and TARSAP (defined below) portions of compensation do not meet the performance-based compensation criteria of Section 162(m). The restricted stock plan permits deferral by participants of the receipt of restricted stock prior to the lapse of restrictions. Any such deferral does not represent compensation paid during the year, and thus, is not currently subject to the Section 162(m) limitation. The Committee’s practice is to continue to consider ways to maximize the deductibility of executive compensation while retaining the discretion deemed necessary to compensate executive officers in a manner commensurate with performance and the competitive market for executive talent.

(i) The CEO’s Compensation

     Mr. Horn was Chairman and CEO until Mr. Glass’ election as CEO, effective July 15, 2002, after which Mr. Horn retained the office of Chairman and Mr. Glass retained the office of President. References herein to CEO apply to both individuals.

     Base Salary: The Committee establishes the CEO’s base salary annually based on corporate performance, achievement of objectives in his individualized written personal plan, and competitive practices within the industry.

     The CEO develops his personal plan and submits it to the Committee for review and recommendation. The Board of Directors approves the plan, which generally contains strategic, quality and financial goals. A salary increase of 6.0 percent was approved for Mr. Horn and Mr. Glass in February of 2002 based on substantial achievement of personal plan objectives and competitive practices. Although no specific weight is assigned to these factors, the Committee places greater emphasis on personal performance than on competitive practices within the industry. In addition, a salary increase of 9.1 percent was approved for Mr. Glass in July of 2002 based on the significant increase in responsibilities due to his election as CEO. The Committee used multiple resources to obtain recommendations regarding the appropriate remuneration of Mr. Glass. Base salary is intended to represent approximately 20 percent to 30 percent of the CEO’s total compensation potential.

     Annual Bonus: The CEO’s annual bonus is based entirely on our corporate performance against financial objectives established by the Committee at the beginning of each year. The financial objectives for 2002 were based on EPS growth. The CEO may be awarded a target annual bonus of a maximum of 125 percent of his salary dollars earned during the year. The degree of success in reaching corporate objectives determines a payout of zero percent to 125 percent of the CEO’s target annual bonus. During 2002, corporate performance resulted in a payout of 125% of targeted bonus. Mr. Horn’s and Mr. Glass’ bonuses were prorated to reflect the period of time that each served as CEO. The portion of their target bonus earned while serving as CEO was calculated at a maximum of 125 percent. The remainder of their target bonus was calculated at a maximum of 100 percent.

     Long-term Awards: The CEO’s long-term incentive compensation consists of restricted stock and stock options.

     Our restricted stock program includes performance criteria as a condition to early vesting of awards to executive officers. The objective of this time accelerated restricted stock award plan (TARSAP) feature is to associate more closely the long-term compensation of executive officers with shareholder interests. Under the TARSAP feature, restricted stock is granted with accelerated vesting if performance criteria established by the Committee are met with respect to specified performance periods. Performance periods are for three years and overlap: e.g., 2000-2002, 2001-2003, 2002-2004. Performance criteria have always been based, for all participants, including the CEO, on total shareholder return (appreciation in the market value of our stock with dividends reinvested-TSR) targets established at the beginning of each performance period. Targets are based on our percentile ranking in a peer group (the “100-bank peer group”) of approximately the 100 largest banking organizations by asset size traded on U.S. exchanges, with the condition that TSR must be a positive number. The 100-bank peer group is different from the peer group used to compare shareholder returns. The 100-bank peer group was originally selected in 1990, prior to the adoption of SEC rules requiring disclosure of a shareholder return performance graph, because the Committee believed that it was an appropriate index with which to associate more closely

25

 


Table of Contents

long-term compensation of executives with shareholder interests. The restricted stock program which contains the 100-bank peer group has produced the desired results, and thus, the Committee has continued to use it for the restricted stock program. In addition to the TSR targets, the Committee adopted alternative criteria for the accelerated vesting of TARSAP awards made in 1996 and future years based upon our percentile ranking within the 100-bank peer group with respect to operating EPS growth rate (or exceeding a minimum operating EPS growth rate) and average operating ROE, with the condition that TSR must be a positive number. In January 2003, the Committee approved the accelerated vesting of the TARSAP shares for the 2000-2002 performance period because the primary criteria, as described above, were met.

     In addition to performance-based restricted stock awards, the Committee generally awards stock options to executive officers, including the CEO, as a part of a broad-based stock option program under which awards are made to all employees, both full-time and part-time. The CEO’s option award (which is disclosed in the “Option/SAR Grants in Last Fiscal Year Table”) was based on an estimated value of the option which in combination with the restricted stock award provides the basis for a competitive long-term incentive package. The option grant contained a performance-based, accelerated vesting feature, which is described in part (ii) of this report. Mr. Glass also received a special award of 125,000 options in July 2002 in recognition of his increased responsibilities as CEO. This option award has a term of 7 years and vests 50% after 3 years and 100% after 4 years. The exercise price of this special award is $36.35. Because the value of the option to the CEO is a function of the price growth of our stock, the amount realized by the CEO is tied directly to increases in shareholder value.

     Other Benefits: The CEO’s compensation reported in the Summary Compensation Table also includes accrual of above-market rates of interest on compensation deferred prior to 1996 and the cost of insurance to fund a supplemental retirement plan and life insurance benefit, which are not directly based on corporate performance. Above-market rates are accrued for deferred compensation of the CEO and other named executive officers, who deferred prior to 1996, for retention purposes. Generally, the plan under which this benefit was offered requires that the amount deferred be automatically recalculated at market rates if termination occurs prior to retirement.

(ii) Other Executive Officer Compensation

     Base Salary: The CEO recommends and the Committee approves the base salary for executive officers other than the CEO. Recommendations are generally based on corporate performance (as measured by financial, quality and strategic objectives), individual overall performance during the prior year, and competitiveness in the market place. It is our policy to maintain a competitive salary commensurate with the duties and responsibilities of the executive officers. Salary represents approximately 30 percent to 45 percent of an executive officer’s potential annual compensation.

     Annual Bonus: Executive officers’ annual bonus is based on achievement of corporate financial objectives and performance against personal objectives for the year, which are recorded in individualized written personal plans. Individual objectives must include financial, quality and strategic goals. The degree of completion of goals determines the award. Financial objectives for 2002 were based on EPS growth. Although the CEO has an individualized personal plan, his annual bonus is based entirely on corporate financial performance, and the Chief Credit Officer’s and Controller’s annual bonuses are based solely on individualized personal plans. The maximum target annual bonus of executive officers other than the CEO is between 45 percent and 100 percent of salary dollars earned during the year. During 2002, our corporate performance resulted in a payment of 125% of target annual bonus for any executive officer whose bonus was based on corporate performance.

     Long-term Awards: The executive officers named in the Summary Compensation Table and all but two of the other executive officers currently participate in the TARSAP program described above in part (i) of this report. The performance criteria are identical. The number of shares awarded for a three-year performance period is generally 50 percent of the greater of the participant’s salary or salary grade mid-point, based on market value of the shares at the time of the award. The Company does not provide a federal income tax gross-up to executive officers at the vesting of restricted stock.

26

 


Table of Contents

     In addition to performance-based restricted stock awards, the Committee generally awards stock options on our stock annually to executive officers, including the CEO, as a part of the option program discussed in part (i) of this report. The number of shares awarded to executive officers is equal to a percentage of salary (ranging from 100 percent to 200 percent, with 200 percent used for the CEO) divided by the market value (or for the CEO and the COO/President, the Black-Scholes value) of one share of our stock at the time of grant. Executive officers may also be awarded shares in addition to those calculated as a percent of salary if in the opinion of the Committee additional shares are required to ensure a competitive compensation package. The exercise price is the market value at the time of grant. Options are awarded based on personal performance and to encourage future performance as well as for retention purposes (with a seven-year term and vesting at 50 percent after three years and 100 percent after four years). The February 2002 grant’s exercise price is $35.14. This grant contains a provision for accelerated vesting if the closing market price per share equals at least $48.06 for five consecutive business days in the three years following the grant or at the end of the three year period. Options granted annually beginning March 2000 to the Chairman and the CEO were based in part on prior corporate performance.

     Other Benefits: We have adopted certain broad-based employee benefit plans in which executive officers participate and certain other retirement, life and health insurance plans and we provide customary personal benefits. Except for our stock fund (ESOP) within our 401(k) plan, the benefits under these plans are not tied to corporate performance. The executive officers named in the Summary Compensation Table participate in the other benefits described above with respect to the CEO.

     
    Human Resources Committee
     
    R. Brad Martin, Chairman
James A. Haslam
Vicki R. Palmer

27

 


Table of Contents

     The following graph compares the yearly percentage change in our cumulative total shareholder return with returns based on the Standard and Poor’s 500 index and a peer group index, which is described below and in a footnote to the graph. It should be noted that the “total shareholder return” reflected in the graph is not comparable to the “total shareholder return” described in the Compensation Committee Report because the former has a different measurement period and it has been adjusted and weighted for the market capitalization of the companies in the peer group, as required by SEC regulations. Our peer group consists of the American Banker Top 50 banking organizations (excluding First Tennessee) as measured by market capitalization as of the end of the most recent fiscal year.

PERFORMANCE GRAPH

COMPANIES
                                                   

      1997   1998   1999   2000   2001   2002

First Tennessee   $ 100     $ 117     $ 89     $ 95     $ 122     $ 124  
S&P 500
    100       139       133       143       123       93  
American Banker     100       113       119       146       140       123  
 
Top 50
                                               
The graph assumes $100 is invested on December 31, 1997, and dividends are reinvested Returns are market-capitalization weighted.

28

 


Table of Contents

     The American Banker Top 50 consists of the following (with First Tennessee excluded): AmSouth Bancorporation, Associated Bane Corp, Banknorth Group, Inc., Bane One Corporation, BankAmerica Corporation, Bank of New York Co., Inc., Branch Banking and Trust Company, Charter One Financial, Inc., Citigroup Inc., City National Corp., Comerica Incorporated, Commerce Bancorp, Commerce Bancshares, Inc., Compass Bancshares, Inc., Fifth Third Bancorp, First Virginia Banks, Inc., First Merit Corp, Fleet Boston Financial Corp., Fulton Financial Corp., Hibernia Corporation, Huntington Bancshares Incorporated, J.P. Morgan Chase & Co., KeyCorp, M & T Bank Corporation, Marshall & Ilsley Corporation, Mellon Financial Corporation, Mercantile Bankshares Corporation, National City Corporation, National Commerce Bancorp, North Fork Bancorporation, Northern Trust Corporation, Pacific Century Financial Corp., PNC Financial Services, Popular Inc., Regions Financial Corp, Sky Financial Group, Inc. SouthTrust Corporation, State Street Corporation, SunTrust Banks, Inc., Synovus Financial Corporation, TCF Financial Corp, UnionBanCal Corporation, Union Planters Corporation, U.S. Bancorp, Valley National Bancorp, Wachovia Corporation, Wells Fargo & Company, Wilmington Trust, and Zions Bancorporation.

Compensation of Directors

     During 2002, each nonemployee director was paid a retainer quarterly at an annual rate of $25,000 plus a fee of $1,000 for each day of each Board and each committee meeting attended. The chairpersons of the Audit and Human Resources Committees were paid quarterly an additional retainer at an annual rate of $3,000 each. We also reimburse our directors for their expenses incurred in attending meetings. In addition, the following benefits have been approved by the Board as additional compensation to non-employee directors for service as a director: a personal account executive, a no fee personal checking account for the director and his or her spouse, a FirstCheck card, a 25% reduction in commissions charged by First Tennessee Brokerage, Inc., a no fee VISA gold card, no fee for a safe deposit box, no fee for traveler’s checks and cashier’s checks, and if the Board has authorized a stock repurchase program, the repurchase of shares of our common stock at the day’s volume-weighted average price with no payment of any fees or commissions if the repurchase of the director’s shares is otherwise permissible under the repurchase program that has been authorized. Our practice is to hold Board and committee meetings jointly with the Bank’s Board and committees. All of our directors are also directors of the Bank. Directors are not separately compensated for Bank Board or committee meetings except for those infrequent meetings that do not occur jointly. Directors who are officers are not separately compensated for their services as directors. Under the terms of our 1992 Restricted Stock Incentive Plan, which was approved by the shareholders and which terminated in April 2002, all nonemployee directors received an automatic, nondiscretionary award of 6,000 shares (adjusted for stock splits) of restricted stock on May 1, 1992, and all new nonemployee directors received such award upon election to the Board. Restrictions lapse at the rate of 10 percent annually. Such shares are forfeited if the director terminates for any reason other than death, disability, retirement, or the acquisition by a person of 20 percent of the voting power of our stock. Upon termination for any of the four listed reasons, all shares vest. Directors may elect to defer their retainers and fees. Under the 2000 Non-Employee Directors’ Deferred Compensation Stock Option Plan, all non-employee directors elected to receive stock options in lieu of fees through 2004. The exercise price per share is 80 percent (85% under a prior plan for options granted prior to the year 2000) of fair market value of one share of our common stock on the date of grant, and the number of shares subject to option granted equals the amount of fees deferred divided by 20 percent (15 percent under a prior plan with respect to options granted prior to the year 2000) of the fair market value of one share on the date of grant. The 2003 Equity Compensation Plan, under which nonemployee directors may receive awards, has been proposed for shareholder approval. For a description of that plan, see Vote Item No. 2 above. Under the Directors and Executives Deferred Compensation Plan, not offered with respect to compensation earned since 1995, under which up to six annual deferrals may be elected, amounts deferred accrue interest at rates ranging from 17-22 percent annually, based on age at the time of deferral, with a reduction to a guaranteed rate based on 10-year Treasury obligations if a participant terminates prior to a change-in-control for a reason other than death, disability or retirement. Interim distributions in an amount between 85 percent and 100 percent of the amount originally deferred are made in the eighth through the eleventh years following the year of deferral, with the amount remaining in a participant’s account and accrued interest generally paid monthly over the 15 years following retirement at age 65. Certain restrictions and limitations apply on payments and distributions. Under other deferral agreements, nonemployee directors have deferred and may defer amounts, which generally accrue interest at a rate tied to 10-year Treasury obligations.

29

 


Table of Contents

Section 16(a) Beneficial Ownership Reporting Compliance

     Section 16(a) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) requires our directors and officers to file with the SEC initial reports of ownership and reports of changes in ownership of our common stock and to furnish us with copies of all forms filed.

     To our knowledge, based solely on a review of the copies of such reports furnished to us and written representations that no other reports were required, during the past fiscal year all Section 16(a) filing requirements applicable to our officers and directors were complied with except that Mr. Rose filed one report concerning one purchase of 288 shares through a custodial account late, and Mr. Larry Martin, an executive officer, filed one report concerning one transaction, a 27 share gift, late. Neither transaction created a short swing profit.

AVAILABILITY OF ANNUAL REPORT ON FORM 10-K

     A copy of our Annual Report on Form 10-K, including the financial statements and schedules thereto, which is filed with the Securities and Exchange Commission, is available free of charge to each shareholder of record upon written request to the Treasurer, First Tennessee National Corporation, P. O. Box 84, Memphis, Tennessee, 38101. Each such written request must set forth a good faith representation that as of the record date specified in the notice of annual shareholders’ meeting the person making the request was a beneficial owner of a security entitled to vote at the annual meeting of shareholders.

     The exhibits to the Annual Report on Form 10-K will also be supplied upon written request to the Treasurer and payment to us of the cost of furnishing the requested exhibit or exhibits. A document containing a list of each exhibit to Form 10-K, as well as a brief description and the cost of furnishing each such exhibit, will accompany the Annual Report on Form 10-K.

     
BY ORDER OF THE
BOARD OF DIRECTORS
   
 
-s- Clyde A. Billings, Jr.    
 
Assistant Corporate Secretary
March 18, 2003
   

30

 


Table of Contents

Appendix A

FIRST TENNESSEE NATIONAL CORPORATION
2003 EQUITY COMPENSATION PLAN

SECTION 1 - Purpose

This plan shall be known as the “First Tennessee National Corporation 2003 Equity Compensation Plan” (the “Plan”). The purpose of the Plan is to promote the interests of First Tennessee National Corporation, a Tennessee corporation (the “Company”), and its shareholders by (i) attracting and retaining officers, employees, and non-employee directors of the Company and its Subsidiaries, (ii) motivating such individuals by means of performance-related incentives to achieve long-range performance goals, (iii) enabling such individuals to participate in the long-term growth and financial success of the Company, (iv) encouraging ownership of stock in the Company by such individuals, and (v) linking compensation to the long-term interests of shareholders. With respect to any awards granted under the Plan that are intended to comply with the requirements of “performance-based compensation” under Section 162(m) of the Code (as defined below), the Plan shall be interpreted in a manner consistent with such requirements.

SECTION 2 - Definitions

As used in the Plan, the following terms shall have the meanings set forth below:

“Award” shall mean any Option, Restricted Stock, Restricted Stock Unit or Performance Award granted under the Plan, whether singly or in combination, to a Participant pursuant to such terms, conditions, restrictions and/or limitations, if any, as may be established from time to time.

“Award Agreement” shall mean any written or electronic agreement, contract, notice or other instrument or document evidencing any Award, which may, but need not, be executed or acknowledged by a Participant.

“Board” shall mean the Board of Directors of the Company.

“Cause” shall mean (i) a Participant’s conviction of, or plea of guilty or nolo contendere (or similar plea) to, (A) a misdemeanor charge involving fraud, false statements or misleading omissions, wrongful taking, embezzlement, bribery, forgery, counterfeiting or extortion, (B) a felony charge or (C) an equivalent charge to those in clauses (A) and (B) in jurisdictions which do not use those designations; (ii) the engaging by a Participant in any conduct which constitutes an employment disqualification under applicable law (including statutory disqualification as defined under the Exchange Act); (iii) a Participant’s failure to perform his or her duties to the Company or its Subsidiaries; (iv) a Participant’s violation of any securities or commodities laws, any rules or regulations issued pursuant to such laws, or the rules and regulations of any securities or commodities exchange or association of which the Company or any of its Subsidiaries or affiliates is a member; (v) a Participant’s violation of any policy of the Company or its Subsidiaries concerning hedging or confidential or proprietary information, or a Participant’s material violation of any other policy of the Company or its Subsidiaries as in effect from time to time; (vi) the engaging by a Participant in any act or making any statement which impairs, impugns, denigrates, disparages or negatively reflects upon the name, reputation or business interests of the Company or its Subsidiaries; or (vii) the engaging by the Participant in any conduct detrimental to the Company or its Subsidiaries. The determination as to whether Cause has occurred shall be made by the Committee in its sole discretion. The Committee shall also have the authority in its sole discretion to waive the consequences under the Plan or any Award Agreement of the existence or occurrence of any of the events, acts or omissions constituting Cause.

“Change in Control” shall mean, unless otherwise defined in the applicable Award Agreement, the occurrence of any one of (and shall be deemed to have occurred on the date of the earliest to occur of) the following events:

  (i)   individuals who, on January 21, 1997, constitute the Board (the “Incumbent Directors”) cease for any reason to constitute at least a majority of the Board, provided that any person becoming a director subsequent to January 21, 1997, whose election or nomination for election was approved by a vote

A-1

 


Table of Contents

      of at least three-fourths (3/4) of the Incumbent Directors then on the Board (either by a specific vote or by approval of the proxy statement of the Company in which such person is named as a nominee for director, without written objection to such nomination) shall be an Incumbent Director; provided, however, that no individual elected or nominated as a director of the Company initially as a result of an actual or threatened election contest with respect to directors or as a result of any other actual or threatened solicitation of proxies or consents by or on behalf of any person other than the Board shall be deemed to be an Incumbent Director;

  (ii)   any “Person” (for purposes of this definition only, as defined under Section 3(a)(9) of the Exchange Act as used in Section 13(d) or Section 14(d) of the Exchange Act) is or becomes a “beneficial owner” (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing 20% or more of the combined voting power of the Company’s then outstanding securities eligible to vote for the election of the Board (the “Company Voting Securities”); provided, however, that the event described in this paragraph (ii) shall not be deemed to be a Change in Control by virtue of any of the following acquisitions: (A) by the Company or any Subsidiary, (B) by an employee stock ownership or employee benefit plan or trust sponsored or maintained by the Company or any Subsidiary, (C) by any underwriter temporarily holding securities pursuant to an offering of such securities, or (D) pursuant to a Non-Qualifying Transaction (as defined in paragraph (iii) hereof);

  (iii)   the shareholders of the Company approve a merger, consolidation, share exchange or similar form of corporate transaction involving the Company or any of its Subsidiaries that requires the approval of the Company’s shareholders, whether for such transaction or the issuance of securities in the transaction (a “Business Combination”), unless immediately following such Business Combination: (A) more than 50% of the total voting power of (x) the corporation resulting from such Business Combination (the “Surviving Corporation”), or (y) if applicable, the ultimate parent corporation that directly or indirectly has beneficial ownership of 100% of the voting securities eligible to elect directors of the Surviving Corporation (the “Parent Corporation”), is represented by Company Voting Securities that were outstanding immediately prior to the consummation of such Business Combination (or, if applicable, is represented by shares into which such Company Voting Securities were converted pursuant to such Business Combination), and such voting power among the holders thereof is in substantially the same proportion as the voting power of such Company Voting Securities among the holders thereof immediately prior to the Business Combination, (B) no Person (other than any employee benefit plan sponsored or maintained by the Surviving Corporation or the Parent Corporation), is or becomes the beneficial owner, directly or indirectly, of 20% or more of the total voting power of the outstanding voting securities eligible to elect directors of the Parent Corporation (or, if there is no Parent Corporation, the Surviving Corporation) and (C) at least a majority of the members of the board of directors of the Parent Corporation (or, if there is no Parent Corporation, the Surviving Corporation) were Incumbent Directors at the time of the Board’s approval of the execution of the initial agreement providing for such Business Combination (any Business Combination which satisfies all of the criteria specified in (A), (B) and (C) above shall be deemed to be a “Non-Qualifying Transaction”); or

  (iv)   the shareholders of the Company approve a plan of complete liquidation or dissolution of the Company or a sale of all or substantially all of the Company’s assets.

Computations required by paragraph (iii) shall be made on and as of the date of shareholder approval and shall be based on reasonable assumptions that will result in the lowest percentage obtainable. Notwithstanding the foregoing, a Change in Control of the Company shall not be deemed to have occurred solely because any Person acquires beneficial ownership of more than twenty percent (20%) of the Company Voting Securities as a result of the acquisition of Company Voting Securities by the Company which reduces the number of Company Voting Securities outstanding; provided, that if after such acquisition by the Company such Person becomes the beneficial owner of additional Company Voting Securities that increases the percentage of outstanding Company Voting Securities beneficially owned by such Person, a Change in Control of the Company shall then occur.

A-2

 


Table of Contents

“Code” shall mean the Internal Revenue Code of 1986, as amended from time to time.

“Committee” shall mean a committee of the Board composed solely of not less than two Non-Employee Directors, all of whom shall (i) satisfy the requirements of Rule 16b-3(b)(3) of the Exchange Act, (ii) be “outside directors” within the meaning of Section 162(m) and (iii) otherwise meet any “independence” requirements promulgated by any stock exchange on which the shares are listed. The members of the Committee shall be appointed by and serve at the pleasure of the Board.

“Company” shall mean First Tennessee National Corporation, a Tennessee corporation, and its successors and assigns.

“Covered Officer” shall mean at any date (i) any individual who, with respect to the previous taxable year of the Company, was a “covered employee” of the Company within the meaning of Section 162(m); provided, however, that the term “Covered Officer” shall not include any such individual who is designated by the Committee, in its discretion, at the time of any Award or at any subsequent time, as reasonably expected not to be such a “covered employee” with respect to the current taxable year of the Company, and (ii) any individual who is designated by the Committee, in its discretion, at the time of any Award or at any subsequent time, as reasonably expected to be such a “covered employee” with respect to the current taxable year of the Company or with respect to the taxable year of the Company in which any applicable Award will be paid.

“Disability” shall mean, unless otherwise defined in the applicable Award Agreement, a disability that would qualify as a total and permanent disability under the long-term disability plan then in effect at the Employer employing the Participant at the onset of such total and permanent disability.

“Employee” shall mean an employee of any Employer.

“Employer” shall mean the Company or any Subsidiary.

“Exchange Act” shall mean the Securities Exchange Act of 1934, as amended from time to time.

“Fair Market Value” with respect to the Shares, shall mean, as of any date, (i) the mean between the high and low sales prices at which Shares were sold on the New York Stock Exchange, or, if the shares are not listed on the New York Stock Exchange, on any other such exchange on which the Shares are traded, on such date, or, in the absence of reported sales on such date, the mean between the high and low sales prices on the immediately preceding date on which sales were reported, or (ii) in the event there is no public market for the Shares on such date, the fair market value as determined in good faith by the Committee in its sole discretion.

“Non-Employee Director” shall mean a member of the Board who is not an Employee.

“Option” shall mean an option to purchase Shares from the Company that is granted under Section 6 or 9 of the Plan and is not intended to meet the requirements of Section 422 of the Code or any successor provision thereto.

“Option Price” shall mean the purchase price payable to purchase one Share upon the exercise of an Option.

“Participant” shall mean any Employee, Non-Employee Director or Regional Board Member who receives an Award under the Plan.

“Performance Award” shall mean any right granted under Section 8 of the Plan.

“Person” shall mean any individual, corporation, partnership, association, joint-stock company, limited liability company, trust, unincorporated organization, government or political subdivision thereof or other entity.

A-3

 


Table of Contents

“Plan” shall mean this First Tennessee National Corporation 2003 Equity Compensation Plan.

“Regional Board Member” shall mean any First Tennessee Bank National Association regional board member and any member of the board of directors of any bank subsidiary of the Company, other than First Tennessee Bank National Association, in each case excluding any Employee.

“Restricted Stock” shall mean any Share granted under Section 7 or 9 of the Plan.

“Restricted Stock Unit” shall mean any unit granted under Section 7 or 9 of the Plan.

“Retirement” shall mean, unless otherwise defined in the applicable Award Agreement, the Termination of Employment of a Participant after the Participant has fulfilled all age and service requirements for retirement under the terms of the First Tennessee National Corporation Pension Plan, as amended from time to time.

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

“Section 16” shall mean Section 16 of the Exchange Act and the rules promulgated thereunder and any successor provision thereto as in effect from time to time.

“Section 162(m)” shall mean Section 162(m) of the Code and the rules promulgated thereunder or any successor provision thereto as in effect from time to time.

“Shares” shall mean shares of the common stock, $0.625 par value, as adjusted from time to time for stock splits or reverse stock splits, of the Company.

“Subsidiary” shall mean any Person of which a majority of its voting power or its equity securities or equity interest is owned directly or indirectly by the Company.

“Substitute Awards” shall mean Awards granted solely in assumption of, or in substitution for, outstanding awards previously granted by a Person acquired by the Company or with which the Company or one of its Subsidiaries combines.

“Termination of Employment” shall mean the termination of the employee-employer relationship between a Participant and the Employer for any reason, with or without Cause, including, but not by way of limitation, a termination by resignation, discharge, death, Disability, Workforce Reduction or Retirement, but excluding (i) terminations where there is a simultaneous reemployment or continuing employment of the Participant by another Employer; (ii) at the discretion of the Committee, terminations which result in a temporary severance of the employee-employer relationship; and (iii) at the discretion of the Committee, terminations which are followed by the simultaneous establishment of a consulting relationship by an Employer with the Participant. The Committee, in its absolute discretion, shall determine the effect of all matters and questions relating to Termination of Employment, including, but not by way of limitation, the question of whether a Termination of Employment resulted from a discharge for Cause, and all questions of whether particular leaves of absence constitute Terminations of Employment. However, notwithstanding any provision of this Plan, an Employer has an absolute and unrestricted right to terminate an Employee’s employment at any time for any reason whatsoever, with or without Cause.

“Workforce Reduction” shall mean any termination of the employee-employer relationship between a Participant and the Employer as a result of the discontinuation by the Company of a business or line of business or a realignment of the Company, or a part thereof, or any other similar type of event, provided that the Committee or the Board has designated such discontinuation, realignment or other event as a “Workforce Reduction” for purposes of this Plan.

A-4

 


Table of Contents

SECTION 3 - Administration

(A)   Authority of Committee. Except as provided by Section 9 hereof, the Plan shall be administered by the Committee, it being understood that the Board retains the right to make Awards under the Plan. Subject to the terms of the Plan and applicable law, and in addition to other express powers and authorizations conferred on the Committee by the Plan, the Committee shall have full power and authority in its discretion to: (i) designate Participants; (ii) determine the type or types of Awards to be granted to a Participant; (iii) determine the number of Shares to be covered by, or with respect to which payments, rights, or other matters are to be calculated in connection with, Awards; (iv) determine the timing, terms, and conditions of any Award; (v) accelerate the time at which all or any part of an Award may be settled or exercised; (vi) determine whether, to what extent, and under what circumstances Awards may be settled or exercised in cash, Shares, other securities, other Awards or other property, or canceled, forfeited, or suspended, and the method or methods by which Awards may be settled, exercised, canceled, forfeited, or suspended; (vii) determine whether, to what extent, and under what circumstances cash, Shares, other securities, other Awards, other property, and other amounts payable with respect to an Award shall be deferred either automatically or at the election of the holder thereof or of the Committee; (viii) interpret and administer the Plan and any instrument or agreement relating to, or Award made under, the Plan; (ix) amend or modify the terms of any Award after grant; (x) establish, amend, suspend, or waive such rules and regulations and appoint such agents as it shall deem appropriate for the proper administration of the Plan; and (xi) make any other determination and take any other action that the Committee deems necessary or desirable for the administration of the Plan subject to the exclusive authority of the Board under Section 13 hereunder to amend, suspend or terminate the Plan.

(B)   Committee Discretion Binding. Unless otherwise expressly provided in the Plan, all designations, determinations, interpretations, and other decisions under or with respect to the Plan or any Award shall be within the sole discretion of the Committee, may be made at any time and shall be final, conclusive, and binding upon all Persons, including any Employer, any Participant, any holder or beneficiary of any Award, any Employee, any Non-Employee Director and any Regional Board Member.

(C)   Action by the Committee. Except as otherwise provided by the Board, the provisions of this Section 3(C) shall apply to the Committee. The Committee shall select one of its members as its chairperson and shall hold its meetings at such times and places and in such manner as it may determine. A majority of its members shall constitute a quorum. Any decision or determination reduced to writing and signed by all of the members of the Committee shall be fully effective as if it had been made by a majority vote at a meeting duly called and held. The Committee may appoint a secretary and may make such rules and regulations for the conduct of its business as it shall deem advisable.

(D)   Delegation. Subject to the terms of the Plan, the Board or the Committee may, to the extent permitted by law, delegate to (i) a subcommittee of the Committee, (ii) one or more officers or managers of an Employer or (iii) a committee of such officers or managers, the authority, subject to such terms and limitations as the Board or the Committee shall determine, to grant Awards to, or to cancel, modify or waive rights with respect to or to alter, discontinue, suspend, or terminate Awards held by, Participants who are not officers or directors of the Company for purposes of Section 16 or who are otherwise not subject to Section 16, and who are not Covered Officers.

(E)   Indemnification. No member of the Board or the Committee or any Employee (each such person a “Covered Person”) shall have any liability to any person (including any grantee) for any action taken or omitted to be taken or any determination made in good faith with respect to the Plan or any Award. Each Covered Person shall be indemnified and held harmless by the Company against and from any loss, cost, liability, or expense (including attorneys’ fees) that may be imposed upon or incurred by such Covered Person in connection with or resulting from any action, suit or proceeding to which such Covered Person may be a party or in which such Covered Person may be involved by reason of any action taken or omitted to be taken under the Plan or any Award Agreement and against and from any and all amounts paid by such Covered Person, with the Company’s approval, in settlement thereof, or paid by such Covered Person in satisfaction of any judgment in

A-5

 


Table of Contents

    any such action, suit or proceeding against such Covered Person, provided that the Company shall have the right, at its own expense, to assume and defend any such action, suit or proceeding and, once the Company gives notice of its intent to assume the defense, the Company shall have sole control over such defense with counsel of the Company’s choice. The foregoing right of indemnification shall not be available to a Covered Person to the extent that a court of competent jurisdiction in a final judgment or other final adjudication, in either case, not subject to further appeal, determines that the acts or omissions of such Covered Person giving rise to the indemnification claim resulted from such Covered Person’s bad faith, fraud or willful misconduct. The foregoing right of indemnification shall not be exclusive of any other rights of indemnification to which Covered Persons may be entitled under the Company’s Restated Charter or Bylaws, as a matter of law, or otherwise, or any other power that the Company may have to indemnify such persons or hold them harmless.

SECTION 4 - Shares Available for Awards

(A)   Shares Available. Subject to the provisions of Section 4(B) hereof, the stock to be subject to Awards under the Plan shall be Shares and the maximum number of Shares which may be issued with respect to Awards shall be 3,000,000, of which no more than 300,000 shall be issued with respect to Awards other than Options. If, after the effective date of the Plan, any Shares covered by an Award granted under this Plan, or to which such an Award relates, are forfeited, or if such an Award is settled for cash or otherwise terminates, expires unexercised, or is canceled without the delivery of Shares, then the Shares covered by such Award, or to which such Award relates, or the number of Shares otherwise counted against the aggregate number of Shares which may be issued with respect to Awards, to the extent of any such settlement, forfeiture, termination, expiration, or cancellation, shall again become Shares which may be issued with respect to Awards. In the event that any Option or other Award granted hereunder is exercised through the delivery of Shares by the Participant or in the event that withholding tax liabilities arising from such Award are satisfied by the withholding of Shares by the Company from the total number of Shares that otherwise would have been delivered to the Participant, the number of Shares which may be issued with respect to Awards shall be increased by the number of Shares so surrendered or withheld. Notwithstanding the foregoing and subject to adjustment as provided in Section 4(B) hereof, the number of Shares with respect to which Options may be granted to any one Participant in any one calendar year shall be no more than 500,000 Shares.

(B)   Adjustments. The number of Shares covered by each outstanding Award, the number of Shares available for Awards, the number of Shares that may be subject to Awards to any one Participant, and the price per Share covered by each such outstanding Award shall be proportionately adjusted for any increase or decrease in the number of issued Shares resulting from a stock split, reverse stock split, stock dividend, recapitalization, combination or reclassification of the Shares, and may be proportionately adjusted, as determined in the sole discretion of the Board, for any other increase or decrease in the number of issued Shares effected without receipt of consideration by the Company or to reflect any distributions to holders of Shares other than regular cash dividends. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of Shares subject to an Award. After any adjustment made pursuant to this paragraph, the number of Shares subject to each outstanding Award shall be rounded to the nearest whole number.

(C)   Substitute Awards. Any Shares issued by the Company as Substitute Awards shall not reduce the Shares available for Awards under the Plan.

(D)   Sources of Shares Deliverable Under Awards. Any Shares delivered pursuant to an Award may consist, in whole or in part, of authorized and unissued Shares or of issued Shares which have been reacquired by the Company.

A-6

 


Table of Contents

SECTION 5 - Eligibility

Any Employee (including any officer or employee-director of an Employer), Non-Employee Director or Regional Board Member shall be eligible to be designated a Participant; provided, however, that Non-Employee Directors shall only be eligible to receive Awards granted pursuant to Section 9 hereof.

SECTION 6 - Stock Options

(A)   Grant. Except as provided by Sections 3 and 9 hereof, the Committee shall have sole and complete authority to determine the Participants to whom Options shall be granted, the number of Shares subject to each Award, the exercise price and the conditions and limitations applicable to the exercise of an Option. A person who has been granted an Option under this Plan may be granted additional Options under the Plan if the Committee shall so determine.

(B)   Option Price. The Committee, in its sole discretion, shall establish the Option Price at the time each Option is granted. Except in the case of Substitute Awards, the Option Price of an Option may not be less than 100% of the Fair Market Value of the Shares with respect to which the Option is granted on the date of grant of such Option. Notwithstanding the prior sentence, the Option Price of an Option may be less than 100% of the Fair Market Value of the Shares with respect to which the Option is granted on the date of grant of such Option if (i) the grantee of the Option has entered into an agreement with the Company pursuant to which the grant of the Option is in lieu of the payment of compensation and (ii) the amount of such compensation when added to the Option Price of the Option equals at least 100% of the Fair Market Value of the Shares with respect to which the Option is granted on the date of grant of such Option. Notwithstanding the foregoing and except as provided by Sections 4(B) and 13(C) hereof, the Committee shall not have the power to (i) amend the terms of previously granted Options to reduce the Option Price of such Options, or (ii) cancel such Options and grant substitute Options with a lower Option Price than the cancelled Options, without shareholder approval.

(C)   Term. Subject to the Committee’s authority under Section 3(A) hereof, each Option and all rights and obligations thereunder shall expire on the date determined by the Committee and specified in the Award Agreement. The Committee shall be under no duty to provide terms of like duration for Options granted under the Plan. Notwithstanding the foregoing, no Option shall be exercisable after the expiration of ten (10) years from the date such Option was granted.

(D)   Transfer Restrictions. Except as otherwise provided in this Section 6(D), no Option shall be sold, assigned, transferred, pledged, hypothecated or otherwise encumbered, hedged or disposed of, in any manner, whether voluntarily or involuntarily, including by operation of law (other than by will or the laws of descent and distribution). The Committee may in its discretion permit the transfer of an Option by a Participant to or for the benefit of the Participant’s Immediate Family (including, without limitation, to a trust for the benefit of the Participant’s Immediate Family or to a partnership or limited liability company for one or more members of the Participant’s Immediate Family), subject to such limits as the Committee may establish, and the transferee shall remain subject to all the terms and conditions applicable to the Option prior to such transfer. The foregoing right to transfer the Option shall apply to the right to consent to amendments to any Award Agreement evidencing such Option and, in the discretion of the Committee, shall also apply to the right to transfer ancillary rights associated with the Option. For purposes of this paragraph, the term “Immediate Family” shall mean the Participant’s spouse, parents, children, stepchildren, adopted relations, sisters, brothers, grandchildren and step-grandchildren.

(E)   Exercise.

  (i)   Each Option shall be exercisable at such times and subject to such terms and conditions as the Committee may, in its sole discretion, specify in the applicable Award Agreement or thereafter. The Committee shall have full and complete authority to determine whether an Option will be

A-7

 


Table of Contents

    exercisable in full at any time or from time to time during the term of the Option, or to provide for the exercise thereof in such installments, upon the occurrence of such events and at such times during the term of the Option as the Committee may determine.

  (ii)   The Committee may impose such conditions with respect to the exercise of Options, including without limitation, any relating to the application of federal, state or foreign securities laws or the Code, as it may deem necessary or advisable. The exercise of any Option granted hereunder shall be effective only at such time as the sale of Shares pursuant to such exercise will not violate any state or federal securities or other laws, as determined by the Committee in its sole discretion.

  (iii)   An Option may be exercised in whole or in part at any time, with respect to whole Shares only, within the period permitted thereunder for the exercise thereof, and shall be exercised by written notice of intent to exercise the Option, delivered to the Company at its principal office, and payment in full to the Company at said office of the amount of the Option Price for the number of Shares with respect to which the Option is then being exercised.

  (iv)   Payment of the Option Price shall be made in cash or cash equivalents, or, at the discretion of the Committee, (i) by tendering, either by way of actual delivery of Shares or attestation, whole Shares that have been owned by the Option holder for not less than six (6) months, if acquired directly from the Company, or that have been owned for any period of time, if acquired on the open market, prior to the date of exercise, valued at the Fair Market Value of such Shares on the date of exercise, together with any applicable withholding taxes, (ii) by a combination of such cash (or cash equivalents) and such Shares or (iii) by such other method of exercise as may be permitted from time to time by the Committee; provided, however, that the optionee shall not be entitled to tender Shares pursuant to successive, substantially simultaneous exercises of an Option or any other stock option of the Company. Subject to applicable securities laws and at the discretion of the Committee, an Option may also be exercised by delivering a notice of exercise of the Option and simultaneously selling the Shares thereby acquired, pursuant to a brokerage or similar agreement or program approved in advance by the Committee. Until the optionee has been issued the Shares subject to such exercise, he or she shall possess no rights as a shareholder with respect to such Shares and shall not be entitled to any dividend or distribution the record date of which is prior to the date of issuance of such Shares.

  (v)   Notwithstanding anything in this Plan to the contrary, a Participant shall be required to pay to the Company an amount equal to the spread realized in connection with the Participant’s exercise of an Option within six months prior to such Participant’s termination of employment by resignation in the event that such Participant, within six months following such Participant’s termination of employment by resignation, engages directly or indirectly in any activity determined by the Committee, in its sole discretion, to be competitive with any activity of the Company or any of its Subsidiaries. This subsection (v) shall be void and of no legal effect upon a Change in Control.

SECTION 7 - Restricted Stock and Restricted Stock Units

(A)   Grant.

  (i)   Except as provided by Sections 3 and 9 hereof, the Committee shall have sole and complete authority to determine the Participants to whom Restricted Stock and Restricted Stock Units shall be granted, the number of shares of Restricted Stock and/or the number of Restricted Stock Units to be granted to each Participant, the duration of the period during which, and the conditions under which, the Restricted Stock and Restricted Stock Units may be forfeited to the Company, and the other terms and conditions of such Awards. The Restricted Stock and Restricted Stock Unit Awards shall be evidenced by Award Agreements in such form as the Committee shall from time to time approve, which agreements shall comply with and be subject to the terms and conditions provided hereunder

A-8

 


Table of Contents

    and any additional terms and conditions established by the Committee that are consistent with the terms of the Plan.

  (ii)   Each Restricted Stock or Restricted Stock Unit Award made under the Plan shall be for such number of Shares as shall be determined by the Committee and set forth in the agreement containing the terms of such Restricted Stock or Restricted Stock Unit Award. Such agreement shall set forth a period of time during which the grantee must remain in the continuous employment of one or more Employers in order for the forfeiture and transfer restrictions to lapse. If the Committee so determines, the restrictions may lapse during such restricted period in installments with respect to specified portions of the Shares covered by the Restricted Stock or Restricted Stock Unit Award. The agreement may also, in the discretion of the Committee, set forth performance or other conditions that, if satisfied, will result in the lapsing of any applicable forfeiture and transfer restrictions. The Committee may, at its discretion, waive all or any part of the restrictions applicable to any or all outstanding Restricted Stock and Restricted Stock Unit Awards.

(B)   Delivery of Shares and Transfer Restrictions. The Company may implement the grant of a Restricted Stock Award by (i) book-entry issuance of Shares to the Participant in an account maintained by the Company at its transfer agent or (ii) delivery of certificates for Shares to the Participant who must execute appropriate stock powers in blank and return the certificates and stock powers to the Company. Such certificates and stock powers shall be held by the Company or any custodian appointed by the Company for the account of the grantee subject to the terms and conditions of the Plan, and the certificate shall bear such a legend setting forth the restrictions imposed thereon as the Committee, in its discretion, may determine. Unless otherwise determined by the Committee, the grantee shall have all rights of a shareholder with respect to the shares of Restricted Stock, including the right to receive dividends and the right to vote such Shares, subject to the following restrictions: (i) in the case of certificated Shares, the grantee shall not be entitled to delivery of the stock certificate until the expiration of the restricted period and the fulfillment of any other restrictive conditions set forth in the Award Agreement with respect to such Shares; (ii) none of the Shares may be sold, assigned, transferred, pledged, hypothecated or otherwise encumbered, hedged or disposed of, in any manner, whether voluntarily or involuntarily, including by operation of law (other than by will or the laws of descent and distribution) until the expiration of the restricted period and the fulfillment of any other restrictive conditions set forth in the Award Agreement with respect to such Shares; and (iii) except as otherwise determined by the Committee, all of the Shares shall be forfeited and all rights of the grantee to such Shares shall terminate, without further obligation on the part of the Company, unless the grantee remains in the continuous employment of one or more Employers for the entire restricted period in relation to which such Shares were granted and unless any other restrictive conditions relating to the Restricted Stock Award are met. Any Shares, any other securities of the Company and any other property (except for cash dividends) distributed with respect to the Shares subject to Restricted Stock Awards shall be subject to the same restrictions, terms and conditions as such Restricted Stock.

(C)   Termination of Restrictions. At the end of the restricted period and provided that any other restrictive conditions of the Restricted Stock Award are met, or at such earlier time as otherwise determined by the Committee, all restrictions set forth in the Award Agreement relating to the Restricted Stock Award or in the Plan shall lapse as to the restricted Shares subject thereto, and, if certificated, a stock certificate for the appropriate number of Shares, free of the restrictions and restricted stock legend imposed thereon by the Committee as described in the second sentence of Subsection (B) of this Section 7, shall be delivered to the Participant or the Participant’s beneficiary or estate, as the case may be.

(D)   Payment of Restricted Stock Units. Each Restricted Stock Unit shall have a value equal to the Fair Market Value of a Share. Restricted Stock Units shall be paid in cash, Shares, other securities or other property, as determined in the sole discretion of the Committee, upon the lapse of the restrictions applicable thereto, or otherwise in accordance with the applicable Award Agreement. The Committee may, in its sole and absolute discretion, credit Participants with dividend equivalents on any Restricted Stock Units credited to the Participant’s account at the time of any payment of dividends to shareholders on Shares. The amount of any such dividend

A-9

 


Table of Contents

        equivalents shall equal the amount that would have been payable to the Participant as a shareholder in respect of a number of Shares equal to the number of Restricted Stock Units then credited to him. Any such dividend equivalents shall be credited to the Participant’s account as of the date on which such dividend would have been payable and shall be converted into additional Restricted Stock Units based upon the Fair Market Value of a Share on the date of such crediting. Restricted Stock Units may not be sold, assigned, transferred, pledged, hypothecated or otherwise encumbered, hedged or disposed of, in any manner, whether voluntarily or involuntarily, including by operation of law (other than by will or the laws of descent and distribution) until the expiration of the applicable restricted period and the fulfillment of any other restrictive conditions relating to the Restricted Stock Unit Award. Except as otherwise determined by the Committee, all Restricted Stock Units and all rights of the grantee to such Restricted Stock Units shall terminate, without further obligation on the part of the Company, unless the grantee remains in continuous employment of one or more Employers for the entire restricted period in relation to which such Restricted Stock Units were granted and unless any other restrictive conditions relating to the Restricted Stock Unit Award are met.

SECTION 8 - Performance Awards

(A)   Grant. The Committee shall have sole and complete authority to determine the Participants who shall receive a Performance Award, which shall consist of a right that is (i) denominated in cash and/or Shares, (ii) valued, as determined by the Committee, in accordance with the achievement of such performance goals during such performance periods as the Committee shall establish, and (iii) payable at such time and in such form as the Committee shall determine. The Committee may, in its sole and absolute discretion, designate whether any Performance Award being granted to any Participant is intended to be “performance-based compensation” as that term is used in Section 162(m). Any Performance Awards designated by the Committee as “performance-based compensation” shall be subject to the terms and provisions of Section 10 hereof.

(B)   Terms and Conditions. Subject to the terms of the Plan, the Committee shall determine the performance goals to be achieved during any performance period, the length of any performance period, the amount of any Performance Award and the amount and kind of any payment or transfer to be made pursuant to any Performance Award, and may change specific provisions of the Performance Award, provided, however, that such change may not adversely affect existing Performance Awards made within a performance period commencing prior to implementation of the change.

(C)   Payment of Performance Awards. Performance Awards may be paid in a lump sum or in installments following the close of the performance period or, in accordance with the procedures established by the Committee, on a deferred basis. If a Participant ceases to be employed by any Employer during a performance period because of death, Disability, Retirement or other circumstance in which the Committee in its discretion finds that a waiver would be appropriate, that Participant, as determined by the Committee, may be entitled to a payment of a Performance Award, or a portion thereof, at the end of the performance period; provided, however, that the Committee may provide for an earlier payment in settlement of such Performance Award in such amount and under such terms and conditions as the Committee deems appropriate or desirable. Unless otherwise determined by the Committee, Termination of Employment prior to the end of any performance period will result in the forfeiture of the Performance Award, and no payments will be made. A Participant’s rights to any Performance Award may not be sold, assigned, transferred, pledged, hypothecated or otherwise encumbered, hedged or disposed of in any manner, whether voluntarily or involuntarily, including by operation of law (other than by will or the laws of descent and distribution).

SECTION 9 - Non-Employee Director Awards

The Board may provide that all or a portion of a Non-Employee Director’s annual retainer and/or meeting fees, or other forms of compensation, be payable (either automatically or at the election of a Non-Employee Director) in the form of Options, Restricted Stock or Restricted Stock Units. The Board shall determine the terms and conditions of any such Awards, including the terms and conditions which shall apply upon a termination of the Non-Employee Director’s service as a member of the Board, and shall have full power and authority in its discretion to administer such Awards, subject to the terms of the Plan and applicable law.

A-10

 


Table of Contents

SECTION 10 - Provisions Applicable to Covered Officers and Performance-Based Awards

Notwithstanding anything in the Plan to the contrary, unless the Committee determines otherwise, all performance-based Restricted Stock Awards, Restricted Stock Unit Awards or Performance Awards shall be subject to the terms and provisions of this Section 10.

(A)   Restricted Stock Awards, Restricted Stock Unit Awards and Performance Awards to Covered Officers shall vest or become exercisable upon the attainment of performance targets related to one or more performance goals selected by the Committee from among the goals specified below. For the purposes of this Section 10, performance goals shall be limited to one or a combination of the following Employer, operating unit, division, line of business, department, team or business unit financial performance measures: stock price; dividends; total shareholder return; earnings per share; price/earnings ratio; market capitalization; book value; revenues; expenses; loans; deposits; non-interest income; net interest income; fee income; operating income before or after taxes; net income before or after taxes; net income before securities transactions; net or operating income excluding non-recurring charges; return on assets; return on equity; return on capital; cash flow; credit quality; service quality; market share; customer retention; efficiency ratio; strategic business objectives, consisting of one or more objectives based on meeting specified cost targets, business expansion goals and goals relating to acquisitions or divestitures; and, except in the case of a Covered Officer, any other performance criteria established by the Committee. Each goal may be expressed on an absolute and/or relative basis, may be based on or otherwise employ comparisons based on internal targets, the past performance of the Company (consolidated or unconsolidated) and/or the past or current performance of other companies, the performance of other companies over one or more years or an index of the performance of other companies, markets or economic metrics over one or more years, and in the case of earnings-based measures, may use or employ comparisons relating to capital, shareholders’ equity and/or Shares outstanding, or to assets or net assets.

(B)   The maximum annual number of Shares in respect of which all performance-based Restricted Stock Awards, Restricted Stock Unit Awards and Performance Awards may be granted to a Participant under the Plan is 100,000 and the maximum annual amount of any Awards settled in cash to a Participant under the Plan is $4,000,000.

(C)   To the extent necessary to comply with Section 162(m), with respect to performance-based Restricted Stock Awards, Restricted Stock Unit Awards and Performance Awards, no later than 90 days following the commencement of each performance period (or such other time as may be required or permitted by Section 162(m)), the Committee shall, in writing, (1) select the performance goal or goals applicable to the performance period, (2) establish the various targets and bonus amounts which may be earned for such performance period, and (3) specify the relationship between performance goals and targets and the amounts to be earned by each Covered Officer for such performance period. Following the completion of each performance period, the Committee shall certify in writing whether the applicable performance targets have been achieved and the amounts, if any, payable to Covered Officers for such performance period. In determining the amount earned by a Covered Officer for a given performance period, subject to any applicable Award Agreement, the Committee shall have the right to reduce (but not increase) the amount payable at a given level of performance to take into account additional factors that the Committee may deem relevant to the assessment of individual or corporate performance for the performance period.

SECTION 11 - Termination of Employment

The Committee shall have the full power and authority to determine the terms and conditions that shall apply to any Award upon a Termination of Employment and shall provide such terms in the Award Agreement. Notwithstanding the foregoing and subject to the limitation contained in the last sentence of Section 6(c) hereof, upon the Termination of Employment as a result of a Workforce Reduction of an Employee who has received an Award of Options, such Options shall expire on the date specified by the Committee at the time of the Termination of Employment, not to exceed five (5) years after the date of such Termination of Employment.

A-11

 


Table of Contents

SECTION 12 – Change in Control

Upon a Change in Control, all outstanding Awards shall vest, become immediately exercisable or payable or have all restrictions lifted, as the case may be.

SECTION 13 – Amendment, Suspension and Termination

(A)   Termination, Suspension or Amendment of the Plan. The Board may amend, alter, modify, suspend, discontinue, or terminate the Plan or any portion thereof at any time, except that the Board shall not amend the Plan in violation of law. No such amendment, alteration, modification, suspension, discontinuation or termination shall materially and adversely affect any right acquired by any Participant or beneficiary of a Participant under the terms of an Award granted before the date of such amendment, alteration, modification, suspension, discontinuation or termination, unless such Participant or beneficiary shall consent.

(B)   Termination, Suspension or Amendment of Awards. Subject to the restrictions of Section 6(B) hereof, the Committee may waive any conditions or rights under, amend any terms of, or modify, alter, suspend, discontinue, cancel or terminate, any Award theretofore granted, prospectively or retroactively; provided that any such waiver, amendment, modification, alteration, suspension, discontinuance, cancellation or termination that would materially and adversely affect the rights of any Participant or any holder or beneficiary of any Award theretofore granted shall not to that extent be effective without the consent of the affected Participant, holder, or beneficiary; provided, however, that it shall be conclusively presumed that any adjustment for changes in capitalization as provided in Section 4 hereof does not materially and adversely affect any such rights.

(C)   Adjustments of Awards Upon the Occurrence of Certain Unusual or Nonrecurring Events. The Committee is hereby authorized to make adjustments in the terms and conditions of, and the criteria included in, Awards in recognition of unusual or nonrecurring events (including, without limitation, the events described in Section 4(B) hereof) affecting the Company, any Subsidiary, or the financial statements of the Company or any Subsidiary, or of changes in applicable laws, regulations, or accounting principles, whenever the Committee is required to make such adjustments pursuant to section 4(B) hereof or whenever the Board, in its sole discretion, determines that such adjustments are appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan; provided that, with respect to Awards intended to comply with Section 162(m), no such adjustment shall be authorized to the extent that such authority would be inconsistent with having either the Plan or any Awards granted hereunder meeting the requirements of Section 162(m).

SECTION 14 – General Provisions

(A)   Dividend Equivalents. In the sole and complete discretion of the Committee, an Award (other than an Option) may provide the Participant with dividends or dividend equivalents, payable in cash, Shares, other securities or other property on a current or deferred basis. All dividend or dividend equivalents which are not paid currently may, at the Committee’s discretion, accrue interest, be reinvested into additional Shares, or in the case of dividends or dividend equivalents credited in connection with Performance Awards, be credited as additional Performance Awards and paid to the Participant if and when, and to the extent that, payment is made pursuant to such Award. The total number of Shares available for Awards under Section 4 hereof shall not be reduced to reflect any dividends or dividend equivalents that are reinvested into additional Shares or credited as Performance Awards.

(B)   No Rights to Awards. No Person shall have any claim to be granted any Award, and there is no obligation for uniformity of treatment of Employees, Non-Employee Directors, Regional Board Members or holders or beneficiaries of Awards. The terms and conditions of Awards need not be the same with respect to each recipient.

A-12

 


Table of Contents

(C)   Share Certificates. All certificates for Shares or other securities of the Company or any Subsidiary delivered under the Plan pursuant to any Award or the exercise thereof shall be subject to such stop transfer orders and other restrictions as the Committee may deem advisable under the Plan or the rules, regulations, and other requirements of the SEC, any stock exchange upon which such Shares or other securities are then listed, and any applicable federal, state or foreign laws, and the Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions.

(D)   Withholding. A Participant may be required to pay to an Employer, and each Employer shall have the right and is hereby authorized to withhold from any Award, from any payment due or transfer made under any Award or under the Plan or from any compensation or other amount owing to a Participant, the amount (in cash, Shares, other securities, other Awards or other property) of any applicable withholding or other taxes in respect of an Award, its exercise, or any payment or transfer under an Award or under the Plan and to take such other action as may be necessary in the opinion of the Company to satisfy all obligations for the payment of such taxes.

(E)   Award Agreements. Each Award hereunder shall be evidenced by an Award Agreement that shall specify the terms and conditions of the Award and any rules applicable thereto. An Award shall be effective only upon delivery to a Participant, either electronically or by paper means, of an Award Agreement. In the event of a conflict between the terms of the Plan and any Award Agreement, the terms of the Plan shall prevail.

(F)   No Limit on Other Compensation Arrangements. Nothing contained in the Plan shall prevent the Company or any Subsidiary from adopting or continuing in effect other compensation arrangements, which may, but need not, provide for the grant of Options, Restricted Stock, Shares and other types of Awards provided for hereunder.

(G)   No Right to Employment. The grant of an Award shall not be construed as giving a Participant the right to be retained in the employ of any Employer. Further, an Employer may at any time dismiss a Participant from employment, free from any liability or any claim under the Plan, unless otherwise expressly provided in the Plan or in any Award Agreement.

(H)   No Rights as Shareholder. Subject to the provisions of the applicable Award, no Participant or holder or beneficiary of any Award shall have any rights as a shareholder with respect to any Shares to be distributed under the Plan until such Shares are issued to such Participant, holder or beneficiary and shall not be entitled to any dividend or distribution the record date of which is prior to the date of such issuance.

 (I)   Governing Law. The validity, construction, and effect of the Plan and any rules and regulations relating to the Plan and any Award Agreement shall be determined in accordance with the laws of the State of Tennessee without giving effect to the conflict of law principles thereof.

(J)   Severability. If any provision of the Plan or any Award is, or becomes, or is deemed to be, invalid, illegal, or unenforceable in any jurisdiction or as to any Person or Award, or would disqualify the Plan or any Award under any law deemed applicable by the Committee, such provision shall be construed or deemed amended to conform to the applicable laws, or if it cannot be construed or deemed amended without, in the determination of the Committee, materially altering the intent of the Plan or the Award, such provision shall be stricken as to such jurisdiction, Person or Award and the remainder of the Plan and any such Award shall remain in full force and effect.

(K)   Other Laws. The Committee may refuse to issue or transfer any Shares or other consideration under an Award if, acting in its sole discretion, it determines that the issuance or transfer of such Shares or such other consideration might violate any applicable law or regulation (including applicable non-U.S. laws or regulations) or entitle the Company to recover the same under Section 16(b) of the Exchange Act, and any payment tendered to the Company by a Participant, other holder or beneficiary in connection with the exercise of such Award shall be promptly refunded to the relevant Participant, holder, or beneficiary. Without limiting the generality of

A-13

 


Table of Contents

    the foregoing, no Award granted hereunder shall be construed as an offer to sell securities of the Company, and no such offer shall be outstanding, unless and until the Committee in its sole discretion has determined that any such offer, if made, would be in compliance with all applicable requirements of the U.S. federal or non-U.S. securities laws and any other laws to which such offer, if made, would be subject.

(L)   No Trust or Fund Created. Neither the Plan nor any Award shall create or be construed to create a trust or separate fund of any kind or a fiduciary relationship between the Company or any Subsidiary and a Participant or any other Person. To the extent that any Person acquires a right to receive payments from the Company or any Subsidiary pursuant to an Award, such right shall be no greater than the right of any unsecured general creditor of the Company or any Subsidiary.

(M)   No Fractional Shares. No fractional Shares shall be issued or delivered pursuant to the Plan or any Award, and the Committee shall determine whether cash, other securities, or other property shall be paid or transferred in lieu of any fractional Shares or whether such fractional Shares or any rights thereto shall be canceled, terminated or otherwise eliminated.

(N)   Headings. Headings are given to the Sections and subsections of the Plan solely as a convenience to facilitate reference. Such headings shall not be deemed in any way material or relevant to the construction or interpretation of the Plan or any provision thereof.

(O)   Binding Effect. The terms of the Plan shall be binding upon the Company and its successors and assigns and the Participants and their legal representatives, and shall bind any successor of the Company (whether direct or indirect, by purchase, merger, consolidation or otherwise), in the same manner and to the same extent that the Company would be obligated under this Plan if no succession had taken place. In the case of any transaction in which a successor would not by the foregoing provision or by operation of law be bound by this Plan, the Company shall require such successor expressly and unconditionally to assume and agree to perform the Company’s obligations hereunder, in the same manner and to the same extent that the Company would be required to perform if no such succession had taken place.

(P)   No Third Party Beneficiaries. Except as expressly provided herein or therein, neither the Plan nor any Award Agreement shall confer on any person other than the Company and the grantee of any Award any rights or remedies hereunder or thereunder. The exculpation and indemnification provisions of Section 3(E) shall inure to the benefit of a Covered Person’s estate and beneficiaries and legatees.

(Q)   Additional Transfer Restrictions. No transfer or an Award by a grantee by will or by laws of descent and distribution shall be effective to bind the Company unless the Company shall have been furnished with written notice thereof and an authenticated copy of the will and/or such other evidence as the Committee may deem necessary to establish the validity of the transfer.

SECTION 15 -Term of the Plan

(A)   Effective Date. The Plan shall be effective as of the date it has been approved by the Company’s shareholders (the “Effective Date”).

(B)   Expiration Date. No new Awards shall be granted under the Plan after the tenth (10th) anniversary of the Effective Date. Unless otherwise expressly provided in the Plan or in an applicable Award Agreement, any Award granted hereunder may, and the authority of the Board or the Committee to amend, alter, modify, adjust, suspend, discontinue, or terminate any such Award or to waive any conditions or rights under any such Award shall, continue after the authority for grant of new Awards hereunder has been exhausted.

A-14

 


Table of Contents


FINANCIAL INFORMATION AND DISCUSSION


TABLE OF CONTENTS

           
Selected Financial and Operating Data
    F-2  
     
Management’s Discussion and Analysis
    F-3  
     
 
General Information
    F-3  
     
 
Forward Looking Statements
    F-4  
     
 
Financial Summary
    F-4  
     
 
Critical Accounting Policies
    F-4  
     
 
Income Statement Analysis (2002 compared to 2001)
    F-13  
     
 
Cumulative Effect of Changes in Accounting Principles
    F-26  
     
 
Business Line Review
    F-26  
     
 
Income Statement Analysis (2001 compared to 2000)
    F-30  
     
 
Balance Sheet Review
    F-31  
     
 
Risk Management
    F-38  
     
 
Other
    F-50  
     
 
Accounting Changes
    F-51  
     
Glossary
    F-53  
     
Consolidated Statements of Condition
    F-56  
     
Consolidated Statements of Income
    F-57  
     
Consolidated Statements of Shareholders’ Equity
    F-58  
     
Consolidated Statements of Cash Flows
    F-59  
     
Notes to Consolidated Financial Statements
    F-60  
     
Independent Auditors Report
    F-107  
     
Consolidated Average Balance Sheets and Related Yields and Rates
    F-108  
     
Consolidated Historical Statements of Income
    F-110  
     
     
     
     
First Tennessee National Corporation   F-1

 


Table of Contents

SELECTED FINANCIAL AND OPERATING DATA

                                                               

(Dollars in millions except per share data)   2002   2001   2000   1999   1998   1997

Net income before cumulative adjustment*
  $ 376.5     $ 326.4     $ 232.6     $ 247.5     $ 226.4     $ 197.5  
Net income
    376.5       318.2       232.6       247.5       226.4       197.5  

Common Stock Data
                                                           
Earnings per share before cumulative adjustment*
  $ 2.97     $ 2.55     $ 1.79     $ 1.90     $ 1.77     $ 1.54  
Earnings per share
    2.97       2.49       1.79       1.90       1.77       1.54  
Diluted earnings per share before cumulative adjustment*
    2.89       2.48       1.77       1.85       1.72       1.50  
Diluted earnings per share
    2.89       2.42       1.77       1.85       1.72       1.50  
Cash dividends declared per share
    1.05       .91       .88       .79       .685       .615  
Year-end book value per share
    13.35       11.66       10.70       9.52       8.50       7.44  
Closing price of common stock per share:
                                                           
 
High
    40.45       37.25       29.06       45.19       38.06       33.75  
 
Low
    30.05       27.38       16.06       27.56       23.81       18.38  
 
Year-end
    35.94       36.26       28.94       28.50       38.06       33.38  
Dividends per share/year-end closing price
    2.9 %     2.5 %     3.0 %     2.8 %     1.8 %     1.8 %
Dividends per share/diluted earnings per share
    36.3       36.7       49.7       42.7       39.8       41.0  
Price/earnings ratio
    12.4 x     15.0 x     16.3 x     15.4 x     22.1 x     22.3 x  
Market capitalization
  $ 4,553.9     $ 4,597.0     $ 3,744.7     $ 3,715.1     $ 4,920.8     $ 4,279.0  
Average shares outstanding (thousands)
    126,714       127,777       129,865       130,573       128,235       128,365  
Period-end shares outstanding (thousands)
    125,600       125,865       128,745       129,878       128,974       128,209  
Volume of shares traded (thousands)
    139,946       110,154       99,469       96,207       107,837       135,205  

Selected Average Balances
                                                           
Total assets
  $ 20,704.0     $ 19,227.2     $ 19,325.3     $ 18,625.3     $ 16,724.7     $ 13,284.6  
Total loans**
    10,634.5       10,104.3       9,932.0       8,818.8       8,242.1       7,945.1  
Investment securities
    2,466.4       2,595.3       2,862.7       2,702.7       2,425.8       2,139.4  
Earning assets
    17,397.4       16,125.4       16,095.5       15,583.7       14,320.5       11,512.1  
Deposits
    13,495.2       12,421.7       12,860.8       12,302.1       10,996.4       9,207.1  
Term borrowings
    685.5       521.5       384.3       371.1       252.7       185.5  
Shareholders’ equity
    1,568.3       1,401.3       1,276.6       1,186.8       996.0       878.8  

Selected Period-End Balances
                                                           
Total assets
  $ 23,823.1     $ 20,621.6     $ 18,559.6     $ 18,378.0     $ 18,738.1     $ 14,391.9  
Total loans**
    11,345.4       10,283.1       10,239.5       9,363.2       8,557.1       8,311.4  
Investment securities
    2,700.3       2,525.9       2,839.0       3,101.3       2,426.3       2,186.5  
Earning assets
    19,999.8       17,085.7       15,193.3       14,944.2       15,694.6       12,220.2  
Deposits
    15,713.9       13,606.3       12,188.7       11,358.7       11,723.0       9,671.8  
Term borrowings
    929.7       550.4       409.7       358.7       414.5       168.9  
Shareholders’ equity
    1,691.2       1,477.8       1,384.2       1,241.5       1,099.5       954.1  

Selected Ratios
                                                           
Return on average shareholders’ equity before cumulative adjustment
    24.00 %     23.29 %     18.22 %     20.86 %     22.73 %     22.47 %
Return on average shareholders’ equity
    24.00       22.71       18.22         20.86       22.73       22.47  
Return on average assets before cumulative adjustment
    1.82       1.70       1.20       1.33       1.35       1.49  
Return on average assets
    1.82       1.66       1.20       1.33       1.35       1.49  
Net interest margin
    4.33       4.27       3.73       3.80       3.80       4.23  
Allowance for loan losses to loans**
    1.27       1.46       1.36       1.44       1.54       1.47  
Net charge-offs to average loans**
    .93       .80       .62       .59       .46       .54  
Average shareholders’ equity to average assets
    7.58       7.29       6.61       6.37       5.96       6.62  
Average tangible equity to average tangible assets
    6.70       6.66       5.98       5.70       5.23       5.81  
Average shareholders’ equity to average net loans
    14.96       14.07       13.04       13.67       12.28       11.23  

Return to Shareholders
                                                           
Stock appreciation
    (.9 )%     25.3 %     1.5 %     (25.1 )%     14.0 %     78.0 %
Dividend yield
    2.9       3.1       3.1       2.1       2.1       3.3  
Total return
    2.0       28.4       4.6       (23.0 )     16.1       81.3  

*   Cumulative adjustment reflects the effect of changes in accounting principles related to derivatives.
**   Net of unearned income.
See accompanying notes to consolidated financial statements. Common stock data reflects the 1998 two-for-one stock split.
     
F-2   First Tennessee National Corporation

 


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS (MD&A) OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

GENERAL INFORMATION

First Tennessee National Corporation (First Tennessee) is headquartered in Memphis, Tennessee, and is a nationwide, diversified financial services institution which provides banking and other financial services to its customers through various regional and national business lines. Effective January 1, 2002, the business segment information has been adapted to better reflect First Tennessee’s strategic alignment and positioning and to conform to similar changes in internal segment reporting. Prior periods have been restated for comparability. The new segments are FTN Banking Group, First Horizon, FTN Financial, Transaction Processing, Corporate and Strategic Initiative Items. FTN Banking Group includes the Retail/Commercial Bank, Investments, Insurance, Financial Planning, Trust Services and Asset Management, Credit Card and Cash Management. This segment offers traditional banking financial services and products and also promotes comprehensive financial planning to address customer needs and desires for investments, insurance, estate planning, education funding, cash reserves and retirement goals. First Horizon includes First Horizon Home Loans, First Horizon Equity Lending and First Horizon Money Centers (the last two were previously included in the Retail/Commercial Bank). These business lines were combined to create a common focus and a stronger presence in the national market. During third quarter 2002, First Tennessee sold the loan portfolio and closed the offices of First Horizon Money Centers as part of an ongoing plan to improve long-term growth by enhancing overall business mix. See also Business Line Review and Note 2 – Divestitures/Acquisitions for additional detail. As part of the segment realignment, FTN Financial added Strategic Alliances and Correspondent Services to the existing business mix that included Capital Markets, Equity Research and Investment Banking. Strategic Alliances is a customer relationship service group formed to enhance a portfolio of innovative investment services. Correspondent Services was previously a part of the Retail/Commercial Bank. Transaction Processing continues to offer credit card merchant processing, nationwide bill payment processing, check clearing operations and other products and services. The Corporate segment includes certain corporate expenses, interest expense on trust preferred and REIT preferred stock, select components of SFAS 133 hedge ineffectiveness (see Other – Accounting for Derivative Instruments and Hedging Activities), and other items not allocated or not specifically assigned to business segments. The Strategic Initiative Items segment isolates items occurring in 2001 that were related to a strategic initiative to enhance growth and business mix, as announced by First Tennessee in 2000 (see Business Line Review for additional details).

Based on management’s best estimates, certain revenues and expenses are allocated and equity is assigned to the various segments to reflect the inherent risk in each business line. These allocations are periodically reviewed and may be revised from time to time to more accurately reflect current business conditions and risks; the previously reported amounts have been adjusted to ensure comparability.

For the purpose of this management discussion and analysis (MD&A), noninterest income (also called fee income) and total revenue exclude securities gains and losses. Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for certain tax-exempt loans and investments included in earning assets. Earning assets, including loans, have been expressed as averages, net of unearned income. First Tennessee Bank National Association, the primary bank subsidiary, is also referred to as FTBNA in this discussion.

The following financial discussion should be read with the accompanying consolidated financial statements and notes. A glossary is included at the end of the MD&A to assist with terminology.

     
First Tennessee National Corporation   F-3

 


Table of Contents

FORWARD-LOOKING STATEMENTS

Management’s discussion and analysis may contain forward-looking statements with respect to First Tennessee’s beliefs, plans, goals, expectations, and estimates. Forward-looking statements are statements that are not a representation of historical information but rather are related to future operations, strategies, financial results or other developments. The words “believe”, “expect”, “anticipate”, “intend”, “estimate”, “should”, “is likely”, “will”, “going forward”, and other expressions that indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, operational, economic and competitive uncertainties and contingencies, many of which are beyond a company’s control, and many of which, with respect to future business decisions and actions (including acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; expectations of and actual timing and amount of interest rate movements (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation; the financial condition of borrowers and other counterparties; competition within and outside the financial services industry; geo-political developments including possible terrorist activity; technology; and new products and services in the industries in which First Tennessee operates. Other factors are those inherent in originating and servicing loans, including prepayment risks and fluctuation of collateral values and changes in customer profiles. Additionally, the actions of the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and other regulators; regulatory and judicial proceedings and changes in laws and regulations applicable to First Tennessee; and First Tennessee’s success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. First Tennessee assumes no obligation to update any forward-looking statements that are made from time to time.

FINANCIAL SUMMARY

Earnings for 2002 were $376.5 million, or $2.89 diluted earnings per share. This represents 18 percent growth from 2001 earnings of $318.2 million, or $2.42 diluted earnings per share. Return on average shareholders’ equity and return on average assets for 2002 were 24.0 percent and 1.82 percent, respectively, and were 22.7 percent and 1.66 percent in 2001. Total assets were $23.8 billion, shareholders’ equity was $1.7 billion and market capitalization was $4.6 billion on December 31, 2002, compared to $20.6 billion, $1.5 billion and $4.6 billion, respectively, on December 31, 2001.

CRITICAL ACCOUNTING POLICIES

APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

First Tennessee’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations. The consolidated financial statements of First Tennessee are prepared in conformity with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. The preparation of the financial statements requires management to make certain judgments and assumptions in determining accounting estimates. Accounting estimates are considered critical if (a) the estimate requires management to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (b) different estimates reasonably could have been used in the current period, or changes in the accounting estimate are reasonably likely to occur from period to period, that would have a material impact on the presentation of First Tennessee’s financial condition, changes in financial condition or results of operations. Management believes that the items discussed below are properly recorded in the financial statements for all periods presented.

     
F-4   First Tennessee National Corporation

 


Table of Contents

Management believes the following critical accounting policies are both important to the portrayal of the company’s financial condition and results of operations and require subjective or complex judgments. Management has discussed with the Board of Directors’ Audit Committee these critical accounting policies, including the development, selection and disclosure of the critical accounting estimates. These judgments about critical accounting estimates are based on information available as of the date of the financial statements.

Mortgage Servicing Rights and Other Related Retained Interests

When First Horizon Home Loans sells mortgage loans in the secondary market to investors, it generally retains the right to service the loans sold in exchange for a servicing fee that is collected over the life of the loan as the payments are received from the borrower. The expected present value of the anticipated cash flows received for servicing the loan, net of the estimated costs of servicing the loan, is capitalized as an asset known as mortgage servicing rights (MSR’s) on the Consolidated Statements of Condition. In certain cases, when First Horizon Home Loans sells mortgage loans in the secondary market, it retains an interest in the mortgage loans sold primarily through interest-only certificates. Interest-only certificates are financial assets, which represent rights to receive earnings from serviced assets that exceed contractually specified servicing fees.

MSR Estimated Fair Value

The fair value of MSR’s typically rises as market interest rates increase and declines as market interest rates decrease; however, the extent to which this occurs depends in-part on (1) the magnitude of changes in market interest rates, and (2) the differential between the then current market interest rates for mortgage loans and the mortgage interest rates included in the mortgage servicing portfolio.

Since sales of MSR’s tend to occur in private transactions and the precise terms and conditions of the sales are typically not readily available, there is a limited market to refer to in determining the fair value of MSR’s. As such, like other participants in the mortgage banking business, First Horizon Home Loans relies primarily on a discounted cash flow model to estimate the fair value of its MSR’s. This model calculates estimated fair value of the MSR’s using numerous tranches of MSR’s, which share similar key characteristics, such as interest rates, type of product (fixed vs. variable), age (new, seasoned, moderate), agency type and other factors. First Horizon Home Loans uses assumptions in the model that it believes are comparable to those used by other participants in the mortgage banking business and reviews estimated fair values and assumptions with third-party brokers and other service providers on a quarterly basis. First Horizon Home Loans also compares its estimates of fair value and assumptions to recent market activity and against its own experience.

Estimating the cash flow components of net servicing income from the loan and the resultant fair value of the MSR requires First Horizon Home Loans to make several critical assumptions based upon current market and loan production data.

Prepayment speeds: Generally, when market interest rates decline and other factors favorable to prepayments occur there is a corresponding increase in actual and expected borrower prepayments as customers refinance existing mortgages under more favorable interest rate terms. When a mortgage loan is prepaid, or is expected to prepay faster than originally expected, the anticipated cash flows associated with servicing that loan are terminated or reduced, resulting in a reduction, or impairment, to the fair value of the capitalized MSR. To estimate prepayment speeds, First Horizon Home Loans utilizes a third-party prepayment model, which is based upon statistically derived data linked to certain key principal indicators involving historical borrower prepayment activity associated with mortgage loans in the secondary market, current market interest rates and other factors. For purposes of model valuation, estimates are made for each product type within the MSR portfolio on a monthly basis.

Discount rate: Represents the rate at which the expected cash flows are discounted to arrive at the net present value of servicing income. Estimated discount rates will change with market conditions (i.e., supply vs. demand) and be reflective of the yields expected to be earned by market participants investing in MSR’s.

     
First Tennessee National Corporation   F-5

 


Table of Contents

Cost to service: Expected costs to service are estimated based upon the costs that a market participant would use in evaluating the potential acquisition of MSR’s.

Float income: Estimated float income is driven by expected float balances (principal and interest payments that are held pending remittance to the investor) and current market interest rates, including the thirty day London Inter-Bank Offered Rate (LIBOR) and five-year swap interest rates, which are updated on a monthly basis for purposes of estimating the fair market value of MSR’s.

First Horizon Home Loans engages in a process referred to as “price discovery” on a monthly basis to assess the reasonableness of the estimated fair value of MSR’s. Price discovery is conducted through a process of obtaining the following information: (a) monthly informal valuation of the servicing portfolio by a prominent mortgage-servicing broker, and (b) a collection of surveys and benchmarking data available through third party participants in the mortgage banking business. Although there is no single source of market information that can be relied upon to assess the fair value of MSR’s, First Horizon Home Loans reviews all information obtained during price discovery to determine whether the estimated fair value of MSR’s is reasonable when compared to market information. On December 31, 2002, 2001 and 2000, based upon the information obtained through price discovery, First Horizon Home Loans determined that its MSR’s valuations and assumptions were within the acceptable range compared to its peers.

The overall assessment of the estimated fair value of MSR’s is submitted monthly for review by the First Horizon Risk Management Committee (FHRMC). The FHRMC is responsible for approving the critical assumptions used by management to determine the estimated fair value of First Horizon Home Loans’ MSR’s. Each quarter, First Tennessee’s MSR Committee reviews the original valuation, impairment, and the initial capitalization rates for newly originated MSR’s. In addition, the Executive Committee of First Tennessee’s board of directors reviews the initial capitalization rates and approves the calculation of amortization expense.

MSR’s are included on the Consolidated Statements of Condition, net of accumulated amortization. The changes in fair value of MSR’s are included as a component of Mortgage Banking – Noninterest Income on the Consolidated Statements of Income.

Hedging the Fair Value of MSR’s

In order to provide protection from a decline in the fair value of MSR’s, First Horizon Home Loans employs a hedging strategy. This strategy uses derivative financial instruments expected to change in fair value in response to changes in a certain benchmark interest rate (specifically, the 10-year LIBOR) in amounts which will substantially offset the change in fair value of certain MSR’s. On December 31, 2002 and 2001, hedged MSR’s approximated 90 percent and 99 percent of the total MSR portfolio, as measured on a dollar at risk basis. In order to substantially hedge the change in fair value of the hedged MSR’s, First Horizon Home Loans generally maintains a coverage ratio (the ratio of the notional amount of derivatives to the carrying amount of the hedged MSR’s) approximating 100 percent of the hedged MSR portfolio. As noted above, to the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments and could result in significant earnings volatility. Pursuant to SFAS No. 133, in any hedge period the difference between the change in fair value of the hedged MSR, attributed to the change in the benchmark interest rate, and the change in fair value of the derivatives used to hedge the change in fair value of the MSR’s is recognized as gains or losses in current earnings. First Horizon Home Loans generally attempts to hedge 100 percent of the exposure to a change in the fair value of the hedged MSR’s attributed to a change in the benchmark interest rate, which requires a regular assessment of the amount of derivative financial instruments required to maintain a 100 percent hedge ratio. On December 31, 2002 and 2001, the hedge coverage ratio was approximately 100 percent of the hedged MSR portfolio.

As further discussed in the Notes to Consolidated Financial Statements, certain components of the fair value of derivatives used to hedge certain MSR’s are excluded from the assessment of hedge effectiveness. Although those amounts are excluded from the assessment of hedge effectiveness, they are included as a component of current earnings in the Consolidated Statements of Income.

     
F-6   First Tennessee National Corporation

 


Table of Contents

The derivative financial instruments used to hedge the change in fair value of hedged MSR’s primarily include interest rate floors, interest rate swaps, swaptions and forward purchase contracts of mortgage backed securities (known as “to be announced” mortgage backed securities, or TBA’s).

First Horizon Home Loans generally experiences increased loan origination and production in periods of low interest rates, which result in the capitalization of new MSR’s associated with new production – this provides for a “natural hedge” in the mortgage banking business cycle. The “replenishment rate” during 2002 – meaning the ratio of new loans originated for every existing customer mortgage loan that prepays – was almost two to one, which includes the retention of existing First Horizon Home Loans customers who prepay their mortgage loans. First Horizon Home Loans capitalized $401.9 million of MSR’s during 2002, thereby providing a significant offset to the impairment charges recognized related to MSR’s. This new production volume contributed significantly to the overall positive results experienced during 2002, despite record prepayments and significant MSR’s impairment charges (see Table 1 for additional information). New production and origination does not prevent First Horizon Home Loans from recognizing impairment expense on existing servicing rights as a result of prepayments; rather, the new production volume results in loan origination fees and the capitalization of MSR’s as a component of realized gains related to the sale of such loans in the secondary market, thus the “natural hedge” which tends to offset a portion of the MSR’s impairment charges during a period of low interest rates. In a period of increased borrower prepayments, impairment can be significantly offset by a strong replenishment rate and strong net margins on new loan originations. To the extent that First Horizon Home Loans is unable to maintain a strong replenishment rate, or in the event that the net margin on new loan originations declines from historical experience, the value of the natural hedge may diminish, thereby significantly impacting the results of operations in a period of increased borrower prepayments.

First Horizon Home Loans does not specifically hedge the change in fair value of MSR’s attributed to other risks, including anticipated prepayments (representing the difference between actual prepayment experience and estimated prepayments derived from the model, as described above), basis risk (meaning, the risk that changes in the benchmark interest rate may not correlate to changes in the mortgage market interest rates), discount rates, cost to service and other factors. To the extent that these other factors result in changes to the fair value of MSR’s, First Horizon Home Loans experiences volatility in current earnings due to the fact that these risks are not currently hedged.

Actual vs. Estimated MSR’s Critical Assumptions

As discussed above, the estimate of the cash flow components of net servicing income associated with MSR’s requires management to make several critical assumptions based upon current market and loan production data, including prepayment speeds, discount rate, cost to service and float income. Inherent in estimating such assumptions are uncertainties associated with the mortgage banking business (primarily, the change in market interest rates which vary significantly due to multiple economic and non-economic factors) as well as the composition of the MSR portfolio, which is not static and changes significantly based upon the production and sale of new loans, customer prepayment experience and other factors. As a result, the estimated assumptions used to value MSR’s – particularly the estimate of prepayment speeds – can vary significantly from actual experience, resulting in the recognition of additional impairment charges in current earnings. Table 1 provides a summary of actual and estimated weighted average prepayment speeds and float income used in determining the estimated fair value of MSR’s for the years ended December 31, 2002, 2001 and 2000.

During 2002, 2001 and 2000, impairment charges associated with MSR’s of $150.2 million, $115.4 million and $31.2 million, respectively, were recognized, which were principally associated with differences between actual and estimated prepayment speeds and other factors, including basis risk associated with benchmark interest rates and actual float income earnings. The decrease in value of MSR’s was significantly offset by an expected increase in value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s (see Table 6 - MSR’s net hedge results).

Although the estimates of discount rates, cost to service and float income assumptions used in determining the estimated fair value of MSR’s can vary from actual experience, such differences have not been material for the years ended December 31, 2002, 2001 and 2000.

     
First Tennessee National Corporation   F-7

 


Table of Contents

Table 1 summarizes First Horizon Home Loans’ MSR’s activity and critical assumptions for the years ended December 31, 2002, 2001 and 2000.

Table 1 - MSR’s Activity and Critical Assumptions

                           
(Dollars in millions)   2002   2001   2000

Mortgage servicing income
  $ 168.0     $ 157.1     $ 161.5  
Originated mortgage servicing rights, net
    401.9       232.3       169.9  
Amortization
    (117.8 )     (109.3 )     (81.6 )
Impairment
    (150.2 )     (115.4 )     (31.2 )
MSR net hedge loss
    -       -       (47.7 )
MSR hedge ineffectiveness, net*
    100.8       33.8       -  

Prepayment speeds
                       
 
Actual
    42.7 %     34.5 %     9.6 %
 
Estimated**
    42.9       24.8       9.7  
Float income
                       
 
Actual
  $ 41.7     $ 45.2     $ 37.7  
 
Estimated
    36.8       38.5       39.4  

*   MSR hedge ineffectiveness is expressed net of time decay of MSR’s hedges.
**   Estimated prepayment speeds represent monthly average prepayment speed estimates for each of the years presented.

Interest-Only Certificates Fair Value

Consistent with MSR’s, the fair value of an interest-only certificate typically rises as market interest rates increase and declines as market interest rates decrease. Additionally, similar to MSR’s, the market for interest-only certificates is limited, and the precise terms of transactions involving interest-only certificates are not typically readily available. Accordingly, First Horizon Home Loans relies primarily on a discounted cash flow model to estimate the fair value of its interest-only certificates.

Estimating the cash flow components and the resultant fair value of the interest-only certificates requires First Horizon Home Loans to make certain critical assumptions based upon current market and loan production data. The primary critical assumptions used by First Horizon Home Loans to estimate the fair value of interest-only securities include prepayment speeds and discount rates, as discussed above. First Horizon Home Loans interest-only certificates are included as a component of trading securities on the Consolidated Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of mortgage banking income on the Consolidated Statements of Income.

Hedging the Fair Value of Interest-Only Certificates

First Horizon Home Loans employs an economic hedging strategy, which uses derivative financial instruments expected to change in fair value in response to changes in a certain benchmark interest rate (specifically, the 10-year LIBOR) in amounts which will substantially offset the change in fair value of certain interest-only certificates. First Horizon Home Loans’ hedging strategy for interest-only certificates does not qualify for hedge accounting under SFAS No. 133 and, accordingly, realized and unrealized gains and losses associated with the change in fair value of derivatives used to hedge interest-only securities are included in current earnings on the Consolidated Statements of Income. The extent to which the change in fair value of interest-only securities is offset by the change in fair value of the derivatives used to hedge these instruments depends primarily on the hedge coverage ratio maintained by First Horizon Home Loans. Also, as noted above, to the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments, which could significantly impact First Horizon Home Loans’ ability to effectively hedge certain components of the change in fair value of interest-only certificates and could result in

     
F-8   First Tennessee National Corporation

 


Table of Contents

significant earnings volatility. The derivative financial instruments used to hedge the change in fair value of hedged interest-only certificates primarily include interest rate floors, interest rate swaps, swaptions and TBA’s.

Pipeline and Warehouse

During the period of loan origination, and prior to the sale of mortgage loans in the secondary market, First Horizon Home Loans has exposure to mortgage loans that are in the “mortgage pipeline” and the “mortgage warehouse”. The mortgage pipeline consists of loan applications that have been received, but have not yet closed as loans. Pipeline loans are either “floating” or “locked”. A floating pipeline loan is one on which an interest rate has not been locked by the borrower. A locked pipeline loan is one on which the potential borrower has set the interest rate for the loan by entering into an interest rate lock commitment (IRLC) resulting in interest rate risk to First Horizon Home Loans. Once a mortgage loan is closed and funded, it is included within the mortgage warehouse, or the “inventory” of mortgage loans that are awaiting sale and delivery into the secondary market. First Horizon Home Loans is also exposed to credit risk while a mortgage loan is in the warehouse.

An IRLC binds First Horizon Home Loans to lend funds to the potential borrower at the set interest rate, which expires on a fixed date regardless of whether or not interest rates change in the market. IRLC’s generally have a term of up to 60-days before the closing of the loan. The IRLC, however, does not bind the potential borrower to entering into the loan, nor does it guarantee that First Horizon Home Loans will approve the potential borrower for the loan. Therefore, First Horizon Home Loans makes estimates of expected “fallout” (locked pipeline loans not expected to close), to estimate expected exposure to interest rate risk. Fallout can occur for a variety of reasons including falling rate environments when a borrower will abandon an IRLC at one lender and enter into a new lower IRLC at another, when a borrower is not approved as an acceptable credit by the lender, or for a variety of other non-economic reasons. Expected fallout is estimated by management based upon actual cumulative historical fallout rates. Note that once a loan is closed, the risk of fallout is eliminated and the associated mortgage loan is included in the mortgage loan warehouse. Under SFAS No. 133, IRLC’s qualify as derivative financial instruments and, therefore, the changes in fair value of IRLC’s are included in current earnings in the Consolidated Statements of Income.

Like other participants in the mortgage banking business, First Horizon Home Loans relies primarily on an internal valuation model and one of several industry valuation techniques to estimate the fair value of IRLC’s and the mortgage warehouse. This model calculates the estimated fair value using tranches of mortgage loans that are determined to share similar key characteristics, including product type and interest rate bands. For purposes of determining the market interest rates for forward commitments to sell mortgage loans in the secondary market, First Horizon Home Loans obtains market interest rates from independent third parties, which represent actual trade activity in the secondary market. For purposes of determining the fair value of IRLC’s, management utilizes the median broker price information obtained in the secondary market, resulting in an asset with an estimated fair value of $59.9 million and a liability with an estimated fair value of $2.0 million on December 31, 2002 and 2001, respectively.

To hedge against changes in fair value of the mortgage pipeline and warehouse due to changes in interest rates, First Horizon Home Loans utilizes various derivative financial instruments, which management expects will experience changes in fair value opposite to the change in fair value of the loans in the pipeline and warehouse, thus minimizing earnings volatility. The instruments and techniques used to hedge the pipeline and warehouse include forward sales commitments and other interest rate derivatives. The extent to which First Horizon Home Loans is able to economically hedge changes in the mortgage pipeline depends largely on the hedge coverage ratio that is maintained relative to mortgage loans in the pipeline. The hedge ratio can change significantly due to changes in market interest rates and the associated forward commitment prices for sales of mortgage loans in the secondary market. Increases or decreases in the hedge coverage ratio can result in significant earnings volatility to First Horizon Home Loans. First Horizon Home Loans does not specifically hedge the change in fair value of the mortgage pipeline attributed to other risks, including basis risk and other factors.

     
First Tennessee National Corporation   F-9

 


Table of Contents

Foreclosure Reserves

As discussed above, First Horizon Home Loans typically originates mortgage loans with the intent to sell those loans to Government Sponsored Enterprises (GSE’s) and other private investors in the secondary market. Certain of the mortgage loans are sold with limited or full recourse in the event of foreclosure. On December 31, 2002 and 2001, approximately $4.5 billion and $5.1 billion of mortgage loans were outstanding which were sold under limited recourse arrangements. On December 31, 2002 and 2001, approximately $175.9 million and $211.1 million of mortgage loans were outstanding which were sold under full recourse arrangements.

Loans sold with limited recourse include loans sold under government guaranteed mortgage loan programs including Department of Housing and Urban Development (HUD), Federal Housing Administration (FHA) and Veterans Administration (VA). First Horizon Home Loans continues to absorb limited risk of credit losses in the event of foreclosure of the mortgage loan sold. Generally, the amount of recourse liability in the event of foreclosure is determined based upon the respective government program and/or the sale or disposal of the foreclosed property collateralizing the mortgage loan. Another instance of limited recourse is the VA/No bid. In this case, the VA guarantee is limited and First Horizon Home Loans may be required to fund any deficiency in excess of the VA guarantee if the loan goes to foreclosure.

Loans sold with full recourse generally include mortgage loans sold to investors in the secondary market which are uninsurable under government guaranteed mortgage loan programs, due to issues associated with underwriting activities, documentation or other concerns.

Management closely monitors historical experience, borrower payment activity, current economic trends and other risk factors, and establishes a reserve for foreclosure losses for loans sold with limited and full recourse which management believes is sufficient to cover incurred foreclosure losses in the portfolio. The reserve for foreclosure losses is based upon a historical progression model using a rolling 12-month average, which predicts the probability of a mortgage loan entering foreclosure. In addition, other factors are considered, including qualitative and quantitative factors (e.g., current economic conditions, past collection experience, risk characteristics of the current portfolio and other factors), which are not defined by historical loss trends. Table 2 provides a summary of reserves for foreclosure losses for the years ended December 31, 2002, 2001 and 2000.

Table 2 - Reserves for Foreclosure Losses

                         
(Dollars in millions)   2002   2001   2000

Beginning balance
  $ 25.2     $ 17.8     $ 14.1  
Provision for foreclosure losses
    19.1       15.7       10.1  
Charge-offs
    (17.5 )     (11.2 )     (10.1 )
Recoveries
    6.2       2.9       3.7  

Ending balance
  $ 33.0     $ 25.2     $ 17.8  

Allowance for Loan Losses

Management’s policy is to maintain the allowance for loan losses at a level sufficient to absorb estimated probable incurred losses in the loan portfolio. Management performs periodic and systematic detailed reviews of its loan portfolio to identify trends and to assess the overall collectibility of the loan portfolio. Accounting standards require that loan losses be recorded when management determines it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because: changes in it can materially affect the provision for loan losses and net income, it requires management to predict borrowers’ likelihood or capacity to repay, and it requires management to distinguish between losses incurred as of a balance sheet date and losses expected to be incurred in the future. Accordingly, this is a highly subjective process and requires significant judgment since it is often difficult to determine when specific loss events may

     
F-10   First Tennessee National Corporation

 


Table of Contents

actually occur. The allowance for loan losses is increased by the provision for loan losses and recoveries and is decreased by charged-off loans. This critical accounting estimate applies primarily to the FTN Banking Group, First Horizon and FTN Financial business segments.

First Tennessee’s methodology for estimating the allowance for loan losses is not only critical to the accounting estimate, but to the credit risk management function as well. Key components of the estimation process are as follows: (1) commercial loans determined by management to be individually impaired loans are evaluated individually and specific reserves are determined based on the difference between the outstanding loan amount and the estimated net realizable value of the collateral (if collateral dependent) or the present value of expected future cash flows; (2) individual commercial loans not considered to be individually impaired are segmented based on similar credit risk characteristics (a summary is provided in Table 21) and evaluated on a pool basis; (3) retail loans are segmented based on loan types; (4) reserve rates for each portfolio segment are calculated based on historical charge-offs and are adjusted by management to reflect current events, trends and conditions (including economic factors and trends); and (5) management’s estimate of probable incurred losses reflects the reserve rate applied against the balance of loans in each segment of the loan portfolio.

Principal loan amounts are charged off against the allowance for loan losses in the period in which the loan or any portion of the loan is deemed to be uncollectible.

First Tennessee believes that the critical assumptions underlying the accounting estimate made by management include: (i) the commercial loan portfolio has been properly risk graded based on information about borrowers in specific industries and specific issues with respect to single borrowers; (ii) borrower specific information made available to First Tennessee is current and accurate; (iii) the loan portfolio has been segmented properly and individual loans have similar credit risk characteristics and will behave similarly; (iv) no significant loss events have occurred that management should consider at the time of assessing the adequacy of the allowance for loan losses; (v) the economic factors utilized in the allowance for loan losses estimate are used as a measure of actual incurred losses; (vi) the period of history used for historical loss factors is indicative of the current environment; and (vii) the reserve rates, as well as other adjustments estimated by management for current events, trends, and conditions, utilized in the process reflect an estimate of losses that have been incurred as of the date of the financial statements.

While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses and methodology may be necessary if economic or other conditions differ substantially from the assumptions used in making the estimates or, if required by regulators, based upon information at the time of their examinations. Such adjustments (discussed below) to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels vary from previous estimates.

On December 31, 2001, and in all prior periods, management recorded as a component of its allowance for loan losses a general reserve to reflect management’s estimate of additional probable losses that have been incurred but not specifically identified in the commercial portfolio. This reserve helped to minimize the risks related to the imprecision inherent in the underwriting and grading process and provided for other factors not considered in computation of reserve rates applied to loan pools. In 2002 management decided to specifically quantify risks previously identified and provided for by the general reserve and adjust reserve rates accordingly to reserve for these items in the appropriate pools, and will no longer separately present a general reserve as a component of the allowance for loan losses. As a result of this decision, management has presented the prior period’s reserve to reflect this methodology change (see Table 21). Except as noted in this paragraph, there have been no significant changes to the methodology for the three years in the period ended December 31, 2002. The change in reserve rates is a function of the consistent application of the current methodology and those changes are further discussed in the Credit Risk Management/Asset Quality section.

     
First Tennessee National Corporation   F-11

 


Table of Contents

Goodwill and Assessment of Impairment

First Tennessee’s policy is to assess goodwill for impairment at the reporting unit level on an annual basis or between annual assessments 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. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Accounting standards require management to estimate the fair value of each reporting unit in making the annual assessment of impairment. Upon adoption of the new accounting standards on January 1, 2002, goodwill is no longer amortized with a periodic charge to earnings. First Tennessee performed the initial impairment test as of January 1, 2002. Subsequent to the initial evaluation, the annual impairment test will be performed each year as of October 1. The valuations as of January 1, 2002, and October 1, 2002, indicated no goodwill impairment for any of the reporting units.

Management believes the accounting estimates associated with determining fair value as part of the goodwill impairment test is a “critical accounting estimate” because estimates and assumptions are made about First Tennessee’s future performance and cash flows, as well as other prevailing market factors (interest rates, economic trends, etc.). First Tennessee’s policy allows management to make the determination of fair value using internal cash flow models or by engaging independent third parties. If a charge to operations for impairment results, this amount would be reported separately as a component of noninterest expense. This critical accounting estimate applies to the FTN Banking Group, First Horizon, FTN Financial, and Transaction Processing business segments. Reporting units have been defined as the same level as the operating business segments.

The impairment testing process conducted by First Tennessee begins by assigning net assets and goodwill to each reporting unit. First Tennessee then completes “step one” of the impairment test by comparing the fair value of each reporting unit (as determined based on the discussion below) with the recorded book value (or “carrying amount”) of its net assets, with goodwill included in the computation of the carrying amount. If the fair value of a reporting unit exceeds its carrying amount, goodwill of that reporting unit is not considered impaired, and “step two” of the impairment test is not necessary. If the carrying amount of a reporting unit exceeds its fair value, step two of the impairment test is performed to determine the amount of impairment. Step two of the impairment test compares the carrying amount of the reporting unit’s goodwill to the “implied fair value” of that goodwill. The implied fair value of goodwill is computed by assuming all assets and liabilities of the reporting unit would be adjusted to the current fair value, with the offset as an adjustment to goodwill. This adjusted goodwill balance is the implied fair value used in step two. An impairment charge is recognized for the amount by which the carrying amount of goodwill exceeds its implied fair value.

As noted above, a key estimate made by management during the assessment of impairment is the fair value of each reporting unit. During first quarter 2002, First Tennessee engaged an independent valuation firm to compute the fair value estimates of each reporting unit as part of its initial impairment assessment as of January 1, 2002. The independent valuation utilized three separate valuation methodologies and applied a weighted average to each methodology in order to determine fair value for each reporting unit. As of October 1, 2002, First Tennessee performed an internal analysis of each reporting unit to determine whether impairment existed at that date.

In connection with obtaining the independent valuation, management provided certain data and information that was utilized by the third party in their determination of fair value. This information included the 2002 budget and forecasted earnings of First Tennessee. Management believes that this information is a critical assumption underlying the estimate of fair value. The independent third party made other assumptions critical to the process, including discount rates, asset and liability growth rates, and other income and expense estimates, through discussions with management. Even though the January 1, 2002, impairment analysis was obtained from an independent third party, management may elect to perform these valuations internally in the future.

While management uses the best information available to estimate future performance for each reporting unit, future adjustments to management’s projections may be necessary if economic conditions differ substantially from the assumptions used in making the estimates.

     
F-12   First Tennessee National Corporation

 


Table of Contents

Contingent Liabilities

A liability is contingent if the amount is not presently known, but may become known in the future as a result of the occurrence of some uncertain future event. First Tennessee estimates its contingent liabilities based on management’s estimates about the probability of outcomes and their ability to estimate the range of exposure. Accounting standards require that a liability be recorded if management determines that it is probable that a loss has occurred and the loss can be reasonably estimated. In addition, it must be probable that the loss will be confirmed by some future event. As part of the estimation process, management is required to make assumptions about matters that are by their nature highly uncertain.

The assessment of contingent liabilities, including legal contingencies and income tax liabilities, involves the use of critical estimates, assumptions and judgments. Management’s estimates are based on their belief that future events will validate the current assumptions regarding the ultimate outcome of these exposures. However, there can be no assurance that future events, such as court decisions or I.R.S. positions, will not differ from management’s assessments. Whenever practicable, management consults with third party experts (attorneys, accountants, claims administrators, etc.) to assist with the gathering and evaluation of information related to contingent liabilities. Based on internally and/or externally prepared evaluations, management makes a determination whether the potential exposure requires accrual in the financial statements.

Note 1 – Summary of Significant Accounting Policies provides more detail on the accounting policies applied in the preparation of First Tennessee’s financial statements.

INCOME STATEMENTS ANALYSIS – 2002 COMPARED TO 2001

Earnings in 2002, were $376.5 million, an increase of 18 percent from $318.2 million earned in 2001. Diluted earnings per common share were $2.89 in 2002, an increase of 19 percent from the $2.42 earned in 2001. Earnings per common share were $2.97 in 2002, up 19 percent from the $2.49 earned in 2001. Return on average assets (ROA) was 1.82 percent in 2002 compared with 1.66 percent in 2001. Return on average shareholders’ equity (ROE) was 24.0 percent in 2002 compared with 22.7 percent in 2001.

On December 31, 2002, First Tennessee was ranked as one of the top 50 bank holding companies nationally in market capitalization ($4.6 billion) and total assets ($23.8 billion). On December 31, 2001, market capitalization was $4.6 billion and total assets were $20.6 billion.

Total revenue grew 18 percent to $2,304.3 million from $1,952.4 million in 2001, with a 23 percent increase in fee income (noninterest income excluding securities gains and losses) and a 10 percent increase in net interest income.

NONINTEREST INCOME

Fee income provides the majority of First Tennessee’s revenue. During 2002 fee income increased 23 percent, to $1,550.3 million from $1,263.9 million, and contributed 67 percent to total revenue in 2002 compared with 65 percent in 2001. The December 31, 2001, acquisition of Synaxis Group, Inc. (Synaxis), a commercial insurance broker, impacted the results of 2002, adding $39.0 million to noninterest income. Excluding the impact of Synaxis in 2002, total fee income would have increased 20 percent. Table 3 provides six years of detailed information concerning First Tennessee’s noninterest income. The following discussion provides additional information on various line items reported in the table.

     
First Tennessee National Corporation   F-13

 


Table of Contents

Table 3 - Analysis of Noninterest Income

                                                                     
                                                        Compound Annual
                                                        Growth Rates (%)
                                                       
(Dollars in thousands)   2002   2001   2000   1999   1998   1997   02/01   02/97

Noninterest income:
                                                               
Mortgage banking
  $ 665,837     $ 449,647     $ 238,031     $ 479,886     $ 449,514     $ 287,812       48.1 +       18.3 +  
Capital markets
    447,359       343,647       117,870       126,835       147,353       98,310       30.2 +       35.4 +  
Deposit transactions and cash management
    143,315       133,631       116,080       106,240       90,444       86,047       7.2 +       10.7 +  
 
Insurance premiums and commissions
    50,446       16,844       12,203       10,912       8,725       6,457       199.5 +       50.9 +  
Merchant processing
    48,403       45,426       48,232       49,711       37,462       32,111       6.6 +       8.6 +  
Trust services and investment management
    48,369       56,705       65,817       59,807       51,198       40,941       14.7 -       3.4 +  
Divestitures     4,550       80,357       157,635       4,246       567           NM   NM
Equity securities gains/(losses), net     (9,435 )     (3,290 )     754       2,313       3,940       (854 )   NM   NM
Debt securities gains/(losses), net     255       (1,041 )     (4,961 )     (56 )     36       141     NM   NM
All other income:
                                                               
   
Other service charges
    21,204       24,932       23,199       17,430       14,863       10,474       15.0 -       15.1 +  
   
Cardholder fees
    20,145       20,137       29,666       25,579       21,046       19,833       –          .3 +  
   
Check clearing fees
    13,180       11,615       11,129       11,143       9,199       13,043       13.5 +       .2 +  
   
Other
    87,437       81,026       97,019       76,173       42,304       31,496       7.9 +       22.7 +  

Total other income
    141,966       137,710       161,013       130,325       87,412       74,846       3.1 +       13.7 +  

Total noninterest income
  $ 1,541,065     $ 1,259,636     $ 912,674     $ 970,219     $ 876,651     $ 625,811       22.3 +       19.8 +  

Certain previously reported amounts have been reclassified to agree with current presentation.
NM - Due to the variable nature of these items the growth rate is considered to be not meaningful.

Mortgage Banking

First Horizon Home Loans, an indirect subsidiary of First Tennessee and the major component of the First Horizon business segment, offers residential mortgage banking products and services to customers, which consist primarily of the origination or purchase of single-family residential mortgage loans for sale to secondary market investors and the subsequent servicing of those loans.

First Horizon Home Loans originates mortgage loans through its retail and wholesale operations and also purchases mortgage loans from third-party mortgage bankers (known as “correspondent brokers”). Table 4 provides a summary of First Horizon Home Loans’ production/origination of mortgage loans during 2002, 2001 and 2000.

Table 4 - Production/Origination of Mortgage Loans

                         
    2002   2001   2000

Retail channel
    57.0 %     55.0 %     53.0 %
Wholesale channel
    33.0       33.0       33.0  
Correspondent brokers
    10.0       12.0       14.0  

In 2002, First Horizon Home Loans received fees derived from the mortgage origination process (loan origination fees, profits from the sale of loans, flow sales of MSR’s, and other secondary marketing activities) of

     
F-14   First Tennessee National Corporation

 


Table of Contents

$642.9 million (weighted average origination fee of 181.7 basis points) and incurred direct costs of $446.8 million (weighted average origination expense of 126.3 basis points). This compares with fees from the mortgage origination process of $469.9 million (weighted average origination fee of 178.9 basis points) and incurred direct costs of $343.1 million (weighted average origination expense of 130.7 basis points) in 2001.

The secondary market for mortgages allows First Horizon Home Loans to sell mortgage loans to investors, including GSE’s, such as Freddie Mac, Fannie Mae and Ginnie Mae. Many private investors are also active in the secondary market as issuers and investors. The majority of First Horizon Home Loans’ mortgage loans are sold through transactions with GSE’s. The risk of credit loss with regard to the principal amount of the loans sold is generally transferred to investors upon sale to the secondary market. To the extent that transferred mortgage loans are subsequently determined not to meet the agreed-upon qualifications or criteria, the purchaser has the right to return those loans to First Horizon Home Loans. In addition, certain mortgage loans are sold to investors with limited or full recourse in the event of mortgage foreclosure. (Refer to discussion of foreclosure reserves under Critical Accounting Policies.)

When First Horizon Home Loans sells mortgage loans in the secondary market to investors, it generally retains the right to service the loans sold in exchange for a servicing fee that is collected over the life of the loan as the payments are received from the borrower. The expected present value of the anticipated cash flows received for servicing the loan, net of the estimated costs of servicing the loan, is capitalized as an asset known as MSR’s on the Consolidated Statements of Condition (refer to discussion of MSR’s under Critical Accounting Policies). During 2002, First Horizon Home Loans originated $401.9 million of MSR’s in connection with sales of mortgage loans in the secondary market compared to $232.3 million in 2001. During 2001 a significant portion of the rights to service mortgage loans was sold under a flow servicing sale agreement. On December 31, 2002 and 2001, the total outstanding principal amount of First Horizon Home Loans’ servicing portfolio aggregated $56.0 billion and $45.5 billion, respectively, which places them among the top 20 servicers in the mortgage industry as reported by Inside Mortgage Finance.

In certain cases, when mortgage loans are sold in the secondary market, First Horizon Home Loans retains an interest in the mortgage loans sold through an interest-only or principal-only certificate. During 2002, $124.8 million and $1.5 million of interest-only and principal-only certificates, respectively, were retained through the sale of mortgage loans in the secondary markets. This compares to $98.3 million of interest-only and no principal-only certificates retained in 2001.

Table 5 provides the fair value of First Horizon Home Loans’ retained interests in mortgage loans sold in the secondary market on December 31, 2002, 2001 and 2000.

Table 5 - Fair Value of Retained Interests

                         
(Dollars in millions)   2002   2001   2000

Mortgage servicing rights*
  $ 464.1     $ 685.0     $ 765.1  
Interest-only securities**
    109.7       125.8       146.9  
Principal-only securities
    3.9       4.9       4.2  

*   Excludes hedge assets and liabilities with a net asset balance of $288.0 million and $69.2 million as of December 31, 2002 and 2001, respectively, which are included as components of capital markets receivables and other assets and capital markets payables and other liabilities.
**   Excludes derivative assets and liabilities with a net asset balance of $53.1 million and $10.8 million as of December 31, 2002 and 2001, respectively, which are included as components of capital markets receivables and other assets and capital markets payables and other liabilities.

Origination fees and gains or losses from the sale of loans are recognized at the time a mortgage loan is sold into the secondary market. A portion of the gain or loss is recognized at the time an IRLC is made to the customer. Secondary marketing activities include gains or losses from secondary marketing trading gains, product pricing decisions, and gains or losses from the sale of loans into the secondary market including the capitalized net present value of the MSR’s. As discussed under Critical Accounting Policies, First Horizon Home

     
First Tennessee National Corporation   F-15

 


Table of Contents

Loans employs hedging strategies intended to counter a change in the value of its MSR’s through changing interest rate environments. MSR’s hedge gains/(losses) reflect effects of hedging including servicing rights net value changes (see Other - Accounting for Derivative Instruments and Hedging Activities). Other income includes income from the foreclosure repurchase program, bulk sales of MSR’s, and other miscellaneous items. Mortgage trading securities gains/(losses) relate to market value adjustments primarily on interest-only strips that are classified as trading securities beginning in 2001 and related hedges. As shown in Table 6, total mortgage banking fee income increased 48 percent in 2002.

Table 6 - Mortgage Banking

                                           
                              Compound Annual
                              Growth Rates (%)
                             
(Dollars and volume in millions)   2002   2001   2000   02/01   02/00

Noninterest income:
                                       
  Loan origination fees
  $ 243.6     $ 190.9     $ 127.2       27.6+       38.4+  
  Secondary marketing activities
    399.3       279.0       115.3       43.1+       86.1+  
  Mortgage servicing fees
    168.0       157.1       161.5       7.0+       2.0+  
  MSR’s net hedge results*     122.0       48.0       (47.7 )   NM      NM
  Other income
    33.1       22.6       32.6       46.4+       .8+  
  Mortgage trading securities net losses
    (11.0 )     (9.1 )           20.7+       N/A  
  Amortization of MSR’s
    (117.8 )     (109.3 )     (81.6 )     7.8+       20.2+  
  MSR’s impairment loss
    (150.2 )     (115.4 )     (31.2 )     30.1+       119.4+  
  Time decay and amortization of MSR’s hedges
    (21.2 )     (14.2 )     (38.0 )     49.9+       25.3-  

               
 
Total mortgage noninterest income
  $ 665.8     $ 449.6     $ 238.1       48.1+       67.2+  

               
  Refinance originations
  $ 22,094     $ 15,373     $ 2,700       43.7+       186.1+  
  New loan originations
    10,837       9,991       11,774       8.5+       4.1-  

               
 
Mortgage loan originations
  $ 32,931     $ 25,364     $ 14,474       29.8+       50.8+  

               
  Servicing portfolio
  $ 55,993     $ 45,460     $ 47,394       23.2+       8.7+  

*   For 2002 and 2001, subsequent to the adoption of SFAS No. 133, MSR’s net hedge results represent the net gain or loss
resulting from the change in value of the hedged component of MSR’s and the offsetting change in value of servicing
hedges exclusive of time decay of MSR’s hedges (see Note 1 -Summary of Significant Accounting Policies).
NM - Due to the variable nature of these items the growth rate is considered to be not meaningful.

Origination activity increased 30 percent to $32.9 billion compared to $25.4 billion in 2001. Driven by low mortgage interest rates, refinance activity increased 44 percent to $22.1 billion and represented 67 percent of total originations during 2002 compared to 61 percent in 2001. Due to the high origination volumes, loan sales into the secondary market increased 42 percent to $30.8 billion in 2002 compared to last year. Fees derived from the mortgage origination process increased 37 percent in 2002, to $642.9 million from $469.9 million in 2001. The revenue growth was primarily due to increases in origination fees, in revenue recognized on loans sold, in the value recognized on loans in process and higher net secondary marketing trading gains. Secondary marketing activities increased $120.3 million primarily due to an increase of $112.8 million in net secondary marketing trading gains resulting primarily from increased production and the favorable interest rate environment experienced during 2002.

While the growth in refinance activity produced increased origination fee income, it also substantially increased actual and projected MSR’s prepayment speeds. As a result of the increased mortgage prepayment speeds experienced in 2002, the expected future cash flows that support the carrying values of MSR’s were substantially reduced, resulting in an 8 percent increase, to $117.8 million in MSR’s amortization expense and a $150.2 million impairment loss in 2002. MSR’s amortization was $109.3 million in 2001 and there was a MSR’s impairment loss of $115.4 million in 2001. The decrease in fair value of MSR’s attributed to declining interest rates was significantly offset by an expected increase in the value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s. Net MSR’s hedging gains (MSR’s net hedge results less time decay of MSR’s hedges) were $100.8 million in 2002 compared to $33.8 million in 2001 (both years represent an increase in the value of hedges offset by a decrease in the value of hedged MSR’s).

     
F-16   First Tennessee National Corporation

 


Table of Contents

The mortgage-servicing portfolio (which includes servicing for ourselves and others) totaled $56.0 billion on December 31, 2002, compared to $45.5 billion on December 31, 2001 (see Note 6 – Mortgage Servicing Rights for information summarizing changes in MSR’s). As a result of the strong originations, there was a “natural hedge” (see Critical Accounting Policies), which generated an increase in capitalized MSR’s during 2002 of $401.9 million, net of sales. Mortgage servicing fee income increased 7 percent to $168.0 million in 2002 primarily due to an 8 percent increase in the average mortgage-servicing portfolio.

Other mortgage income increased 46 percent to $33.1 million for 2002 compared with $22.6 million in 2001. The increase was primarily due to the agency insured foreclosure repurchase program, under which First Horizon Home Loans buys delinquent loans to reduce future foreclosure costs, which increased 49 percent in 2002 to $25.7 million from $17.2 million in 2001.

In 2002 mortgage trading securities net losses were $11.0 million compared to net losses of $9.1 million in 2001. Mortgage trading securities net gains or losses represent market value adjustments on interest-only and principal-only strips and related hedges.

Going forward, fee income from refinance loan originations will depend on mortgage interest rates. An increase in rates should reduce origination fees and profit from the sale of loans, but should also reduce MSR amortization expense and impairment losses, while a decrease in rates should increase this net revenue. Flat to rising interest rates should reduce net secondary marketing trading gains, while falling rates should increase this net revenue. Home purchase-related originations should reflect the relative strength or weakness of the economy. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

Capital Markets

Capital markets fee income, the major component of revenue in the FTN Financial segment, is primarily generated from the purchase and sale of securities as both principal and agent and from investment banking, portfolio advisory and equity research services. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. Inventory is hedged to protect against movements in interest rates.

For 2002, capital markets fee income increased 30 percent to $447.4 million from $343.7 million in 2001. This increase reflects continued growth and penetration into the targeted institutional customer base through expanded products, services, sales force and marketing efforts. This growth has also been influenced by the increased liquidity our depository institution customers have experienced as deposit growth has exceeded loan growth. In addition, revenue has been favorably impacted by changes in the interest rate environment and the equity markets. As shown in Table 7, revenue from depository and non-depository customers as well as from other sources has increased in 2002. Total securities bought and sold increased 19 percent to $1.7 trillion from $1.4 trillion in 2001.

Going forward, revenues will fluctuate based on factors which include the expansion or contraction of the customer base, the volume of investment banking transactions and the introduction of new products, as well as the strength of loan growth in the U.S. economy and volatility in the interest rate environment and the equity markets. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

     
First Tennessee National Corporation   F-17

 


Table of Contents

Table 7 – Capital Markets

                                           
                              Compound Annual
                              Growth Rates (%)
                             
(Dollars in millions)   2002   2001   2000   02/01   02/00

Noninterest income:
                                       
  Fixed income – depository
  $ 182.2     $ 142.1     $ 51.4       28.2 +       88.3 +  
  Fixed income – non-depository
    119.9       88.5       41.7       35.5 +       69.6 +  
  Other products
    145.3       113.1       24.8       28.5 +       142.1 +  

               
 
Total capital markets noninterest income
  $ 447.4     $ 343.7     $ 117.9       30.2 +       94.8 +  

               
  Securities bought and sold (billions)
  $ 1,669.8     $ 1,408.5     $ 774.5       18.6 +       48.2 +  

               

Deposit Transactions and Cash Management

Deposit transactions include services related to retail deposit products (such as service charges on checking accounts), cash management products and services such as electronic transaction processing (automated clearing house and Electronic Data Interchange), account reconciliation services, cash vault services, lockbox processing, and information reporting (Prime Connection). Noninterest income from deposit transactions and cash management increased 7 percent in 2002, to $143.3 million from $133.6 million primarily due to growth in cash management fees related primarily to a lower earnings credit rate on corporate deposits.

Insurance Premiums and Commissions

Insurance premiums and commissions come from the sale of insurance products and annuities. During 2002 total noninterest income from insurance premiums and commissions increased 199 percent, to $50.4 million from $16.8 million in 2001. This increase is due to the acquisition of Synaxis, a Nashville-based insurance broker operating through a network of major regional and community-based insurance agencies in Georgia, Kentucky and Tennessee, on December 31, 2001. Synaxis contributed $38.8 million to insurance premiums and commissions in 2002.

Merchant Processing

Merchant processing involves converting transactions from plastic media such as debit cards, credit cards, purchase cards, and private label credit cards into cash for merchants that sell goods and services to consumers and businesses. Fee income from merchant processing increased 7 percent in 2002, to $48.4 million from $45.4 million in 2001, primarily due to a portfolio acquisition in second quarter 2002, the impact of which was partially offset by the negative effect of a slowdown in the hospitality industry.

Trust Services and Investment Management

Trust services and investment management fees come from the product lines of investment management, personal trust, employee benefits and custodial trust services. During 2002 total noninterest income from trust services and investment management decreased 15 percent, to $48.4 million from $56.7 million. This decrease was primarily due to declining asset management fees related to a contraction in equity market valuations. Assets under management fell 15 percent to $7.3 billion on December 31, 2002, from $8.7 billion on December 31, 2001. The net decrease in fee income was as follows: the asset management business lines decreased 14 percent; personal trust was down 13 percent; and employee benefits decreased 19 percent primarily due to exiting less profitable product lines. Going forward, fee income from trust services and investment management should increase if the equity market improves and should decrease if the equity market experiences further declines.

     
F-18   First Tennessee National Corporation

 


Table of Contents

Divestitures

Gains from divestitures totaled $4.6 million in 2002 and $80.4 million in 2001. The gain in 2002 reflects First Horizon Money Centers’ loan portfolio sale and an adjustment to the gain recognized on the sale of Check Solutions Company in 2001. The gains in 2001 reflect First Tennessee’s divestitures of its interests in Check Solutions Company ($42.7 million); the sale of Peoples and Union Bank ($13.1 million); the sale of a portfolio of student loans ($11.8 million); the final phase of the sale of certain single relationship credit card accounts ($8.2 million); and an earn-out related to the 2000 divestiture of First Tennessee’s corporate and municipal trust business ($4.6 million) (see Note 2 – Acquisitions/Divestitures).

All Other Noninterest Income

All other noninterest income increased 3 percent in 2002, to $142.0 million from $137.7 million. Other service charges decreased 15 percent, or $3.7 million, due to declines in revenues from securitizations. Check clearing fees increased 13 percent, or $1.6 million, in 2002. Other noninterest income increased 8 percent, or $6.4 million, in 2002 with the growth being spread over several categories.

SECURITIES GAINS/(LOSSES)

In 2002 there were $9.2 million of net securities losses compared to $4.3 million of net securities losses for 2001. In 2002 and 2001, the losses were primarily related to impairment of equity investments held by First Tennessee’s venture capital subsidiaries. The fair value of the securities portfolio for the venture capital subsidiaries was $33.3 million on December 31, 2002, compared to $37.2 million on December 31, 2001.

NET INTEREST INCOME

During 2002, net interest income increased 10 percent to $754.0 million from $688.4 million in 2001. Earning asset growth of 8 percent generated most of this increase and was primarily related to rising levels of mortgage originations pushing the mortgage warehouse higher and the increase in home equity lines of credit primarily originated across the markets served by First Horizon Home Loans. The consolidated net interest spread for 2002 was 3.93 percent compared with 3.61 percent for 2001. The consolidated net interest margin (margin) increased to 4.33 percent for 2002 compared with 4.27 percent for 2001.

As shown in Table 8, the margin is affected by the activity levels and related funding for First Tennessee’s mortgage production and servicing and capital markets activities. These activities typically produce different margins than traditional banking activities. Mortgage production and servicing activities can affect the overall margin based on a number of factors, including the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of MSR’s. Capital markets activities tend to compress the margin because of its strategy to reduce market risk by hedging its inventory in the cash markets, which effectively eliminates net interest income on these positions. As a result, First Tennessee’s consolidated margin cannot be readily compared to that of other bank holding companies. Going forward, the consolidated margin will continue to be influenced by the activity levels of mortgage production and servicing and capital markets. Over the near term, if interest rates remain at current low levels, the net interest margin is likely to compress further. Over the long term, the margin could be unfavorably impacted if the yield curve flattens significantly. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

Table 8 details the computation of the net interest margin for First Tennessee and the impact that mortgage production and capital markets had on the consolidated margin for the years 2000 through 2002.

     
First Tennessee National Corporation   F-19

 


Table of Contents

Table 8 - Net Interest Margin

                             
        2002   2001   2000

Traditional banking activities - NIM
    4.73 %     4.86 %     3.83 %
 
Mortgage production and servicing activities
    (.15 )     (.37 )     .13  
 
Capital markets activities
    (.25 )     (.22 )     (.23 )

FTNC - NIM
    4.33 %     4.27 %     3.73 %

Consolidated yields and rates:
                       
 
Investment securities
    5.83 %     6.53 %     6.99 %
 
Loans, net of unearned income
    6.07       7.83       9.01  
 
Other earning assets
    5.43       6.47       7.64  

Yields on earning assets
    5.88       7.33       8.37  

 
Interest-bearing core deposits
    1.91       3.36       4.08  
 
Certificates of deposit $100,000 and more
    2.08       4.36       6.44  
 
Federal funds purchased and securities sold under agreements to repurchase
    1.45       3.66       5.84  
 
Commercial paper and other short-term borrowings
    4.02       5.11       6.55  
 
Term borrowings
    4.17       5.79       6.34  

Rates paid on interest-bearing liabilities
    2.04       3.84       5.33  

Net interest spread
    3.84       3.49       3.04  
 
Effect of interest-free sources
    .40       .67       .59  
 
Loan fees
    .10       .12       .11  
 
FRB interest and penalties
    (.01 )     (.01 )     (.01 )

FTNC - NIM
    4.33 %     4.27 %     3.73 %

Interest rate sensitivity is primarily a function of the repricing structure of First Tennessee’s balance sheet (Consolidated Statements of Condition). Table 9 shows the assets and liabilities as of year-end, subject to repricing in specified time intervals with each maturity interval referring to the earliest repricing opportunity (i.e., the earlier of scheduled contractual maturity or repricing date) for each asset and liability category. The resulting gap is one tool, though not a predominant management tool, used to measure the sensitivity of net interest income to changes in interest rates. It should be noted that the required gap analysis does not take into account future management actions that could be undertaken to alter the simulated results, the effect of interest-free sources, or a change in the slope of the yield curve. (For additional information see the Risk Management - Interest Rate Risk Management section.)

In order to reflect more appropriately the repricing structure of First Tennessee’s balance sheet, management has made certain adjustments to the balances shown in the table from their actual contractual terms. Based on historical and industry data, an estimate of the expected prepayments on retail loans and investment securities is reflected in the balances in Table 9. Changes in the economic and interest rate environments may also affect these expected prepayments.

Similarly, an adjustment to deposits is made to reflect the behavioral characteristics of certain core deposits that do not have specified contractual maturities (i.e., interest checking, savings and money market deposit accounts). Historically, balances on these deposit accounts have remained relatively stable despite changes in market interest rates. Management has classified certain of these accounts as non-interest sensitive based on management’s historical pricing practices and runoff experience. Table 9 does not take into account the effect of interest-free sources, which can be significant to First Tennessee.

Simulation analysis is the primary tool used by First Tennessee to manage the exposure of net interest income and margin to volatile interest rates, changing market spreads, forecasted changes in balance sheet mix, and rate sensitivity. This type of analysis computes the amount of net interest income at risk from dynamic changes

     
F-20   First Tennessee National Corporation

 


Table of Contents

in the market place and related rate, pricing and balance sheet movements. The simulation models create various at-risk scenarios looking at increases and/or decreases in interest rates from an instantaneous movement, or a staggered movement over a certain time period. Management reviews these different scenarios to determine probable actions. The models are then updated to incorporate management action. A level of acceptable net interest income at risk based on a staggered increase or decrease in interest rates of 300 basis points is a component of internal guidelines. Due to the current abnormally low level of rates, the Fed funds rate was modeled into the simulation analysis using a floor of 75 basis points starting in the second half of 2002. Based on First Tennessee’s rate sensitivity position during 2002, net interest income at risk in 2002 when modeling a staggered change in rates was estimated to be less than 1 percent. Based on the rate sensitivity position on December 31, 2002, net interest income exposure over the next 12 months to a 300 basis point staggered increase in interest rates is estimated to be approximately 1 percent of projected 2003 net interest income. Net interest income exposure to a 50 basis point staggered decrease in interest rates is projected to be approximately a .5 percent decrease of projected 2003 net interest income. A 300 basis point staggered increase or 50 basis point staggered decrease in interest rates is a hypothetical rate scenario. These scenarios are used as one estimate of risk, and do not necessarily represent management’s current view of future interest rates or market developments and may well vary from actual results for a number of reasons, including those presented in the Forward-Looking Statements section of the MD&A. Table 10 provides rate and volume changes in interest income and interest expense for earning assets and interest-bearing liabilities for the past three years.

     
First Tennessee National Corporation   F-21

 


Table of Contents

Table 9 - Rate Sensitivity Analysis on December 31, 2002

                                                   
    Within 3   After 3 Months   After 6 Months   After 1 Year   After    
(Dollars in millions)   Months   Within 6 Months   Within 12 Months   Within 5 Years   5 Years   Total

Earning assets:
                                               
Loans
  $ 7,380     $ 336     $ 570     $ 2,610     $ 449     $ 11,345  
Investment securities
    397       224       355       1,298       426       2,700  
Loans held for sale
    4,798                               4,798  
Federal funds sold and securities purchased under agreements to resell
    261                               261  
Other earning assets
    782                         114       896  

Total earning assets
  $ 13,618     $ 560     $ 925     $ 3,908     $ 989     $ 20,000  

Earning asset funding:
                                               
Savings
  $ 10     $ 10     $ 20     $ 190     $ 67     $ 297  
Checking interest
    63       63       127       75       1,043       1,371  
Money market
    1,913                         260       2,173  
CD’s under $100,000 and other time
    429       332       294       785       70       1,910  
CD’s $100,000 and more
    4,581       46       53       102       31       4,813  
Short-term borrowed funds
    3,388             100                   3,488  
Term borrowings
    555       50       5       84       236       930  

Total earning asset funding
  $ 10,939     $ 501     $ 599     $ 1,236     $ 1,707     $ 14,982  

Rate sensitivity gap:
                                               
Period
  $ 2,679     $ 59     $ 326     $ 2,672     $ (718 )        
Cumulative
    2,679       2,738       3,064       5,736       5,018          

Rate sensitivity gap adjusted
                                               
 
for interest rate swaps
                                               
Period
  $ 2,629     $ 109     $ 326     $ 2,672     $ (718 )        
Cumulative
    2,629       2,738       3,064       5,736       5,018          

Rate sensitivity gap adjusted for
                                               
 
interest rate swaps and mortgage
                                               
 
custodials*
                                               
Period
  $ 1,169     $ 109     $ 326     $ 2,672     $ (1,201 )        
Cumulative
    1,169       1,278       1,604       4,276       3,075          

Adjusted gap as a percentage of total earning assets:
                                               
Period
    5.8 %     .6 %     1.6 %     13.4 %     (6.0 )%        
Cumulative
    5.8       6.4       8.0       21.4       15.4          

*   As a result of the refinance market at year-end, mortgage custodial balances included a significant amount of loan payoffs not yet remitted to investors.
Interest-sensitive categories represent ranges in which assets and liabilities can be repriced, not necessarily their actual maturities. The ‘After 5 Years’ column includes assets and liabilities with interest sensitivity of more than five years or with indefinite repricing schedules. Noninterest earning/bearing balances have been excluded from this analysis but are included in management’s internal analysis of interest income.
     
F-22   First Tennessee National Corporation

 


Table of Contents

Table 10 - Analysis of Changes in Net Interest Income

                                                     
    2002 Compared to 2001   2001 Compared to 2000
    Increase/(Decrease) Due to*   Increase/(Decrease) Due to*
(Fully taxable equivalent)  
 
(Dollars in thousands)   Rate**   Volume**   Total   Rate**   Volume**   Total

Interest income - FTE:
                                               
Loans
  $ (187,119 )   $ 40,698     $ (146,421 )   $ (118,634 )   $ 15,259     $ (103,375 )
Investment securities:
                                               
 
U.S. Treasury and other U.S. government agencies
    (13,504 )     3,975       (9,529 )     (4,560 )     2,847       (1,713 )
 
States and municipalities
    (113 )     (1,168 )     (1,281 )     25       150       175  
 
Other
    (4,121 )     (10,639 )     (14,760 )     (7,990 )     (21,267 )     (29,257 )

                   
                     
 
   
Total investment securities
    (17,440 )     (8,130 )     (25,570 )     (12,530 )     (18,265 )     (30,795 )

                   
                     
 
Other earning assets:
                                               
 
Loans held for sale
    (22,318 )     40,456       18,138       (26,393 )     (5,021 )     (31,414 )
 
Investment in bank time deposits
    (81 )     (10 )     (91 )     30       (11 )     19  
 
Federal funds sold and securities purchased under agreements to resell
    (5,195 )     3,685       (1,510 )     (8,028 )     (5,041 )     (13,069 )
 
Mortgage banking trading securities
    90       368       458       -       12,088       12,088  
 
Capital markets securities inventory
    (8,070 )     2,661       (5,409 )     (7,566 )     9,472       1,906  

                   
                     
 
   
Total other earning assets
    (39,209 )     50,795       11,586       (39,561 )     9,091       (30,470 )

                   
                     
 
Total earning assets
    (249,807 )     89,402       (160,405 )     (167,103 )     2,463       (164,640 )

 
Total interest income - FTE
                  $ (160,405 )                   $ (164,640 )

 
Interest expense:
                                               
Interest-bearing deposits:
                                               
 
Savings
  $ (1,631 )   $ (22 )   $ (1,653 )   $ (1,191 )   $ (506 )   $ (1,697 )
 
Checking interest and money market
    (48,031 )     221       (47,810 )     (31,426 )     5,489       (25,937 )
 
Certificates of deposit under $100,000 and other time
    (32,100 )     (7,748 )     (39,848 )     (6,099 )     (12,010 )     (18,109 )
 
Certificates of deposit $100,000 and more
    (83,024 )     25,773       (57,251 )     (71,651 )     (46,134 )     (117,785 )

                   
                     
 
   
Total interest-bearing deposits
    (165,947 )     19,385       (146,562 )     (121,566 )     (41,962 )     (163,528 )

                   
                     
 
Federal funds purchased and securities sold under agreements to repurchase
    (69,122 )     (1,027 )     (70,149 )     (67,896 )     14,128       (53,768 )
Commercial paper and other short-term borrowings
    (6,311 )     (1,418 )     (7,729 )     (12,692 )     (27,952 )     (40,644 )
Term borrowings
    (9,668 )     8,093       (1,575 )     (2,192 )     8,033       5,841  

                   
                     
 
Total interest-bearing liabilities
    (250,264 )     24,249       (226,015 )     (202,546 )     (49,553 )     (252,099 )

 
Total interest expense
                  $ (226,015 )                   $ (252,099 )

 
Net interest income - FTE
                  $ 65,610                     $ 87,459  

*   The changes in interest due to both rate and volume have been allocated to change due to rate and change due to volume in proportion to the absolute amounts of the changes in each.
**   Variances are computed on a line-by-line basis and are non-additive.
     
First Tennessee National Corporation   F-23

 


Table of Contents

PROVISION FOR LOAN LOSSES

The provision for loan losses is the charge to operating earnings that management determines to be necessary to maintain the allowance for loan losses at an adequate level reflecting management’s estimate of probable incurred losses in the loan portfolio. An analytical model based on historical loss experience adjusted for current events, trends and economic conditions is used by management to determine the amount of provision to be recognized and to assess the adequacy of the loan loss allowance. The provision for loan losses decreased 1 percent, to $92.2 million in 2002 compared with $93.2 million in 2001, reflecting improvement in asset quality of retail loans, the impact of whole-loan insurance being provided for a segment of the retail loan portfolio and the change in risk profile after the sale of the Money Center loans. These positive impacts were largely offset by deterioration in commercial credits resulting primarily from the impact on our customer base of a weakened economy. The ratio of allowance for loan losses to total loans, net of unearned income, was 1.27 percent in 2002, compared to 1.46 percent in 2001, primarily reflecting improvement in the retail loan portfolio’s risk profile and the transfer of certain classified and nonperforming residential mortgage loans to held for sale. A more detailed discussion follows in the Risk Management - Credit Risk Management/Asset Quality section.

NONINTEREST EXPENSE

Total noninterest expense for 2002 increased 20 percent to $1,643.3 million from $1,364.1 million in 2001. The acquisition of Synaxis impacted the results of 2002, adding $34.2 million to noninterest expense. Excluding the impact of Synaxis in 2002 and Strategic Initiative Items in 2001 (see Business Line Review – Strategic Initiative Items below), total noninterest expense would have increased 22 percent. Expenses in First Horizon and FTN Financial fluctuate significantly based on the type and level of activity. Excluding First Horizon and FTN Financial in both periods, Synaxis in 2002 and Strategic Initiative Items in 2001, total operating expense would have increased 15 percent. Also impacting noninterest expense growth in 2002 was a $45.0 million contribution to First Tennessee Foundation (see Business Line Review – Corporate for further discussion of the First Tennessee Foundation). Excluding this expense in addition to the items previously mentioned, total operating expense would have increased 7 percent. Going forward, the level of activity in FTN Financial and First Horizon will continue to influence the level of noninterest expense. Table 11 provides detail by category for the past six years with growth rates.

     
F-24   First Tennessee National Corporation

 


Table of Contents

Table 11 - Analysis of Noninterest Expense

                                                                                                                                       
                                                      Compound Annual
                                                      Growth Rates (%)
                                                     
(Dollars in thousands)   2002   2001   2000   1999   1998   1997   02/01   02/97

Noninterest expense:
                                                               
Employee compensation, incentives and benefits
  $ 998,562     $ 797,841     $ 598,017     $ 633,640     $ 563,576     $ 409,783       25.2 +       19.5 +  
Occupancy
    76,669       69,069       80,453       73,052       51,421       42,848       11.0 +       12.3 +  
Equipment rentals, depreciation and maintenance
    68,736       74,106       68,230       57,807       45,771       40,093       7.2 -       11.4 +  
Operations services
    60,238       59,635       70,875       64,545       58,505       49,879       1.0 +       3.8 +  
Communications and courier
    53,448       48,771       47,337       51,937       41,468       34,899       9.6 +       8.9 +  
Amortization of intangible assets
    6,200       10,805       11,738       10,492       11,114       9,631       42.6 -       8.4 -  
All other expense:
                                                               
  Charitable contributions     48,337       1,745       1,188       1,335       1,499       1,167     NM     110.6 +  
 
Legal and professional fees
    37,340       32,087       26,794       22,492       24,551       13,999       16.4 +       21.7 +  
 
Advertising and public relations
    35,982       35,508       26,693       30,187       25,184       18,722       1.3 +       14.0 +  
 
Contract employment
    32,799       32,115       28,868       43,685       35,937       17,420       2.1 +       13.5 +  
 
Computer software
    26,140       25,107       19,205       15,410       11,629       6,731       4.1 +       31.2 +  
 
Travel and entertainment
    22,501       17,489       13,891       18,698       19,485       13,802       28.7 +       10.3 +  
 
Foreclosed real estate
    21,479       25,452       16,080       6,585       31,019       10,827       15.6 -       14.7 +  
 
Supplies
    17,946       16,200       18,170       22,006       20,195       15,267       10.8 +       3.3 +  
 
Fed service fees
    9,597       7,761       7,112       6,471       5,307       5,799       23.7 +       10.6 +  
 
Distributions on guaranteed preferred securities
    8,070       8,070       8,070       8,070       8,070       8,070        -        -  
 
Distributions on preferred stock of subsidiary
    4,564       4,535       1,178       -       -       -       .6 +       N/A  
 
Deposit insurance premium
    2,393       2,463       2,589       1,790       1,578       1,485       2.8 -       10.0 +  
 
Other
    112,333       95,369       60,044       54,682       56,672       41,215       17.8 +       22.2 +  

               
 
Total other expense
    379,481       303,901       229,882       231,411       241,126       154,504       24.9 +       19.7 +  

               
 
Total noninterest expense
  $ 1,643,334     $ 1,364,128     $ 1,106,532     $ 1,122,884     $ 1,012,981     $ 741,637       20.5 +       17.2 +  

               
Certain previously reported amounts have been reclassified to agree with current presentation.
NM - not meaningful

Employee compensation, incentives and benefits (personnel expense), the largest component of noninterest expense, increased 25 percent to $998.5 million from $797.8 million in 2001. This increase is primarily due to higher activity levels for both FTN Financial and First Horizon and the Synaxis acquisition. Excluding the two business lines in both periods and Synaxis in 2002, total personnel expense increased 3 percent.

Occupancy expense increased 11 percent to $76.7 million compared to $69.1 million in 2001 primarily related to costs associated with the opening of new offices by First Horizon Home Loans due to increased origination volume and expenses incurred by Synaxis in 2002. Equipment rentals, depreciation and maintenance expense decreased 7 percent in 2002 to $68.7 million from $74.1 million in 2001, primarily due to fixed asset write-offs in 2001 which were in part related to office closings and divestitures. Operations services remained relatively flat at $60.2 million compared to $59.6 million in 2001. Communications and courier expense increased 10 percent to $53.5 million in 2002 from $48.8 million in 2001 primarily due to the increased activity levels of FTN Financial. Amortization of intangible assets decreased 43 percent to $6.2 million from $10.8 million in 2001 due to the implementation of new accounting standards (see Note 1 – Summary of Significant Accounting Policies and Note 7 – Intangible Assets for additional detail). All other expense increased 25 percent to $379.5 million in 2002 from $303.9 million. This increase includes the $45.0 million contribution to First Tennessee Foundation and increased costs for First Horizon related to the origination volume in 2002. Also included in both periods are debt restructurings that resulted in pre-tax losses of $3.7 million in 2002 and $5.1 million in 2001. The adoption of

     
First Tennessee National Corporation   F-25

 


Table of Contents

SFAS No. 145 in 2002 resulted in the debt restructuring loss for 2001 being presented on a pre-tax basis in all other expense. Previously, pursuant to SFAS No. 4, the debt restructuring was classified as an extraordinary item, net of related income tax effect (see Note 1 – Summary of Significant Accounting Policies). Additional information related to expenses by business line is provided in Table 12 (see also Business Line Review for additional information).

Table 12 – Noninterest Expense Composition

                         
(Dollars in millions)   2002   2001   2000

First Horizon
  $ 632.2     $ 510.4     $ 431.9  
FTN Banking Group
    473.9       423.3       427.6  
FTN Financial
    329.6       247.7       93.4  
Transaction Processing
    108.0       92.9       92.0  
Corporate
    99.6       46.4       27.7  
Strategic Initiative Items
          43.4       33.9  

Total noninterest expense
  $ 1,643.3     $ 1,364.1     $ 1,106.5  

INCOME TAXES

The effective tax rate for 2002 was 32.5 percent compared to 33.2 percent for 2001. Contributing to this variance was a change in tax status of a subsidiary of FTBNA, which resulted in a $7.5 million decrease in 2002 tax expense. This change will not affect 2003 tax expense.

CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES

SFAS No. 133 and EITF 99-20 were adopted on January 1, 2001. At that date all freestanding derivative instruments were measured at fair value with differences between the previous book value and fair value reported as a one-time accounting adjustment. Likewise, offsetting gains and losses on hedged assets, liabilities and firm commitments were recognized as adjustments of their respective book values at the adoption date as part of this accounting adjustment, except to the extent that they related to hedges of the variable cash flow exposure of a forecasted transaction. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the accounting adjustment, a $1.4 million after-tax gain, was reported as a cumulative effect adjustment of comprehensive income (see Note 17 – Earnings Per Share). Additionally, the rules regarding the recognition of impairment and income of interest-only strips were adopted. The net one-time accounting adjustments reported on the income statement as the cumulative effect of changes in accounting principles were a $13.0 million pre-tax ($8.2 million after-tax) loss.

BUSINESS LINE REVIEW

There were several revenue and expense items in 2001 that make it difficult to compare this year’s results with last year’s results. The items were related to an initiative announced in 2000 to enhance growth and business mix (Strategic Initiative Items). The initiative, completed in fourth quarter 2001, resulted in net pre-tax revenues in excess of expenses of $33.7 million for the year 2001. In the discussions of business segment performance, these 2001 Strategic Initiative Items are excluded, but are disclosed separately as a segment. Total revenues for the segments include securities gains and losses.

FTN BANKING GROUP

Pre-tax income for FTN Banking Group decreased 16 percent to $210.5 million for 2002, compared to $250.4 million for 2001. Total revenues for the segment were $748.6 million, an increase of 3 percent from $724.9 million in 2001. Total noninterest expense increased 12 percent in 2002 to $473.9 million from $423.3 million last year.

     
F-26   First Tennessee National Corporation

 


Table of Contents

The acquisition of Synaxis Group, Inc. (Synaxis), a commercial insurance broker, on December 31, 2001, impacted the results of operations for 2002. The following discussion of FTN Banking Group’s performance is adjusted to exclude this acquisition.

Total revenues decreased 2 percent to $713.5 million for 2002. Net interest income remained flat at $457.5 million in 2002, compared to $457.4 million in 2001. The net interest margin from traditional banking activities has declined 13 basis points since 2001 primarily due to a change in the mix of the loan portfolio to floating rate products and the repricing of term assets in this low interest rate environment. Fee income (noninterest income excluding securities gains and losses) decreased 1 percent to $265.2 million in 2002, reflecting declining trust and investment management fees resulting from a contraction in equity market valuations. The effect of these declining revenues was largely negated by increased revenues from cash management fees. Net securities losses were $9.2 million in 2002, compared with net losses of $1.0 million in 2001. The losses in 2002 were primarily related to permanent impairment of equity investments held by First Tennessee’s venture capital subsidiaries.

The provision for loan losses increased to $64.2 million in 2002 from $51.2 million in 2001 primarily due to the continued impact on our customer base of an ongoing economic period of slow growth. Going forward the level of provision for loan losses should fluctuate primarily with the strength or weakness of the Tennessee economy.

Total noninterest expense increased 4 percent to $439.7 million in 2002 compared to $423.3 million in 2001. Contributing to this increase were personnel, marketing, consulting and contract termination expenses associated with First Tennessee’s ongoing emphasis on improving long-term growth by making investments designed to enhance future performance.

Going forward, as term assets continue to reprice to lower rates, net interest margin should decline further in the near-term. Over the long term First Tennessee’s relatively neutral balance sheet position should allow the net interest margin to stabilize after the effect of this repricing has occurred. Going forward, fee income from trust services and investment management should increase if the equity market improves and should decrease if the equity market experiences further declines.

FIRST HORIZON

Pre-tax income for First Horizon increased 186 percent to $277.7 million for 2002, compared to $97.2 million for 2001. The sale in 2002 of a portfolio of loans originated through First Horizon Money Centers and the closing of the related Money Center offices, were responsible for $7.0 million of this increase. The loan portfolio sale and the closing of offices will have a nominal impact on the future earnings of First Horizon.

Total revenues were $937.2 million, an increase of 45 percent from $647.2 million in 2001. Net interest income increased 34 percent to $241.6 million in 2002, reflecting the benefits of lower funding costs and a larger portfolio of loans held for sale (warehouse). Net interest spread on the warehouse, which was positively impacted by the lower funding costs and the relative steepness of the yield curve, increased to 4.39 percent in 2002 from 3.20 percent in 2001. Total fee income increased 49 percent to $695.6 million in 2002. Fee income consists primarily of mortgage banking-related fees from the origination process, fees from mortgage servicing and MSR’s net hedge gains or losses. Total fee income is net of amortization, impairment and other expenses related to MSR’s and related hedges.

Origination activity increased 30 percent to $32.9 billion compared to $25.4 billion in 2001. Driven by low mortgage interest rates, refinance activity increased 44 percent to $22.1 billion and represented 67 percent of total originations during 2002 compared to 61 percent in 2001. Due to the high origination volumes, loan sales into the secondary market increased 42 percent to $30.8 billion in 2002 compared to last year. Fees derived from the mortgage origination process increased 37 percent in 2002, to $642.9 million from $469.9 million in 2001. The fee growth was primarily due to increases in origination fees, in revenue recognized on loans sold, in the value recognized on loans in process and higher net secondary marketing trading gains. Secondary marketing activities increased $120.3 million primarily due to an increase of $112.8 million in net secondary

     
First Tennessee National Corporation   F-27

 


Table of Contents

marketing trading gains resulting primarily from increased production and the favorable interest rate environment experienced during 2002.

While the growth in refinance activity produced increased origination fee income, it also substantially increased actual and projected MSR’s prepayment speeds. As a result of the increased mortgage prepayment speeds experienced in 2002, the expected future cash flows that support the carrying values of MSR’s were substantially reduced, resulting in an 8 percent increase, to $117.8 million in MSR’s amortization expense and a $150.2 million impairment loss in 2002. MSR’s amortization was $109.3 million in 2001 and there was a MSR’s impairment loss of $115.4 million. The decrease in fair value of MSR’s attributed to declining interest rates was significantly offset by an expected increase in the value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s. Net MSR’s hedging gains (MSR’s net hedge results less time decay of MSR’s hedges) were $106.6 million in 2002 compared to $28.8 million in 2001 (both years represent an increase in the value of hedges offset by a decrease in the value of hedged MSR’s).

The mortgage-servicing portfolio (which includes servicing for ourselves and others) totaled $56.0 billion on December 31, 2002, compared to $45.5 billion on December 31, 2001 (see Note 6 – Mortgage Servicing Rights for information summarizing changes in MSR’s). As a result of the strong originations, there was a “natural hedge” (see Critical Accounting Policies), which generated an increase in capitalized MSR’s during 2002 of $401.9 million, net of sales. Mortgage servicing fee income increased 7 percent to $168.0 million in 2002 primarily due to an 8 percent increase in the average mortgage-servicing portfolio.

The provision for loan losses decreased to $27.3 million in 2002 compared to $39.6 million in 2001. This reduction resulted from improvement in asset quality of retail loans, the change in risk profile caused by the sale of the Money Center loans, from certain classified and nonperforming residential mortgage loans being transferred to held for sale and from whole-loan insurance being provided for a segment of the retail loan portfolio. Going forward, the provision for loan losses should benefit from the improvements in the retail loan portfolio’s risk profile while expected loan growth may lessen this impact.

Total noninterest expense increased 24 percent to $632.2 million in 2002. The increase was primarily the result of a 33 percent increase in personnel expense that includes the impact of increased salary and commission expense related to the increased mortgage origination volume produced during 2002. The impact of investments made by First Horizon in growing the retail sales force is also reflected in this expense growth. In 2002, the sales force increased by approximately 48 percent.

Going forward, fee income from refinance loan originations will depend on mortgage interest rates. An increase in rates should reduce origination fees and profit from the sale of loans, but should also reduce MSR amortization expense and impairment losses, while a decrease in rates should increase this net revenue. Flat to rising interest rates should reduce net secondary marketing trading gains, while falling rates should increase this net revenue. If total origination volume increases and/or the yield curve steepens, net interest income from the warehouse should increase, while if volume decreases and/or the yield curve flattens, this revenue should decrease. Home purchase-related originations should reflect the relative strength or weakness of the economy and will also be influenced by the size of the sales force. The continuing success of national cross-sell strategies should increase revenues from products other than traditional mortgage origination and servicing. Actual results could differ because of various factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

FTN FINANCIAL

Pre-tax income for FTN Financial increased 22 percent to $159.8 million for 2002, compared to $131.3 million for 2001.

Total revenues were $490.1 million, an increase of 28 percent from $381.4 million in 2001. Fee income increased 30 percent to $455.2 million in 2002. This increased revenue reflects continued growth and penetration into FTN

     
F-28   First Tennessee National Corporation

 


Table of Contents

Financial’s targeted institutional customer base through expanded products, services, sales force and marketing efforts. FTN Financial’s enhanced institutional product and service lines experienced revenue growth of 30 percent in 2002. Revenue growth has also been influenced by the increased liquidity that our capital markets depository customers have experienced as deposit growth has exceeded loan growth. Also impacting our capital markets revenue growth has been the favorable interest rate environment and the recent volatile nature of the equity markets. Total securities bought and sold increased 19 percent to $1.7 trillion from $1.4 trillion in 2001.

The provision for loan losses was $.7 million in 2002 compared to $2.4 million in 2001.

Total noninterest expense increased 33 percent to $329.6 million in 2002 primarily due to an increase in personnel expense, the largest component of noninterest expense, resulting from commissions and incentives associated with the higher fee income this year.

Going forward, revenues will fluctuate based on factors which include the expansion or contraction of the customer base, the volume of investment banking transactions and the introduction of new products, as well as the strength of loan growth in the U.S. economy and volatility in the interest rate environment and the equity markets.

TRANSACTION PROCESSING

Pre-tax income for Transaction Processing was $12.4 million in 2002, compared to $17.0 million in 2001. Processing errors in the check clearing operation resulted in losses of $6.8 million in 2002, related to uncollectible return items. In addition, expenses of $1.6 million were incurred to support initiatives intended to remedy the impact of a processing error to credit card merchant processing customers.

CORPORATE

The Corporate segment’s results showed a pre-tax net decrease of $61.9 million from 2001. Included in this decline is a $45.0 million contribution to First Tennessee Foundation, a non-profit entity dedicated to supporting charitable causes in the diverse communities where First Tennessee does business. The additional funding provided by First Tennessee will enable the Foundation to provide increased ongoing support to communities reached through First Tennessee’s nationwide expansion strategy. Without the contributions from the Foundation, First Tennessee’s obligation to its communities would be funded in the future solely from noninterest expense. In addition, select components of SFAS 133 hedge ineffectiveness (see Other – Accounting for Derivative Instruments and Hedging Activities) and consulting fees caused further declines from 2001. Also included in both periods are debt restructurings that resulted in pre-tax losses of $3.7 million in 2002 and $5.1 million in 2001. The adoption of SFAS No. 145 in 2002 resulted in the debt restructuring loss for 2001 being presented on a pretax basis in noninterest expense. Previously, pursuant to SFAS No. 4, the debt restructuring was classified as an extraordinary item, net of related income tax effect (see Note 1 – Summary of Significant Accounting Policies).

STRATEGIC INITIATIVE ITEMS

First Tennessee’s third quarter 2000 earnings press release dated October 18, 2000, announced an ongoing initiative to enhance growth and business mix, in which several slower growth businesses were being considered for divestiture. Several strategic divestitures occurred in 2000 and 2001 – the corporate and municipal trust business and the MONEY BELT ATM network in fourth quarter 2000; the single relationship credit card portfolio in fourth quarter 2000 and first quarter 2001; and the student loan portfolio, Peoples and Union Bank, and a partnership interest in Check Solutions Company in second quarter 2001. In connection with this announced initiative, First Tennessee also announced plans to incur costs and expenses associated with various revenue and expense enhancement programs. First Tennessee has disclosed these revenue and expense items (“Strategic Initiative Items”) separately in order to enhance the comparability of period-to-period results. Table 13 provides information on the items included in this initiative. This initiative was completed in 2001.

     
First Tennessee National Corporation   F-29

 


Table of Contents

Table 13 - Strategic Initiative Items

                 
(Dollars in thousands)   2001   2000

Strategic Initiative Items:
               
Divestiture gains
  $ 80,357     $ 116,714  
MSR hedge restructuring loss
    -       (49,889 )
MSR delinquent loan valuation loss
    -       (13,737 )
Securities losses
    (3,250 )     (6,209 )
Expenses related to strategic initiatives*
    (43,381 )     (23,905 )
Cumulative effect of changes in accounting principles**
    (12,994 )     -  

    Net pre-tax income/(expense) items
    20,732       22,974  
Applicable income tax
    (7,714 )     (8,542 )

Net after-tax income/(expense) items
  $ 13,018     $ 14,432  

*   Includes marketing, litigation, severance, asset write-offs, professional fees, process workflow, divestiture costs and other expenses.
**   Reflecting the effect of adopting accounting principles related to derivatives (SFAS No. 133 and EITF 99-20).

INCOME STATEMENT ANALYSIS – 2001 COMPARED TO 2000

Earnings in 2001 were $318.2 million, an increase of 37 percent from $232.6 million earned in 2000. Diluted earnings per common share increased 37 percent to $2.42 in 2001 from $1.77 in 2000. Earnings per common share increased 39 percent to $2.49 in 2001 from $1.79 in 2000. ROA was 1.66 percent in 2001 compared with 1.20 percent in 2000, and ROE was 22.7 percent in 2001 compared with 18.2 percent in 2000.

Noninterest income increased 38 percent during 2001, to $1,264.0 million from $916.9 million and contributed 65 percent to total revenue in 2001 compared to 61 percent in 2000. During 2001 mortgage-banking fees increased 89 percent, to $449.6 million from $238.1 million due to increased origination volumes resulting from declining interest rates. This increased activity resulted in higher fees from the mortgage origination process, which increased 94 percent to $469.9 million in 2001 primarily due to the higher volumes, improved pricing margin management and an improvement in the results in pipeline and warehouse hedging and other loan sale activities. While growth in refinance activity produced increased origination fee income, it also substantially increased actual and projected MSR’s prepayment speeds, which was the primary reason for the 34 percent increase, to $109.3 million, in MSR’s amortization expense and a $115.4 million impairment loss in 2001 compared to a $31.2 million loss in 2000. The decrease in fair value of MSR’s attributed to declining interest rates was significantly offset by an expected increase in the value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s. Net MSR’s hedging gains, (MSR’s net hedge results less amortization and time decay of MSR’s hedges) were $33.8 million in 2001 (an increase in the value of hedges offset by a decrease in the value of hedged MSR’s). In 2000 net MSR’s hedging losses of $85.7 million included a $49.9 million loss related to the repositioning of the mortgage servicing hedge portfolio in preparation for the adoption of SFAS No. 133. See Table 6 for a breakout of mortgage banking fee income. Gains from divestitures totaled $80.4 million and $157.6 million in 2001 and 2000, respectively. The gains in 2001 reflect First Tennessee’s divestitures of its interests in Check Solutions Company ($42.7 million); the sale of Peoples and Union Bank ($13.1 million); the sale of a portfolio of student loans ($11.8 million); the final phase of the sale of certain single relationship credit card accounts ($8.2 million); and an earn-out related to the 2000 divestiture of First Tennessee’s corporate and municipal trust business ($4.6 million). The gains in 2000 reflect First Tennessee’s divestitures of single relationship credit card accounts ($50.2 million); the sale of the corporate and municipal trust business ($33.4 million); the sale of the MONEY BELT® ATM network ($33.1 million); and the sale of the HomeBanc mortgage division ($40.9 million) (see Note 2 – Acquisitions/Divestitures). Capital market’s fee income increased 192 percent in 2001, to $343.7 million from $117.9 million, while securities bought and sold increased 85 percent, to $1.4 trillion from $.8 trillion in 2000. The increase in fee income reflects continued growth and penetration into our targeted institutional customer base and changes in product mix. Additionally, fee income was favorably impacted in 2001 by an enhanced institutional product and service line that experienced revenue growth of 356 percent to $113.1 million from $24.8 million in 2000. Additionally, capital markets fee income in 2001 benefited from an improvement in the distressed market conditions experienced in 2000. During 2001 deposit transactions and cash management fees increased 15 percent, to $133.6 million from

     
F-30   First Tennessee National Corporation

 


Table of Contents

$116.1 million, primarily due to growth in return check charges and cash management fees. During 2001 total noninterest income from trust services and investment management decreased 14 percent, to $56.7 million from $65.8 million. This decrease was primarily due to the divestiture of corporate and municipal trust in fourth quarter 2000 and a decline in market values of managed portfolios, which fell 11 percent to $8.7 billion on December 31, 2001, from $9.8 billion on December 31, 2000. During 2001, insurance premiums and commissions increased 38 percent, to $16.8 million from $12.2 million. Merchant processing fees decreased 6 percent, to $45.4 million from $48.2 million, which reflects the slowdown in the hospitality industry. All other noninterest income decreased 14 percent in 2001, to $137.7 million from $161.0 million primarily due to divestitures.

In 2001 there were $4.3 million of net securities losses compared with $4.2 million of net securities losses for 2000. In 2001, the majority of the security losses were related to equity investments at First Tennessee’s venture capital subsidiaries. In 2000 First Tennessee recognized $4.6 million of security losses as a result of the sale of lower-yielding securities in the investment portfolio.

During 2001 net interest income increased 15 percent to $688.4 million from $600.9 million primarily due to lower funding costs. The consolidated net interest margin increased to 4.27 percent for 2001 compared with 3.73 percent for 2000. Lower funding costs and a reduction in the amount of purchased funds used to fund the balance sheet as core deposits grew, positively impacted the margin. See Table 8 for detailed computation of the net interest margin for First Tennessee and the impact that mortgage production and capital markets had on the consolidated margin for the years 2001 and 2000.

The provision for loan losses increased 38 percent, to $93.2 million in 2001 compared with $67.5 million in 2000, reflecting economic conditions including the impact of increased nonperforming loans and higher charge-offs. In 2001 the provision increased $9.1 million due to the classification as nonperforming of two large commercial credits totaling approximately $20 million and increased approximately $4 million due to further deterioration of an existing commercial credit classified as nonperforming in 2000. The remaining $13 million increase was primarily due to deterioration in economic conditions and increased charge-offs of retail loans with higher risk and reward profiles.

Total noninterest expense for 2001 increased 23 percent, to $1,364.1 million from $1,106.5 million in 2000. Expenses in First Horizon and FTN Financial fluctuate based on the type and level of activity. Excluding First Horizon and FTN Financial in both periods, total operating expense increased 4 percent. Employee compensation, incentives and benefits increased 33 percent to $797.8 million from $598.0 million in 2000. This increase is primarily due to higher activity levels for both FTN Financial and First Horizon. Equipment rentals, depreciation and maintenance expense increased 9 percent in 2001 to $74.1 million from $68.2 million in 2000 due primarily to losses on disposals of fixed assets including those related to office closings. Occupancy expense decreased 14 percent, or $11.4 million, due to the closure of less profitable mortgage production offices during 2000. Operations services decreased 16 percent to $59.6 million from $70.9 million in 2000 due principally to First Tennessee internalizing certain of its operations, which resulted in increased expenses in various other expense line items. All other expense increased 32 percent to $303.9 million in 2001 from $229.9 million in 2000 primarily due to increased expenses in contract employment, foreclosed real estate, software, dividends on preferred stock, marketing, litigation and professional fees.

BALANCE SHEET REVIEW

On December 31, 2002, First Tennessee reported total assets of $23.8 billion compared with $20.6 billion at the end of 2001 and $18.6 billion at the end of 2000. Average assets were $20.7 billion in 2002 compared with $19.2 billion in 2001 and $19.3 billion in 2000. In 2002 an increase in earning assets accounted for 86 percent of the growth in average assets.

EARNING ASSETS

Earning assets primarily consist of loans, loans held for sale and investment securities. During 2002, earning assets averaged $17.4 billion compared with $16.1 billion for 2001 and 2000. Average earning assets were 84 percent of total average assets in 2002, 84 percent in 2001 and 83 percent in 2000.

     
First Tennessee National Corporation   F-31

 


Table of Contents

Loans

Average loans increased 5 percent to $10.6 billion during 2002 principally as a result of the 16 percent increase in retail residential loans, and grew 2 percent to $10.1 billion during 2001. First Tennessee sold approximately $200 million of loans originated through its Money Centers in 2002, approximately $300 million of its single-relationship credit card receivables in 2001 and 2000, approximately $340 million of student loans in 2001, and Peoples and Union Bank with total loans of approximately $110 million in 2001. Average loans represented 61 percent of average earning assets in 2002; 63 percent in 2001; and 62 percent in 2000. During years prior to 2001 certain retail loans were securitized. The securities resulting from the securitization of residential real estate loans from the loan portfolio are owned by subsidiaries of First Tennessee, including FTBNA, and are classified as investment securities (see Note 24 – Securitizations). Additional loan information is provided in Table 14 and Note 4 – Loans.

Table 14 - Average Loans

                                                                   
            2002           2001        
        Percent   Growth       Percent   Growth       Percent
(Dollars in millions)   2002   of Total   Rate   2001   of Total   Rate   2000   of Total

Commercial:
                                                               
 
Commercial, financial and industrial
  $ 3,986.6       37 %     (2.2 )%   $ 4,075.2       40 %     7.5 %   $ 3,792.0       38 %
 
Real estate commercial
    1,028.7       10       9.3       941.2       9       7.1       878.5       9  
 
Real estate construction
    516.7       5       18.4       436.2       4       8.9       400.5       4  
Retail:
                                                               
 
Real estate residential
    4,185.1       39       15.8       3,613.6       36       12.0       3,227.3       32  
 
Real estate construction
    261.9       2       40.4       186.5       2       22.1       152.7       2  
 
Other retail
    390.7       4       (32.2 )     575.9       6       (37.8 )     926.4       9  
 
Credit card receivables
    264.8       3       (4.0 )     275.7       3       (50.3 )     554.6       6  

         
         
Total loans, net of unearned
  $ 10,634.5       100 %     5.2 %   $ 10,104.3       100 %     1.7 %   $ 9,932.0       100 %

         
         

Commercial loans, consisting of commercial, financial and industrial; commercial real estate; and commercial construction loans, averaged $5.5 billion and grew 1 percent, or $79.4 million during 2002, and averaged $5.5 billion and grew 8 percent, or $381.6 million in 2001. Commercial, financial and industrial loans continued as the single largest loan category in 2002 and represented 72 percent of the commercial loan portfolio in 2002 and 75 percent in both 2001 and 2000. Commercial real estate loans grew 9 percent, or $87.5 million in 2002 and grew 7 percent, or $62.7 million in 2001. Commercial construction loans grew 18 percent in 2002, or $80.5 million after increasing 9 percent, or $35.7 million in 2001. Commercial real estate construction lending increased in 2002 primarily from growth in loans to single-family residential builders, reflecting the strong demand for single-family housing. Additional commercial loan information is provided in Table 15.

Table 15 - Contractual Maturities of Commercial Loans on December 31, 2002

                                   
        After 1 Year        
(Dollars in thousands)   Within 1 Year   Within 5 Years   After 5 Years   Total

Commercial, financial and industrial
  $ 2,359,120     $ 1,540,056     $ 234,982     $ 4,134,158  
Real estate commercial
    405,794       534,614       96,933       1,037,341  
Real estate construction
    417,255       131,632       2,562       551,449  

Total commercial loans, net of unearned income
  $ 3,182,169     $ 2,206,302     $ 334,477     $ 5,722,948  

For maturities over one year:
                               
 
Interest rates - floating
          $ 1,140,343     $ 1,106,832     $ 1,247,175  
 
Interest rates - fixed
            1,065,959       227,645       1,293,604  

Total
          $ 2,206,302     $ 334,477     $ 2,540,779  

The retail loan portfolio consists of residential real estate (principally secured by first and/or second liens on residential property), other retail (automobile and other retail installment loans requiring periodic payments of principal and

     
F-32   First Tennessee National Corporation

 


Table of Contents

interest), credit card, and retail construction loans. In 2002 retail loans averaged $5.1 billion and increased 10 percent, or $450.8 million, and in 2001 averaged $4.6 billion and decreased 4 percent, or $209.3 million.

Residential real estate loans accounted for 82 percent of the retail loan portfolio in 2002, 78 percent in 2001 and 66 percent in 2000. The residential real estate loan portfolio grew 16 percent, or $571.5 million in 2002 and grew 12 percent, or $386.3 million in 2001 primarily due to growth in home equity lines of credit. The retail real estate construction portfolio increased 40 percent, or $75.4 million in 2002 after growing 22 percent, or $33.8 million in 2001. Retail real estate residential construction loans are made to individuals for the purpose of constructing a home where First Horizon Home Loans is committed to make the permanent mortgage. The increase in these loans reflects the expansion of this product line and the favorable housing environment. Other retail loans decreased 32 percent, or $185.2 million in 2002 due in part to the divestiture of the Money Centers’ loans in 2002 and decreased 38 percent, or $350.5 million in 2001 due to the sale of the student loan portfolio (See Note 2 – Acquisitions/ Divestitures for additional information).

Total credit card receivables (Visa and MasterCard) averaged $264.8 million in 2002, and decreased 4 percent, or $10.9 million in 2002, and in 2001 averaged $275.7 million, and decreased 50 percent, or $278.9 million due to First Tennessee’s decision to focus on core multi-relationship customers and sell almost $300 million of affinity, co-branded and certain single relationship credit card receivables which did not fit this strategic focus (see Note 2 – Acquisitions/Divestitures for additional information).

Going forward, First Tennessee expects loan growth to reflect the relative strength of the economy. First Tennessee will continue to evaluate alternative sources of funding which may include loan sales, securitizations, syndications, and debt offerings.

Investment Securities

The investment portfolio of First Tennessee consists principally of debt securities used as a source of income, liquidity and collateral for repurchase agreements or public fund deposits. Additionally, the investment portfolio is used as a tool to manage risk from movements in interest rates. On December 31, 2002, the investment portfolio totaled $2.7 billion. The investment portfolio is classified into two categories: securities available for sale (AFS) and securities held to maturity (HTM). Table 16 shows information pertaining to the composition, yields and contractual maturities of the investment securities portfolio.

Table 16 - Contractual Maturities of Investment Securities on December 31, 2002 (Amortized Cost)

                                                                 
                    After 1 Year   After 5 Years    
    Within 1 Year   Within 5 Years   Within 10 Years   After 10 Years
   
 
 
 
(Dollars in thousands)   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield

Securities held to maturity (HTM):
                                                               
States and municipalities*
  $ 1,473       6.07 %   $ 3,252       6.48 %   $ 1,577       7.32 %   $ -       - %
Privately issued CMO’s
    -       -       -       -       132,777       6.53       141,298       6.81  

Total
  $ 1,473       6.07 %   $ 3,252       6.48 %   $ 134,354       6.54 %   $ 141,298       6.81 %

Securities available for sale (AFS):
                                                               
Mortgage-backed securities and collateralized mortgage obligations**
  $ 210       6.97 %   $ 2,259       7.45 %   $ 43,987       4.48 %   $ 2,036,643       5.43 %
U.S. Treasury and other U.S government agencies
    55,213       2.77       26,847       5.62       1,451       5.20       112       3.24  
States and municipalities*
    1,865       4.61       2,063       5.45       -       -       19,035       7.31  
Other
    2,371       7.89       11,538       6.22       4,310       5.90       166,458 ***     4.12  

Total
  $ 59,659       3.05 %   $ 42,707       5.87 %   $ 49,748       4.62 %   $ 2,222,248       5.35 %

*   Weighted average yields on tax-exempt obligations have been computed by adjusting allowable tax-exempt income to a fully taxable equivalent basis using a tax rate of 39 percent.
**   Represents government agency issued mortgage-backed securities and collateralized mortgage obligations which, when adjusted for early paydowns, have an estimated average life of 2.3 years.
***   Represents equity securities with no stated maturity.
     
First Tennessee National Corporation   F-33

 


Table of Contents

Average investment securities decreased 5 percent, or $128.9 million in 2002 to $2.5 billion primarily due to the declining balances of retained securitization interests, which are paying down without being replenished. During 2001 average investment securities decreased 9 percent, or $267.4 million. The decrease in 2001 was primarily due to the transfer of mortgage banking’s interest-only strips to trading securities and the declining balances of privately issued CMO’s, which are paying down without being replenished. Investment securities represented 14 percent of earning assets in 2002, 16 percent of earning assets in 2001 and 18 percent in 2000.

On December 31, 2002, the AFS securities totaled $2.4 billion and had an average life of 2.3 years. AFS securities consisted primarily of mortgage-backed securities, collateralized mortgage obligations (CMO’s), U.S. Treasuries, U.S. government agencies, and equities. On December 31, 2002, these securities had approximately $45.5 million of net unrealized gains that resulted in an increase in book equity of approximately $28.0 million, net of $17.5 million of deferred income taxes (see Note 3 – Investment Securities for additional detail). On December 31, 2001, the AFS securities portfolio totaled $2.1 billion and had approximately $39.9 million of net unrealized gains that resulted in an increase in book equity of approximately $24.5 million, net of $15.4 million of deferred income taxes. On December 31, 2000, the AFS securities portfolio totaled $2.2 billion and had approximately $23.9 million of net unrealized gains that resulted in an increase in book equity of approximately $14.6 million, net of $9.3 million of deferred income taxes.

On December 31, 2002, the HTM securities totaled $280.4 million and had an average life of 1.6 years. HTM securities include privately issued CMO’s and municipal securities. The privately issued CMO’s represent retail real estate loans that have been securitized and retained through the use of a Real Estate Mortgage Investment Conduit (REMIC).The HTM securities portfolio had a net unrealized gain on December 31, 2002, of $4.1 million. On December 31, 2001, the HTM securities totaled $461.3 million and had a net unrealized loss of $2.2 million, and on December 31, 2000, the HTM securities portfolio totaled $638.3 million and had a net unrealized loss of $18.6 million.

Loans Held for Sale

Loans held for sale consist of the mortgage warehouse and student loans. The warehouse accounts for the majority of loans held for sale. Loans held for sale represented 17 percent of total earning assets in 2002 compared with 15 percent in 2001 and 2000. During 2002 loans held for sale averaged $3.0 billion and increased 27 percent or $636.2 million from 2001 as a result of a higher level of originations. During 2001 loans held for sale averaged $2.4 billion and decreased 3 percent or $62.8 million from 2000. Since the mortgage warehouse loans are generally held in inventory for a short period of time, there may be significant differences between average and period-end balances. At year-end 2002, loans held for sale totaled $4.8 billion compared with $3.4 billion and $1.7 billion at year-end 2001 and 2000, respectively.

DEPOSITS, OTHER SOURCES OF FUNDS AND LIQUIDITY MANAGEMENT

Deposits

During 2002 core deposits increased 4 percent, or $373.2 million, and averaged $9.7 billion. This compares to an increase of 4 percent, or $377.9 million, and an average balance of $9.3 billion in 2001. In 2000, these deposits averaged $8.9 billion. Interest-bearing core deposits, which averaged $5.8 billion in 2002, decreased 2 percent, or $147.6 million, primarily due to the loss of funds related to one institutional investor. Interest-bearing core deposits averaged $6.0 billion in 2001 and 2000. Noninterest-bearing core deposits grew 16 percent, or $520.9 million, during 2002, due to growth in a cash management investment product, demand deposit accounts and mortgage escrow accounts, and averaged $3.9 billion. In 2001, noninterest-bearing core deposits grew 16 percent, or $452.1 million, primarily from expanded usage of a cash management investment product and growth in mortgage escrow accounts, and averaged $3.3 billion. Noninterest-bearing core deposits averaged $2.9 billion in 2000.

     
F-34   First Tennessee National Corporation

 


Table of Contents

Other Sources of Funds

Short-term purchased funds averaged $7.5 billion for 2002, up 9 percent, or $644.0 million, from the previous year. Short-term purchased funds decreased 13 percent, or $1,038.8 million in 2001 and averaged $6.9 billion and $7.9 billion during 2001 and 2000, respectively. Short-term purchased funds accounted for 42 percent of First Tennessee’s funding (core deposits plus purchased funds and term borrowings) in 2002, 41 percent in 2001, and 46 percent in 2000 (see Note 9 – Short-Term Borrowings for additional information).

Term borrowings include senior and subordinated borrowings and advances with maturities greater than one year. On average, term borrowings increased 31 percent, or $164.0 million, during 2002 and averaged $685.5 million, compared to an increase of 36 percent, or $137.2 million, and an average balance of $521.5 million in 2001. Term borrowings averaged $384.3 million in 2000. Term borrowings on December 31, 2002, were $929.7 million, an increase of 69 percent, or $379.4 million from 2001 year-end. This increase was due to the issuance of additional bank notes to maintain liquidity as assets, primarily loans in the portfolio and the warehouse, increased $3.2 billion from 2001 year-end (see Note 10 – Term Borrowings for additional information).

Liquidity Management

The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers and the requirements of ongoing operations. The Asset/Liability Committee, a committee consisting of senior management that meets regularly, is responsible for managing these needs by taking into account the marketability of assets; the sources, stability and availability of funding; and the level of unfunded commitments (see Note 18 – Restrictions, Contingencies, Commitments, and Other Disclosures). Core deposits are First Tennessee’s primary source of funding and have been a stable source of liquidity for banks. These deposits are insured by the Federal Deposit Insurance Corporation to the maximum extent authorized by law. For 2002, the average total loan to core deposit ratio was 110 percent compared with 109 percent and 112 percent in 2001 and 2000, respectively. FTBNA has a bank note program available for additional liquidity, under which the bank may borrow funds from time to time, at maturities of 30 days to 30 years. On December 31, 2002, approximately $1.6 billion was available under current conditions through the bank note program as a long-term (greater than one year) funding source compared to $1.4 billion in 2001. First Tennessee also evaluates alternative sources of funding, including loan sales, securitizations, syndications, Federal Home Loan Bank borrowings and debt offerings in its management of liquidity.

First Tennessee has a loan funding arrangement with a commercial paper conduit facility. The majority of loans made under this facility would qualify for First Tennessee’s highest grades of low risk commercial loans if First Tennessee had made these loans. First Tennessee provides a liquidity facility and a credit enhancement to the conduit. Loans referred to the conduit totaled $232.6 million and $215.4 million on December 31, 2002 and 2001, respectively. The loans in the conduit are not reflected on First Tennessee’s Statement of Condition. Given the relatively small volume of loans currently referred to the conduit, this facility does not represent a critical element of First Tennessee’s liquidity. Upon adoption of the provisions of Interpretation No. 46, “Consolidation of Variable Interest Entities”, First Tennessee believes it is reasonably possible that consolidation of the conduit facility will be required (see Note 1 – Summary of Significant Accounting Policies for additional detail).

First Horizon Home Loans originates conventional conforming and federally insured single-family residential mortgage loans. Likewise, First Tennessee Capital Assets Corporation frequently purchases the same types of loans from our customers. Substantially all of these mortgage loans are exchanged for securities, which are issued through GNMA for federally insured loans and FNMA and FHLMC for conventional loans, and then sold in the secondary markets. In many cases First Horizon Home Loans retains the right to service and receive servicing fees on these loans. After sale, these loans are not reflected on the Consolidated Statement of Condition. Each of these GSE’s has specific guidelines and criteria for sellers and servicers of loans backing their respective securities. First Tennessee’s use of these GSE’s as an efficient outlet for our mortgage loan production is an essential source of liquidity for First Tennessee and other participants in the housing industry. During 2002 and 2001, approximately $23.9 billion and $16.1 billion, respectively, of conventional and federally insured mortgage loans were securitized and sold by First Horizon Home Loans through these GSE’s.

     
First Tennessee National Corporation   F-35

 


Table of Contents

Certain of First Horizon Home Loans’ originated loans do not conform to the requirements for sale or securitization by FNMA and FHLMC due to exceeding the maximum loan size of approximately $301 thousand (jumbo loans). First Horizon Home Loans pools and securitizes these jumbo loans in proprietary transactions. After securitization and sale, these loans are not reflected on the Consolidated Statements of Condition except as described hereafter. These transactions, which are conducted through single-purpose business trusts, are the most efficient way for First Horizon Home Loans and other participants in the housing industry to monetize these assets. In most cases First Horizon Home Loans retains the right to service and receive servicing fees on these loans and, on occasion, has retained senior principal-only certificates that are classified on the Consolidated Statement of Condition as trading securities. On December 31, 2002 and 2001, the outstanding principal amount of loans in these off-balance sheet business trusts was $4.5 billion and $2.8 billion, respectively. Given the significance of First Horizon Home Loans’ origination of non-conforming loans, the use of single-purpose business trusts to securitize these loans is an important source of liquidity to First Tennessee (see Note 24 – Securitizations).

Other securitization activity includes an automobile loan securitization in 2000. There was $24.0 million and $62.6 million in unpaid principal balance of loans in the securitization trust on December 31, 2002 and 2001, respectively. This securitization is not an essential element of First Tennessee’s liquidity (see Note 24 – Securitizations).

In addition to these transactions, liquidity has been obtained in prior years through issuance of guaranteed preferred beneficial interests in First Tennessee’s junior subordinated debentures through a consolidated Delaware business trust wholly owned by First Tennessee ($100.0 million on December 31, 2002 and 2001 – see Note 11 – Guaranteed Preferred Beneficial Interests in First Tennessee’s Junior Subordinated Debentures) and through preferred stock issued by an indirect wholly owned subsidiary of First Tennessee ($44.4 million and $44.2 million on December 31, 2002 and 2001, respectively – see Note 12 – Preferred Stock of Subsidiary).

First Tennessee has a lease arrangement with a single-purpose entity for First Horizon Home Loans’ main office headquarters in Dallas. Under this arrangement, First Tennessee has guaranteed a significant portion of the residual value of the Dallas property through the end of the lease term in 2011. Approximately $41 million of the construction cost of the property is not reflected on First Tennessee’s Consolidated Statements of Condition but is rather owned by the single-purpose entity. If at the end of the lease, the lessor decides to sell the property to another party and the sales price of the building is below the original construction cost, First Tennessee would be obligated to reimburse the single-purpose entity for a portion of the deficiency, if any, up to a maximum of $29.8 million. On December 31, 2002, the impact of fulfilling this guarantee would have been immaterial to the financial condition and results of operations of First Tennessee. The use of this leasing arrangement is not an essential element of First Tennessee’s liquidity. Upon adoption of the provisions Interpretation No. 46, “Consolidation of Variable Interest Entities”, First Tennessee believes it is reasonably possible that consolidation of the lease arrangement will be required (see Note 1 – Summary of Significant Accounting Policies for additional detail).

Parent company liquidity is maintained by cash flows stemming from dividends and interest payments collected from subsidiaries, which represent the primary source of funds to pay dividends to shareholders and interest to debtholders. The amount of dividends from bank subsidiaries is subject to certain regulatory restrictions that are described in Note 18 – Restrictions, Contingencies, Commitments, and Other Disclosures. The parent company statements are presented in Note 25 – Parent Company Financial Information. The parent company also has the ability to enhance its liquidity position by raising equity or incurring debt. Under an effective shelf registration statement on file with the SEC, First Tennessee, as of December 31, 2002, may offer from time to time at its discretion, debt securities, and common and preferred stock aggregating up to $225 million. In addition, First Tennessee also has an effective capital securities shelf registration statement on file with the SEC under which up to $200 million of capital securities is available for issuance.

Maintaining adequate credit ratings on debt issues is critical to liquidity because it affects the ability of First Tennessee to attract funds from various sources, such as brokered deposits or wholesale borrowings of which First Tennessee had $3.5 billion and $2.9 billion on December 31, 2002 and 2001, respectively, on a cost-competitive basis. The various credit ratings are detailed in Table 17. The availability of funds other than core deposits is also dependent upon marketplace perceptions of the financial soundness of Fi