10-K 1 v369811_10k.htm FORM 10-K
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 

 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
For the Year Ended December 31, 2013
 
Commission File No. 0-22345
 
SHORE BANCSHARES, INC.
(Exact name of registrant as specified in its charter) 
 
 
Maryland
 
52-1974638
 
 
(State or Other Jurisdiction of
 
(I.R.S. Employer
 
 
Incorporation or Organization)
 
Identification No.)
 
  
 
28969 Information Lane, Easton, Maryland
21601
 
 
(Address of Principal Executive Offices)
(Zip Code)
 
 
Registrant’s Telephone Number, Including Area Code:  (410) 763-7800
 
Securities Registered pursuant to Section 12(b) of the Act:
 
Title of Each Class:
 
Name of Each Exchange on Which Registered:
Common stock, par value $.01 per share
 
Nasdaq Global Select Market
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  ¨ Yes þ No
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes þ No
 
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 þ No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (check one): 
 
Large accelerated filer ¨
Accelerated filer ¨
Non-accelerated filer ¨
Smaller Reporting Company þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes ¨ No þ
 
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter:  $59,623,353.
 
The number of shares outstanding of the registrant’s common stock as of the latest practicable date: 8,471,289 as of February 28, 2014.
 
Documents Incorporated by Reference
 
Certain information required by Part III of this annual report is incorporated therein by reference to the definitive proxy statement for the 2014 Annual Meeting of Stockholders.
 
 
 
INDEX
 
Part I
 
 
Item 1.
Business
4
Item 1A.
Risk Factors
16
Item 1B.
Unresolved Staff Comments
25
Item 2.
Properties
25
Item 3.
Legal Proceedings
26
Item 4.
Mine Safety Disclosures
26
 
 
 
Part II
 
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and
 
 
Issuer Purchases of Equity Securities
27
Item 6.
Selected Financial Data
29
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
30
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
46
Item 8.
Financial Statements and Supplementary Data
46
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
87
Item 9A.
Controls and Procedures
87
Item 9B.
Other Information
87
 
 
 
Part III
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
87
Item 11.
Executive Compensation
88
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
88
Item 13.
Certain Relationships and Related Transactions, and Director Independence
88
Item 14.
Principal Accountant Fees and Services
88
 
 
 
Part IV
 
 
Item 15.
Exhibits and Financial Statement Schedules
89
SIGNATURES
90
 
 
EXHIBIT LIST
91
 
 
 
This Annual Report on Form 10-K of Shore Bancshares, Inc. (the “Company” and “we,” “our” or “us” on a consolidated basis) contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995.  In some cases, you can identify these forward-looking statements by words like “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “predict,” “potential,” or “continue” or the negative of those words and other comparable terminology, although not all forward-looking statements contain these words.  Forward-looking statements are not a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by, which such performance or results will be achieved.  We caution that the forward-looking statements are based largely on our expectations and information available at the time the statements are made and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are in many instances, beyond our control.  Actual results, performance or achievements could differ materially from those contemplated, expressed, or implied by the forward-looking statements.  You should bear this in mind when reading this annual report and not place undue reliance on these forward-looking statements.  The following factors, among others, could cause our financial performance to differ materially from that expressed in such forward-looking statements:
 
· general economic conditions, whether national or regional, and conditions in the lending markets in which we participate that may have an adverse effect on the demand for our loans and other products, our credit quality and related levels of nonperforming assets and loan losses, and the value and salability of the real estate that we own or that is the collateral for our loans;
 
· results of examinations of us by our regulators, including the possibility that our regulators may, among other things, require us to increase our reserve for loan losses or to write-down assets;
 
· changing bank regulatory conditions, policies or programs, whether arising as new legislation or regulatory initiatives, that could lead to restrictions on activities of banks generally, or our subsidiary banks in particular, more restrictive regulatory capital requirements, increased costs, including deposit insurance premiums, regulation or prohibition of certain income producing activities or changes in the secondary market for loans and other products;
 
· changes in market rates and prices may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet;
 
· our liquidity requirements could be adversely affected by changes in our assets and liabilities;
 
· the effect of legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry;
 
· competitive factors among financial services organizations, including product and pricing pressures and our ability to attract, develop and retain qualified banking professionals;
 
· the growth and profitability of non-interest or fee income being less than expected;
 
· the effect of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board, the Securities and Exchange Commission (the “SEC”), the Public Company Accounting Oversight Board and other regulatory agencies; and
 
· the effect of fiscal and governmental policies of the United States federal government.
 
You should also consider carefully the Risk Factors contained in Item 1A of Part I of this annual report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition.  The risks discussed in this annual report are factors that, individually or in the aggregate, management believes could cause our actual results to differ materially from expected and historical results.  You should understand that it is not possible to predict or identify all such factors.  Consequently, you should not consider such disclosures to be a complete discussion of all potential risks or uncertainties. 
 
The forward-looking statements speak only as of the date on which they are made, and, except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.  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. 
 
 
3

 
PART I
 
Item 1. Business.
 
BUSINESS
 
General
 
The Company was incorporated under the laws of Maryland on March 15, 1996 and is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”).  The Company is the largest independent financial holding company headquartered on the Eastern Shore of Maryland.  The Company’s primary business is acting as the parent company to several financial institution and insurance entities.  The Company engages in the banking business through CNB, a Maryland commercial bank with trust powers, The Talbot Bank of Easton, Maryland, a Maryland commercial bank (“Talbot Bank”), and, until January 1, 2011, The Felton Bank, a Delaware commercial bank (“Felton Bank”).  On January 1, 2011, Felton Bank merged into CNB, with CNB as the surviving bank.  Until December 31, 2009, CNB did business as The Centreville National Bank of Maryland, a national banking association.  It was converted to a Maryland charter on that date.  As used in this annual report, the term “Banks” refers to CNB, Talbot Bank and Felton Bank for periods prior to January 1, 2011 and to CNB and Talbot Bank for all other periods.
 
The Company engages in the insurance business through two general insurance producer firms, The Avon-Dixon Agency, LLC, a Maryland limited liability company, and Elliott Wilson Insurance, LLC, a Maryland limited liability company; one marine insurance producer firm, Jack Martin & Associates, Inc., a Maryland corporation; three wholesale insurance firms, Tri-State General Insurance Agency, LTD, a Maryland corporation, Tri-State General Insurance Agency of New Jersey, Inc., a New Jersey corporation, and Tri-State General Insurance Agency of Virginia, Inc., a Virginia corporation (collectively “TSGIA”); and an insurance premium finance company, Mubell Finance, LLC, a Maryland limited liability company, (all of the foregoing are collectively referred to as the “Insurance Subsidiaries”). 
 
The Company has three inactive subsidiaries, Wye Financial Services, LLC, Shore Pension Services, LLC, and Wye Mortgage, LLC, all of which were organized under Maryland law. 
 
Talbot Bank owns all of the issued and outstanding securities of Dover Street Realty, Inc., a Maryland corporation that engages in the business of holding and managing real property acquired by Talbot Bank as a result of loan foreclosures. 
 
We operate in two business segments:  community banking and insurance products and services.  Financial information related to our operations in these segments for each of the two years ended December 31, 2013 is provided in Note 25 to the Company’s Consolidated Financial Statements included in Item 8 of Part II of this annual report.
 
Banking Products and Services
 
CNB is a Maryland commercial bank with trust powers that commenced operations in 1876.  CNB was originally chartered as a national banking association but converted to its present charter effective January 1, 2010.  Talbot Bank is a Maryland commercial bank that commenced operations in 1885 and was acquired by the Company in its December 2000 merger with Talbot Bancshares, Inc.  Felton Bank was a Delaware commercial bank that commenced operations in 1908 and was acquired by the Company in April 2004 when it merged with Midstate Bancorp, Inc.  The Banks operate 18 full service branches and 20 ATMs and provide a full range of commercial and consumer banking products and services to individuals, businesses, and other organizations in Kent County, Queen Anne’s County, Caroline County, Talbot County and Dorchester County in Maryland and in Kent County, Delaware.  The Banks’ deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”). 
 
The Banks are independent community banks and serve businesses and individuals in their respective market areas.  Services offered are essentially the same as those offered by larger regional institutions that compete with the Banks. Services provided to businesses include commercial checking, savings, certificates of deposit and overnight investment sweep accounts. The Banks offer all forms of commercial lending, including secured and unsecured loans, working capital loans, lines of credit, term loans, accounts receivable financing, real estate acquisition development, construction loans and letters of credit.  Merchant credit card clearing services are available as well as direct deposit of payroll, internet banking and telephone banking services.
 
Services to individuals include checking accounts, various savings programs, mortgage loans, home improvement loans, installment and other personal loans, credit cards, personal lines of credit, automobile and other consumer financing, safe deposit boxes, debit cards, 24-hour telephone banking, internet banking, and 24-hour automatic teller machine services.  The Banks also offer nondeposit products, such as mutual funds and annuities, and discount brokerage services to their customers.  Additionally, the Banks have Saturday hours and extended hours on certain evenings during the week for added customer convenience.
 
 
4

 
Lending Activities
 
The Banks originate secured and unsecured loans for business purposes. Commercial loans are typically secured by real estate, accounts receivable, inventory, equipment and/or other assets of the business. Commercial loans generally involve a greater degree of credit risk than one to four family residential mortgage loans.  Repayment is often dependent on the successful operation of the business and may be affected by adverse conditions in the local economy or real estate market. The financial condition and cash flow of commercial borrowers is therefore carefully analyzed during the loan approval process, and continues to be monitored by obtaining business financial statements, personal financial statements and income tax returns. The frequency of this ongoing analysis depends upon the size and complexity of the credit and collateral that secures the loan. The Banks request personal guarantees from the principals of the commercial loan borrowers.
 
The Banks’ commercial real estate loans are primarily secured by land for residential and commercial development, agricultural purpose properties, service industry buildings such as restaurants and motels, retail buildings and general purpose business space.  The Banks attempt to mitigate the risks associated with these loans through thorough financial analyses, conservative underwriting procedures, including loan to value ratio standards, obtaining additional collateral, closely monitoring construction projects to control disbursement of funds on loans, and management’s knowledge of the local economy in which the Banks lend.
 
The Banks provide residential real estate construction loans to builders and individuals for single family dwellings. Residential construction loans are usually granted based upon “as completed” appraisals and are secured by the property under construction.  Additional collateral may be taken if loan to value ratios exceed 80%.  Site inspections are performed to determine pre-specified stages of completion before loan proceeds are disbursed.  These loans typically have maturities of six to 12 months and may have fixed or variable rate features.  Permanent financing options for individuals include fixed and variable rate loans with three- and five-year balloon features and one-, three- and five-year adjustable rate mortgage loans.  The risk of loss associated with real estate construction lending is controlled through conservative underwriting procedures such as loan to value ratios of 80% or less at origination, obtaining additional collateral, and closely monitoring construction projects to control disbursement of funds on loans.
 
The Banks originate fixed and variable rate residential mortgage loans.  As with any consumer loan, repayment is dependent on the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy, among other factors.  Underwriting standards recommend loan to value ratios not to exceed 80% at origination based on appraisals performed by approved appraisers. The Banks rely on title insurance to protect their lien priorities and protect the property securing the loans by requiring fire and casualty insurance.
 
A variety of consumer loans are offered to customers, including home equity loans, credit cards and other secured and unsecured lines of credit and term loans.  Careful analysis of an applicant’s creditworthiness is performed before granting credit, and ongoing monitoring of loans outstanding is performed in an effort to minimize risk of loss by identifying problem loans early.
 
Deposit Activities
 
The Banks offer a full array of deposit products including checking, savings and money market accounts, and regular and IRA certificates of deposit.  The Banks also offer the CDARS program, providing up to $50 million of FDIC insurance to our customers.  In addition, we offer our commercial customers packages which include Cash Management services and various checking opportunities.
 
Trust Services
 
CNB has a trust department through which it markets trust, asset management and financial planning services to customers within our market areas using the trade name Wye Financial & Trust.
 
Insurance Activities
 
The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC were formed as a result of the Company’s acquisition of the assets of The Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company on May 1, 2002.  In November 2002, The Avon-Dixon Agency, LLC acquired certain assets of W. M. Freestate & Son, Inc., a full-service insurance producer firm located in Centreville, Maryland.  Jack Martin & Associates, Inc., Tri-State General Insurance Agency, LTD, Tri-State General Insurance Agency of New Jersey, Inc., and Tri-State General Insurance Agency of Virginia, Inc. were acquired on October 1, 2007.
 
The Insurance Subsidiaries offer a full range of insurance products and services to customers, including insurance premium financing.
 
 
5

 
Seasonality
 
Management does not believe that our business activities are seasonal in nature. 
 
Employees
 
At February 28, 2014, we employed 332 persons, of which 302 were employed on a full-time basis. 
 
COMPETITION
 
The banking business is highly competitive.  Within our market areas, we compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with money market and mutual funds and other investment alternatives for deposits, with consumer finance companies for loans, with insurance companies, agents and brokers for insurance products, and with other financial institutions for various types of products and services.  There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas.
 
The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours.  The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.  The primary factors in competing for insurance customers are competitive rates, the quality and range of insurance products offered, and quality, personalized service.
 
To compete with other financial services providers, we rely principally upon local promotional activities, including advertisements in local newspapers, trade journals and other publications and on the radio, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet customers’ needs.  In those instances in which we are unable to accommodate the needs of a customer, we will arrange for those services to be provided by other financial services providers with which we have a relationship.  We additionally rely on referrals from satisfied customers.
 
The following tables set forth deposit data for FDIC-insured institutions in Kent County, Queen Anne’s County, Caroline County, Talbot County and Dorchester County in Maryland and in Kent County, Delaware as of June 30, 2013, the most recent date for which comparative information is available.
 
 
 
 
 
% of
 
Kent County, Maryland
 
Deposits
 
Total
 
 
 
(in thousands)
 
 
 
Peoples Bank of Kent County, Maryland
 
$
181,128
 
34.36
%
PNC Bank, NA
 
 
152,604
 
28.95
 
Chesapeake Bank and Trust Co.
 
 
69,059
 
13.10
 
Branch Banking & Trust
 
 
52,023
 
9.87
 
CNB
 
 
45,883
 
8.70
 
SunTrust Bank
 
 
26,467
 
5.02
 
 
 
 
 
 
 
 
Total
 
$
527,164
 
100.00
%
 
Source:  FDIC DataBook
 
 
6

 
 
 
 
 
% of
 
Queen Anne’s County, Maryland
 
Deposits
 
Total
 
 
 
(in thousands)
 
 
 
The Queenstown Bank of Maryland
 
$
352,581
 
39.41
%
CNB
 
 
234,511
 
26.21
 
Bank of America, NA
 
 
69,762
 
7.80
 
PNC Bank, NA
 
 
63,618
 
7.11
 
M&T
 
 
56,790
 
6.35
 
First National Bank of Pennsylvania
 
 
41,862
 
4.68
 
Branch Banking & Trust
 
 
24,787
 
2.77
 
Capital One Bank, NA
 
 
22,557
 
2.52
 
Peoples Bank
 
 
20,081
 
2.24
 
Sun Trust Bank
 
 
8,134
 
0.91
 
 
 
 
 
 
 
 
Total
 
$
894,683
 
100.00
%
 
Source:  FDIC DataBook
 
 
 
 
 
% of
 
Caroline County, Maryland
 
Deposits
 
Total
 
 
 
(in thousands)
 
 
 
Provident State Bank, Inc
 
$
154,427
 
41.04
%
PNC Bank, NA
 
 
95,010
 
25.25
 
CNB
 
 
63,761
 
16.95
 
M&T
 
 
28,937
 
7.69
 
Branch Banking & Trust
 
 
28,710
 
7.63
 
The Queenstown Bank of Maryland
 
 
5,403
 
1.44
 
 
 
 
 
 
 
 
Total
 
$
376,248
 
100.00
%
 
Source:  FDIC DataBook
 
 
 
 
 
% of
 
Talbot County, Maryland
 
Deposits
 
Total
 
 
 
(in thousands)
 
 
 
The Talbot Bank of Easton, Maryland
 
$
477,431
 
43.10
%
PNC Bank, NA
 
 
140,590
 
12.69
 
Bank of America, NA
 
 
125,445
 
11.32
 
Easton Bank & Trust
 
 
118,264
 
10.68
 
The Queenstown Bank of MD
 
 
47,964
 
4.33
 
Branch Banking & Trust
 
 
47,281
 
4.27
 
M&T
 
 
47,247
 
4.26
 
SunTrust Bank
 
 
34,893
 
3.15
 
Provident State Bank, Inc
 
 
25,419
 
2.29
 
Capital One Bank, NA
 
 
22,971
 
2.07
 
First Mariner Bank
 
 
20,309
 
1.83
 
 
 
 
 
 
 
 
Total
 
$
1,107,814
 
100.00
%
 
Source:  FDIC DataBook
 
 
7

 
 
 
 
 
 
% of
 
Dorchester County, Maryland
 
Deposits
 
Total
 
 
 
 
(in thousands)
 
 
 
The National Bank of Cambridge
 
$
176,662
 
32.59
%
Hebron Savings Bank
 
 
107,363
 
19.80
 
Provident State Bank, Inc
 
 
64,810
 
11.95
 
Branch Banking & Trust
 
 
59,298
 
10.94
 
M&T
 
 
37,489
 
6.92
 
The Talbot Bank of Easton, Maryland
 
 
35,730
 
6.59
 
Bank of America, NA
 
 
30,732
 
5.67
 
SunTrust Bank
 
 
30,040
 
5.54
 
 
 
 
 
 
 
 
Total
 
$
542,124
 
100.00
%
 
Source:  FDIC DataBook
 
 
 
 
 
 
% of
 
Kent County, Delaware
 
Deposits
 
Total
 
 
 
 
(in thousands)
 
 
 
M&T
 
$
521,198
 
28.49
%
PNC Bank Delaware
 
 
334,671
 
18.29
 
First NB of Wyoming
 
 
241,717
 
13.21
 
RBS Citizens NA
 
 
182,323
 
9.97
 
Wells Fargo
 
 
155,519
 
8.50
 
Wilmington Savings Fund Society
 
 
136,516
 
7.46
 
CNB
 
 
68,650
 
3.75
 
TD Bank National Assn
 
 
60,338
 
3.30
 
Artisans Bank
 
 
46,566
 
2.55
 
County Bank
 
 
39,734
 
2.17
 
Midcoast Community Bank
 
 
34,496
 
1.89
 
Fort Sill National Bank
 
 
7,743
 
0.42
 
 
 
 
 
 
 
 
Total
 
$
1,829,471
 
100.00
%
 
Source:  FDIC DataBook
 
For further information about competition in our market areas, see the Risk Factor entitled “We operate in a highly competitive market and our inability to effectively compete in our markets could have an adverse impact on our financial condition and results of operations” in Item 1A of Part I of this annual report.
 
SUPERVISION AND REGULATION
 
The following is a summary of the material regulations and policies applicable to us and is not intended to be a comprehensive discussion.  Changes in applicable laws and regulations may have a material effect on our business, financial condition and results of operations.
 
General
 
The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the FRB.
 
CNB and Talbot Bank are Maryland commercial banks subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year).  The primary federal regulator of CNB is the FRB.  The primary federal regulator of Talbot Bank is the FDIC, which is also entitled to conduct regular examinations.  The deposits of the Banks are insured by the FDIC, so certain laws and regulations administered by the FDIC also govern their deposit taking operations.  In addition to the foregoing, the Banks are subject to numerous state and federal statutes and regulations that affect the business of banking generally.
 
 
8

 
Nonbank affiliates of the Company are subject to examination by the FRB, and, as affiliates of the Banks, may be subject to examination by the Banks’ regulators from time to time.  In addition, the Insurance Subsidiaries are each subject to licensing and regulation by the insurance authorities of the states in which they do business.  Retail sales of insurance products by the Insurance Subsidiaries to customers of the Banks are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994, as amended, by the FDIC, the FRB and the other federal banking agencies.
 
Regulation of Financial Holding Companies
 
In November 1999, the Gramm-Leach-Bliley Act (the “GLB Act”) was signed into law.  Effective in pertinent part on March 11, 2000, the GLB Act revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution.  Under the GLB Act, a bank holding company can elect, subject to certain qualifications, to become a “financial holding company.”  The GLB Act provides that a financial holding company may engage in a full range of financial activities, including insurance and securities underwriting and agency activities, merchant banking, and insurance company portfolio investment activities, with new expedited notice procedures.
 
Under FRB policy, the Company is expected to act as a source of strength to its subsidiary banks, and the FRB may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required.  This support may be required at times when the bank holding company may not have the resources to provide the support.  Under the prompt corrective action provisions, if a controlled bank is undercapitalized, then the regulators could require the bank holding company to guarantee the bank’s capital restoration plan.  In addition, if the FRB believes that a bank holding company’s activities, assets or affiliates represent a significant risk to the financial safety, soundness or stability of a controlled bank, then the FRB could require the bank holding company to terminate the activities, liquidate the assets or divest the affiliates. The regulators may require these and other actions in support of controlled banks even if such actions are not in the best interests of the bank holding company or its stockholders.  Because the Company is a bank holding company, it is viewed as a source of financial and managerial strength for any controlled depository institutions, like the Banks.
 
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which made sweeping changes to the financial regulatory landscape and will impact all financial institutions, including the Company and the Banks.  The Dodd-Frank Act also directs federal bank regulators to require that all companies that directly or indirectly control an insured depository institution serve as sources of financial strength for the institution.  The term “source of financial strength” is defined under the Dodd-Frank Act as the ability of a company to provide financial assistance to its insured depository institution subsidiaries in the event of financial distress.  The appropriate federal banking agency for such a depository institution may require reports from companies that control the insured depository institution to assess their abilities to serve as sources of strength and to enforce compliance with the source-of-strength requirements.  The appropriate federal banking agency may also require a holding company to provide financial assistance to a bank with impaired capital.  Under this requirement, in the future the Company could be required to provide financial assistance to the Banks should they experience financial distress.
 
In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default.  Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss.  Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its stockholders and obligations to other affiliates.
 
Federal Regulation of Banks
 
Federal and state banking regulators may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believe are unsafe or unsound banking practices.  These banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices.  Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions. 
 
 
9

 
The Banks are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act.  Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its nonbank affiliates by the Banks.  Section 23B requires that transactions between any of the Banks and the Company and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates. 
 
The Banks are also subject to certain restrictions on extensions of credit to executive officers, directors, and principal stockholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as are available to third parties dealing with the Banks and not involve more than the normal risk of repayment.  Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.
 
As part of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority.  These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits.  An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards.  Failure to submit or implement such a plan may subject the institution to regulatory sanctions.  The Company, on behalf of the Banks, believes that the Banks meet substantially all standards that have been adopted.  FDICIA also imposes capital standards on insured depository institutions. 
 
The Community Reinvestment Act (“CRA”) requires that, in connection with the examination of financial institutions within their jurisdictions, the federal banking regulators evaluate the record of the financial institution in meeting the credit needs of their communities including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks.  These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility.  As of the date of its most recent examination report, each of the Banks has a CRA rating of “Satisfactory.”
 
The Banks are also subject to a variety of other laws and regulations with respect to the operation of their businesses, including, but not limited to, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Expedited Funds Availability (Regulation CC), Reserve Requirements (Regulation D), Privacy of Consumer Information (Regulation P), Margin Stock Loans (Regulation U), the Right To Financial Privacy Act, the Flood Disaster Protection Act, the Homeowners Protection Act, the Servicemembers Civil Relief Act, the Real Estate Settlement Procedures Act, the Telephone Consumer Protection Act, the CAN-SPAM Act, the Children’s Online Privacy Protection Act, and the John Warner National Defense Authorization Act.
 
The Dodd-Frank Act
 
The Dodd-Frank Act, enacted in July 2010, significantly changed the bank regulatory structure and affected the lending, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires the FRB to set minimum capital levels for bank holding companies that are as stringent as those required for insured depository institutions.  The legislation also establishes a floor for capital of insured depository institutions that cannot be lower than the standards in effect today, and directs the federal banking regulators to implement new leverage and capital requirements.  The new leverage and capital requirements must take into account off-balance sheet activities and other risks, including risks relating to securitized products and derivatives.  Pursuant to the Dodd-Frank Act, the FDIC has backup enforcement authority over a depository institution holding company, such as the Company, if the conduct or threatened conduct of such holding company poses a risk to the Deposit Insurance Fund (“DIF”), although such authority may not be used if the holding company is generally in sound condition and does not pose a foreseeable and material risk to the DIF.  In addition, the Dodd-Frank Act contains a wide variety of provisions (many of which are not yet effective) affecting the regulation of depository institutions, including restrictions related to mortgage originations, risk retention requirements as to securitized loans and the establishment of the Consumer Financial Protection Bureau (“CFPB”). 
 
The full impact of the Dodd-Frank Act on our business and operations will not be known for years until regulations implementing the statute are written and adopted.  The Dodd-Frank Act will increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers.  In particular, the Dodd-Frank Act will require us to invest significant management attention and resources so that we can evaluate the impact of this law and its regulations and make any necessary changes to our product offerings and operations.  These impacts may be material. 
 
 
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Capital Requirements
 
General
 
FDICIA established a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the federal banking regulators are required to rate supervised institutions on the basis of five capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized;” and to take certain mandatory actions (and are authorized to take other discretionary actions) with respect to institutions in the three undercapitalized categories.  The severity of the actions will depend upon the category in which the institution is placed.  A depository institution is “well capitalized” if it has a total risk based capital ratio of 10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any order, regulatory agreement, or written directive to meet and maintain a specific capital level for any capital measure.  An “adequately capitalized” institution is defined as one that has a total risk based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMEL rating of 1).
 
FDICIA generally prohibits a depository institution from making any capital distribution, including the payment of cash dividends, or paying a management fee to its holding company if the depository institution would thereafter be undercapitalized.  Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans.  For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee (subject to certain limitations) that the institution will comply with such capital restoration plan.
 
Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets and stop accepting deposits from correspondent banks.  Critically undercapitalized depository institutions are subject to the appointment of a receiver or conservator; generally within 90 days of the date such institution is determined to be critically undercapitalized.
 
As of December 31, 2013, Talbot Bank was categorized as “adequately capitalized” and CNB as “well capitalized.”  For more information regarding the capital condition of the Company, see Note 1 to the Consolidated Financial Statements under the caption “Regulatory Enforcement Actions” and Note 16 to the Consolidated Financial Statements appearing in Item 8 of Part II of this annual report.
 
The Collins Amendment provisions of the Dodd-Frank Act
 
The Collins Amendment provision of the Dodd-Frank Act imposes increased capital requirements in the future. The Collins Amendment also requires federal banking regulators to establish minimum leverage and risk-based capital requirements to apply to insured depository institutions, bank and thrift holding companies, and systemically important nonbank financial companies. These capital requirements must not be less than the Generally Applicable Risk Based Capital Requirements and the Generally Applicable Leverage Capital Requirements as of July 21, 2010, and must not be quantitatively lower than the requirements that were in effect for insured depository institutions as of July 21, 2010.  The Collins Amendment defines Generally Applicable Risk Based Capital Requirements and Generally Applicable Leverage Capital Requirements to mean the risk-based capital requirements and minimum ratios of Tier 1 risk-based capital to average total assets, respectively, established by the appropriate federal banking agencies to apply to insured depository institutions under the Prompt Corrective Action provisions, regardless of total consolidated asset size or foreign financial exposure. 
 
Basel III — Capital, Liquidity and Stress Testing Requirements
 
The Basel Committee on Banking Supervision (“Basel”) has drafted frameworks for the regulation of capital and liquidity of internationally active banking organizations, generally referred to as “Basel III.” On June 7, 2012, the FRB issued a notice of proposed rulemaking that would implement elements of Sections 165 and 166 of the Dodd-Frank Act that encompass certain aspects of Basel III with respect to capital and liquidity.  On November 9, 2012, following a public comment period, the U.S. federal banking agencies issued a joint press release announcing that the January 1, 2013 effective date was being delayed so the agencies could consider operational and transitional issues identified in the large volume of public comments received.  In July 2013, the U.S. federal banking agencies published the final rules (the “Basel III Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations.  
 
Capital Requirements
 
The Basel III Capital Rules implement the Basel III capital standards and establish minimum capital levels required under the Dodd-Frank Act, which apply to all U.S. banks, subject to various transition periods.  The Basel III Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions compared to the current U.S. risk-based capital rules.  The Basel III Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions’ regulatory capital ratios.  The Basel III Capital Rules also address risk weights and other issues affecting the denominator in banking institutions’ regulatory capital ratios and replace the existing risk-weighting approach with a more risk-sensitive approach.  The Basel III Capital Rules are effective for the Company on January 1, 2015 and will be fully phased in on January 1, 2019.
 
 
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The Basel III Capital Rules, among other things, (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consist of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions/adjustments as compared to existing regulations.
 
When fully phased in on January 1, 2019, the Basel III Capital Rules will require the Company to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer,” (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0% (increased from 4.0%), plus the capital conservation buffer, (iii) a minimum ratio of Total capital to risk-weighted assets of at least 8.0% (unchanged from current rules), plus the capital conservation buffer and (iv) a minimum leverage ratio of 4% (unchanged from current rules), calculated as the ratio of Tier 1 capital to average assets.  The Basel III Capital Rules eliminate the inclusion of certain instruments, such as trust preferred securities, from Tier 1 capital.  Instruments issued prior to May 19, 2010 will be grandfathered for companies with consolidated assets of $15 billion or less. 
 
The capital conservation buffer is designed to absorb losses during periods of economic stress.  Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.  The implementation of the capital conservation buffer will begin on January 1, 2016 at 0.625% and be phased in over a four-year period, increasing by that amount on each January 1, until it reaches 2.5% on January 1, 2019.
 
The Basel III Capital Rules also revise the “prompt corrective action” regulations by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status and (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%).  The Basel III Capital Rules do not change the total risk-based capital requirement for any prompt corrective action category.
 
The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes to current rules impacting the Company’s risk-weighted assets include, among other things:
 
· Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.
 
· Assigning a 150% risk weight to loans (other than residential mortgage) that are 90 days or more past due or on nonaccrual.
 
· Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable, currently at 0%.
 
Management believes that the Company will meet all capital adequacy requirements under the Basel III Capital Rules when they become effective for the Company on January 1, 2015.
 
Liquidity Requirements
 
Historically, regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures.  The Basel III liquidity framework, however, requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation.  Current rules and proposals from the U.S. federal banking agencies do not specifically address the Basel III liquidity requirements.
 
Deposit Insurance
 
The Banks are members of the FDIC and pay an insurance premium on a quarterly basis.  Deposits are insured by the FDIC through the DIF and such insurance is backed by the full faith and credit of the United States Government.  Under the Dodd-Frank Act, a permanent increase in deposit insurance to $250,000 was authorized.  The coverage limit is per depositor, per insured depository institution, for each account ownership category. 
 
The Dodd-Frank Act also set a new minimum DIF reserve ratio at 1.35% of estimated insured deposits.  The FDIC is required to attain this ratio by September 30, 2020.  The Dodd-Frank Act required the FDIC to redefine the deposit insurance assessment base for an insured depository institution.  Prior to the Dodd-Frank Act, an institution’s assessment base has historically been its domestic deposits, with some adjustments.  As redefined pursuant to the Dodd-Frank Act, an institution’s assessment base is now an amount equal to the institution’s average consolidated total assets during the assessment period minus average tangible equity.  Institutions with $1.0 billion or more in assets at the end of a fiscal quarter must report their average consolidated total assets on a daily basis and report their average tangible equity on an end-of-month balance basis.  Institutions with less than $1.0 billion in assets at the end of a fiscal quarter may opt to report average consolidated total assets and average tangible equity on a weekly and end-of-quarter basis, respectively. 
 
 
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The Federal Deposit Insurance Reform Act of 2005, which created the DIF, gave the FDIC greater latitude in setting the assessment rates for insured depository institutions which could be used to impose minimum assessments.  On May 22, 2009, the FDIC imposed an emergency insurance assessment of five basis points in an effort to restore the DIF to an acceptable level.  On November 12, 2009, the FDIC adopted a final rule requiring insured depository institutions to prepay their estimated quarterly risk-based deposit assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution’s risk based deposit insurance assessment for the third quarter of 2009.  It was also announced that the assessment rate would increase by 3 basis points effective January 1, 2011.  The prepayment was accounted for as a prepaid expense and amortized quarterly.  The prepaid assessment qualified for a zero risk weight under the risk-based capital requirements.  The Banks’ three-year prepaid assessment was $5.4 million.  The Banks expensed a total of $1.8 million in FDIC premiums during 2013. The FDIC has the flexibility to adopt actual deposit assessment rates that are higher or lower than the total base assessment rates adopted without notice and comment, if certain conditions are met. 
 
DIF-insured institutions pay a Financing Corporation (“FICO”) assessment in order to fund the interest on bonds issued in the 1980s in connection with the failures in the thrift industry. For the fourth quarter of 2013, the FICO assessment was equal to 0.155 basis points computed on assets as required by the Dodd-Frank Act.  These assessments will continue until the bonds mature in 2019.
 
The FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions.  It is also authorized to terminate a depository bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency.  The termination of deposit insurance for either of the Banks would have a material adverse effect on our earnings, operations and financial condition.
 
Bank Secrecy Act/Anti-Money Laundering
 
The Bank Secrecy Act (“BSA”), which is intended to require financial institutions to develop policies, procedures, and practices to prevent and deter money laundering, mandates that every national bank have a written, board-approved program that is reasonably designed to assure and monitor compliance with the BSA.
 
The program must, at a minimum:  (i) provide for a system of internal controls to assure ongoing compliance; (ii) provide for independent testing for compliance; (iii) designate an individual responsible for coordinating and monitoring day-to-day compliance; and (iv) provide training for appropriate personnel.  In addition, state-chartered banks are required to adopt a customer identification program as part of its BSA compliance program.  State-chartered banks are also required to file Suspicious Activity Reports when they detect certain known or suspected violations of federal law or suspicious transactions related to a money laundering activity or a violation of the BSA.
 
In addition to complying with the BSA, the Banks are subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”). The USA Patriot Act is designed to deny terrorists and criminals the ability to obtain access to the United States’ financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The USA Patriot Act mandates that financial service companies implement additional policies and procedures and take heightened measures designed to address any or all of the following matters:  (i) customer identification programs; (ii) money laundering; (iii) terrorist financing; (iv) identifying and reporting suspicious activities and currency transactions; (v) currency crimes; and (vi) cooperation between financial institutions and law enforcement authorities.
 
Ability-to-Repay and Qualified Mortgage Rule
 
Pursuant to the Dodd Frank Act, the CFPB issued a final rule on January 10, 2013 (effective on January 10, 2014), amending Regulation Z, as implemented by the Truth in Lending Act, that requires mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms.  Mortgage lenders are required to determine consumers’ ability to repay in one of two ways.  The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision:  (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the covered transaction; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) the monthly debt-to-income ratio or residual income; and (viii) credit history. Alternatively, the mortgage lender can originate “qualified mortgages,” which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years.  In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed three percent of the total loan amount.  Qualified mortgages that are “higher-priced” (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g. prime loans) are given a safe harbor of compliance.
 
 
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Volcker Rule
 
The Dodd-Frank Act prohibits insured depository institutions from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of three percent (3%) of Tier 1 Capital in private equity and hedge funds (known as the “Volcker Rule”).  The FRB released a final rule on February 9, 2011 (effective on April 1, 2011) which requires a “banking entity,” a term that is defined to include banks like the Banks, to bring its proprietary trading activities and investments into compliance with the Dodd-Frank Act restrictions no later than two years after the earlier of:  (i) July 21, 2012; or (ii) 12 months after the date on which interagency final rules are adopted.
 
On December 10, 2013, the U.S. federal banking agencies, including the FRB, adopted a final rule implementing the Volcker Rule. Although the final rule provides some tiering of compliance and reporting obligations based on size, the fundamental prohibitions of the Volcker Rule apply to banking entities of any size. Banking entities with total assets of $10 billion or more that engage in activities subject to the Volcker Rule will be required to establish a six-element compliance program to address the prohibitions of, and exemptions from, the Volcker Rule. The final rule becomes effective April 1, 2014; however, at the time the agencies released the final Volcker Rule, the FRB announced an extension of the conformance period for all banking entities until July 21, 2015.  In response to industry questions regarding the final Volcker Rule, the U.S. federal banking agencies, the SEC, and the Commodity Futures Trading Commission issued a clarifying interim final rule on January 14, 2014, permitting banking entities to retain interests in certain collateralized debt obligations (“CDOs”) backed by trust preferred securities if the CDO meets certain requirements.  
 
The Banks do not, nor intend to, engage in proprietary trading or own equity interests in private equity and hedge funds restricted by the Dodd-Frank Act.  However, the Banks intend to review the implications of the interagency rules on their investments once those rules are issued and will plan for any adjustments of their activities or their holdings so that they will be in compliance by the announced compliance date.
 
Federal Securities Laws
 
The shares of the Company’s common stock are registered with the SEC under Section 12(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and listed on the NASDAQ Global Select Market.  The Company is subject to information reporting requirements, proxy solicitation requirements, insider trading restrictions and other requirements of the Exchange Act, including the requirements imposed under the federal Sarbanes-Oxley Act of 2002 and the rules of The NASDAQ Stock Market, LLC.  Among other things, loans to and other transactions with insiders are subject to restrictions and heightened disclosure, directors and certain committees of the Board must satisfy certain independence requirements, and the Company is generally required to comply with certain corporate governance requirements.
 
Governmental Monetary and Credit Policies and Economic Controls
 
The earnings and growth of the banking industry and ultimately of the Company are affected by the monetary and credit policies of governmental authorities, including the FRB.  An important function of the FRB is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the FRB to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits.  These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid for deposits.  The monetary policies of the FRB authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.  In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the FRB, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and its subsidiaries.
 
 
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REGULATORY ENFORCEMENT ACTIONS
 
Talbot Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Agreement”) with the FDIC, a Stipulation and Consent to the Issuance of a Consent Order (the “Maryland Consent Agreement” and together with the Consent Agreement, the “Consent Agreements”) with the Maryland Commissioner of Financial Regulation (the “Commissioner”) and an Acknowledgement of Adoption of the Order by the Commissioner (the “Acknowledgement”). The FDIC and the Commissioner issued the related Consent Order (the “Order”), effective May 24, 2013. The description of the Consent Agreements, the Order and the Acknowledgement along with Talbot Bank’s progress with the requirements, are set forth below. 
 
Management. Talbot Bank is required to have and retain experienced, qualified management, and to assess management’s ability to (1) comply with the requirements of the Order; (2) operate Talbot Bank in a safe and sound manner; (3) comply with all applicable laws, rules and regulations; and (4) restore all aspects of Talbot Bank to a safe and sound condition, including capital adequacy, asset quality, and management effectiveness. Talbot Bank has implemented certain changes to comply with the Order which include expanding our credit administration and loan workout units with the addition of experienced new staff members, in an effort to accelerate the resolution of our credit issues and position Talbot Bank for future growth. Additionally, Talbot Bank is conducting an internal and external search for a chief financial officer.
 
Board Participation. Talbot Bank’s board of directors is required to increase its participation in the affairs of Talbot Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all Talbot Bank activities. This participation shall include comprehensive, documented meetings to be held no less frequently than monthly. The board of directors must also develop a program to monitor Talbot Bank’s compliance with the Order. Talbot Bank has completed a plan to increase the participation of its board of directors which includes increasing the frequency of board meetings from monthly to biweekly and establishing a risk management committee of the board.
 
Loss Charge-Offs. The Order requires that Talbot Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” by the FDIC or the Commissioner. Talbot Bank has eliminated from its books all such classified assets.
 
Classified Assets Reduction. Within 60 days of the effective date of the Order, Talbot Bank was required to submit a Classified Asset Plan to the FDIC and Commissioner to reduce the risk position in each asset in excess of $750,000 which was classified “Substandard” and “Doubtful” by the FDIC or Commissioner. Talbot Bank revised its existing Classified Asset Plan to address the terms of the Order and submitted the updated plan to the FDIC and Commissioner in accordance with the Order.
 
Allowance for Loan and Lease Losses. Within 60 days of the effective date of the Order, the board of directors was required to review the adequacy of the allowance for loan and lease losses (the “ALLL”), establish a policy for determining the adequacy of the ALLL and submit such ALLL policy to the FDIC and Commissioner. Talbot Bank amended its ALLL policy to comply with the terms of the Order and submitted the updated policy to the FDIC and Commissioner in accordance with the Order.
 
Loan Policy. Within 60 days from the effective date of the Order, Talbot Bank was required to (i) review its loan policies and procedures (“Loan Policy”) for adequacy, (ii) make all appropriate revisions to the Loan Policy to address the lending deficiencies identified by the FDIC, and (iii) submit the Loan Policy to the FDIC and Commissioner. Talbot Bank completed its review of and made the required revisions to the Loan Policy. The updated Loan Policy was submitted to the FDIC and Commissioner in accordance with the terms of the Order.
 
Loan Review Program. Within 30 days from the effective date of the Order, the Board was required to establish a program of independent loan review that provides for a periodic review of Talbot Bank’s loan portfolio and the identification and categorization of problem credits (the “Loan Review Program”) and submit the Loan Review Program to the FDIC and Commissioner. Talbot Bank enhanced its existing Loan Review Program and submitted it to the FDIC and Commissioner in accordance with the terms of the Order.
 
Capital Requirements. Within 90 days from the effective date of the Order, Talbot Bank was required to meet and maintain the following minimum capital levels, after establishing an appropriate ALLL, (i) a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8%, and (ii) a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 12%. As of December 31, 2013, the leverage ratio and total risk-based capital ratio were 4.98% and 8.17%, respectively, for Talbot Bank. Per the Order, Talbot Bank submitted a written plan to the FDIC and the Commissioner describing the means and timing by which it will increase its capital ratios up to or in excess of the required minimums including earnings from operations, capital infusions from the Company and other capital raising alternatives such as equity issuances by the Company.
 
Profit and Budget Plan. Within 60 days from the effective date of the Order and within 30 days of each calendar year-end thereafter, Talbot Bank was and will be required to submit a profit and budget plan to the FDIC and Commissioner consisting of goals and strategies, consistent with sound banking practices, and taking into account Talbot Bank’s other plans, policies or other actions required by the Order.  In accordance with the Order, Talbot Bank developed a profit and budget plan which was submitted to the FDIC and Commissioner within 60 days from the effective date of the Order and one which was submitted within 30 days of the end of 2013.
 
Dividend Restriction. While the Order is in effect, Talbot Bank cannot declare or pay dividends or fees to the Company without the prior written consent of the FDIC and Commissioner.  Talbot Bank is in compliance with this provision of the Order.
 
 
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Brokered Deposits. The Order provides that Talbot Bank may not accept, renew, or rollover any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. Talbot Bank is in compliance with this provision of the Order.
 
Oversight Committee. Within 30 days from the effective date of the Order, Talbot Bank was required to establish a board committee to monitor and coordinate compliance with the Order. Talbot Bank has established a board committee to comply with this provision of the Order.
 
Progress Reports. Within 45 days from the end of each calendar quarter following the effective date of the Order, Talbot Bank must furnish the FDIC and Commissioner with progress reports detailing the form, manner and results of any actions taken to secure compliance with the Order. Talbot Bank has and will continue to submit progress reports to comply with this provision of the Order.
 
The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
 
AVAILABLE INFORMATION
 
The Company maintains an Internet site at www.shorebancshares.com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.  In addition, stockholders may access these reports and documents on the SEC’s web site at www.sec.gov.
 
Item 1A.  RISK FACTORS.
 
The significant risks and uncertainties related to us, our business and the Company’s securities of which we are aware are discussed below.  You should carefully consider these risks and uncertainties before making investment decisions in respect of the Company’s securities.  Any of these factors could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of the Company’s securities.  If any of these risks materialize, you could lose all or part of your investment in the Company.  Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations.  You should also consider the other information contained in this annual report, including our financial statements and the related notes, before making investment decisions. 
 
Risks Relating to Our Business
 
The current economic environment poses significant challenges for us and could continue to adversely affect our financial condition and results of operations.
 
The Banks are operating in a challenging and uncertain economic environment, including generally uncertain national and local conditions.  Financial institutions continue to be affected by sharp declines in the real estate  market  and constrained  financial markets.  There have been dramatic declines in the housing market over the past several years, with falling home prices and increasing foreclosures and high levels of unemployment, resulting in significant write-downs of asset values by financial institutions.  While conditions appear to have begun to improve generally, continued declines in real estate values, home sales volumes, and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on the  Banks' borrowers or  their customers, which could adversely affect our financial condition and results of operations.  A worsening of these conditions would likely exacerbate the adverse effects on us and others in the financial services industry.  For example, further deterioration in local economic conditions in our markets could drive losses beyond that which is provided for in our allowance for loan losses.  We may also face the following risks in connection with these events:
 
Economic conditions that negatively affect housing prices and the job market may result in further deterioration in credit quality of our loan portfolio, and such deterioration in credit quality could have a negative impact on our business;
 
Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities;
 
Demand for our products and services may decline;
 
Collateral for loans made by us may decline in value, in turn reducing a client's borrowing power, and reducing the value of assets and collateral associated with our loans held for investment;
 
 
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Our loan customers may not repay their loans according to their terms and any collateral securing payment may be insufficient to fully compensate us for the outstanding balance of the loan plus the costs we incur disposing of the collateral;
 
The processes we use to estimate the allowance for loan losses may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation;
 
A reduction in the size, spending or employment levels of the federal, state and/or local governments in the Washington, DC metropolitan area could have a negative effect on the economy of the region, on our customers, and on real estate prices;
 
Continued turmoil in the market, and loss of confidence in the banking system, could require the Banks to pay higher interest rates to obtain deposits to meet the needs of their depositors and borrowers, resulting in reduced margin and net interest income. If conditions worsen significantly, it is possible that banks such as the Banks may be unable to meet the needs of their depositors and borrowers, which could, in the worst case, result in the Banks being placed into receivership; and
 
Compliance with increased regulation of the banking industry may increase our costs, limit our ability to pursue business opportunities, and divert management efforts. 
 
As these conditions or similar ones continue to exist or worsen, we could experience continuing or increased adverse effects on our financial condition and results of operations.
 
A majority of our business is concentrated in Maryland and Delaware, a significant amount of which is concentrated in real estate lending, so a decline in the local economy and real estate markets could adversely impact our financial condition and results of operations.
 
Because most of our loans are made to customers who reside on the Eastern Shore of Maryland and in Delaware, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose loan portfolios are geographically diverse.  Further, a significant portion of our loan portfolio is secured by real estate, including construction and land development loans, all of which are in greater demand when interest rates are low and economic conditions are good.  Accordingly, a further decline in local economic conditions would likely have an adverse impact on our financial condition and results of operations, and the impact on us would likely be greater than the impact felt by larger financial institutions whose loan portfolios are geographically diverse. We cannot guarantee that any risk management practices that we implement to address our geographic and loan concentrations will be effective to prevent losses relating to our loan portfolio. 
 
In the case of real estate acquisition, construction and development projects that we have financed, these challenging economic conditions have caused some of our borrowers to default on their loans.  Because of the deterioration in the market values of real estate collateral caused by the recession, banks, including the Banks, have been unable to recover the full amount due under their loans when forced to foreclose on and sell real estate collateral.  As a result, the Banks have realized significant impairments and losses in their loan portfolios, which have materially and adversely impacted our financial condition and results of operations.  These conditions and their consequences are likely to continue until the nation fully recovers from the recent economic recession.  Management cannot predict the extent to which these conditions will cause future impairments or losses, nor can it provide any assurances as to when, or if, economic conditions will improve. 
 
Our concentrations of commercial real estate loans could subject us to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit our future commercial lending activities.
 
The FRB and the FDIC, along with the other federal banking regulators, issued guidance in December 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” directed at institutions that have particularly high concentrations of commercial real estate loans within their lending portfolios.  This guidance suggests that these institutions face a heightened risk of financial difficulties in the event of adverse changes in the economy and commercial real estate markets.  Accordingly, the guidance suggests that institutions whose concentrations exceed certain percentages of capital should implement heightened risk management practices appropriate to their concentration risk.  The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in commercial real estate.  Based on our concentration of commercial real estate and construction lending as of December 31, 2013, we may be subject to heightened supervisory scrutiny during future examinations and/or be required to take steps to address our concentration and capital levels.  Management cannot predict the extent to which this guidance will impact our operations or capital requirements.  Further, we cannot guarantee that any risk management practices we implement will be effective to prevent losses resulting from concentrations in our commercial real estate portfolio. 
 
 
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Interest rates and other economic conditions will impact our results of operations.
 
Our results of operations may be materially and adversely affected by changes in prevailing economic conditions, including declines in real estate values, rapid changes in interest rates and the monetary and fiscal policies of the federal government.  Our results of operations are significantly impacted by the spread between the interest rates earned on assets and the interest rates paid on deposits and other interest-bearing liabilities (i.e., net interest income), including advances from the Federal Home Loan Bank (the “FHLB”) of Atlanta.  Interest rate risk arises from mismatches (i.e., the interest sensitivity gap) between the dollar amount of repricing or maturing assets and liabilities.  If more assets reprice or mature than liabilities during a falling interest rate environment, then our earnings could be negatively impacted.  Conversely, if more liabilities reprice or mature than assets during a rising interest rate environment, then our earnings could be negatively impacted.  Fluctuations in interest rates are not predictable or controllable. 
 
Changes in interest rates, particularly by the Federal Reserve Board, which implements national monetary policy in order to mitigate recessionary and inflationary pressures, also affect the value of our loans.   In setting its policy, the Federal Reserve Board may utilize techniques such as: (i) engaging in open market transactions in United States government securities; (ii) setting the discount rate on member bank borrowings; and (iii) determining reserve requirements.   These techniques may have an adverse effect on our deposit levels, net interest margin, loan demand or our business and operations.  In addition, an increase in interest rates could adversely affect borrowers'  ability to pay the principal or interest on existing loans or reduce their desire to borrow more money.  This may lead to an increase in our nonperforming assets, a decrease in loan originations, or a reduction in the value of and income from our loans, any of which could have a material and negative effect on our results of operations.  We try to minimize our exposure to interest rate risk, but we are unable to completely eliminate this risk. Fluctuations in market rates and other market disruptions are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations.
 
The Banks may experience credit losses in excess of their allowances, which would adversely impact our financial condition and results of operations.
 
The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan.  Management of each of the Banks bases the allowance for credit losses upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality.  If management’s assumptions and judgments prove to be incorrect and the allowance for credit losses is inadequate to absorb future losses, or if the bank regulatory authorities, as a part of their examination process, require our bank subsidiaries to increase their respective allowance for credit losses, our earnings and capital could be significantly and adversely affected.  Material additions to the allowance for credit losses of one of the Banks would result in a decrease in that Bank’s net income and capital and could have a material adverse effect on our financial condition. 
 
Although we believe that our allowance for loan losses is maintained at a level adequate to absorb any inherent losses in our loan portfolio, these estimates of loan losses are necessarily subjective and their accuracy depends on the outcome of future events.
 
While we strive to carefully monitor credit quality and to identify loans that may become nonperforming, at any time there are loans included in the portfolio that have not been identified as nonperforming or potential problem loans, but that will result in losses.  We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on those loans that are identified.  As a result, future additions to the allowance may be necessary.
 
Economic conditions and increased uncertainty in the financial markets could adversely affect our ability to accurately assess our allowance for loan losses.  Our ability to assess the creditworthiness of our customers or to estimate the values of our assets and collateral for loans will be reduced if the models and approaches we use become less predictive of future behaviors, valuations, assumptions or estimates.  We estimate losses inherent in our loan portfolio, the adequacy of our allowance for loan losses and the values of certain assets by using estimates based on difficult, subjective, and complex judgments, including estimates as to the effects of economic conditions and how those economic conditions might affect the ability of our borrowers to repay their loans or the value of assets.
 
The failure of the Company and Talbot Bank to comply with applicable regulatory requirements and regulatory enforcement actions could result in further restrictions and enforcement actions.
 
While the Company and Talbot Bank intend to take such actions as may be necessary to comply with both the requirements of the Order and other regulatory requirements, the Company and Talbot Bank may be unable to comply fully with such requirements, and efforts to comply with such requirements may have adverse effects on the operations and financial condition of the Company and Talbot Bank.  In addition, Talbot Bank from time to time may require waivers, amendments or modifications in order to remain in compliance with the Order, and FDIC and Commissioner may not grant such relief.  Any material failure by Talbot Bank to comply with the provisions of the Order could result in further enforcement actions by the FDIC, the Commissioner and the FRB which could impact our ability to operate in the normal course of business and, thereby, adversely affect our results of operations.
 
The Company may not be successful if it is not able to grow its subsidiaries and their businesses.
 
The Company’s primary business activity for the foreseeable future will be to act as the holding company of CNB, Talbot Bank, and its other subsidiaries.  Therefore, the Company’s future profitability will depend on the success and growth of these subsidiaries. The heightened regulatory scrutiny of the Company and Talbot Bank could impede the ability of the Company to expand its operations.
 
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The market value of our investments might decline.
 
As of December 31, 2013, we had classified 97% of our investment securities as available-for-sale pursuant to the Accounting Standards Codification (“ASC”) Topic 320 (“ASC 320”) of the Financial Accounting Standards Board (“FASB”)  relating to accounting for investments.  ASC 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in stockholders’ equity (net of tax) as accumulated other comprehensive income.  The remaining investment securities are classified as held-to-maturity in accordance with ASC 320 and are stated at amortized cost.
 
In the past, gains on sales of investment securities have not been a significant source of income for us.  There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities.  Stockholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments.  There can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in stockholders’ equity.
 
CNB and Talbot Bank are members of the FHLB of Atlanta.  A member of the FHLB system is required to purchase stock issued by the relevant FHLB bank based on how much it borrows from the FHLB and the quality of the collateral pledged to secure that borrowing.  Accordingly, our investments include stock issued by the FHLB of Atlanta..  These investments could be subject to future impairment charges and there can be no guaranty of future dividends. 
 
Management believes that several factors will affect the market values of our investment portfolio.  These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates).  Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value.  These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.  
 
Impairment of investment securities, goodwill, other intangible assets, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.
 
We are required to record a non-cash charge to earnings when management determines that an investment security is other-than-temporarily impaired.  In assessing whether the impairment of investment securities is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. 
 
Under current accounting standards, goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount.  Intangible assets other than goodwill are also subject to impairment tests at least annually.  A decline in the price of the Company’s common stock or occurrence of a triggering event following any of our quarterly earnings releases and prior to the filing of the periodic report for that period could, under certain circumstances, cause us to perform goodwill and other intangible assets impairment tests and result in an impairment charge being recorded for that period which was not reflected in such earnings release.  In the event that we conclude that all or a portion of our goodwill or other intangible assets may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings.  At December 31, 2013, we had recorded goodwill of $12.5 million and other intangible assets of $3.5 million, representing approximately 12.1% and 3.4% of stockholders’ equity, respectively.
 
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.  Assessing the need for, or the sufficiency of, a valuation allowance requires management to evaluate all available evidence, both negative and positive, including the recent trend of quarterly earnings.  Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carryback and carry forward periods is available under the tax law, including the use of tax planning strategies.  When negative evidence (e.g., cumulative losses in recent years, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary.  At December 31, 2013, our deferred tax assets were approximately $19.1 million.  There was no valuation allowance for deferred taxes recorded at December 31, 2013 as management believes it is more likely than not that all of the deferred taxes will be realized because they were supported by positive evidence such as the expected generation of a sufficient level of future taxable income from operations and tax planning strategies. These deferred tax assets include net operating loss carryovers that can be used to offset taxable income in future periods and reduce income taxes payable in those future periods.  Each quarter, we determine the probability of the realization of deferred tax assets, using significant judgments and estimate with respect to, among other things, historical operating results, expectations of future earnings and tax planning strategies.  If we determine in the future that there is not sufficient positive evidence to support the valuation of these assets, due to the risk factors described herein or other factors, we may be required to establish a valuation allowance to reduce our deferred tax assets.  Such a reduction could result in material non-cash expenses in the period in which the valuation allowance is established and could have a material adverse effect on our results of operations.
 
 
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The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.  See Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this annual report for further information.
 
Our future success will depend on our ability to compete effectively in the highly competitive financial services industry.
 
We face substantial competition in all phases of our operations from a variety of different competitors.  We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other local and community, super-regional, national and international financial institutions that operate offices in our primary market areas and elsewhere.  Our future growth and success will depend on our ability to compete effectively in this highly competitive financial services environment.
 
Many of our competitors are well-established, larger financial institutions and many offer products and services that we do not.  Many have substantially greater resources, name recognition and market presence that benefit them in attracting business.  Some of our competitors are not subject to the same regulations that are imposed on us, including credit unions that do not pay federal income tax, and, therefore, have regulatory advantage over us in accessing funding and in providing various services.  While we believe we compete effectively with these other financial institutions in our primary markets, we may face a competitive disadvantage as a result of our smaller size, smaller asset base, lack of geographic diversification and inability to spread our marketing costs across a broader market.  If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected.  Failure to compete effectively to attract new, or to retain existing, clients may reduce or limit our net income and our market share and may adversely affect our results of operations, financial condition and growth.
 
Our funding sources may prove insufficient to replace deposits and support our future growth.
 
We rely on customer deposits, advances from the FHLB, and lines of credit at other financial institutions to fund our operations.  Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change.  Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates.  Finally, if we are required to place greater reliance on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our profitability would be adversely affected.
 
In addition, the FRB has issued rules pursuant to the Dodd-Frank Act governing debit card interchange fees that apply to institutions with greater than $10 billion in assets.  Although we are not subject to these rules, market forces may effectively require all banks to adopt debit card interchange fee structures that comply with these rules, in which case our non-interest income for future periods could be materially and adversely affected.
 
The loss of key personnel could disrupt our operations and result in reduced earnings.
 
Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel.  Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel.  Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry.  Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings. 
 
Our lending activities subject us to the risk of environmental liabilities.
 
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
 
 
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We may be subject to other claims.
 
We may from time to time be subject to claims from customers for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, the failure to comply with applicable laws and regulations, or many other reasons.  Also, our employees may knowingly or unknowingly violate laws and regulations.  Management may not be aware of any violations until after their occurrence.  This lack of knowledge may not insulate the Company or our subsidiaries from liability.  Claims and legal actions may result in legal expenses and liabilities that may reduce our profitability and hurt our financial condition. 
 
Our exposure to operational, technological and organizational risk may adversely affect us.
 
We are exposed to many types of operational risks, including reputation, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, clerical or record-keeping errors, and errors resulting from faulty or disabled computer or telecommunications systems.
 
Certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect.  We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability.  We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as are we) and to the risk that our (or our vendors’) business continuity and data security systems prove to be inadequate.
 
We depend on the accuracy and completeness of information about customers and counterparties and our financial condition could be adversely affected if we rely on misleading information.
 
In deciding whether to extend credit or to enter into other transactions with customers and counterparties, we may rely on information furnished to us by or on behalf of customers and counterparties, including financial statements and other financial information, which we do not independently verify.  We also may rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors.  For example, in deciding whether to extend credit to customers, we may assume that a customer’s audited financial statements conform with accounting principles generally accepted in the U.S. (“GAAP”) and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer.  Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with GAAP or are materially misleading.
 
We rely on other companies to provide key components of our business infrastructure.
 
Third parties provide key components of our business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, internet connections and network access.  While we have selected these third party vendors carefully, we do not control their actions.  Any problem caused by these third parties, including poor performance of services, failure to provide services, disruptions in communication services provided by a vendor and failure to handle current or higher volumes, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business, and may harm our reputation.  Financial or operational difficulties of a third party vendor could also hurt our operations if those difficulties interface with the vendor’s ability to serve us.  Replacing these third party vendors could also create significant delay and expense.  Accordingly, use of such third parties creates an unavoidable inherent risk to our business operations.
 
Our information  systems may experience an interruption or breach in security.
 
We rely heavily on communications and information systems to conduct business.  Any failure, interruption, or breach in security of these systems could result in failures or disruptions in our internet banking, deposit, loan and other systems.  While we have policies and procedures designed to prevent or limit the effect of such failure, interruption or security breach of our information systems, there can be no assurance that they will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failure, interruption or security breach of our communications and information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability.
 
 
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Technological changes affect our business, and we may have fewer resources than many competitors to invest in technological improvements.
 
The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to serving customers better, the effective use of technology may increase efficiency and may enable financial institutions to reduce costs. Our future success will depend, in part, upon our ability to use technology to provide products and services that provide convenience to customers and to create additional efficiencies in operations. We may need to make significant additional capital investments in technology in the future, and we may not be able to effectively implement new technology-driven products and services. Many of our competitors have substantially greater resources to invest in technological improvements.
 
Risks Relating to the Regulation of our Industry
 
We operate in a highly regulated environment, which could restrain our growth and profitability.
 
We are subject to extensive laws and regulations that govern almost all aspects of our operations.  These laws and regulations, and the supervisory framework that oversees the administration of these laws and regulations, are primarily intended to protect depositors, the Deposit Insurance Fund and the banking system as a whole, and not shareholders and consumers.  These laws and regulations, among other matters, affect our lending practices, capital structure, investment practices, dividend policy, operations and growth.  Compliance with the myriad laws and regulations applicable to our organization can be difficult and costly.  In addition, these laws, regulations and policies are subject to continual review by governmental authorities, and changes to these laws, regulations and policies, including changes in interpretation or implementation of these laws, regulations and policies, could affect us in substantial and unpredictable ways and often impose additional compliance costs.  Further, any new laws, rules and regulations, such as the Dodd-Frank Act and regulatory capital rules, could make compliance more difficult or expensive.  All of these laws and regulations, and the supervisory framework applicable to our industry, could have a material adverse effect on our business, financial condition and results of operations.
 
Federal and state regulators periodically examine our business, and we may be required to remediate adverse examination findings.
 
The FRB, the FDIC and the Commissioner periodically examine our business, including our compliance with laws and regulations.  If, as a result of an examination, the FRB, the FDIC or the Commissioner were to determine that our financial condition, capital resource, asset quality, earnings prospects, management, liquidity or other aspects of any of our operations had become unsatisfactory, or that we were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate.  These actions include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in our capital, to restrict our growth, to assess civil monetary penalties against our officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate our deposit insurance and place us into receivership or conservatorship.  Any regulatory action against us could have a material adverse effect on our business, financial condition and results of operations.  For more information, see “Business-Regulatory Enforcement Actions.”
 
Our FDIC deposit insurance premiums and assessments may increase.
 
The deposits of the Banks are insured by the FDIC up to legal limits and, accordingly, subject to the payment of FDIC deposit insurance assessments.  The Banks’ regular assessments are determined by their risk classifications, which are based on their regulatory capital levels and the level of supervisory concern that they pose.  High levels of bank failures since the beginning of the financial crisis and increases in the statutory deposit insurance limits have increased resolution costs to the FDIC and put significant pressure on the Deposit Insurance Fund.  In order to maintain a strong funding position and restore the reserve ratios of the Deposit Insurance Fund, the FDIC increased deposit insurance assessment rates and charged a special assessment to all FDIC-insured financial institutions.  Further increase in assessment rates or special assessments may occur in the future, especially if there are significant additional financial institution failures.  Any future special assessments, increases in assessment rates or required prepayments in FDIC insurance premiums could reduce our profitability or limit our ability to pursue certain business opportunities, which could have a material adverse effect on our business, financial condition and results of operations.  The FDIC deposit insurance assessments for Talbot Bank increased $428 thousand, or 43%, for 2013 when compared to 2012 as a result of the Order.
 
 
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The short-term and long-term impact of recently adopted regulatory capital rules is uncertain.
 
In July 2013, the federal banking agencies approved rules that will significantly change the regulatory capital requirements of all banking institutions in the United States.  The new rules are designed to implement the recommendations with respect to regulatory capital standards, commonly known as Basel III, approved by the International Basel Committee on Bank Supervision.  We will become subject to the new rules over a multi-year transition period commencing January 1, 2015.  The new rules establish a new regulatory capital standard based on tier 1 common equity and increase the minimum leverage and risk-based capital ratios.  The rules also change how a number of the regulatory capital components are calculated.  The new rules will generally require us and the Banks to maintain greater amounts of regulatory capital.  A significant increase in our capital requirements could have a material adverse effect on our business, financial condition and results of operations.
 
We are subject to numerous laws designed to protect consumers, including the Community Reinvestment Act and fair lending laws, and failure to comply with these laws could lead to a wide variety of sanctions.
 
The Community Reinvestment Act, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on  financial institutions.  The Department of Justice and other federal agencies are responsible for enforcing these laws and regulations.  A successful regulatory challenge to an institution's performance under the Community Reinvestment Act or fair lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisition activity, restrictions on expansion and restrictions on entering new business lines.  Private parties may also have the ability to challenge an institution's performance under fair lending laws in private class action litigation.  Such actions could have a material adverse effect on our business, financial condition and results of operations.
 
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statues and regulations.
 
The Bank Secrecy Act, the USA PATRIOT Act of 2001 and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction  reports as appropriate. The federal Financial Crimes Enforcement Network is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration and Internal Revenue Service. We are also subject to increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have a material adverse effect on our business, financial condition and results of operations.
 
Risks Relating to the Company’s Securities
 
The Company’s common stock is not insured by any governmental entity.
 
Our common stock is not a deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental entity.  Investment in our common stock is subject to risk, including possible loss.
 
The Company’s ability to pay dividends is limited.
 
The Company’s ability to pay dividends is subject to the requirements of Maryland corporate laws, federal and state banking laws, and the policies and actions of our regulators.  Moreover, the Company’s ability to pay dividends to stockholders is largely dependent upon its earnings in future periods and upon the receipt of dividends from the Banks.  Under corporate law, stockholders are entitled to dividends on their shares of common stock if, when, and as declared by the Company’s Board of Directors out of funds legally available for that purpose.  FRB guidance requires a bank holding company, like the Company, to consult with the FRB before paying dividends if the Company’s earnings do not exceed the aggregate amount of the proposed dividend.  The FRB has the ability to prohibit a dividend in such a situation.  Both federal and state laws impose restrictions on the ability of the Banks to pay dividends.  Federal law prohibits the payment of a dividend by an insured depository institution if the depository institution is considered “undercapitalized” or if the payment of the dividend would make the institution “undercapitalized.”  Maryland banking law provides that a state-chartered bank may pay dividends out of undivided profits or, with the prior approval of the Commissioner, from surplus in excess of 100% of required capital stock.  If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, then cash dividends may not be paid in excess of 90% of net earnings.  In addition to these specific restrictions, bank regulatory agencies also have the ability to prohibit proposed dividends by a financial institution that would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice.  Both the Company and Talbot Bank are currently prohibited from paying any dividends without the consent of the FRB or the FDIC and the Commissioner, respectively.  Thus, even if the Company and/or Talbot Bank had cash sufficient under corporate and banking laws to lawfully pay dividends, the FRB and/or the FDIC and the Commissioner could deny a request to do so.  Because of these limitations, there can be no guarantee that the Company’s Board will declare dividends in any fiscal quarter.
 
 
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The shares of the Company’s common stock are not heavily traded.
 
Shares of our common stock are listed on the NASDAQ Global Select Market, but shares are not heavily traded.  Securities that are not heavily traded can be more volatile than stock trading in an active public market.  Factors such as our financial results, the introduction of new products and services by us or our competitors, and various factors affecting the banking industry generally may have a significant impact on the market price of the shares of the common stock.  Management cannot predict the extent to which an active public market for the shares of the common stock will develop or be sustained in the future.  Accordingly, holders of shares of our common stock may not be able to sell them at the volumes, prices, or times that they desire.
 
The Company’s Articles of Incorporation and By-Laws and Maryland law may discourage a corporate takeover which may make it more difficult for stockholders to receive a change in control premium.
 
The Company’s Amended and Restated Articles of Incorporation, as supplemented (the “Charter”), and Amended and Restated By-Laws, as amended (the “By-Laws”), contain certain provisions designed to enhance the ability of the Board of Directors to deal with attempts to acquire control of the Company.  The Charter and By-Laws provide for the classification of the Board into three classes; directors of each class generally serve for staggered three-year periods.  No director may be removed except for cause and then only by a vote of at least two-thirds of the total eligible stockholder votes.  The Charter gives the Board certain powers in respect of the Company’s securities.  First, the Board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities.  Second, a majority of the Board, without action by the stockholders, may amend the Charter to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class that the Company has authority to issue.  The Board could use these powers, along with its authority to authorize the issuance of securities of any class or series, to issue securities having terms favorable to management to persons affiliated with or otherwise friendly to management. 
 
Maryland law also contains anti-takeover provisions that apply to the Company.  The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder.  An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock.  The Maryland Control Share Acquisition Act applies to acquisitions of “control shares,” which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power:  one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power.  Control shares have limited voting rights.  The By-Laws exempt the Company’s capital securities from the Maryland Control Share Acquisition Act, but the Board has the authority to eliminate the exemption without stockholder approval.
 
Although these provisions do not preclude a takeover, they may have the effect of discouraging, delaying or deferring a tender offer or takeover attempt that a stockholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock.  Such provisions will also render the removal of the Board of Directors and of management more difficult and, therefore, may serve to perpetuate current management.  These provisions could potentially adversely affect the market price of the Company’s common stock.
 
We may issue debt and equity securities that are senior to the common stock as to distributions and in liquidation, which could negatively affect the value of the common stock.
 
In the future, we may increase our capital resources by entering into debt or debt-like financing or issuing debt or equity securities, which could include issuances of senior notes, subordinated notes, preferred stock or common stock.  In the event of the Company’s liquidation, our lenders and holders of our debt or preferred securities would receive a distribution of the Company’s available assets before distributions to the holders of our common stock.  The Company’s decision to incur debt and issue securities in future offerings will depend on market conditions and other factors beyond our control.  The Company cannot predict or estimate the amount, timing or nature of its future offerings and debt financings.  Future offerings could reduce the value of shares of our common stock and dilute a stockholder’s interest in the Company.
 
 
24

 
Item 1B.                Unresolved Staff Comments.
 
None.
 
Item 2.                  Properties.
 
Our offices are listed in the tables below.  The address of the Company’s main office is 28969 Information Lane in Easton, Maryland.  The Company owns the real property at this location, which also houses the Operations, Information Technology and Finance departments of the Company and its subsidiaries, and certain operations of The Avon-Dixon Agency, LLC.
 
The Talbot Bank of Easton, Maryland
 
Branches
 
Main Office
18 East Dover Street
Easton, Maryland 21601
Elliott Road Branch
8275 Elliott Road
Easton, Maryland 21601
Tred Avon Square Branch
212 Marlboro Road
Easton, Maryland 21601
 
 
 
St. Michaels Branch
1013 South Talbot Street
St. Michaels, Maryland 21663
Sunburst Branch
424 Dorchester Avenue
Cambridge, Maryland 21613
Tilghman Branch
5804 Tilghman Island Road
Tilghman, Maryland 21671
 
 
 
 
Trappe Branch
29349 Maple Avenue, Suite 1
Trappe, Maryland  21673
 
 
 
 
 
ATMs
 
 
 
 
Memorial Hospital at Easton
219 South Washington Street
Easton, Maryland 21601
Talbottown
218 North Washington Street
Easton, Maryland 21601
 
 
 
25

 
CNB
Branches
 
Main Office
109 North Commerce Street
Centreville, Maryland 21617
Route 213 South Branch
2609 Centreville Road
Centreville, Maryland 21617
Chester Branch
300 Castle Marina Road
Chester, Maryland 21619
 
 
 
Denton Branch
850 South 5th Avenue
Denton, Maryland 21629
Grasonville Branch
202 Pullman Crossing
Grasonville, Maryland 21638
Stevensville Branch
408 Thompson Creek Road
Stevensville, Maryland 21666
 
 
 
Tuckahoe Branch
22151 WES Street
Ridgely, Maryland 21660
 
Washington Square Branch
899 Washington Avenue
Chestertown, Maryland 21620
 
Felton Branch
120 West Main Street
Felton, Delaware 19943
 
 
 
 
Milford Branch 
698-A North Dupont Boulevard
Milford, Delaware 19963
 
Camden Branch
4580 South DuPont Highway
Camden, Delaware 19934
 
Division Office - Wye Financial & Trust
16 North Washington Street, Suite 1
Easton, Maryland 21601
 
 
 
The Avon-Dixon Agency, LLC
Headquarters
106 North Harrison Street
Easton, Maryland 21601
Benefits Office
28969 Information Lane
Easton, Maryland 21601
Centreville Office
105 Lawyers Row
Centreville, Maryland 21617
 
 
 
Elliott-Wilson Insurance, LLC
106 North Harrison Street
Easton, Maryland 21601 
Mubell Finance, LLC
106 North Harrison Street
Easton, Maryland 21601
Jack Martin & Associates, Inc.
135 Old Solomon’s Island Road
Annapolis, Maryland 21401
 
 
 
 
Tri-State General Insurance Agencies, Inc.
One Plaza East, 4th Floor
Salisbury, Maryland 21802 
 
 
Talbot Bank owns the real property on which all of its offices are located, except that it operates under leases at its St. Michaels, Tilghman and Trappe branches.  CNB owns the real property on which all of its Maryland offices are located, except that it operates under a lease at the office of Wye Financial and Trust in Easton.  CNB leases the real property on which all of its Delaware offices are located, except that it owns the real property on which the Camden Branch is located.  The Insurance Subsidiaries do not own any real property, but operate under leases.  For information about rent expense for all leased premises, see Note 4 to the Consolidated Financial Statements appearing in Item 8 of Part II of this annual report.
 
Item 3.         Legal Proceedings.
 
We are at times, in the ordinary course of business, subject to legal actions.  Management, upon the advice of counsel, believes that losses, if any, resulting from current legal actions will not have a material adverse effect on our financial condition or results of operations.
Item 4. Mine Safety Disclosures.
 
This item is not applicable. 
 
 
26

 
PART II
 
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
MARKET PRICE, HOLDERS AND CASH DIVIDENDS
 
The shares of the Company’s common stock are listed on the NASDAQ Global Select Market under the symbol “SHBI”.  As of February 28, 2014, the Company had approximately 1,542 holders of record.  The high and low sales prices for the shares of common stock of the Company, as reported on the NASDAQ Global Select Market, and the cash dividends declared on those shares for each quarterly period of 2013 and 2012 are set forth in the table below.  
 
 
 
2013
 
2012
 
 
 
Price Range
 
Dividends
 
Price Range
 
Dividends
 
 
 
High
 
Low
 
Paid
 
High
 
Low
 
Paid
 
First Quarter
 
$
6.91
 
$
5.20
 
$
-
 
$
7.40
 
$
4.91
 
$
0.01
 
Second Quarter
 
 
7.75
 
 
5.97
 
 
-
 
 
7.45
 
 
5.51
 
 
-
 
Third Quarter
 
 
9.06
 
 
7.06
 
 
-
 
 
6.33
 
 
4.98
 
 
-
 
Fourth Quarter
 
 
9.45
 
 
8.50
 
 
-
 
 
6.98
 
 
4.65
 
 
-
 
 
 
 
 
 
 
 
 
$
-
 
 
 
 
 
 
 
$
0.01
 
 
On February 28, 2014, the closing sales price for the shares of common stock as reported on the NASDAQ Global Select Market was $9.47 per share.
 
The Company did not declare or pay any dividends in 2013 and paid aggregate dividends of $85 thousand in 2012.  Dividends paid per share exceeded earnings per share in 2012.  In an effort to preserve the Company’s capital, the quarterly cash dividend on common stock was reduced from $0.06 to $0.01 per share, beginning with the dividend that was payable May 31, 2011.  On May 3, 2012, the Company’s Board of Directors voted to suspend quarterly cash dividends until further notice.  As a general matter, the payment of dividends is at the discretion of the Company’s Board of Directors, based on such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return.  The Company’s ability to pay dividends is limited by federal banking and state corporate law and is generally dependent on the ability of the Company’s subsidiaries, particularly the Banks, to declare dividends to the Company.  Further, our regulators have the ability to prohibit the payment of dividends even if dividends could otherwise be paid under applicable law if they determine that such payment would not be in our best interests.  As noted above, the Company and Talbot Bank are currently prohibited from paying any dividends without the prior consent of their respective regulators.  For more information regarding these dividend limitations, see “Business – Regulatory Enforcement Actions” and “Risk Factors - The Company’s ability to pay dividends is limited”, which is incorporated herein by reference.
 
The transfer agent for the Company’s common stock is:
 
 
Registrar & Transfer Company
 
10 Commerce Drive
 
Cranford, New Jersey 07016
 
Investor Relations:  1-800-368-5948
 
E-mail for investor inquiries: info@rtco.com.
 
www.rtco.com
 
 
27

 
The performance graph below compares the cumulative total stockholder return on the common stock of the Company with the cumulative total return on the equity securities included in the NASDAQ Composite Index (reflecting overall stock market performance), the NASDAQ Bank Index (reflecting changes in banking industry stocks), and the SNL Small Cap Bank Index (reflecting changes in stocks of banking institutions of a size similar to the Company) assuming in each case an initial $100 investment on December 31, 2008 and reinvestment of dividends as of the end of each of the Company’s fiscal years between December 31, 2008 and December 31, 2013.  Returns are shown on a total return basis.  The performance graph represents past performance and should not be considered to be an indication of future performance.
 
 
 
 
Period Ending
 
Index
 
12/31/08
 
12/31/09
 
12/31/10
 
12/31/11
 
12/31/12
 
12/31/13
 
Shore Bancshares, Inc.
 
100.00
 
62.74
 
46.57
 
23.01
 
24.13
 
41.27
 
NASDAQ Composite
 
100.00
 
145.36
 
171.74
 
170.38
 
200.63
 
281.22
 
NASDAQ Bank
 
100.00
 
83.70
 
95.55
 
85.52
 
101.50
 
143.84
 
SNL Small Cap Bank
 
100.00
 
70.29
 
85.86
 
82.01
 
95.53
 
133.24
 
 
EQUITY COMPENSATION PLAN INFORMATION
 
Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information regarding the Corporation’s equity compensation plans required by this Item pursuant to Item 201(d) of Regulation S-K is located in Item 12 of Part III of this annual report and is incorporated herein by reference.
 
 
28

  
Item 6.         Selected Financial Data.
 
The following table sets forth certain selected financial data for each of the five years ended December 31, 2013, and is qualified in its entirety by the detailed statistical and other information contained in this annual report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 7 of Part II of this annual report and the financial statements and notes thereto appearing in Item 8 of Part II of this annual report.
 
 
 
 
Years Ended December 31,
 
(Dollars in thousands, except per share data)
 
 
2013
 
 
2012
 
 
2011
 
 
2010
 
 
2009
 
RESULTS OF OPERATIONS:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 
 
$
41,351
 
 
$
45,901
 
 
$
50,852
 
 
$
55,461
 
 
$
58,789
 
Interest expense
 
 
 
6,475
 
 
 
10,562
 
 
 
11,088
 
 
 
12,822
 
 
 
17,411
 
Net interest income
 
 
 
34,876
 
 
 
35,339
 
 
 
39,764
 
 
 
42,639
 
 
 
41,378
 
Provision for credit losses
 
 
 
27,784
 
 
 
27,745
 
 
 
19,470
 
 
 
21,119
 
 
 
8,986
 
Net interest income after provision
     for credit losses
 
 
 
7,092
 
 
 
7,594
 
 
 
20,294
 
 
 
21,520
 
 
 
32,392
 
Noninterest income
 
 
 
17,459
 
 
 
15,758
 
 
 
17,318
 
 
 
18,041
 
 
 
19,541
 
Noninterest expense
 
 
 
40,686
 
 
 
39,555
 
 
 
39,167
 
 
 
41,720
 
 
 
40,248
 
(Loss) income before income taxes
 
 
 
(16,135)
 
 
 
(16,203)
 
 
 
(1,555)
 
 
 
(2,159)
 
 
 
11,685
 
Income tax (benefit) expense
 
 
 
(6,501)
 
 
 
(6,565)
 
 
 
(658)
 
 
 
(492)
 
 
 
4,412
 
Net (loss) income
 
 
 
(9,634)
 
 
 
(9,638)
 
 
 
(897)
 
 
 
(1,667)
 
 
 
7,273
 
Preferred stock dividends and
     discount accretion
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
1,876
 
Net (loss) income available to
     common shareholders
 
 
$
(9,634)
 
 
$
(9,638)
 
 
$
(897)
 
 
$
(1,667)
 
 
$
5,397
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PER COMMON SHARE DATA:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net (loss) income – basic
 
 
$
(1.14)
 
 
$
(1.14)
 
 
$
(0.11)
 
 
$
(0.20)
 
 
$
0.64
 
Net (loss) income – diluted
 
 
 
(1.14)
 
 
 
(1.14)
 
 
 
(0.11)
 
 
 
(0.20)
 
 
 
0.64
 
Dividends paid
 
 
 
-
 
 
 
0.01
 
 
 
0.09
 
 
 
0.24
 
 
 
0.64
 
Book value (at year end)
 
 
 
12.19
 
 
 
13.48
 
 
 
14.34
 
 
 
14.51
 
 
 
15.18
 
Tangible book value (at year end)1
 
 
 
10.31
 
 
 
11.56
 
 
 
12.37
 
 
 
12.32
 
 
 
12.64
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
FINANCIAL CONDITION (at year
     end):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 
 
$
711,919
 
 
$
785,082
 
 
$
841,050
 
 
$
895,404
 
 
$
916,557
 
Assets
 
 
 
1,054,124
 
 
 
1,185,807
 
 
 
1,158,193
 
 
 
1,130,311
 
 
 
1,156,516
 
Deposits
 
 
 
933,468
 
 
 
1,049,273
 
 
 
1,009,919
 
 
 
979,516
 
 
 
990,937
 
Long-term debt
 
 
 
-
 
 
 
-
 
 
 
455
 
 
 
932
 
 
 
1,429
 
Stockholders’ equity
 
 
 
103,299
 
 
 
114,026
 
 
 
121,249
 
 
 
122,513
 
 
 
127,810
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PERFORMANCE RATIOS (for the
     year):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Return on average total assets
 
 
 
(0.89)
%
 
 
(0.82)
%
 
 
(0.08)
%
 
 
(0.15)
%
 
 
0.48
%
Return on average stockholders’ equity
 
 
 
(8.64)
 
 
 
(8.07)
 
 
 
(0.74)
 
 
 
(1.33)
 
 
 
4.00
 
Net interest margin
 
 
 
3.48
 
 
 
3.23
 
 
 
3.74
 
 
 
4.02
 
 
 
3.90
 
Efficiency ratio2
 
 
 
77.59
 
 
 
77.17
 
 
 
68.35
 
 
 
68.75
 
 
 
66.07
 
Dividend payout ratio
 
 
 
-
 
 
 
(0.88)
 
 
 
(81.82)
 
 
 
(120.00)
 
 
 
100.00
 
Average stockholders’ equity to average
     total assets
 
 
 
10.31
 
 
 
10.18
 
 
 
10.66
 
 
 
11.05
 
 
 
11.96
 
 ____________________
1Total stockholders’ equity, net of goodwill and other intangible assets, divided by the number of shares of common stock outstanding at year end.
2Noninterest expense as a percentage of total revenue (net interest income plus total noninterest income).  Lower ratios indicate improved productivity.
 
 
29

 
Item 7.          Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
The following discussion compares the Company’s financial condition at December 31, 2013 to its financial condition at December 31, 2012 and the results of operations for the years ended December 31, 2013, 2012, and 2011.  This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto appearing in Item 8 of Part II of this annual report. 
 
PERFORMANCE OVERVIEW
The Company recorded a net loss of $9.6 million for both 2013 and 2012, and $897 thousand for 2011.  The basic and diluted loss per common share was $1.14 for both 2013 and 2012, and $0.11 for 2011.  When comparing 2013 to 2012, results were flat due to higher noninterest income of $1.7 million which was offset by higher noninterest expenses of $1.1 million and lower net interest income of $463 thousand.  When comparing 2012 to 2011, the principal factors for the difference in results were an $8.3 million increase in the provision for credit losses, a $4.4 million decline in net interest income and a $1.3 million loss incurred to terminate the ineffective portion of a cash flow hedge. 
 
Total assets were $1.054 billion at December 31, 2013, a $131.7 million, or 11.1%, decrease when compared to the $1.186 billion at December 31, 2012.  The decrease in assets was primarily due to a decline in loans of $73.2 million and interest-bearing deposits with other banks of $55.5 million.  The decline in loans was mainly due to charge-offs and the execution of agreements by Talbot Bank to sell loans and other real estate owned (the “Asset Sale”).  On October 28, 2013, Talbot Bank entered into agreements to sell assets with an aggregate book value of $45.0 million for a price of $25.2 million.  The assets consisted of $11.1 million of nonaccrual loans, $30.4 million of accruing troubled debt restructurings (“TDRs”), $1.8 million of adversely classified performing loans and $1.7 million of other real estate owned.  Loans subject to the Asset Sale were transferred to loans held for sale and charge-offs of $19.6 million were taken to reflect the value to be realized upon sale.  Subsequently, the provision for credit losses was increased $19.6 million to replenish the allowance for credit losses while other real estate owned subject to the Asset Sale was written down $182 thousand for a total pretax loss of $19.8 million.  The Asset Sale reflects managment’s difficult but prudent decision to sell a significant amount of Talbot Bank’s problem loans, a portion of which had mirgrated from performing to non-performing status between the 3rd and 4th quarters of fiscal 2013, recognize the loss on such loans, reduce its risk-based assets and allow management to focus on returning to profitability. At December 31, 2013, loans of $3.5 million originally included in the Asset Sale remained in the balance of loans held for sale since they were not purchased by the investors but management’s continued intent is to sell them. 
 
Total deposits decreased $115.8 million, or 11.0%, to $933.5 million at December 31, 2013.  The decrease in deposits was mainly due to a decline in money market deposit accounts of $67.9 million and time deposits of $56.0 million, partially offset by an increase in noninterest-bearing demand deposits of $18.8 million.  The decrease in money market deposit accounts was associated with the Company’s participation in the Promontory Insured Network Deposits Program (“IND Program”).  In December 2012, the Company decided to partially exit the IND Program to decrease its excess liquidity and, in June 2013, the Company fully exited the IND Program.  The decrease in time deposits also reduced the Company’s excess liquidity.  Total stockholders’ equity declined $10.7 million, or 9.4%, to $103.3 million, or 9.8% of total assets at December 31, 2013. 
 
CRITICAL ACCOUNTING POLICIES
The Company’s consolidated financial statements are prepared in accordance with GAAP and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.  Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event.  Carrying assets and liabilities at fair value inherently results in more financial statement volatility.  The fair values and the information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices, collateral value or are provided by other third-party sources, when available.
 
The most significant accounting policies that the Company follows are presented in Note 1 to the Consolidated Financial Statements.  These policies, along with the disclosures presented in the notes to the financial statements and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.  Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, goodwill and other intangible assets, deferred tax assets, and fair value are critical accounting policies.  These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available. 
 
 
30

 
The allowance for credit losses represents management’s estimate of credit losses inherent in the loan portfolio as of the balance sheet date.  Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on the consolidated balance sheets.  Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for credit losses.  A discussion of the factors driving changes in the amount of the allowance for credit losses is included in the “Asset Quality - Provision for Credit Losses and Risk Management” section below.
 
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired.  Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability.  Goodwill and other intangible assets are required to be recorded at fair value.  Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment.  Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate.  Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing.  Impairment testing requires that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill.  The Company’s reporting units were identified based on an analysis of each of its individual operating segments.  If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss.
 
Deferred tax assets and liabilities are determined by applying the applicable federal and state income tax rates to cumulative temporary differences.  These temporary differences represent differences between financial statement carrying amounts and the corresponding tax bases of certain assets and liabilities.  Deferred taxes result from such temporary differences.  A valuation allowance, if needed, reduces deferred tax assets to the expected amount most likely to be realized.  Realization of deferred tax assets is dependent on the generation of a sufficient level of future taxable income, recoverable taxes paid in prior years and tax planning strategies.
 
The Company measures certain financial assets and liabilities at fair value, with the measurements made on a recurring or nonrecurring basis.  Significant financial instruments measured at fair value on a recurring basis are investment securities and interest rate caps.  Impaired loans and other real estate owned are significant financial instruments measured at fair value on a nonrecurring basis.  Fair value is defined as the exchange price that would be received for 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 on the measurement date.  In determining fair value, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs, reducing subjectivity.
 
RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS
Note 1 to the Consolidated Financial Statements discusses new accounting policies that the Company adopted during 2013 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted.  To the extent the adoption of new accounting standards materially affects our financial condition, results of operations or liquidity, the impacts are discussed in the applicable section(s) of this discussion and Notes to the Consolidated Financial Statements.
 
RESULTS OF OPERATIONS
 
Net Interest Income and Net Interest Margin
Net interest income remains the most significant factor affecting our results of operations.  Net interest income represents the excess of interest and fees earned on total average earning assets (loans, investment securities, federal funds sold and interest-bearing deposits with other banks) over interest owed on average interest-bearing liabilities (deposits and borrowings).  Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments.  As shown in the table below, tax-equivalent net interest income for 2013 was $35.0 million.  This represented a $523 thousand, or 1.5%, decrease from 2012, significantly lower than the $4.5 million, or 11.2%, decrease for 2012 when compared to 2011.  The decrease in both comparison periods was due to a greater decline in interest income than the decline in interest expense.  When comparing 2013 to 2012, interest income decreased $4.6 million while interest expense decreased $4.1 million.  When comparing 2012 to 2011, interest income decreased $5.0 million while interest expense decreased only $526 thousand.   
 
The decrease in interest expense when comparing 2013 to 2012 was mainly due to the Company exiting the IND Program.  By exiting the IND Program and terminating the interest rate caps used to hedge the interest rates on the deposits associated with the program, money market deposit account balances and related interest expense declined which benefitted the net interest margin.  See the discussion below relating to interest expense and Note 20 in the Notes to Consolidated Financial Statements for additional information.
 
 
31

 
Our net interest margin (i.e., tax-equivalent net interest income divided by average earning assets) represents the net yield on earning assets. The net interest margin is managed through loan and deposit pricing and asset/liability strategies. The net interest margin was 3.48% for 2013, 25 basis points higher than the 3.23% for 2012 mainly due to the impact of reduced average rates on deposits associated with the IND program termination resulting in a reduction in both the money market account balances as well as the associated higher rate on this program. Additionally, there was a positive effect of decreases in average balances of lower yielding interest bearing deposits with other banks tied to the funding from the IND program. The net interest margin declined 51 basis points in 2012 when compared to 2011 primarily due to both a decrease in net interest income and an increase in average earning assets mainly in lower-yielding interest-bearing deposits with other banks.  The net interest spread, which is the difference between the average yield on earning assets and the rate paid for interest-bearing liabilities, was 3.31% for 2013, 3.02% for 2012 and 3.52% for 2011. The increase in the net interest spread between 2012 and 2013 was primarily due to the effects associated with exiting the IND program discussed above.
 
The following table sets forth the major components of net interest income, on a tax-equivalent basis, for the years ended December 31, 2013, 2012, and 2011.
 
 
 
 
2013
 
 
2012
 
 
2011
 
 
 
Average
 
Interest
 
Yield/
 
Average
 
Interest
 
Yield/
 
Average
 
Interest
 
Yield
 
(Dollars in thousands)
 
Balance
 
(1)
 
Rate
 
Balance
 
(1)
 
Rate
 
Balance
 
(1)
 
/Rate
 
Earning assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans (2) (3)
 
$
764,659
 
$
39,062
 
5.11
%
$
814,167
 
$
42,808
 
5.26
%
$
873,155
 
$
47,688
 
5.46
%
Loans held for sale
 
 
3,857
 
 
90
 
2.34
 
 
-
 
 
-
 
-
 
 
-
 
 
-
 
-
 
Investment securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Taxable
 
 
138,701
 
 
2,072
 
1.49
 
 
134,697
 
 
2,815
 
2.09
 
 
109,059
 
 
3,031
 
2.78
 
Tax-exempt
 
 
540
 
 
26
 
4.84
 
 
2,989
 
 
157
 
5.25
 
 
4,509
 
 
234
 
5.19
 
Federal funds sold
 
 
3,850
 
 
4
 
0.10
 
 
10,185
 
 
10
 
0.10
 
 
23,808
 
 
25
 
0.10
 
Interest-bearing deposits
 
 
94,704
 
 
200
 
0.21
 
 
135,813
 
 
274
 
0.20
 
 
58,927
 
 
93
 
0.16
 
Total earning assets
 
 
1,006,311
 
 
41,454
 
4.12
%
 
1,097,851
 
 
46,064
 
4.20
%
 
1,069,458
 
 
51,071
 
4.78
%
Cash and due from banks
 
 
22,603
 
 
 
 
 
 
 
20,256
 
 
 
 
 
 
 
19,198
 
 
 
 
 
 
Other assets
 
 
67,724
 
 
 
 
 
 
 
68,813
 
 
 
 
 
 
 
67,695
 
 
 
 
 
 
Allowance for credit losses
 
 
(15,511)
 
 
 
 
 
 
 
(14,468)
 
 
 
 
 
 
 
(16,408)
 
 
 
 
 
 
Total assets
 
$
1,081,127
 
 
 
 
 
 
$
1,172,452
 
 
 
 
 
 
$
1,139,943
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
 
$
171,244
 
 
266
 
0.16
%
$
160,741
 
 
294
 
0.18
%
$
145,533
 
 
300
 
0.21
%
Money market and savings deposits (4)
 
 
221,808
 
 
1,086
 
0.49
 
 
279,126
 
 
3,279
 
1.17
 
 
265,910
 
 
2,654
 
1.00
 
Certificates of deposit, $100,000 or more
 
 
202,053
 
 
2,580
 
1.28
 
 
238,241
 
 
3,442
 
1.44
 
 
245,214
 
 
3,965
 
1.62
 
Other time deposits
 
 
195,045
 
 
2,516
 
1.29
 
 
204,644
 
 
3,486
 
1.70
 
 
205,154
 
 
4,076
 
1.99
 
Interest-bearing deposits
 
 
790,150
 
 
6,448
 
0.82
 
 
882,752
 
 
10,501
 
1.19
 
 
861,811
 
 
10,995
 
1.28
 
Short-term borrowings
 
 
10,980
 
 
27
 
0.24
 
 
14,976
 
 
45
 
0.30
 
 
15,319
 
 
56
 
0.37
 
Long-term debt
 
 
-
 
 
-
 
-
 
 
341
 
 
16
 
4.61
 
 
814
 
 
37
 
4.50
 
Total interest-bearing liabilities
 
 
801,130
 
 
6,475
 
0.81
%
 
898,069
 
 
10,562
 
1.18
%
 
877,944
 
 
11,088
 
1.26
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest-bearing deposits
 
 
160,182
 
 
 
 
 
 
 
146,057
 
 
 
 
 
 
 
130,260
 
 
 
 
 
 
Other liabilities
 
 
8,370
 
 
 
 
 
 
 
8,967
 
 
 
 
 
 
 
10,243
 
 
 
 
 
 
Stockholders’ equity
 
 
111,445
 
 
 
 
 
 
 
119,359
 
 
 
 
 
 
 
121,496
 
 
 
 
 
 
Total liabilities and stockholders’ equity
 
$
1,081,127
 
 
 
 
 
 
$
1,172,452
 
 
 
 
 
 
$
1,139,943
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread
 
 
 
 
$
34,979
 
3.31
%
 
 
 
$
35,502
 
3.02
%
 
 
 
$
39,983
 
3.52
%
Net interest margin
 
 
 
 
 
 
 
3.48
%
 
 
 
 
 
 
3.23
%
 
 
 
 
 
 
3.74
%
 
___________________
 (1) All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 34.0%, exclusive of the alternative minimum tax rate and nondeductible interest expense.  The tax-equivalent adjustment amounts used in the above table to compute yields aggregated $103 thousand in 2013, $163 thousand in 2012 and $219 thousand in 2011.
(2) Average loan balances include nonaccrual loans.
(3) Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.
(4) Interest on money market and savings deposits includes an adjustment to expense related to interest rate caps and the hedged deposits from the Promontory Insured Network Deposits Program associated with them.  This adjustment increased interest expense by $695 thousand for 2013, $2.0 million for 2012 and $1.3 million for 2011.  The interest rate caps were terminated in June of 2013.
 
On a tax-equivalent basis, total interest income was $41.5 million for 2013, compared to $46.1 million for 2012 and $51.1 million for 2011. The decline in interest income for 2013 and 2012 was primarily due to loan activity which included the Asset Sale in 2013, and loan charge-offs and decreased loan demand in both periods.  During 2013 and 2012, average loans decreased $49.5 million and $59.0 million, respectively, and the yield earned on loans decreased 15 and 20 basis points, respectively.  Excluding average nonaccrual loans, the yield on loans would have been 5.30%, 5.57% and 5.78% for 2013, 2012, and 2011, respectively.  Other earning assets impacting the change in interest income for 2013 included taxable investment securities, which increased $4.0 million while the related yield declined 60 basis points, which reduced interest income $743 thousand.  The yield on taxable investment securities decreased because the reinvestment rates on investment securities purchased during 2013 were lower than the yields on the investment securities that matured or were sold during the period.  Federal funds sold and tax-exempt investment securities declined $6.3 million and $2.4 million, respectively.  The yield on federal funds sold remained unchanged while the yield on tax-exempt securities decreased 41 basis points.  The changes in the balances and yields of these earning assets reduced interest income a combined $137 thousand.  Although the yield on interest-bearing deposits with other banks increased one basis point, the average balance declined $41.1 million, which reduced interest income $74 thousand when comparing 2013 to 2012.  The decline in these earning assets reflected a reduction in excess liquidity.
 
 
32

 
When comparing 2012 to 2011, the changes in other average earning assets included an increase in interest-bearing deposits with other banks of $76.9 million and an increase of four basis points in the related yield, which increased interest income $181 thousand.  Beginning in 2011 and continuing in 2012, the investment of excess cash from customers’ deposits shifted from federal funds sold to interest-bearing deposits with other banks, primarily with the Federal Reserve Bank, to take advantage of higher yields on these deposits.  While taxable investment securities increased $25.6 million, the related yield declined 69 basis points, which reduced interest income by $216 thousand.  The remaining earning assets, federal funds sold and tax-exempt investment securities, declined $13.6 million and $1.5 million, respectively.  The yield on tax-exempt securities increased six basis points while the yield on federal funds sold remained the same.  The changes in the balances and yields of these earning assets reduced interest income a combined $92 thousand.
 
As a percentage of total average earning assets, loans, investment securities, federal funds sold and interest-bearing deposits were 76.0%, 13.8% , 0.4% and 9.4%, respectively, for 2013 which reflected a shift to higher-yielding earning assets when compared to 2012.  The comparable percentages for 2012 were 74.2%, 12.5%, 0.9%, and 12.4%, respectively, and for 2011 were 81.7%, 10.6%, 2.2% and 5.5%, respectively.  When comparing 2013 to 2012, the overall decrease in average balances of earning assets produced $2.6 million less in interest income and the decrease in yields on earning assets produced $2.0 million less in interest income, as seen in the Rate/Volume Variance Analysis below. When comparing 2012 to 2011, the overall decrease in both yields on and average balances of earning assets produced $2.5 million less in interest income primarily driven by a $59 million decline in average loan balances as well as a 20 basis point decline in average loan yields.  Declines in balances were associated with weak loan demand and the impact of refinancing. The decline in yields resulted from repricing pressure and the impact of increasing nonperforming loans. 
 
The following table sets forth the average balance of the components of average earning assets as a percentage of total average earning assets for the year ended December 31.
 
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
Loans
 
76.0
%
74.2
%
81.7
%
84.9
%
85.5
%
Loans held for sale
 
0.4
 
-
 
-
 
-
 
-
 
Investment securities
 
13.8
 
12.5
 
10.6
 
10.0
 
8.6
 
Federal funds sold
 
0.4
 
0.9
 
2.2
 
3.7
 
5.6
 
Interest-bearing deposits with other banks
 
9.4
 
12.4
 
5.5
 
1.4
 
0.3
 
 
 
100.0
%
100.0
%
100.0
%
100.0
%
100.0
%
 
Interest expense was $6.5 million for 2013, compared to $10.6 million for 2012 and $11.1 million for 2011.  The decline in interest expense for 2013 was primarily due to lower expense on money market and savings deposits and time deposits.  Interest expense on money market and savings deposits declined $2.2 million in 2013 when compared to 2012 due to a decrease of $57.3 million in average balances of these deposits and a decrease of 68 basis points on rates paid on these deposits.  The decrease in balances of money market and savings deposits was primarily due to the decline in deposits associated with the IND Program, which the Company fully exited in June of 2013, and the lower rates were primarily due to terminating the interest rate caps used to hedge the interest rates on the deposits associated with the IND Program.  See Note 20 to the Consolidated Financial Statements for additional discussion regarding the effect of the interest rate caps on interest expense.  Interest expense on time deposits (certificates of deposit of $100,000 or more and other time deposits) declined $1.8 million when compared to 2012 due to a decrease of $45.8 million in average time deposits and a decrease of 28 basis points on rates paid on these deposits.  The decrease in average time deposits reflected a decrease in the Company’s liquidity needs and the lower rates reflected current market conditions. 
 
The decline in interest expense for 2012 relative to 2011 was primarily due to lower expense on time deposits which was partially offset by higher expense on money market and savings accounts.  Interest expense on time deposits declined $1.1 million in 2012 when compared to 2011 due to a decrease of $7.5 million in average time deposits and a decrease of 23 basis points on rates paid on these deposits.  Interest expense on money market and savings deposits increased $625 thousand due to an increase of $13.2 million in average balances of these deposits primarily due to the Company’s participation in the IND Program and an increase of 17 basis points on rates paid on these deposits primarily due to the interest rate caps used to hedge the interest rates on the deposits associated with the IND Program. 
 
During 2013, lower rates on interest-bearing liabilities produced $2.9 million less in interest expense and decreased volume produced $1.2 million less in interest expense, as shown in the table below.  In 2012, lower rates on interest-bearing liabilities produced $562 thousand less in interest expense and increased volume produced $36 thousand more in interest expense. 
 
 
33

 
The following Rate/Volume Variance Analysis identifies the portion of the changes in tax-equivalent net interest income attributable to changes in volume of average balances or to changes in the yield on earning assets and rates paid on interest-bearing liabilities.  The rate and volume variance for each category has been allocated on a consistent basis between rate and volume variances, based on a percentage of rate, or volume, variance to the sum of the absolute two variances.
 
 
 
 
2013 over (under) 2012
 
2012 over (under) 2011
 
 
 
Total
 
Caused By
 
Total
 
Caused By
 
(Dollars in thousands)
 
Variance
 
Rate
 
Volume
 
Variance
 
Rate
 
Volume
 
Interest income from earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans and loans held for sale
 
$
(3,656)
 
$
(1,196)
 
$
(2,460)
 
$
(4,880)
 
$
(1,715)
 
$
(3,165)
 
Taxable investment securities
 
 
(743)
 
 
(825)
 
 
82
 
 
(216)
 
 
(843)
 
 
627
 
Tax-exempt investment securities
 
 
(131)
 
 
(11)
 
 
(120)
 
 
(77)
 
 
3
 
 
(80)
 
Federal funds sold
 
 
(6)
 
 
-
 
 
(6)
 
 
(15)
 
 
-
 
 
(15)
 
Interest-bearing deposits
 
 
(74)
 
 
13
 
 
(87)
 
 
181
 
 
30
 
 
151
 
Total interest income
 
 
(4,610)
 
 
(2,019)
 
 
(2,591)
 
 
(5,007)
 
 
(2,525)
 
 
(2,482)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense on deposits
    and borrowed funds:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand deposits
 
 
(28)
 
 
(41)
 
 
13
 
 
(6)
 
 
(41)
 
 
35
 
Money market and savings deposits
 
 
(2,193)
 
 
(1,620)
 
 
(573)
 
 
625
 
 
484
 
 
141