HIGHLANDS BANKSHARES INC /VA/ - FORM 10-K

Attached files

file	filename
EX-21 - EXHIBIT 21 - HIGHLANDS BANKSHARES INC /VA/	exhibit21.htm
EX-31.2 - EXHIBIT 31.2 - HIGHLANDS BANKSHARES INC /VA/	exhibit312.htm
EX-31.3 - EXHIBIT 31.3 - HIGHLANDS BANKSHARES INC /VA/	exhibit313.htm
EX-32.3 - EXHIBIT 32.3 - HIGHLANDS BANKSHARES INC /VA/	exhibit323.htm
EX-31.1 - EXHIBIT 31.1 - HIGHLANDS BANKSHARES INC /VA/	exhibit311.htm
EX-13.1 - EXHIBIT 13.1 - HIGHLANDS BANKSHARES INC /VA/	exhibit131.htm
EX-32.2 - EXHIBIT 32.2 - HIGHLANDS BANKSHARES INC /VA/	exhibit322.htm
EX-23.1 - EXHIBIT 23.1 - HIGHLANDS BANKSHARES INC /VA/	exhibit231.htm
EX-32.1 - EXHIBIT 32.1 - HIGHLANDS BANKSHARES INC /VA/	exhibit321.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2009

Commission File Number 000-27622

HIGHLANDS BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1796693 (I.R.S. Employer Identification No.)
340 West Main Street Abingdon, Virginia (Address of principal executive offices)	24210-1128 (Zip Code)

Registrant’s telephone number, including area code: (276) 628-9181

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.625 par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12

months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and

posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit

and post such files).

Yes o No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s

knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. (See definition of “large

accelerated filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the Act).

Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer o Smaller Reporting Company ý

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last

sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $34,624,085.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date. As of March 10, 2010, there were 5,011,152

shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Annual Financial Statements for year ended December 31, 2009 – Part II

Proxy Statement for the 2010 Annual Meeting of Shareholders—Part III

	Table of Contents
		Page Number
Part I

Item 1.	Business	2
Item 1A.	Risk Factors	15
Item 1B.	Unresolved Staff Comments	19
Item 2.	Properties	19
Item 3.	Legal Proceedings	20
Item 4.	Reserved	20


Part II

Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	20
Item 6.	Selected Financial Data	21
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	42
Item 8.	Financial Statements and Supplementary Data	42
Item 9A	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	42
Item 9A.(T)	Controls and Procedures	42
Item 9B.	Other Information	43


Part III

Item 10.	Directors, Executive Officers and Corporate Governance	43
Item 11.	Executive Compensation	43
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	43
Item 13.	Certain Relationships and Related Transactions, and Director Independence	44
Item 14.	Principal Accounting Fees and Services	44


Part IV

Item 15.	Exhibits, Financial Statement Schedules	44

Part I.

Item I. Business

History and Business

Highlands Bankshares, Inc. (the “Company”) is a one-bank holding company organized under the laws of Virginia in 1995 and registered under the Bank Holding Company Act (BHCA). The Company conducts the majority of its business operations through its wholly-owned bank subsidiary, Highlands Union Bank (the “Bank”). The Company has two direct subsidiaries as of December 31, 2009: the Bank, which was formed in 1985, and Highlands Capital Trust I (HCTI), a statutory business trust (the “Trust”) which was formed in 1998.

Highlands Union Bank

The Bank is a Virginia state chartered bank that was incorporated in 1985. The Bank operates a full-service banking business from its headquarters in Abingdon, Virginia, and its twelve area full service branch offices. The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans.

Highlands Union Insurance Services, Inc.

Highlands Union Insurance Services, Inc., a wholly owned subsidiary of the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of approximately forty-seven other financial institutions to form Bankers’ Insurance, LLC. Bankers’ Insurance, LLC, as of December 31, 2009, had purchased eight full service insurance agencies across the state of Virginia. HUIS is used to sell insurance services through Bankers’ Insurance, LLC. The number of owner banks involved with Bankers’ Insurance, LLC was thirty-four as of December 31, 2009.

Highlands Union Financial Services, Inc.

The Bank operated a financial services department for the purpose of brokering various investment vehicles until January 2, 2001. At that time, Highlands Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was created to convert that department into a separate legal entity in order to offer third –party mutual funds and other financial services to its customers in all market areas served. During 2004, changes to the NASD rules required financial services to be operated underneath the bank structure once again. The only activity in Highlands Union Financial Services now relates to commissions from the sale of life insurance.

In February 2005, the Bank became an equity owner in Bankers’ Investments, LLC, headquartered in Richmond, Virginia. The Bank’s equity investment was $250,000 for two units of ownership. Bankers’ Investments, LLC was formed for the purpose of providing owner banks the ability to offer a full line of financial services to their customers. During 2007, Bankers

Investments was acquired by Infinex, LLC, a full service provider of a wide array of investment sevices. Infinex, LLC is owned by member banks and banking associations.

Lending Activities

Commercial Loans

The Bank makes both secured and unsecured loans to businesses and to individuals for business purposes. Loan requests are granted based upon several factors including credit history, past and present relationships with the Bank, marketability of collateral and the cash flow of the borrowers. Unsecured commercial loans must be supported by a satisfactory balance sheet and income statement. Collateralized business loans may be secured by a security interest in marketable investments, accounts receivable, business equipment and/or general intangibles of the business. In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate. The risks associated with commercial loans are related to the strength of the individual business, the value of loan collateral and the general health of the economy.

Residential Real Estate Loans

Loans secured by residential real estate are originated and held by the Bank. Residential real estate loans carry risks associated with the continued credit–worthiness of the borrower and changes in the value of collateral. The Bank also offers secondary market fixed rate mortgages through multiple sources. These loans and servicing rights are generally sold immediately into the secondary market and fees received are recorded as income. These loans must meet certain criteria generally set by the secondary market.

Construction Loans

The Bank makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals. These loans are subject to the same credit criteria as commercial and residential real estate loans. In addition to the risks associated with all real estate loans, construction loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget or the value of the collateral may at any point in time be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be the Bank's loan customer, is unable to finish the construction project as planned because of financial pressures unrelated to the project. Loans to customers that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures. During the current economic crisis, the Company has seen a decline in the area of construction lending.

Consumer Loans

The Bank routinely makes consumer loans, both secured and unsecured. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative changes in a customer's financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value adds risk to consumer loans.

Participation Loans

The Bank will occasionally buy or sell all or a portion of a loan. The Bank will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan to a single borrower will exceed the Bank's legal lending limit, which is 15 percent of the unimpaired capital and unimpaired surplus of the bank; (ii) the full amount of the loan, when combined with a borrower's previously outstanding loans, will exceed the Bank's legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with the Bank; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by Bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location, one industry or in one particular type of loan. The Bank will consider purchasing a participation in a loan from another financial institution if the loan meets all applicable credit quality standards and (i) the Bank's loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase.

The following table sets forth, for the two fiscal years ended December 31, 2009 and 2008, the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods.

Period	Class of Service	Percentage of Total Revenues

December 31, 2009	Interest and Fees on Loans	83.75%
December 31, 2008	Interest and Fees on Loans	86.76%

Market Area

Highlands Union Bank Market Area

The Bank’s primary market area consists of:

all of Washington County, Virginia

portions of Smyth County, Virginia

the City of Bristol, Virginia

the City of Bristol, Tennessee and adjacent portions of Sullivan County, Tennessee

the Town of Rogersville, Tennessee and adjacent portions of Hawkins County, Tennessee

the City of Sevierville, Tennessee and adjacent portions of Sevier County, Tennessee,

the City of Knoxville, Tennessee and adjacent portions of Knox County, Tennessee

the Town of Banner Elk, North Carolina and adjacent portions of Avery County, North Carolina

the Town of Boone, North Carolina and adjacent portions of Watauga County, North Carolina

the Town of West Jefferson, North Carolina and adjacent portions of Ashe County, North Carolina

The economy in the markets we serve is diverse and is oriented toward retail and service, light manufacturing, higher education and agriculture.

The independent city of Bristol, Virginia is located in far southwestern Virginia and lies directly on the Virginia-Tennessee state line. Washington County surrounds Bristol to the west, north and east. In the Bristol/Washington County community, manufacturing, retail trade, healthcare services, and Governmental sectors are the largest industries, in terms of total number of jobs in 2009. These sectors contribute at total 61.2% of the total city/county employment. The latest unemployment figures as of December 2009 reflect an unemployment rate of 10.0% and 9.3% for the Bristol, Virginia and Washington County, Virginia respectively.

The Bank has a branch office located in Marion which is the county seat of Smyth County, Virginia. Marion is approximately 30 miles northeast of Abingdon, Virginia. The latest unemployment figures reflect an unemployment rate of 10.9% reported as of December 2009. In Smyth County, manufacturing is the largest employment industry and makes up 27.3% of all jobs throughout the county, totaling 3,175 individuals. The educational and Governmental sectors account for 25.6% of the total jobs, totaling 2,972 individuals.

Bristol, Tennessee is located in Sullivan County, Tennessee and is Bristol, Virginia’s twin city. Bristol, Tennessee’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 9.3% as of December 2009. The healthcare services and manufacturing sectors make up 42.4% of all jobs throughout the county.

Rogersville, Tennessee is located in Hawkins County approximately 45 miles southwest of Bristol, Tennessee. Rogersville is the county seat for Hawkins County. Rogersville’s three largest employment sectors are services, manufacturing and retail trade. The latest unemployment figures reflect an unemployment rate of 10.4% as of December 2009. In Hawkins County, manufacturing, education, and retail trade are the largest sectors, in terms of total employment. These sectors combined make up 69.7% of all jobs throughout the county.

Sevierville, Tennessee is located in Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is the largest city located in Sevier County. Major employers for the county include tourism, retail, and service related industries, which make up 69.2% of all jobs throughout the county. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses. The latest unemployment figures reflect an unemployment rate of 10.7% as of December 2009.

Knoxville, Tennessee is located in Knox County, Tennessee. Knoxville, Tennessee is located approximately 20 miles west of Sevierville, Tennessee. Knoxville serves as the county seat and is the third largest city in the state of Tennessee. Major employers for the county include healthcare services, retail trade, accommodation/food services and warehousing/distributing industries. These sectors contribute to 51.9% of all jobs throughout the county. The latest unemployment figures reflect an unemployment rate of 8.1% as of December 2009. Knoxville’s central location to two major interstate highways which link the eastern half of the United States continues to provide many opportunities for economic growth in the future.

Boone, North Carolina is located in Watauga County in the northwestern mountains of North Carolina. Watauga County, North Carolina has an estimated population of 45,190 as of December 2008. Watauga County’s three largest employment sectors are private industry, education services and retail trade. The latest unemployment figures reflect an unemployment rate of 7.4% as of December 2009. Watauga County’s largest employer is Appalachian State University. Appalachian State is the sixth largest university in the University of North Carolina

system. Employment at Appalachian State University has remained relatively stable over the past four years.

Banner Elk, North Carolina is located in Avery County in the northwestern mountains of North Carolina. Avery County, North Carolina had an estimated population of 17,884 as of December 2008. In Avery County, education, health and social services, retail trade, and the accommodation and food services sectors are the largest industries, in terms of total number of jobs in 2008. The latest unemployment figures reflect an unemployment rate of 9.7% as of December 2009.

West Jefferson, North Carolina is located in Ashe County in the northwestern mountains of North Carolina. Ashe County, North Carolina had a population that was estimated at 25,702 as of December 2008. In Ashe County, manufacturing, education and health services, and public administration are the largest employment industries. The latest unemployment figures reflect an unemployment rate of 12.3% as of December 2009.

Competition

The banking and financial service business in the markets we serve is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. The Bank competes for loans and deposits with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, money market funds, credit unions and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. In order to compete, the Bank relies upon service-based business philosophies, personal relationships with customers, specialized services tailored to meet customers' needs and the convenience of office locations and extended hours of operation. In addition, the Bank is generally competitive with other financial institutions in its market areas with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts. Deposit market share for each of the Bank’s market areas can be found on the FDIC’s website at www.fdic.gov under the Industry Analysis/Summary of Deposits section.

Certain Regulatory Considerations

The Company and the Bank are subject to various state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking, financial institutions, including the Company and the Bank, are disadvantaged relative to other competitors who are not as highly regulated, and their costs of doing business are much higher.

The following is a summary of the material provisions of certain statutes, rules and regulations which affect the Company and the Bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below, and is not intended to be an exhaustive description of the statutes or regulations which are applicable to the businesses of the Company and the Bank. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company and the Bank.

Highlands Bankshares, Inc.

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and Chapter 13 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of the Company also are governed by the Gramm-Leach-Bliley Act of 1999.

The Bank Holding Company Act. The BHCA is administered by the Federal Reserve Board, and the Company is required to file with the Federal Reserve Board an annual report and any additional information the Federal Reserve Board may require under the BHCA. The Federal Reserve Board also is authorized to examine the Company and its subsidiaries. The BHCA requires every bank holding company to obtain the approval of the Federal Reserve Board before (i) it or any of its subsidiaries (other than a bank) acquires substantially all the assets of any bank; (ii) it acquires ownership or control of any voting shares of any bank if after the acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of the bank; or (iii) it merges or consolidates with any other bank holding company.

The BHCA and the Change in Bank Control Act, together with regulations promulgated by the Federal Reserve Board, require that, depending on the particular circumstances, either Federal Reserve Board approval must be obtained or notice must be furnished to the Federal Reserve Board and not disapproved prior to any person or company acquiring "control" of a bank holding company, such as the Company, subject to certain exemptions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the Company. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities of the Company. The regulations provide a procedure for challenging the rebuttable control presumption.

Under the BHCA, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities, unless the Federal Reserve Board, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be incident to banking. The Federal Reserve Board imposes certain capital requirements on the Company under the BHCA, including a minimum leverage ratio and a minimum ratio of "qualifying" capital to risk-weighted assets. Subject to its capital requirements and certain other restrictions, the Company can borrow money to make a capital contribution to the Bank, and these loans may be repaid from dividends paid from the Bank to the Company (although the ability of the Bank to pay dividends are subject to regulatory restrictions). The Company can raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the GLBA) permits significant combinations among different sectors of the financial services industry; allows for significant expansion of financial service activities by bank holding companies and provides for a regulatory framework by various governmental authorities responsible for different financial activities; and offers certain financial privacy protections to consumers. The GLBA repealed affiliation and management interlock prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new substantive provisions to the non-banking activities permitted under the BHCA with the creation of the financial holding company. The GLBA preempts most state laws that prohibit financial holding companies from engaging in insurance activities. The GLBA permits affiliations between banks and securities firms within the same holding company structure, and the GLBA permits financial holding companies to directly engage in a broad range of securities and merchant banking activities. The Company has not elected to become a financial holding company.

The Gramm-Leach-Bliley Act has led to important changes in the manner in which financial services are delivered in the United States. Bank holding companies and their subsidiary banks are able to offer a much broader array of financial services; however, there is greater competition in all sectors of the financial services market.

The Virginia Banking Act. All Virginia bank holding companies must register with the Virginia State Corporation Commission (the “Commission”) under the Virginia Banking Act. A registered bank holding company must provide the Commission with information with respect to the financial condition, operations, management and inter-company relationships of the holding company and its subsidiaries. The Commission also may require such other information as is necessary to keep itself informed about whether the provisions of Virginia law and the regulations and orders issued under Virginia law by the Commission have been complied with, and may make examinations of any bank holding company and its subsidiaries. The Virginia Banking Act allows bank holding companies located in any state to acquire a Virginia bank or bank holding company if the Virginia bank or bank holding company could acquire a bank holding company in their state and the Virginia bank or bank holding company to be acquired has been in existence and continuously operated for more than two years. The Virginia Banking Act permits bank holding companies from throughout the United States to enter the Virginia market, subject to federal and state approval.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the “SOX Act”) implemented legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board that enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the law restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client requires pre-approval by the issuer’s audit committee members and the SOX Act also restricts certain services that the audit firm may perform. In addition, the audit partners must be rotated. The SOX Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the SOX Act, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief financial officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

Troubled Asset Relief and Temporary Liquidity Guarantee Programs. On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”). The legislation was the result of a proposal by Treasury Secretary Henry Paulson to the U.S. Congress in response to the financial crises affecting the banking system and financial markets and threats to investment banks and other financial institutions. Pursuant to the EESA, the U.S. Treasury had authority to among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On October 14, 2008 the U.S. Department of Treasury announced a program under the EESA pursuant to which it would make senior preferred stock investments in participating financial institutions (the “TARP Capital Purchase Program”). On October 14, 2008, the Federal Deposit Insurance Corporation announced the development of a guarantee program under the systemic risk exception to the Federal Deposit Act (“FDA”) pursuant to which the FDIC would offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to be paid to the FDIC by issuing financial institutions (the “FDIC Temporary Liquidity Guarantee Program”).

Under the TARP Capital Purchase Program, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock and warrants (from the $700 billion authorized by the EESA). Participating financial institutions are required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program.

The American Reinvestment and Recovery Act of 2009 (the “AARA”) was enacted on February 17, 2009. The ARRA included a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, the ARRA amended the compensation and corporate governance obligations on all current and future TARP Capital Purchase Program recipients.

There can be no assurance, however, as to the actual long - term impact that the EESA, ARRA and their implementing regulations, the FDIC programs, or any other governmental program will have on the financial markets. The failure to the EESA, ARRA, the FDIC, or the U.S. government to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock. Additionally, if EESA fails to bring stability to the financial markets, additional burdensome regulation may be enacted.

In December of 2008, the Company applied for and received preliminary approval to issue up to $14.4 million of preferred stock to the U. S. Treasury. During the first quarter of 2009, the Company began the process of requesting shareholder approval to amend its Articles of Incorporation to issued preferred shares. After careful consideration, the Company’s Board of Directors decided to not participate.

The Company and Bank elected to participate in the Temporary Liquidity Guarantee Program. The program provides full FDIC insurance to all non-interest bearing transaction accounts and all deposit transaction accounts with an interest rate up to .50%. Beginning in December of 2008, the Bank began taking full advantage of this additional insurance.

Highlands Union Bank.

General. The Bank, as a state chartered member of the Federal Reserve, is subject to regulation and examination by the Virginia State Corporation Commission and the Federal Reserve Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation. Deposits in the Bank are insured by the FDIC up to a maximum amount (generally $250,000 per depositor, subject to aggregation rules). The Federal Reserve Board and the Virginia Bureau of Financial Institutions regulate or monitor all areas of the Bank’s operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates paid on deposits, interest rates or fees charged on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The Federal Reserve Board requires the Bank to maintain certain capital ratios. The Bank is required by the Federal Reserve Board to prepare quarterly reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with minimum standards and procedures prescribed by the Federal Reserve Board. The Bank also is required by the Federal Reserve Board to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While appropriate for safety and soundness of banks, these requirements impact banking overhead costs.

The Bank is organized as a Virginia-chartered banking corporation and is regulated and supervised by the Bureau of Financial Institutions (BFI) of the Virginia State Corporation Commission. In addition, as a federally insured bank, the Bank is regulated and supervised by the Federal Reserve Board, which serves as its primary federal regulator, and is subject to certain regulations promulgated by the FDIC. Under the provisions of federal law, federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service.

The Virginia State Corporation Commission and the Federal Reserve Board conduct regular examinations of the Bank reviewing the adequacy of the loan loss reserves, quality of the loans and investments, propriety of management practices, compliance with laws and regulations and other aspects of the bank's operations. In addition to these regular examinations, Virginia chartered banks must furnish to the Federal Reserve Board quarterly reports containing detailed financial statements and schedules.

Community Reinvestment Act. The Bank is subject to the provisions of the Community Reinvestment Act of 1977 (the “CRA”), which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank's record in meeting the credit needs of the community served by the bank, including low and moderate-income neighborhoods. The focus of the regulations is on the volume and distribution of a bank's loans, with particular emphasis on lending activity in low and moderate-income areas and to low and moderate-income persons. The regulations place substantial importance on a bank's product delivery system, particularly branch locations. The regulations require banks to comply with significant data collection requirements. The regulatory agency's assessment of the bank's record is made available to the public. Further, this assessment is required for any bank which has applied to, among other things, establish a new branch office that will accept deposits, relocate an existing office, or merge, consolidate with or acquire the assets or assume the liabilities of a federally regulated financial institution. Management expects that the Bank’s compliance with the CRA, as well as other fair lending laws, will face ongoing government scrutiny and that costs associated with compliance will continue to increase. The Bank received "Satisfactory" CRA ratings in the last examination by bank regulators.

Federal Deposit Insurance Corporation Improvement Act of 1991. The difficulties encountered nationwide by financial institutions from the 1980s through 1991 prompted federal legislation designed to reform the banking industry and to promote the viability of the industry and of the deposit insurance system. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) bolstered the deposit insurance fund, tightened bank and thrift regulation and trimmed the scope of federal deposit insurance as summarized below.

FDICIA requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other operational and managerial standards as the agency determines to be appropriate. The compensation standards would prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements

that provide excessive compensation, fees or benefits or could lead to material financial loss. In addition, each federal banking regulatory agency must prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency determines to be appropriate. If an insured institution fails to meet any of the standards promulgated by regulation, then such institution will be required to submit a plan to its federal regulatory agency specifying the steps it will take to correct the deficiency.

Prompt corrective action measures adopted in FDICIA impose significant restrictions and requirements on depository institutions that fail to meet their minimum capital requirements. Under Section 38 of the Federal Deposit Insurance Act (the FDI Act), the federal banking regulatory agencies have developed a classification system pursuant to which all depository institutions are placed into one of five categories based on their capital levels and other supervisory criteria: well capitalized, adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized.

The Bank met the requirements at December 31, 2009 to be classified as “well capitalized.” This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Bank’s overall financial condition.

If its principal federal regulator determines that an adequately capitalized institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, it may require the institution to submit a corrective action plan, restrict its asset growth and prohibit branching, new acquisitions and new lines of business. An institution’s principal federal regulator may deem it to be engaging in unsafe or unsound practices if it receives a less than satisfactory rating for asset quality, management, earnings or liquidity in its most recent examination.

Section 36 of FDICIA significantly affects financial institutions with more than $500 million in total assets. The Bank came under the provisions beginning in January 2004. Effective December 28, 2005, the FDIC lessened the requirements of Part 363 by raising the asset size threshold from $500 million to $1 billion for internal control assessments by management and external auditors. For institutions under $1 billion, management is no longer required to assess and report on the effectiveness of internal control over financial reporting, the external auditors are no longer required to examine and attest to management’s internal control assertions, and only a majority of the outside directors on the audit committee must be independent of management. Section 36 of FDICIA requires insured depository institutions with at least $500 million but less than $1 billion in total assets to file annual reports that must include the following:

Audited comparative annual financial statements.

The independent public accountant’s report on the audited financial statements.

A management report that contains a statement of management’s responsibilities for preparing the financial statement, establishing and maintaining an adequate internal control structure over financial reporting and complying with the laws and regulations designed by the FDIC and appropriate banking regulators.

An assessment by management of the institutions compliance with the designated laws and regulations during the year.

These amendments provide relief for covered institutions of less than $1 billion in assets only for purposes of this section of Part 363. These covered institutions must continue to fully

comply with the remaining provisions of Part 363 including the annual financial statement audit requirement. These amendments do not relieve public companies of their obligations to comply with the SOX Act and the SEC’s rules on internal control reporting and audit committee independence.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) allows bank holding companies to acquire banks in any state, without regard to state law, except that if the state has a minimum requirement for the amount of time a bank must be in existence, that law must be preserved. Under the Virginia Banking Act, a Virginia bank or all of the subsidiaries of Virginia holding companies sought to be acquired must have been in continuous operation for more than two years before the date of such proposed acquisition. The Interstate Act also permits banks to acquire out-of-state branches through interstate mergers, if the state has not opted out of interstate branching. De novo branching, where an out-of-state bank holding company sets up a new branch in another state, requires a state's specific approval. An acquisition or merger is not permitted under the Interstate Act if the bank, including its insured depository affiliates, will control more than 10% of the total amount of deposits of insured depository institutions in the United States, or will control 30% or more of the total amount of deposits of insured depository institutions in any state.

Virginia has, by statute, elected to opt-in fully to interstate branching under the Interstate Act. Under the Virginia statute, Virginia state banks may, with the approval of the Virginia State Corporation Commission, establish and maintain a de novo branch or acquire one or more branches in a state other than Virginia, either separately or as part of a merger. Procedures also are established to allow out-of-state domiciled banks to establish or acquire branches in Virginia, provided the "home" state of the bank permits Virginia banks to establish or acquire branches within its borders. The activities of these branches are subject to the same laws as Virginia domiciled banks, unless such activities are prohibited by the law of the state where the bank is organized. The Virginia State Corporation Commission has the authority to examine and supervise out-of-state state banks to ensure that the branch is operating in a safe and sound manner and in compliance with the laws of Virginia. The Virginia statute authorizes the Bureau of Financial Institutions to enter into cooperative agreements with other state and federal regulators for the examination and supervision of out-of-state banks with Virginia operations, or Virginia domiciled banks with operations in other states. Likewise, national banks, with the approval of the OCC, may branch into and out of the state of Virginia. Any Virginia branch of an out-of-state state chartered bank is subject to Virginia law (enforced by the Virginia Bureau of Financial Institutions) with respect to intrastate branching, consumer protection, fair lending and community reinvestment as if it were a branch of a Virginia bank, unless preempted by federal law.

Deposit Insurance. The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC. The DIF was created by the merger of the Bank Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF) provided for in the Federal Deposit Insurance Reform Act of 2005 (FDIRA), as enacted in February 2006. This legislation also increased coverage for retirement accounts to $250,000 and indexed the insurance levels for inflation, among other changes. In addition, as a result of the FDIRA, the FDIC has adopted a revised, risk-based assessment system to determine assessment rates to be paid by member institutions, such as the Bank. Under this revised assessment system, risk is defined and measured using an institution’s supervisory ratings, combined with certain other risk measures, including certain financial ratios and long-term debt issuer ratings.

During 2008, the FDIC increased the “base” amount of FDIC insurance from $100,000 to $250,000. This additional coverage is extended until December 31, 2013. The FDIC has also issued revisions to its premium scale which will approximately double the amount of FDIC premium that the Bank is currently paying. The new FDIC rates are effective in 2009. Currrently the Bank is categorized in the highest or most beneficial classification in terms of deposit

insurance premiums. On February 27th, 2009, the FDIC also approved a special assessment to all banks payable on September 30th, 2009 to replenish the fund to an acceptable level during this time of economic crisis and numerous bank failures. The Bank expensed a total of $1.18 million during 2009 to cover both the increased annual assessment and the special assessment. At the end of December 2009, the FDIC also collected a full 3 years of prepaid premiums from FDIC insured institutions to replenish the fund. This prepayment will be expensed thru 2012.

Gramm- Leach- Bliley Act. The Gramm-Leach-Bliley Act of 1999 (the GLBA) allows banks, with primary regulator approval, to acquire financial subsidiaries to engage in any activity that is financial in nature or incidental to a financial activity, as defined in the Bank Holding Act, except (i) insurance underwriting, (ii) merchant or insurance portfolio investments, and (iii) real estate development or investment. Well-capitalized banks are also given the authority to engage in municipal bond underwriting.

To establish or acquire a financial subsidiary, a bank must be well-managed, and the consolidated assets of its financial subsidiary must not exceed the lesser of 45% of the consolidated total assets of the bank or $50 billion. The relationship between a bank and a financial subsidiary are subject to a variety of supervisory enhancements from regulators.

USA Patriot Act. The USA Patriot Act facilitates the sharing of information among government entities and financial institutions to combat terrorism and money laundering. The USA Patriot Act creates an obligation on banks to report customer activities that may involve terrorist activities or money laundering.

Government Policies. The operations of the Bank are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, the Federal Reserve Board regulates money and credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Limits on Dividends and Other Payments. As a state member bank subject to the regulations of the Federal Reserve Board, the Bank must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits, as defined by the Federal Reserve Board, for that year, combined with its retained net profits for the preceding two years. In addition, a state member bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts. For this purpose, bad debts are generally defined to include the principal amount of loans which are in arrears with respect to interest by six months or more, unless such loans are fully secured and in the process of collection. Moreover, for purposes of this limitation, a state member bank is not permitted to add the balance in its allowance for loan losses account to its undivided profits then on hand; however, it may net the sum of its bad debts as so defined against the balance in its allowance for loan losses account and deduct from undivided profits only bad debts as so defined in excess of that account.

In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that depletes a bank's capital base could be deemed to constitute such an unsafe or

unsound practice. The Federal Reserve Board has indicated that banking organizations should generally pay dividends only out of current operating earnings.

Virginia law also imposes restrictions on the ability of the Bank to pay dividends. A Virginia state bank is permitted to declare a dividend out of its "net undivided profits", after providing for all expenses, losses, interest and taxes accrued or due by the bank. In addition, a deficit in capital originally paid in must be restored to its initial level, and no dividend can be paid which could impair the Bank's paid in capital. The Bureau of Financial Institutions further has authority to limit the payment of dividends by a Virginia bank if it determines the limitation is in the public interest and is necessary to ensure the bank's financial soundness.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements.

Capital Requirements. The Federal Reserve Board has adopted risk-based capital guidelines which are applicable to the Company and the Bank. The Federal Reserve Board guidelines redefine the components of capital, categorize assets into different risk classes and include certain off-balance sheet items in the calculation of risk-weighted assets. The minimum ratio of qualified total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8.0%. At least half of the total capital must be comprised of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted assets of 4.0%. The remainder may consist of a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan and lease loss reserves.

In addition, the Federal Reserve Board has established minimum leverage ratio (Tier 1 capital to total average assets less intangibles) guidelines that are applicable to the Company and the Bank. These guidelines provide for a minimum ratio of 4.0% for banks that meet certain specified criteria, including that they have the highest regulatory CAMELS rating and are not anticipating or experiencing significant growth and have well-diversified risk. All other banks will be required to maintain an additional cushion of at least 100 to 200 basis points, based upon their particular circumstances and risk profiles. The guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Other Legislative and Regulatory Concerns

Other legislative and regulatory proposals regarding changes in banking and the regulation of banks, thrifts and other financial institutions are periodically considered by the executive branch of the federal government, Congress and various state governments, including Virginia. New proposals could significantly change the regulation of banks and the financial services industry. It cannot be predicted what might be proposed or adopted or how these proposals would affect the Company.

Registrant's Organization and Employment

The Company, the Bank, HCTI, HUFS and HUIS are organized in a holding company/subsidiary structure. As of December 31, 2009, the Company had no employees, except for officers, and it conducted substantially all of its operations through its subsidiaries. All cash

compensation paid to the Company’s officers was paid by the subsidiary bank, including fees paid to its directors. In previous years, stock based compensation, through the form of stock options, was paid/granted through the Company. At December 31, 2009, the Bank employed 227 full time equivalent employees at its main office, operations center and branch offices. The Company, HCTI, HUFS and HUIS had no employees at this time.

The Company’s relationship with its employees is considered to be good. Employment has remained very stable over the last several years with very little turnover. There are no employment contracts in existence for any employee or officer.

Company Website

The Bank maintains a website at www.hubank.com. The Company makes available through the Bank’s website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, free of charge, as soon as reasonably practicable after the material is electronically filed with the Securities and Exchange Commission.

Item 1A. Risk Factors

The current economic environment poses significant challenges for the Company and could adversely affect its financial condition and results of operations.

The Company is operating in a challenging and uncertain economic environment, including generally uncertain national and local conditions. Financial institutions continue to be affected by sharp declines in the real estate market and constrained financial markets. Dramatic declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions. Continued declines in real estate values, home sales volumes, and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on the Company’s borrowers or their customers, which could adversely affect the Company’s financial condition and results of operations. A worsening of these conditions would likely exacerbate the adverse effects on the Company and others in the financial institutions industry. For example, further deterioration in local economic conditions in the Company’s markets could drive losses beyond that which is provided for in its allowance for loan losses. The Company may also face the following risks in connection with these events:

•	Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of the Company’s loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on the Company’s business.

•	Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities.

•	The processes the Company uses to estimate allowance for loan losses and reserves may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation.

•	The Company’s ability to assess the creditworthiness of its customers may be impaired if the models and approaches it uses to select, manage, and underwrite its customers become less predictive of future charge-offs.

•	The Company expects to face increased regulation of its industry, and compliance with such regulation may increase our costs, limit our ability to pursue business opportunities, and increase compliance challenges.

As these conditions or similar ones continue to exist or worsen, the Company could experience continuing or increased adverse effects on its financial condition.

Changes in interest rates could have an adverse effect on our income.

If market interest rates rise, our net interest income can be negatively affected in the short term. The direction and speed of interest rate changes affect our net interest margin and net interest income. In the short term, rising interest rates can negatively affect our net interest income, because our interest-bearing liabilities (generally deposits) reprice sooner than our interest-earning assets (generally loans).

We may become subject to additional regulatory oversight.

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Due to the difficult economic conditions and the effects of these conditions on us, we may become subject to additional regulatory oversight by one or more of these agencies. While we do not know what form or content such oversight may take, it could, among other things, limit our ability to grow our assets, open new branch offices or pay dividends and may adversely affect our operations and our financial results. In addition, our management and board of directors may be required to focus considerable time and attention on taking actions to respond to and comply with the our regulators requirements.

Our failure to maintain adequate capital could have adverse effects on our financial condition.

Highlands Bankshares, Inc. and its bank subsidiary are subject to regulatory capital adequacy guidelines. If the Bank fails to meet capital adequacy guidelines, it could have a material effect on our financial condition and could subject us to a variety of enforcement actions, as well as impose restrictions on our business. In addition, it could lead to a decline in the confidence that our customers have in us and a reduction in the demand for our products and services. If we are not in compliance with governmental regulation, we can be subject to fines, penalties or restrictions of our business.

If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.

We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our clients relative to their financial obligations with us.

The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rate; that may be beyond our control, and these losses may exceed our current estimates. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different from those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

Regulation of the financial services industry is undergoing major changes, and future legislation could increase our cost of doing business or harm our competitive position.

In 2009, many emergency government programs enacted in 2008 in response to the financial crisis and the recession slowed or wound down, and global regulatory and legislative focus has generally moved to a second phase of broader reform and a restructuring of financial institution regulation. Legislators and regulators in the United States are currently considering a wide range of proposals that, if enacted, could result in major changes to the way banking operations are regulated. Some of these major changes may take effect as early as 2010, and could materially impact the profitability of our business, the value of assets we hold or the collateral available for our loans, require changes to business practices or force us to discontinue businesses and expose us to additional costs, taxes, liabilities, enforcement actions and reputational risk.

Certain reform proposals under consideration could result in our becoming subject to stricter capital requirements and leverage limits, and could also affect the scope, coverage, or calculation of capital, all of which could require us to reduce business levels or to raise capital, including in ways that may adversely impact our shareholders or creditors. In addition, we anticipate the enactment of certain reform proposals under consideration that would introduce stricter substantive standards, oversight and enforcement of rules governing consumer financial products and services, with particular emphasis on retail extensions of credit and other consumer-directed financial products or services. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, financial condition, or results of operations.

Our profitability and the value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

Our businesses are subject to stringent regulation by federal and state governmental and regulatory agencies and self-regulatory organizations. In addition, our customers have a number of complex confidentiality and fiduciary requirements. We have established policies, procedures and systems that are designed to comply with these regulatory and operational risk requirements. However, as a financial services institution, we face complexity and costs related to our compliance efforts. We also face the potential for loss resulting from failed or inadequate internal processes and from external events, which could have a material impact on our results of operations. Adverse publicity and damage to our reputation from the failure or perceived failure to comply with legal, regulatory or capital requirements could affect our ability to attract or maintain customers or maintain access to capital markets, or could result in enforcement actions, fines, penalties and lawsuits.

Our business is subject to various lending and other economic risks that could adversely impact our results of operations and financial condition.

We do business in a small geographic area, and a large percentage of our loans are made in our market area. If the region suffers a significant or prolonged period of economic downturn, there is a greater likelihood that more of our customers could become delinquent on their loans or other obligations which could adversely affect our performance. If more competitors come into our market area, our business could suffer.

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry

Inadequate disaster recovery plans could significantly impact our operations.

If the disaster recovery plans that we have in place are not adequate to continue our operations in the event of a disaster, the business disruption can adversely impact our operations. Natural or man-made disasters, such as fires, storms, terrorist or military actions could cause damage to our physical facilities, or could cause delays or disruptions to operational functions, including information processing and / or check settlements. In addition, our vendors could suffer from such events. Should these events affect us or the vendors with whom we do business, our results of operations could be negatively impacted.

An interruption or breach of our information systems may result in a loss of customers.

We rely heavily on communications and information systems to conduct our business. In addition, we rely on third parties to provide key components of our infrastructure, including internet connections and network access. Any disruption in service of these key components could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our operations. Furthermore, any security breach of our information systems or data, whether managed by us or by third parties, could harm our reputation or cause a decrease in the number of customers that choose to do business with us.

Our liquidity is dependent on dividends from the Bank.

The Bank’s ability to pay dividends to the Company is limited by various statutes and regulations. Currently, the Bank must obtain approval from the Federal Reserve Board to pay a dividend to the Company because any dividend would exceed the aggregate of the Bank’s net profit for the most recent fiscal year and its retained net profits for the two preceding years. This restriction may have a negative impact on the Company’s liquidity and could have a material adverse effect on the market price of our common stock.

Our performance depends on attracting and retaining key employees and skilled personnel to operate our business effectively.

There are a limited number of qualified personnel in the markets we serve, so our success depends in part on the continued services of many of our current management and other key employees. Failure to maintain our key officers and employees and maintain adequate staffing of qualified personnel could adversely impact our operations and ability to compete.

Uncertainty in the financial markets could adversely affect our investment portfolio values.

The upheaval in the financial markets over the past year has adversely impacted investor demand for all classes of securities and has resulted in volatility in the fair values of our investment securities. Significant prolonged reduction in investor demand could result in lower fair values for these securities and may result in recognition of an other-than-temporary impairment charge, which would have a direct adverse impact on results of operations.

Item 1B. Unresolved Staff Comments

None

Item 2. Properties

The Company’s and the Bank’s headquarters are located at 340 W. Main Street, Abingdon, Virginia. In addition to the Bank's Main Office location, the Bank owns twelve branch offices: one in the Town of Abingdon, Virginia; one in Washington County, Virginia; two in the City of Bristol, Virginia; one in the Town of Glade Spring, Virginia; one in the Town of Marion, Virginia; one in the City of Bristol, Tennessee; one in the Town of Rogersville, Tennessee; one in the Town of Boone, North Carolina; one in the Town of Banner Elk, North Carolina; two in the City of Sevierville, Tennessee; and one in the City of Knoxville, Tennessee. The Bank owns the land and buildings of all of these branch offices as well as the main office for the Company and Bank.

The Bank also owns the land and 2 buildings used for its Collections, Human Resources, Customer Call Center, IRA Operations, Internal Audit and Facilities departments in Abingdon, Virginia. The Bank owns a vacant piece of land in Bristol, Tennessee and two parcels in Washington County, Virginia that are being held for potential future branch sites. The Bank leases office space in West Jefferson, North Carolina for a loan production office.

The Bank also owns the land and buildings used as the Bank’s Operations Center and Technology House in Abingdon, Virginia. The Bank owns approximately 14 acres of vacant land in Abingdon, Virginia for future possible development of a corporate headquarters. The Bank also owns an additional lot in Boone, North Carolina (approximately 1 acre) for future branching.

All of the existing properties are in good operating condition and are adequate for the Company’s present and anticipated future needs.

The Bank owns all its computer and data processing hardware and is a licensee of the software it utilizes.

Item 3. Legal Proceedings

The Company is not currently involved in any pending legal proceedings, other than routine litigation incidental to the Bank’s banking business. These proceedings are not material to the Company or the Bank.

Item 4. Reserved

Part II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Common Stock Information and Dividends

Trades in the Company’s common stock are reported on the Over-The-Counter Bulletin Board (OTCBB) and in the Pinksheets by at least five broker dealers under the symbol HBKA.OB. In addition, the Company maintains a list of individuals who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Company. The stock transfer agent of the Company attempts to keep a record of stock sales by asking the parties about the trade price per share. Please refer to the table below entitled Common Stock Performance for a summary of sales prices known to the Company for each of the four quarters of 2009 and 2008.

Common Stock Performance – 2009

	High	Low	Quarterly Average	Dividends per Share

First Quarter	$14.00	$ 9.10	$11.30	$ -

Second Quarter	$ 9.34	$ 9.00	$ 9.19	$ -

Third Quarter	$14.00	$ 8.89	$11.81	$ .11

Fourth Quarter	$13.00	$ 9.00	$11.96	$ -

Common Stock Performance – 2008

	High	Low	Quarterly Average	Dividends per Share

First Quarter	$17.00	$14.25	$16.94	$ -

Second Quarter	$18.00	$13.20	$16.77	$ 0.22

Third Quarter	$17.00	$ 8.50	$15.79	$ -

Fourth Quarter

$17.00

$ 8.16

$10.79

$ -

The Company historically has paid cash dividends on an annual basis. During 2009, the Company announced a change in which dividends would be considered at the end of the second and fourth quarters of each fiscal year. The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiaries, principally the Bank, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies as discussed in Item 1. “Business – Certain Regulatory Considerations,” above. In July 2009, the Board declared a cash dividend of $0.11 per share. In February, the 2010, however, the Board announced that it had suspended its cash dividend as a result of the challenging economic environment. The Board will be further considering the current economic downturn and its effect on the earnings stream of the Company.

Due to the economic environment, the Board has also determined that, effective April 15th, 2010, the Company will defer interest payments on the junior subordinated debt securities held by the Company’s subsidiary, Highlands Capital Trust I. As a result, distribution payments to holders of the Highlands Capital Trust I 9.25% Capital Securities will also be deferred.

As of March 10, 2010, the Company had approximately 1,482 shareholders of record.

Issuer Repurchases of Equity Securities

The Company had no repurchases of common stock during the three months ended December 31, 2009. The Company does not anticipate any significant repurchases during 2010 in an effort to retain regulatory capital.

The Company currently has 5,011,152 shares of common stock outstanding.

Item 6. Selected Financial Data

Not Applicable

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The purpose of this discussion is to provide information about the financial condition and results of operations of the Company and its wholly-owned subsidiaries and other information included in this report. This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and Notes to Consolidated Financial Statements.

Caution About Forward-Looking Statements

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, includeing certain plans, expectations, goals and projections, which are inherently subject to numerous assumptions, risks and uncertainties. The Company's actual results could differ materially from those set forth or implied in the forward-looking statements.

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:

Difficult market conditions in our industry;

Unprecedented levels of market volatility;

Effects of soundness of other financial institutions;

Uncertain outcome of recently enacted legislation to stabilize the U.S. financial system;

Potential impact on us of recently enacted legislation;

Further deterioration in the housing market;

Continued problems related to the national credit crisis and deepening recession;

Unemployment continuing to rise;

The ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;

The ability to continue to attract low cost core deposits to fund asset growth;

The ability to attract and maintain capital levels adequate to support the Company’s growth;

Maintaining cost controls and asset qualities as the Company opens or acquires new branches;

Reliance on the Company’s management team, including its ability to attract and retain key personnel;

The successful management of interest rate risk;

Changes in general economic and business conditions in the Company’s market area;

Changes in interest rates and interest rate policies;

Risks inherent in making loans such as repayment risks and fluctuating collateral values;

Competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

Demand, development and acceptance of new products and services;

Problems with technology utilized by the Company;

Changing trends in customer profiles and behavior; and

Changes in banking and other laws and regulations applicable to the Company.

Overview

At December 31, 2009, the Bank had total assets of $648.21 million. Total deposits at this date were $521.31 million. The Bank’s net loss for 2009 was $5.74 million which produced a return on average assets of -.86% and a return on average stockholders' equity of –13.07%. Refer to Note 21 of the Notes to Consolidated Financial Statements for the Bank’s risk-based capital ratios.

The Bank offers general retail and commercial banking services to individuals, businesses and local government units. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making real estate, commercial, revolving, consumer, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally

offered by commercial banks. The Bank makes loans in all major loan categories, including commercial, commercial and residential real estate, construction and consumer loans.

The Company makes money primarily by earning an interest rate spread between the interest rates it earns on loans and securities and interest rates it pays on deposits and other borrowed money. The Company also earns money through fees, service charges and other non-interest income.

The Company plans to reduce the asset size of the bank in the next couple of years in an effort to increase its regulatory capital ratios. The Company plans to reduce its commercial real estate loan portfolio and its time deposits over the next several months. The Company also plans to make a concerted effort to reduce its non-performing assets.

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to Consolidated Financial Statements and management’s discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is a discussion of the Accounting Policy that management believes is important to the understanding of the Company’s financial condition and results of operations. This critical accounting policy requires management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood. See also Note 1 of the Notes to Consolidated Financial Statements.

Allowance for Loan Losses

The Company monitors and maintains an allowance for loan losses to absorb the estimate of probable losses inherent in the loan portfolio. The allowance for loan losses is based on management’s judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties, and variability related to the factors used. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.

Other than Temporary Impairment

On a quarterly basis the Company reviews any securities which are considered to be impaired as defined by accounting guidance. During this review, the Company determines if the impairment is deemed to be other-than-temporary. If it is determined that the impairment is other-than-temporary, i.e. impaired because of credit issues, the investment is written down through the Statement of Operations in accordance with accounting guidance.

Performance Summary

The following table shows the Company’s key performance ratios for the years ended December 31, 2009 and 2008:

	2009	2008	2007

Return on Average Assets	(-0.96%)	0.02%	0.76%
Return on Average Equity	(-16.02%)	0.27%	10.61%
Basic Earnings (Loss) Per Share	($-1.27)	$ 0.02	$0.95
Fully Diluted Earnings (Loss) Per Share	($-1.27)	$ 0.02	$0.94
Net Interest Margin (1)	3.28%	3.41%	3.43%

(1) Net Interest Margin - Year-to-date tax equivalent net interest income divided by year-to-date average earning assets. .	5.98%	6.30	7.13%

Growth

The following table shows the Company’s key growth indicators for the years ended December 31, 2009 and 2008:

(dollar amounts in thousands)

	12/31/09	12/31/08

Securities	$ 70,948	$ 106,647
Loans, net	$ 474,438	$ 485,254
Deposits	$ 519,904	$ 522,736
Assets	$ 645,307	$ 668,996

Asset Quality

The following table shows the Company’s key asset quality indicators for the years ended December 31, 2009 and 2008:

(dollar amounts in thousands)

	12/31/09	12/31/08

Non- accrual loans	$ 11,559	$ 6,278
Loans past due over 90 days	4,260	656
Other real estate owned	6,847	3,792
Allowance for loan losses to total loans	2.40%	1.05%
Net charge-off ratio	0.63%	0.21%

For further information see the discussion under "Provision and Allowances for Loan Losses".

2008-2009 Economic Environment-

In response to the financial crises affecting the banking system and financial markets, the Emergency Economic Stabilization Act of 2008 ( “EESA”) was signed into law in October 2008. Pursuant to EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Of that $700 billion, the Treasury made $250 billion of capital available to financial institutions in the form of preferred stock and warrants through the Troubled Asset Relief Program Capital Purchase Program (the “TARP Capital Purchase Program”). Participating financial institutions were required to adopt the Treasury’s standards for executive compensation and corporate governance pursuant to EESA, as amended by the American Reinvestment and

Recovery Act of 2009. On December 30, 2008, the Company received preliminary approval from the Treasury to participate in the Program by issuing up to $14.4 million of preferred stock to the Treasury. Because the Company’s Articles of Incorporation did not authorize the Company to issue preferred stock, the Company held a Special Meeting of Shareholders on March 23, 2009 at which the Company’s shareholders approved an amendment to the Company’s Articles of Incorporation to authorize the issuance of preferred stock. Due to its concerns with the potential for additional regulatory burdens associated with the TARP Capital Purchase Program and the possibility that Congress could further change the terms of the transaction or impose additional burdens at any time, the Company began looking for alternative sources of capital. In April 2009, the Company announced that it entered into a $7,500,000 Loan Commitment with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company a Revolving Line of Credit of up to $3,000,000 and a Closed-End Term Loan of up to $4,500,000 (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. The Loan proceeds may be down-streamed to the Bank and counted as Tier 1 capital at the Bank level. As a result, the Board of Directors of the Company determined that it was not in the best interests of the Company or its shareholders to participate in the TARP Capital Purchase Program and declined the opportunity.

In November 2008, the Federal Deposit Insurance Corporation (the “FDIC”) established the Temporary Liquidity Guarantee Program (“TLGP”). Under the TLGP, the FDIC will fully guarantee, all non-interest-bearing transaction accounts, including NOW accounts with interest rates of 0.5 percent or less and IOLTAs (lawyer trust accounts). On December 3, 2008, the Bank elected to participate in both guarantee programs.

In addition, the limit on FDIC coverage has been temporarily increased to $250,000 for all accounts through December 31, 2013. The costs association with bank resolutions or failures also have substantially depleted the Deposit Insurance Fund. As a result, the FDIC has been implementing and considering different methodologies by which it may increase premium amounts. The FDIC almost doubled its assessment rate on well-capitalized institutions by raising the assessment rate 7 basis points at the beginning of 2009. In May 2009, the FDIC issued a final rule regarding a special assessment of 5 basis points on an institution’s total assets minus its Tier 1 capital as of June 30, 2009. The FDIC adopted another final rule effective April 1, 2009, to change the way that the FDIC’s assessment system differentiates for risk, make corresponding changes to assessment rates beginning with the second quarter of 2009, as well as other changes to the deposit insurance assessment rules. In November 2009, the FDIC voted to require insured depository institutions to prepay slightly over three years of estimated insurance assessments. Additionally, the FDIC has proposed using executive compensation as a factor in assessing the premiums paid by insured depository institutions to the Deposit Insurance Fund.

Many of these emergency government programs enacted in 2008 in response to the financial crisis and the recession slowed or wound down in 2009, and global regulatory and legislative focus has generally moved to a second phase of broader reform and a restructuring of financial institution regulation. Legislators and regulators in the United States are currently considering a wide range of proposals that, if enacted, could result in major changes to the way banking operations are regulated. Some of these major changes may take effect as early as 2010. Certain reform proposals under consideration could result in our becoming subject to stricter capital requirements and leverage limits, and could also affect the scope, coverage, or calculation of capital, all of which could require us to reduce business levels or to raise capital. In addition, the enactment of certain reform proposals under consideration could introduce stricter substantive standards, oversight and enforcement of rules governing consumer financial products and services, with particular emphasis on retail extensions of credit and other consumer-directed financial products or services.

Results of Operations

Net Interest Income

(dollar amounts in thousands)

Net interest income for 2009 was $18,329 or a decrease of $1.360 million over 2008. During 2009 interest income decreased by $4,843. This was a result of both existing interest earning assets re-pricing at lower rates and new loans made and securities purchased at lower rates. Average interest earning assets decreased approximately $22,575 from 2008.. Additionally, the amount of non-accruing assets increased over 2008. Interest-bearing liabilities also re-priced downward, causing a decrease in interest expense of $3,478.The average balance of interest earning assets declined only 169 thousand from 2008. During the latter part of 2007, the Federal Reserve Board began lowering interest rates due to recessionary fears and the current weaknesses in the economy. The Fed continued to lower rates during 2008 with the Fed Funds target rate falling to historic lows due the credit crisis / recession. The net result of these changes was a decrease in the Company’s net interest margin to 3.28% in 2009 from 3.41% in 2008. During December 2009, the Company decreased its net funding from the FHLB by pre-paying 2 advances totaling $13,000. The Company paid these advances off by selling approximately 13,000 of available for sale securities. Both advances carried interest rates exceeding 6%. The continued competition for deposits in the Company’s market areas has slowed deposit growth. The tax equivalent yield on earning assets for 2009 was 5.99%, decreasing 59 basis points during the year. During the same period, the yield on interest bearing liabilities was 3.00%, which was a decrease of 65 basis points. During 2008, the Bank also became a member of the CDARS network, both to provide alternative funding and to provide its customers with full FDIC insurance by “swapping” deposits with other FDIC insured banks”. The Bank utilized the CDARS program throughout 2009. See additional information on the CDARS network in the “Deposits” section below. The Bank continues to look for alternative funding sources in an effort to reduce its cost of funds.

Analysis of Net Interest Earnings

The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the interest earned or paid, the average yield or rate on the average balance outstanding, net interest income and net yield on average interest-earning assets and average interest spread for the years indicated.

	Year Ended December 31,
	2009			2008				2007
	(Dollars in Thousands)
	Average Balance	Interest Income/ Expense	Yield/ Rate	Average Balance	Interest Income/ Expense	Yield/ Rate	Average Balance		Interest Income/ Expense	Yield/ Rate
ASSETS
Interest earning assets (taxable-equivalent basis):
Loans (net of unearned discount (1)	$490,481	$ 30,338	6.19%	$477,027	$ 32,937	6.90%	$441,308		$ 32,832	7.44%
Securities (2)(3)	98,791	4,126	5.41	137,664	6,296	5.60	148,500		7,175	5.89
Federal funds sold	6,838	10	0.15	4,163	85	2.04	6,521		338	5.18
Total interest-earning assets	$596,110	$ 34,474	5.99%	$618,854	$ 39,318	6.58%	$596,329		$ 40,345	7.03%
LIABILITIES
Interest bearing liabilities:
Interest bearing deposits	$434,983	$ 11,246	2.59%	$430,347	$ 14,823	3.44%	$426,116		$ 16,886	3.96%
Other interest bearing liabilities	103,071	4,899	4.75	107,876	4,800	4.45	88,694		4,555	5.14
Total interest-bearing liabilities	$538,054	$ 16,145	3.00%	$538,223	$ 19,623	3.65%	$514,810		$ 21,441	4.16%
Net interest income		$ 18,329			$ 19,694				$ 18,904
Net margin on interest earning assets on a tax equivalent basis			3.28%			3.41%				3.43%
Average interest spread			2.99%			2.93%				2.87%

(1) For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
(2)Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax.
(3)The yield on securities classified as available for sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by Financial Accounting Standard 115.

Analysis of Changes in Interest Income and Interest Expense

The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).

Increase/(Decrease) Due to Volume and Rate

	2009 Compared to 2008
Increase (Decrease) in	Increase (decrease) due to change in volume	Increase (decrease) due to change in rate	Net increase (decrease)
	(Dollars in Thousands)
INTEREST INCOME Securities	$ (2,104)	$ (66)	$ (2,170)
Federal funds sold	4	(78)	(74)
Loans	832	(3,431)	( 2,599)
Total Income Change	$ (1,268)	$ (3,575)	$ (4,843)
INTEREST EXPENSE Savings and time deposits	$ 120	$ (3,697)	$ (3,577)
Other interest-bearing liabilities	(228)	327	99
Total Expense Change	$ (108)	$ (3,370)	$ (3,478)
Increase (Decrease) in Net Interest Income	$ (1,160)	$ (205)	$ (1,365)

	2008 Compared to 2007
Increase (Decrease) in	Increase (decrease) due to change in volume	Increase (decrease) due to change in rate	Net increase (decrease)
	(Dollars in Thousands)
INTEREST INCOME Securities	$ (607)	$ (272)	$ (879)
Federal funds sold	(48)	(205)	(253)
Loans	2,466	(2,361)	105
Total Income Change	$ 1,811	$ (2,838)	$ (1,027)
INTEREST EXPENSE Savings and time deposits	$ 146	$ (2,209)	$ (2,063)

Other interest-bearing liabilities	853	(608)	245
Total Expense Change	$ 999	$ (2,817)	$ (1,818)
Increase (Decrease) in Net Interest Income	$ 812	$ (21)	$ 791

Non-interest Income

(dollar amounts in thousands)

Non-interest income for 2009 included an “other-than-temporary-impairment charge” in the amount of $5.62 million. The entire $5.62 million write-down was related to our TRUP CDOs, which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. The cash flow projections for the pooled trust preferred securities utilize a discounted cash flow test that uses variables such as the estimate of future cash flows, creditworthiness of the underlying banks and determination of probability of default of the underlying collateral. Cash flows are constructed in an INTEX cash flow model. It includes each individual deal’s structural features updated with trustee information, including asset-by-asset detail, as it becomes available. The modeled cash flows are then used to determine if all the scheduled principal and interest payments of our investments will be returned.

The expected future default assumptions for the pooled trust preferred securities are based upon the Company’s best estimate of future bank deferrrals. Banks currently in default or deferring interest payments are assigned a 100% probability of default. In all cases, a 15% projected recovery rate is applied to current deferrals and projected defaults.

In addition, the risk of future OTTI may be influenced by additional bank failures, prolonged recession in the U.S. economy, changes in real estate values, interest deferrals, and whether the federal government provides assistance to certain financial institutions. (See Footnote 2 in the Company’s Consolidated Financial Report for further discussion concerning OTTI).

In 2008 the Company made the decision to record a $5.99 million “other than temporary impairment” charge on its holdings of preferred stock of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Corporation (Fannie Mae”), both government sponsored enterprises (“GSE”). The decision to recognize the unrealized mark-to-market loss on these securities as an “other-than-temporary impairment (“OTTI”) was based on the significant decline in the market value of the securities caused by recent events.

Excluding OTTI charges, the Company’s non-interest income increased by $1.01 million from 2008 to 2009. The majority of this increase was related to life insurance benefits in the amount of $656 and a gain on the sale of a parcel of land in the amount of $292. Service charges on deposit accounts (primarily NSF fees) decreased $189 as compared to 2008. The number of checks processed continues to decline as the number of electronic transactions increases. Debit card fee income increased by $86 over 2008 due to increases in visa check card interchange fees. The use of debit cards continued to increase significantly over the prior period. The Company also introduced a rewards points program related to signature based debit card transactions during the latter part of 2008. This program is geared to increase the Company’s debit card fee income in future periods.

Earnings related to the Company’s holdings of Bank Owned Life Insurance totaled $458 in 2009 and $499 in 2008.

Net securities gains totaled $380 in 2009 compared to $137 in 2008.

Non-interest Expense

(dollar amounts in thousands)

Non-interest expense is comprised of salaries and employee benefit costs, occupancy expenses, furniture and equipment expenses and other operating expenses. Non-interest expense for 2009 was $20,349, an increase of $2,172 over 2008. Salaries and employee benefits increased by 2.93% or $301 primarily due to the Company opening a new branch in Sevierville, TN in the fourth quarter of 2008. Expenditures related to these branch expansions also increased occupancy expense and furniture and fixtures expense over 2008. Medical insurance costs increased $302 over 2008. Recent technology enhancements, however, have allowed the bank to leverage its existing personnel base to help minimize overall increases in personnel costs. As a result of the severe economic recession and the numerous bank failures, FDIC premiums increased $852 over 2008. OREO write-downs and subsequent losses on sales of OREO increased $911 over 2008. The drop in market values resulting from the economic recession has made the selling of OREO very challenging even after significantly lowering asking prices.

Income Taxes

(dollar amounts in thousands)

Income tax expense for 2009 decreased $3,691 when compared to 2008 as a result of the decrease in pretax income. Significant increases in the provision for loan losses and OTTI charges during 2009 were the primary contributors to the Company’s net loss before taxes. Life insurance benefits, interest income from tax exempt municipal bonds and earnings related to the Company’s investment in BOLI are the primary elements of tax exempt income.

Provision and Allowance for Loan Losses

(dollar amounts in thousands)

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions. The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The internal credit review department also prepares regular analyses of the adequacy of the allowance for loans losses. These analyses include calculations based upon a mathematical formula that considers identified potential losses on specific loans and makes pool allocations for historical losses for various loan types. In recent years, the Company has used a rolling three year history by loan category in determining pool allocation factors. However, due to the severe economic recession, the Company based its pool allocations as of December 31, 2009 to more closely match 2009 losses. In addition, an amount is allocated based upon such factors as changing trends in the loan mix, the effects of changes in business conditions and market area, unemployment trends, the effects of any changes in loan policies, the effects of competition, regulatory factors, and environment factors on the loan portfolio. As a result of the continued recession, the Company increased its 2009 provision for loan losses by $8.02 million over 2008 due to the significant increase in non-performing and past due loans.

The internal credit review department as well as management has determined that the Company's allowance for loan losses is sufficient.

The following table presents the Company’s loan loss experience for the past five years:

	Years Ended December 31, (Dollars in Thousands)
	2009	2008	2007	2006	2005
Allowance for loan losses at beginning of year	$ 5,171	$ 4,630	$ 4,565	$ 4,359	$ 4,181
Loans charged off:
Commercial	698	195	47	206	131
Real Estate – mortgage	1,659	283	99	58	205
Consumer	670	607	444	539	791
Other	220	231	242	277	0
Total	$ 3,247	$ 1,316	$ 832	$ 1,080	$ 1,127
Recoveries of loans previously charged off:
Commercial	$ 12	$ 122	$ 36	$ 14	$ 17
Real Estate – mortgage	1	1	54	10	10
Consumer	114	144	121	115	123
Other	16	0	1	0	0
Total	$ 143	$ 267	$ 212	$ 139	$ 150

Net loans charged off	$ 3,104	$ 1,049	$ 620	$ 941	$ 977

Provision for loan losses	9,614	1,590	685	1,147	1,155
Allowance for loan losses end of year	$ 11,681	$ 5,171	$ 4,630	$ 4,565	$ 4,359
Average total loans (net of unearned income)	$ 490,481	$ 477,027	$ 441,308	$ 422,525	$ 400,759
Total loans (net of unearned income) at year-end	$ 486,119	$ 490,425	$ 451,291	$ 437,599	$ 411,633
Ratio of net charge-offs to average loans	0.633%	0.220%	0.140%	0.223%	0.244%
Ratio of provision for loan losses to average loans	1.960%	0.333%	0.155%	0.271%	0.288%
Ratio of provision for loan losses to net charge-off	309.729%	151.573%	110.484%	121.892%	118.219%
Allowance for loan losses to year-end loans	2.402%	1.054%	1.026%	1.043%	1.059%

Non-performing loans

(dollar amounts in thousands)

The loan portfolio of the Bank is reviewed regularly by senior officers to monitor loan performance. The frequency of the review is based on the rating of credit worthiness of the borrower utilizing various factors such as net worth, credit history and customer relationship. The evaluations emphasize different factors depending upon the type of loan involved. Commercial and real estate loans are reviewed on the basis of projections of cash flow and estimated net realizable value through an evaluation of collateral and the financial strength of the borrower.

Installment loans are evaluated largely on the basis of delinquency data because of the large number of such loans and relatively small size of each individual loan.

Management’s review of commercial and other loans may result in a determination that a loan should be placed on non-accrual. It is the policy of the Bank to discontinue the accrual of interest on any loan on which full repayment of principal and / or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt. Placing a loan on non-accrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and

the financial condition of the borrower, serve as more reliable indications of potential loss of principal.

The policy of the Bank is that non-performing loans consist of loans accounted for on a non-accrual basis and loans which are contractually past due 90 days or more in regards to interest and/or principal payments. The following table presents non-performing loans at December 31.

	2009	2008	2007	2006	2005
	(Amounts in thousands)

Non-performing loans	$ 15,819	$ 6,934	$ 8,117	$ 3,400	$ 4,201

Non-accrual loans	$ 11,559	$ 6,278	$ 7,849	$ 2,696	$ 2,920

Loans past-due 90 days and more and still accruing	$ 4,260	$ 656	$ 268	$ 704	$ 1,281

Interest income lost on non-accruing loans	$ 497	$ 417	$ 333	$ 234	$ 227

Troubled Debt Restructurings	$ 6,010	$ 4,393	--	--	--

The 2 most significant components of the Bank’s non-performing assets at December 31, 2009 are two large commercial credits. The first credit totals approximately $4.2 million. The Company is currently acquiring the property through foreclosure and bankruptcy proceedings. Approximately $1.3 million of the balance was transferred to OREO in June of 2008. The second credit totals approximately $4.24 million and is currently past due in excess of 90 days. In the event the collateral value is over-estimated or deteriorates management believes a sufficient amount of loan loss reserve has been allocated to the remainder of the credits to cover any potential future losses. The Company has seen the greatest deterioration of its commercial real estate portfolio in its Sevierville TN market area.

Due to the significant increase in non-performing loans the Company significantly increased its loan loss provision and reserve balance during 2009. Management feels that at December 31, 2009, reserves are adequate to absorb future losses. The adequacy of the loan loss reserve is reviewed and approved quarterly by the Board of Directors.

Allocation of the allowance for loan losses

The following table provides an allocation of the allowance for loan losses at December 31, 2009, 2008, 2007, 2006 and 2005.

	December 31, Percent of Loans on each Category (Dollars in Thousands)
	2009			2008			2007
	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans
Commercial	$ 814	6.97%	9.21%	$ 262	5.07%	9.83%	$ 1,005	21.71%	9.46%
Real Estate	9,450	80.90	84.02	3,401	65.78	82.79	2,187	47.22	81.94
Consumer	918	7.86	6.14	455	8.79	6.35	589	12.72	7.42
Other / Unallocated	499	4.27	0.63	1,053	20.36	1.03	849	18.35	1.18
Total	$ 11,681	100.00%	100.00%	$ 5,171	100.00%	100.00%	$ 4,630	100.00%	100.00%

	2006			2005
	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans	Allowance for Loan Loss	Percentage of Total Allowance	Percentage of Total Loans
Commercial	$ 1,691	37.04%	9.76%	$ 710	16.29%	9.38%
Real Estate	593	12.99	80.77	1,255	28.79	79.42
Consumer	768	16.82	8.14	858	19.68	10.07
Other / Unallocated	1,513	33.15	1.33	1,536	35.24	1.13
Total	$ 4,565	100.00%	100.00%	$ 4,359	100.00%	100.00%

_________________________________________________________________________________________________________________

Financial Condition

Balance Sheet

(dollar amounts in thousands)

Total assets for the Company decreased by $23,689 or 3.54% in 2009. During December 2009, the Company decreased its net funding from the FHLB by pre-paying 2 advances totaling $13,000. The Company paid these advances off by selling approximately 13,000 of available for sale securities. Both advances carried interest rates exceeding 6%. Interest earning assets decreased by $22,744 or 3.68% for the year. The primary reason for the drop in interest earning assets was the investment earning portfolio drastically reducing during the year. Average interest bearing liabilities decreased by $169 or 0.03% in 2009. The Company plans to continue to reduce its asset size in 2010 and 2011 in an effort to increase its regulatory capital ratios by reducing its holdings of commercial real estate loans.

Loans

(dollar amounts in thousands)

Loans net of unearned income and deferred fees decreased by $4,306 or 0.88% in 2009. Loan demand has significantly subsided during the economic downturn. Loans secured by real estate increased approximately $2,274 whereas loans secured by collateral other than real estate and unsecured loans decreased approximately $6,592.

Prior to 2009, the Company’s portfolio of commercial, construction and land development loans has also experienced significant growth. During 2008, this segment of loans grew $19,544 or 12.23%. The Company made a concerted effort over the past 2 years to reduce its construction and development portfolios as these types of loans faced the greatest risk of loss due to the recession and began curtailing its lending for these types of loans during 2008 as the economy began to suffer. This segment of loans decreased by $5,586 or 3.11% during 2009. As the sales of real estate has slowed significantly in the latter part of the year a diligent effort was made to concentrate on permanent financing for residential mortgages and owner occupied commercial real estate loans.

The Company has also implemented a separate credit analysis department to review the larger loan requests, typically loan requests in excess of $250,000. This department operates separately from the loan origination arm of the Company and completes independent and unbiased reviews of each new loan request. The senior officer of this department meets monthly with the Loan Committee of the Board of Directors.

Loan Portfolio

The table below classifies gross loans by major category and percentage distribution at December 31, for each of the past five years:

	December 31, (Dollars in thousands)
	2009		2008		2007		2006		2005
	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage	Amount	Percentage
Real Estate Secured:
Residential 1-4 family	$ 183,983	35.89%	$ 176,239	35.89%	$163,918	36.28%	$ 156,753	35.77%	$151,815	36.88%
Multi-family	12,895	2.67	13,114	2.67	9,420	2.08	10,520	2.40	4,148	1.01
Commercial, Construction and Land Development	173,752	36.52	179,339	36.52	159,795	35.35	152,491	34.80	140,178	34.05
Second Mortgages	16,980	3.77	18,499	3.77	17,964	3.97	15,305	3.49	10,962	2.66
Equity Line of Credit	10,164	2.03	9,984	2.03	9,782	2.16	9,493	2.17	9,800	2.38
Farmland	11,176	1.93	9,501	1.93	9,475	2.10	9,343	2.13	10,015	2.43
	$ 408,950	82.81%	$ 406,676	82.81%	$ 370,354	81.94%	$ 353,905	80.77%	$ 326,918	79.41%
Secured, Other:
Personal	$ 20,671	4.45%	$ 21,854	4.45%	$ 24,741	5.47%	$ 27,384	6.25%	$ 33,395	8.11%
Commercial	30,449	6.66	32,725	6.66	26,433	5.85	26,943	6.15	25,628	6.23
Agricultural	2,263	0.88	4,319	0.88	4,232	0.94	5,093	1.16	3,653	.89
	$ 53,383	11.99%	$ 58,898	11.99%	$ 55,406	12.26%	$ 59,420	13.56%	$ 62,676	15.23%

Unsecured:	$ 24,420	5.20%	$ 25,497	5.20%	$ 26,192	5.80%	$ 24,845	5.67%	$ 22,048	5.36%

Loans, gross	$ 486,753	100.00%	$ 491,071	100.00%	$ 451,952	100.00%	$ 438,170	100.00%	$ 411,642	100.00%

The following table shows the maturity of loans outstanding, inclusive of contractual amortization, at December 31, 2009:

	December 31, 2009 (Amounts in Thousands)
	Within One Year		After One Year But Within Five Years		After Five Years
	Fixed	Floating	Fixed	Floating	Fixed	Floating	Total

Real Estate Secured:
Residential 1-4 Family	$ 15,556	$ 4,636	$ 42,310	$ 7.694	$ 58,833	$ 54,954	$ 183,983
Multi-family	1,947	0	6,573	0	1,783	2,592	12,895
Commercial, Construction & Land Development	31,590	15,469	79,539	8,245	33,582	5,327	173,752
Second Mortgages	2,279	4,007	5,708	46	4,919	20	16,980
Equity Line of Credit	0	814	0	3,669	0	5,682	10,164
Farmland	3,334	1,287	4,683	107	1,398	367	11,176
Secured, Other:
Personal	7,747	1	12,148	4	728	43	20,671
Commercial	8,383	5,934	10,029	43	6,060	0	30,449
Agricultural	747	1,200	311	6		0	2,263
Unsecured	8,115	9,095	4,946	1,729	535	0	24,420
Loans, Gross	$ 79,698	$ 42,443	$166,247	$ 21,543	$ 107,838	$ 68,985	$ 486,753

Securities

(dollar amounts in thousands)

Investment securities available for sale decreased $35,699 (market value) from December 31, 2008 to December 31, 2009 as a result of maturities, sales, prepayments and write-downs.. The Company made fewer purchases during 2009 primarily due to the worsening credit crisis and the possible need for on balance sheet liquidity.

Yields on typical investment securities were very low during 2009. Purchases during the year consisted primarily of fixed rate GNMA mortgage backed securities. During the year, management has continued its investment strategy to purchase securities that will not only blend in with the Company’s overall asset liability strategy but also maximize yield. The majority of the pay downs were contractual amortization and prepayments on variable rate securities as a result of prepayments occurring on the underlying mortgages. GNMA securities also carry a favorable risk weighting as it pertains to regulatory risk based capital.

The segment of our portfolio that contains the largest unrealized loss is our pooled trust preferred securities (TRUP CDOs) which represent trust preferred securities issued primarily by banks and a limited number of insurance companies and real estate investment trusts. As of December 31, 2009, our TRUP CDOs amortized cost totaled $5.64 million.

The Company continues to review its investment portfolio on a quarterly basis for indications of other-than-temporary impairment (“OTTI”).

During 2009, the Company incurred credit-related OTTI charges of $5.62 million. The entire $5.62 million write-down was related to the TRUP CDOs. The cash flow projections for the pooled trust preferred securities utilize a discounted cash flow test that uses variables such as the estimate of future cash flows, creditworthiness of the underlying banks and determination of probability of default of the underlying collateral.

During the third quarter of 2008 the Company made the decision to record a $5.99 million “other than temporary impairment” charge on its holdings of preferred stock of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal National Mortgage Corporation (Fannie Mae”), both government sponsored enterprises (“GSE”). The decision to recognize the unrealized mark-to-market loss on these securities as an “other-than-temporary impairment (“OTTI”) was based on the significant decline in the market value of the securities caused by recent events.

After considering the impact of the 2009 and 2008 charges to earnings, both the company and the bank remained “well capitalized” under regulatory guidelines. Being a non-cash impairment charge, the write-downs do not affect the Company’s cash flows.

Investment Portfolio

The following table presents the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2009.

	(Dollars in Thousands)
	Within One Year	One Year Through Five Years	Five Years Through Ten Years	After Ten Years	Yield	Market Value	Amortized Cost

Mortgage-backed Sec – fixed rate	$ 309	$ 185	$ 28	$ 6,132	4.12%	$ 6,654	$ 6,516
Mtg.-backed Sec – variable rate	-	-	178	11,108	3.64	11,286	11,134
State & Municipal’s – tax exempt	-	-	1,236	44,600	6.21	45,836	46,475
State & Municipal’s – taxable	-	325	202	985	5.41	1,511	1,527
U.S. Agencies – fixed rate	-	-	-	1,507	5.63	1,507	1,498
Agency Preferred – variable rate	-	-	-	141	0.00	141	262
Corporate bonds – fixed rate	-	-	-	1,075	6.98	1,075	1,430
Corporate bonds – variable rate	-	-	385	1,711	0.45	2,096	6,664
SBA bonds – variable rate	-	-	-	45	0.80	45	47
CMO’s – fixed rate	-	-	-	786	3.46	786	783
CMO’s – variable rate	-	-	-	10	3.93	10	10
TOTAL	309	$ 510	$ 2,029	$ 68,100		$ 70,948	$ 76,326
Total fixed rate securities	$ 309	$ 510	$ 1,466	$ 55,130		$ 57,414	$ 58,276
Total variable rate securities	$ -	$ -	$ 563	$ 12,970		$ 13,534	$ 18,050

Deposits / Funding

(dollar amounts in thousands)

Total deposits decreased by $2,832 or 0.54% in 2009. Non-interest bearing demand deposits increased by $3,904. Interest bearing demand deposits increased by $9,537. Total time deposits decreased by $22,213. Savings accounts increased by $5,940 during the year. The decrease in time deposits is primarily a result of the Company’s actions to reduce its higher cost CD’s in an effort to lower its overall cost of funds. The Company and banks nationwide are continuing to face the challenge of gathering deposits, especially non-interest bearing deposits. The Company over the years has used its alternative funding sources (primarily FHLB advances) to help facilitate growth. However during 2009, the Company decreased its net borrowings from the FHLB by $13,000. The $13,000 was made up of three advances that carried rates greater than 6%.The total amount of FHLB borrowings as of December 31, 2009 was $82,049. See Footnotes 9 and 10 in the Company’s consolidated financial statements for a description of the Bank’s outstanding FHLB advances. The Company secures the FHLB advances with a selected group of residential mortgage loans and commercial real estate loans as well as a specific group of securities available for sale. During 2008, the Company also joined the “CDARS” network. This deposit placement service allows banks to swap funds with each other while still allowing their customers only one institution to deal with. All of the funds placed in the CDARS network are fully insured by the FDIC. The Company also participates in the FDIC’s Temporary Liquidity Guarantee Program that was implemented in the fourth quarter of 2008. Under this program, non-interest bearing transaction accounts and transaction accounts earning a rate of up to 0.50% are fully insured above and beyond the existing FDIC insurance coverage amount.

The following table provides a breakdown of deposits at December 31 as indicated:

	December 31,
	(Amounts in Thousands)
	2009	2008

Non-interest bearing demand deposits	$ 84,073	$ 80,169
Interest bearing demand deposits	75,560	66,023
Savings deposits	55,745	49,805
Time deposits	304,526	326,739
Total Deposits	$ 519,904	$ 522,736

The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table:

	Year Ended December 31, (Dollars in Thousands)
	2009			2008			2007

	Amount	Rate	Amount	Rate	Amount	Rate
Non-interest bearing demand deposits	$ 83,760	0.00%	$ 85,719	0.00%	$ 81,746	0.00%
Interest-bearing demand deposits	68,059	0.93	62,300	1.53	59,468	1.92
Savings deposits	55,187	0.69	50,389	0.98	50,497	1.25
Time deposits	312,735	3.27	317,656	4.21	316,151	4.78
Total	$519,741		$516,064		$507,862

The remaining maturities of time deposits greater than or equal to $100,000 at December 31, 2009 are as follows (Amount in thousands):

Maturity	Amount
3 months or less	$ 29,125
Over 3 months through 6 months	21,338
Over 6 months through 12 months	32,351
Over 12 months	28,823
Total	$ 111,637

Effects of Inflation

The Company's consolidated statements of income generally reflect the effects of inflation. Since interest rates, loan demand, and deposit levels are related to inflation, the resulting changes are included in net income. The most significant item which does not reflect the effects of inflation is depreciation expense. Historical dollar values used to determine depreciation expense do not reflect the effects of inflation on the market value of depreciable assets after their acquisition.

Liquidity and Capital Resources

(dollar amounts in thousands)

Liquidity is the measure of the Bank’s ability to generate sufficient funds in order to meet customers’ demands for withdrawal of deposit balances and for the funding of loan requests. The Bank maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and has sufficient flow of funds from investment security payments as well as loan payments to meet current liquidity needs.

Management of the Bank continuously monitors and plans the Bank’s liquidity position for the future. Liquidity is provided from cash and due from banks, federal funds sold, loan and investment security payments, core deposits, the national certificate of deposit market, lines of credit with correspondent banks and lines of credit with the Federal Home Loan Bank. Management believes that these sources of funds provide sufficient and timely liquidity for the foreseeable future.

The Company’s liquidity ultimately depends on dividends paid by the Bank, its wholly owned subsidiary. Dividend payments by the Bank are heavily regulated by state and federal regulators, including a requirement that dividends in any calendar year may not exceed the total of the Bank’s net profits for that year and the Bank’s retained net profits for the two preceding years without prior approval by the Federal Reserve Board. Due to the Bank’s net loss for the 2009 fiscal year, and based on our expected future results, we do not expect that the Bank will be permitted to pay dividends to the Company without prior approval until at least 2012.

In April 2009, the Company announced that it entered into a $7,500,000 Loan Commitment with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to the Company a Revolving Line of Credit of up to $3,000,000 and a Closed-End Term Loan of up to $4,500,000 (collectively, the “Loans”). The Company pledged the stock of the Bank as collateral for the Loans. The Loan proceeds may be down-streamed to the Bank and counted as Tier 1 capital at the Bank level.

As of December 31, 2009 the outstanding balances on the Loans were $0 for the Line of Credit and $3,000,000 for the Term Loan.

The Line of Credit accrues interest at the U.S. prime rate, subject to a floor of 5% and a ceiling of 9%. The Term Loan accrues interest at a rate of 6.75% using a ten year amortization period with a balloon date in five years. The Loans may be repaid in whole or in part at any time without penalty. The Line of Credit matures on April 21,2012. The Term Loan matures on April 21, 2014. The Company is currently in compliance with the terms of both of the Loans. Both loans may be renewed assuming no conditions of default exist.

Both the Company and the Bank remained “well capitalized” under regulatory guidelines. (See Footnote 21 in the Company’s Consolidated Financial Report for further discussion concerning regulatory capital requirements).

Recent Accounting Pronouncements

See Note 1 of Notes to Consolidated Financial Statements for information relating to recent accounting pronouncements.

Off-Balance Sheet Arrangements

See Note 16 of Notes to Consolidated Financial Statements for information relating to Off-Balance Sheet Arrangements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Not Applicable.

Item 8. Financial Statements and Supplementary Data

The following financial statements are incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2009:

Report of Independent Registered Public Accounting Firm on the Financial Statements;

Consolidated Balance Sheets as of December 31, 2009 and 2008;

Consolidated Statements of Income for the years ended December 31, 2009 and 2008;

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2009 and 2008;

Consolidated Statements of Cash Flows for the years ended December 31, 2009 and 2008; and

Notes to Consolidated Financial Statements for December 31, 2009

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A(T). Controls and Procedures

On an on-going basis, senior management monitors and reviews the internal controls established for the various operating activities of the Bank. Additionally, the Company has created a Disclosure Review Committee to review not only internal controls but the information used by Company’s financial officers to prepare the Company’s periodic SEC filings and corresponding financial statements. The Committee is comprised of the Senior Management Team of the Bank and meets at least quarterly. Internal audits conducted by the Company’s internal audit department are also reviewed by senior officers to assist them in assessing the adequacy of the Company’s internal control structure. These audits are also discussed in detail with the Company’s Audit Committee.

We have carried out an evaluation, under the supervision and the participation of our management, including our Executive Vice President and Chief Executive Officer, our Chief Financial Officer and our Vice President of Accounting, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Act”), as of the end of the fiscal year covered by this report. Based upon that evaluation, our CEO, CFO and VP Accounting concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (b) such information is accumulated and communicated to our management, including our CEO, CFO and VP Accounting, as appropriate to allow timely decisions regarding required disclosure.

There were not any changes in the Company’s internal controls over financial reporting during the fourth fiscal quarter of the fiscal year covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B. Other Information

None

Part III.

Item 10. Directors, Executive Officers and Corporate Governance

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “The Nominees,” “Executive Officers Who Are Not Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “The Board of Directors and its Committees” and “Code of Ethics” in the Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.

Item 11. Executive Compensation

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Executive Compensation” in the Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Security Ownership of Management and Certain Beneficial Owners” in the Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.

The following table sets forth information as of December 31, 2009, with respect to compensation plans under which shares of Common Stock are authorized for issuance.

Equity Compensation Plan Information

Plan Category	Number of Securities to Be Issued upon Exercise of Outstanding Options, Warrants and Rights	Weighted Average Exercise Price of Outstanding Options, Warrants and Rights	Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (a)

Equity Compensation Plans Approved by Shareholders	262,779	$ 13.51	--

Equity Compensation Plans Not Approved by Shareholders (b)	-	$ -	200,000

Total	262,779	$ 13.51	200,000

(a)	Amounts exclude any securities to be issued upon exercise of outstanding options, warrants and rights.

(b)

On September 13, 2006, the Board of Directors of the Company approved the Highlands Bankshares, Inc. 2006 Equity Compensation Plan (the Plan). The Plan authorizes the Personnel and Compensation Committee (the Committee) of the Board of Directors to grant options, stock appreciation rights, stock awards and stock units to directors, officers, key employees, consultants and advisors to the Company and its subsidiaries who are designated by the Committee. The Company is authorized to issue under the Plan up to 200,000 shares of its Common Stock. Generally, if an award is forfeited, expires or terminates, the shares allocated to that award under the Plan may be reallocated to new awards under the Plan. Shares surrendered pursuant to the exercise of a stock option or other award or in satisfaction of tax withholding requirements under the Plan may also be reallocated to other awards.

Item 13. Certain Relationships and Related Transactions, and Director Independence

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Transactions with Related Parties” and “The Board of Directors and its Committees” in the Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Services and Fees” and “Pre-Approved Policies and Procedures” in the Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.

Part IV.

Item 15. Exhibits, Financial Statement Schedules

(a) (1) The response to this portion of Item 15 is submitted as a separate section of this report.

(2)

All applicable financial statement schedules required by Regulation S-X are included in the Notes to the 2008 Consolidated Financial Statements.

(3)

Exhibits:

3.1

Amended and Restated Articles of Incorporation of Highlands Bankshares, Inc., filed as Exhibit 3.1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009.

3.2

Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference.

10.1

Highlands Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002, File No. 000-27622, incorporated herein by reference.

10.2

Highlands Bankshares, Inc. 2006 Equity Compensation Plan, filed as Exhibit 3.1 to the Current Report on Form 8-K, File No. 000-27622, filed with the Commission on September 20, 2006, incorporated herein by reference.

13.1

Annual Report to Shareholders – Financial Statements

Subsidiaries of the Corporation.

23.1

Consent of Brown, Edwards & Company, L.L.P.

31.1

Section 302 Certification of Chief Executive Officer.

31.2

Section 302 Certification of Chief Financial Officer of the Corporation

31.3

Section 302 Certification of Vice President of Accounting

32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.

32.2

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.

32.3

Statement of Vice President of Accounting Pursuant to 18 U.S.C. § 1350.

(b) Exhibits.

The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted as a separate section of this report.

The response to this portion of Item 15 is submitted as a separate section of this report.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

HIGHLANDS BANKSHARES, INC.

Date: April 14th, 2010 BY: /s/ Samuel L. Neese

Samuel L. Neese

Executive Vice President and

Chief Executive Officer

BY: /s/ Robert M. Little, Jr. BY: /s/ James R. Edmondson

Robert M. Little, Jr. James R. Edmondson

Chief Financial Officer Vice President of Accounting
Principal Financial Officer Principal Accounting Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated on April 14, 2010.

Signature	Title	Date

/s/ James D. Morefield James D. Morefield	Chairman of the Board, and Director	April 14, 2010
/s/ Dr. James D. Moore, Jr. Dr. James D. Moore, Jr.	President	April 14, 2010
/s/ J. Carter Lambert J. Carter Lambert	Vice Chairman	April 14, 2010

/s/ Samuel L. Neese

Samuel L. Neese

Executive Vice President, and Chief Executive Officer (principal executive officer)

April 14, 2010

/s/ William E. Chaffin William E. Chaffin	Director	April 14, 2010
/s/ E. Craig Kendrick E. Craig Kendrick	Director	April 14, 2010
/s/ Clydes B. Kiser Clydes B. Kiser	Director	April 14, 2010
/s/ Charles P. Olinger Charles P. Olinger	Director	April 14, 2010
/s/ William J. Singleton William J. Singleton	Director	April 14, 2010
/s/ Dr. H. Ramsey White, Jr. Dr. H. Ramsey White, Jr.	Director	April 14, 2010

EXHIBIT INDEX

Exhibit No. Description

3.1

Amended and Restated Articles of Incorporation of Highlands Bankshares, Inc., filed as Exhibit 3.1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009.

3.2

10.1

10.2

Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2008 Annual Report to Shareholders and incorporated herein by reference).

13.1

Annual Report to Shareholders – Financial Statements

Subsidiaries of the Corporation.

23.1

Consent of Brown, Edwards & Company, L.L.P.

31.1

Section 302 Certification of Chief Executive Officer.

31.2

Section 302 Certification of Chief Financial Officer of the Corporation

31.3

Section 302 Certification of Vice President of Accounting of the Bank.

32.1

Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.

32.2

Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. § 1350.

32.3

Statement of Vice President of Accounting Pursuant to 18 U.S.C. § 1350.

Attached files

HIGHLANDS BANKSHARES INC /VA/ Reports

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