UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2016

Commission File Number: 001-36839

 

AVENUE FINANCIAL HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code (615) 736-6940

 

 

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

Indicate by check mark whether the registrant had 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 such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o

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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one)

 

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

As of May 5, 2016, Avenue Financial Holdings, Inc., had 10,419,888 shares of common stock outstanding.

 

 

 

 

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AVENUE FINANCIAL HOLDINGS, INC.

REPORT ON FORM 10-Q

March 31, 2016

TABLE OF CONTENTS

 

 

 

 

 

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Certain statements in this quarterly report on Form 10-Q contain forward-looking statements. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would,” and “outlook,” or the negative version of those words or other comparable words of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although we believe that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements.

You should not place undue reliance on any forward-looking statements. There are or will be important factors that could cause our actual results to differ materially from those indicated in these forward-looking statements, including, but are not limited to, the following:

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The foregoing factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2015. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made, and we do not undertake any obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise. New risks and uncertainties arise from time to time, and it is not possible for us to predict those events or how they may affect us. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

 

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PART 1. FINANCIAL INFORMATION

ITEM 1.

AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Balance Sheets

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Income

(unaudited)

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Comprehensive Income

(unaudited)

 

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Changes in Stockholders’ Equity

(unaudited)

 

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows

(unaudited)

 

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Condensed Consolidated Statements of Cash Flows, Continued

(unaudited)

 

 

 

See accompanying notes to condensed consolidated financial statements (unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The accounting principles followed and the methods of applying those principles conform with accounting principles generally accepted in the United States of America and to general practices in the banking industry. The significant accounting policies applicable to Avenue Financial Holdings, Inc. (the Corporation) and its wholly owned subsidiary, Avenue Bank (the Bank) (collectively, the Company) are summarized as follows.

The Company provides a variety of financial services to individuals and middle market businesses through its offices in middle Tennessee. Its primary deposit products are checking, savings, money market and term certificate accounts and its primary lending products are residential real estate, commercial and industrial, commercial real estate, construction and consumer loans.

The consolidated financial statements include the accounts of the Corporation and the Bank. All significant intercompany balances and transactions have been eliminated in consolidation.

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) necessary for fair representation have been included. The results of operations and other data for the three months ended March 31, 2016, are not necessarily indicative of results that may be expected for the entire fiscal year ending December 31, 2016.  The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and, therefore, do not include information or footnotes necessary for a complete presentation of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles.  Accordingly, the accompanying unaudited consolidated financial statements should be read in conjunction with the Corporation’s consolidated financial statements and related notes appearing in the 2015 Annual Report previously filed on Form 10-K.  The consolidated balance sheet of the Company as of December 31, 2015 has been derived from the audited consolidated balance sheet of the Company as of that date.

In preparing consolidated financial statements in conformity with U.S. GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of deferred tax assets, other real estate owned, and investment securities including other-than-temporary impairment.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The payments received on these loans are applied to the principal balance until the loan qualifies for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current with on time payments for six consecutive months and future payments are reasonably assured.

In April 2015, the FASB issued Accounting Standards Update (ASU) 2015-03, Simplifying the Presentation of Debt Issuance Costs, which changes the presentation of debt issuance costs in financial statements. ASU 2015-03 requires an entity to present such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs will continue to be reported as interest expense. It was effective for annual reporting periods beginning after December 15, 2015, with early adoption permitted. The Company early adopted ASU 2015-03 on June 30, 2015 at which time the Company reclassified approximately $404,000 of debt issuance costs associated with the Company's subordinated debt from other assets to subordinated debt on the Consolidated Balance Sheet. A reclassification was also applied retrospectively to each prior period presented.

In June 2014, the FASB issued ASU No. 2014-12 Compensation - Stock Compensation (Topic 718) - Accounting for Share Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Requisite Service Period. ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for interim and annual periods beginning after December 15, 2015. The amendments can be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented and to all new or modified awards thereafter. Early adoption is permitted. The Company adopted ASU 2014-12 on January 1, 2016 and it did not have a material impact on its accounting and disclosures.

In May 2014, the FASB issued ASU No. 2014-09 Revenue from Contracts with Customers (Topic 606). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. On July 9, 2015, the FASB approved amendments deferring the effective date by one year. ASU 2014-09 is now effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. The amendments can be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this Update recognized at the date of initial application. Early application is permitted but not before the original public entity effective date, i.e., annual periods beginning after December 15, 2016. The Company is assessing the impact of ASU 2014-09 on its accounting and disclosures.  

In February 2016, the FASB issued ASU 2016-2, Leases (Topic 842). ASU 2016-2, among other things, requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. ASU 2016-2 will be effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Nonpublic business entities should apply the amendments for fiscal years beginning after December 15, 2019 and interim periods within fiscal years beginning after December 15, 2020. Early application is permitted for all public business entities and all nonpublic entities upon issuance. The Company is currently evaluating the impact of adopting the new guidance on the consolidated financial statements.

Basic net income per common share available to common stockholders is computed by dividing net income available to common stockholders by the weighted average common shares outstanding for the period. Diluted net income per common share available to common stockholders excludes any common stock options or restricted share awards agreements whose exercise would be antidilutive. Typically the difference between basic and diluted weighted average shares outstanding is attributable to common stock options and restricted share awards. For the three months ended March 31, 2016 and 2015, there were no antidilutive stock options calculated under the treasury stock method as the strike price for an option was above the fair market value of a common share.  The Company also calculated earnings per common share using the two-class method and determined that there was no material impact for the three months ended March 31, 2016 and 2015.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The following is a summary of the basic and diluted earnings per common share calculation for each of the three months ended March 31, 2016 and 2015:

 

 

Certain items in prior financial statements have been reclassified to conform to the current presentation.  These reclassifications had no effect on net income.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

In 2015, management evaluated all operating leases to prepare for the upcoming accounting pronouncement ASU 2016-2.  The discount rate initially selected to calculate the present value of the minimum lease payments related to the lease for the Green Hill Branch was not the incremental borrowing rate.  It was determined that the incremental borrowing rate of 5.59% at lease inception was more appropriate.  Due to this change the present value of lease payments exceeded 90% of the fair value of the building at inception of the lease, resulting in capital lease classification rather than operating lease classification, as previously reflected in the Company’s consolidated financial statements.  The Company assessed the materiality of the capital lease classification on its financial statements for previously issued financial statements in accordance with SEC’s Staff Accounting Bulletin (SAB) No. 99 and concluded that the impact of the adjustments was not  material to its financial statements had the errors been corrected for prior period financial statements.  Accordingly, the March 31, 2015 consolidated statements of income, consolidated statements of comprehensive income and consolidated statements of cash flows were revised to correct the change in presentation.  The change in presentation for the lease resulted in a decrease in net income of $4,000 as of March 31, 2015.  

The effects of the necessary adjustments and related tax impact on the Company's consolidated financial statements for the three months ended March 31, 2015 are detailed in the following tables:

 

 

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The amortized cost and fair value of securities available-for-sale and held-to-maturity at March 31, 2016 and December 31, 2015 are summarized as follows:

 

 

Gross realized gains and losses from security sales for the three months ended March 31, 2016 and 2015 are as follows:

 

 

Realized gains and losses from securities sales are recognized in the consolidated statements of income upon disposition of the securities using the specific identification method on a trade date basis.  Proceeds from sales totaled $41.2 million for the three months ended March 31, 2016.  There were no sales for the three months ended March 31, 2015.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Expected maturities of mortgage backed securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Therefore, these securities are not included in the maturity categories in the following maturity summary.

The amortized cost and estimated fair value of securities at March 31, 2016, by contractual maturity, are shown below:  

 

 

Securities with an amortized cost of $25.9 million and $24.7 million and fair value of $25.8 million and $24.5 million at March 31, 2016 and December 31, 2015, respectively, were pledged to secure deposits, borrowings and for other purposes as required or permitted by law.  

Security fair values are established by an independent pricing service as of the approximate dates indicated. The difference between book value and fair value reflects current interest rates and represents the potential gain (loss) had the portfolio been liquidated on those dates.

At March 31, 2016 and December 31, 2015, the Bank did not hold investment securities of any single issuer, other than obligations of U.S. government agencies, whose aggregate book value exceeded 10% of stockholders’ equity.

Securities available-for-sale and held-to-maturity with unrealized losses as of March 31, 2016 and December 31, 2015, and the length of time they have been in continuous loss positions were as follows:

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

As noted in the table above, at March 31, 2016, the Bank had unrealized losses of $456,000 on $47.5 million of available-for-sale and held-to-maturity securities. The Bank does not consider these securities to be other-than-temporarily impaired. Unrealized losses on securities issued by states and political subdivisions in the U.S., U.S. government agency securities, and mortgage backed securities have not been recognized into income because the securities are backed by the U.S. government, its agencies, or political subdivisions for municipal bonds and management has the intent and ability to hold these securities until maturity. For corporate bonds with unrealized losses, the Bank currently does not intend to sell these securities and it is more likely than not that the Bank will have the intent and ability to hold these securities to recovery of their amortized cost.  The decline in value of these securities is primarily attributable to interest rates and not credit losses.

 

The Bank has six loan segments for financial reporting purposes, residential real estate, commercial and industrial, commercial real estate, construction and land development, consumer, and other. The Bank classifies its loan portfolio based on the underlying collateral utilized to secure each loan. These classifications are consistent with those utilized in the Quarterly Report of Condition and Income, filed by the Bank with the Federal Deposit Insurance Corporation (FDIC).

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The following table summarizes the balance of loans outstanding by segment and class as of March 31, 2016 and December 31, 2015:

 

 

Commercial loans are assigned risk ratings by the lender that are subject to validation by a third party loan reviewer or the Bank’s internal credit committee. Risk ratings are categorized as pass, special mention, substandard, non-accrual and doubtful. As of March 31, 2016, approximately 70% of the loan portfolio was classified as a commercial loan type and was specifically assigned a pass risk rating. Pass rated loans include all loans other than those included in special mention, substandard, non-accrual and doubtful, which are defined as follows:

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The following tables present the loan balances (recorded investment) by segment as well as risk rating category as of March 31, 2016 and December 31, 2015:

 

 

 

As of March 31, 2016 and December 31, 2015, all loans classified as non-accrual were considered to be impaired. In addition, certain substandard loans were determined to be impaired due to management’s knowledge of certain facts surrounding the credit such as lack of collateral or limited cash flow. The principal balance of these impaired loans amounted to $1.2 million as of March 31, 2016 and December 31, 2015.  At the date that impaired loans were placed on non-accrual status, the Bank reversed all previously accrued interest income against the current year earnings. The payments received on these loans are applied to the principal balance until the loan qualifies for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current with on time payments for six consecutive months and future payments are reasonably assured.  

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Additional information on the Bank’s impaired loans that were evaluated for specific loss allowance as of March 31, 2016 and December 31, 2015 including the recorded investment on the balance sheet and the unpaid principal balance is shown below:

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

A loan is considered past due when payment is 30 days or more late based on the contractual terms of the loan.  As shown in the table below, the Bank had $122,000 and $147,000 of loans past due 30 days or more that were still accruing as of March 31, 2016 and December 31, 2015, respectively. The following tables present past due balances at March 31, 2016 and December 31, 2015 and by loan segment allocated between performing and non-accrual status:

 

 

At March 31, 2016 and December 31, 2015, all loans classified as non-accrual were deemed to be impaired. The principal balance of these non-accrual loans amounted to $433,000 and $550,000 at March 31, 2016 and December 31, 2015, respectively. At the date such loans were placed on non-accrual status, the Bank reversed all previously accrued interest income against current year earnings. Had these non-accruing loans been on accruing status, interest income would have been higher by $4,000 and $2,000 for the periods ended March 31, 2016 and December 31, 2015, respectively.  Management elected to not record payments received in interest income during the periods ended March 31, 2016 and December 31, 2015.

The Bank attempts to work with borrowers, when advantageous to both parties, to extend or modify terms to better align with the borrowers current ability to repay. These extensions and modifications are made in accordance with internal policies, which conform to regulatory guidance. Each modification is unique to the borrower and is evaluated separately, and as such, qualification criteria and payments terms consider the borrower’s current and prospective ability to comply with the modified terms of the loan.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

A modification is classified as a TDR if the borrower is experiencing financial difficulty and it is determined that the Bank has granted a concession to the borrower that would have otherwise not been granted and is not available to other borrowers. The Bank may determine that a borrower is experiencing financial difficulty if the borrower is currently in default on any debt, or if it is probable that a borrower may default in the foreseeable future without a modification.  Examples of concessions that would qualify as a TDR include: 1) a reduction in interest rates, 2) extension of the maturity date at a rate lower than current market rate for a new loan with similar risk, 3) principal forgiveness, 4) reduction of accrued interest, or 5) a period of interest only payments. When evaluating if it is in the Bank’s interest to restructure troubled debt, management may consider whether the borrower has provided additional collateral or guarantors and whether such additions adequately compensate the Bank for the restructured terms. The determination of whether a restructuring of a loan meets the criteria for classification as a TDR is subjective in nature and management’s judgment is required in the evaluation process.  As of March 31, 2016, one consumer loan, two commercial and industrial loans and one commercial real estate loans were newly classified as TDRs.  A TDR is considered an impaired loan pursuant to U.S. GAAP. No loans were restructured or modified due to declining credit quality during the three months ended March 31, 2015.  The following table outlines the amount of each TDR categorized by loan segment made during the three months ended March 31, 2016:

 

 

Of the $424,000 in loans reported as TDRs as of December 31, 2015, an additional $342,000 was modified as TDRs during the period ended March 31, 2016. No TDRs were foreclosed upon during the three month periods ended March 31, 2016 and 2015. As of March 31, 2016, and March 31, 2015, there were no commitments to lend additional funds to debtors owing receivables whose terms have been modified in a TDR.

The adequacy of the allowance for loan losses is assessed by management at the end of each calendar quarter. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.  During the three months ended March 31, 2016 the lookback period of the allowance for loan losses methodology for construction and land development loans was changed to six years to reflect an economic cycle and be consistent with other loan types.  A five years lookback period was previously used due to outliers in the 2009 data.

Key components of the estimation process are as follows: (1) loans determined by management to be impaired are evaluated individually and specific allowances are determined based on the difference between the outstanding loan amount and the net realizable value of the present value of expected future cash flows or the collateral less estimated cost to sell (if collateral dependent); (2) loans not meeting the definition of impairment are segmented based on similar collateral types and evaluated on a pool basis; (3) loss rates for the segments are calculated based on historical gross charge offs (or minimum loss rates if no historical gross charge offs) over the lookback period determined to be most appropriate by management and, multiplied by the loss emergence period (LEP).  The LEP is the period between when initial deterioration in the borrower’s financial capacity is first identified by Bank personnel to the time of charge-off.  The historical loss factors are then adjusted by management to reflect the current outlook for each of the following qualitative factors:

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

The following table presents the balance in the recorded investment in loans by loan segment based on impairment method:

 

 

Consumer loans less than $25,000 are charged off no later than when the loan becomes 120 days past due. All other loans are charged off when it is determined that the loan is uncollectible.  Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The following table provides a roll forward of the allowance for loan losses from December 31, 2014 to March 31, 2015 and December 31, 2015 to March 31, 2016 by loan segment:

 

 

The following table presents the balance in the allowance for loan losses by loan segment based on impairment method:

 

 

At March 31, 2016, the Bank had approximately $4.6 million of mortgage loans held-for-sale compared with approximately $19.4 million at December 31, 2015. Loans held-for-sale are carried at the lower of cost or market and consist of two distinct groups, secondary market and portfolio mortgage loans held-for-sale. Secondary market loans are typically sold at or before loan closing to an investor on a loan-by-loan basis and generally settle within two to four weeks of loan closing. At March 31, 2016 and December 31, 2015 the Bank had $1.6 million and $5.2 million, respectively of secondary market loans. Portfolio mortgage loans held-for-sale are maintained on the Bank’s core loan accounting system and sold in bulk or individually generally within one year of being classified as held-for-sale. All loan sales executed by the Bank include the transfer of servicing rights to the investor.  The Bank had $3.0 million and $14.2 million of portfolio mortgage loans held-for-sale as of March 31, 2016 and December 31, 2015, respectively.  For the three months ended March 31, 2016 the Bank sold $13.0 million of portfolio loans held-for-sale for a gain of $256,000.  For the three months ended March 31, 2015 the Bank sold $11.2 million of portfolio loans held-for-sale loan for a gain of $236,000.

The secondary market mortgage sales are sold typically on a best efforts basis to investors that follow conventional government sponsored entities and the Department of Housing and Urban Development (HUD) guidelines. Generally, the investor has delegated underwriting authority to the Bank.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Credit risk is generally transferred to the investors upon sale, however, the investors may have recourse rights for up to six months after the loan sale during which the Bank would be obligated to repurchase the loan if the borrower defaults during the recourse period. Also, the purchase agreements require the Bank to make certain representations and warranties regarding the existence and sufficiency of file documentation and the absence of fraud by borrowers or other third parties such as appraisers in connection with obtaining the loan. If it is determined that the loans sold were in breach of these representations or warranties, the Bank is obligated to either repurchase the loan for the unpaid principal balance and related investor fees or make the investor whole for the economic benefits of the loan.

Based on information currently available, management believes that it does not have a material exposure to losses arising from borrower defaults or faulty representations and warranties that it has made in connection with its mortgage loan sales.

For portfolio mortgages, the Bank determines at origination if the loan will be held-for-investment or held-for-sale.  If circumstances arise after origination that the loan is no longer sellable to investors or could be sold it is moved accordingly.  

At March 31, 2016, the Bank has $137.9 million of home equity and consumer mortgage loans which are secured by first or second liens on residential properties. Foreclosure activity in this portfolio has been minimal. Any foreclosures on these loans are handled by designated Bank personnel and external legal counsel, as appropriate, following established policies regarding legal and regulatory requirements. The Bank has not imposed any freezes on foreclosures. Based on information currently available, management believes that it does not have material exposure to faulty foreclosure practices.

 

Financial derivatives are reported at fair value in other assets or other liabilities. The accounting for changes in fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship.

The Bank has entered into interest rate swaps to facilitate customer transactions and meet their financing needs. Upon entering into these instruments, the Bank also entered into offsetting positions in order to minimize risk. These swaps qualify as derivatives, but are not designated as hedging instruments.

Interest rate swap contracts involve counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes the Bank, and results in credit risk. When the fair value of a derivative instrument contract is negative, the Bank owes the customer or counterparty and has no credit risk.

A summary of interest rate swaps to facilitate customer transactions as of March 31, 2016 and December 31, 2015 is included in the following table:

 

As part of its activities to manage interest rate risk, the Bank enters into delayed interest rate swap agreements to manage exposure to future interest rate risk through modification of the Bank’s net interest sensitivity to levels deemed to be appropriate.  The interest rate swap agreements were entered into to convert a portion of its forecasted variable-rate debt to a fixed rate, which is a cash flow hedge of a forecasted transaction.  

In 2014 the Bank entered into three delayed interest rate swap agreements to manage exposure to future interest rate risk on deposits. The Bank receives a variable rate based on one month LIBOR from a counterparty and pays a fixed rate of interest.  In 2015, the Bank terminated one of the derivative instruments with a notional value of $10.0 million for a loss of $393,000 that is carried in Accumulated Other Comprehensive (Loss) Income.  Beginning in November 2015 the loss is being recognized on the Consolidated Statements of Income over the original terms of the contract of 66 months and will conclude in May 2021.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

In 2015 the Bank entered into one interest rate swap agreement designated as a cash flow hedge intended to protect against the variability of cash flows on selected LIBOR based loans.  The Bank receives a fixed rate of interest from a counterparty and pays a fixed rate.

The terms of the individual contracts within the existing relationship at March 31, 2016 and December 31, 2015 is as follows:

 

 

The cash flow hedges were determined to be fully effective during the periods presented.  Therefore, no amount of ineffectiveness has been included in net income. The aggregate fair value of the interest rate swap is recorded in other liabilities with changes in fair value recorded in accumulated other comprehensive (loss) income, net of tax. If a hedge was deemed to be ineffective, the amount included in accumulated other comprehensive (loss) income would be reclassified into a line item within the statement of income that impacts operating results. The hedge would no longer be considered effective if a portion of the hedge becomes ineffective, the item hedged is no longer in existence or the Bank discontinues hedge accounting. Related to the terminated hedge approximately $44,000 will be reclassified from accumulated other comprehensive (loss) income in the next twelve months.

 

FASB ASC 820, Fair Value Measurements and Disclosures, establishes the framework for fair value. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date.

ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of the observable inputs that may be used to measure fair value. An asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. The three levels of the fair value hierarchy are described below:

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. These valuation methodologies were applied to all of the Company’s financial assets and financial liabilities carried at fair value effective March 31, 2016 and December 31, 2015. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.  While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process.

Financial assets and financial liabilities measured at fair value on a recurring basis include the following:

Where quoted prices are available for identical securities in an active market, securities are classified within Level 1 of the valuation hierarchy. If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs, market spreads, and cash flows or quoted prices of securities with similar characteristics and are classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation and more complex pricing models are used, securities are classified within Level 3 of the valuation hierarchy.

The carrying amount of interest rate swap agreements is based on pricing models that utilize observable market inputs. The Company reflects these assets within Level 2 of the valuation hierarchy.

For purposes of potential valuation adjustments to its derivative positions, the Company evaluates the credit risk of its counterparties. Accordingly, the Company has considered factors such as the likelihood of default by its counterparties, its net exposures, and remaining contractual life, among other things, in determining if any fair value adjustments related to credit risk are required. Counterparty exposure is evaluated by netting positions that are subject to master netting arrangements, as well as considering the amount of collateral securing the position. The Company reviews its counterparty exposure on a regular basis, and, when necessary, appropriate business actions are taken to adjust the exposure. The Company also utilizes this approach to estimate its own credit risk on derivative liability positions. To date, the Company has not realized any significant losses due to a counterparty’s inability to pay any net uncollateralized position. The change in value of derivative assets and derivative liabilities attributable to credit risk was not significant during the reported periods.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The following tables summarize financial assets and financial liabilities measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

 

 

The Company did not have any financial instruments classified within Level 3 of the valuation hierarchy for assets and liabilities measured at fair value on a recurring basis at March 31, 2016 and December 31, 2015.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Financial assets and liabilities measured at fair value on a nonrecurring basis include the following:

Certain impaired loans are reported at the fair value and are measured based on the value of the underlying collateral securing the loans and are determined using several methods.  The fair value of real estate is generally determined based on appraisals by qualified licensed independent appraisers less estimated selling costs.  The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach.  If an appraisal is not available, the fair value may be determined by using a cash flow analysis.  Fair value on other collateral such as business assets is typically ascertained by assessing, either singularly or some combination of, asset appraisals, accounts receivable aging reports, inventory listings and/or customer financial statements.  Both appraised values and values based on borrower’s financial information are discounted as considered appropriate based on age and quality of the information and current market conditions. As of March 31, 2016 and December 31, 2015, impaired loans with a carrying value of $1.1 million and $1.2 million, were reduced by specific valuation allowance allocations totaling $60,000 and $61,000 to a net reported fair value of $1.0 million and $1.1 million, respectively, based on collateral valuations utilizing Level 3 valuation inputs.

Other real estate is measured and reported on the value of the collateral securing the real estate and is determined based on appraisals by qualified licensed independent appraisers less estimated selling costs.  The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach.  There were no fair value adjustments as of March 31, 2016.  As of December 31, 2015, OREO was $268,000. OREO is included in Level 3 of the valuation hierarchy.

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring level 3 fair value measurements at March 31, 2016 and December 31, 2015:

 

 

The Company monitors the valuation technique utilized by various pricing agencies, in the case of the investment securities to ascertain when transfers between levels have been affected. The nature of the remaining assets and liabilities is such that transfers in and out of any level are expected to be rare. For the period ended March 31, 2016, there were no transfers between levels.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

FASB ASC 820 requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are measured and reported at fair value on a recurring basis or nonrecurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or nonrecurring basis are discussed above. The methodologies for other financial assets and financial liabilities are discussed below:

The carrying amounts of cash and due from banks, federal funds sold, interest-bearing time deposits in banks and federal funds sold approximate their fair values due to their short-term nature and liquidity.  

Fair values for securities held-to-maturity are based on quoted market prices. If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs, market spreads, and cash flows or quoted prices of securities with similar characteristics.

The inputs for valuation of these assets are based on the anticipated sales prices of these loans as the loans are usually sold within a few weeks to four months of their origination.

The carrying values, reduced by estimated inherent credit losses, of variable rate loans and other loans with short-term characteristics are considered fair values. For fixed rate loans, the fair values are calculated by discounting scheduled future cash flows using current interest rates offered on loans with similar terms adjusted to reflect the estimated credit losses inherent in the portfolio. This method of estimating fair value does not incorporate the exit price/market participant concept of fair value prescribed by ASC 820-10 and generally produces a higher value than an exit approach/market participant approach. Fair values for impaired loans are estimated using discounted cash flow models or based on the fair value of the underlying collateral.

The fair values disclosed for demand deposits (e.g. interest and non-interest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amount). The carrying value of variable rate Federal Home Loan Bank of Cincinnati (FHLB) advances and Federal funds purchased approximate their fair values based on their short-term nature. The fair value of certificates of deposit, fixed rate advances from the FHLB and fixed rate subordinated debt are based on the discounted value of contractual cash flows, calculated using the discounted rate that equaled the interest rates offered at the valuation date for deposits of similar remaining maturities.

The fair values of off-balance sheet financial instruments are based on fees charged to enter into similar agreements. However, commitments to extend credits do not represent a significant value to the Company until such commitments are funded and the Company does not include a fair value associated with these commitments.  At March 31, 2016 and December 31, 2015 the fair value of the Company’s standby letters of credits were $58,000 and $55,000, respectively and reflects the off-balance sheet reserves included in other liabilities on the Consolidated Balance Sheets.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The estimated fair values of financial instruments at March 31, 2016 and December 31, 2015 were as follows:

 

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

 

The Bank is a party to credit related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.

The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making off-balance sheet commitments as it does for on balance sheet instruments.

The following financial instruments were outstanding whose contract amounts represent credit risk:

 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized and usually do not contain a specified maturity date and ultimately may not be drawn upon to the total extent to which the Bank is committed.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. All letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

The Bank had $58,000 and $55,000 in off-balance sheet reserves included in other liabilities on the Consolidated Balance Sheet as of March 31, 2016 and December 31, 2015, respectively.

From time to time, the Company may be a party to various legal proceedings incident to its business. As of March 31, 2016 there are no material pending legal proceedings to which the Corporation or any of its subsidiaries is a party or of which any of the Corporation or its subsidiaries’ properties are subject.  

 

The Corporation and the Bank file consolidated U.S. Federal and State of Tennessee income tax returns. Each entity provides for income taxes based on its contribution to income or loss of the consolidated group. ASC 740, Accounting for Income Taxes, defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more likely than not” to be sustained by the taxing authority. This section also provides guidance on the derecognition, measurement, and classification of income tax uncertainties in interim periods. As of March 31, 2016, the Company had no unrecognized tax benefits related to federal or state income tax matters. The Company accounts for interest and penalties, if any, as a component of income tax expense.

The Company’s effective tax rate for the three months ended March 31, 2016 was 33.9%, compared with 33.5% for the three months ended March 31, 2015.  The effective tax rate differs from the statutory Federal rate of 34% and Tennessee excise rate of 6.5% primarily due to investments in qualified municipal securities; company owned life insurance and certain non-deductible expenses.  

 

 

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate 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 Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative criteria by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined).

In July 2013, the Federal Reserve Board and the FDIC approved final rules that substantially amend the regulatory risk-based capital rules applicable to the Bank and the Corporation. The final rules implement the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" (Basel III) and changes required by the Dodd-Frank Act.

Under these rules which became effective on January 1, 2015, the leverage and risk-based capital ratios of bank holding companies may not be lower than the leverage and risk-based capital ratios for insured depository institutions. The final rules also include new minimum risk-based capital and leverage ratios. Moreover, these rules refine the definition of what constitutes "capital" for purposes of calculating those ratios, including the definitions of Tier 1 capital and Tier 2 capital.

The rules also establish a "capital conservation buffer" of 2.5% (to be phased in over three years) above the new regulatory minimum risk-based capital ratios, and result in the following minimum ratios once the capital conservation buffer is fully phased in:

(i) a common equity Tier 1 risk-based capital ratio of 7.0%,

(ii) a Tier 1 risk-based capital ratio of 8.5%, and

(iii) a total risk-based capital ratio of 10.5%.

The capital conservation buffer requirement is to be phased in beginning in January 2016 at 0.625% of risk-weighted assets and will increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if capital levels fall below minimum levels plus the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

As of March 31, 2016, management believes the Corporation and the Bank met all capital adequacy requirements to which they are subject to be classified as Well Capitalized and in compliance with the capital conservation buffer requirement.  There are no conditions or events that have occurred since March 31, 2016 that management believes have impacted the Corporation and the Bank’s regulatory capital classification.

 

The Corporation’s charter authorizes 10,000,000 shares of preferred stock, no par value. Shares of the preferred stock may be issued from time to time in one or more series, each such series to be so designated as to distinguish the shares from the shares of all other series and classes. The Board of Directors has the authority to divide any or all classes of preferred stock into series and to fix and determine the relative rights and preferences of the shares of any series so established.

In October 2008, the Emergency Economic Stabilization Act of 2008 was enacted and the U.S. Department of the Treasury (Treasury) announced the Troubled Asset Relief Program Capital Purchase Program (CPP). On February 27, 2009, the Corporation entered into a Letter of Agreement with Treasury pursuant to which, among other things, the Corporation sold to Treasury for an aggregate purchase price of $7.4 million, 7,400 shares of Series A Preferred Stock and a warrant to purchase up to 370 shares of Series B Preferred Stock. The warrant was exercised by Treasury concurrent with the Series A Preferred Stock purchase.

On September 15, 2011, the Corporation redeemed all preferred shares the Corporation originally issued to Treasury under the CPP. The Corporation paid Treasury approximately $7.8 million, which included accrued dividends. Concurrently, the Corporation entered into a Securities Purchase Agreement with Treasury, pursuant to which the Corporation issued 18,950

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

shares of Senior Non Cumulative Perpetual Preferred Stock, Series C (Preferred Stock), having a liquidation amount per share of $1,000, for a total purchase price of $18,950,000. The Corporation contributed $18.14 million of the purchase price to its wholly owned subsidiary, the Bank. On March 2, 2015, the Corporation redeemed all 18,950 outstanding shares of the Preferred Stock at a redemption price of $1,000 per share, plus any unpaid and accrued dividends.

Dividends. The Corporation has not paid any cash dividends on our common stock since inception; however, our growth plans may provide the opportunity for us to consider a dividend program at some point in the future. Pursuant to Tennessee banking law, the Bank may not, without the prior consent of the Tennessee Department of Financial Institutions, pay any dividends to the Corporation in a calendar year in excess of the total of the Bank’s net profits for that year plus the retained profits for the preceding two years. Our future dividend policy will depend on earnings, capital position, financial condition and other factors, including new regulatory capital requirements, as they become known to us.

 

Significant amounts reclassified out of Accumulated other comprehensive income (loss) for the three months ended March 31, 2016 and 2015 are as follows:

 

 

The activity in accumulated other comprehensive income (loss) for the three months ended March 31, 2016 and 2015 is as follows:

 

 

 

(11)Subsequent Events

On January 28, 2016, the Corporation entered into an Agreement and Plan of Merger with Pinnacle Financial Partners, Inc., a Tennessee corporation (Pinnacle) providing for the merger of the Corporation with and into Pinnacle, with Pinnacle being the surviving entity. The proposed merger of the Corporation with and into Pinnacle has been approved unanimously by each company’s Board of Directors and is expected to close either late in the second quarter or early in the third quarter of 2016.

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AVENUE FINANCIAL HOLDINGS, INC. AND SUBSIDIARY

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

Completion of the transaction is subject to satisfaction of customary closing conditions, including the receipt of required regulatory approvals and the approval of the Corporation’s shareholders.

Under the terms of the merger agreement, the Corporation’s shareholders will receive 0.36 shares of Pinnacle’s common stock and $2.00 in cash for every Corporation share. All fractional shares will be cashed out based on the average 10-day closing price of Pinnacle common stock as of the closing. Additionally, the Corporation’s outstanding stock options and unvested shares of restricted stock will be fully vested upon consummation of the merger pursuant to the Corporation’s stock option plan, and all outstanding options that are unexercised prior to the closing will be cashed out at $20 per share. At closing, and assuming all outstanding Corporation options are cashed out as of the merger date, Avenue shareholders will own approximately 8.1 percent of the combined firm on a fully diluted basis.  

On May 9, 2016 a purported class action complaint was filed in the Chancery Court for the State of Tennessee, 20^th Judicial District at Nashville, styled Stephen Bushansky, on behalf of himself and all others similarly situated, Plaintiff, versus Avenue Financial Holdings, Inc. Ronald L. Samuels, Kent Cleaver, David G. Anderson, Agenia Clark, James F. Deutsch, Marty Dickens, Patrick G. Emery, Nancy Falls, Joseph C. Galante, David Ingram. Stephen Moore, Ken Robold, Karen Saul and Pinnacle Financial Partners, Inc., Defendants (Case No. 16-489-IV), alleging that the individual defendants breached their fiduciary duties by, among other things, approving the sale of the Company for an inadequate price as the result of a flawed sales process, agreeing to the inclusion of unreasonable deal protection devices in the Merger Agreement, approving the transaction in order to receive benefits not equally shared by all other shareholders of the Company, and issuing materially misleading and incomplete disclosures to shareholders.  The lawsuit also alleges claims against the Company and Pinnacle Financial Partners, Inc. for aiding and abetting the individual defendants’ breaches of fiduciary duties.  The plaintiff purports to seek class-wide relief, including but not limited to:  an injunction enjoining Defendants from proceeding with the Merger, monetary damages, and an award of interest, attorney’s fees, and expenses.  The Company believes the claims asserted in this action to be without merit and intends to vigorously defend the litigation.  However, at this time, it is not possible to predict the outcome of the proceeding of its impact on the Company or the proposed Merger.

 

 

 

 

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This section presents management’s perspective on our financial condition at March 31, 2016 and December 31, 2015 and our results of operations for the three months ended March 31, 2016 and 2015. The following discussion and analysis is intended to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements and related notes, and should be read in conjunction with the accompanying tables and our financial statements and related notes.

Overview

Net income available to common stockholders totaled $1.41 million for the three months ended March 31, 2016 compared with $1.42 million for the three months ended March 31, 2015.  Net income per diluted share was $0.14 in the first quarter of 2016 compared with $0.15 in the first quarter of 2015.  The decrease was attributable primarily to $801,000 or approximately $0.05 per diluted share on a tax equivalent basis in legal and accounting fees related to the proposed acquisition by Pinnacle Financial Partners, Inc. and a higher provision for loan losses that reflected the growth in loan volume, offset partially by growth in loan volume that benefited net interest income, and higher loan sales, including Small Business Administration (SBA) loans that boosted non-interest income.

Total assets increased $39.8 million, or 3.4%, to $1.21 billion at March 31, 2016, from $1.17 billion at December 31, 2015. Net loans increased $110.9 million, or 13.3%, to $946.6 million at March 31, 2016 compared with $835.8 million at December 31, 2015.

Deposits totaled $966.5 million at March 31, 2016 a decrease of $3.1 million, or 0.3%, compared with $969.6 million at December 31, 2015. Stockholders’ equity increased to $98.5 million, or $9.51 per common share, at March 31, 2016, from $94.4 million, or $9.16 per common share, at December 31, 2015.

The following table presents certain ratios of our results of operations for the three and three months ended March 31, 2016 and 2015:

 

Critical Accounting Policies and Estimates

The accounting principles we follow and our methods of applying these principles conform with U.S. generally accepted accounting principles (U.S. GAAP) and with general practices within the banking industry. There have been no significant changes to our Critical Accounting Policies as described in our Annual Report on Form 10-K for the year ended December 31, 2015.

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The following table presents a summary of our statements of income, including the percentage change in each category for the three months ended March 31, 2016 compared with the three months ended March 31, 2015:

 

 

Net Interest Income

Net interest income is the difference between the income we earn on our interest-earning assets and the cost of our interest-bearing liabilities. Our net interest income depends upon the volume of our interest-earning assets and our interest-bearing liabilities and the interest rates we earn or pay on them. Our management’s ability to respond to changes in interest rates by effective asset-liability management techniques is critical to maintaining the stability of the net interest margin and the momentum of our primary source of earnings.

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

Net interest income increased $1.5 million, or 20.3%, to $9.0 million for the three months ended March 31, 2016 from $7.5 million for the three months ended March 31, 2015. This was due primarily to growth in loans offset partially by increased in rates paid on deposits. Average loans outstanding from the first quarter of 2015 to the first quarter of 2016 increased 26.4%

Net Interest Margin Analysis

The net interest margin is impacted by the average volumes of interest-sensitive assets and interest-sensitive liabilities and by the difference between the yield on interest-sensitive assets and the cost of interest-sensitive liabilities, referred to as the “spread.” Loan fees collected at origination represent an additional adjustment to the yield on loans. Our spread can be affected by economic conditions, the competitive environment, loan demand, and deposit flows. The net yield on earning assets is an indicator of the effectiveness of our ability to manage the net interest margin by managing the overall yield on assets and cost of funding those assets.

The following tables show, for the three months ended March 31, 2016 and 2015, the average balances of each principal category of our assets, liabilities and stockholders’ equity, and an analysis of net interest income, and the change in interest income and interest expense segregated into amounts attributable to changes in volume and changes in rates. This table is presented on a fully taxable equivalent basis, if applicable. The adjustment to convert non-taxable income to a fully taxable equivalent basis consists of dividing tax exempt income by one minus the statutory federal income tax rate of 34.0%.

 

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The following table reflects changes in our net interest margin as a result of changes in the volume and rates of our interest bearing assets and liabilities for the three months ended March 31, 2016 compared with the three months ended March 31, 2015.

 

 

In the table above, changes in net interest income are attributable to (i) changes in average balances (volume variance), (ii) changes in rates (rate variance), or (iii) changes in rate and average balances (rate/volume variance). The volume variance is calculated as the change in average balances times the old rate. The rate variance is calculated as the change in rates times the old average balance. The rate/volume variance is calculated as the change in rates times the change in average balances. The rate/volume variance is allocated on a pro rata basis between the volume variance and the rate variance in the table above.

The two primary factors that make up the spread are the interest rates received on loans and investments and the interest rates paid on deposits and subordinated debt. We have been disciplined in lowering interest rates on deposits as the market allowed and thereby managing our cost of funds. Also, we have not competed for new loans on interest rate alone, but rather we have relied significantly on effective marketing to and relationships with business customers.

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

Our net interest spread and net interest margin were 3.09% and, 3.28% respectively, for the three months ended March 31, 2016, compared with 3.03% and 3.20%, respectively, for the three months ended March 31, 2015. Our average interest earning assets for the three months ended March 31, 2016 increased $161.9 million, or 16.8%, to $1.1 billion from $962.4 million for the three months ended March 31, 2015. This increase in our average interest earning assets was due to increased loan demand. Our average interest bearing liabilities increased $112.1 million, or 15.2%, to $848.9 million for the three months ended March 31, 2016 from $736.8 million for the three months ended March 31, 2015. This increase in our average interest bearing liabilities was primarily due to an increase of $101.5 million in all deposit liabilities.  The ratio of our average interest earning assets to average interest bearing liabilities was 132.4% and 130.6% for the three months ended March 31, 2016 and 2015, respectively.

Our average interest earning assets produced a taxable equivalent yield of 3.87% for the three months ended March 31, 2016, compared with 3.77% for the three months ended March 31, 2015. This increase was due to increases in bond yields. The average rate paid on interest bearing liabilities was 0.78% for the three months ended March 31, 2016, compared with 0.74% for the three months ended March 31, 2015. This increase was attributable primarily to an increase in money market and time deposit rates.

Provision for Loan Losses

The provision for loan losses represents the amount determined by management to be necessary to maintain the allowance for loan losses at a level capable of absorbing inherent losses in the loan portfolio. Our Allowance Committee, Audit Committee and

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Board of Directors review the adequacy of the allowance for loan losses on a quarterly basis. The allowance for loan losses calculation is segregated by call report code and then further segregated into risk ratings using a ten-point risk grade scale by loan officers that are subject to validation by a third party loan review or our Bank’s internal credit committee.   Risk ratings are categorized as pass, special mention, substandard, non-accrual and doubtful, with either a general or specific allocation of reserves based on these risk grades. A pass rated loan is generally characterized by a very low average risk of default and in which management perceives there is a minimal risk of loss. At March 31, 2016, total loans rated special mention and substandard were $1.5 million, or 0.16% of total loans, compared with $1.5 million, or 0.17% of total loans, at December 31, 2015.  

As of March 31, 2016 and December 31, 2015, all loans classified as non-accrual were considered to be impaired. In addition, certain substandard loans were determined to be impaired due to management’s knowledge of certain facts surrounding the credit. The principal balance of these impaired loans amounted to $1.2 million as of March 31, 2016 and December 31, 2015, respectively.  Impaired loans are reviewed individually under FASB ASC 310-10-35, Subsequent Measurement of Impaired Loans, to determine the appropriate reserve allocation. Our management compares the investment in an impaired loan with one of the following measures (1) present value of expected future cash flow discounted at the loan’s effective interest rate, (2) the loan’s observable market price or (3) the fair value of the collateral, less selling costs, if the loan is collateral-dependent, to determine the specific reserve allowance. Reserve percentages assigned to non-impaired loans are based on the average annual charge-off over a look back period, plus qualitative adjustments multiplied by the loss emergence period (LEP) by loan segment. Management analyzes all loan charge-offs occurring during the previous six years by loan segment.  The LEP is the period between when initial deterioration in the borrower’s financial capacity is first identified by Bank personnel to the time of charge-off. A LEP is calculated for each loan segment and then averaged and applied as a multiplier to the general loss factor, adjusted for qualitative factors. The qualitative factors reviewed include:

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

Provision for loan losses totaled $774,000 for the three months ended March 31, 2016 an increase of $620,000 from $154,000 for three months ended March 31, 2015.  This increase in provision for loan losses is primarily due to loan growth and loan segment mix compared with the first three months of 2015.

Non-accruing loans decreased to $433,000, or 0.05% of total loans, at March 31, 2016 from $550,000, or 0.06% of total loans, at December 31, 2015. During the first three months of 2016, we had net recoveries totaling $54,000, compared with net charge-offs of $2,000 for the same period in 2015. The allowance for loan losses totaled $10.9 million, or 1.14% of total loans, at March 31, 2016 compared with $10.1 million, or 1.19% of total loans, at December 31, 2015.

Non-interest Income

Non-interest income is an important component of our revenue and is comprised of fees generated from loan and deposit relationships, debit card and ATM fees, gain on sale of loans, gain on sale of available-for-sale securities, and mortgage banking income. Although we expect sales of investment securities to occur regularly as part of our banking operations, gains or losses experienced on these sales are less predictable than many of the other components of our non-interest income because the amount of realized gains or losses are impacted by a number of factors, including the nature of the security sold, the interest rate environment and other market conditions.

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The following tables present a summary of non-interest income, including the percentage change in each category, for the three months ended March 31, 2016 compared with the three months ended March 31, 2015:

 

 

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

Non-interest income increased 52.0% to $1.9 million, in the first quarter of 2016 from $1.3 in first quarter of 2015.  The growth in non-interest income resulted from an 11.8% increase in customer service fees to $751,000, a 29.4% increase in cash surrender value of life insurance to $185,000, and a 46.3% increase in mortgage banking fees to $300,000. Net gains on mortgage loan sales increased to $256,000 compared with $236,000 in the first quarter of 2015. Net gains on SBA loan sales rose to $189,000 in the first quarter of 2016, compared with no gains in the first quarter of 2015. Net gain on sale of securities totaled $228,000 in the first quarter of 2016 with no comparable securities gains in the first quarter of 2015. The proceeds from the sale of securities in the first quarter of 2016 were used to fund, in part, the growth in new loans generated during the quarter.

Non-interest Expenses

Non-interest expenses, in absolute terms, have increased significantly over the past few years as we have expanded our presence and invested in our infrastructure to support our balance sheet growth. Non-interest expenses include salaries and employee benefits, occupancy expense, equipment and data processing, advertising and promotion, OREO and professional fees, among other expenses. The following tables present a summary of non-interest expenses, including the percentage change in each category, for the three months ended March 31, 2016 compared with the three months ended March 31, 2015:

 

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

For the three months ended March 31, 2016, non-interest expenses totaled $8.0 million, an increase of $1.6 million, or 25.0%, from $6.4 million for the three months ended March 31, 2015. The increase was due primarily to higher compensation costs related to growth in employee headcount and higher legal and accounting fees related to the pending acquisition by Pinnacle Financial Partners, Inc.  

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Income Tax Expense

The provision for income taxes includes both federal and state taxes. Fluctuations in effective tax rates reflect the effect of the differences in the inclusion or deductibility of certain income and expenses for income tax purposes. Our future effective income tax rate will fluctuate based on the mix of taxable and tax-free investments we make, periodic increases in surrender value of company-owned life insurance policies for certain Bank officers and our overall taxable income.

Three months ended March 31, 2016 compared with the three months ended March 31, 2015

Income tax expense was $726,000 for the three months ended March 31, 2016, compared with $733,000 for the three months ended March 31, 2015. Our effective tax rate for three months ended March 31, 2016 and 2015 was 33.9% and 33.5% respectively.

Dividends

Dividends paid to U.S. Department of the Treasury on our Series C Preferred Stock totaled $32,000 for the three months ended March 31, 2015 and equaled one percent per annum as a percentage of the liquidation amount. There were no dividends paid on Series C Preferred Stock for the three months ended March 31, 2016.  On March 2, 2015, we redeemed all 18,950 outstanding shares of our Series C Preferred Stock at a redemption price of $1,000 per share, plus any unpaid and accrued dividends.

Financial Condition

Our total assets at March 31, 2016 were $1.21 billion, an increase of $39.8 million, or 3.4%, over total assets of $1.17 billion at December 31, 2015. The primary driver of the increase in assets was an increase in gross loans of $111.7 million, or 13.2%, to a record $957.5 million at March 31, 2016 compared with $845.8 million at December 31, 2015. Mortgage loans held-for-sale decreased by $14.9 million, or 76.4%, to $4.6 million at March 31, 2016 compared with $19.4 million at December 31, 2015.  This decrease is due to the sale of $13.0 million of portfolio mortgage loans held-for sale during 2016.  Securities available-for-sale were $163.2 million at March 31, 2016 compared with $209.6 million at December 31, 2015, a decrease of $46.4 million from investment sales, maturities, prepayments and calls.

Earning assets include loans, mortgage loans held-for-sale, securities, and short-term investments. Including company owned life insurance contracts, our level of earning assets is higher than the average of our peers because we allocate fewer of our resources to facilities, ATMs, and cash and due-from-bank accounts used for transaction processing. Earning assets at March 31, 2016 were $1.17 billion, or 96.8% of total assets of $1.21 billion. Earning assets at December 31, 2015 were $1.12 billion, or 95.8% of total assets of $1.17 billion. We believe this ratio is expected to generally continue at these levels, although it may be affected by economic factors beyond our control.

Investment Portfolio

Our securities portfolio is used to make various term investments, manage interest rate risk exposures, maintain a source of liquidity and serve as collateral for certain types of deposits and borrowings. We manage our investment portfolio according to a written investment policy approved by our Board of Directors. Investment balances in our securities portfolio are subject to change over time based on our funding needs and interest rate risk management objectives. Our liquidity levels take into account anticipated future cash flows and all available sources of credits and are maintained at levels management believes are appropriate to assure future flexibility in meeting our anticipated funding needs.

We balance the market and credit risks against the potential investment return, make investments compatible with the pledge requirements of any secured borrowings and maintain compliance with regulatory investment requirements. Our investment policy allows portfolio holdings to include short-term securities purchased to provide us with needed liquidity and longer term securities purchased to generate level income for us over periods of interest rate fluctuations.

Our securities portfolio consists primarily of U.S. government agency obligations, mortgage backed securities and municipal securities, although we also hold corporate bonds and other debt securities, all with varying contractual maturities. However, these maturities do not necessarily represent the expected life of the securities as the securities may be called or paid down without penalty prior to their stated maturities, and our targeted duration for our investment portfolios is in the four-to-five year range. No investment in any of these securities exceeds any applicable limitation imposed by law or regulation. The Asset Liability Management Committee, or ALCO, reviews the investment portfolio on an ongoing basis to ensure that the investments conform to our investment policy.  The Board of Directors annually reviews and approves the investment portfolio.

Our investment portfolio consists mainly of “available-for-sale” securities. As a result, the carrying values of our investment securities are adjusted on a monthly basis for unrealized gain or loss as a valuation allowance, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity. Periodically, we may need to assess whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. In any such instance, we would consider many factors, including the severity and duration of the impairment, our intent and ability to hold the security for a period of time sufficient for a recovery in value, recent events specific to the issuer or industry, and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized

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loss that is deemed to be other than temporarily impaired are written down to fair value, with the write-down recorded as a realized loss in securities gains.

Our available-for-sale securities, carried at their fair market value, decreased to $163.2 million as of March 31, 2016 from $209.6 million at December 31, 2015. The decrease in available-for-sale securities was due to investment sales of $41.2 million to fund loan growth and manage future interest rate risk.  As of March 31, 2016, investment securities having a carrying value of $25.8 million were pledged to secure deposits, borrowings and for other purposes as required or permitted by law.

At March 31, 2016 and December 31, 2015 we had $1.2 million and $675,000 of federal funds sold, respectively.  Most of our excess cash balances are held at correspondent banks for credit to our reserve account at the Federal Reserve Bank of Atlanta. At March 31, 2016, there were no holdings of securities of any issuer, other than U.S. government agencies, in an amount greater than 10% of our stockholders’ equity.

Loan Portfolio

The following table details composition of our loan portfolio and percentage composition, by category, at the dates indicated:

 

 

Over the past five years, we have experienced significant growth in our loan portfolio, although the relative composition of our loan portfolio has not changed significantly over that time. Our primary focus has been on commercial real estate (CRE) and commercial and industrial lending, which constituted 70% of our loan portfolio as of March 31, 2016. Although we expect continued growth with respect to our loan portfolio, we do not expect any significant changes over the foreseeable future in the composition of our loan portfolio or in our emphasis on CRE and commercial and industrial lending. Our loan growth since inception has been reflective of the market we serve. Our CRE and commercial and industrial lending portfolios have continued to experience strong growth, as economic conditions within our market have improved. A portion of our CRE exposure represents loans to commercial businesses secured by owner occupied real estate, which, in effect, are commercial loans with the borrowers’ real estate providing a secondary source of repayment. Commercial and Industrial loans represent the second largest category of loans in our portfolio. We attribute our commercial loan growth primarily to our relationship-based banking model and the success of our relationship managers in transitioning commercial banking relationships from other local financial institutions and in competing for new business from attractive small to mid-sized commercial customers located in our market for which our approach to customer service is desirable. Many of our larger commercial customers have lengthy relationships with members of our senior management team or our relationship managers that date back to former institutions.

Asset Quality

One of our key objectives is to maintain a high level of asset quality in our loan portfolio. We have established procedures to assist us in maintaining the overall quality of our loan portfolio. In addition, we have adopted underwriting guidelines to be followed by our lending officers that require senior management review of proposed extensions of credit exceeding certain thresholds. When delinquencies exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. Our loan review procedures include approval of lending policies and underwriting guidelines by the Board of Directors, a semi-annual independent loan review, approval of larger credit relationships by our Bank’s Credit Committee and loan quality documentation procedures. Like other financial institutions, we are subject to the risk that our loan portfolio will be subject to increasing pressures from deteriorating borrower credit due to general economic conditions.

Loans are placed on non-accrual status or charged-off if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans, including troubled debt restructurings, that are placed on non-accrual status or charged off is

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reversed against interest income. The payments received on these loans are applied to the principal balance until the loan qualifies for return to accrual status. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current with on time payments for six consecutive months and future payments are reasonably assured.

We target small and medium-sized businesses as loan customers. Because of their size, these borrowers may be less able to withstand competitive or economic pressures than larger borrowers in periods of economic weakness. If loan losses occur at a level where the loan loss reserve is not sufficient to cover actual loan losses, our earnings will decrease. We use an independent loan review firm to review our loans semi-annually for quality in addition to the reviews that may be conducted by bank regulatory agencies as part of their examination process.

Our Bank has procedures and processes in place intended to assess whether losses exceed the potential amounts documented in our Bank’s impairment analyses and to reduce potential losses in the remaining performing loans within our loan portfolio. These procedures and processes include the following:

 

As of March 31, 2016 and December 31, 2015, we had impaired loans of $1.2 million, inclusive of non-accrual loans. We allocated $134,000 and $87,000 of our allowance for loan losses at March 31, 2016 and December 31, 2015, to these impaired loans, respectively. We had no charge offs as of March 31, 2016 and $75,000 of gross charge-offs as of March 31, 2015. A loan is considered impaired if it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan.  Impairment does not always indicate credit loss, but provides an indication of collateral exposure based on prevailing market conditions and third-party valuations.  Impaired loans are measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral-dependent. The amount of any initial impairment and subsequent changes in impairment are included in the allowance for loan losses. Interest accruing on impaired loans is recognized as long as such loans do not meet the criteria for non-accrual status. Our credit administration group performs verification and testing to ensure appropriate identification of impaired loans and that proper reserves are allocated to these loans. Of the $1.2 million of impaired loans reported as of March 31, 2016, $457,000 were residential real estate mortgages, $413,000 were construction and land development loans, $100,000 were commercial and industrial loans, $152,000 were CRE loans and $117,000 were consumer loans.

Non-performing Assets

The balance of non-performing assets can fluctuate due to changes in economic conditions. We have established a policy to discontinue accruing interest on a loan (that is, place the loan on non-accrual status) after it has become 90 days delinquent as to payment of principal or interest, unless the loan is considered to be well-collateralized and is actively in the process of collection. A loan may be placed on non-accrual status before it becomes 90 days delinquent if management believes that the collection of principal and interest in accordance with contractual terms is doubtful. Interest previously accrued but uncollected on such loans is reversed and charged against current income when the receivable is determined to be uncollectible. If we believe that a loan will not be collected in full, we will increase the allowance for loan losses to reflect management’s estimate of any potential exposure or loss. The payments received on non-accrual loans are applied directly to principal.

Allowance for Loan Losses

Our net charge-offs (recoveries) as a percentage of average loans for the three months ended March 31, 2016 was (0.02)% compared with none for the three months ended March 31, 2015. There were no charge-offs in the first three months of 2016 with recoveries in commercial and industrial loans and construction and land development loans.  

The allowance is established and maintained at levels needed to absorb anticipated credit losses from identified and otherwise inherent risks in the loan portfolio as of the balance sheet date. In assessing the adequacy of the allowance, management considers its evaluation of the loan portfolio, past due loan experience, collateral values, current economic conditions and other factors considered necessary to maintain the allowance at an adequate level. Our management believes that the allowance was adequate at March 31, 2016.

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Cash Surrender Value of Company Owned Life Insurance

At March 31, 2016, we maintained investments of $25.9 million in company owned life insurance policies as protection against the loss of key employees, as compared with $25.7 million at December 31, 2015. Our tax equivalent yield on these products was 4.35% for the three months ended March 31, 2016 and 4.45% and year ending December 31, 2015.

Deferred Tax Asset

We had a net deferred tax asset of $7.9 million as of March 31, 2016 due to the temporary differences related to our loan loss provision, deferred compensation and depreciation for tax purposes. We test the recoverability of our deferred tax asset quarterly, and the current level of taxable income provides for the ultimate realization of the carrying value of these deferred tax assets. Fluctuation in net deferred tax assets $7.9 million as of March 31, 2016 compared with $9.0 million as of December 31, 2015, is primarily a result of changes in the net unrealized gains/losses on securities available-for-sale and interest rate swap agreements.

Deposits

The principal funding source for our asset growth is client deposits. We offer a competitive array of deposit and commercial treasury services, including checking, savings, money market and time deposit accounts, very similar to many competitors in the market place. Our business model has a heavy emphasis on banking small and medium size commercial operating companies, local not-for-profit organizations and middle market real estate developers. Accordingly, we have a heavy emphasis on commercial checking accounts as a key, low cost funding source. We offer participation in the Certificate of Deposit Account Registry Service, or CDARs, through our membership with Promontory Interfinancial Network. This enables our Bank to provide deposit customers access to FDIC insurance in amounts exceeding the existing FDIC limit in order to attract and retain large businesses, non-profit organizations and individuals who require an additional assurance of safety. The option to keep deposits on the balance sheet or, with customer permission, to sell such deposits (just the funding, not the relationship) to other members of the Promontory Interfinancial Network in exchange for fee income is decided based on liquidity management needs.

We promote electronic banking services by providing them to our clients without charge. These services include on-line bill pay, remote deposit capture, mobile banking and free ATM usage.

The following table presents the average balance and average rate paid on deposits for each of the following categories for the three months ended March 31, 2016 and the year ended December 31, 2015:

 

 

Total average deposits for the three months ended March 31, 2016 were $963.2 million, an increase of $103.9 million, or 12.1% over total average deposits of $859.3 million for the year ended December, 31, 2015. Our intentional focus on demand deposits has resulted in an increase in average balances of $31.7 million, or 15.4%, in non-interest bearing demand deposits and an increase of $10.7 million, or 17.2%, in interest bearing demand deposits when comparing the average for the three months ended March 31, 2016 to the year ended December 31, 2015. As short-term interest rates have remained flat over the past several years, we have experienced some level of deposit migration away from time deposits and into money market accounts, even as we have continued to lower the interest rates on these deposits.  However, after a recent rate increase there was a rollover of time deposits, CDARs and ICS deposits that caused a higher cost of funds.

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The following table presents the maturities of our certificates of deposit as of March 31, 2016 and December 31, 2015:

 

 

Borrowed Funds

Our Bank is a member of the Federal Home Loan Bank of Cincinnati (FHLB) and as a result, is eligible for advances from the FHLB pursuant to the terms of various borrowing agreements, which assist us in the funding of our loan and investment portfolios. As of March 31, 2016 and December 31, 2015 we had $39.0 million and $45.0 million in long-term notes outstanding, respectively. The Bank also has outstanding advances under the Cash Management Variable Rate Advance Program (CMA) of $66.5 million and $23.0 million as of March 31, 2016 and December 31, 2015, respectively. The weighted average interest rate on all advances at March 31, 2016 and December 31, 2015 was of 0.72% and 0.83%, respectively. As of March 31, 2016, our Bank is eligible to use the Federal Reserve discount window for short term borrowings. Based on assets available for collateral as of that date, our Bank’s borrowing availability was approximately $281.3 million. As of March 31, 2016 and December 31, 2015, our Bank had no outstanding advances. Qualifying 1-4 family residential first mortgages, home equity lines of credit, CRE and investment securities approximating $221.2 million have been pledged as collateral for potential advances.  The Bank also has a capital lease obligation for its Green Hills branch at a discount rate of 7.22%.  

Derivatives

As part of its activities to manage interest rate risk due to interest rate movements, the Bank enters into interest rate swaps to facilitate customer transactions and meet their financing needs. Interest rate swap contracts involve counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes the Bank, and results in credit risk. When the fair value of a derivative instrument contract is negative, the Bank owes the customer or counterparty and has no credit risk.  At March 31, 2016 and December 31, 2015 the Bank had interest rate swaps to facilitate customer transactions with a notional amount of $32.4 million and $18.4 million and a fair value of $1.1 million and $417,000, respectively.  

The Bank has also entered into delayed interest rate swap agreements or cash flow hedges to manage exposure to future interest rate risk through modification of the Bank’s net interest sensitivity to levels deemed to be appropriate. Interest rate swap agreements are entered into to convert a portion of the Bank’s forecasted variable-rate time deposits and commercial and industrial loans to a fixed rate. The Bank had at fair value $853,000 and $541,000 of cash flow hedges as of March 31, 2016 and December 31, 2015, respectively.  The notional amount at March 31, 2016 and December 31, 2015 was $45.0 million. In 2015, the Bank terminated one of the derivative instruments with a notional value of $10.0 million for a loss of $393,000 that is carried in Accumulated Other Comprehensive Loss. Beginning in November 2015 the loss is being recognized on the Consolidated Statements of Income over the original terms of the contract of 66 months and will conclude in May 2021.

Subordinated Debt

On December 29, 2014, the Corporation issued our fixed / floating rate subordinated notes (Subordinated Notes) in an aggregate principal amount of $20.0 million in a private placement to qualified institutional buyers. The Subordinated Notes have an outstanding

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balance of $20.0 million and an interest rate of 6.75% as of March 31, 2016 and December 31, 2015.  The Subordinated Notes are reduced by the issuance costs of $372,000 and $383,000 as of March 31, 2016 and December 31, 2015, respectively.  Interest is due quarterly on the Subordinated Notes and principal is due on the maturity date, which is December 29, 2024.

Stockholders’ Equity

Stockholders’ equity increased $4.1 million to $98.5 million at March 31, 2016 from $94.4 million at December 31, 2015. The increase in stockholders’ equity resulted from, net income of $1.4 million, a reduction of $1.9 million of additional other comprehensive loss, an increase of $502,000 from employee common stock options exercised and $298,000 in additional paid-in-capital related to stock compensation expense as of March 31, 2016.

Off-Balance Sheet Arrangements

In the normal course of business, we are a party to financial credit arrangements with off-balance sheet risk to meet the financing needs of our customers. These financial credit arrangements include commitments to extend credit beyond current fundings, credit card arrangements, standby letters of credit and financial guarantees. Those credit arrangements involve, to varying degrees, elements of credit risk in excess of the amount recognized on our balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement we have in those particular financial credit arrangements. All such credit arrangements bear interest at variable rates and we have no such credit arrangements which bear interest at fixed rates. The Bank has $58,000 and $55,000 in allowance for off-balance sheet exposures included in other liabilities on the Consolidated Balance Sheet as of March 31, 2016 and December 31, 2015, respectively.

Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit, credit card arrangements and standby letters of credit is represented by the contractual or notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we use for on-balance sheet instruments.

Commitments to extend credit beyond current fundings are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Such commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by us upon extension of credit is based on our management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. All letters of credit are due within one year or less of the original commitment date. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Asset and Liability Management

The principal objective of our asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing net income and preserving adequate levels of liquidity and capital. The Asset Liability Management Committee, or ALCO, of our Bank’s Board of Directors has oversight of our asset and liability management function, which is managed by our Chief Financial Officer. Our Chief Financial Officer meets with our ALCO quarterly to review, among other things, the sensitivity of our assets and liabilities to market interest rate changes, local and national market conditions and market interest rates. ALCO also reviews the liquidity, capital, deposit mix, loan mix and investment positions of our company.

Our management and our Board of Directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit our exposure to interest rate risk. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans, securities and deposits, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows.

Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate earnings at risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and use various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows. In addition to the instantaneous parallel rate shifts, we also model unique shifts in the yield curve as well as a growth versus flat balance sheet, to understand the impact to earnings and capital. We also analyze the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows.

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The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.

Quantitative and Qualitative Disclosures about Market Risk

At March 31, 2016 and December 31, 2015, our modeling indicated that we are in compliance with our asset liability management policies. Our model results also indicated that our balance sheet is sensitive to parallel shifts in interest rates in increments of 100 basis points, or bps. The asset sensitivity present at the 100 and 200 bps increment levels is primarily attributable to an increasing percentage of variable rate loans with no floors and a reduction in fixed rate exposure from our investment portfolio.  Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including balance sheet growth, the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown below do not include actions that our management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates. As part of our asset/liability management strategy, our management has emphasized the origination of new loans, as well as obtaining longer term funding sources to manage interest rate risks. Our strategy with respect to liabilities has been to emphasize transaction accounts, particularly non-interest or low interest-bearing, nonmaturing deposit accounts, which are less sensitive to changes in interest rates.

Each of the below analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types may lag behind changes in general market rates.

In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as interest rate caps and floors) which limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments. The ability of many borrowers to service their debts also may decrease during periods of rising interest rates. Our ALCO reviews each of the below interest rate sensitivity analyses along with several different interest rate scenarios as part of its responsibility to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing, and capital policies.

The interest rate risk model performs a “rate shock” test of the balance sheet. The rate shock procedure measures the impact on the economic value of equity, or EVE, which is a measure of long term interest rate risk. EVE is the difference between the market value of our assets and our liabilities and is our liquidation value. In this analysis, the model calculates the discounted cash flow or market value of each category on the balance sheet. The percent change in EVE is a measure of the volatility of risk. Our guidelines specify a maximum change of 25% for a 200 basis points rate change. Short term rates dropped to historically low levels during 2009 and have remained at those low levels. We could not assume further drops in interest rates in our model, and as a result we believe the down rate shock scenarios are not meaningful. At March 31, 2016, the (0.41)% change for a 200 basis points rate change is well within our guidance range. This compares favorably to the results as of December 31, 2015 of (5.85)% for a 200 basis point rate as the loan and investment portfolios moved towards a shorter duration.

The chart below identifies the EVE impact of an upward shift in rates of 100 and 200 basis points.

 

 

The EVE simulation model is a static model that provides information only at a certain point in time. For example, in a rising rate environment, the model does not take into account actions that management might take to change the impact of rising rates on us. Given that limitation, it is still useful in assessing the impact of an unanticipated movement in interest rates.

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The following chart presents the percentage change in our net interest income, earnings at risk, as a result of an upward shift in interest rates of 100, 200 and 300 basis points over a one- and two-year period measured as of March 31, 2016 and December 31, 2015 on a static balance sheet.  This compares favorably to the results as of December 31, 2015 due to an increasing percentage of variable rate loans with no floors and a reduction in fixed rate exposure from our investment portfolio.  

 

 

Our ALCO develops its view of future rate trends by monitoring economic indicators, examining the views of economists and other experts and conducts a quarterly analysis of the rate sensitivity position using growth balance sheet projections with several possible rate path scenarios in order to gain a more realistic view of future interest rate risks. The results of the analysis and resulting strategies are reported to our Board of Directors.

Liquidity and Capital Adequacy

Liquidity

Liquidity is a bank’s capacity to meet its current cash and collateral obligations. Maintaining an adequate level of liquidity depends on the bank’s ability to efficiently meet both expected and unexpected cash flow and collateral needs without adversely affecting either daily operations or the financial condition of the bank. The factors that determine liquidity are:

We are subject to general FDIC guidelines which require a minimum level of liquidity. Management believes our liquidity ratios meet or exceed these guidelines. Our management is not currently aware of any trends or demands that are reasonably likely to result in liquidity increasing or decreasing in any material manner.

The retention of existing deposits and attraction of new deposit sources through new and existing customers is critical to our liquidity position. In the event of compression in liquidity due to a run-off in deposits, we have a liquidity policy and procedure that provides for certain actions under varying liquidity conditions. These actions include borrowing from existing correspondent banks, selling or participating loans and the curtailment of loan commitments and funding. At March 31, 2016, our liquid assets, represented by cash and due from banks, federal funds sold and available-for-sale securities, totaled $189.3 million. Additionally, as of March 31, 2016, we had available to us approximately $88.8 million in unused federal funds lines of credit with regional banks, subject to certain restrictions and collateral requirements, to meet short term funding needs. We believe these sources of funding are adequate to meet immediate anticipated funding needs, but we will need additional capital to maintain our current growth. Our management meets on a weekly basis to review sources and uses of funding to determine the appropriate strategy to ensure an appropriate level of liquidity, and we have increased our focus on the generation of core deposit funding to supplement our liquidity position. At the current time, our long-term liquidity needs primarily relate to funds required to support loan originations and commitments and deposit withdrawals.

Our regular sources of funding are from the growth of our deposit base, repayment of principal and interest on loans, the sale of loans and the renewal of time deposits.

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Capital Adequacy

As of March 31, 2016 and December 31, 2015 our Bank was well-capitalized under the regulatory framework for prompt corrective action. To remain categorized as well-capitalized, our Bank must maintain minimum total risk-based, Tier 1 risk-based, Common equity Tier 1 and Tier 1 leverage ratios as disclosed in the table below:

 

 

Impact of Inflation

Our consolidated financial statements and related data presented herein have been prepared in accordance with U.S. GAAP which requires the measure of financial position and operating results in terms of historic dollars, without considering changes in the relative purchasing power of money over time due to inflation.

Inflation generally increases the costs of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect on the performance of a financial institution than the effects of general levels of inflation. In addition, inflation affects financial institutions’ cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings and stockholders’ equity. Mortgage originations and refinancings tend to slow as interest rates increase and likely will reduce our volume of such activities and the income from the sale of residential mortgage loans in the secondary market.

Adoption of Recent Accounting Pronouncements

There are currently no new accounting standards that have been issued that will have a significant impact on the Company’s financial position, results of operations or cash flows upon adoption.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

See the section “Quantitative and Qualitative Disclosures about Market Risk” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this quarterly report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (Exchange Act)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

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Changes in Internal Controls

We made the following changes to our internal controls over financial reporting for the quarter ended March 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Management identified the following deficiencies in internal control over financial reporting as of December 31, 2015 that management considered to be material weaknesses:

To remediate the material weaknesses described above, and enhance our internal controls over financial reporting, management completed the following changes during the quarter ended March 31, 2016:

 

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PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On May 9, 2016 a purported class action complaint was filed in the Chancery Court for the State of Tennessee, 20^th Judicial District at Nashville, styled Stephen Bushansky, on behalf of himself and all others similarly situated, Plaintiff, versus Avenue Financial Holdings, Inc. Ronald L. Samuels, Kent Cleaver, David G. Anderson, Agenia Clark, James F. Deutsch, Marty Dickens, Patrick G. Emery, Nancy Falls, Joseph C. Galante, David Ingram. Stephen Moore, Ken Robold, Karen Saul and Pinnacle Financial Partners, Inc., Defendants (Case No. 16-489-IV), alleging that the individual defendants breached their fiduciary duties by, among other things, approving the sale of the Company for an inadequate price as the result of a flawed sales process, agreeing to the inclusion of unreasonable deal protection devices in the Merger Agreement, approving the transaction in order to receive benefits not equally shared by all other shareholders of the Company, and issuing materially misleading and incomplete disclosures to shareholders.  The lawsuit also alleges claims against the Company and Pinnacle Financial Partners, Inc. for aiding and abetting the individual defendants’ breaches of fiduciary duties.  The plaintiff purports to seek class-wide relief, including but not limited to:  an injunction enjoining Defendants from proceeding with the Merger, monetary damages, and an award of interest, attorney’s fees, and expenses.  The Company believes the claims asserted in this action to be without merit and intends to vigorously defend the litigation.  However, at this time, it is not possible to predict the outcome of the proceeding of its impact on the Company or the proposed Merger.

From time to time, we are a party to various legal proceedings incident to our business. As of March 31, 2016, other than the legal proceeding mentioned above, there are no other material pending legal proceedings to which we or any of our subsidiaries is a party or of which any of our or our subsidiaries’ properties are subject.

ITEM 1A. RISK FACTORS

There have been no material changes to our risk factors as previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

 ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

None

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ITEM 6. EXHIBITS

 

 

 

 

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SIGNATURES

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

 

 

 

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