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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| x | ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2010
| ¨ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File Number: 0-11255
HERITAGE BANKSHARES, INC.
(Exact Name of Registrant as Specified in its Charter)
| Virginia | 54-1234322 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
| 150 Granby Street Norfolk, Virginia |
23510 | |
| (Address of Principal Executive Offices) | (Zip Code) | |
Registrant’s telephone number (757) 648-1700
Securities registered pursuant to Section 12(b) of the Exchange Act:
None
Securities registered pursuant to Section 12(g) of the Exchange Act:
Common Stock, $5.00 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Section 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 x No ¨
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer | ¨ | Accelerated filer | ¨ | |||
| Non-accelerated filer | ¨ (Do not check if a smaller reporting company) | Smaller reporting company | x | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant as of June 30, 2010 was approximately $19,071,000. Aggregate market value was computed by reference to the sales price of the Common Stock of the registrant on June 30, 2010 of $12.00 per share and 1,589,265 shares of voting stock held by non-affiliates of the registrant on that date.
As of February 28, 2011, 2,307,502 shares of Common Stock of the registrant, par value $5.00 per share, were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2011 Annual Meeting of Shareholders (the “2011 Proxy Statement”), currently scheduled for June 16, 2011, are incorporated by reference into Part III hereof.
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PART I
As used in this annual report on Form 10-K, the “Company,” “we,” “our” and “us” refer to Heritage Bankshares, Inc. and its subsidiaries, collectively, unless the context requires otherwise.
Forward-Looking Statements
Statements contained in this annual report on Form 10-K that are not historical facts are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of such words as “may,” “will,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential”, among others, though these words are not the exclusive means of identifying such forward-looking statements. These forward-looking statements relate to, among other things, expectations regarding the business environment in which we operate, projections of future performance and perceived opportunities in the market, and they are based on management’s current beliefs, assumptions and expectations. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. For a detailed discussion of the factors that might cause such a difference, see Item 1A, “Risk Factors.”
Factors that might affect forward-looking statements include, among other things:
| • | the demand for our products and services; |
| • | actions taken by our competitors; |
| • | changes in prevailing interest rates; |
| • | changes in delinquencies and defaults by our borrowers; |
| • | changes in loan quality and performance; |
| • | changes in FDIC insurance assessments; |
| • | legislative or regulatory changes or actions that affect our business, including new regulations imposed by the Dodd-Frank Act; |
| • | our ability to achieve financial goals and strategic plans; |
| • | our participation in the TARP Capital Purchase Program; |
| • | litigation; and |
| • | credit and other risks of lending activities. |
As a result, we cannot assure you that our future results of operations, financial condition or other matters will be consistent with those expressed or implied in any forward-looking statements. You should not place undue reliance on these forward-looking statements, as they all are based only on information available at this time, and we assume no obligation to update any of these statements.
| ITEM 1. | BUSINESS |
General
Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and serves as the holding company for its wholly-owned subsidiary, Heritage Bank. Since 1992, the Company has operated as a one bank holding company. The principal executive office of the Company is located at 150 Granby Street, Norfolk, Virginia. Currently, the Company does not transact any material business other than through Heritage Bank. Information concerning the Company and Heritage Bank may be found on our website located at www.heritagebankva.com.
Heritage Bank (the “Bank”) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank was incorporated in Virginia on September 19, 1975 and commenced business in Norfolk, Virginia on February 7, 1977. On December 31, 2010, the Bank had assets of $264.2 million, with total loans held for investment, net, of $214.3 million and deposits of $224.2 million.
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The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (“Sentinel Financial”). At December 31, 2010, Sentinel Financial owned an interest in Infinex Investments, Inc. and Bankers Insurance, LLC, each of which offer various insurance and investment services. Our ownership interest in these companies, through Sentinel Financial, allows the Bank to provide various investment and insurance services to our customers; however, the Bank does not at this time market insurance services to our customers.
Principal Products or Services
The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of individuals and small to medium sized businesses in its primary service area, which includes Chesapeake, Norfolk and Virginia Beach, Virginia. The principal business of the Bank is to attract deposits and to lend or invest those deposits on profitable terms. These deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts, certificates of deposit and IRA accounts.
The Company actively extends both consumer and commercial credit and is involved in the construction and real estate lending market. Loans consist of varying terms and may be secured or unsecured. Loans to individuals are for personal, household and family purposes. Loans to businesses are made for purposes such as working capital, financing of facilities, and equipment purchases. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for a breakdown of loans by classification.
The Bank’s lending policies, deposit products and related services are intended to meet the needs of individuals and businesses in its market area. The Bank’s plan of operation for future periods is to continue to operate as a community bank and to focus its lending and deposit activities in its primary service area. Consistent with its focus on providing community based financial services, the Bank currently does not plan to diversify its loan portfolio geographically by making significant loans outside of its primary service area. While the Bank and its borrowers will be directly affected by the economic conditions and the prevailing real estate market in the area, the Bank is better able to monitor the financial condition of its borrowers by concentrating its lending activities in its primary service area. The Bank will evaluate the feasibility of entering into other markets as opportunities to do so become available.
Market Area
The Company is located in the Norfolk-Virginia Beach-Newport News Metropolitan Statistical Area (“MSA”), which extends approximately 65 miles from Williamsburg, Virginia, to Virginia Beach, Virginia, and Currituck County, North Carolina. This MSA is the 31st largest Metropolitan Statistical Area in the United States with a population of approximately 1.6 million persons. The Company’s principal market within this MSA is the Hampton Roads area, which comprises the cities of Norfolk, Portsmouth, Virginia Beach, Chesapeake, Suffolk, Hampton, and Newport News. The Company maintains its corporate headquarters in Norfolk, Virginia, and as of December 31, 2010 the Bank has a total of six retail offices located in the cities of Norfolk and Virginia Beach, Virginia.
Although the Hampton Roads area supports a wide range of industrial and commercial activities, the area’s principal employer is the United States Navy and other branches of the Armed Forces of the United States. Significant cutbacks in defense spending and consolidations of domestic military installations could affect the general economy of the market area in which the Company operates. Depending on whether the Hampton Roads area experiences an overall increase or decrease in military and federal wages and salaries, the potential future impact of any such cutbacks or consolidations could be either favorable or unfavorable.
Competition
The banking business in the MSA, and the Company’s principal market area of Hampton Roads, is highly competitive, and the Company faces significant competition both in making loans and in attracting deposits. At June 30, 2010, the Company’s deposit market share as a percentage of FDIC-insured institutions’ deposits in the MSA was 1.16%. The Company’s competition for loans comes from commercial banks, savings banks, mortgage banking subsidiaries of regional commercial banks, national mortgage bankers, insurance companies, and other institutional lenders. The Company’s most direct competition for deposits has historically come from savings banks, commercial banks, credit unions and other financial institutions. The Company may face an increase in competition as a result of the continuing reduction in the restrictions on the interstate operations of financial institutions. The Company also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds. (For additional discussion regarding competition facing the Company, see Item 1A, “Risk Factors,” below.)
Employees
At December 31, 2010, we employed 58 full-time equivalent employees. None of our employees are represented by any collective bargaining agreements, and employee relations are considered excellent.
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Participation in TARP Capital Purchase Program
On September 25, 2009, as part of the Capital Purchase Program (the “Capital Purchase Program”) established under the Troubled Asset Relief Program (“TARP”), the Company and the U.S. Department of the Treasury (“Treasury”) entered into a Letter Agreement and a Securities Purchase Agreement – Standard Terms attached thereto (collectively, the “Securities Purchase Agreement”), as amended by a side letter agreement, pursuant to which we issued and sold, and the Treasury purchased, for an aggregate purchase price of $10,103,000 in cash, (i) 10,103 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share (“Series A Preferred Shares”), and (ii) a warrant (the “Warrant”) to purchase up to 303.00303 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B, having a liquidation preference of $1,000 per share (“Series B Preferred Shares”), at an exercise price of $0.01 per share. The Warrant was exercised by the Treasury on a cashless basis immediately following the closing of the transaction, resulting in the issuance to the Treasury of 303 Series B Preferred Shares.
The Series A Preferred Shares qualify as Tier 1 capital and pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Series B Preferred Shares will pay cumulative dividends at a rate of 9% per annum. Dividends are payable on both the Series A Preferred Shares and the Series B Preferred Shares (collectively, the “Preferred Shares”) quarterly and are payable on February 15, May 15, August 15 and November 15 of each year.
The Preferred Shares and the Warrant were issued in a private placement transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. We agreed to register for resale the Preferred Shares upon the request of the Treasury. The Securities Purchase Agreement provides that the Preferred Shares will not be subject to any contractual restrictions on transfer.
The Articles of Amendment to our Articles of Incorporation filed in advance of the closing under the Capital Purchase Program provide that we may not redeem the Preferred Shares for three years except with the proceeds from a “Qualified Equity Offering” (as defined in the Articles of Amendment). However, under the American Recovery and Reinvestment Act of 2009 (the “ARRA”), which amended the Emergency Economic Stabilization Act of 2008 (the “EESA”), and pursuant to an agreement with the Treasury pertaining to the ARRA, we may, subject to consultation with the Federal Reserve Bank of Richmond, redeem all or certain portions of the Preferred Shares at any time for the aggregate liquidation preference amount plus any accrued and unpaid dividends, without first raising additional capital in an equity offering.
The Preferred Shares are not convertible into any other securities and generally are non-voting. The Preferred Shares have no maturity date and rank senior to our common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company. In addition, the Securities Purchase Agreement provides for certain restrictions on dividend payments and stock repurchases by the Company. The Treasury may unilaterally amend the Securities Purchase Agreement and all related documents to the extent required to comply with any changes in applicable federal statutes after the execution thereof. For additional description of the restrictions on the Company associated with its participation in the Capital Purchase Program, see Item 1A, “Risk Factors,” elsewhere in this report.
Consistent with our strategic plan, and following approval from the Treasury and other applicable regulatory authorities, on March 16, 2011 we paid approximately $2.617 million to redeem 2,606 Series A Preferred Shares, representing approximately 25% of all issued and outstanding Preferred Shares.
Small Business Lending Fund
The Small Business Jobs Act of 2010 was signed into law on September 27, 2010. The Act establishes a $30 billion Small Business Lending Fund (“SBLF”), designed to provide small banks, like the Bank, with capital to increase the availability of credit for small businesses. Qualifying banks that are currently participating in the TARP Capital Purchase Program will have the opportunity to “refinance” their TARP investment with an investment under the SBLF program, by exchanging their existing TARP preferred stock for new SBLF program preferred stock. The dividend rate payable on SBLF investments could be reduced to as low as 1% from an initial dividend rate of 5%, to the extent participating institutions achieve certain levels of additional small business lending.
We have submitted an application to the United States Treasury to participate in this new SBLF program. If our application is accepted, the Board of Directors will make a final decision about participation in the SBLF program. If we do in fact consummate an SBLF transaction, all of our TARP preferred stock would be exchanged for SBLF preferred stock (or otherwise redeemed by the Company) and we would no longer be subject to the provisions of the ARRA or EESA described above; instead, we would be subject only to regulatory requirements under the SBLF program, which may be more or less restrictive than the TARP requirements. However, at this time we cannot predict whether we will be accepted to participate (or if we will participate, if accepted) in the SBLF program or what impact (if any) participation in the SBLF would have on our business or operations.
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Supervision and Regulation
Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly describes certain significant provisions of applicable federal and state laws and applicable regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future and impact the operations of the Company and the Bank.
Dodd-Frank Act
Generally, the regulatory capital framework under which the Company and the Bank operate is in a period of change with likely legislation or regulation that will continue to modify the current standards and perhaps increase capital requirements for the entire banking industry. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010 (the “Dodd-Frank Act”), has already resulted, and will continue to result, in sweeping changes in the regulation of financial institutions designed to strengthen the operation of the financial services sector. Many of the Dodd-Frank Act’s provisions generally apply to and/or are or more likely to affect larger institutions. However, the Dodd-Frank Act contains numerous other provisions that will affect all banks and bank holding companies, including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased regulatory examination fees; and (iii) numerous other provisions designed to improve supervision and oversight of, and strengthening soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. Many of the requirements called for in the Dodd-Frank Act will be implemented over time and most will be subject to implementing regulations over the course of several years. Given uncertainty associated with the manner in which certain provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and/or leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements. In light of the relatively early stages of this new legislation, however, it is difficult to anticipate its overall financial impact on the Company, the Bank, our customers or the financial industry in general.
The Company
Bank Holding Company Act. The Company is registered with the Federal Reserve Bank (“Federal Reserve”) as a financial holding company under the Bank Holding Company Act of 1956 (the “BHCA”), as amended by the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”), and is subject to ongoing regulation, supervision and examination by the Federal Reserve. The Company is required to file with the Federal Reserve periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. The Federal Reserve also supervises the Company’s operations and major transactions affecting its capital structure, including mergers, acquisitions and share redemptions.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, a bank holding company and any subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit to its customers. Among other limitations, a subsidiary bank may not extend credit, lease or sell property or furnish any services, or fix or vary the consideration for any of the foregoing, on the condition that: (i) the customer obtain or provide some additional credit, property or services from or to such bank, other than a loan, discount, deposit or trust service; (ii) the customer obtain or provide some additional credit, property or service from or to company or any other subsidiary of the company; or (iii) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to ensure the soundness of credit extended.
Certain other provisions of the BHCA are described below under “Change of Control”.
Capital Adequacy. The Federal Reserve has promulgated capital adequacy regulations for all bank holding companies with assets in excess of $150 million. The Federal Reserve’s capital adequacy regulations are based upon a risk-based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on- and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.
The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in
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consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.
Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio (Tier 1 capital to risk-weighted assets) of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies, and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner.
The Federal Reserve guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets.
Consistent with the general changing regulatory environment described above, under the Dodd-Frank Act, bank regulators are required to establish new minimum leverage and risk-based capital requirements for certain bank holding companies (and systematically important non-bank financial companies). The new minimum thresholds will not be lower than existing regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher once established.
Source of Strength for Subsidiary. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength for its subsidiaries and to commit resources to support them. More specifically, pursuant to the Dodd-Frank Act, the federal banking regulators are required to issue, within two years of enactment, rules that require a bank holding company to serve as a source of financial strength for any depository institution subsidiary such as the Bank. In addition, any capital loans made by the Company to its subsidiaries may be repaid only after the applicable subsidiary’s deposits and various other obligations are repaid in full and, in the unlikely event of the Company’s bankruptcy, any commitment by it to a federal bank regulatory agency to maintain the capital of the Bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, the Company’s ability to pay cash dividends to its shareholders depends upon the cash dividends it receives from the Bank. The Company must first pay operating expenses from funds it receives from the Bank; therefore, shareholders may receive cash dividends from the Company only to the extent that funds are available after payment of operating expenses. In addition, the Federal Reserve generally prohibits bank holding companies from paying cash dividends except out of operating earnings and permits dividends only if the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. As a Virginia corporation, the Company’s payment of cash dividends is also subject to the restrictions under Virginia law on the declaration of cash dividends. Under such provisions, a corporation is prohibited from paying any cash dividends if after paying such cash dividend the corporation would not be able to pay its debts as they become due in the usual course of business or the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy certain preferential liquidation rights. Furthermore, as a result of our participation in the TARP Capital Purchase Program, (i) we may not pay dividends on our common stock unless we have paid (and continue to pay) in full all dividends owed on the Preferred Shares issued to the Treasury under the Capital Purchase Program, and (ii) we may not increase the quarterly dividends we pay on our common stock (currently $0.06 per share) without the Treasury’s prior consent. (See “The Bank - Dividends” below for discussion regarding regulatory considerations for dividends payable by the Bank.)
Change of Control. State and federal banking law restricts the amount of voting stock of a bank that a person may acquire without the prior approval of banking regulators. The BHCA requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank or acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire the Company by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, the Company’s shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies.
In addition, under certain amendments to the Virginia Financial Institutions Holding Company Act that became effective July 1, 1983, no corporation, partnership or other business entity may acquire, or make any public offer to acquire, more than 5% of the stock of any Virginia financial institution, or any Virginia financial institution holding company, unless it first files an application
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with the Virginia State Corporation Commission (the “SCC”). The SCC is directed by the statute to solicit the views of the affected financial institution, or financial institution holding company, with respect to such stock acquisition and is also empowered to conduct an investigation during the 60 days following receipt of such an application. If the SCC takes no action within the prescribed period, or if during the prescribed period it issues notice of its intent not to disapprove an application, the acquisition may be completed.
Corporate Governance. The Dodd-Frank Act will enhance corporate governance requirements to include, perhaps among other things, (i) requiring publicly traded companies (not just financial institutions) to give shareholders a non-binding vote on executive compensation on a periodic basis (and at least every three years) and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders; (ii) authorizing the Securities and Exchange Commission (the “SEC”) to promulgate rules that would allow shareholders to nominate their own candidates for election as directors using a company’s proxy materials (so called “proxy access” rules, which have been temporarily stayed pending further review by applicable regulatory agencies); (iii) directing federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether or not the company is publicly traded; and (iv) authorizing the SEC to prohibit broker discretionary voting on the election of directors and on executive compensation matters. Some of these provisions will not apply to the Company. Others, in particular the “say-on-pay” for executive compensation and “golden parachute” payments, provide a temporary exemption for smaller reporting companies like the Company, which will not have to comply with the requirements for two years; however, as discussed elsewhere in this report, as a participant in the TARP Capital Purchase Program the Company is currently subject to “say-on-pay” voting requirements and numerous restrictions on the compensation payable to certain of its executives. We expect the remaining provisions, including the changes in broker discretionary voting and, when and if implemented, the proxy access rules to apply to the Company.
Legislation
Sarbanes-Oxley Act. The Sarbanes-Oxley Act (“SOX”) was enacted on July 30, 2002. SOX is not a banking law, but applies to all public companies, including the Company. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. Given the extensive role of the SEC in implementing and interpreting the rules relating to many of SOX’s requirements, and the continuing evolution of SOX’s requirements, the impact on the Company of these requirements has changed and may continue to change for some time. SOX includes additional disclosure requirements and corporate governance rules for public companies and other related rules adopted by the SEC for public companies, increases criminal penalties for violations of the securities laws, and mandates further studies of specified issues by the SEC and other federal government agencies. SOX also provides for the federal regulation of accounting firms that provide services to public companies and mandates additional listing standards for the securities exchanges. Not all of the rules that the SEC has adopted implementing the provisions of SOX presently apply to the Company because certain of the rules have delayed effective dates and/or do not apply to companies, like us, whose securities are quoted solely on over-the counter securities markets. The SEC has also extended the effective dates of certain rules after their adoption.
Bank Secrecy Act; USA PATRIOT Act. Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report to the United States Treasury cash transactions involving more than $10,000. In addition, financial institutions are required to file suspicious activity reports for any transaction that involves more than $5,000 and which the financial institution knows, suspects or otherwise has reason to suspect involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001 (the “Patriot Act”), enacted in response to the September 11, 2001 terrorist attacks, strengthens the anti-money laundering provisions of the BSA. Many of the provisions added by the Patriot Act apply to accounts at or held by foreign banks, or accounts of or transactions with foreign entities, and thus do not apply to the Bank because it does not have significant foreign business. However, the Patriot Act does require federal banking regulators to consider a bank’s record of compliance under the BSA in acting on any application filed with such federal regulators. The Bank’s record of compliance with the BSA will be an additional factor in any applications filed with federal regulators in the future.
United States Treasury Department Oversight (TARP and SBLF). In October 2008, the United States Department of the Treasury, the Federal Reserve Board and the Federal Deposit Insurance Corporation jointly announced additional programs pursuant to the EESA to address instability in the financial markets. Subsequently, on February 17, 2009, the ARRA was enacted and modified many previously established provisions of the EESA. As described in greater detail above under “Business - Participation in TARP Capital Purchase Program”, we applied under the TARP Capital Purchase Program established pursuant to the EESA (and modified by the ARRA) for additional capital in the form of preferred stock, and we were approved for and on September 25, 2009 received $10.103 million in additional capital. Until we repay the investment by the Treasury under the Capital Purchase Program, we will be subject to all applicable provisions of the EESA and ARRA, and the regulations promulgated thereunder, which include, among other things, certain restrictions on capital repurchases, cash dividends and executive compensation.
For instance, under the Securities Purchase Agreement entered into in connection with the Capital Purchase Program, for a period of three years following the closing date, unless we have redeemed the Preferred Shares or the Treasury has transferred the Preferred Shares to a third party, our ability to declare or pay any dividend or make any distribution on our capital stock or other
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equity securities of any kind will be subject to restrictions, including a restriction against (i) increasing the quarterly cash dividend per share to an amount larger than the last quarterly cash dividend paid on our common stock prior to November 17, 2008 ($0.06 per share), or (ii) redeeming, purchasing or acquiring any shares of our common stock or other equity or capital securities, other than in connection with benefit plans consistent with past practice and certain circumstances specified in the Securities Purchase Agreement. If the Treasury still holds the Preferred Shares ten years after the closing date, we may not thereafter pay any dividend or repurchase any equity securities without the consent of the Treasury unless and until the Preferred Shares are transferred by the Treasury or redeemed by the Company. In addition, the Series B Preferred Shares may not be redeemed unless all the Series A Preferred Shares have been redeemed. Finally, our ability to declare or pay dividends and/or repurchase our common stock or other equity or capital securities is subject to restrictions in the event we fail to declare and pay or set aside for payment full dividends on all of the Preferred Shares.
In addition, we also are subject to the executive compensation limitations contained in the EESA and ARRA, which apply to certain of our senior and highly compensated officers and apply so long as we hold TARP funds. Currently the limitations include: (i) a prohibition on accruing or paying any bonus, retention award or incentive compensation to our most highly-compensated officer (currently our Chief Executive Officer); (ii) a prohibition on making “golden parachute payments” (as defined under the ARRA) to certain senior and highly-compensated officers; (iii) a prohibition on the payment of any “tax gross-up” to certain senior and highly-compensated officers; (iv) the recovery of any bonus or incentive compensation paid to certain senior and highly-compensated officers if the financial criteria on which such bonus or incentive compensation was based is later proven to be materially inaccurate; and (v) a prohibition on compensation that encourages employees to take unnecessary and excessive risks that could threaten the value of the Company. The Company’s Compensation Committee must also certify that it has reviewed with the Company’s senior risk officers at least every six months: (a) the Company’s compensation plans for senior executive officers to ensure that the plans do not encourage unnecessary and excessive risks that may threaten the value of the Company; and (b) all employee compensation plans “in light of the risks posed to the Company.” The ARRA also authorizes the Treasury Secretary to review bonus, retention and other compensation paid to senior executive officers that have received TARP assistance to determine if the compensation was inconsistent with the purposes of the ARRA or TARP, or otherwise contrary to the public interest and, if so, seek reimbursements.
These restrictions and limitations generally will apply to the Company until we have redeemed the Preferred Shares we sold to the Treasury under the Capital Purchase Program. Under the ARRA, such redemption is permitted without penalty and without the need to raise new capital (as was required under the terms of the original Program), subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency. Consistent with our strategic plan, and following approval from the Treasury and other applicable regulatory authorities, on March 16, 2011 we paid approximately $2.617 million to redeem 2,606 Series A Preferred Shares, representing approximately 25% of all issued and outstanding Preferred Shares.
The Small Business Jobs Act of 2010 was signed into law on September 27, 2010. The Act establishes a $30 billion SBLF, designed to provide small banks, like the Bank, with capital to increase the availability of credit for small businesses. Qualifying banks that are currently participating in the TARP Capital Purchase Program will have the opportunity to “refinance” their TARP investment with an investment under the SBLF program, by exchanging their existing TARP preferred stock for new SBLF program preferred stock. The dividend rate payable on SBLF investments could be reduced to as low as 1% from an initial dividend rate of 5%, to the extent participating institutions achieve certain levels of additional small business lending.
We have submitted an application to the United States Treasury to participate in this new SBLF program. If our application is accepted, the Board of Directors will make a final decision about participation in the SBLF program. If we do in fact consummate an SBLF transaction, all of our TARP preferred stock would be exchanged for SBLF preferred stock (or otherwise redeemed by the Company) and we would no longer be subject to the provisions of the ARRA or EESA described above; instead, we would be subject only to regulatory requirements under the SBLF program, which may be more or less restrictive than the TARP requirements. However, at this time we cannot predict whether we will be accepted to participate (or if we will participate, if accepted) in the SBLF program, or what impact (if any) participation in the SBLF would have on our business or operations.
The Consumer Financial Protection Bureau. The Dodd-Frank Act creates the Consumer Financial Protection Bureau (the “CFP Bureau”) within the Federal Reserve Board. The CFP Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The CFP Bureau has rulemaking authority over many of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the CFP Bureau and state attorneys general are permitted to enforce consumer protection rules adopted by the CFP Bureau against state-chartered institutions.
The Bank
General. The Bank operates as a state bank subject to supervision and regulation by the Bureau of Financial Institutions of the SCC. The Bureau of Financial Institutions regulates all areas of a Virginia state bank’s commercial banking operations, including reserves, loans, mergers, payment of dividends, establishment of branches and other aspects of operations.
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Transactions with Affiliates; Loans to Insiders. Federal laws strictly limit the ability of banks to engage in transactions with their affiliates, including their bank holding companies. Regulations promulgated by the Federal Reserve Board limit the types and amounts of these transactions that may take place and generally require those transactions to be on an arm’s-length basis. In general, these regulations require that any “covered transactions” between a subsidiary bank and its parent company (or the non-bank subsidiaries of the bank holding company) be limited to 10% of a bank subsidiary’s capital and surplus and, with respect to such parent company (and all such nonbank subsidiaries), to an aggregate of 20% of the bank subsidiary’s capital and surplus. Further, loans and extensions of credit generally are required to be secured by eligible collateral in specified amounts. The Dodd-Frank Act significantly expands the coverage and scope of the limitations on affiliate transactions within a banking organization. For example, commencing in July 2011, the Dodd-Frank Act will require that the 10% of capital limit on these transactions begin to apply to financial subsidiaries as well. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve Board) from the affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Federal law also limits a bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the bank’s capital. Banks are also subject to prohibitions on certain tying arrangements by which a depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
Regulation of Lending Activities. Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, the Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies are available to the borrower or consumer and the Bank is subject to penalties if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.
Privacy Standards. The Bank is subject to the FDIC’s regulations implementing the privacy protection provisions of the GLB Act. These regulations require the Bank to disclose its privacy policy, including identifying with whom it shares “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. The regulations also require the Bank to provide its customers with initial and annual notices that accurately reflect its privacy policies and practices. In addition, the Bank is required to provide its customers with the ability to “opt-out” of having the Bank share their non-public personal information with unaffiliated third parties before they can disclose such information, subject to certain exceptions. The Bank is subject to regulatory guidelines establishing standards for safeguarding customer information. These regulations implement certain provisions of the GLB Act. The guidelines describe the agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer.
Branch Banking. All banks located in Virginia are authorized to branch statewide. Accordingly, a bank located anywhere in Virginia has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within the Bank’s market area. Applicable Virginia statutes permit regulatory authorities to approve de novo branching in Virginia by institutions located in states that would permit Virginia institutions to branch on a de novo basis into those states. Prior to the enactment of the Dodd-Frank Act, national and state-chartered banks were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch.
Reserve Requirements. Pursuant to regulations of the Federal Reserve, the Bank must maintain average daily reserves against its transaction accounts. During 2010, no reserves were required to be maintained on the first $10.7 million of net transaction accounts, but reserves equal to 3.0% were required on the aggregate balances of those accounts between $10.7 million and $55.2 million, and additional reserves were required on aggregate balances in excess of $55.2 million in an amount equal to 10.0% of the excess. These percentages are subject to annual adjustment by the Federal Reserve, which has advised that for 2011, no reserves will be required to be maintained on the first $10.7 million of net transaction accounts, but reserves equal to 3.0% will be required on the aggregate balances of those accounts between $10.7 million and $58.8 million, and additional reserves are required on aggregate balances in excess of $58.8 million in an amount equal to 10.0% of the excess. Required reserves must be maintained in the form of vault cash or in an interest-bearing account at a Federal Reserve Bank. As of December 31, 2010, the Bank met its reserve requirements.
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Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA does however require the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The Bank’s current CRA performance rating is “satisfactory.”
Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. The monetary policies available to the Federal Reserve include, among other things, changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve have had a significant impact on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, we cannot make any prediction as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.
Dividends. All dividends paid by the Bank are paid to the Company, the sole shareholder of the Bank. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon such factors as future earnings, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions. The ability of the Bank to pay dividends is also restricted under applicable law and regulations. Under Virginia banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if the Bank’s surplus is less than 50% of its paid-in capital. In addition, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC.
Capital Adequacy. The capital adequacy regulations that apply to state banks, such as the Bank, are similar to the Federal Reserve requirements promulgated with respect to bank holding companies discussed above.
Enforcement Authority. The federal banking laws contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties,” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse effect on the institution, in each case who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate. The Bank is current in all required filings with the Federal Reserve.
Prompt Corrective Action. Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital:
| • | A bank is considered “well-capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of 6% or more and a leverage ratio of 5% or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. |
| • | A bank is considered “adequately capitalized” if it has a total risk-based capital ratio of 8% or more, a core capital ratio of 4% or more and a leverage ratio of 4% or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of 3% or more). |
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| • | A bank is considered “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a core capital ratio of less than 4% or a leverage ratio of less than 3%. |
| • | A bank is considered “significantly undercapitalized” if it has a risk-based capital ratio of less than 6%, a core capital ratio of less than 3% and a leverage ratio of less than 3%. |
| • | A bank is considered “critically undercapitalized” if it has a leverage ratio of less than or equal to 2%. |
| • | In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (though not to “critically undercapitalized”) based on other considerations even if the bank meets the otherwise applicable capital guidelines. |
If a state member bank, such as the Bank, is classified as “undercapitalized,” the bank is required to submit a capital restoration plan to the Federal Reserve. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the Federal Reserve of a capital restoration plan for that bank. The Federal Reserve may also take other actions to correct the capital position of a state member bank that is classified as “undercapitalized”.
If a state member bank is classified as “significantly undercapitalized,” the Federal Reserve is required to take one or more prompt corrective actions. These actions include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers.
If a bank is classified as “critically undercapitalized,” the bank must be placed into conservatorship or receivership within 90 days, unless the FDIC determines otherwise.
The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities; capital classification also affects the deposit insurance assessments paid by the bank. Furthermore, banks may be restricted in their ability to accept brokered deposits depending on their capital classification. “Well-capitalized” banks are permitted to accept brokered deposits, but banks that are not well-capitalized may not accept such deposits. (The Federal Reserve may, on a case-by-case basis, permit member banks that are “adequately capitalized” to accept brokered deposits if the Federal Reserve determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank.) At December 31, 2010, the Bank was classified as “well-capitalized.”
FDIC Insurance Assessments. The FDIC insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures our customer deposits through the Deposit Insurance Fund (the “DIF”) up to prescribed limits for each depositor. Under the Dodd-Frank Act, (i) the maximum deposit insurance amount has been permanently increased from $100,000 to $250,000 per depositor, and (ii) certain non-interest bearing deposit accounts are accorded unlimited insurance until December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors.
All FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. The FICO assessment rates, which are determined quarterly, averaged 1.05% of insured deposits in fiscal 2010. These assessments will continue until the FICO bonds mature in 2017.
On November 17, 2009, the FDIC imposed a prepayment requirement on most insured depository organizations, requiring that the organizations prepay estimated quarterly risk-based assessments for the fourth quarter of 2009 and for each calendar quarter for calendar years 2010, 2011 and 2012. The prepaid assessments were based on the institutions’ estimated deposit levels over the period. The amount of our prepaid assessment, which as noted covers the fourth quarter of 2009 through the end of 2012, was approximately $1.1 million and was paid in December 2009. Subsequent to December 31, 2009, we have and will continue to expense our regular FDIC assessment and record an offsetting credit to the prepaid assessment asset until the asset is exhausted. If the prepaid assessment is not exhausted by June 30, 2013, any remaining amount will be returned to the Bank. The FDIC has stated that the prepayment requirement was imposed in response to a negative balance in the DIF, and has further indicated that prepayment of DIF assessments was in lieu of additional special assessments; however, there can be no guarantee that continued pressures on the DIF will not result in additional special assessments being imposed in the future.
Under the Dodd-Frank Act, the FDIC is also required to change its method of assessment of insurance premiums to an assessment based on the average total consolidated assets of the insured depository institution less the institutions average tangible equity for the assessment period. Currently, we anticipate that the future change in the assessment base will decrease the deposit insurance premium from the amounts paid under the current assessment method based on total deposits.
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The FDIC is also required to set its designated reserve ratio for each year at 1.35% of estimated insured deposits and take actions necessary to reach a reserve ratio of 1.35% of total estimated insured deposits by September 30, 2020. The FDIC may be required to increase deposit insurance premium assessments to meet the reserve ratio requirements. However, under the Dodd-Frank Act, the effects of any increases in deposit insurance premium assessments are to be offset for the benefit of depository institutions, like the Bank, with total consolidated assets of less than $10 billion.
The FDIC has the authority to further increase insurance assessments. In addition, insurance of deposits may be terminated by the FDIC upon a finding that an insured institution has engaged in unsafe or unsound practices, is in unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Available Information
We maintain an Internet website at www.heritagebankva.com. Among other Company-related information, this website contains a link to our current and prior-period filings with the SEC on Form 10-K, Form 10-Q, and Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The reports are made available on our website as soon as practicable following the filing of the reports with the SEC. Copies of the Company’s Code of Conduct and Excessive and Luxury Expenditures Policy, required under TARP, are also included on the Company’s website and are therefore available to the public. The foregoing information is free of charge and may be reviewed, downloaded and printed from our website at any time. You may also read and copy any material we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the SEC’s Public Reference Room by calling the SEC at (202) 942-8090. Copies of these materials may be obtained at prescribed rates from the SEC at such address. These materials can also be inspected on the SEC’s web site at www.sec.gov.
| ITEM 1A. | RISK FACTORS |
Our business, operations and financial condition are subject to various risks. In addition to the other information contained in this Form 10-K, before making an investment in our common stock, you should carefully consider the risks, uncertainties and other factors described below because they could materially and adversely affect our business, financial condition, operating results, cash flow and prospects and/or the market price of our common stock. This section does not describe all risks that may be applicable to us, our business or our industry, and the information is included solely as a summary of certain material risk factors.
| • | U.S. credit markets and economic conditions could adversely affect our liquidity, financial condition and profitability. U.S. and local market and economic conditions continue to be disruptive and volatile and the disruption has particularly had a negative impact on the financial sector. The possible duration and severity of this adverse economic cycle is unknown. Although we remain well capitalized and have not suffered any liquidity issues as a result of these recent events, the cost and availability of funds may be adversely affected by illiquid credit markets. Continued turbulence in U.S. and local markets and economies could also adversely affect our financial condition and profitability. Furthermore, as a result of the disruptions in the financial markets, significant new federal laws and regulations relating to financial institutions, including the EESA and TARP, have been adopted, and the potential exists for additional federal or state laws and regulations regarding, among other matters, lending and funding practices and liquidity standards. While we believe we are well-positioned to respond to additional regulatory requirements, any such new legislation could negatively impact our operations by restricting our business operations, including our ability to originate loans, and adversely impact our financial performance. |
| • | Our need to comply with extensive and complex government regulation could have an adverse effect on our business. The banking industry is subject to extensive regulation by state and federal authorities to protect depositors, the public and/or the insurance funds maintained by the FDIC. In particular, the Dodd-Frank Act, enacted in July 2010 (and described above under Item 1, “Business-Supervision and Regulation”), implemented major changes to the regulatory regimes for banks and other financial institutions, which have resulted in some immediate effects on the Company and the Bank and will likely continue to impact us for the foreseeable future. Banking regulations affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our business. These requirements may constrain our rate of growth, and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks, including the Bank, at a competitive disadvantage compared to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to operate profitably. (See Item 1, “Business – Supervision and Regulation” above, for more information about applicable banking laws and regulations.) Further, because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future nor the impact those changes may have on our operations. We fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws and regulations will be adopted further regulating specific banking practices. |
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| • | We rely heavily on our management team and on our ability to attract and retain key personnel. We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in large part by the relationships maintained with our customers by our Chief Executive Officer and our other executive and senior lending officers. We also rely heavily on our management team to maintain and evolve our internal controls, accounting and reporting systems. We have entered into employment agreements with our Chief Executive Officer, Chief Financial Officer and certain other key executives. The existence of such agreements, however, does not necessarily ensure that we will be able to continue to retain their services; in particular, these agreements were all amended in connection with our participation in the TARP Capital Purchase Program, which resulted in certain restrictions on and adverse changes in the compensation payable (and/or that would in certain circumstances become payable) to these employees for so long as we continue as a participant in the TARP Capital Purchase Program. These restrictions, in turn, could jeopardize the Company’s relationships with the employees and make it more difficult to attract suitable candidates to serve as executive officers. The loss of our Chief Executive Officer, Chief Financial Officer or other key employees for any reason could have a material adverse effect on our business and possibly result in reduced revenues and earnings. |
| • | We depend on the profitability of the Bank. We are a single bank holding company and our business is owning all of the outstanding stock of the Bank. As a result, our operating results and financial position depend on the operating results and financial position of the Bank. Many factors could adversely affect our short- and long-term operating performance, including those described below. |
| • | We may incur losses if we are unable to successfully manage interest rate risk. Our profitability will depend in substantial part upon the spread between the interest rates we earn on loans and investments and the interest rates we pay on deposits and other interest-bearing liabilities. We occasionally engage in marketing and promotions that offer above-market rates to attract deposits; however, we have not in the past and currently do not expect to solicit or accept brokered deposits. Changes in interest rates will affect our operating performance and financial condition in diverse ways, including the pricing of loans and deposits, the volume of loan originations in our mortgage banking business and the value we can recognize on the sale of mortgage loans in the secondary market. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. |
| • | We may be adversely affected by economic conditions in our market area. We are headquartered in Norfolk, Virginia, and our market includes the Hampton Roads metropolitan area. Because our lending is concentrated in this market, we will be affected by the general economic conditions in the Hampton Roads and neighboring areas. Changes in the economy may influence the growth rate of our loans and deposits and the quality of our loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, continued or worsening recession, unemployment or other factors beyond our control would impact local economic conditions and the demand for banking products and services generally, which could negatively affect our financial condition and performance. |
| • | Our loans secured by real estate may increase our credit losses, which would adversely affect our financial results. We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. Continued or worsening decline in the real estate market could adversely affect the value of our collateral for real estate loans and our customers’ ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, however, and as a result loan losses may occur in the future. |
| • | 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 our 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 customers 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 rates, that may be beyond our control, and these losses may exceed our current estimates. Although as noted we believe our allowance for loan losses represents a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or guarantee 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 than those of our management. Any increase in the amount of our loan loss provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results. |
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| • | We may suffer losses in the Bank’s loan portfolio despite our underwriting practices; we could be adversely impacted by declines in credit quality. We seek to mitigate the risks inherent in our loan portfolio by adhering to specific underwriting practices. These practices include analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers, and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for our loans, we may incur losses on loans that meet these criteria. Furthermore, we could be adversely affected in spite of sound underwriting practices if borrowers, guarantors or related parties fail to perform in accordance with the terms of their loans or if we fail to detect or respond to deterioration in asset quality in a timely manner; moreover, problems with credit quality or asset quality could cause our interest income and net interest margin to decrease and our provisions for loan losses to increase, which could adversely affect our business, financial condition and results of operations. These risks have been exacerbated by the recent developments in financial markets, and we are unable to accurately predict what effect these uncertain market conditions will continue to have on these risks. |
| • | Our future success is dependent on our ability to compete effectively in the highly competitive banking industry. We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions, for deposits, loans and other financial services in our market area. Most of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. We also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations, which may be able to offer financing on more favorable terms than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us; as a result, these non-bank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition. |
| • | The costs of being a public bank holding company are proportionately higher for small companies like us. The U.S. PATRIOT Act, the BSA, SOX, the EESA, the ARRA and related regulations of the Securities and Exchange Commission have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. As a result, we have experienced and may continue to incur increased compliance costs, including costs related to implementing, maintaining and periodically assessing and evaluating our compliance with all applicable regulations. These necessary compliance costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors. |
| • | Our ability to operate profitably may be affected by our ability to implement technologies into our operations. The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our market may be affected by the extent to which we are able to utilize technological changes. If we are not able to implement new technologies at a cost that is reasonable and appropriate for a bank of our size, properly or timely anticipate such new technologies, or properly train our staff to use them, our business, financial condition or operating results could be adversely affected. |
| • | There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them. The trading in the shares of our common stock has historically been limited. Our common stock is quoted on both the OTC Bulletin Board (“OTCBB”) and the Pink Sheets over-the-counter markets. Trading on the OTCBB and Pink Sheets is more limited than on the national exchanges such as the New York Stock Exchange or NASDAQ, so there is, and likely will continue to be, a limited trading market for our stock. Even if a more active market for our stock develops, there can be no assurance that it will continue or that you will be able to sell your shares at the desired price. |
| • | Our participation in the TARP Capital Purchase Program may adversely affect the value of our common stock and the rights of our common stockholders. The rights of the holders of the Company’s common stock may be adversely affected by the Company’s participation in the Program. For example: |
| • | Prior to the earlier of September 25, 2012 and the date on which all of the Preferred Shares have been redeemed by the Company or transferred by Treasury to third parties, we may not, without the consent of Treasury (subject to limited exceptions), redeem, repurchase or otherwise acquire shares of our common stock. |
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| • | We may not pay dividends on our common stock unless we have fully paid all required dividends on the Preferred Shares. Although we fully expect to be able to pay all required dividends on the Preferred Shares, there is no guarantee that we will be able to do so. |
| • | As long as the Treasury owns the securities purchased from the Company under the Capital Purchase Program, we may not, without the prior consent of the Treasury, increase the quarterly dividends we pay on our common stock above $0.06 per share. |
| • | The Preferred Shares will receive preferential treatment in the event of liquidation, dissolution, or winding up of the Company. |
| • | In addition, terms of the Preferred Shares require that quarterly dividends be paid on the Series A Preferred Shares at the rate of 5% per annum for the first five years and 9% per annum thereafter until the stock is redeemed by the Company (dividends on the Series B Preferred Shares are payable at the rate of 9% per annum until they are redeemed). The payments of these dividends will decrease the excess cash we otherwise have available to pay dividends on our common stock and to use for general corporate purposes, including working capital. |
If the Company consummates a transaction under the SBLF program described above, some of the limitations described above may be eliminated; on the other hand, as part of the SBLF program, certain other restrictions may remain in effect and/or be replaced by other similar or more stringent terms.
| ITEM 1B. | UNRESOLVED STAFF COMMENTS |
Not applicable.
| ITEM 2. | PROPERTIES |
At December 31, 2010, the Bank operated from seven locations:
| Office Location |
Type of Facility |
Owned/ Leased |
Approximate Square Footage | |||
| 150 Granby Street, Suite 175, Norfolk, Virginia | Retail Banking Office | Leased | 3,739 sq. ft | |||
| 150 Granby Street, Suite 150, Norfolk, Virginia | Corporate Headquarters (Executive, Commercial Loans and Loan Administration) | Leased | 8,403 sq. ft. | |||
| 841 North Military Highway, Norfolk, Virginia | Retail Banking Office and Deposit Operations | Owned | 6,250 sq. ft. | |||
| 815 Colley Avenue, Norfolk, Virginia | Retail Banking Office | Owned | 3,000 sq. ft. | |||
| 735 East Ocean View Avenue, Norfolk, Virginia | Retail Banking Office | Owned | 3,000 sq. ft. | |||
| 601 Lynnhaven Parkway, Virginia Beach, Virginia | Retail Banking Office | Owned | 3,165 sq. ft. | |||
| 1756 Laskin Road, Virginia Beach, Virginia | Retail Banking Office and Commercial Loans | Owned | 5,640 sq. ft. | |||
We believe that all of our properties are adequately covered by insurance, are in good operating condition (ordinary wear and tear excepted) and are adequate and suitable for the ordinary and regular conduct of our business.
| ITEM 3. | LEGAL PROCEEDINGS |
There are no legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is the subject, other than ordinary routine litigation incidental to the business of the Company and its subsidiaries.
| ITEM 4. | (REMOVED AND RESERVED) |
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PART II
| ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
Market Information
The Company’s common stock is currently quoted on the OTC Bulletin Board and Pink Sheets over-the-counter markets under the symbol “HBKS.” The following table sets forth the high and low closing sales price for our common stock, as reported by the OTC Bulletin Board, by calendar quarter for 2010 and 2009. These quotations represent inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
| HIGH | LOW | |||||||
| 2010 |
||||||||
| Fourth Quarter |
$ | 13.00 | $ | 11.51 | ||||
| Third Quarter |
12.50 | 11.30 | ||||||
| Second Quarter |
12.50 | 9.90 | ||||||
| First Quarter |
11.50 | 9.50 | ||||||
| 2009 |
||||||||
| Fourth Quarter |
$ | 10.25 | $ | 9.50 | ||||
| Third Quarter |
10.25 | 9.50 | ||||||
| Second Quarter |
11.00 | 8.00 | ||||||
| First Quarter |
9.95 | 8.00 | ||||||
Holders
At December 31, 2010, there were approximately 877 holders of record of the 2,307,502 outstanding shares of the Company’s common stock.
Dividends
The Company has historically paid cash dividends on a quarterly basis, though the final determination regarding whether to declare and pay dividends on our common stock, and the amount of such dividends, is made at the sole discretion of the Company’s Board of Directors. Determinations by the Board of Directors with respect to dividend payments take into account the financial condition, results of operations and capital requirements of the Company and its subsidiaries, principally the Bank, as well as other relevant factors including applicable law and general business conditions, and depending on such factors the Company’s dividend policy may change from time to time at the discretion of the Board of Directors. Our ability to declare and pay dividends on our common stock is also affected by regulatory restrictions on the payment of dividends by both the Bank to the Company and the Company to its stockholders, as discussed above in Item 1, “Business - Supervision and Regulation”, including restrictions resulting from the Company’s participation in the TARP Capital Purchase Program. The Company declared and paid cash dividends of $0.24 per common share, in aggregate ($0.06 per common share in quarterly dividends), in each of 2010 and 2009.
Recent Sales of Unregistered Securities
No securities were sold by the Company within the past three years that were not registered under the Securities Act that were not previously reported in a Quarterly Report on Form 10-Q or in a Current Report on Form 8-K.
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Equity Compensation Plan Information
The Company makes grants of options to purchase common stock of the Company pursuant to its stock option plans. Information regarding the Company’s outstanding equity compensation plans as of December 31, 2010 is set forth in the following table:
| Plan Category |
Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a) |
Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights (b) |
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) (c) |
|||||||||
| Equity Compensation Plans Approved by Security Holders (1) |
241,400 | $ | 12.62 | 43,600 | ||||||||
| Equity Compensation Plans Not Approved by Security Holders |
— | — | — | |||||||||
| Total |
241,400 | $ | 12.62 | 43,600 | ||||||||
| (1) | The Heritage 2006 Equity Incentive Plan previously approved by our shareholders, as amended and restated by our Board of Directors effective January 28, 2009 (“2006 Incentive Plan”), authorizes the grant of stock options, stock appreciation rights, restricted stock and certain other equity awards with respect to not more than 250,000 shares of the Company’s common stock. The Company’s ability to issue new awards under its pre-existing 1987 Stock Option Plan and 1999 Stock Option Plan was terminated concurrently with approval of the 2006 Incentive Plan. |
Repurchases of Equity Securities by Issuer and Affiliated Purchasers
The Company did not repurchase any shares of its common stock during the fourth quarter of its fiscal year ending December 31, 2010.
| ITEM 6. | SELECTED FINANCIAL DATA |
The Company is a smaller reporting company and thus is not required to provide the information required by this Item 6.
| ITEM 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Management’s discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. The discussion and analysis should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this annual report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.
Overview
The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of individuals and small to medium sized businesses in its primary service area. The principal business of the Company is to attract deposits and to lend or invest those deposits on profitable terms. These deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts, certificates of deposit and IRA accounts.
The Company actively extends both personal and commercial credit and is involved in the construction and real estate lending market. Loans consist of varying terms and can be secured or unsecured. Loans to individuals are for personal, household and family purposes. Loans to businesses are for such purposes as working capital, financing of facilities and equipment purchases.
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Critical Accounting Policies
The preparation of our consolidated financial statements and accompanying notes are governed by accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to use judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. While we believe our judgments, estimates and assumptions are reasonable under the circumstances, actual results may differ materially under different conditions or using different assumptions.
We believe our critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.
The Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (the “Codification” or “ASC”). In June 2009, the FASB issued an accounting standard which established the Codification to become the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, with the exception of guidance issued by the U.S. Securities and Exchange Commission and its staff. All guidance contained in the Codification carries an equal level of authority. The Codification is not intended to change GAAP, but rather is expected to simplify accounting research by reorganizing current GAAP into approximately 90 accounting topics. We adopted this accounting standard in preparing our consolidated financial statements for the period ended December 31, 2009. The adoption of this accounting standard, which was subsequently codified into ASC Topic 105, “Generally Accepted Accounting Principles,” had no impact on retained earnings and will have no impact on our statements of income and condition.
Allowance for Loan Losses; Impairment of Loans. The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. If judgments and assumptions were to differ significantly from those used by management to estimate the allowance, the allowance for loan losses and the provision for loan losses on our income statement could be impacted materially. In addition, the allowance for loan losses is subject to review by various regulators who conduct examinations of the allowance for loan losses and may require adjustments to the allowance based upon the regulators’ assessment regarding our adequacy and the methodology used. (For further discussion of the Company’s allowance for loan losses, see “Lending Activities – Allowance for Loan Losses” located below in this Management’s Discussion and Analysis of Financial Condition and Results of Operations.)
A loan is considered impaired when it is probable that we will be unable to collect all interest and principal payments due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.
Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when fair value of the asset declines below cost and is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.
Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting policies relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan’s yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, we utilize estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management’s estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.
Accounting for Income Taxes. The determination of the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, our tax returns are subject to audit by various tax authorities. Although we believe our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.
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Selected Financial Ratios
The information presented below is derived in part from our audited consolidated financial statements and notes thereto, which appear elsewhere in this annual report on Form 10-K (see Item 8, “Financial Statements and Supplementary Data,” below). This information should be read in conjunction with our consolidated financial statements.
| FOR THE YEARS ENDED DECEMBER 31, | ||||||||||||
| 2010 | 2009 | 2008 | ||||||||||
| Return on average assets (1) |
0.74 | % | 0.40 | % | 0.28 | % | ||||||
| Return on average equity (2) |
5.60 | % | 3.62 | % | 2.60 | % | ||||||
| Average equity to average assets (3) |
13.29 | % | 10.99 | % | 10.89 | % | ||||||
| Dividend payout ratio (4) |
36.92 | % | 61.54 | % | 82.76 | % | ||||||
| (1) | Net income after tax, before preferred stock dividend and accretion of discount, divided by average total assets. |
| (2) | Net income after tax, before preferred stock dividend and accretion of discount, divided by average equity. |
| (3) | Average equity divided by average total assets. |
| (4) | Represents common dividends declared per share divided by basic net income per share. |
Financial Condition of the Company
Total Assets. The Company’s total assets decreased by $7.5 million, or 2.7%, from $274.6 million at December 31, 2009 to $267.1 million at December 31, 2010. The decrease in assets resulted primarily from a $7.3 million, or 28.1%, decrease in cash and cash equivalents. A $32.8 million, or 18.1%, increase in loans, net of allowance, was almost entirely offset by a $32.7 million decrease in investment securities available for sale.
Liquid Assets. Liquid assets, which include cash and cash equivalents, certificates of deposit in other banks and investment securities, decreased by $40.0 million, from $76.0 million at December 31, 2009 to $36.0 million at December 31, 2010. Investment securities available for sale were $17.4 million at December 31, 2010 compared to $50.1 million at December 31, 2009, a decrease of $32.7 million, or 65.3%.
Loans. Loans held for investment, net, were $214.3 million at December 31, 2010, an increase of $32.8 million, or 18.1%, from the loan balance of $181.5 million at December 31, 2009.
Asset Quality. Nonperforming assets were $263,000, or 0.10% of assets, at December 31, 2010, compared to $314,000, or 0.11% of assets, at December 31, 2009. The Company’s sole nonperforming asset as of December 31, 2010 consisted of a Bank branch site that we no longer plan to utilize.
Deposits. Average total deposits increased by $6.7 million, or 3.0%, from $223.5 million during the twelve months ended December 31, 2009 to $230.2 million during the twelve months ended December 31, 2010. Average core deposits increased by $9.6 million over the comparable twelve-month periods, partially offset by a $2.9 million decrease in certificates of deposit. In addition, the mix of average noninterest-bearing deposits to average total deposits increased from 29.1% in 2009 to 34.4% in 2010, further contributing to the improvement in our net interest margin.
At December 31, 2010, an increase in noninterest-bearing deposits of $8.9 million partially offset a decrease in interest-bearing deposits of $13.9 million, resulting in a net decrease in total deposits of $5.0 million, or 2.2%, from $229.1 million at December 31, 2009 to $224.1 million at December 31, 2010. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, decreased by $11.6 million, or 6.2%, from $187.3 million at December 31, 2009 to $175.7 million at December 31, 2010. Certificates of deposit increased by $6.6 million between the comparable twelve month periods.
Borrowed Funds. Borrowed funds decreased by $3.5 million, from $7.0 million at December 31, 2009 to $3.5 million at December 31, 2010, primarily from repayments of Federal Home Loan Bank medium term advances.
Capital. Stockholders’ equity increased by $802,000, or 2.2%, from $36.8 million at December 31, 2009 to $37.6 million at December 31, 2010, primarily as a result of a $947,000 increase in retained earnings and $124,000 in proceeds and associated tax benefits from stock option exercises recorded in additional paid-in capital. These increases were offset by a decrease in other comprehensive income of $466,000, primarily attributable to a $32.7 million decrease in the balance of available for sale investment securities between the periods.
Net Interest Income
Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, primarily from loan and investment securities portfolios, and interest expense, primarily on
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customer deposits and other Company borrowings. Changes in net interest income result from changes in volume, spread and margin. For purposes of determining such changes in net interest income, (a) volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, (b) spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and (c) margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-bearing liabilities. During the years ended December 31, 2010 and 2009, our average interest-earning assets were $262.6 million and $247.6 million, respectively. During these same years, our net interest margins, on a tax-equivalent basis, were 3.89% and 3.66%, respectively.
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Average Balances and Average Rates Earned and Paid. The following table sets forth for the Company, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts on a tax-equivalent basis of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. In preparing the table, nonaccrual loans are included in the average loan balance.
| YEAR ENDED DECEMBER 31, 2010 |
YEAR ENDED DECEMBER 31, 2009 |
YEAR ENDED DECEMBER 31, 2008 |
||||||||||||||||||||||||||||||||||
| Average Balance (1) |
Interest | Yield/ Cost |
Average Balance (1) |
Interest | Yield/ Cost |
Average Balance (1) |
Interest | Yield/ Cost |
||||||||||||||||||||||||||||
| (Dollars in Thousands) | ||||||||||||||||||||||||||||||||||||
| Interest-earning assets (2) |
||||||||||||||||||||||||||||||||||||
| Loans (2) (3) |
$ | 193,394 | $ | 10,218 | 5.28 | % | $ | 177,897 | $ | 9,022 | 5.07 | % | $ | 167,596 | $ | 9,863 | 5.87 | % | ||||||||||||||||||
| Investment securities - taxable |
41,996 | 1,404 | 3.34 | % | 54,790 | 2,141 | 3.91 | % | 36,377 | 1,663 | 4.57 | % | ||||||||||||||||||||||||
| Investment securities - non-taxable (2) |
— | — | — | % | — | — | — | % | 765 | 50 | 6.48 | % | ||||||||||||||||||||||||
| FHLB and Federal Reserve Stock |
2,232 | 40 | 1.79 | % | 1,718 | 27 | 1.59 | % | 1,054 | 47 | 4.48 | % | ||||||||||||||||||||||||
| Federal funds sold |
651 | 1 | 0.12 | % | 3,210 | 2 | 0.06 | % | 8,008 | 143 | 1.76 | % | ||||||||||||||||||||||||
| Other interest income |
24,365 | 132 | 0.54 | % | 9,943 | 93 | 0.93 | % | 563 | 7 | 1.28 | % | ||||||||||||||||||||||||
| Total interest-earning assets |
262,638 | 11,795 | 4.49 | % | 247,558 | 11,285 | 4.56 | % | 214,363 | 11,773 | 5.48 | % | ||||||||||||||||||||||||
| Noninterest-earning assets |
||||||||||||||||||||||||||||||||||||
| Other real estate owned |
102 | 181 | — | |||||||||||||||||||||||||||||||||
| Other assets |
17,656 | 17,049 | 18,812 | |||||||||||||||||||||||||||||||||
| Total assets |
$ | 280,396 | $ | 264,788 | $ | 233,175 | ||||||||||||||||||||||||||||||
| Interest-bearing liabilities |
||||||||||||||||||||||||||||||||||||
| Money market, NOW accounts |
$ | 98,962 | $ | 586 | 0.59 | % | $ | 103,646 | $ | 688 | 0.66 | % | $ | 88,469 | $ | 1,419 | 1.60 | % | ||||||||||||||||||
| Savings deposits |
2,957 | 6 | 0.20 | % | 2,883 | 17 | 0.58 | % | 2,459 | 22 | 0.92 | % | ||||||||||||||||||||||||
| Certificates of deposit |
49,072 | 806 | 1.64 | % | 52,026 | 1,371 | 2.64 | % | 52,609 | 2,035 | 3.86 | % | ||||||||||||||||||||||||
| Total interest-bearing deposits |
150,991 | 1,398 | 0.93 | % | 158,555 | 2,076 | 1.31 | % | 143,537 | 3,476 | 2.42 | % | ||||||||||||||||||||||||
| Other borrowings |
10,982 | 144 | 1.30 | % | 10,104 | 140 | 1.36 | % | 9,147 | 236 | 2.54 | % | ||||||||||||||||||||||||
| Total interest-bearing liabilities |
161,973 | 1,542 | 0.96 | % | 168,659 | 2,216 | 1.31 | % | 152,684 | 3,712 | 2.43 | % | ||||||||||||||||||||||||
| Noninterest-bearing liabilities |
||||||||||||||||||||||||||||||||||||
| Demand deposits |
79,237 | 65,009 | 52,660 | |||||||||||||||||||||||||||||||||
| Other liabilities |
1,930 | 2,030 | 2,440 | |||||||||||||||||||||||||||||||||
| Total liabilities |
243,140 | 235,698 | 207,784 | |||||||||||||||||||||||||||||||||
| Stockholders’ equity |
$ | 37,256 | $ | 29,090 | $ | 25,391 | ||||||||||||||||||||||||||||||
| Total liabilities and stockholders’ equity |
$ | 280,396 | $ | 264,788 | $ | 233,175 | ||||||||||||||||||||||||||||||
| Net interest income and interest rate spread |
$ | 10,253 | 3.53 | % | $ | 9,069 | 3.25 | % | $ | 8,061 | 3.05 | % | ||||||||||||||||||||||||
| Net interest margin |
3.89 | % | 3.66 | % | 3.75 | % | ||||||||||||||||||||||||||||||
| Ratio of average interest-earning assets to average interest-bearing liabilities |
162.15 | % | 146.78 | % | 140.40 | % | ||||||||||||||||||||||||||||||
| (1) | The calculations are based on daily average balances. |
| (2) | Yields are stated on a taxable-equivalent basis assuming tax rates in effect for the periods presented. |
| (3) | For the purposes of these computations, non-accrual loans are included in average loan balances. |
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Rate/Volume Analysis
The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.
| Year Ended December 31, 2010 vs. 2009 Increase (Decrease) Due to |
Year Ended December 31, 2009 vs. 2008 Increase (Decrease) Due to |
|||||||||||||||||||||||
| Volume | Rate | Total | Volume | Rate | Total | |||||||||||||||||||
| (Dollars in Thousands) | ||||||||||||||||||||||||
| Interest income |
||||||||||||||||||||||||
| Loans |
$ | 808 | $ | 388 | $ | 1,196 | $ | 570 | $ | (1,411 | ) | $ | (841 | ) | ||||||||||
| Investment securities taxable |
(454 | ) | (283 | ) | (737 | ) | 745 | (267 | ) | 478 | ||||||||||||||
| Investment securities non-taxable |
— | — | — | (50 | ) | — | (50 | ) | ||||||||||||||||
| FHLB & FRB stock |
9 | 4 | 13 | 20 | (40 | ) | (20 | ) | ||||||||||||||||
| Federal funds sold |
(2 | ) | 1 | (1 | ) | (54 | ) | (87 | ) | (141 | ) | |||||||||||||
| Other interest income |
91 | (52 | ) | 39 | 88 | (2 | ) | 86 | ||||||||||||||||
| Total interest income |
452 | 58 | 510 | 1,319 | (1,807 | ) | (488 | ) | ||||||||||||||||
| Interest expense |
||||||||||||||||||||||||
| Deposits: |
||||||||||||||||||||||||
| Money Market/NOW accounts |
(30 | ) | (72 | ) | (102 | ) | 210 | (941 | ) | (731 | ) | |||||||||||||
| Savings deposits |
— | (11 | ) | (11 | ) | 4 | (9 | ) | (5 | ) | ||||||||||||||
| Certificates of deposit |
(74 | ) | (491 | ) | (565 | ) | (23 | ) | (641 | ) | (664 | ) | ||||||||||||
| Borrowings |
11 | (7 | ) | 4 | 22 | (118 | ) | (96 | ) | |||||||||||||||
| Total interest expense |
(93 | ) | (581 | ) | (674 | ) | 213 | (1,709 | ) | (1,496 | ) | |||||||||||||
| Net interest income Increase (decrease) |
$ | 545 | $ | 639 | $ | 1,184 | $ | 1,106 | $ | (98 | ) | $ | 1,008 | |||||||||||
Comparison of Operating Results for the Twelve Months Ended December 31, 2010 and 2009
Overview. The Company’s pretax income was $3.2 million for the twelve months ended December 31, 2010, compared to a pretax income of $1.6 million for the twelve months ended December 31, 2009, an increase of $1.6 million. Compared to the 2009 full year, net interest income increased by $1.1 million, provision for loan losses increased by $199,000, noninterest income increased by $1.1 million, and noninterest expense increased by $420,000.
Net Interest Income. The Company’s net interest income before provision for loan losses increased by $1.1 million to $10.2 million for the twelve months of 2010, compared to $9.1 million in the twelve months of 2009. This increase in net interest income was primarily attributable to a $15.1 million increase in average interest-earning assets and a $6.7 million decrease in average interest-bearing liabilities between 2009 and 2010. These year over year changes, along with a 35 basis point decrease in the cost of interest-bearing liabilities, partially offset by a 7 basis point decrease in the yield on interest-earning assets, resulted in a 28 basis point increase in net interest spread; specifically, our net interest spread increased from 3.25% for the twelve months ended December 31, 2009 to 3.53% for the twelve months ended December 31, 2010. Additionally, average noninterest-bearing deposits increased by $14.2 million, and net interest margin increased by 23 basis points, from 3.66% for 2009 to 3.89% for 2010.
Provision for Loan Losses. The Company’s provision for loan losses was $368,000 in 2010, compared to a provision of $169,000 in 2009. The increase was primarily attributable to a $33.1 million increase in total loans in 2010. Net charge-offs were $51,000 in the twelve months ended December 31, 2010, compared to $48,000 in net charge-offs in the twelve months ended December 31, 2009.
Noninterest Income. Total noninterest income increased by $1.1 million, from $782,000 in 2009 to $1.8 million in 2010, primarily due to gains of $994,000 on the sale of investment securities.
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Noninterest Expense. Total noninterest expense increased by $420,000, from $8.1 million for 2009 to $8.5 million for 2010. The Bank repaid $15.0 million in medium term FHLB advances, incurring a loss of $263,000 on the early extinguishment of debt. Increases in compensation expense of $366,000 were offset by decreases in FDIC assessment expenses and professional fees of $149,000 and $119,000, respectively. The decrease in FDIC assessment relates primarily to a $121,000 special assessment in June 2009 that did not recur in 2010.
Income Taxes. The Company’s income tax expense for 2010 was $1.1 million, reflecting an effective tax rate of 34.4%, compared to income tax expense of $541,000 for 2009, reflecting an effective tax rate of 34.0%.
Net Income Available to Common Stockholders. After the impact of dividends on our outstanding TARP preferred stock, net income available to common stockholders was $1,499,000 for the twelve months ended December 31, 2010, compared to $896,000 for the comparable 2009 period. The Company issued TARP preferred stock on September 25, 2009, so the impact of the TARP dividends on net income in deriving net income available to common stockholders for the twelve months ended December 31, 2009 was a reduction of $156,000, compared to a reduction of $587,000 for the full twelve month period in 2010.
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The following tables set forth, for the periods indicated, components of noninterest income and noninterest expense:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Noninterest income |
||||||||
| Service charges on deposit accounts |
$ | 445,122 | $ | 398,186 | ||||
| Gain on sale of investment securities |
993,590 | — | ||||||
| Gains on sale of loans held for sale, net |
— | 3,367 | ||||||
| Income from bank-owned life insurance |
18,151 | 53,601 | ||||||
| ATM transaction fees |
137,937 | 126,903 | ||||||
| Credit card interchange fees |
40,231 | 32,556 | ||||||
| Merchant discount fees |
39,043 | 36,142 | ||||||
| Late charges and other fees on loans |
85,387 | 42,861 | ||||||
| Other |
83,468 | 88,030 | ||||||
| Total noninterest income |
$ | 1,842,929 | $ | 781,646 | ||||
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Noninterest expense |
||||||||
| Compensation |
$ | 4,431,787 | $ | 4,066,419 | ||||
| Data processing |
555,963 | 505,638 | ||||||
| Occupancy |
771,639 | 793,460 | ||||||
| Furniture and equipment |
585,833 | 629,585 | ||||||
| Taxes and licenses |
342,066 | 272,538 | ||||||
| Professional fees |
349,967 | 468,510 | ||||||
| FDIC assessment |
307,016 | 456,459 | ||||||
| Loss on early extinguishment of debt |
262,800 | — | ||||||
| Marketing |
121,851 | 82,050 | ||||||
| Telephone |
115,925 | 102,282 | ||||||
| Stationery and supplies |
74,528 | 78,373 | ||||||
| Loss on disposal or impairment of fixed assets |
6,484 | 7,588 | ||||||
| Service bureau |
57,731 | 60,798 | ||||||
| ATM expense |
114,237 | 106,627 | ||||||
| Expenses related to other real estate owned |
29,972 | 38,322 | ||||||
| Travel |
26,786 | 26,450 | ||||||
| Seminars and education |
23,576 | 17,113 | ||||||
| Loan servicing |
29,237 | 18,464 | ||||||
| Courier |
32,899 | 32,154 | ||||||
| Corporate insurance |
48,530 | 53,455 | ||||||
| Postage |
58,646 | 67,561 | ||||||
| Shareholder expense |
45,391 | 52,992 | ||||||
| Other miscellaneous |
109,065 | 144,970 | ||||||
| Total noninterest expense |
$ | 8,501,929 | $ | 8,081,808 | ||||
Lending Activities
Loans held for investment, net of allowance for loan losses and unearned fees and costs, at December 31, 2010 were $214.3 million compared with $181.5 million at December 31, 2009, an increase of $32.8 million, or 18.1%, primarily attributable to an increase in loans secured by real estate. As a percentage of average earning assets, average loans were 73.6% for the year ended 2010 and 71.9% for the year ended 2009.
General. We engage in a wide range of lending activities, which include the origination, primarily in our market area, of (1) commercial business loans, (2) commercial real estate loans, (3) construction loans, (4) land acquisition and development loans, and (5) home equity, consumer and residential mortgage loans.
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Commencing in early 2005, we have taken a number of steps, such as the recruitment of highly knowledgeable and experienced lending officers, the introduction of centralized loan processing, the implementation of new underwriting and documentation requirements and the regular utilization of the loan committee process, to improve the underwriting, documentation and administration of the Bank’s loan portfolio. The discussion in this section relates to the lending practices we have utilized since early 2005 and continue to use today.
Loan Policy. Our Loan Policy provides general guidance on underwriting of loans, risk management, credit approval, loan administration and problem asset management. The Loan Policy is designed to help ensure that loan growth is accompanied by acceptable asset quality with uniform and consistently applied approval, administration and documentation practices and standards.
Commercial Business Lending. We actively solicit commercial business loans of all types. Commercial business loans include revolving lines of credit to provide working capital, term loans to finance the purchase of vehicles and equipment, letters of credit to guarantee payment and performance, and other loans to assist businesses in cash management or growth opportunities.
Revolving lines of credit are typically secured by various assets of the borrower, provide for the acceleration of repayment upon any event of default, are monitored monthly or quarterly to ensure compliance with loan covenants, when appropriate, and are re-underwritten annually before renewal. Interest rates on revolving lines of credit are generally variable. Term loans are generally advanced for the purchase of, and are secured by, vehicles and equipment and are normally fully amortized over a term of two to five years, on either a fixed or variable rate basis. In general, these credit facilities carry the unconditional guarantees of the owners and/or stockholders of the borrower.
Commercial Real Estate Lending. Our commercial real estate loans are primarily secured by real property and the income arising from such property. The proceeds of commercial real estate loans are generally used by the borrower to finance or refinance the cost of acquiring and/or improving a commercial property. The properties that typically secure these loans are office and warehouse facilities, retail facilities and other commercial properties. In addition, we will on a more limited basis make loans secured by special purpose facilities such as hotels, mini-storage warehouses and manufacturing facilities. We actively seek to make commercial real estate loans to borrowers who will occupy or use the financed property in connection with their normal business operations. We also make commercial real estate loans for other purposes if the borrower is in strong financial condition and presents a substantial business opportunity for the Bank, taking into account (when circumstances warrant) the extent to which the property is leased or pre-leased.
Our commercial real estate loans are usually amortized over a period of time ranging from 15 years to 25 years and usually have a term to maturity ranging from five years to 15 years. These loans normally include provisions for interest rate adjustments after the loan is three to five years old. The Bank’s maximum loan-to-value ratio for a commercial real estate loan is 85%; however, this maximum can be waived for particularly strong borrowers on an exception basis. Most commercial real estate loans are further secured by one or more unconditional personal guarantees.
We structure some of our commercial real estate loans as mini-permanent loans. The amortization period, term and interest rates for these loans vary based on borrower preferences and our assessment of the loan and the degree of risk involved. If the borrower prefers a fixed rate of interest, we usually offer a loan with a fixed rate of interest for a term of three to five years with an amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial term. If the borrower prefers a variable or floating rate of interest, we usually offer a loan with a variable interest rate tied to a readily recognizable index, such as the Bank’s prime rate, for a term of three to five years with an amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial term.
Loans secured by commercial real estate are generally larger and involve a greater degree of risk than residential mortgage loans. Because payments on loans secured by commercial real estate are usually dependent on successful operation or management of the properties securing such loans, repayment of such loans is subject to changes in both general and local economic conditions and the borrower’s business and income. As a result, events beyond our control, such as a continued or worsening downturn in the local economy, could adversely affect the performance of our commercial real estate loan portfolio. We seek to minimize these risks by lending to established customers or experienced real estate developers and generally restricting our commercial real estate loans to our primary market area. Emphasis is placed on the income producing characteristics and repayment capacity of the collateral.
Construction Lending. We have a construction lending program consisting of loans for the construction of one-to-four family residences, multi-family dwellings, office and warehouse facilities and other nonresidential projects, generally limited to borrowers who are owner-occupants or who present other business opportunities for the Bank.
The amounts, interest rates and terms for construction loans vary, depending upon market conditions, the size and complexity of the project, and the financial strength of the borrower and any guarantors of the loan. The term for our typical construction loan ranges from nine months to 15 months for the construction of an individual residence and from 15 months to a maximum of three years for larger residential or commercial projects. We typically do not amortize construction loans, and the borrower pays interest monthly on the outstanding principal balance of the loan. Our construction loans generally have a floating or variable rate of interest
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but occasionally have a fixed interest rate. We generally do not finance the construction of commercial real estate projects built on a purely speculative basis. For residential builder loans, we limit the number of models and/or speculative units allowed depending on market conditions, the builder’s financial strength and track record and other factors. Generally, the maximum loan-to-value ratio for one-to-four family residential construction loans is 80% of the property’s fair market value, or 85% of the property’s fair market value if the property will be the borrower’s primary residence. The fair market value of a project is determined on the basis of an appraisal of the project usually conducted by an independent, outside appraiser acceptable to us or on the basis of an internal evaluation when permitted under our policies and applicable regulatory guidelines. For larger projects, where unit absorption or leasing is a concern, we may also obtain a feasibility study or other acceptable information from the borrower or other sources about the likely disposition of the property following the completion of construction.
Construction loans for nonresidential projects and multi-unit residential projects are generally larger and involve a greater degree of risk than residential mortgage loans. We attempt to minimize such risks by (1) making construction loans in accordance with the Bank’s underwriting standards to established customers of the Bank or experienced real estate developers in our primary market area and (2) monitoring the quality, progress and cost of construction. We have established a maximum loan-to-value ratio of 80% for non-residential construction projects and multi-unit residential construction projects; however, this maximum can be waived for particularly strong borrowers on an exception basis.
Land Acquisition and Development Lending. Land acquisition and development loans are made to builders and developers for the purpose of acquiring unimproved land to be developed for residential building sites, residential housing subdivisions, multi-family dwellings and a variety of commercial uses. We generally do not make land acquisition and development loans for commercial developments but will make such loans for borrowers seeking to build owner-occupied facilities on the subject land.
We underwrite and process land acquisition and development loans in much the same manner as commercial construction loans and commercial real estate loans. For residential land acquisition and development loans, we use a lower loan-to-value ratio, which is a maximum of 65% for unimproved land and 75% of the appraised value of the developed lots as determined in accordance with our appraisal policies for developed lots for single-family or townhouse construction and discounted, when appropriate, to reflect absorption periods in excess of one year. We can waive the maximum loan-to-value ratio for particularly strong borrowers on an exception basis. The term of land acquisition and development loans ranges from a maximum of two years for loans relating to the acquisition of unimproved land to, generally, a maximum of three years for other types of projects. All land acquisition and development loans generally are further secured by one or more unconditional personal guarantees. Because these loans are usually larger in amount and involve more risk than individual lot loans, we carefully evaluate the borrower’s assumptions and projections about market conditions and absorption rates in the community in which the property is located and the borrower’s ability to carry the loan if their assumptions and/or projections prove inaccurate.
Home Equity and Consumer Lending and Residential Mortgage Lending. We offer our customers home equity lines of credit and home equity loans that enable them to borrow funds secured by the equity in their homes. Home equity lines of credit are offered with adjustable rates of interest on an open-end revolving basis. Home equity loans are offered with fixed rates for a fixed period of time, usually between five and 15 years. Home equity lines of credit and home equity loans are secured by liens on personal residences and generally do not present as much risk as other types of consumer loans.
We also offer a variety of consumer loans, including automobile loans, personal secured and unsecured loans, credit card loans, loans secured by savings accounts or certificates of deposit, and loans to purchase residential lots for the later construction of owner-occupied residences. The shorter terms and generally higher interest rates on consumer loans help the Bank maintain a profitable spread between its average loan yield and its cost of funds. Consumer loans secured by collateral other than a personal residence generally involve more credit risk than residential mortgage loans because of the type and nature of the collateral or, in certain cases, the absence of collateral. However, we believe the higher yields generally earned on such loans compensate for the increased credit risk associated with such loans.
We originate residential mortgage loans secured by properties located in our primary market area in Hampton Roads, Virginia, offering various types of residential mortgage loans in addition to traditional long-term, fixed-rate or adjustable-rate mortgage loans. We generally underwrite loans to be retained by the Bank on terms consistent with secondary mortgage market standards. We underwrite loans to be sold to secondary market investors after closing on terms specified by the investors.
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The following table sets forth, at the dates indicated, our loan portfolio composition by type of loan:
| At December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| Commercial |
$ | 37,227,510 | $ | 31,909,596 | $ | 32,847,457 | $ | 26,108,173 | $ | 19,752,244 | ||||||||||
| Real estate - mortgage |
156,283,295 | 127,086,368 | 112,371,561 | 101,095,900 | 92,513,346 | |||||||||||||||
| Real estate - construction |
18,350,483 | 18,276,222 | 27,883,927 | 23,104,633 | 23,780,496 | |||||||||||||||
| Installment and consumer |
3,898,757 | 5,362,277 | 4,385,595 | 4,149,881 | 4,731,529 | |||||||||||||||
| Total gross loans |
215,760,045 | 182,634,463 | 177,488,540 | 154,458,587 | 140,777,615 | |||||||||||||||
| Allowance for loan losses |
(2,089,557 | ) | (1,773,125 | ) | (1,652,174 | ) | (1,399,875 | ) | (1,373,000 | ) | ||||||||||
| Unearned loan costs (fees) |
671,276 | 683,132 | 725,238 | 791,439 | 713,894 | |||||||||||||||
| Loans, net |
$ | 214,341,764 | $ | 181,544,470 | $ | 176,561,604 | $ | 153,850,151 | $ | 140,118,509 | ||||||||||
The following table presents, at December 31, 2010, (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of such loans maturing after one year by fixed and variable rates:
Loan Portfolio Composition and Maturities at December 31, 2010
| Within 1 Year |
After 1 Year but Within 5 Years |
After 5 Years |
Total | Percentage of Total Loan Portfolio |
||||||||||||||||
| Commercial |
$ | 16,033,801 | $ | 10,547,963 | $ | 10,645,746 | $ | 37,227,510 | 17.25 | % | ||||||||||
| Real Estate-mortgage |
4,832,382 | 18,710,633 | 132,740,280 | 156,283,295 | 72.43 | % | ||||||||||||||
| Real Estate-construction |
6,287,470 | 9,390,870 | 2,672,143 | 18,350,483 | 8.51 | % | ||||||||||||||
| Installment and consumer |
1,513,077 | 1,198,562 | 1,187,118 | 3,898,757 | 1.81 | % | ||||||||||||||
| $ | 28,666,730 | $ | 39,848,028 | $ | 147,245,287 | $ | 215,760,045 | 100.00 | % | |||||||||||
| Loans Maturing After 1 Year | Total | |||
| Fixed rate loans |
$ | 60,540,327 | ||
| Variable rate loans (includes loans subject to call) |
126,552,988 | |||
| $ | 187,093,315 | |||
Allowance For Loan Losses
The Bank maintains an allowance for loan losses at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance, (2) recoveries on loans previously charged-off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.
We analyze our loan portfolio through ongoing credit review processes and construct a comprehensive allowance analysis for our loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.
The Bank evaluates various loans individually for impairment as required by generally accepted accounting principles related to receivables. An evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.
For loans without an individual measure of impairment, we estimate for groups of loans as required by generally accepted accounting principles related to contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans. We then consider the impact of various bank, industry, economic and other environmental factors and documents, which are further used in the analysis.
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Our allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by generally accepted accounting principles related to receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance for contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.
Our allowance for loan losses was $2,089,557, or 0.97% of total loans held for investment, net of unearned fees and costs, at December 31, 2010. This compares to an allowance of $1,773,125, or 0.97% of such loans, at year-end 2009. These allowance figures are reflected in the table below.
Management currently believes that our allowance for loan losses is adequate. However, the allowance is subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Such agencies may require us to recognize additions to the allowance for loan losses based on their judgments about information available at the time of their examinations.
The following table sets forth, for the periods indicated, a summary of activity in our allowance for loan losses:
| At or for the Year Ended December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| Balance at beginning of year |
$ | 1,773,125 | $ | 1,652,174 | $ | 1,399,875 | $ | 1,373,000 | $ | 1,335,001 | ||||||||||
| Charge-offs: |
||||||||||||||||||||
| Commercial |
13,000 | 7,659 | 130,429 | 188,911 | 28,623 | |||||||||||||||
| Real estate |
135,217 | 87,966 | 231,370 | — | — | |||||||||||||||
| Consumer |
13,401 | 928 | 36,019 | 8,030 | 62,228 | |||||||||||||||
| Total charge-offs |
161,618 | 96,553 | 397,818 | 196,941 | 90,851 | |||||||||||||||
| Recoveries |
||||||||||||||||||||
| Commercial |
14,258 | 47,066 | 186,740 | 106,245 | 42,606 | |||||||||||||||
| Real estate |
82,484 | — | — | — | — | |||||||||||||||
| Consumer |
13,808 | 1,365 | 10,607 | 12,927 | 21,982 | |||||||||||||||
| Total recoveries |
110,550 | 48,431 | 197,347 | 119,172 | 64,588 | |||||||||||||||
| Net (recoveries) charge-offs |
51,068 | 48,122 | 200,471 | 77,769 | 26,263 | |||||||||||||||
| Provision for loan losses |
367,500 | 169,073 | 452,770 | 104,644 | 64,262 | |||||||||||||||
| Balance at end of period: |
$ | 2,089,557 | $ | 1,773,125 | $ | 1,652,174 | $ | 1,399,875 | $ | 1,373,000 | ||||||||||
| Ratio of net charge-offs to average loans outstanding |
0.03 | % | 0.03 | % | 0.12 | % | 0.05 | % | 0.02 | % | ||||||||||
| Ratio of allowance for loan losses to outstanding loans held for investment, net of unearned fees and costs at end of year |
0.97 | % | 0.97 | % | 0.93 | % | 0.90 | % | 0.97 | % | ||||||||||
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Breakdown of Allowance for Loan Losses by Category
The following table presents an allocation of our allowance for loan losses and the percentage of loans in each category to the total amount of loans at December 31, 2010, 2009, 2008, 2007 and 2006. The allocation presented for each year reflects an allocation methodology that we adopted in 2005 for the year ended December 31, 2004 and that we have continued to utilize in all subsequent years.
| At December 31 | ||||||||||||||||||||||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||||||||||||||||||||||
| Amount | Percent of Total Loans (1) |
Amount (2) |
Percent of Total Loans (1) |
Amount (2) |
Percent of Total Loans (1) |
Amount | Percent of Total Loans (1) |
Amount | Percent of Total Loans (1) |
|||||||||||||||||||||||||||||||
| (Dollars in Thousands) | ||||||||||||||||||||||||||||||||||||||||
| Loan Type Allocation |
||||||||||||||||||||||||||||||||||||||||
| Real estate – mortgage |
$ | 1,393 | 72.43 | % | $ | 1,132 | 69.59 | % | $ | 991 | 63.31 | % | $ | 849 | 65.45 | % | $ | 812 | 65.72 | % | ||||||||||||||||||||
| Real estate – construction |
162 | 8.51 | % | 161 | 10.00 | % | 244 | 15.71 | % | 194 | 14.96 | % | 18 | 16.89 | % | |||||||||||||||||||||||||
| Commercial |
327 | 17.25 | % | 279 | 17.47 | % | 296 | 18.51 | % | 231 | 16.90 | % | 365 | 14.03 | % | |||||||||||||||||||||||||
| Consumer |
34 | 1.81 | % | 47 | 2.94 | % | 38 | 2.47 | % | 35 | 2.69 | % | 75 | 3.36 | % | |||||||||||||||||||||||||
| 1,916 | 100.00 | % | 1,619 | 100.00 | % | 1,569 | 100.00 | % | 1,309 | 100.00 | % | 1,270 | 100.00 | % | ||||||||||||||||||||||||||
| Specific problem loans |
— | — | — | 20 | — | |||||||||||||||||||||||||||||||||||
| Unallocated |
174 | 154 | 83 | 71 | 103 | |||||||||||||||||||||||||||||||||||
| $ | 2,090 | $ | 1,773 | $ | 1,652 | $ | 1,400 | $ | 1,373 | |||||||||||||||||||||||||||||||
| (1) | Represents total of all outstanding loans in each category as a percent of total loans outstanding. |
| (2) | As a result of loan reclassification, allocations between loan categories may have changed to maintain comparability between years. |
Nonperforming Assets
Our nonperforming assets include nonperforming loans (nonaccrual and restructured loans) and other real estate owned (“REO”). We generally do not accrue interest on loans that are 90 days or more past due and reverse all previously accrued, but uncollected, interest on loans that are placed in nonaccrual status (with the exception of credit card loans on which the Company does not accrue interest over 120 days).
REO is recorded at the lower of cost or estimated fair value as determined generally by appraisals. If the fair value of REO is less than the book value of the loan formerly secured by such REO, the fair value becomes the new cost basis of the REO, and the difference between the book value and the fair value is charged against either the allowance for loan losses on the date of foreclosure or completion of the appraisal, or the allowance for REO at the date of change of management’s intent with regard to its own property. Subsequent valuations are periodically performed and valuation allowances are established if the carrying value of the real estate exceeds estimated fair value. Other repossessed assets are carried at the lower of cost or estimated fair value as determined by independent surveys or appraisals at the time of repossession. If the fair value of the repossessed asset is less than the book value of the loan formerly secured by such repossessed asset, the difference between the book value and the fair value is charged to the allowance for loan losses on the date of repossession.
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The following table sets forth, for the dates indicated, information with respect to our nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans and restructured loans) and total nonperforming assets:
| At December 31, | ||||||||||||||||||||
| 2010 | 2009 | 2008 | 2007 | 2006 | ||||||||||||||||
| Nonaccrual loans (1) |
$ | — | $ | 935 | $ | 30,754 | $ | 136,650 | $ | 169,642 | ||||||||||
| Accruing loans past due 90 days or more |
— | 48 | 9,937 | 26,709 | 7,865 | |||||||||||||||
| Total nonperforming loans |
— | 983 | 40,691 | 163,359 | 177,507 | |||||||||||||||
| Real estate owned, net |
263,413 | 313,300 | 177,500 | — | — | |||||||||||||||
| Total nonperforming assets |
$ | 263,413 | $ | 314,283 | $ | 218,191 | $ | 163,359 | $ | 177,507 | ||||||||||
| Total nonperforming assets to total assets |
0.10 | % | 0.11 | % | 0.08 | % | 0.07 | % | 0.08 | % | ||||||||||
| (1) | Includes restructured loans of $136,650 and $169,642 at December 31, 2007 and 2006, respectively. There were no restructured loans at December 31, 2008. Restructured loans of $1,469,771 at December 31, 2009 are not included as nonaccrual loans because, both at December 31, 2009 and currently, we expect that the applicable borrowers will satisfy in full all of their payment obligations, both interest payments and repayment of principal, in accordance with the modified terms of their respective loans. There were no restructured loans at December 31, 2010. |
As of the end of the period ended December 31, 2010, there are no loans in respect of which any known information about possible credit problems of borrowers cause our management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms. Any such doubts or concerns that develop subsequent to that date, if any, may later result in loans being disclosed as nonaccrual, accruing but past due 90 days or more, or troubled debt restructurings.
Loans Held for Sale
There were no loans held for sale at December 31, 2010 or 2009.
Investment Securities
Our investment portfolio is a source of liquidity and is our second largest category of earning assets. At December 31, 2010, our investment portfolio included FNMA and FHLMC mortgage-backed securities. In addition to the investment securities, we also invest in federal funds sold as well as certificates of deposits and money market accounts in other banks. Securities available for sale were $17.4 million at December 31, 2010, compared with $50.1 million at December 31, 2009. There were no securities held to maturity at December 31, 2010 or 2009.
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The following table summarizes the amortized cost, gross unrealized gains and losses and the estimated fair value of securities available for sale and securities held to maturity, in each case as applicable, for the years ended December 31, 2010, 2009 and 2008:
| Amortized Cost | Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | |||||||||||||
| At December 31, 2010 |
||||||||||||||||
| Securities available for sale |
||||||||||||||||
| Mortgage-backed securities |
$ | 16,744,391 | $ | 624,006 | $ | — | $ | 17,368,397 | ||||||||
| Total securities available for sale |
16,744,391 | 624,006 | — | 17,368,397 | ||||||||||||
| Total securities (1) |
$ | 16,744,391 | $ | 624,006 | $ | — | $ | 17,368,397 | ||||||||
| (1) | At December 31, 2010, the Company held no securities classified as held to maturity. |
| At December 31, 2009 |
||||||||||||||||
| Securities available for sale |
||||||||||||||||
| U.S. government sponsored enterprises |
$ | 5,000,000 | $ | — | $ | 25,000 | $ | 4,975,000 | ||||||||
| Mortgage-backed securities |
43,773,714 | 1,354,652 | — | 45,128,366 | ||||||||||||
| Total securities available for sale |
48,773,714 | 1,354,652 | 25,000 | 50,103,366 | ||||||||||||
| Total securities (1) |
$ | 48,773,714 | $ | 1,354,652 | $ | 25,000 | $ | 50,103,366 | ||||||||
| (1) | At December 31, 2009, the Company held no securities classified as held to maturity. |
| At December 31, 2008 |
||||||||||||||||
| Securities available for sale |
||||||||||||||||
| U.S. Treasury Securities |
$ | 1,761,259 | $ | 12,493 | $ | 3 | $ | 1,773,749 | ||||||||
| Mortgage-backed securities |
57,961,180 | 1,011,768 | 3,751 | 58,969,197 | ||||||||||||
| Total securities available for sale |
$ | 59,722,439 | $ | 1,024,261 | $ | 3,754 | $ | 60,742,946 | ||||||||
| Total securities (1) |
$ | 59,722,439 | $ | 1,024,261 | $ | 3,754 | $ | 60,742,946 | ||||||||
| (1) | At December 31, 2008, the Company held no securities classified as held to maturity. |
The following table presents the contractual maturity distribution and estimated weighted average yields, based on amortized cost, of our investment securities portfolio at December 31, 2010. Actual maturities will differ from contractual maturities because mortgage-backed securities will amortize and may be prepaid prior to their contractual maturity.
| 1 Year or Less | After 1 Year but through 5 Years |
After 5 Years but through 10 Years |
After 10 Years | Total | ||||||||||||||||||||||||||||||||||||
| Amortized Cost |
Yield | Amortized Cost |
Yield | Amortized Cost |
Yield | Amortized Cost |
Yield | Amortized Cost |
Yield | |||||||||||||||||||||||||||||||
| Mortgage-backed securities |
$ | 492,055 | 4.04 | % | $ | 10,960,561 | 3.58 | % | $ | 5,291,775 | 4.31 | % | $ | — | — | % | $ | 16,744,391 | 3.82 | % | ||||||||||||||||||||
| Total |
$ | 492,055 | 4.04 | % | $ | 10,960,561 | 3.58 | % | $ | 5,291,775 | 4.31 | % | $ | — | — | % | $ | 16,744,391 | 3.82 | % | ||||||||||||||||||||
At December 31, 2010, there were no securities of any issuer (other than FNMA and FHLMC mortgage-backed securities) that exceeded 10% of the Company’s stockholders’ equity.
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SOURCES OF FUNDS
Deposit Activities
We provide a range of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Our strategy has been to fund asset growth through increases in core deposits rather than the use of any brokered deposits, and we strive to establish customer relationships to attract core deposits in noninterest-bearing and other transactional accounts and thus to reduce our cost of funds.
Our deposit base includes large denomination certificates of deposit of $100,000 or more. These large denomination CDs represented approximately 0.8% and 1.3% of total deposits at December 31, 2010 and 2009, respectively.
The following table sets forth, for the periods indicated, the average balance outstanding and average interest rates for each major category of deposits:
| Year Ended December 31, | ||||||||||||||||||||||||
| 2010 | 2009 | 2008 | ||||||||||||||||||||||
| Average Balance |
Average Rate |
Average Balance |
Average Rate |
Average Balance |
Average Rate |
|||||||||||||||||||
| Interest-bearing NOW, money market and savings accounts |
$ | 101,918,669 | 0.58 | % | $ | 106,528,856 | 0.66 | % | $ | 90,928,206 | 1.59 | % | ||||||||||||
| Time deposits |
49,071,815 | 1.64 | % | 52,026,226 | 2.64 | % | 52,609,295 | 3.86 | % | |||||||||||||||
| Total interest-bearing deposits |
150,990,484 | 0.93 | % | 158,555,082 | 1.31 | % | 143,537,501 | 2.42 | % | |||||||||||||||
| Demand and other noninterest-bearing deposits |
79,237,551 | — | 65,008,976 | — | 52,660,199 | — | ||||||||||||||||||
| Total average deposits |
$ | 230,228,035 | 0.61 | % | $ | 223,564,058 | 0.93 | % | $ | 196,197,700 | 1.77 | % | ||||||||||||
The following table sets forth the amounts and maturities of certificates of deposit with balances of $100,000 or more at December 31, 2010:
Remaining maturity
| Less than three months |
$ | — | ||
| Over three months through six months |
760,411 | |||
| Over six months through twelve months |
839,204 | |||
| Over twelve months |
215,192 | |||
| Total |
$ | 1,814,807 | ||
Borrowings
As additional sources of funding, the Company utilizes unsecured credit lines from correspondent banks, advances from the Federal Home Loan Bank of Atlanta (“FHLB”) under a secured line of credit, and securities sold under agreements to repurchase which are secured transactions with customers and generally mature the day following the day sold. At December 31, 2010, borrowings included $2,377,697 million in securities sold under agreements to repurchase. Other borrowings of $1,086,547 at December 31, 2010 consisted of participated loans sold by the Bank with disproportionate cash flows to the buyer. Generally accepted accounting principles consider these loans to be incomplete transfers because risk is not proportionate and require that this type of participation be classified as a borrowing. Because of this treatment, the entire loan balance is reported in loans held for investment and not reduced for the participation.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Liquidity refers to the availability of sufficient funds to meet the needs of depositors, borrowers, creditors and investors and to fund operations. Our primary sources of funds are customer deposits, cash, investment securities available for sale, loan repayments and borrowings. These funds are used to make loans, purchase investment securities, meet depositor withdrawals and fund operations.
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Liquid assets, which include cash and due from banks, certificates of deposit in other banks, fed funds sold and nonpledged securities available for sale, totaled $33.6 million at December 31, 2010. In addition, our funding sources at December 31, 2010 consisted of established borrowing capacity with the FHLB, subject to qualifying collateral availability, equal to 20.0% of the Bank’s total assets, or $52.8 million, and established federal funds lines with correspondent banks. At December 31, 2010, there was no outstanding balance with the FHLB.
Certificates of deposit that are scheduled to mature within one year totaled $31.6 million at December 31, 2010. These deposits are generally considered to be rate sensitive. While our liquidity could be impacted by a decrease in the renewals of deposits or general deposit runoff, we believe we have the ability to raise additional deposits by conducting deposit promotions. In the event we require funds beyond our ability to generate them internally, we could borrow from established lines or obtain funds through the sale of investment securities from our available for sale portfolio. Management believes our liquidity sources are sufficient to satisfy our current operational requirements and obligations. We maintain a high level of liquidity due to a concentration in some customer deposits, which can fluctuate significantly as depositor needs change.
Capital Resources
The Company’s capital is reflected in its stockholders’ equity, which was $37.6 million, or 14.1% of assets, at December 31, 2010, compared to $36.8 million, or 13.4% of assets, at December 31, 2009. Stockholders’ equity increased primarily as a result of a $947,000 increase in retained earnings and $124,000 in proceeds and associated tax benefits from stock option exercises recorded in additional paid-in capital. These increases were offset by a decrease in other comprehensive income of $466,000. The Company paid aggregate dividends of $0.24 per common share in each of 2010 and 2009. The dividend payout ratio on our common shares was 36.92% in 2010, compared to 61.54% in 2009.
The Company’s capital continues to exceed regulatory requirements for total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to tangible assets (leverage ratio). Our total capital ratio was 17.15% at December 31, 2010, compared to 18.36% at December 31, 2009; our Tier 1 capital ratio was 16.24% at December 31, 2010, compared to 17.50% at December 31, 2009; and our leverage ratio was 13.24% at December 31, 2010, compared to 13.06% at December 31, 2009. These ratios all exceed the mandated minimum regulatory capital requirements.
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The following table presents information on the capital amounts and ratios for the Company and the Bank as of December 31, 2010 and 2009:
| (Dollars in thousands) |
Actual | For Capital Adequacy Purposes |
Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions |
|||||||||||||||||||||
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||||||
| At December 31, 2010 |
||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 39,257 | 17.15 | % | $ | 18,313 | 8.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 35,978 | 15.75 | % | $ | 18,270 | 8.0 | % | $ | 22,837 | 10.0 | % | ||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,168 | 16.24 | % | $ | 9,156 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,888 | 14.84 | % | $ | 9,135 | 4.0 | % | $ | 13,702 | 6.0 | % | ||||||||||||
| Tier 1 Capital (to Average Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,168 | 13.24 | % | $ | 11,225 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,888 | 12.16 | % | $ | 11,145 | 4.0 | % | $ | 13,931 | 5.0 | % | ||||||||||||
| At December 31, 2009 |
||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,674 | 18.36 | % | $ | 16,416 | 8.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 34,785 | 16.99 | % | $ | 16,382 | 8.0 | % | $ | 20,477 | 10.0 | % | ||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 35,901 | 17.50 | % | $ | 8,208 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,012 | 16.12 | % | $ | 8,191 | 4.0 | % | $ | 12,286 | 6.0 | % | ||||||||||||
| Tier 1 Capital (to Average Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 35,901 | 13.06 | % | $ | 10,999 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,012 | 12.08 | % | $ | 10,927 | 4.0 | % | $ | 13,659 | 5.0 | % | ||||||||||||
Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. Loans or advances to the Company are limited to 10% of the Bank’s stockholders’ equity. For additional detail, see Item 1, “Business – Supervision and Regulation,” above.
Contractual Obligations and Commitments
In the normal course of business we have various outstanding contractual obligations that will require future cash outflows. In addition, we have commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows. The following table presents information regarding our outstanding contractual obligations as of December 31, 2010:
| Payments Due by Period | ||||||||||||||||||||
| Contractual Obligations | Total | On Demand Or Within 1 Year |
1-3 Years | 3-5 Years | More than 5 Years |
|||||||||||||||
| (dollars in thousands) | ||||||||||||||||||||
| Securities sold under agreements to repurchase |
$ | 2,378 | $ | 2,378 | $ | — | $ | — | $ | — | ||||||||||
| Other borrowings |
1,087 | 306 | 646 | 135 | — | |||||||||||||||
| Operating lease obligations |
1,620 | 239 | 493 | 513 | 375 | |||||||||||||||
| Deposits |
224,102 | 207,287 | 16,353 | 462 | — | |||||||||||||||
| Deferred compensation |
1,137 | 68 | 121 | 100 | 848 | |||||||||||||||
| Purchase obligations |
2,465 | 1,094 | 1,110 | 261 | — | |||||||||||||||
| Total contractual cash obligations |
$ | 232,789 | $ | 211,372 | $ | 18,723 | $ | 1,471 | $ | 1,223 | ||||||||||
We are a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or loans approved but not yet funded, standby letters of credit, and commitments to sell loans. These instruments involve, to varying degrees, elements of risk which have not been recognized in our consolidated balance sheets.
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Loan commitments are agreements to extend credit to a customer so long as there are no violations of the applicable contract terms prior to the funding. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Because certain of the commitments are expected to be withdrawn or expire unused, the total commitment amount does not necessarily represent future cash requirements. Standby letters of credit are written unconditional commitments to guarantee the performance of a Bank customer to a third party.
We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with credit risk.
The following table reflects our other commitments outstanding as of December 31, 2010:
| Commitments to extend credit |
$ | 34,178,926 | ||
| Standby letters of credit |
184,000 | |||
| Total other commitments |
$ | 34,362,926 | ||
Asset/Liability Management
Our primary market risk exposure is interest rate risk. Fluctuations in interest rates will impact both the level of our interest income and interest expense and the market value of our interest-earning assets and interest-bearing liabilities. Our ability to manage interest rate risk generally depends on our ability to match the maturities, repricing characteristics and expected future cash flows of our assets and liabilities while taking into account the separate goals of maintaining asset quality, liquidity and achieving the desired level of net interest income.
One of the methods we use to manage interest rate risk is the management of the Bank’s net interest income at risk. This technique estimates the impact of instantaneous and parallel changes in interest rates on net interest income over the twelve months following a specified balance sheet date. In this analysis, a base net interest income scenario is computed assuming interest rates that existed on interest-bearing assets and liabilities at the balance sheet date. With the balance sheet held constant, instantaneous and parallel interest rate changes are then applied to the base interest rates and net interest income is calculated for each level of increase and decrease in interest rates. The sensitivity of net interest income to each change in interest rates is measured by the change in net interest income from the base net interest income scenario.
Numerous factors may result in the net interest income estimates resulting from this methodology to differ from actual results. Changes to the shape of the yield curve are typically not consistent with an instantaneous and parallel shift in interest rates. Also, changes in interest rates do not affect all assets and liabilities equally. For example, interest rates of certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types of assets and liabilities may lag behind changes in market rates. Certain assets may have features that restrict changes on their interest rates on a short term basis.
The following table illustrates the expected effect on net interest income for the twelve months following the end of 2010 due to immediate and parallel changes in interest rates. Estimated changes in net interest income are dependent on assumptions including, but not limited to, those discussed above.
Effect on Bank Net Interest Income
| For the Twelve Months Following December 31, 2010 | ||||||||
| Change in Net Interest Income | ||||||||
| (dollars in thousands) | ||||||||
| Change in Interest Rates |
Amount | % | ||||||
| +200 basis points |
$ | (340.3 | ) | (3.13 | %) | |||
| +100 basis points |
(193.6 | ) | (1.78 | %) | ||||
| -100 basis points |
NM | (1) | N | M(1) | ||||
| -200 basis points |
NM | (1) | N | M(1) | ||||
| (1) | NM – Due to historically low interest rates, management believes that parallel interest rate changes on interest-bearing assets and interest-bearing liabilities in these scenarios are not meaningful. |
Off Balance Sheet Arrangements
In the normal course of business, we are a party to financial instruments with off-balance-sheet risk. Those financial instruments, designed to meet the financing needs of customers, include commitments to sell loans, issue standby letters of credit and
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otherwise extend credit. Those instruments involve both credit and interest rate risk in addition to the amount recognized on the balance sheet. The contractual amounts of these financial instruments reflect the extent of involvement in the event of nonperformance by the other party to the financial instrument. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments, and we obtain collateral based on our credit assessment of the customer in each instance.
Additional information related to our off-balance-sheet risk exposure is detailed in Note 15 to the accompanying consolidated financial statements under Item 8, “Financial Statements and Supplementary Data,” below.
Effects of Inflation
The effect of changing prices is typically different for financial institutions than for other companies because a financial institution’s assets and liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price-level indices. Our consolidated financial statements under Item 8, “Financial Statements and Supplementary Data,” below reflect the impact of inflation on interest rates, loan demands and deposits.
| ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
The Company is a smaller reporting company and thus is not required to provide the information specified by this Item 7A.
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| ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Heritage Bankshares, Inc.
Norfolk, Virginia
We have audited the consolidated balance sheets of Heritage Bankshares, Inc. and subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Bankshares, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
/s/ Elliott Davis LLC
Galax, Virginia
March 23, 2011
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HERITAGE BANKSHARES, INC.
CONSOLIDATED BALANCE SHEETS
At December 31, 2010 and 2009
| 2010 | 2009 | |||||||
| ASSETS |
||||||||
| Cash and due from banks |
$ | 3,055,518 | $ | 4,597,898 | ||||
| Interest-bearing deposits in other banks |
12,923,520 | 14,738,116 | ||||||
| Federal funds sold |
400,402 | 2,667,701 | ||||||
| Total cash and cash equivalents |
16,379,440 | 22,003,715 | ||||||
| Certificates of deposit in other banks |
2,259,592 | 3,936,031 | ||||||
| Securities available for sale, at fair value |
17,368,397 | 50,103,366 | ||||||
| Loans, net |
||||||||
| Held for investment, net of allowance for loan losses of $2,089,557 and $1,773,125, respectively |
214,341,764 | 181,544,470 | ||||||
| Accrued interest receivable |
668,173 | 746,466 | ||||||
| Stock in Federal Reserve Bank (“FRB”), at cost |
587,150 | 586,000 | ||||||
| Stock in Federal Home Loan Bank of Atlanta (“FHLB”), at cost |
1,773,300 | 1,475,800 | ||||||
| Other real estate owned |
263,413 | 313,300 | ||||||
| Premises and equipment, net |
11,164,513 | 11,890,993 | ||||||
| Other assets |
2,282,247 | 1,954,020 | ||||||
| Total assets |
$ | 267,087,989 | $ | 274,554,161 | ||||
| LIABILITIES AND STOCKHOLDERS’ EQUITY |
||||||||
| Liabilities |
||||||||
| Deposits |
||||||||
| Noninterest-bearing |
$ | 85,308,242 | $ | 76,429,367 | ||||
| Interest-bearing |
138,794,096 | 152,706,795 | ||||||
| Total deposits |
224,102,338 | 229,136,162 | ||||||
| Federal Home Loan Bank Advance |
— | 5,000,000 | ||||||
| Securities sold under agreements to repurchase |
2,377,697 | 2,016,235 | ||||||
| Other borrowings |
1,086,547 | — | ||||||
| Accrued interest payable |
100,506 | 118,401 | ||||||
| Other liabilities |
1,841,432 | 1,504,928 | ||||||
| Total liabilities |
229,508,520 | 237,775,726 | ||||||
| Commitments and contingencies |
— | — | ||||||
| Stockholders’ equity |
||||||||
| Preferred stock, no par value – 1,000,000 shares authorized: |
||||||||
| Fixed rate cumulative perpetual preferred stock, Series A, 10,103 shares issued and outstanding at both December 31, 2010 and December 31, 2009 |
10,103,000 | 10,103,000 | ||||||
| Fixed rate cumulative perpetual preferred stock, Series B, 303 shares issued and outstanding at both December 31, 2010 and December 31, 2009 |
303,000 | 303,000 | ||||||
| Common stock, $5 par value – 6,000,000 shares authorized; 2,307,502 and 2,291,352 shares issued and outstanding at December 31, 2010 and December 31, 2009, respectively |
11,537,510 | 11,456,760 | ||||||
| Additional paid-in capital |
6,657,704 | 6,472,893 | ||||||
| Retained earnings |
8,801,093 | 7,854,024 | ||||||
| Discount on preferred stock |
(234,681 | ) | (288,812 | ) | ||||
| Accumulated other comprehensive income, net |
411,843 | 877,570 | ||||||
| Total stockholders’ equity |
37,579,469 | 36,778,435 | ||||||
| Total liabilities and stockholders’ equity |
$ | 267,087,989 | $ | 274,554,161 | ||||
The notes to consolidated financial statements are an integral part of these statements.
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HERITAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2010 and 2009
| 2010 | 2009 | |||||||
| Interest and dividend income |
||||||||
| Loans and fees on loans |
$ | 10,170,857 | $ | 9,015,074 | ||||
| Taxable investment securities |
1,403,457 | 2,140,695 | ||||||
| Dividends on FRB and FHLB stock |
39,996 | 27,276 | ||||||
| Interest on federal funds sold |
812 | 2,085 | ||||||
| Other interest income |
132,378 | 92,586 | ||||||
| Total interest income |
11,747,500 | 11,277,716 | ||||||
| Interest expense |
||||||||
| Deposits |
1,397,569 | 2,076,112 | ||||||
| Borrowings |
144,281 | 139,458 | ||||||
| Total interest expense |
1,541,850 | 2,215,570 | ||||||
| Net interest income |
10,205,650 | 9,062,146 | ||||||
| Provision for loan losses |
367,500 | 169,073 | ||||||
| Net interest income after provision for loan losses |
9,838,150 | 8,893,073 | ||||||
| Noninterest income |
||||||||
| Service charges on deposit accounts |
445,122 | 398,186 | ||||||
| Gains on sale of loans held for sale, net |
— | 3,367 | ||||||
| Income from bank-owned life insurance |
18,151 | 53,601 | ||||||
| Gain on sale of investment securities |
993,590 | — | ||||||
| Late charges and other fees on loans |
85,387 | 42,861 | ||||||
| Other |
300,679 | 283,631 | ||||||
| Total noninterest income |
1,842,929 | 781,646 | ||||||
| Noninterest expense |
||||||||
| Compensation |
4,431,787 | 4,066,419 | ||||||
| Data processing |
555,963 | 505,638 | ||||||
| Occupancy |
771,639 | 793,460 | ||||||
| Furniture and equipment |
585,833 | 629,585 | ||||||
| Taxes and licenses |
342,066 | 272,538 | ||||||
| Professional fees |
349,967 | 468,510 | ||||||
| FDIC assessment |
307,016 | 456,459 | ||||||
| Loss on early extinguishment of debt |
262,800 | — | ||||||
| Marketing |
121,851 | 82,050 | ||||||
| Telephone |
115,925 | 102,282 | ||||||
| Stationery and supplies |
74,528 | 78,373 | ||||||
| Loss on disposal or impairment of fixed assets |
6,484 | 7,588 | ||||||
| Other |
576,070 | 618,906 | ||||||
| Total noninterest expense |
8,501,929 | 8,081,808 | ||||||
| Income before provision for income taxes |
3,179,150 | 1,592,911 | ||||||
| Provision for income taxes |
1,093,229 | 541,245 | ||||||
| Net income |
2,085,921 | 1,051,666 | ||||||
| Preferred stock dividends and accretion of discount |
(586,551 | ) | (156,166 | ) | ||||
| Net income available to common stockholders |
$ | 1,499,370 | $ | 895,500 | ||||
| Earnings per common share |
||||||||
| Basic |
$ | 0.65 | $ | 0.39 | ||||
| Diluted |
$ | 0.65 | $ | 0.39 | ||||
| Dividends per common share |
$ | 0.24 | $ | 0.24 | ||||
| Weighted average common shares outstanding – basic |
2,301,957 | 2,285,074 | ||||||
| Effect of dilutive stock options |
8,933 | 10,287 | ||||||
| Weighted average common shares outstanding – assuming dilution |
2,310,890 | 2,295,361 | ||||||
The notes to consolidated financial statements are an integral part of these statements
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HERITAGE BANKSHARES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2010 and 2009
| Preferred Shares | Common Stock | Additional Paid-in Capital |
Retained Earnings |
Accumulated Other Comprehensive Income |
Total | |||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | |||||||||||||||||||||||||||||
| Balance, December 31, 2008 |
— | $ | — | 2,279,252 | $ | 11,396,260 | $ | 6,329,854 | $ | 7,438,911 | $ | 673,535 | $ | 25,838,560 | ||||||||||||||||||
| Comprehensive income: |
||||||||||||||||||||||||||||||||
| Net income for 2009 |
— | — | — | — | — | 1,051,666 | — | 1,051,666 | ||||||||||||||||||||||||
| Change in unrealized gain on securities available-for-sale, net of tax of $105,110 |
— | — | — | — | — | — | 204,035 | 204,035 | ||||||||||||||||||||||||
| Total comprehensive income |
— | — | — | — | — | — | — | 1,255,701 | ||||||||||||||||||||||||
| Exercise of stock options and related tax benefits |
— | — | 12,100 | 60,500 | 37,321 | — | — | 97,821 | ||||||||||||||||||||||||
| Equity-based compensation expense |
— | — | — | — | 216,642 | — | — | 216,642 | ||||||||||||||||||||||||
| Issuance of Series A preferred stock |
10,103 | 10,103,000 | — | — | — | — | — | 10,103,000 | ||||||||||||||||||||||||
| Issuance of Series B preferred stock |
303 | 303,000 | — | — | — | — | — | 303,000 | ||||||||||||||||||||||||
| Costs related to issuance of preferred stock |
— | — | — | — | (110,924 | ) | — | — | (110,924 | ) | ||||||||||||||||||||||
| Net accretion from issuance of preferred stock warrants |
— | (288,812 | ) | — | — | — | (14,188 | ) | — | (303,000 | ) | |||||||||||||||||||||
| Cash dividends on preferred stock |
— | — | — | — | — | (73,947 | ) | — | (73,947 | ) | ||||||||||||||||||||||
| Cash dividends on common stock ($0.24 per share) |
— | — | — | — | — | (548,418 | ) | — | (548,418 | ) | ||||||||||||||||||||||
| Balance, December 31, 2009 |
10,406 | $ | 10,117,188 | 2,291,352 | $ | 11,456,760 | $ | 6,472,893 | $ | 7,854,024 | $ | 877,570 | $ | 36,778,435 | ||||||||||||||||||
| Comprehensive income: |
||||||||||||||||||||||||||||||||
| Net income for 2010 |
— | — | — | — | — | 2,085,921 | — | 2,085,921 | ||||||||||||||||||||||||
| Change in unrealized gain on securities available-for-sale, net of tax of $239,920 |
— | — | — | — | — | — | (465,727 | ) | (465,727 | ) | ||||||||||||||||||||||
| Total comprehensive income |
— | — | — | — | — | — | — | 1,620,194 | ||||||||||||||||||||||||
| Exercise of stock options and related tax benefits |
— | — | 16,150 | 80,750 | 43,473 | — | — | 124,223 | ||||||||||||||||||||||||
| Equity-based compensation expense |
— | — | — | — | 141,338 | — | — | 141,338 | ||||||||||||||||||||||||
| Net accretion from issuance of preferred stock warrants |
— | 54,131 | — | — | — | (54,131 | ) | — | — | |||||||||||||||||||||||
| Cash dividends on preferred stock |
— | — | — | — | — | (532,420 | ) | — | (532,420 | ) | ||||||||||||||||||||||
| Cash dividends on common stock ($0.24 per share) |
— | — | — | — | — | (552,301 | ) | — | (552,301 | ) | ||||||||||||||||||||||
| Balance, December 31, 2010 |
10,406 | $ | 10,171,319 | 2,307,502 | $ | 11,537,510 | $ | 6,657,704 | $ | 8,801,093 | $ | 411,843 | $ | 37,579,469 | ||||||||||||||||||
The notes to consolidated financial statements are an integral part of these statements.
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HERITAGE BANKSHARES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
Years Ended December 31, 2010 and 2009
| 2010 | 2009 | |||||||
| Cash flows from operating activities: |
||||||||
| Net income |
$ | 2,085,921 | $ | 1,051,666 | ||||
| Adjustments to reconcile net income to net cash provided by operating activities: |
||||||||
| Provision for loan loss |
367,500 | 169,073 | ||||||
| Amortization of loan yield adjustments, net |
363,526 | 381,426 | ||||||
| Depreciation, amortization and accretion, net |
828,838 | 914,917 | ||||||
| Stock-based compensation |
141,338 | 216,642 | ||||||
| Deferred compensation |
65,591 | 149,655 | ||||||
| Exercise of stock options tax benefit |
31,173 | 14,496 | ||||||
| Net (gains) losses on: |
||||||||
| Sale of securities |
(993,590 | ) | — | |||||
| Sale, disposal or impairment of property, plant and equipment |
6,484 | 7,588 | ||||||
| Sale or impairment of other real estate owned |
29,627 | 24,200 | ||||||
| Net gain on bank-owned life insurance |
(18,151 | ) | (53,601 | ) | ||||
| Changes in assets/liabilities, net |
||||||||
| Decrease(increase) in interest receivable and other assets |
8,136 | (1,179,713 | ) | |||||
| Increase(decrease) in interest payable and other liabilities |
267,792 | (283,198 | ) | |||||
| Net cash provided by operating activities |
3,184,185 | 1,413,151 | ||||||
| Cash flows from investing activities: |
||||||||
| Proceeds from maturities and principal repayments of securities available for sale |
36,321,130 | 20,888,769 | ||||||
| Purchases of securities available for sale |
(46,052,671 | ) | (26,064,135 | ) | ||||
| Proceeds from sales of securities available for sale |
42,499,712 | — | ||||||
| Net decrease/(increase) in certificates of deposit in other banks |
1,676,439 | (2,976,031 | ) | |||||
| Proceeds from sale of other real estate owned |
283,673 | — | ||||||
| Net increase in loans held for investment |
(33,528,320 | ) | (5,693,363 | ) | ||||
| Purchases of Federal Home Loan Bank stock and Federal Reserve Bank stock |
(438,750 | ) | (1,999,500 | ) | ||||
| Redemption of Federal Home Loan Bank stock and Federal Reserve Bank stock |
140,100 | 883,200 | ||||||
| Purchases of premises and equipment |
(132,287 | ) | (631,729 | ) | ||||
| Proceeds from sales of premises and equipment |
— | 14,945 | ||||||
| Proceeds from bank owned life insurance |
— | 134,463 | ||||||
| Net cash provided by/(used for) investing activities |
769,026 | (15,443,381 | ) | |||||
| Cash flows from financing activities: |
||||||||
| Proceeds from exercise of stock options |
93,050 | 83,325 | ||||||
| Net increase/(decrease) in deposits |
(5,033,824 | ) | 13,354,471 | |||||
| Proceeds from Federal Home Loan Bank advances |
101,355,000 | 154,550,000 | ||||||
| Repayments of Federal Home Loan Bank advances |
(106,355,000 | ) | (154,550,000 | ) | ||||
| Net increase in securities sold under agreements to repurchase |
361,462 | 769,699 | ||||||
| Proceeds from federal funds purchased |
— | 43,735,000 | ||||||
| Repayment of federal funds purchased |
— | (43,736,000 | ) | |||||
| Proceeds from other borrowings |
1,160,000 | — | ||||||
| Repayments of other borrowings |
(73,453 | ) | — | |||||
| Net proceeds from issuance of preferred stock |
— | 9,992,076 | ||||||
| Cash dividends paid |
(1,084,721 | ) | (622,365 | ) | ||||
| Net cash provided by/(used for) financing activities |
(9,577,486 | ) | 23,576,206 | |||||
| Increase(decrease) in cash and cash equivalents |
(5,624,275 | ) | 9,545,976 | |||||
| Cash and cash equivalents, beginning of period |
22,003,715 | 12,457,739 | ||||||
| Cash and cash equivalents, end of period |
$ | 16,379,440 | $ | 22,003,715 | ||||
| Supplemental disclosure: |
||||||||
| Interest paid |
$ | 1,559,745 | $ | 2,333,806 | ||||
| Income taxes paid |
$ | 1,193,052 | $ | 445,000 | ||||
| Noncash financing activities: |
||||||||
| Transfer of loans to other real estate owned |
$ | — | $ | 160,000 | ||||
| Noncash investing activities: |
||||||||
| Transfer of premises and equipment to other real estate owned |
$ | 263,413 | — | |||||
The notes to consolidated financial statements are an integral part of these statements.
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HERITAGE BANKSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2010 AND 2009
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Heritage Bankshares, Inc. and its wholly-owned subsidiary, Heritage Bank. All significant intercompany balances and transactions have been eliminated in consolidation.
Nature of Operations
Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and at December 31, 2010 the Company serves as the holding company for its wholly-owned subsidiary, Heritage Bank.
Heritage Bank (the “Bank”) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank is a full-service bank conducting a general commercial and consumer banking business with its customers located throughout the Hampton Roads area of Virginia. The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (“Sentinel Financial”). At December 31, 2010, Sentinel Financial owned an interest in Infinex Investments, Inc. (formerly Bankers Investment Group, LLC) and Bankers Insurance, LLC, providers of various insurance and investment products. The financial activities pertaining to these interests are recorded on the cost method of accounting for investments. In addition, at December 31, 2010, Sentinel Financial owned other real estate owned. This real estate is recorded at fair value.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and the valuation of deferred tax assets.
Significant Group Concentrations of Credit Risk
The Company invests in a variety of securities, principally obligations of the United States, U.S. government sponsored enterprises, mortgage-backed securities and obligations of states and political subdivisions. Note 4 presents the Company’s investment activities. Substantially all of the Company’s lending activities are with customers located in southeastern Virginia. Note 5 presents the Company’s lending activities. The Company does not have any significant concentrations of loans in any one industry or customer.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and overnight investments with Federal Home Loan Bank.
Certificates of Deposit in Other Banks
The Company invests in certificates of deposit at other financial institutions with original maturity dates between six and twenty-five months. All such existing certificates of deposit will mature during the year 2011.
Investment Securities
Investment securities are classified in three categories and accounted for as follows:
| • | Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. |
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| • | Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. |
| • | Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as other comprehensive income, a separate component of stockholders’ equity. |
Gains and losses on sales of securities are computed based on specific identification of the adjusted cost of each security and included in other income. Amortization of premiums and accretion of discounts are computed by the effective yield method and recognized in interest income.
Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary would result in write-downs of the individual securities to fair value. These write-downs would be included in the Company’s calculation of earnings as realized losses.
Loans
Loans are reported at their principal outstanding balance, net of charge-offs, deferred loan fees and costs on originated loans, unearned income, and unamortized premiums or discounts, if any, on purchased loans. Interest income is generally recognized when income is earned using the interest method. Loan origination fees and certain direct loan origination costs are deferred and the net amounts are amortized as an adjustment to yield on the respective loans.
Loans Held For Sale
Mortgage loans originated and intended for sale in the secondary market, if any, are carried at cost. Loans held for sale are pre-committed to secondary market investors and, subsequent to being closed, are held for short holding periods pending receipt of loan documents.
Allowance For Loan Losses
The Bank maintains an allowance for loan losses at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance, (2) recoveries on loans previously charged-off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.
The Bank analyzes its loan portfolio through ongoing credit review processes and constructs a comprehensive allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.
The Bank evaluates various loans individually for impairment based on guidance for receivables. An evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.
For loans without an individual measure of impairment, the Bank makes estimates of losses for groups of loans as provided by guidance for contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans.
The Bank then considers the impact of various bank, industry, economic and other environmental factors and documents which factors are used in the analysis.
The Bank’s allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by generally accepted accounting principles related to receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance on contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.
Income Recognition on Nonaccrual Loans
Loans are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful, or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.
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Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance by the borrower.
While a loan is classified as nonaccrual, and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis.
Other Real Estate Owned
Other real estate owned is comprised of real estate acquired through foreclosure, acceptance of a deed in lieu of foreclosure or loans in which the Company receives physical possession of the debtor’s real estate or change of management’s intent towards its own property. Other real estate owned is carried at the lower of the recorded investment in the loan or the fair value of the real estate. Net operating income of such properties, exclusive of depreciation, is included in other income and related depreciation expense is included in other expense.
Restructured Loans
Loans are considered troubled debt restructurings if, for economic or legal reasons, a concession has been granted to the borrower related to the borrower’s financial difficulties that the Company would not have otherwise considered. The Company restructures certain loans in instances where a determination is made that greater economic value will be realized under new terms rather than through foreclosure, liquidation or other disposition. The terms of the renegotiation generally involve some or all of the following characteristics: a reduction in the interest pay rate to reflect actual operating income, an extension of the loan maturity date to allow time for stabilization of operating income, and/or partial forgiveness of principal and interest.
The carrying value of a restructured loan is reduced by the fair value of assets or equity interest received from the borrower, if any. The Company generally classifies restructured loans as nonaccrual until such time as the loans demonstrate performance. The accrual of interest resumes when such loans can demonstrate performance, generally evidenced by six months of pre- or post-restructuring payment performance in accordance with the restructured terms, or by the presence of other significant factors. In addition, at the time of restructuring, loans are generally classified as impaired. A restructured loan that is not impaired, based on the restructured terms, and has a stated interest rate greater than or equal to a market interest rate at the date of the restructuring, is reclassified as unimpaired in the year immediately following the year it was disclosed as restructured.
Off Balance Sheet Credit Related Financial Instruments
In the ordinary course of business, the Company enters into commitments to extend credit and issue standby letters of credit. Such financial instruments are recorded when they are funded.
Rate Lock Commitments
The Company has in the past entered, and may from time to time in the future enter, into commitments to originate residential mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e., rate lock commitments). Any such rate lock commitments on mortgage loans to be sold in the secondary market are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 15 to 90 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. In such instances, the Company is not exposed to losses nor will it realize gains related to its rate lock commitments due to changes in interest rates.
The market values of rate lock commitments and best efforts contracts are not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss is recognized on the rate lock commitments.
Sale of Loans
Transfers of loans are accounted for as sales when control over the loans has been surrendered. Control over transferred loans is deemed to be surrendered when (1) the loans have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loans, and (3) the Company does not maintain effective control over the transferred loans through an agreement to repurchase them before their maturity.
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Premises and Equipment
Land is carried at cost. Buildings, leasehold improvements and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives of the assets, ranging from 2 years to 40 years.
Federal Reserve Bank Stock and Federal Home Loan Bank Stock
As a member of the Federal Reserve Bank (“FRB”), the Company is required to hold shares of FRB capital stock, $100 par value, in an amount equal to 6% of the Bank’s total common stock and capital surplus.
As a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, the Company is required to hold shares of capital stock in the FHLB in an amount equal to 0.18% of total assets plus 4.50% of borrowings from the FHLB.
FRB stock and FHLB stock are carried at cost.
Income Taxes
The Company files a consolidated tax return. Provisions for income taxes reflect tax expense incurred as a consolidated group. Tax expense is allocated among the members of the consolidated group in accordance with an intercompany agreement for tax expense. Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of investment securities, deferred loan fees, allowance for loan losses, allowance for losses on foreclosed real estate, premises and equipment and deferred compensation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. An allowance is provided if it is more likely than not that the Company will not realize the benefits of a deferred tax asset. Through December 31, 2010, no valuation allowance has been provided against the Company’s deferred tax asset.
The Company analyzes tax positions taken or expected to be taken on its tax returns to determine if it has any liability related to uncertain tax positions in accordance with guidance on income taxes. Liabilities, if any, resulting from this evaluation are recorded in the current period.
Deferred Compensation Plans
The Company maintains deferred compensation agreements with certain current and former directors and the beneficiary of its former chief executive officer, as well as a Supplemental Executive Retirement Plan with its current Chief Executive Officer. The Company’s policy is to accrue the present value of estimated amounts to be paid under the contracts over the required service period to the date the participant is fully eligible to receive the benefits. At December 31, 2010, the discount rate the Company utilized to determine the deferred compensation liability under such plans was determined by computing the average of the last three year-end periods’ AA corporate bond yield, whose approximate maturity corresponded to the approximate time remaining to pay out the expected benefits for each participant.
Bank-Owned Life Insurance
The Company has purchased life insurance policies on certain current and former directors. Company-owned life insurance is recorded at its cash surrender value, or the amount that can be realized.
Stock Compensation Plans
At December 31, 2010, the Company has one stock-based compensation plan, the Heritage 2006 Equity Incentive Plan, as amended and restated effective January 28, 2009 (the “2006 Incentive Plan”). The Company has adopted accounting guidance related to share-based payments, which requires that the fair value of equity instruments, such as stock options, be recognized as an expense in the issuing entity’s financial statements as services are performed. The Company had no existing stock options that remained unvested as of January 1, 2006. A description of the 2006 Incentive Plan and additional required disclosures are included in Note 10.
Earnings Per Common Share
Basic earnings per common share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method. Earnings per common share calculations are presented in Note 9.
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Comprehensive Income
Accounting principles generally require that recognized revenue and expenses, and realized gains and losses, be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Components of other comprehensive income are presented in Note 2.
Business Segments
The Company currently reports its activities as a single business segment. In determining appropriate segment definition and reporting, the Company considers components of the business about which financial information relating to performance and resource allocation is available and regularly evaluated by management. Management determines components for which it will implement performance and resource measurement procedures based upon criteria of relative importance and materiality to the organization.
Reclassifications
Certain reclassifications have been made to prior year financial statements to conform them to the current year presentation.
Recent Accounting Pronouncements
The following is a summary of recent authoritative pronouncements:
In March 2010, guidance related to derivatives and hedging was amended to exempt embedded credit derivative features related to the transfer of credit risk from potential bifurcation and separate accounting. Embedded features related to other types of risk and other embedded credit derivative features are not exempt from potential bifurcation and separate accounting. The amendments were effective for the Company on July 1, 2010. These amendments will have no impact on the financial statements.
In April 2010, guidance was issued related to accounting for acquired troubled loans that are subsequently modified. The guidance provides that if these loans meet the criteria to be accounted for within a pool, modifications to one or more of these loans does not result in the removal of the modified loan from the pool even if the modification would otherwise be considered a troubled debt restructuring. The pool of assets in which the loan is included will continue to be considered for impairment. The amendments do not apply to loans not meeting the criteria to be accounted for within a pool. These amendments are effective for modifications of loans accounted for within pools occurring in the first interim or annual period ending on or after July 15, 2010. These amendments had no impact on the financial statements.
In July 2010, the Receivables topic of the FASB Accounting Standards Codification (“ACS”) was amended to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments will require the allowance disclosures to be provided on a disaggregated basis. The Company is required to begin to comply with the disclosures in its financial statements for the year ended December 31, 2010. Disclosures about Troubled Debt Restructurings (“TDRs”) required by the Update have been deferred by FASB in an update issued in early 2011. The TDR disclosures are anticipated to be effective for periods ending after June 15, 2011.
As described above under Item 1, “Business – Supervision and Regulation”, on July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which significantly changes the regulation of financial institutions and the financial services industry. The Dodd-Frank Act includes several provisions that will affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future. Among other things, these provisions abolish the Office of Thrift Supervision and transfer its functions to the other federal banking agencies, relax rules regarding interstate branching, allow financial institutions to pay interest on business checking accounts, change the scope of federal deposit insurance coverage, and impose new capital requirements on bank and thrift holding companies. The Dodd-Frank Act also establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which will be given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting originator compensation, minimum repayment standards, and pre-payments. Management is actively reviewing the provisions of the Dodd-Frank Act and assessing its probable impact on our business, financial condition, and results of operations.
In August 2010, two updates were issued to amend various SEC rules and schedules pursuant to Release No. 33-9026: Technical Amendments to Rules, Forms, Schedules and Codification of Financial Reporting Policies and based on the issuance of SEC Staff Accounting Bulletin 112. The amendments related primarily to business combinations and removed references to “minority interest” and added references to “controlling” and “noncontrolling interests(s)”. The updates were effective upon issuance but had no impact on the Company’s financial statements.
Also in December 2010, the Business Combinations topic of the ASC was amended to specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business
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combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendment also requires that the supplemental pro forma disclosures include a description of the nature and amount of any material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. This amendment is effective for the Company for business combinations for which the acquisition date is on or after January 1, 2011, although early adoption is permitted. The Company does not expect the amendment to have any impact on the financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
Subsequent Events
In accordance with accounting guidance, the Company evaluated events and transactions for potential recognition or disclosure in our financial statements through the date the financial statements were issued.
NOTE 2 – OTHER COMPREHENSIVE INCOME
The components of other comprehensive income and related tax effects are as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Unrealized holding gains on available-for-sale securities |
$ | 287,944 | $ | 309,145 | ||||
| Realized gains on sales of available-for-sale securities, net of tax |
(993,590 | ) | — | |||||
| Tax effect on realized gains |
337,820 | — | ||||||
| Tax effect on unrealized gain |
(97,901 | ) | (105,110 | ) | ||||
| Other comprehensive income, net of tax |
$ | (465,727 | ) | $ | 204,035 | |||
NOTE 3 – RESTRICTIONS ON CASH AND DUE FROM BANKS
The Bank is required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2010 and 2009, these required reserve balances amounted to $3,532,000 and $3,935,000, respectively.
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NOTE 4 – SECURITIES
| Amortized Cost | Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | |||||||||||||
| At December 31, 2010 |
||||||||||||||||
| Securities available for sale |
||||||||||||||||
| Mortgage-backed securities |
$ | 16,744,391 | $ | 624,006 | $ | — | $ | 17,368,397 | ||||||||
| Total securities available for sale |
$ | 16,744,391 | $ | 624,006 | $ | — | $ | 17,368,397 | ||||||||
| Total securities (1) |
$ | 16,744,391 | $ | 624,006 | $ | — | $ | 17,368,397 | ||||||||
| At December 31, 2009 |
||||||||||||||||
| Securities available for sale |
||||||||||||||||
| U.S. Treasury securities |
$ | 5,000,000 | $ | — | $ | 25,000 | $ | 4,975,000 | ||||||||
| Mortgage-backed securities |
43,773,714 | 1,354,652 | — | 45,128,366 | ||||||||||||
| Total securities available for sale |
$ | 48,773,714 | $ | 1,354,652 | $ | 25,000 | $ | 50,103,366 | ||||||||
| Total securities (1) |
$ | 48,773,714 | $ | 1,354,652 | $ | 25,000 | $ | 50,103,366 | ||||||||
| (1) | At December 31, 2010 and 2009, the Company held no securities classified as held to maturity. |
Investment securities having an amortized cost of $6,396,463 and $3,717,818 at December 31, 2010 and 2009, respectively, are made available for retail repurchase agreements. The estimated fair values of these securities were $6,621,095 and $3,943,615 at December 31, 2010 and 2009, respectively.
Gross proceeds from sales of securities available for sale were $42,499,712 in 2010. Gross gains associated with these sales were $993,590; there were no gross losses from these sales. There were no sales of securities available for sale during the year 2009.
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The following tables show gross unrealized losses and fair value on investment securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2010 and 2009. The current year unrealized losses on investment securities, if any, are a result of changes in interest rates during the periods. All unrealized losses on investment securities are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.
| At December 31, 2010 | ||||||||||||||||||||||||
| Less Than 12 Months | 12 Months or More | Total | ||||||||||||||||||||||
| Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
|||||||||||||||||||
| U.S. government sponsored enterprises |
$ | — | $ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||||
| Mortgage-backed securities |
— | — | — | — | — | — | ||||||||||||||||||
| Total temporarily impaired securities |
$ | — | $ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||||
| At December 31, 2009 | ||||||||||||||||||||||||
| Less Than 12 Months | 12 Months or More | Total | ||||||||||||||||||||||
| Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
Fair Value | Unrealized Losses |
|||||||||||||||||||
| U.S. government sponsored enterprises |
$ | 4,975,000 | $ | 25,000 | $ | — | $ | — | $ | 4,975,000 | $ | 25,000 | ||||||||||||
| Mortgage-backed securities |
— | — | — | — | — | — | ||||||||||||||||||
| Total temporarily impaired securities |
$ | 4,975,000 | $ | 25,000 | $ | — | $ | — | $ | 4,975,000 | $ | 25,000 | ||||||||||||
The amortized cost and fair value of investment securities at December 31, 2010, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because some securities may be called or prepaid prior to their contractual maturity:
| Securities Available for Sale | Securities Held to Maturity (1) | |||||||||||||||
| Amortized Cost | Fair Value | Amortized Cost | Fair Value | |||||||||||||
| Due in one year or less |
$ | 492,055 | $ | 501,601 | $ | — | $ | — | ||||||||
| Due after one year through five years |
10,960,561 | 11,324,702 | — | — | ||||||||||||
| Due after five years through ten years |
5,291,775 | 5,542,094 | — | — | ||||||||||||
| Due after ten years |
— | — | — | — | ||||||||||||
| Total |
$ | 16,744,391 | $ | 17,368,397 | $ | — | $ | — | ||||||||
| (1) | At December 31, 2010, the Company held no securities classified as held to maturity. |
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Table of Contents
NOTE 5 – LOANS
Loans consist of the following:
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Commercial |
$ | 37,227,510 | $ | 31,909,596 | ||||
| Real estate - mortgage |
156,283,295 | 127,086,368 | ||||||
| Real estate - construction |
18,350,483 | 18,276,222 | ||||||
| Installment and consumer |
3,898,757 | 5,362,277 | ||||||
| Total loans: |
215,760,045 | 182,634,463 | ||||||
| Allowance for loan losses |
(2,089,557 | ) | (1,773,125 | ) | ||||
| Unearned loan fees/costs |
671,276 | 683,132 | ||||||
| Loans net |
$ | 214,341,764 | $ | 181,544,470 | ||||
Nonperforming assets were:
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Nonaccrual loans |
$ | — | $ | 935 | ||||
| Accruing loans past due 90 days or more |
— | 48 | ||||||
| Total nonperforming loans |
— | 983 | ||||||
| Real estate owned, net |
263,413 | 313,300 | ||||||
| Total nonperforming assets |
$ | 263,413 | $ | 314,283 | ||||
If interest on nonaccrual loans had been accrued, such interest would have approximated $240 and $5,450, in 2010 and 2009, respectively, none of which was recognized in income. There were no nonaccrual loans at December 31, 2010.
A summary of the activity in the allowance for loan losses account is as follows:
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Balance, beginning of year |
$ | 1,773,125 | $ | 1,652,174 | ||||
| Provision for loan losses |
367,500 | 169,073 | ||||||
| Loans charged-off |
(161,618 | ) | (96,553 | ) | ||||
| Recoveries |
110,550 | 48,431 | ||||||
| Balance, end of year |
$ | 2,089,557 | $ | 1,773,125 | ||||
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The following table presents the aging analysis of the Company’s loan portfolio at December 31, 2010:
| 30-59 Days Past Due |
60-89 Days Past Due |
90 days or more Past Due |
Total Past Due |
Current | Total Loans Outstanding |
Loans 90 days past due and accruing |
||||||||||||||||||||||
| Commercial |
$ | — | $ | — | $ | — | $ | — | $ | 37,227,510 | $ | 37,227,510 | $ | — | ||||||||||||||
| Real Estate Mortgage |
129,131 | — | — | 129,131 | 156,154,164 | 156,283,295 | — | |||||||||||||||||||||
| Real Estate Construction |
— | — | — | — | 18,350,483 | 18,350,483 | — | |||||||||||||||||||||
| Consumer |
— | — | — | — | 3,898,757 | 3,898,757 | — | |||||||||||||||||||||
| Total |
$ | 129,131 | $ | — | $ | — | $ | 129,131 | $ | 215,630,914 | $ | 215,760,045 | $ | — | ||||||||||||||
The Bank utilizes an internal system based on payment history as its primary credit indicator on its commercial and commercial real estate loan portfolios. Loans that consistently meet an established historical payment schedule are not given further scrutiny other than that given in the ordinary course of business. Any loan that misses its normal payment date falls into a category of heightened scrutiny to determine whether a potential weakness exists. Based upon the collection and analysis of certain data, if there is a determination that no weakness exists, the loan will be given no further heightened scrutiny. If, however, current financial information indicates a potential weakness, aggressive investigation will begin into collateral values and borrower ability to pay to determine loss potential to the Bank. If loss potential is small, the loan is placed into a category of continued monitoring. If loss potential is high, the process of collateral realization may begin.
The following table is a summary of credit quality indicators related to the Bank’s commercial and real estate loans at December 31, 2010:
| Commercial | Commercial Real Estate |
Real Estate Construction |
Total | |||||||||||||
| 2010 | 2010 | 2010 | 2010 | |||||||||||||
| Category: |
||||||||||||||||
| Normal review |
$ | 37,227,510 | $ | 99,516,228 | $ | 18,350,483 | $ | 155,094,221 | ||||||||
| Closely monitored |
— | 1,470,536 | — | 1,470,536 | ||||||||||||
| In collection |
— | — | — | — | ||||||||||||
| Total |
$ | 37,227,510 | $ | 100,986,764 | $ | 18,350,483 | $ | 156,564,757 | ||||||||
For regulatory purposes, the Bank utilizes an internal credit classification system to manage the credit quality of its commercial and real estate loan portfolios. Loans classified as substandard have well-defined weaknesses and typically have experienced a degradation in either the current value of the pledged collateral or of the paying capacity of the borrower. These loans carry a distinct possibility that the Bank could sustain some loss unless the weakness is corrected. Loans classified as doubtful have uncorrected weaknesses that have a high possibility of loss. A loan may reside in this classification temporarily until a currently unquantifiable expected loss can be determined with a greater degree of accuracy. Any loan classified in the Loss risk class is considered uncollectible and is to be charged-off within 30 days or less.
The following table presents a summary of commercial and real estate loans classified by this internal credit classification at December 31, 2010:
| Commercial | Commercial Real Estate |
Real Estate Construction |
Total | |||||||||||||
| 2010 | 2010 | 2010 | 2010 | |||||||||||||
| Grade: |
||||||||||||||||
| Pass |
$ | 37,220,245 | $ | 98,435,617 | $ | 16,756,896 | $ | 152,412,758 | ||||||||
| Substandard |
7,265 | 2,551,147 | 1,593,587 | 4,151,999 | ||||||||||||
| Doubtful |
— | — | — | — | ||||||||||||
| Loss |
— | — | — | — | ||||||||||||
| Total |
$ | 37,227,510 | $ | 100,986,764 | $ | 18,350,483 | $ | 156,564,757 | ||||||||
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The Bank utilizes delinquency status in its evaluation of credit exposure for consumer loans, which include both revolving and closed-end mortgages, installment, and personal loans. Consumer loans are considered to be nonperforming when severely delinquent, defined as 90 days or more past due.
The following table represents the credit risk profile for the consumer portfolio at December 31, 2010:
| Consumer Mortgages |
Installment and Other Consumer |
Total | ||||||||||
| Performing |
$ | 55,296,531 | $ | 3,898,757 | $ | 59,195,288 | ||||||
| Nonperforming |
— | — | — | |||||||||
| Total |
$ | 55,296,531 | $ | 3,898,757 | $ | 59,195,288 | ||||||
The following tables present an allocation of the Company’s allowance for loan losses and the respective loans evaluated based on its allowance methodology:
| Allowance for Loan Losses and Recorded Investment in Loans | ||||||||||||||||||||||||
| For the Year Ended December 31, 2010 | ||||||||||||||||||||||||
| Commercial | Real Estate Mortgage |
Real Estate Construction |
Consumer | Unallocated | Total | |||||||||||||||||||
| Allowance for loan losses: |
||||||||||||||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Individually evaluated for impairment (1) |
$ | — | $ | 12,867 | $ | — | $ | — | $ | — | $ | 12,867 | ||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Collectively evaluated for impairment |
326,858 | 1,380,071 | 161,332 | 34,258 | 174,171 | 2,076,690 | ||||||||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Loans acquired with deteriorated credit quality |
— | — | — | — | — | — | ||||||||||||||||||
| Total Ending Balance |
$ | 326,858 | $ | 1,392,938 | $ | 161,332 | $ | 34,258 | $ | 174,171 | $ | 2,089,557 | ||||||||||||
| Commercial | Real Estate Mortgage |
Real Estate Construction |
Consumer | Total | ||||||||||||||||||||
| Total loans: |
||||||||||||||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Individually evaluated for impairment |
$ | — | $ | 1,470,536 | $ | — | $ | — | $ | 1,470,536 | ||||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Collectively evaluated for impairment |
37,227,510 | 154,812,759 | 18,350,483 | 3,898,757 | 214,289,509 | |||||||||||||||||||
| Ending balance: |
||||||||||||||||||||||||
| Loans acquired with deteriorated credit quality |
— | — | — | — | — | |||||||||||||||||||
| Total Ending Balance |
$ | 37,227,510 | $ | 156,283,295 | $ | 18,350,483 | $ | 3,898,757 | $ | 215,760,045 | ||||||||||||||
| (1) | Certain loans were evaluated for impairment at December 31, 2010. Based on this evaluation process, it was determined that no impairment was required. |
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The Company had no impaired loans at December 31, 2010. The following table reflects the average daily recorded investment in impaired loans during the year and interest income recognized on those loans:
| Impaired Loans For the Year Ended December 31, 2010 |
||||||||||||||||||||
| Recorded Investment |
Unpaid Balance |
Related Allowance |
Average Daily Recorded Investment |
Interest Income Recognized |
||||||||||||||||
| With no allowance recorded: |
||||||||||||||||||||
| Commercial |
$ | — | $ | — | $ | — | $ | 44,148 | $ | 2,541 | ||||||||||
| Real Estate Mortgage |
— | — | — | — | — | |||||||||||||||
| Real Estate Construction |
— | — | — | — | — | |||||||||||||||
| Consumer |
— | — | — | 9,181 | 660 | |||||||||||||||
| Total |
$ | — | $ | — | $ | — | $ | 53,329 | $ | 3,201 | ||||||||||
| With an allowance recorded: |
||||||||||||||||||||
| Commercial |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Real Estate Mortgage |
— | — | — | — | — | |||||||||||||||
| Real Estate Construction |
— | — | — | — | — | |||||||||||||||
| Consumer |
— | — | — | — | — | |||||||||||||||
| Total |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Total |
||||||||||||||||||||
| Commercial |
$ | — | $ | — | $ | — | $ | 44,148 | $ | 2,541 | ||||||||||
| Real Estate Mortgage |
— | — | — | — | — | |||||||||||||||
| Real Estate Construction |
— | — | — | — | — | |||||||||||||||
| Consumer |
— | — | — | 9,181 | 660 | |||||||||||||||
| Total |
$ | — | $ | — | $ | — | $ | 53,329 | $ | 3,201 | ||||||||||
The following is a summary of information pertaining to impaired loans for the year ending December 31, 2009:
| At December 31, | ||||
| 2009 | ||||
| Impaired loans without a valuation allowance |
$ | 1,470,706 | ||
| Impaired loans with a valuation allowance |
— | |||
| Total impaired loans: |
$ | 1,470,706 | ||
| Valuation allowance related to impaired loans |
$ | — | ||
| Year Ended December 31, | ||||
| 2009 | ||||
| Daily average investment in impaired loans during the year |
$ | 534,814 | ||
| Interest income recognized on impaired loans |
$ | 23,315 | ||
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NOTE 6 – PREMISES AND EQUIPMENT
Premises and equipment consist of the following:
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Land and improvements |
$ | 3,745,091 | $ | 4,008,504 | ||||
| Buildings and improvements |
5,379,511 | 5,341,873 | ||||||
| Leasehold improvements |
1,710,267 | 1,710,267 | ||||||
| Equipment, furniture and fixtures |
3,256,609 | 3,203,404 | ||||||
| Fixed assets not in service |
12,429 | 15,200 | ||||||
| 14,103,907 | 14,279,248 | |||||||
| Less - accumulated depreciation |
(2,939,394 | ) | (2,388,255 | ) | ||||
| $ | 11,164,513 | $ | 11,890,993 | |||||
Depreciation expense for the years ended December 31, 2010 and 2009 was $588,870 and $626,247, respectively. In 2010 and 2009, the Company incurred losses on disposal and impairment charges related to equipment of $6,484 and $7,588, respectively.
The Company leases approximately 12,000 square feet of office space for executive and operating offices and a branch. The initial lease term, which began in 2007, is for ten years expiring in 2017 with four renewal options of five years each. The Company pays a minimum rent plus annual adjustments based on a CPI index. Total rent expense for the years ended December 31, 2010 and 2009 amounted to $219,950 and $266,908, respectively.
Future minimum lease payments, by year and in the aggregate, under noncancelable leases with remaining terms of one year or more at December 31, 2010 were as follows:
| 2011 |
$ | 239,290 | ||
| 2012 |
244,075 | |||
| 2013 |
248,957 | |||
| 2014 |
253,936 | |||
| 2015 |
259,015 | |||
| 2016-2017 |
375,092 | |||
| $ | 1,620,365 | |||
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Table of Contents
NOTE 7 – DEPOSITS
Interest-bearing deposits consist of the following at the dates indicated:
| December 31, | ||||||||
| 2010 | 2009 | |||||||
| Money Market and NOW |
$ | 87,467,499 | $ | 108,244,180 | ||||
| Savings |
2,902,126 | 2,652,171 | ||||||
| Certificates of deposit $100,000 and over |
1,814,807 | 3,089,532 | ||||||
| Other time deposits |
46,609,664 | 38,720,912 | ||||||
| $ | 138,794,096 | $ | 152,706,795 | |||||
At December 31, 2010, the scheduled maturities of time deposits are as follows:
| 2011 |
$ | 31,609,679 | ||
| 2012 |
15,929,936 | |||
| 2013 |
422,631 | |||
| 2014 and thereafter |
462,225 | |||
| $ | 48,424,471 | |||
NOTE 8 – SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS
Investment securities having an amortized cost of $6,396,463 and $3,717,818 and fair values of $6,621,095 and $3,943,615 were made available to secure retail repurchase agreements at December 31, 2010 and 2009, respectively. Information concerning securities sold under agreements to repurchase is summarized as follows:
| December 31, | ||||||||
| 2010 | 2009 | |||||||
| Balance at end of year |
$ | 2,377,697 | $ | 2,016,235 | ||||
| Average balance during the year |
$ | 2,324,621 | $ | 2,441,107 | ||||
| Weighted average interest rate during the year |
0.19 | % | 0.18 | % | ||||
| Interest expense during the year |
$ | 4,417 | $ | 4,403 | ||||
| Maximum month-end balance during the year |
$ | 5,389,039 | $ | 3,626,402 | ||||
The Bank is a member of the FHLB of Atlanta, which had established, at December 31, 2010, a credit availability for the Bank in an amount equal to 20% of the Bank’s total assets. At December 31, 2010, the Bank had no outstanding advances under the FHLB credit line. Borrowings from the Federal Home Loan Bank are secured by a blanket collateral agreement on a pledged portion of the Bank’s 1-4 family residential real estate loans, home equity lines of credit, multifamily mortgage loans, and commercial real estate loans.
| December 31, | ||||||||
| 2010 | 2009 | |||||||
| Balance at end of year |
$ | — | $ | 5,000,000 | ||||
| Average balance during the year |
$ | 8,275,726 | $ | 7,493,288 | ||||
| Weighted average interest rate during the year |
1.49 | % | 1.82 | % | ||||
| Interest expense during the year |
$ | 125,340 | $ | 134,271 | ||||
| Maximum month-end balance during the year |
$ | 23,500,000 | $ | 22,550,000 | ||||
Other borrowings consist of participated loans sold by the Bank with disproportionate cash flows to the buyer. Generally accepted accounting principles consider these loans to be incomplete transfers because risk is not proportionate and require that this type of participation be classified as a borrowing. Because of this treatment, the entire loan balance is reported in loans held for investment and not reduced for the participation. At December 31, 2010, the outstanding balance for other borrowings was $1,086,547.
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Table of Contents
NOTE 9 – EARNINGS PER SHARE RECONCILIATION
The Company calculates its basic and diluted earnings per common share (“EPS”) in accordance with generally accepted accounting principles related to earnings per share. EPS is calculated after giving effect to payments made and other obligations in respect of the Company’s outstanding shares of preferred stock, and the components of the Company’s EPS calculations are as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Net income available to common stockholders (numerator, basic and diluted) |
$ | 1,499,370 | $ | 895,500 | ||||
| Weighted average common shares outstanding (denominator) |
2,301,957 | 2,285,074 | ||||||
| Earnings per common share – basic |
$ | 0.65 | $ | 0.39 | ||||
| Effect of dilutive securities |
||||||||
| Weighted average common shares outstanding |
2,301,957 | 2,285,074 | ||||||
| Effect of stock options |
8,933 | 10,287 | ||||||
| Diluted average common shares outstanding (denominator) |
2,310,890 | 2,295,361 | ||||||
| Earnings per common share – assuming dilution |
$ | 0.65 | $ | 0.39 | ||||
Basic earnings per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by applying the treasury stock method. Under the treasury stock method, the exercise of dilutive stock options is assumed. The sum of the assumed proceeds of (a) the stock option exercises, (b) the amount of any tax benefits that would be credited to additional paid-in capital assuming exercise of the options, and (c) the unamortized compensation expense on in-the-money options not yet recognized pursuant to generally accepted accounting principles for share-based payments (see Note 10 – Employee and Director Benefit Plans – Stock Compensation Plans) are assumed to be used to purchase common stock at the average market price during the period. The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased), if any, are included in the denominator of the diluted earnings per share calculation.
Any difference in the number of shares used for basic earnings per common share and diluted earnings per common share for each of the two years results solely from the dilutive effect of stock options. Options on an average of 121,374 shares and 232,000 shares were not included in computing diluted earnings per share for the years ended December 31, 2010 and December 31, 2009, respectively, because the effects of the corresponding stock options were antidilutive.
NOTE 10 – EMPLOYEE AND DIRECTOR BENEFIT PLANS
Stock Compensation Plans
Effective January 1, 2006, the Company adopted accounting guidance related to share-based payments, which requires that the fair value of equity instruments, such as stock options, be recognized as an expense in the issuing entity’s financial statements as services are performed. The Company had no existing stock options that remained unvested as of January 1, 2006.
Under the Heritage 2006 Equity Incentive Plan, as amended and restated effective January 28, 2009 (“2006 Incentive Plan”), the Board of Directors may grant up to 250,000 stock options, stock appreciation rights, restricted stock and certain other equity awards, in the aggregate, to officers and nonemployee directors of the Company and the Bank. The Board of Directors may approve the grant of nonstatutory stock options and options qualifying as incentive stock options, and the option price of both a nonstatutory stock option and an incentive stock option will be the Fair Market Value of the Company’s common stock on the date of grant. Prior to January 28, 2009, “Fair Market Value” under the 2006 Incentive Plan was defined generally as the weighted average (based on daily trading volume) during the thirty (30) day period next preceding the date of grant of the “last sale” prices of a share of the Company’s common stock on the five (5) days nearest preceding the date of grant on which at least 300 shares were traded. On January 28, 2009, the Board amended the definition of “Fair Market Value” to consist of the following: (i) the closing price of a share of the Company’s common stock on the OTC Bulletin Board on the grant date of the applicable award, if the grant date is a trading day; or (ii) if shares of the Company’s common stock are not traded on the grant date of the applicable award, then the closing price of a share of the Company’s common stock on the OTC Bulletin Board on the next preceding date on which a trade occurred; or (iii) if (i) and (ii) are inapplicable, the fair market value as determined in good faith by the Board.
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Table of Contents
A total of 206,400 options were outstanding under the 2006 Incentive Plan at December 31, 2010. For purposes of determining the “fair value”, as prescribed by accounting guidance for share-based payments, of options granted under the 2006 Incentive Plan, the measurement date is the date of grant. The fair value of each stock option award is estimated on the measurement date using a Black-Scholes valuation model that uses assumptions described below. Expected volatility is based on the historical volatility of the Company’s stock, using weekly price observations over the expected term of the stock options. The expected term represents the period of time that stock options granted are expected to be outstanding and is estimated based on management’s business plan and provisions of the grant including the contractual term and vesting schedule. The expected dividend yield is based on recent dividend history. The risk-free interest rate is the U.S. Treasury zero coupon yield curve in effect at the measurement date for the period corresponding to the expected life of the option.
All options granted will become exercisable earlier upon a change in control (as defined in the 2006 Incentive Plan) of the Company, subject to any limitations under applicable law, including limitations affecting certain executive and senior officers as a result of the Company’s participation in the TARP Capital Purchase Program. The options may also become exercisable earlier upon the optionee’s retirement, disability or death, and in the case of an optionee who is an employee, the optionee’s termination without cause or resignation for good reason, again subject to any limitations under applicable law. No option may be exercised after ten (10) years from the date of grant.
The estimates of fair value derived from the Black-Scholes option pricing model are theoretical values for stock options, and changes in assumptions used in the model could result in materially different fair value estimates. The actual value of the stock options will depend on the market value of the Company’s common stock when the options are exercised. There were 8,000 options granted in 2009; in addition, in January 2009, the Board of Directors modified the exercise price of a total of 132,000 outstanding option awards held by its named executive officers (see the Company’s Form 8-K filed on February 3, 2009 for additional information regarding such option modifications). No options were granted or modified in 2010. The fair value of options granted/modified, as applicable, were estimated using the following assumptions:
| Year Ended December 31 | ||||||||||||
| 2010 | 2009 | |||||||||||
| New Option Grants |
Modified Options |
|||||||||||
| Expected dividend yield |
— | 2.15 | % | 2.15 | % | |||||||
| Expected stock price volatility |
— | 33.8 | % | 33.8 | % | |||||||
| Risk-free interest rate |
— | 2.85 | % | 1.44-2.14 | % | |||||||
| Expected life of options |
— | 6.5 years | 3.5-4.7 years | |||||||||
| Weighted average fair value of options granted or modified during the period |
— | $ | 2.51 | $ | 1.29 | |||||||
| Incremental average fair value of options modified during the period |
— | — | $ | 0.55 | ||||||||
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The following table presents a summary of stock option activity during 2010 and 2009:
| Shares | Weighted Average Exercise Price |
Weighted Average Remaining Term (Years) |
Aggregate Intrinsic Value |
|||||||||||||
| (in thousands) | ||||||||||||||||
| Outstanding at January 1, 2010 |
267,000 | $ | 12.02 | |||||||||||||
| Granted |
— | — | ||||||||||||||
| Exercised |
(16,150 | ) | 5.76 | |||||||||||||
| Forfeited/expired |
(9,450 | ) | 7.42 | |||||||||||||
| Outstanding at December 31, 2010 |
241,400 | $ | 12.62 | 5.7 | $ | 258 | ||||||||||
| Exercisable at December 31, 2010 |
190,200 | $ | 12.74 | 5.5 | $ | 197 | ||||||||||
| Outstanding at January 1, 2009 |
295,000 | $ | 14.10 | — | — | |||||||||||
| Granted |
8,000 | 8.25 | — | — | ||||||||||||
| Exercised |
(12,100 | ) | 6.89 | — | — | |||||||||||
| Forfeited/expired |
(23,900 | ) | 7.25 | — | — | |||||||||||
| Outstanding at December 31, 2009 |
267,000 | $ | 12.02 | 6.1 | $ | 111 | ||||||||||
| Exercisable at December 31, 2009 |
176,600 | $ | 11.78 | 5.6 | $ | 103 | ||||||||||
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the applicable year and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2010 and 2009, as applicable. The value changes based on the fair market value of the Company’s stock. The Company’s current policy is to issue new shares to satisfy share option exercises.
The aggregate intrinsic value of options exercised for the twelve months ended December 31, 2010 and December 31, 2009 was $91,686 and $42,635, respectively. Cash received from option exercises during 2010 and 2009 was $93,050 and $83,325, respectively. The total fair value of shares underlying options that vested during the same periods was $151,544 and $98,760, respectively.
The amount charged against income, before income tax benefit of $10,694, in relation to the stock-based payment arrangement was $141,338 for the year ended December 31, 2010. The amount charged against income, before income tax benefit of $60,899, in relation to the stock-based payment arrangement was $216,642 for the year ended December 31, 2009. At December 31, 2010, unrecognized compensation expense, net of estimated forfeitures, related to unvested stock option grants was $84,163 and is currently expected to be recognized over a weighted average period of 0.8 years as follows:
| Stock-Based Compensation Expense |
||||
| (in thousands) | ||||
| For the year ended December 31: |
||||
| 2011 |
$ | 68 | ||
| 2012 |
12 | |||
| 2013 |
4 | |||
| Total |
$ | 84 | ||
Stock option awards granted under the 2006 Incentive Plan provide for accelerated vesting under certain circumstances as defined in the Plan, such as a change of control with respect to the Company, the optionee’s retirement, death, permanent disability and, if the optionee is an employee of the Company, resignation for good reason or termination without cause, subject to any limitations under applicable law, including limitations affecting certain executive and senior officers as a result of the Company’s participation in the TARP Capital Purchase Program. Occurrence of these events may cause the requisite service period to be less than reflected in the schedule above and unamortized stock-based compensation expense recognized at that time.
Deferred Compensation Plans
In 1985, the Company entered into a deferred compensation and retirement arrangement with certain directors and subsequently with one officer.
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The Company is a party to a Supplemental Executive Retirement Plan (“SERP”) with Michael S. Ives, President & Chief Executive Officer of the Company and the Bank, that provides for an immediately accrued retirement benefit of $25,000 for Mr. Ives. Under the SERP, Mr. Ives will be paid $25,000 each year for ten years, in equal monthly installments (i.e., $2,083.33), in accordance with the terms and on the schedule set forth in the SERP.
In addition, under his Executive Deferred Compensation Agreement effective February 1, 2010, Mr. Ives may (but is not obligated to) elect to defer a portion of his annual base salary each calendar year (an “Elective Deferral”), pursuant to an advance election process that complies with Internal Revenue Code Section 409A. The Elective Deferrals and related investment earnings are nominally funded through a grantor Deferred Compensation Plan Trust (i.e., a “Rabbi Trust”), where the Company is the grantor for income tax purposes and pursuant to which assets of the Company are maintained as reserves against the Company’s obligations under the Executive Deferred Compensation Agreement. The Elective Deferrals are 100% vested at all times, and the Elective Deferrals and any related investment earnings are payable (in a lump sum and/or installments) at separation from service, a change in control of the Company, a specified date, death and/or disability, as specified by Mr. Ives with respect to each Elective Deferral.
The Company’s policy for these deferred compensation plans is to accrue the present value of estimated amounts to be paid under the applicable agreements over the required service period to the date the participant is fully eligible to receive the benefit. At December 31, 2010 and 2009, other liabilities included $897,393 and $751,348, respectively, related to these plans. Compensation expense related to these plans was $65,591 and $149,655 for the years ended December 31, 2010 and 2009, respectively.
Employee Stock Ownership Plan
The Board of Directors adopted an Employees’ Stock Ownership Plan (the “ESOP”) effective January 1, 1998. The ESOP covers substantially all employees after they have met eligibility requirements, and funds contributed to the plan are used to purchase outstanding common stock of the Company.
The Company recognized no compensation expense related to the ESOP for the years ended December 31, 2010 and 2009, respectively. Dividends received by the ESOP are used for administrative expenses of the plan. At December 31, 2010 and 2009, the ESOP owned 13,686 and 13,385 shares, respectively, of common stock of the Company. There were no stock purchases by the ESOP for the years ended December 31, 2010 or 2009. No shares were distributed from the ESOP to terminated employees during either year. During 2010 and 2009, certain ESOP participants returned a total of 301 and 3,114, respectively, shares of common stock to the Company to correct inadvertent over-distributions of ESOP shares from the plan. At December 31, 2010 and 2009, the fair market value of the shares held by the ESOP totaled $171,075 and $127,158, respectively.
401(k) Retirement Program
Effective January 1, 1993, the Board of Directors adopted a 401(k) Retirement Program (the “401(k) Plan”). Eligible employees who have completed the required months of service are eligible to participate and make contributions. The Company makes employer matching contributions. The Company expensed $94,955 and $78,964 for 401(k) Plan matching contributions during the years ended December 31, 2010 and December 31, 2009, respectively.
NOTE 11 – OTHER REAL ESTATE OWNED
At December 31, 2010, the Company had other real estate owned in the amount of $263,413, consisting of a Bank branch site that the Company does not plan to utilize in the future. At December 31, 2009, the Company had other real estate owned of $313,300.
NOTE 12 – OTHER NONINTEREST INCOME AND EXPENSE
The components of other noninterest income are as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Credit card interchange fees |
$ | 40,231 | $ | 32,556 | ||||
| ATM transaction fees |
137,937 | 126,903 | ||||||
| Merchant discount fees |
39,043 | 36,142 | ||||||
| Other miscellaneous |
83,468 | 88,030 | ||||||
| Total other noninterest income |
$ | 300,679 | $ | 283,631 | ||||
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The components of other noninterest expense are as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| ATM expense |
$ | 114,237 | $ | 106,627 | ||||
| Expenses related to other real estate owned |
29,972 | 38,322 | ||||||
| Postage |
58,646 | 67,561 | ||||||
| Courier |
32,899 | 32,154 | ||||||
| Service bureau |
57,731 | 60,798 | ||||||
| Corporate insurance |
48,530 | 53,455 | ||||||
| Travel |
26,786 | 26,450 | ||||||
| Shareholder expense |
45,391 | 52,992 | ||||||
| Seminars and education |
23,576 | 17,113 | ||||||
| Loan servicing |
29,237 | 18,464 | ||||||
| Other miscellaneous |
109,065 | 144,970 | ||||||
| Total other noninterest expense |
$ | 576,070 | $ | 618,906 | ||||
NOTE 13 – INCOME TAXES
The principal components of income tax expense are as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Federal income tax expense - current |
$ | 1,288,471 | $ | 589,980 | ||||
| Deferred federal income tax benefit |
(195,242 | ) | (48,735 | ) | ||||
| Income tax expense |
$ | 1,093,229 | $ | 541,245 | ||||
A reconciliation of income tax expense calculated at the federal statutory rate and that shown in the statements of income is summarized as follows:
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Federal income tax expense (at 34% statutory rate) |
$ | 1,080,911 | $ | 542,454 | ||||
| Effect of tax-exempt interest |
(30,236 | ) | (4,190 | ) | ||||
| Effect of life insurance proceeds, premiums, and increases in value, net |
(3,737 | ) | (15,790 | ) | ||||
| Effect of incentive stock options |
37,361 | 12,760 | ||||||
| Other |
8,930 | 6,011 | ||||||
| Income tax expense |
$ | 1,093,229 | $ | 541,245 | ||||
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A cumulative net deferred tax asset is included in other assets at December 31, 2010 and 2009. The components of the asset are as follows:
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Deferred Tax Assets |
||||||||
| Deferred compensation |
$ | 300,237 | $ | 255,458 | ||||
| Allowance for loan losses |
639,704 | 532,118 | ||||||
| Non-qualifying options |
117,955 | 107,261 | ||||||
| Investment in partnerships |
22,475 | 16,610 | ||||||
| Other |
21,266 | 7,352 | ||||||
| Total Deferred Tax Assets |
1,101,637 | 918,799 | ||||||
| Deferred Tax Liabilities |
||||||||
| Deferred loan costs, net |
228,234 | 232,265 | ||||||
| Net appreciation on available-for-sale securities |
212,162 | 452,082 | ||||||
| Depreciation on premises and equipment |
210,967 | 233,465 | ||||||
| Other |
645 | 645 | ||||||
| Total Deferred Tax Liabilities |
652,008 | 918,457 | ||||||
| Net Deferred Tax Assets |
$ | 449,629 | $ | 342 | ||||
NOTE 14 – OTHER RELATED PARTY TRANSACTIONS
The Bank has loan and deposit transactions with certain of its executive officers and directors, and with companies in which the officers and directors have a financial interest.
A summary of related party loan activity for the Bank is set forth in the following table:
| 2010 | 2009 | |||||||
| Balance, January 1 |
$ | 17,531,719 | $ | 16,835,672 | ||||
| Originations |
5,141,077 | 3,152,718 | ||||||
| Repayments |
(3,425,887 | ) | (3,297,452 | ) | ||||
| Other* |
— | 840,781 | ||||||
| Balance, December 31 |
$ | 19,246,909 | $ | 17,531,719 | ||||
| * | The “Other” balance above represents the net difference in related party loans in respect of directors who retired and were elected in 2009, as applicable. |
In the opinion of management, such related party loans are made in the ordinary course of business on substantially the same terms, including interest rate and collateral, as those prevailing at the same time for comparable loans to unrelated persons and did not involve more than the normal risk of collectibility or present other unfavorable features.
Commitments to extend credit and letters of credit to such related parties amounted to $4,076,865 and $3,800,282 at December 31, 2010 and 2009, respectively.
The Company maintains a key man life insurance policy on its Chief Executive Officer in the amount of $2 million. The policy has no cash surrender value and the Company is the sole beneficiary.
NOTE 15 – COMMITMENTS AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET CREDIT RISK
The Company is a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit in the form of loans or loans approved but not yet funded, standby letters of credit, and commitments to sell loans. These instruments involve, to varying degrees, elements of risk which have not been recognized in the Company’s consolidated balance sheets.
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Loan commitments are agreements to extend credit to a customer so long as there are no violations of the applicable contract terms prior to the funding. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Because certain of the commitments are expected to be withdrawn or expire unused, the total commitment amount does not necessarily represent future cash requirements. Standby letters of credit are written unconditional commitments to guarantee the performance of a Bank customer to a third party.
The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless otherwise noted, the Company requires collateral or other security to support financial instruments with credit risk. Contractual amounts for financial instruments whose contract amounts represent credit risk at December 31, 2010 and 2009 are set forth in the following table:
| 2010 | 2009 | |||||||
| Commitments to extend credit |
$ | 34,178,926 | $ | 37,159,388 | ||||
| Standby letters of credit |
184,000 | 1,797,060 | ||||||
| $ | 34,362,926 | $ | 38,956,448 | |||||
As of December 31, 2010, the Company had $7.3 million in deposits in financial institutions in excess of amounts insured by the FDIC.
NOTE 16 – REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements may result in certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weighting and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum capital amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of December 31, 2010, the Company and the Bank meet all capital adequacy requirements to which they are subject; further, the Bank is “well capitalized” under the applicable regulatory framework. To be categorized as well capitalized, the Bank must maintain the minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios set forth in the table below. At December 31, 2010, the Company’s total risk-based capital, Tier 1 risk-based capital, and Tier 1 capital (leverage) ratios were 17.15%, 16.24% and 13.24%, respectively, all in excess of the minimum requirements. There are no conditions or events that management believes have changed the Bank’s categorization.
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The capital amounts and ratios for the Company (consolidated) and the Bank as of December 31, 2010 and 2009 are presented in the following table:
| (Dollars in thousands) |
Actual | For Capital Adequacy Purposes |
Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions |
|||||||||||||||||||||
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||||||
| At December 31, 2010 |
||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 39,257 | 17.15 | % | $ | 18,313 | 8.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 35,978 | 15.75 | % | $ | 18,270 | 8.0 | % | $ | 22,837 | 10.0 | % | ||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,168 | 16.24 | % | $ | 9,156 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,888 | 14.84 | % | $ | 9,135 | 4.0 | % | $ | 13,702 | 6.0 | % | ||||||||||||
| Tier 1 Capital (to Average Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,168 | 13.24 | % | $ | 11,225 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,888 | 12.16 | % | $ | 11,145 | 4.0 | % | $ | 13,931 | 5.0 | % | ||||||||||||
| At December 31, 2009 |
||||||||||||||||||||||||
| Total Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 37,674 | 18.36 | % | $ | 16,416 | 8.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 34,785 | 16.99 | % | $ | 16,382 | 8.0 | % | $ | 20,477 | 10.0 | % | ||||||||||||
| Tier 1 Capital (to Risk-Weighted Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 35,901 | 17.50 | % | $ | 8,208 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,012 | 16.12 | % | $ | 8,191 | 4.0 | % | $ | 12,286 | 6.0 | % | ||||||||||||
| Tier 1 Capital (to Average Assets) |
||||||||||||||||||||||||
| Consolidated Company |
$ | 35,901 | 13.06 | % | $ | 10,999 | 4.0 | % | N/A | N/A | ||||||||||||||
| Bank |
$ | 33,012 | 12.08 | % | $ | 10,927 | 4.0 | % | $ | 13,659 | 5.0 | % | ||||||||||||
Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. Loans or advances are limited to 10.0% of the Bank’s stockholders’ equity.
NOTE 17 – DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following summary presents the methodologies and assumptions used to estimate the fair value of the Company’s financial instruments presented below. Because there is no readily available active market for a portion of the Company’s financial instruments, fair values of some financial instruments are based on estimates using present value and other valuation techniques. Much of the information used to determine fair value is highly subjective in nature and therefore the results may not be precise. The subjective factors include, among other things, estimates of cash flows, risk characteristics, credit quality and interest rates, all of which are subject to change. Accordingly, the amounts that will actually be realized or paid upon settlement or maturity of the various instruments could be significantly different from the estimated fair value.
Cash, Due From Banks and Federal Funds Sold
For cash due from banks and federal funds sold, the carrying amount is a reasonable estimate of fair value.
Certificates of Deposit in Other Banks
Because all such certificates of deposit will mature during 2011, carrying value is a reasonable estimate of fair value.
Investment Securities
Fair values of investment securities are based on quoted market prices, where available. For unquoted securities, the fair value is estimated by the Company on the basis of available financial and other information. Securities available for sale are recorded at fair value.
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Loans
The fair value of loans is estimated by discounting the future estimated scheduled cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and significant core deposit relationships. The fair value of loans does not include the value of the customer relationship or the right to fees generated by the account.
Accrued Interest Receivable
The carrying amount of accrued interest receivable approximates fair value.
Stock in Federal Reserve Bank and Federal Home Loan Bank
The carrying value for FRB stock and FHLB stock approximates fair value.
Bank-Owned Life Insurance
The carrying value of bank-owned life insurance approximates fair value, as this investment is carried at cash surrender value.
Other Financial Assets
Because the carrying value of other financial assets is based on market prices, carrying value is a reasonable estimate of fair value.
Deposit Liabilities
The fair value of fixed-maturity certificates of deposit is estimated using a discounted cash flow model based on the rates offered for deposits of similar remaining maturities. Weighted average rates paid and posted rates were used for December 2010 and 2009.
The fair value of deposits with no stated maturities (which includes demand deposits, savings accounts and money market deposits) is the amount payable on demand at the reporting date. Deposit liabilities with no stated maturity are reported at the amount payable on demand without regard for the inherent funding value of these instruments. The Company believes that significant value exists in this funding source. The fair value of deposits does not include the value of the customer relationship or the rights to fees generated by the account.
Federal Home Loan Bank Advances
The fair value of FHLB advances is estimated using discounted cash flow analysis based on rates offered at the reporting date for borrowings of similar remaining maturities.
Other Borrowings and Securities Sold Under Agreements to Repurchase
The fair value of other borrowings is estimated using discounted cash flow analysis based on rates offered at the reporting date for borrowings of similar remaining maturities. The carrying amount for securities sold under agreements to repurchase is a reasonable estimate of fair value.
Accrued Interest Payable
The carrying value of accrued interest payable is a reasonable estimate of fair value.
Loan Commitments and Standby Letters of Credit
The carrying value of notional principal amounts of loan commitments and standby letters of credit are reasonable estimates of fair value.
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The carrying amounts and fair value of the Company’s financial instruments at December 31, 2010 and 2009 are presented in the following table.
| 2010 | 2009 | |||||||||||||||
| Carrying Amount |
Fair Value | Carrying Amount |
Fair Value | |||||||||||||
| (Dollars in Thousands) | ||||||||||||||||
| Financial assets: |
||||||||||||||||
| Cash and due from banks |
$ | 15,978 | $ | 15,978 | $ | 19,336 | $ | 19,336 | ||||||||
| Federal funds sold |
401 | 401 | 2,668 | 2,668 | ||||||||||||
| Certificates of deposit in other banks |
2,260 | 2,260 | 3,936 | 3,936 | ||||||||||||
| Securities available for sale |
17,368 | 17,368 | 50,103 | 50,103 | ||||||||||||
| Loans held for investment |
214,342 | 217,450 | 181,544 | 182,340 | ||||||||||||
| Accrued interest receivable |
668 | 668 | 746 | 746 | ||||||||||||
| Stock in FRB and FHLB |
2,360 | 2,360 | 2,062 | 2,062 | ||||||||||||
| Bank-owned life insurance |
584 | 584 | 553 | 553 | ||||||||||||
| Other financial assets |
148 | 148 | — | — | ||||||||||||
| Financial liabilities: |
||||||||||||||||
| Deposits |
224,102 | 224,337 | 229,136 | 229,214 | ||||||||||||
| Federal Home Loan Bank advance |
— | — | 5,000 | 5,053 | ||||||||||||
| Securities sold under agreements to repurchase |
2,378 | 2,378 | 2,016 | 2,016 | ||||||||||||
| Other borrowings |
1,087 | 1,104 | — | — | ||||||||||||
| Accrued interest payable |
100 | 100 | 118 | 118 | ||||||||||||
Fair Value Hierarchy
“Fair Value Measurements and Disclosures” establishes three levels of inputs that may be used to measure fair value:
Level 1: Valuation is based on quoted prices in active markets for identical assets or liabilities.
Level 2: Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.
Level 3: Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
Investment Securities Available for Sale
Investment securities available for sale are recorded at fair value on a recurring basis. Fair value is measured based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 2 securities include Treasury notes and bills, mortgage-backed securities issued by government sponsored entities, municipal bonds and other securities issued by government sponsored agencies.
Loans
The Company does not record loans at fair value on a recurring basis. From time to time, a loan is considered impaired. Loans that are deemed to be impaired are valued according to guidance related to receivables. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. When the fair value of collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as Level 2. If the fair value of the loan is based on criteria other than observable market prices or current appraised value, the loan is recorded as Level 3.
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Other Real Estate Owned
Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Foreclosed assets are carried at the lower of the carrying value or fair value. Once management’s intentions change regarding utilization of its own property, that property is transferred to other real estate owned at fair value. Fair value is based upon independent observable market prices or appraised values of the collateral, which the Company considers to be Level 2 inputs.
Other Financial Assets
Other financial assets are recorded at fair value on a recurring basis. Fair value is based on quoted market prices and are considered to be Level 2 inputs.
General
The Company has no liabilities carried at fair value or measured at fair value on a recurring or nonrecurring basis.
The Company has no assets or liabilities whose fair values are measured using Level 3 inputs.
| Assets Recorded at Fair Value on a Recurring Basis
|
||||||||||||||||
| December 31, 2010 in thousands |
Total | Level 1 | Level 2 | Level 3 | ||||||||||||
| Investment in securities available for sale: |
||||||||||||||||
| Mortgage-backed securities |
$ | 17,368 | $ | — | $ | 17,368 | $ | — | ||||||||
| Other financial assets |
148 | — | 148 | — | ||||||||||||
| Total Assets at Fair Value |
$ | 17,516 | $ | — | $ | 17,516 | $ | — | ||||||||
| December 31, 2009 in thousands |
Total | Level 1 | Level 2 | Level 3 | ||||||||||||
| Investment in securities available for sale |
$ | 50,103 | — | $ | 50,103 | — | ||||||||||
| Total Assets at Fair Value |
$ | 50,103 | $ | — | $ | 50,103 | $ | — | ||||||||
|
Assets Recorded at Fair Value on a Non-Recurring Basis
|
| |||||||||||||||
| December 31, 2010 in thousands |
Total | Level 1 | Level 2 | Level 3 | ||||||||||||
| Other real estate owned |
$ | 263 | $ | — | $ | 263 | $ | — | ||||||||
| Total Assets at Fair Value |
$ | 263 | $ | — | $ | 263 | $ | — | ||||||||
| December 31, 2009 in thousands |
Total | Level 1 | Level 2 | Level 3 | ||||||||||||
| Other real estate owned |
$ | 313 | $ | — | $ | 313 | $ | — | ||||||||
| Total Assets at Fair Value |
$ | 313 | $ | — | $ | 313 | $ | — | ||||||||
NOTE 18 – TARP CAPITAL PURCHASE PROGRAM
On September 25, 2009, as part of the Capital Purchase Program established under the Troubled Asset Relief Program, the Company and the U.S. Department of the Treasury (“Treasury”) entered into a Letter Agreement and a Securities Purchase Agreement – Standard Terms attached thereto, (collectively, the “Securities Purchase Agreement”), as amended by a side letter agreement, pursuant to which the Company issued and sold, and the Treasury purchased for an aggregate purchase price of $10,103,000 in cash, (i) 10,103 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share (“Series A Preferred Shares”), and (ii) a warrant (the “Warrant”) to purchase up to 303.00303 shares of the
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Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B, having a liquidation preference of $1,000 per share (“Series B Preferred Shares”), at an exercise price of $0.01 per share. The Warrant was exercised on a cashless basis by the Treasury immediately following the closing of the transaction, resulting in the issuance to the Treasury of 303 Series B Preferred Shares.
The Series A Preferred Shares qualify as Tier 1 capital and pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Series B Preferred Shares will pay cumulative dividends at a rate of 9% per annum. Dividends are payable on both the Series A Preferred Shares and the Series B Preferred Shares (collectively, the “Preferred Shares”) quarterly and are payable on February 15, May 15, August 15 and November 15 of each year.
The Preferred Shares are not convertible into any other securities and generally are non-voting. The Preferred Shares have no maturity date and rank senior to the Company’s common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company. In addition, the Securities Purchase Agreement provides for certain restrictions on dividend payments and stock repurchases by the Company. The Treasury may unilaterally amend the Securities Purchase Agreement and all related documents to the extent required to comply with any changes in applicable federal statutes after the execution thereof.
Consistent with its strategic plan, and following approval from the Treasury and other applicable regulatory authorities, on March 16, 2011 the Company paid approximately $2.617 million to redeem 2,606 Series A Preferred Shares, representing approximately 25% of all issued and outstanding Preferred Shares.
The Small Business Jobs Act of 2010 was signed into law on September 27, 2010. The Act establishes a $30 billion Small Business Lending Fund (“SBLF”), designed to provide small banks, like the Bank, with capital to increase the availability of credit for small businesses. Qualifying banks that are currently participating in the TARP Capital Purchase Program will have the opportunity to “refinance” their TARP investment with an investment under the SBLF program, by exchanging their existing TARP preferred stock for new SBLF program preferred stock. The dividend rate payable on SBLF investments could be reduced to as low as 1% from an initial dividend rate of 5%, to the extent participating institutions achieve certain levels of additional small business lending.
The Company has submitted an application to the United States Treasury to participate in this new SBLF program. If the Company’s application is accepted, the Board of Directors will make a final decision about participation in the SBLF program. If the Company does in fact consummate an SBLF transaction, all of its TARP preferred stock would be exchanged for SBLF preferred stock (or otherwise redeemed by the Company) and the Company would no longer be subject to the provisions of the ARRA or EESA described above; instead, the Company would be subject only to regulatory requirements under the SBLF program, which may be more or less restrictive than the TARP requirements. However, at this time the Company cannot predict whether the Company will be accepted to participate (or if it will participate, if accepted) in the SBLF program, or what impact, if any, participation in the SBLF would have on its business or operations.
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NOTE 19 – CONDENSED FINANCIAL INFORMATION OF HERITAGE BANKSHARES, INC.
(Parent Company Only)
The following condensed financial statements of Heritage Bankshares, Inc. are presented below on a parent company only basis for the years indicated.
| At December 31, | ||||||||
| 2010 | 2009 | |||||||
| Condensed Balance Sheets |
||||||||
| Assets |
||||||||
| Cash and interest-bearing deposits in other banks |
$ | 2,548,805 | $ | 1,169,848 | ||||
| Certificates of deposit in other banks |
491,679 | 1,212,754 | ||||||
| Investment in subsidiary bank |
34,300,271 | 33,889,837 | ||||||
| Other assets |
401,793 | 610,840 | ||||||
| Total Assets |
$ | 37,742,548 | $ | 36,883,279 | ||||
| Liabilities and Stockholders’ Equity |
||||||||
| Other liabilities |
$ | 163,079 | $ | 104,844 | ||||
| Total Liabilities |
163,079 | 104,844 | ||||||
| Preferred stock, net of discount of $234,681 and $288,812 at December 31, 2010 and 2009, respectively |
10,171,319 | 10,117,188 | ||||||
| Common stock |
11,537,510 | 11,456,760 | ||||||
| Additional paid-in capital |
6,657,704 | 6,472,893 | ||||||
| Retained earnings |
8,801,093 | 7,854,024 | ||||||
| Accumulated other comprehensive income |
411,843 | 877,570 | ||||||
| Stockholders’ equity |
37,579,469 | 36,778,435 | ||||||
| Total Liabilities and Stockholders’ Equity |
$ | 37,742,548 | $ | 36,883,279 | ||||
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Condensed Statements of Income |
||||||||
| Dividends from subsidiary bank |
$ | 1,500,000 | $ | 1,684,601 | ||||
| Equity in undistributed net income of subsidiaries |
734,822 | (460,012 | ) | |||||
| Interest income |
22,860 | 5,930 | ||||||
| Other expenses |
(247,942 | ) | (267,929 | ) | ||||
| Income before income taxes |
2,009,740 | 962,590 | ||||||
| Income tax benefit |
76,181 | 89,076 | ||||||
| Net income |
$ | 2,085,921 | $ | 1,051,666 | ||||
| Preferred stock dividends and accretion of discount |
(586,551 | ) | (156,166 | ) | ||||
| Net income available to common stockholders |
$ | 1,499,370 | $ | 895,500 | ||||
Certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in the form of cash dividends, loans or advances. Pursuant to federal regulations, dividends are generally restricted to net profits, as defined, for the current year plus retained net profits for the previous two years. The maximum amount available for transfer from the Bank to the Company in the form of loans and advances is 10.0% of the Bank’s stockholders’ equity.
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Heritage Bankshares, Inc.
Statements of Cash Flows
| Years Ended December 31, | ||||||||
| 2010 | 2009 | |||||||
| Cash flows from operating activities |
||||||||
| Net income |
$ | 2,085,921 | $ | 1,051,666 | ||||
| Add (deduct) items not affecting cash during the year |
||||||||
| Stock-based compensation |
141,338 | 216,642 | ||||||
| Undistributed net income of subsidiaries |
(734,822 | ) | 460,012 | |||||
| Exercise of stock options tax benefit |
31,173 | 14,496 | ||||||
| Changes in assets/liabilities, net |
||||||||
| (Increase) decrease in other assets |
67,708 | (373,196 | ) | |||||
| Increase in other liabilities |
58,235 | 77,231 | ||||||
| Net cash provided by operating activities |
1,649,553 | 1,446,851 | ||||||
| Cash flows from investing activities |
||||||||
| Net decrease/(increase) in certificates of deposit |
721,075 | (1,212,754 | ) | |||||
| Investment in wholly-owned bank subsidiary |
— | (8,562,000 | ) | |||||
| Net cash provided by/(used for) investing activities |
721,075 | (9,774,754 | ) | |||||
| Cash flows from financing activities |
||||||||
| Proceeds from exercise of stock options |
93,050 | 83,325 | ||||||
| Proceeds from sale of perpetual preferred stock |
— | 9,992,076 | ||||||
| Cash dividends paid |
(1,084,721 | ) | (622,365 | ) | ||||
| Net cash provided by (used for) financing activities |
(991,671 | ) | 9,453,036 | |||||
| Increase in cash and cash equivalents |
1,378,957 | 1,125,133 | ||||||
| Cash and cash equivalents at beginning of year |
1,169,848 | 44,715 | ||||||
| Cash and cash equivalents at end of year |
$ | 2,548,805 | $ | 1,169,848 | ||||
* * * * *
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| ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE |
None.
| ITEM 9A. | CONTROLS AND PROCEDURES |
Disclosure Controls and Procedures
The Company, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Because of the inherent limitations in all control systems, any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Furthermore, our controls and procedures can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the control, and misstatements due to error or fraud may occur and not be detected on a timely basis.
Management’s Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company as defined in Rule 13a-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements and the reliability of financial reporting.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control – Integrated Framework. Based on our assessment, we believe that, as of December 31, 2010, the Company’s internal control over financial reporting is effective based on those criteria.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to final rules of the Securities and Exchange Commission (as directed under the Dodd-Frank Act) that permit the Company, as a “smaller reporting company”, to provide only management’s report in this annual report.
Changes in Internal Control Over Financial Reporting
There were no changes in the Company’s internal control over financial reporting in the quarter ended December 31, 2010 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
| ITEM 9B. | OTHER INFORMATION |
None.
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PART III
Explanatory Note
The Company will file a definitive proxy statement for its 2011 Annual Meeting of Shareholders pursuant to Regulation 14A (the “2011 Proxy Statement”) within 120 days after the end of the fiscal year covered by this annual report on Form 10-K (i.e., by April 30, 2011); accordingly, certain information that is required under Part III of this annual report on Form 10-K is omitted from this report and will be included in the 2011 Proxy Statement and is incorporated herein by reference to the 2011 Proxy Statement.
| ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE |
The information concerning our Directors, Executive Officers and Corporate Governance, as well as any other information required by this Item 10, shall be included in the 2011 Proxy Statement and is hereby incorporated herein by reference.
Code of Ethics
The Company has adopted a Code of Ethics that applies to its Chief Executive Officer and Chief Financial Officer. The Code of Ethics summarizes the legal, ethical and regulatory standards that such individuals must follow and is a reminder to all of the Company’s directors and executive officers of the seriousness of that commitment. As adopted, the Code of Ethics sets forth written standards that are designed, among other things, to deter wrongdoing and to promote:
| • | honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; |
| • | compliance with applicable governmental laws, rules and regulations; |
| • | the prompt internal reporting of violations of the Code of Ethics to an appropriate person or persons identified in the Code of Ethics; and |
| • | accountability for adherence to the Code of Ethics. |
A copy of the Company’s Code of Ethics may be obtained by any person, without charge, by accessing the Company’s web site at: http://www.heritagebankva.com/ethics.asp.
| ITEM 11. | EXECUTIVE COMPENSATION |
The information concerning Executive Compensation required by this Item 11 shall be included in the 2011 Proxy Statement and is hereby incorporated herein by reference.
| ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |
The information concerning Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters required by this Item 12 shall be included in the 2011 Proxy Statement and is hereby incorporated herein by reference.
| ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE |
The information concerning Certain Relationships and Related Transactions, and Director Independence, required by this Item 13 shall be included in the 2011 Proxy Statement and is hereby incorporated herein by reference.
| ITEM 14. | PRINCIPAL ACCOUNTING FEES AND SERVICES |
The information concerning Principal Accounting Fees and Services required by this Item 14 shall be included in the 2011 Proxy Statement and is hereby incorporated herein by reference.
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PART IV
| ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES |
(a) (1) Financial Statements. The financial statements for the Company are included under Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.
(a) (2) Financial Statement Schedules. All financial statement schedules required under Regulation S-X are omitted because they are inapplicable or because the required information is shown in the financial statements or the notes thereto.
(a) (3) Exhibits. The exhibits required by Item 601 of Regulation S-K are listed below.
| Exhibit |
Description | |
| 3.1 | Amended and Restated Articles of Incorporation of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 10-Q filed on August 11, 2009.) | |
| 3.2 | Articles of Amendment to the Articles of Incorporation of Heritage Bankshares, Inc. Establishing the Terms of the Preferred Shares. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 3.3 | Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 4.1 | Form of Certificate for the Fixed Rate Cumulative Perpetual Preferred Stock, Series A. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 4.2 | Form of Certificate for the Fixed Rate Cumulative Perpetual Preferred Stock, Series B. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 4.3 | Warrant to Purchase up to 303.00303 shares of Series B Preferred Stock, dated September 25, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.1 | 1987 Stock Option Plan. (Incorporated herein by reference to the Company’s Form S-8 filed January 26, 2004.) | |
| *10.4 | Employees Stock Ownership Plan. (Incorporated herein by reference to the Company’s Form 10-K for 1997 filed March 30, 1998.) | |
| *10.5 | 1999 Stock Option Plan for Employees. (Incorporated herein by reference to the Company’s Form S-8 filed January 26, 2004.) | |
| *10.6 | Amendment to the 1999 Stock Option Plan. (Incorporated herein by reference to the Company’s Form S-8 filed January 26, 2004.) | |
| *10.7 | Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on February 11, 2005.) | |
| 10.8 | Amended and Restated Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on May 3, 2005.) | |
| *10.9 | Employment Agreement of John O. Guthrie. (Incorporated herein by reference to the Company’s Form 8-K filed on January 7, 2011.) | |
| *10.10 | Amendment to Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on July 5, 2006.) | |
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| Exhibit |
Description | |
| 10.11 | Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on August 1, 2006.) | |
| *10.15 | Amendment to Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on December 26, 2006.) | |
| *10.16 | Heritage 2006 Equity Incentive Plan (As Amended and Restated Effective January 28, 2009). (Incorporated herein by reference to the Company’s Form S-8 filed on July 29, 2009.) | |
| *10.19 | Amendment to Employment Agreement of Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on March 5, 2009.) | |
| *10.20 | Amended Employment Agreement of Sharon Curling Lessard. (Incorporated herein by reference to the Company’s Form 8-K filed on January 5, 2011.) | |
| *10.21 | Amended Employment Agreement of Leigh C. Keogh. (Incorporated herein by reference to the Company’s Form 8-K filed on January 5, 2011.) | |
| 10.22 | Letter Agreement, dated September 25, 2009, including Securities Purchase Agreement – Standard Terms incorporated by reference therein, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 10.23 | Side Letter, dated September 25, 2009, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| 10.24 | American Recovery and Reinvestment Act Agreement, dated September 25, 2009, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.25 | Form of Waiver for Certain Employees. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.26 | Form of Amendment to Employment Agreement for Certain Employees. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.27 | Amendment to Employment Agreement of Michael S. Ives dated September 23, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.28 | Supplemental Executive Retirement Plan between the Company and Michael S. Ives dated September 23, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.) | |
| *10.29 | Elective Deferred Compensation Agreement with Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on February 2, 2010.) | |
| *10.30 | Deferred Compensation Plan Trust. (Incorporated herein by reference to the Company’s Form 8-K filed on February 2, 2010.) | |
| *10.31 | Amendment to Employment Agreement of Michael S. Ives dated December 22, 2009. (Incorporated herein by reference to the Company’s Form 10-K filed on March 26, 2010.) | |
| 21.1 | Subsidiaries of the Registrant.** | |
| 23.1 | Consent of Elliott Davis LLC.** | |
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| Exhibit |
Description | |
| 31.1 | Certification of Principal Executive Officer, Pursuant to Exchange Act Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.** | |
| 31.2 | Certification of Principal Financial Officer, Pursuant to Exchange Act Rule 13a-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.** | |
| 32.1 | Certification of Principal Executive Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** | |
| 32.2 | Certification of Principal Financial Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.** | |
| 99.1 | Certification of Chief Executive Officer Pursuant to Section 111(b)(4) of the Emergency Economic Stabilization Act of 2008, as amended.** | |
| 99.2 | Certification of Chief Financial Officer Pursuant to Section 111(b)(4) of the Emergency Economic Stabilization Act of 2008, as amended.** | |
| * | Indicates management contract or compensatory plan or arrangement. |
| ** | Filed herewith. |
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SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
| HERITAGE BANKSHARES, INC. | ||
| (Registrant) | ||
| Date: March 28, 2011 | /s/ Michael S. Ives | |
| Michael S. Ives, | ||
| President & Chief Executive Officer | ||
| KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Michael S. Ives and John O. Guthrie, or either of them, as attorney-in-fact, with each having the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. | ||
| In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. | ||
| March 28, 2011 | /s/ Michael S. Ives | |
| Michael S. Ives, | ||
| President & Chief Executive Officer | ||
| (Principal Executive Officer) and Director | ||
| March 28, 2011 | /s/ John O. Guthrie | |
| John O. Guthrie, | ||
| Chief Financial Officer | ||
| (Principal Financial and Accounting Officer) | ||
| March 28, 2011 | /s/ Peter M. Meredith, Jr. | |
| Peter M. Meredith, Jr., | ||
| Chairman of the Board of Directors and Director | ||
| March 28, 2011 | /s/ Stephen A. Johnsen | |
| Stephen A. Johnsen, | ||
| Secretary of the Board of Directors and Director | ||
| March 28, 2011 | /s/ David A. Arias | |
| David A. Arias, | ||
| Director | ||
| March 28, 2011 | /s/ Lisa F. Chandler | |
| Lisa F. Chandler, | ||
| Director | ||
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| March 28, 2011 | /s/ James A. Cummings | |
| James A. Cummings, | ||
| Director | ||
| March 28, 2011 | /s/ Wendell C. Franklin | |
| Wendell C. Franklin, | ||
| Director | ||
| March 28, 2011 | /s/ F. Dudley Fulton | |
| F. Dudley Fulton, | ||
| Director | ||
| March 28, 2011 | /s/ Thomas G. Johnson, III | |
| Thomas G. Johnson, III, | ||
| Director | ||
| March 28, 2011 | /s/ David L. Kaufman | |
| David L. Kaufman, | ||
| Director | ||
| March 28, 2011 | /s/ Charles R. Malbon, Jr. | |
| Charles R. Malbon, Jr., | ||
| Director | ||
| March 28, 2011 | /s/ L. Allan Parrott | |
| L. Allan Parrott, | ||
| Director | ||
| March 28, 2011 | /s/ Donald E. Perry | |
| Donald E. Perry, | ||
| Director | ||
| March 28, 2011 | /s/ Ross C. Reeves | |
| Ross C. Reeves, | ||
| Director | ||
| March 28, 2011 | /s/ Harvey W. Roberts, III | |
| Harvey W. Roberts, III, | ||
| Director | ||
75