10-K 1 v403911_10k.htm 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

 

 

xAnnual Report Pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2014

or

 

¨Transition Report Pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the transition period from                  to                 

 

Commission file number 000-23565

 

 

 

EASTERN VIRGINIA BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

   Virginia   54-1866052
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
  incorporation or organization)    

 

330 Hospital Road

Tappahannock, Virginia 22560

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: (804) 443-8400

 

 

 

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

 

Common Stock, $2 par value per share   The NASDAQ Stock Market LLC
 Title of each class   Name of each exchange on which registered

 

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

NONE

 

 

 

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

 

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

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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 such files). Yes x  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, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨   Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)   Smaller reporting company x

 

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

 

The aggregate market value of common stock held by non-affiliates of the registrant as of June 30, 2014 was $73.3 million.

 

There were 13,023,934 shares of common stock, par value $2.00 per share, outstanding as of March 26, 2015.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the 2014 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 
 

 

TABLE OF CONTENTS

 

Part I    
     
Item 1. Business 3
     
Item 1A. Risk Factors 14
     
Item 1B. Unresolved Staff Comments 24
     
Item 2. Properties 24
     
Item 3. Legal Proceedings 25
     
Item 4. Mine Safety Disclosures 25
     
Part II    
     
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 26
     
Item 6. Selected Financial Data 28
     
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29
     
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 64
     
Item 8. Financial Statements and Supplementary Data 66
     
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 66
     
Item 9A. Controls and Procedures 67
     
Item 9B. Other Information 67
     
Part III    
     
Item 10. Directors, Executive Officers and Corporate Governance 67
     
Item 11. Executive Compensation 68
     
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 68
     
Item 13. Certain Relationships and Related Transactions, and Director Independence 68
     
Item 14. Principal Accountant Fees and Services 68
     
Part IV    
     
Item 15. Exhibits, Financial Statement Schedules 68
     
Signatures 71

 

2
 

 

Part I

 

Item 1. Business

 

General

 

Eastern Virginia Bankshares, Inc. (“Parent”) is a bank holding company headquartered in Tappahannock, Virginia that was organized and chartered under the laws of the Commonwealth of Virginia on September 5, 1997 and commenced operations on December 29, 1997. Through our wholly-owned bank subsidiary, EVB (the “Bank”), we operate twenty-four full service branches and two drive-in facilities in eastern Virginia, and one loan production office in Chesterfield County, Virginia. Two of EVB’s three predecessor banks, Bank of Northumberland, Inc. and Southside Bank, were established in 1910. The third bank, Hanover Bank, was established as a de novo bank in 2000. In April 2006, these three banks were merged and the surviving bank was re-branded as EVB. Additionally, the Parent acquired Virginia Company Bank (“VCB”) on November 14, 2014 and merged VCB with and into the Bank with the Bank surviving, thereby adding three additional branches to the Bank located in Newport News, Williamsburg and Hampton.

 

EVB is a community bank targeting small to medium-sized businesses and consumers in our traditional coastal plain markets and the emerging suburbs outside of the Richmond, Tidewater, and southern Virginia areas. Our mission is dedicated to providing the highest quality financial services to our customers, enriching the health and vitality of the communities we serve, and enhancing shareholder value.

 

The accompanying consolidated financial statements include the accounts of the Parent, the Bank and its subsidiaries, at times collectively referred to as the “Company”, “we”, “our”, or “us,” except where the context requires that “Company” refer only to Eastern Virginia Bankshares, Inc.

 

The Company provides a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.

 

Historically, the Company’s goal has been to expand our footprint in eastern and central Virginia. To accomplish that goal, we have expanded and improved our branch network, including most recently through our acquisition of VCB. Also in 2014, we opened a loan production office in Chesterfield County, Virginia to expand our footprint in the Richmond, Virginia metropolitan area. While we continuously evaluate strategies of building new branches in growing markets and purchasing other locations as the opportunities arise, the economic environment over the past few years has made expansion challenging. We have closed three branches during the last three years, with our Glenns branch closing in December 2011, our Bowling Green branch closing in September 2012 and our Old Church branch closing in October 2013. The decision to close our Glenns branch was based on foot traffic and other metrics, and we can continue to efficiently serve our customers in that area with the three other branches located only a few miles away. The decision to close our Bowling Green branch was based on several factors including the branch location, which was outside our traditional footprint, and the inability to successfully grow the branch due to local economic conditions. The decision to close the Old Church branch was based on several factors including declining branch activity and an absence of community or business initiatives for economic expansion in or around the area in the near future. These branch closures were also part of our strategic focus from 2011 to 2013 of aggressively managing our noninterest expenses. Other changes to the branch system could occur in the future. Our goal continues to be to expand whenever possible when it is financially feasible.

 

3
 

 

The Bank owns EVB Financial Services, Inc., which in turn has a 100% ownership interest in EVB Investments, Inc. EVB Investments, Inc. is a full-service brokerage firm offering a comprehensive range of investment services. On May 15, 2014, the Bank acquired a 4.9% ownership interest in Southern Trust Mortgage, LLC. Pursuant to an independent contractor agreement with Southern Trust Mortgage, LLC, the Company advises and consults with Southern Trust Mortgage, LLC and facilitates the marketing and brand recognition of their mortgage business. In addition, the Company provides Southern Trust Mortgage, LLC with offices at five retail branches in the Company’s market area and access to office equipment at these locations during normal business hours. For its services, the Company receives fixed monthly compensation from Southern Trust Mortgage, LLC in the amount of $1 thousand, which is adjustable on a quarterly basis. The Bank maintained a similar arrangement with Southern Trust Mortgage, LLC from April 2011 until the Bank agreed to acquire its investment in Southern Trust Mortgage, LLC. The Bank had a 75% ownership interest in EVB Title, LLC, which primarily sold title insurance to the mortgage loan customers of the Bank and EVB Mortgage, LLC. Effective January 2014, the Bank has ceased operations of EVB Title, LLC due to low volume and profitability. On October 1, 2014, the Bank acquired a 6.0% ownership interest in Bankers Title, LLC. Bankers Title, LLC is a multi-bank owned title agency providing a full range of title insurance settlement and related financial services. The Bank has a 2.33% ownership in Bankers Insurance, LLC, which primarily sells insurance products to customers of the Bank, and other financial institutions that have an equity interest in the agency. The Bank also has a 100% ownership interest in Dunston Hall LLC, POS LLC, Tartan Holdings LLC and ECU-RE LLC, which were formed to hold the title to real estate acquired by the Bank upon foreclosure on property of real estate secured loans and whose financial position and operating results are not significant to the Company as a whole and are not considered principal activities of the Company at this time.

 

The Company also owns one non-operating subsidiary, EVB Statutory Trust I (the “Trust”), that was formed in September 2003. The Trust was formed for the purpose of issuing $10.0 million of trust preferred capital securities. The Trust is an unconsolidated subsidiary of the Company and its principal asset is $10.3 million of the Company’s junior subordinated deferrable interest debentures securities (referred to herein as “trust preferred debt”) that is reported as a liability of the Company.

 

As previously disclosed, in February 2011 we entered into a written agreement with our federal and state banking regulators. The Written Agreement was terminated on July 30, 2013. As previously disclosed, in September 2013 we entered into a Memorandum of Understanding with our federal and state banking regulators. The Memorandum of Understanding was terminated effective March 13, 2014. For additional discussion of the agreement and Memorandum of Understanding, please see “Regulation and Supervision–Regulatory Agreements” later in Item 1 of this Annual Report on Form 10-K.

 

Market Areas

 

The Company currently conducts business through twenty-four full service branches and two drive-in facilities, primarily in the eastern portion of the state. Our markets are located east of U.S. Route 250 and extend from northeast of Richmond to the Chesapeake Bay and Hampton in central Virginia and across the James River from Colonial Heights to southeastern Virginia. Geographically, we have five primary market areas: Northern Neck, Middle Peninsula, Capital (suburbs of Richmond), Tidewater (Williamsburg, Newport News and Hampton), and Southern.

 

Our Northern Neck and Middle Peninsula regions are in the eastern coastal plain of Virginia, often referred to as River Country. A number of the branches in this locale have been in business for over one hundred years and have strong customer ties going back over multiple generations. According to the Virginia Economic Development Partnership, the region’s industries have traditionally been associated with abundant natural resources that include five rivers and the Chesapeake Bay. The diversified economy includes seafood harvesting, light manufacturing, agriculture, leisure, marine services and service sectors dedicated to many upscale retirement communities.

 

Our Capital region is currently comprised of Chesterfield, Hanover, Henrico and King William counties and Colonial Heights, which are largely emerging suburbs of Richmond. Hanover County is approximately 10 miles from downtown Richmond and eighty-six miles south of Washington, DC. Hanover County is the largest county by area in the Richmond metropolitan area. The county provides residents and businesses the geographic advantages of a growing metropolitan area coupled with substantial acreage for expansion in a suburban setting. With a branch in the adjacent county of Henrico, which is closer to Richmond, we have the advantage of an established economic setting with many small business prospects. Our location in Colonial Heights puts us in the south Richmond suburbs and allows us to capitalize on economic activity related to the U.S. Army facility at Fort Lee. The other county, King William, offers us growth opportunities as the Richmond suburbs expand farther east of their current boundaries.

 

Our Tidewater region is currently comprised of Williamsburg, Newport News and Hampton. This area, located approximately 60 miles east of Richmond along the U.S. Interstate 64 corridor, is part of the Hampton Roads MSA and is a densely populated and well-established area. This major metropolitan area is the second largest metropolitan area in Virginia behind the Northern Virginia area and is home to the third largest harbor in the U.S., which supports extensive military and commercial shipping operations. In addition to being home to four Fortune 500 companies, the region has a high value customer base, such as entrepreneurs, small businesses, and professionals, which often are not well served by our larger competitors. The banking facilities in this region offer a wide range of banking products and services, including mortgage, investment and insurance products.

 

4
 

 

Our Southern region is comprised of New Kent, Surry, Sussex, and Southampton counties. New Kent has shown continued population growth over the past several years. It is located southeast of Richmond and north of Williamsburg placing us in the growth zone of U.S. Interstate 64 that runs from Richmond to the Virginia Beach area of the Virginia Tidewater region. The other three counties are approximately fifty miles southeast of Richmond along or just off the state U.S. Route 460 corridor and are adjacent to the Greater Tidewater area. The ports of Hampton Roads are approximately fifty miles to the east of our Southern region. The region’s close proximity to major military, naval and research centers and transportation infrastructure make this an attractive location for contractors and service and manufacturing companies.

 

Business Strategy

 

As a result of over 100 years of experience serving the Northern Neck and Middle Peninsula regions, we have a stable, loyal customer base and a high deposit market share in these regions. Due to the lower projected population growth of these markets, we expanded in Chesterfield, Hanover, Henrico, Gloucester, New Kent and King William Counties and the city of Colonial Heights to target the higher potential growth in these existing and emerging suburban markets. The deposit market share we have accumulated in our Northern Neck, Middle Peninsula and Southern regions has helped fund our loan growth in the emerging suburban areas in the Capital region. Additionally, we recently expanded into our Tidewater region through the acquisition of VCB. This acquisition adds three branches and expands our footprint along the U.S. Interstate 64 corridor into the attractive and growing markets of the Virginia Peninsula.

 

We believe that economic growth and bank consolidation have created a growing number of businesses and consumers in need of a broad range of products and services, as well as the high level of personal service that we provide. While we work through the economic challenges of the past few years and look at 2015 as a year to strengthen our existing markets, our long-term business plan is to capitalize on the growth opportunity in our markets by further developing our branch network in our existing markets and augmenting our market area by expanding further in areas near the urban markets of Richmond and the Greater Tidewater area.

 

Competition

 

The Bank encounters strong competition for its banking services within its primary market areas. The sources of competition vary based on the particular market of operation, which can range from a small rural town to part of a large urban market. The Bank competes with large national and regional financial institutions, savings associations and other independent community banks, as well as credit unions, mutual funds and life insurance companies. The banking business in the Bank’s primary market areas is highly competitive for both loans and deposits, and is dominated by a relatively small number of large banks with many offices operating over a wide geographic area. Among the advantages such large banks have over the Bank are their ability to offer banking products and services at large branch networks, to launch and finance wide-ranging advertising campaigns and, by virtue of their greater total capitalization, to have substantially higher lending limits than the Bank. In addition, large banks may more easily comply with certain regulations applicable to banking activities and consumer financial products and services.

 

Factors such as interest rates offered, the number and location of branches and the types of products offered, as well as the reputation of the institution, affect competition for deposits and loans. The Bank competes by emphasizing customer service and technology, establishing long-term customer relationships, building customer loyalty, and providing products and services to address the specific needs of its customers. The Bank targets individuals and small to medium sized business customers. No material part of the Bank’s business is dependent upon a single or a few customers, and the loss of any single customer would not have a material adverse effect upon the Bank’s business.

 

Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot foresee how federal regulation of financial institutions may change in the future. However, it is possible that current and future governmental regulatory and economic initiatives could impact the competitive landscape in the Bank’s markets.

 

5
 

 

Employees

 

As of December 31, 2014, the Company had 353 full-time equivalent employees. Management of the Company considers its relations with employees to be excellent. No employees are represented by a union or any similar group, and the Company has never experienced any strike or labor dispute.

 

Regulation and Supervision

 

General

 

Bank holding companies and banks are extensively regulated under both federal and state law. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of shareholders and creditors. The following summary briefly describes significant provisions of currently applicable federal and state laws and certain regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because regulation of financial institutions changes regularly and is the subject of constant legislative and regulatory debate, we cannot forecast how federal and state regulation and supervision of financial institutions may change in the future and affect the Company’s and the Bank’s operations.

 

Regulatory Reform

 

The financial crisis of 2008, including the downturn of global economic, financial and money markets and the threat of collapse of numerous financial institutions, and other recent events led to the adoption of numerous laws and regulations that apply to financial institutions. The most significant of these laws is the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), adopted on July 21, 2010 to implement significant structural reforms to the financial services industry. The Dodd-Frank Act is discussed in more detail below.

 

As a result of the Dodd-Frank Act and other regulatory reforms, the Company continues to experience a period of rapidly changing regulatory requirements. These regulatory changes could have a significant effect on how the Company conducts its business. The full extent of the Dodd-Frank Act and other proposed regulatory reforms cannot yet be fully predicted and will depend to a large extent on the many specific regulations that the Dodd-Frank Act requires to be adopted in the coming months and years to implement these reform initiatives.

 

Regulation of the Company

 

As a public company, the Company is subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As a result, the Company must file annual, quarterly, current and other reports with the Securities and Exchange Commission (the “SEC”), and also comply with other laws and regulations of the SEC applicable to public companies.

 

As a bank holding company, the Company is also subject to the Bank Holding Company Act of 1956 (the “BHCA”) and supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Generally, a bank holding company is required to obtain the approval of the Federal Reserve Board before acquiring direct or indirect ownership or control of more than five percent of the voting shares of a bank or bank holding company, or engaging in an activity considered to be a banking activity, either directly or through a subsidiary. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.

 

Pursuant to the BHCA, the Federal Reserve Board has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the Federal Reserve Board has reasonable grounds to believe that continuation of such activity or ownership constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.

 

The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking or to managing or controlling banks, and permits interstate banking acquisitions subject to certain conditions, including national and state concentration limits. The Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. A bank holding company must be well capitalized and well managed to engage in an interstate acquisition or merger, and banks may branch across state lines provided that the law of the state in which the branch is to be located would permit establishment of the branch if the bank were a state bank chartered by such state.

 

6
 

 

A bank holding company is prohibited from engaging in or acquiring, either directly or indirectly through a subsidiary, ownership or control of more than five percent of the voting shares of any company engaged in non-banking activities. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Federal Reserve Board has determined by regulation or order are so closely related to banking as to be a proper incident to banking. A bank holding company also may become eligible to engage in activities that are financial in nature or complimentary to financial activities by qualifying as a financial holding company under the Gramm-Leach-Bliley Act of 1999 (the “GLBA”). To qualify as a financial holding company, each insured depository institution controlled by the bank holding company must be well-capitalized, well-managed and have at least a satisfactory rating under the Community Reinvestment Act. To date, the Company has not qualified as a financial holding company, and the qualification as such by other bank holding companies has not had a material impact on the business of the Company.

 

Each of the Bank’s depository accounts is insured by the Federal Deposit Insurance Corporation (the “FDIC”) against loss to the depositor to the maximum extent permitted by applicable law, and federal law and regulatory policy impose a number of obligations and restrictions on the Company and the Bank to reduce potential loss exposure to the depositors and to the FDIC insurance funds. For example, pursuant to the Dodd-Frank Act and Federal Reserve Board policy, a bank holding company must commit resources to support its subsidiary depository institutions, which is referred to as serving as a “source of strength.” In addition, insured depository institutions under common control must reimburse the FDIC for any loss suffered or reasonably anticipated by the Deposit Insurance Fund (the “DIF”) as a result of the default of a commonly controlled insured depository institution. The FDIC may decline to enforce the provisions if it determines that a waiver is in the best interest of the DIF. An FDIC claim for damage is superior to claims of stockholders of an insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt, other than affiliates, of the commonly controlled insured depository institution.

 

The Federal Deposit Insurance Act (the “FDIA”) provides that amounts received from the liquidation or other resolution of any insured depository institution must be distributed, after payment of secured claims, to pay the deposit liabilities of the institution before payment of any other general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders if a receiver is appointed to distribute the assets of the Bank.

 

The Company also is subject to regulation and supervision by the Virginia State Corporation Commission Bureau of Financial Institutions (the “Bureau”).

 

Capital Requirements

 

The Federal Reserve Board and the FDIC have adopted rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision and standards for calculating risk-weighted assets and risk-based capital measurements (collectively, the “Basel III Final Rules”) that apply to banking organizations they supervise. For the purposes of these capital rules, (i) common equity tier 1 capital (“CET1”) consists principally of common stock (including surplus) and retained earnings; (ii) Tier 1 capital consists principally of CET1 plus non-cumulative preferred stock and related surplus, and certain grandfathered cumulative preferred stocks and trust preferred securities; and (iii) Tier 2 capital consists principally of Tier 1 capital plus qualifying subordinated debt and preferred stock, and limited amounts of the allowance for loan losses. Each regulatory capital classification is subject to certain adjustments and limitations, as implemented by the Basel III Final Rules. The Basel III Final Rules also establish risk weightings that are applied to many classes of assets held by community banks, importantly including applying higher risk weightings to certain commercial real estate loans.

 

The Basel III Final Rules were effective January 1, 2015, and the Basel III Final Rules capital conservation buffer will be phased in from 2015 to 2019.

 

When fully phased in, the Basel III Final Rules require banks to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

 

7
 

 

The Basel III Final Rules provide deductions from and adjustments to regulatory capital measures, primarily to CET1, including deductions and adjustments that were not applied to reduce CET1 under historical regulatory capital rules. For example, mortgage servicing rights, deferred tax assets, dependent upon future taxable income, and significant investments in non-consolidated financial entities must be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. These deductions from and adjustments to regulatory capital will generally be phased in beginning in 2015 through 2018.

 

The Basel III Final Rules permanently includes in Tier 1 capital trust preferred securities issued prior to May 19, 2010 by bank holding companies with less than $15 billion in total assets, subject to a limit of 25% of Tier 1 capital. The Company expects that its trust preferred securities will be included in the Company’s Tier 1 capital until their maturity.

 

The Basel III Final Rules also implement a “countercyclical capital buffer,” generally designed to absorb losses during periods of economic stress and to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk. This buffer is a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).

 

Under the Basel III Final Rules, the initial minimum capital ratios as of January 1, 2015 are as follows:

 

·4.5 % CET1 to risk-weighted assets.
·6.0% Tier 1 capital to risk-weighted assets.
·8.0% Total capital to risk-weighted assets.

 

The Basel III Final Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories to a much larger and more risk-sensitive number of categories than has been historically applied, 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 that will impact the Company’s determination of 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 exposures (other than residential mortgage exposures) that are 90 days past due.

 

·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 set at 0%).

 

Management believes that, as of December 31, 2014, the Company would have met all capital adequacy requirements under the Basel III Final Rules on a fully phased-in basis as if such requirements were then in effect.

 

Limits on Dividends

 

The Parent is a legal entity that is separate and distinct from the Bank, and the ability of the Company to pay dividends depends upon the amount of dividends declared by the Bank, if any. In addition, the ability of the Company to pay dividends is subject to various laws and regulations, including limits on the sources of dividends and requirements to maintain capital at or above regulatory minimums. Regulatory restrictions also exist with respect to the Bank’s ability to pay dividends. Banking regulators have indicated that Virginia banking organizations should generally pay dividends only (1) from net undivided profits of the bank, after providing for all expenses, losses, interest and taxes accrued or due by the bank, and (2) if the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. In addition, the FDIA prohibits insured depository institutions such as the Bank from making capital distributions, including paying dividends, if after making such distribution the institution would become undercapitalized as defined in the statute.

 

8
 

 

Reporting Obligations

 

As a bank holding company, the Company must file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require pursuant to the BHCA. The Bank must submit to federal and state regulators annual audit reports prepared by independent auditors. The Company’s annual report, which includes the report of the Company’s independent auditors, can be used to satisfy this requirement. The Bank must submit quarterly, to the FDIC, Reports of Condition and Income (referred to in the banking industry as a Call Report). The Company must submit quarterly, to the Federal Reserve Board, Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) and Parent Company Only Financial Statements for Large Bank Holding Companies (FR Y-9LP).

 

The Dodd-Frank Act

 

The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including changes that will affect all bank holding companies and banks, including the Company and the Bank. Provisions that significantly affect the business of the Company and the Bank include the following:

 

·Insurance of Deposit Accounts. The Dodd-Frank Act changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital. The Dodd-Frank Act also made permanent the $250,000 limit for federal deposit insurance and increased the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000.

 

·Payment of Interest on Demand Deposits. The Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

·Creation of the Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act centralized significant aspects of consumer financial protection by creating a new agency, the CFPB, which is discussed in more detail below.

 

·Debit Card Interchange Fees. The Dodd-Frank Act amended the Electronic Fund Transfer Act (“EFTA”) to, among other things, require that debit card interchange fees be reasonable and proportional to the actual cost incurred by the issuer with respect to the transaction. In June 2011, the Federal Reserve Board adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction if the issuer implements additional fraud-prevention standards. Although issuers that have assets of less than $10 billion are exempt from the Federal Reserve Board's regulations that set maximum interchange fees, these regulations could significantly affect the interchange fees that financial institutions with less than $10 billion in assets are able to collect.

 

In addition, the Dodd-Frank Act implements other far-reaching changes to the financial regulatory landscape, including provisions that:

 

·Restrict the preemption of state law by federal law and disallow subsidiaries and affiliates of national banks from availing themselves of such preemption.

 

·Impose comprehensive regulation of the over-the-counter derivatives market, subject to significant rulemaking processes, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself.

 

·Require loan originators to retain 5 percent of any loan sold or securitized, unless it is a "qualified residential mortgage," subject to certain exceptions.

 

·Implement corporate governance revisions that apply to all public companies not just publicly-traded financial institutions.

 

The Dodd-Frank Act contains many other provisions, and federal regulators continue to draft implementing regulations which may affect the Company or the Bank. Accordingly, the topics discussed above are only a representative sample of the types of new or increasing regulatory issues in the Dodd-Frank Act that may have an impact on the Company and the Bank.

 

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Source of Strength Doctrine

 

The Dodd-Frank Act codifies and expands the existing Federal Reserve Board policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under the Dodd-Frank Act, the term “source of financial strength” is defined to mean the “ability of a company that directly or indirectly controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.” As of March 2015, implementing regulations of the Dodd-Frank Act source of strength provisions, however, have not yet been promulgated. It is the Federal Reserve Board’s existing policy that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. Consistent with this, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.

 

Incentive Compensation

 

The Federal Reserve, the Office of the Comptroller of the Currency and the FDIC have issued regulatory guidance (the “Incentive Compensation Guidance”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination and incorporated into the organization’s supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies. The federal banking agencies emphasize that all banking organizations must carefully design and oversee incentive compensation policies to ensure such policies do not undermine the safety and soundness of such organizations.

 

As required by the Dodd-Frank Act, in March 2011 the SEC and the federal bank regulatory agencies proposed regulations that would prohibit financial institutions with assets of at least $1 billion from maintaining executive compensation arrangements that encourage inappropriate risk taking by providing excessive compensation or that could lead to material financial loss to the financial institution, but these regulations have not yet been finalized. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which the Company may structure compensation for its executives. These proposed regulations incorporate the principles discussed in the Incentive Compensation Guidance. A final rule has not yet been published.

 

Regulation of the Bank

 

The Bank, as a state-chartered member bank of the Federal Reserve System, is subject to regulation and examination by the Bureau and the Federal Reserve Board. The various laws and regulations issued and administered by the regulatory agencies (including the CFPB) affect corporate practices, such as the payment of dividends, the incurrence of debt and the acquisition of financial institutions and other companies, and affect business practices and operations, such as the payment of interest on deposits, the charging of interest on loans, and the types of business conduct, the products and terms offered to customers. In addition, the Bank is subject to the rules and regulations of the FDIC, which currently insures substantially all of the Bank’s deposits up to applicable limits of the DIF, and is subject to deposit insurance assessments to maintain the DIF.

 

Prior approval of the applicable primary federal regulatory and the Bureau is required for a Virginia chartered bank or a bank holding company to merge with another bank or bank holding company, or purchase the assets or assume the deposits of another bank or bank holding company, or acquire control of another bank or bank holding company. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant’s performance record under the Community Reinvestment Act and fair housing initiatives, and the applicant’s compliance with and the effectiveness of the subject organizations in combating money laundering activities and complying with Bank Secrecy Act requirements.

 

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FDIC Insurance, Assessments and Regulation

 

The Bank’s deposits are insured by the DIF of the FDIC up to the standard maximum insurance amount for each deposit ownership category. As of March 2015, the basic limit on FDIC deposit insurance coverage was $250,000 per depositor. Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC, subject to administrative and potential judicial hearing and review processes.

 

The DIF is funded by assessments on banks and other depository institutions calculated based on average consolidated total assets minus average tangible equity (defined as Tier 1 capital). As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment scheme, set a target “designated reserve ratio” (described in more detail below) of 2% for the DIF and established a lower assessment rate schedule when the reserve ratio reaches 1.15% and, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2% and 2.5%. An institution's assessment rate depends upon the institution's assigned risk category, which is based on supervisory evaluations, regulatory capital levels and certain other factors. Initial base assessment rates ranges from 2.5 to 45 basis points. The FDIC may make the following further adjustments to an institution's initial base assessment rates: decreases for long-term unsecured debt including most senior unsecured debt and subordinated debt; increases for holding long-term unsecured debt or subordinated debt issued by other insured depository institutions; and increases for broker deposits in excess of 10% of domestic deposits for institutions not well rated and well capitalized.

 

The Dodd-Frank Act transferred to the FDIC increased discretion with regard to managing the required amount of reserves for the DIF, or the “designated reserve ratio.” Among other changes, the Dodd-Frank Act (i) raised the minimum designated reserve ratio to 1.35% and removed the upper limit on the designated reserve ratio, (ii) requires that the designated reserve ratio reach 1.35% by September 2020, and (iii) requires the FDIC to offset the effect on institutions with total consolidated assets of less than $10 billion of raising the designated reserve ratio from 1.15% to 1.35% – which requirement will be met through rules the FDIC intends to propose when the reserve ratio is closer to 1.15%. The FDIA requires that the FDIC consider the appropriate level for the designated reserve ratio on at least an annual basis. On October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act.

 

FDIC insurance expense totaled $921 thousand, $1.8 million and $2.3 million in 2014, 2013 and 2012, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. The FICO assessment rate for the DIF ranged between a high of 0.62 basis points for the first three quarters of 2014, to a low of 0.60 basis points for the fourth quarter of 2014. For the first quarter of 2015, the FICO assessment rate for the DIF is 0.60 basis points resulting in a premium of $0.0060 per $100 of DIF-eligible deposits.

 

Prompt Corrective Action

 

The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities. The Company believes that, as of December 31, 2014, its bank subsidiary, EVB, was “well capitalized” based on the applicable ratios.

 

Mortgage Banking Regulation

 

In connection with making mortgage loans, the Bank is subject to rules and regulations that, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers and, in some cases, restrict certain loan features and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act (“TILA”), Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act (“RESPA”), and Home Ownership Equity Protection Act, and the regulations promulgated under these acts. These laws prohibit discrimination, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level. The Dodd-Frank Act has transferred rulemaking authority under many of these laws to the CFPB.

 

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The Bank’s mortgage origination activities are also subject to Regulation Z, which implements TILA. As amended and effective January 10, 2014, certain provisions of Regulation Z require 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. Alternatively, a mortgage lender can originate “qualified mortgages”, which are generally defined as mortgage loans without negative amortization, interest-only payments, balloon payments, terms exceeding 30 years, and points and fees paid by a consumer equal to or less than 3% of the total loan amount. Higher-priced qualified mortgages (e.g., subprime loans) receive a rebuttable presumption of compliance with ability-to-repay rules, and other qualified mortgages (e.g., prime loans) are deemed to comply with the ability-to-repay rules. The Bank predominately originates mortgage loans that comply with Regulation Z’s “qualified mortgage” rules.

 

Consumer Protection

 

The Dodd-Frank Act created the CFPB, a federal regulatory agency that is responsible for implementing, examining and enforcing compliance with federal consumer financial laws for institutions with more than $10 billion of assets and, to a lesser extent, smaller institutions. The Dodd-Frank Act gives the CFPB authority to supervise and regulate providers of consumer financial products and services, establishes the CFPB’s power to act against unfair, deceptive or abusive practices and gives the CFPB rulemaking authority in connection with numerous federal consumer financial protection laws (for example, but not limited to, TILA and RESPA).

 

As a smaller institution (i.e., with assets of $10 billion or less), most consumer protection aspects of the Dodd-Frank Act will continue to be applied to the Company by the Federal Reserve Board and to the Bank by the FDIC. However, the CFPB may include its own examiners in regulatory examinations by a small institution’s prudential regulators and may require smaller institutions to comply with certain CFPB reporting requirements. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the Federal Reserve Board and FDIC apply consumer protection laws and regulations to financial institutions that are not directly supervised by the CFPB. The precise of the CFPB’s consumer protection activities on the Company and the Bank cannot be determined with certainty.

 

Confidentiality and Required Disclosures of Customer Information

 

The Company and the Bank are subject to various laws and regulations that address the privacy of nonpublic personal financial information of consumers. The GLBA and certain regulations issued thereunder protect against the transfer and use by financial institutions of consumer nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. These privacy provisions generally prohibit a financial institution from providing a customer's personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

 

The Company and the Bank are also subject to various laws and regulations that attempt to combat money laundering and terrorist financing. The Bank Secrecy Act requires all financial institutions to, among other things, create a system of controls designed to prevent money laundering and the financing of terrorism, and imposes recordkeeping and reporting requirements. The USA Patriot Act facilitates information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering, and requires financial institutions to establish anti-money laundering programs. The Federal Bureau of Investigation (“FBI”) sends banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities, and requests banks to search their records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report with the U.S. Department of the Treasury (the “Treasury”) and contact the FBI. The Office of Foreign Assets Control (“OFAC”), which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. If the Bank finds a name of an “enemy” of the United States on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account or place transferred funds into a blocked account, file a suspicious activity report with the Treasury and notify the FBI.

 

Although these laws and programs impose compliance costs and create privacy obligations and, in some cases, reporting obligations, and compliance with all of the laws, programs and privacy and reporting obligations may require significant resources of the Company and the Bank, these laws and programs do not materially affect the Bank’s products, services or other business activities.

 

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Community Reinvestment Act

 

The Community Reinvestment Act (“CRA”) imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs are assessed based on specified factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Following the Bank’s most recent scheduled compliance examination in August 2012, it received a CRA performance evaluation of “satisfactory.”

 

Federal Home Loan Bank of Atlanta

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, which is one of 12 regional FHLBs that provide funding to their members for making housing loans as well as for affordable housing and community development loans. Each FHLB serves as a reserve, or central bank, for the members within its assigned region. Each is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. Each FHLB makes loans to members in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank must purchase and maintain stock in the FHLB of Atlanta. In 2004, the FHLB converted to its new capital structure, which established the minimum capital stock requirement for member banks as an amount equal to the sum of a membership requirement and an activity-based requirement. At December 31, 2014, the Bank held $4.5 million of FHLB of Atlanta stock.

 

Volcker Rule

 

The Dodd-Frank Act prohibits bank holding companies and their subsidiary banks from engaging in proprietary trading except in limited circumstances, and places limits on ownership of equity investments in private equity and hedge funds (the “Volcker Rule”). On December 10, 2013, the U.S. financial regulatory agencies (including the Federal Reserve, the FDIC and the SEC) adopted final rules to implement the Volcker Rule. In relevant part, these final rules would have prohibited banking entities from owning collateralized debt obligations (“CDOs”) backed by trust preferred securities, effective July 21, 2015. However, subsequent to these final rules the U.S. financial regulatory agencies issued an interim rule effective April 1, 2014 to exempt CDOs backed by trust preferred securities from the Volcker Rule and the final rule, provided that (a) the CDO was established prior to May 19, 2010, (b) the banking entity reasonably believes that the CDO’s offering proceeds were used to invest primarily in trust preferred securities issued by banks with less than $15 billion in assets, and (iii) the banking entity acquired the CDO investment on or before December 10, 2013.

 

Smaller bank, with total consolidated assets of $10 billion or less, engaged in modest proprietary trading activities for their own accounts are subject to a simplified compliance program under the final rules. Several portions of the Volcker Rule remain subject to regulatory rulemaking and legislative activity, including to further delay effectiveness of some provisions of the Volcker Rule. The Company believes that its financial condition will not be significantly impacted by the Volcker Rule, and does not expect that any delays in the effectiveness of the Volcker Rule will significantly impact its financial condition.

 

Future Regulation

 

Including and in addition to the specific proposals described above, from time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations, regulatory policies or regulatory guidance or interpretative positions applicable to the Company or any of its subsidiaries could have a material effect on the business of the Company.

 

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Available Information

 

The Company’s SEC filings are filed electronically and are available to the public over the Internet at the SEC’s web site at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company’s SEC filings also are available through our web site at http://www.evb.org under “SEC Filings” as soon as reasonably practicable after they are filed with the SEC. Copies of documents also can be obtained free of charge by writing to the Company’s Corporate Secretary at P.O. Box 1455, Tappahannock, VA 22560 or by calling 804-443-8400. The information on the Company’s website is not, and shall not be deemed to be, a part of this Annual Report on Form 10-K or incorporated into any other filings the Company makes with the SEC.

 

Item 1A. Risk Factors

 

An investment in our common stock involves significant risks inherent to the Company’s business. Like other bank holding companies, we are subject to a number of risks, many of which are outside of our control. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition, results of operations and prospects could be harmed. These risks are not the only ones that we may face. Other risks of which we are not aware, including those which relate to the banking and financial services industry in general and us in particular, or those which we do not currently believe are material, may harm our future business, financial condition, results of operations and prospects. Readers should consider carefully the following important risks, in conjunction with the other information in this Annual Report on Form 10-K including our consolidated financial statements and related notes, in evaluating us, our business and an investment in our securities.

 

Deterioration in economic conditions could adversely affect us.

 

Deterioration in economic and market conditions, such as the economic downturn and recession that resulted from the financial crisis of 2008, could hurt our business and our financial condition and results of operations. Our business is directly affected by general economic and market conditions, broad trends in industry and finance, and inflation, all of which are beyond our control. A deterioration in economic conditions, and in particular an economic slowdown within our markets, could result in increases in loan delinquencies, problem assets and foreclosures, and could result in decreases in demand for our products and services, and values of collateral supporting our loans. Declines in the housing market, including as experienced through falling home prices and rising foreclosures, can negatively impact the credit performance of real estate related loans. Declines in the employment markets, including as experienced through high unemployment and underemployment, can negatively impact the credit performance of consumer loans. Any of the foregoing effects could negatively impact our business, financial condition and results of operations.

 

We operate in a mixed market environment with influences from both rural and urban areas, and we will be affected by economic conditions in our Northern Neck, Middle Peninsula, Capital, Tidewater and Southern market areas. Changes in the local economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio, and loan and deposit pricing. Although we might not have significant credit exposure to all the businesses in our market areas, a downturn in any business sector of a market area or a downturn with respect to any significant business in a market area could have a negative impact on local economic conditions and real estate collateral values in that market area, which could negatively affect our profitability.

 

Deterioration in the soundness of our counterparties could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could create another market-wide liquidity crisis similar to that experienced in late 2008 and early 2009 and could lead to losses or defaults by us or by other institutions. There is no assurance that the failure of our counterparties would not materially adversely affect the Company’s results of operations.

 

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Offerings of our securities and other potential capital strategies or the conversion of shares of our non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) into common stock could dilute your investment or otherwise affect your rights as a shareholder.

 

In the future we may seek to raise additional capital through offerings of our common stock, preferred stock, securities convertible into common stock, or rights to acquire such securities or our common stock. Under our Articles of Incorporation, we have additional authorized shares of common stock that we can issue from time to time at the discretion of our Board of Directors, without further action by shareholders, except where shareholder approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The issuance of any additional shares of common stock or securities convertible into common stock in a subsequent offering could be substantially dilutive to holders of our common stock. Holders of our common stock have no preemptive rights as a matter of law that entitle them to purchase their pro-rata share of any offering or shares of any class or series. In addition, under our Articles of Incorporation, we can authorize and issue additional shares of our preferred stock, in one or more series the terms of which would be determined by our Board of Directors without shareholder approval, unless such approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The market price of our common stock could decline as a result of future sales of our securities or the perception that such sales could occur.

 

New investors, particularly with respect to newly authorized series of preferred stock, also may have rights, preferences, and privileges that are senior to, and that could adversely affect, our then current shareholders, and particularly holders of our common stock. For example, a new series of preferred stock could rank senior to shares of our common stock. As a result, we could be required to make any dividend payments on such preferred stock before any dividends can be paid on our common stock, and in the event of our bankruptcy, dissolution, or liquidation, we may have to pay the holders of this new series of preferred stock in full prior to any distributions being made to the holders of our common stock.

 

In addition, the conversion of shares of our Series B Preferred Stock into common stock would dilute the voting power of our then-outstanding shares of common stock.

 

We cannot predict or estimate the amount, timing, or nature of our future securities offerings or other capital initiatives or whether, when or how many shares of our Series B Preferred Stock will be converted into shares of common stock. Thus, our shareholders bear the risk of our future offerings or future conversions of shares of our Series B Preferred Stock diluting their stock holdings, adversely affecting their rights as shareholders, and/or reducing the market price of our common stock.

 

Affiliates of Castle Creek Capital Partners (“Castle Creek”) and GCP Capital Partners (“GCP Capital”) are substantial holders of our common stock.

 

Castle Creek holds approximately 8.2% of our common stock and approximately 28.1% of our combined common stock and Series B Preferred Stock. GCP Capital holds approximately 8.2% of our common stock and approximately 12.4% of our combined common stock and Series B Preferred Stock. Pursuant to the terms of the securities purchase agreements entered into with Castle Creek and GCP Capital, Castle Creek and GCP Capital each have a right to appoint a representative on our Board of Directors and on the Bank’s board of directors. As previously disclosed, effective July 30, 2013, Boris M. Gutin was elected to the Boards of Directors of the Company and the Bank at the request of an affiliate of GCP Capital, and following the recommendation of the Company’s Nominating and Corporate Governance Committee. Castle Creek and GCP Capital may have individual economic interests that are different from the other’s interests and different from the interests of our other shareholders.

 

Compliance with laws, regulations and supervisory guidance, both new and existing, may adversely impact our business, financial condition and results of operations.

 

We are subject to numerous laws, regulations and supervision from both federal and state agencies. During the past few years, there has been an increase in legislation related to and regulation of the financial services industry. We expect this increased level of oversight to continue. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase our costs and/or limit our ability to pursue certain business opportunities.

 

Laws and regulations, and any interpretations and applications with respect thereto, generally are intended to benefit consumers, borrowers and depositors, not shareholders. The legislative and regulatory environment is beyond our control, may change rapidly and unpredictably and may negatively influence our revenue, costs, earnings, and capital levels. Our success depends on our ability to maintain compliance with both existing and new laws and regulations.

 

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Failure to comply with regulatory requirements could subject us to regulatory action.

 

The Company and the Bank are supervised by the Federal Reserve Board and the Bureau. As such, each is subject to extensive supervision and prudential regulation. Both the Company and the Bank must maintain certain risk-based and leverage capital ratios and operate in a safe and sound manner as required by the Federal Reserve and the Bureau. If the Company or the Bank fails to meet regulatory capital requirements or is deemed to be operating in an unsafe and unsound manner or in violation of law, it may be subject to a variety of informal or formal regulatory actions. Informal regulatory actions may include a memorandum of understanding which is initiated by the regulator and outlines an institution’s agreement to take specified actions within specified time periods to correct violations of law or unsafe and unsound practices. In addition, as part of the regular examination process, regulators may advise the Company or the Bank to operate under various restrictions as a prudential matter. Any of these restrictions, in whatever manner imposed, could have a material adverse effect on our business, financial condition and results of operations.

 

In addition to informal regulatory actions, we may also be subject to formal regulatory actions. Failure to comply with an informal regulatory action could lead to formal regulatory actions. Formal regulatory actions include written agreements, cease and desist orders, the imposition of substantial fines and other penalties. Furthermore, if the Bank became severely undercapitalized, it could become subject to the prompt corrective action framework which imposes progressively more restrictive constraints on operations, management and capital. A failure to meet regulatory capital requirements could also subject the Company to capital raising requirements. Additional capital raisings would be dilutive to holders of our common stock.

 

We were previously subject to a written agreement, dated February 17, 2011, among the Company, the Bank, the Federal Reserve Bank of Richmond (the “Reserve Bank”) and the Bureau (the “Written Agreement”). The Written Agreement had required the Bank, among other things, to develop plans for improving numerous aspects of the Bank’s operations and management, required the Bank to improve asset quality, restricted certain types of credit extensions and imposed a number of measures designed to preserve the Bank’s capital. The Written Agreement was terminated on July 30, 2013, after which we were subject to a memorandum of understanding, dated September 5, 2013, among the Company, the Bank, the Reserve Bank and the Bureau (the “MOU”). Under the terms of the MOU, we agreed that the Company would not, without prior written approval of the Reserve Bank and the Bureau, declare or pay dividends of any kind, or make any payments on the Company’s trust preferred securities; incur or guarantee any debt; or purchase or redeem any shares of the Company’s stock. In addition, under the MOU we had agreed to review and revise the allowance for loan and lease losses methodology (“ALLL”), and on a quarterly basis submit to the Reserve Bank and the Bureau a copy of the internally calculated ALLL worksheet. The MOU was terminated effective March 13, 2014. Although the Written Agreement and MOU have been terminated, there can be no assurance that we will not be subject to similar agreements in the future.

 

Any remedial measure or regulatory action, whether formal or informal, could impose restrictions on our ability to operate our businesses and adversely affect our prospects, financial condition or results of operations. In addition, any formal enforcement action could harm our reputation and our ability to retain and attract customers, and impact the trading price of our common stock.

 

We may need to raise additional capital that may not be available to us.

 

We may need to or may otherwise be required to raise additional capital in the future, including if we incur losses or due to regulatory mandates. The ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, additional capital may not be raised, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to maintain our capital ratios could be materially impaired, and we could face additional regulatory challenges.

 

The Basel III Final Rules require higher levels of capital and liquid assets, which could adversely affect the Company’s net income and return on equity.

 

In July 2013, the federal bank regulatory agencies adopted rules to implement the Basel III capital framework and for calculating risk-weighted assets, as modified by the U.S. federal bank regulators (or the Basel III Final Rules). For further information about these final rules, please see “Regulation and Supervision” under the heading “Capital Requirements” in Item 1 of this Annual Report on Form 10-K.

 

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The Basel III Final Rules represent the most comprehensive overhaul of the U.S. banking capital framework in over two decades. These rules require bank holding companies and their subsidiaries, such as the Company and the Bank, to dedicate more resources to capital planning and regulatory compliance, and maintain substantially more capital as a result of higher required capital levels and more demanding regulatory capital risk-weightings and calculations. The rules also require all banks to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and likely increase risk-weighted assets at many banking organizations as a result of applying higher risk-weightings to certain types of loans and securities. As a result, we may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio, or change the way we manage past-due exposures.

 

Due to the changes to bank capital levels and the calculation of risk-weighted assets, many banks could be required to access the capital markets on short notice and in relatively weak economic conditions, which could result in banks raising capital that significantly dilutes existing shareholders. Additionally, many community banks could be forced to limit banking operations and activities, and growth of loan portfolios and interest income, in order to focus on retention of earnings to improve capital levels. If the Basel III Final Rules require the Company to access the capital markets in this manner, or similarly limit the Bank’s operations and activities, the Basel III Final Rules would have a detrimental effect on our net income and return on equity and limit the products and services we provide to our customers.

 

The Dodd-Frank Act could continue to increase our regulatory compliance burden and associated costs, place restrictions on certain products and services, and limit our future capital strategies.

 

A wide range of regulatory initiatives directed at the financial services industry have been proposed in recent years. One of those initiatives, the Dodd-Frank Act, was signed into law on July 21, 2010. The Dodd-Frank Act represents a sweeping overhaul of the financial services industry within the United States and mandates significant changes in the financial regulatory landscape that has impacted and will continue to impact all financial institutions, including the Company and the Bank. The Dodd-Frank Act will likely continue to increase our regulatory compliance burden and may have a material adverse effect on us, by increasing the costs associated with our regulatory examinations and compliance measures. The federal regulatory agencies, and particularly bank regulatory agencies, are given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations and many of the implementing rules and regulations have not yet been proposed or approved; consequently the full details and impact of the Dodd-Frank Act will depend on the final implementing rules and regulations. Accordingly, it remains too early to fully assess the full impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on our business, financial condition or results of operations.

 

Among the Dodd-Frank Act’s significant regulatory changes, the Dodd-Frank Act creates a new financial consumer protection agency, the CFPB, that could impose new regulations on us and include its examiners in our routine regulatory examinations conducted by the Federal Reserve Bank of Richmond (the “Reserve Bank”), which could increase our regulatory compliance burden and costs and restrict the financial products and services we can offer to our customers. The CFPB, through the agency’s rulemaking and enforcement authority with respect to the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive business practices, may reshape the consumer financial protection laws and directly impact the business operations of financial institutions offering consumer financial products or services, including the Company and the Bank. This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service. Although the CFPB has supervisory jurisdiction over banks with $10 billion or greater in assets, policies and interpretative guidance issued by the CFPB may also apply to the Company or its subsidiaries (including the Bank) by virtue of the adoption of such policies and guidance as “best practices” by the Federal Reserve Board (including the Reserve Bank) and FDIC. The costs and limitations related to this additional regulatory agency and the limitations and restrictions that will be placed upon the Company with respect to its consumer product and service offerings have yet to be determined. However, these costs, limitations and restrictions may produce significant, material effects on our business, financial condition and results of operations.

 

The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate hedging transactions.

 

17
 

 

We have a high concentration of loans secured by both residential and commercial real estate and a further downturn in either or both real estate markets, for any reason, may increase our credit losses, which would negatively affect our financial results.

 

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Most of our loans are secured by real estate (both residential and commercial) in our market areas. At December 31, 2014, approximately 85.2% of our $820.6 million loan portfolio was secured by residential and commercial real estate. Changes in the real estate market, such as a deterioration in market value of collateral, or a decline in local employment rates or economic conditions, could adversely affect our customers’ ability to pay these loans, which in turn could impact our profitability. There has been a slowdown in the housing market across our geographical footprint compared to historical conditions, reflecting depressed prices and excess inventories of houses to be sold. Repayment of our commercial loans is often dependent on the cash flow of the borrower, which may be unpredictable. If the value of real estate serving as collateral for the loan portfolio materially declines, a significant portion of the loan portfolio could become under-collateralized. If the loans that are secured by real estate become troubled when real estate market conditions are declining or have declined, in the event of foreclosure we may not be able to realize the amount of collateral that was anticipated at the time of originating the loan.  In that event, we may have to increase the provision for loan losses, which could have a material adverse effect on our operating results and financial condition.

 

We have a concentration of credit exposure in acquisition and development (or “ADC”) real estate loans.

 

At December 31, 2014, we had approximately $55.3 million in loans for the acquisition and development of real estate and for construction of improvements to real estate, representing approximately 6.7% of our total loans outstanding as of that date. These loans are to developers, builders and individuals. Project types financed include acquisition and development of residential subdivisions and commercial developments, builder lines for 1-4 family home construction and loans to individuals for primary and secondary residence construction. These types of loans are generally viewed as having more risk of default than residential real estate loans. Completion of development projects and sale of developed properties may be affected significantly by general economic conditions, and further downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains acquisition and development loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

 

Our small to medium-sized business target market may have fewer financial resources to weather a downturn in the economy.

 

We target our commercial development and marketing strategy primarily to serve the banking and financial services needs of small and medium-sized businesses. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact this major economic sector in the markets in which we operate, our results of operations and financial condition may be adversely affected.

 

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

 

Making loans is an essential element of our business. The risk of nonpayment is affected by a number of factors, including but not limited to: the duration of the credit; credit risks of a particular customer; changes in economic and industry conditions; and, in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, our loans may not be repaid. 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 will result in losses, but that have not been identified as nonperforming or potential problem loans. 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. We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. Our allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, changes in the size and composition of the loan portfolio and industry information. Also included in our estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. Because any estimate of loan losses is necessarily subjective and the accuracy of any estimate depends on the outcome of future events, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income. We cannot be certain that our allowance for loan losses is adequate to absorb probable losses in our loan portfolio.

 

18
 

 

We may incur losses if we are unable to successfully manage interest rate risk.

 

Our profitability depends in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. These rates are normally in line with general market rates and rise and fall based on the asset liability committee’s view of our financing and liquidity needs. We may selectively pay above-market rates to attract deposits, as we have done in some of our marketing promotions in the past. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, which, in turn, may affect the growth in loan and retail deposit volume. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments.  Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Fluctuations in market rates are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations.

 

Changes in interest rates also affect the value of our loans.  An increase in interest rates could adversely affect our 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 nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our results of operations.

 

We face risks in connection with our strategic and other business initiatives and we may not be able to fully execute on these initiatives, which could have a material adverse effect on our financial condition or results of operations.

 

From time to time we may pursue, develop, and implement strategic business initiatives, which may include acquisitions, investments, asset purchases or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such opportunities or that such opportunities, if pursued, will be successful. In recent years we have announced some significant initiatives – including the issuance of common stock and Series B Preferred Stock through private placements and a rights offering, balance sheet and asset quality initiatives, and initiating repurchases of our fixed rate cumulative perpetual preferred stock, Series A, par value $2.00 per share, having a liquidation preference of $1,000 per share (“Series A Preferred Stock”). Although we have made meaningful progress against certain of our strategic initiatives, we can give no assurance that we will be ultimately successful in completing these initiatives, or that these initiatives once completed will positively impact our business, financial condition or results of operations.

 

We remain focused on building a robust banking franchise and continue to evaluate and undertake various strategic activities and business initiatives. These initiatives may include strategic acquisitions, investments, joint ventures, or partnerships, and may involve banking activities, products or services that are new to us. There can be no assurance that we will successfully identify appropriate initiatives, that we will be able to negotiate or finance such initiatives or that such initiatives, if undertaken, will be successful.

 

Our ability to execute strategic and other business initiatives successfully will depend on a variety of factors. These factors likely will vary based on the nature of the initiative but may include: overall market conditions, meeting applicable regulatory requirements and receiving approval of any regulatory applications or filings, hiring or retaining key employees, achieving anticipated business results, our success in operating effectively with any co-investor or partner with whom we elect to do business, our success in integrating any company that we choose to acquire, and achieving anticipated synergies of any acquisition, investment, joint venture or partnership. Our ability to address these factors successfully cannot be assured. In addition, our strategic efforts may divert resources or management's attention from ongoing business operations and may subject us to additional regulatory scrutiny and potential liability. If we do not successfully execute a strategic initiative, it could adversely affect our business, financial condition, results of operations, reputation or growth prospects. In connection with executing any such initiative, we would expect to incur additional non-interest expense, and perhaps the initiative’s entire cost, in advance of realizing improved financial condition and results of operations as a result of the initiative.

 

19
 

 

We may not be able to successfully manage our long-term growth, which may adversely affect our results of operations and financial condition.

 

A key aspect of our long-term business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:

 

·open new branch offices or acquire existing branches or other financial institutions;
·attract deposits to those locations; and
·identify attractive loan and investment opportunities.

 

We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future, or if we are subject to regulatory restrictions on growth or expansion of our operations. Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth, maintain cost controls and asset quality and successfully integrate any businesses we acquire into our organization. As we identify opportunities to implement our growth strategy by opening new branches or acquiring branches or other banks, we may incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, any plans for branch expansion could decrease our earnings in the short run, even if we efficiently execute our branching strategy.

 

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

 

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. 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 margins and our market share and may adversely affect our results of operations, financial condition and growth.

 

It may be difficult to fully integrate the business of VCB and we may fail to realize all of the anticipated benefits of the acquisition of VCB.

 

If our costs to fully integrate the business of VCB into our existing operations are greater than anticipated, or we are not able to achieve the anticipated benefits of the acquisition, including cost savings and other synergies, our business could be negatively affected. In addition, it is possible that we could lose key employees from VCB’s legacy operations, and that fully integrating VCB’s legacy operations could result in loss of customers, the disruption of our ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with customers and employees or to achieve the anticipated benefits of the acquisition. Integration efforts also may divert management attention and resources, which could adversely affect our ability to service our existing business and generate new business, which in turn could adversely affect our business and financial results.

 

We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.

 

We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our president and chief executive officer and other senior officers. We have entered into employment agreements with certain of our executive officers, including our Chief Executive Officer. The existence of such agreements, however, does not necessarily assure that we will be able to continue to retain their services. The unexpected loss of any of our key employees could have an adverse effect on our business and possibly result in reduced revenues and earnings. We do maintain bank-owned life insurance on key officers that would help cover some of the economic impact of a loss caused by death. The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. The market for these people is competitive, and we cannot assure you that we will be successful in attracting, hiring, motivating or retaining them.

 

20
 

 

Our deposit insurance premiums could increase in the future, which may adversely affect our future financial performance.

 

The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges insured financial institutions premiums to maintain the DIF at a certain level. The financial crisis of 2008 and the resulting recession increased the rate of bank failures and expectations for further bank failures, requiring the FDIC to make payments for insured deposits from the DIF – which depleted the DIF – and prepare for future payments from the DIF.

 

On April 1, 2011, final rules to implement changes required by the Dodd-Frank Act with respect to the FDIC assessment rules became effective. The rules provide that a depository institution’s deposit insurance assessment will be calculated based on the institution’s total assets less tangible equity, rather than the previous base of total deposits. These changes have not materially increased the Company’s FDIC insurance assessments for comparable asset and deposit levels. However, if the Bank’s asset size increases or the FDIC takes other actions to replenish the DIF, the Bank’s FDIC insurance premiums could increase.

 

The dividend rate on our Series A Preferred Stock has increased, and we can provide no assurance as to when we will repurchase all of its Series A Preferred Stock.

 

On January 9, 2009, as part of the Capital Purchase Program established by the Treasury, the Company issued and sold to Treasury 24,000 shares of our Series A Preferred Stock with an aggregate liquidation value of $24.0 million, 9,000 shares of which remain outstanding as of March 31, 2015. On January 9, 2014, the dividend rate on the Series A Preferred Stock increased substantially from 5.0% per annum to 9.0% per annum. This increase in the annual dividend rate could have a material adverse effect on our liquidity, net income available to common shareholders and earnings per share. We cannot provide any assurance as to whether or when we will be able to repurchase the remaining shares of Series A Preferred Stock or whether or not we would need to issue debt or equity for such purpose.

 

Certain losses or other tax assets could be limited if we experience an ownership change, as defined in the Internal Revenue Code.

 

Our ability to use net operating loss carryforwards, built-in losses and certain other tax assets may be limited in the event of an “ownership change” as defined by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5% shareholders” (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period. If an “ownership change” occurs, Section 382 would impose an annual limit on the amount of losses or other tax assets we can use to reduce our taxable income equal to the product of the total value of our outstanding equity immediately prior to the “ownership change” and the applicable federal long-term tax-exempt interest rate. A number of special rules apply to calculating this limit. While stock issuances that we have completed since 2013 and other changes in ownership of certain of our shareholders may have increased the likelihood of an “ownership change,” we currently believe that an “ownership change” has not occurred. If such an ownership change has occurred or occurs in the future, we may not be able to use all of our net operating losses and other tax assets to offset taxable income, thus paying higher income taxes which would negatively impact our financial condition and results of operations.

 

The Company’s disclosure controls and procedures and internal controls may not prevent or detect all errors or acts of fraud.

 

The Company’s disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by the Company in reports it files or submits under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company believes that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or omission. Additionally, controls can be circumvented by individual acts, by collusion by two or more people and/or by override of the established controls. Accordingly, because of the inherent limitations in the Company’s control systems and in human nature, misstatements due to error or fraud may occur and not be detected.

 

21
 

 

Our information systems may experience an interruption in service or breach in security.

 

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach of security of these systems could result in failures or disruptions in our customer relationship management, transaction processing systems and various accounting and data management systems. While we have policies and procedures designed to prevent and/or limit the effect of any failure, interruption or security breach of our communication and information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur, or, if they do occur, they will be adequately addressed on a timely basis. The occurrence of failures, interruptions or security breaches of our communication 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, any of which could have a material adverse effect on our financial condition and results of operations.

 

We continually encounter technological change.

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. Although recently we have significantly increased our focus on technological innovation and have introduced new, more technologically-advanced products and services, we may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

 

Our operations rely on certain external vendors.

 

We are reliant upon certain external vendors to provide products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. We maintain a system of comprehensive policies and a control framework designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition, (iii) changes in the vendor’s support for existing products and services and (iv) changes in the vendor’s strategic focus. While we believe these policies and procedures help to mitigate risk, the failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements could be disruptive to our operations, which could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

 

We are subject to environmental liability risk associated with lending activities.

 

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 or 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.

 

Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact our business.

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. In addition, such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. The occurrence of any such event in the future could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

 

22
 

 

Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially impact our financial statements.

 

From time to time the SEC and the Financial Accounting Standards Board (“FASB”) change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing our financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, the Company may experience unexpected material consequences.

 

Liquidity needs could adversely affect our results of operations and financial condition.

 

The Company relies on dividends from the Bank as its primary source of additional liquidity, and the payment of dividends by the Bank to the Company is restricted by applicable state and federal law. The primary sources of funds of the Bank are client deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to clients on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands.

 

We have goodwill that may become impaired, and thus result in a charge against earnings.

 

The Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis are discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. These assumptions and any fair value determination can involve a high degree of judgment and subjectivity. The Company has elected to bypass the preliminary assessment and conduct a full goodwill impairment analysis on an annual basis through the use of an independent third party specialist. As of December 31, 2014, we had $17.1 million of goodwill related to branch acquisitions in 2003 and 2008 and the acquisition of VCB in 2014. To date, we have not recorded any impairment charges on our goodwill, however there is no guarantee that we may not be forced to recognize impairment charges in the future as operating and economic conditions change. Any material impairment charge would have a negative effect on the Company's financial results and shareholders' equity.

 

Other-than-temporary impairment could reduce our earnings.

 

We may be required to record other-than-temporary impairment (or “OTTI”) charges on our investment securities if they suffer a decline in value that is considered other-than-temporary. Numerous factors, including lack of liquidity for re-sales of certain investment securities, absence of reliable pricing information for certain investment securities, adverse changes in business climate, adverse actions by regulators, or unanticipated changes in the competitive environment could have a negative effect on our securities portfolio in future periods. An OTTI charge could have a material adverse effect on our results of operations and financial condition.

 

We may be parties to certain legal proceedings that may impact our earnings.

 

We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.

 

23
 

 

Our common stock trading volume may not provide adequate liquidity for investors.

 

Although shares of the Company’s common stock are listed on the NASDAQ Global Select Market, the average daily trading volume in the common stock is less than that of many other financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of a sufficient number of willing buyers and sellers of the common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the daily average trading volume of the Company’s common stock, significant sales of the common stock in a brief period of time, or the expectation of these sales, could cause a decline in the price of the Company’s common stock.

 

The Company’s common stock, Series A Preferred Stock and Series B Preferred Stock are not insured deposits.

 

The Company’s common stock, Series A Preferred Stock and non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) are not bank deposits and, therefore, losses in their value are not insured by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in the Company’s common stock, Series A Preferred Stock or Series B Preferred stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this Form 10-K, and is subject to the same market forces and investment risks that affect the price of capital stock in any other company, including the possible loss of some or all principal invested.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

Our principal executive offices are located at 330 Hospital Road, Tappahannock, Virginia 22560 where we opened a 15,632 square foot corporate headquarters and operations center in July 2003. We closed our Old Church office in October 2013, our Bowling Green office in September 2012, and our Glenns office in December 2011. In November 2014 the Company acquired VCB which added three full service branches and one business condo unit housing a commercial and administrative center in the Tidewater region. Of the former VCB properties, one branch and the business condo unit are owned and two branches are under long-term land leases on which the owned branch is located. At the end of 2014, the Company owned twenty-one full service branch buildings including the land on which eighteen of those buildings are located and two remote drive-in facilities. The Company currently has long-term leases for six of its branches and one loan production office. Three of the leases are for branch buildings, three of the leases are for the land on which Company owned branches are located and one lease is for a loan production office building in Chesterfield, Virginia. All leases are under long-term non-cancelable operating lease agreements with renewal options, at total annual rentals of approximately $462 thousand as of December 31, 2015. The counties of Northumberland and Middlesex are each the home to three of our branches. The counties of Essex and Gloucester are home to two branch offices. In addition, Essex County houses the Company’s corporate/operations center. Hanover County houses three branch offices, the Bank’s loan administration center, and an administrative center while , Henrico, King William County, Lancaster, New Kent, Southampton, Surry, Sussex Counties and the cities of Colonial Heights, Hampton, Newport News and Williamsburg each have one full service branch office. In addition, the city of Newport News houses a commercial/administrative center. Southampton County and Sussex County also each have a stand-alone drive-in/automated teller machine location.

 

In June 2010, we purchased 4 business condo units (2,400 square feet per unit) at Atlee Commons in Hanover County. In November 2012, we purchased 3 more business condo units with the same specifications at the same Hanover County location. All of these properties were purchased in anticipation of future space needs and to lower or eliminate current rental costs. In early 2011, land was purchased in Colonial Heights with the intent to build and relocate our existing rented branch. In December 2012, construction was completed on the new Colonial Heights branch and we relocated from our previously rented branch. No other new branches were built or purchased in 2012, 2013 or 2014.

The Company believes its facilities are in good operating condition, are suitable and adequate for its operational needs and are adequately insured.

 

See Item 13. “Certain Relationships and Related Transactions, and Director Independence” and Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 23: Related Party Leases” of this Form 10-K for more information on the Company’s related party leases.

 

24
 

 

Item 3. Legal Proceedings

 

The Company is not a party to, nor is any of its property the subject of, any material pending legal proceedings incidental to its businesses other than those arising in the ordinary course of business. Although the amount of any ultimate liability with respect to such matters cannot be determined, in the opinion of management, any such liability from legal proceedings incidental to the Company’s business will not have a material adverse effect on the consolidated financial position or results of operations of the Company.

 

Item 4. Mine Safety Disclosures

 

None.

 

Executive Officers of the Registrant

 

Following are the persons who are currently executive officers of the Company, their ages as of December 31, 2014, their current titles and positions held during the last five years:

 

Joe A. Shearin, 58, joined the Company in 2001 as the President and Chief Executive Officer of Southside Bank. Mr. Shearin served in that capacity until 2006 when he became President and Chief Executive Officer of the Bank. Mr. Shearin became the President and Chief Executive Officer of the Company in 2002.

 

Joseph H. James, Jr., 59, joined the Company in 2000 as Vice President and Operations Officer. From April 2002 to November 2002, Mr. James served as Vice President and Chief Operations Officer. From November 2002 through April 2006, Mr. James served as Senior Vice President and Chief Operations Officer. From April 2006 to January 2009, Mr. James served as an Executive Vice President of the Bank and the Chief Operations Officer of the Company. In January 2009, Mr. James became our Senior Executive Vice President and Chief Operating Officer.

 

J. Adam Sothen, 38, joined the Company in June 2010 as Vice President and Corporate Controller of the Bank. In September 2011, Mr. Sothen was appointed as the Company’s Chief Financial Officer and the Bank’s Executive Vice President and Chief Financial Officer. Mr. Sothen served as the Corporate Controller until October 2012. Prior to joining the Company, from October 2004 to June 2010, Mr. Sothen served as Vice President and Controller for Bank of the Commonwealth in Norfolk, Virginia.

 

James S. Thomas, 60, joined the Company in 2003 as Senior Vice President and Retail Banking Manager of Southside Bank. In 2005, he became Executive Vice President and Chief Operating Officer of Southside Bank. In April 2006, Mr. Thomas became Executive Vice President of Retail Banking for the Bank. In June 2007, Mr. Thomas was promoted to Executive Vice President and Chief Credit Officer of the Bank.

 

Douglas R. Taylor, 58, joined the Company in April 2010 as Executive Vice President and Chief Risk Officer. From December 2004 until joining the Company, Mr. Taylor served as Director of Risk Management for First Market Bank. From October 2001 until December 2004, Mr. Taylor served as Chief Administrative Officer of Citizens Bank and Trust.

 

Ann-Cabell Williams, 53, joined the Company in July 2011 as Executive Vice President and Retail Executive.  From January 2007 until joining the Company, Ms. Williams served as Chief Operation Officer and Retail Executive for Bank of Virginia.  From June 1999 until January 2007, Ms. Williams served as Area Manager and Senior Vice President for SunTrust Bank.

 

Bruce T. Brockwell, 49, joined the Company in April 2011 as Senior Vice President and Senior Commercial Lending Officer of the Bank. In May 2012, he became Senior Vice President and Director of Commercial Banking of the Bank. In August 2013, Mr. Brockwell was promoted to Executive Vice President and Director of Commercial Banking of the Bank. From November 2006 until joining the Company, Mr. Brockwell served as Chief Credit Officer for Bank of Virginia.

 

Mark C. Hanna, 46, joined the Company in November 2014 as Executive Vice President and Tidewater Regional President of the Bank. From November 2006 until joining the Company, Mr. Hanna served as President and Chief Executive Officer for Virginia Company Bank. From September 2005 to November 2006, Mr. Hanna served as President of Virginia Company Bank. From September 2002 until September 2005, Mr. Hanna served as Peninsula Area Executive for BB&T.

 

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Part II

 

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

 

Common Stock Performance

 

The Company’s common stock is traded on the NASDAQ Global Market under the symbol “EVBS.” As of March 26, 2015, there were approximately 2,715 shareholders of record. As of that date, the closing price of our common stock on the NASDAQ Global Market was $6.18. Set forth in the table below is the high and low sales prices of our common stock as reported by the NASDAQ Stock Market during each quarter for 2014 and 2013.

 

   2014   2013 
Quarter  High   Low   High   Low 
First  $7.25   $6.00   $7.50   $5.25 
Second   6.95    6.20    6.18    4.75 
Third   6.44    6.08    6.30    5.00 
Fourth   6.57    5.33    7.18    5.95 

 

Stock Performance Graph

 

The graph below presents five-year cumulative total return comparisons through December 31, 2014, in stock price appreciation and dividends for the Company’s common stock, the NASDAQ Composite and the SNL $1 billion - $5 billion Bank Index. Returns assume an initial investment of $100 at the market close on December 31, 2008 and reinvestment of dividends. Values as of each year end of the $100 initial investment are shown in the table and graph below.

 

 

   Cumulative Total Return as of Period Ending 
Index  12/31/09   12/31/10   12/31/11   12/31/12   12/31/13   12/31/14 
Eastern Virginia Bankshares, Inc.   100.00    54.93    28.85    77.50    100.47    92.86 
NASDAQ Composite   100.00    118.15    117.22    138.02    193.47    222.16 
SNL Bank $1B-$5B Bank Index   100.00    113.35    103.38    127.47    127.88    144.03 

 

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Dividend Reinvestment and Stock Purchase Plan

 

The Company has a Dividend Reinvestment and Stock Purchase Plan (the “DRIP”), which provides for the automatic conversion of dividends into common stock for enrolled shareholders. The DRIP also permits participants to make voluntary cash payments of up to $20 thousand per shareholder per calendar quarter for the purchase of additional shares of the Company’s common stock. When the administrator of the DRIP purchases shares of common stock from the Company, the purchase price will generally be the market value of the common stock on the purchase date as defined by the Nasdaq Stock Market. When the administrator purchases shares of common stock in the open market, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. When the administrator purchases shares of common stock in privately negotiated transactions, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. Effective March 1, 2012, the DRIP was amended and restated to effect certain design changes to the plan, but not to change the number of shares issuable thereunder.

 

Effective August 15, 2012, the issuance of common stock under the DRIP was temporarily suspended during the Company’s deferral of cumulative dividends on its Series A Preferred Stock. On August 15, 2014, the Company paid $5.5 million of current and all deferred but accumulated dividends on its Series A Preferred Stock. The Company plans to resume operation of the plan during the second quarter of 2015. 

 

Dividend Information

 

The ability of the Company to pay dividends depends upon the amount of dividends declared by the Bank, which is limited by regulatory restrictions on the Bank’s ability to pay dividends. The Company’s quarterly common stock dividend was suspended beginning with the Company’s first quarter of 2011. Subsequent to December 31, 2014, the Company paid a dividend of $0.01 per share to holders of the Company’s common stock and Series B Preferred Stock as of March 6, 2014. For further information regarding payment of dividends, refer to Item 1. “Business,” under the heading “Limits on Dividends” and Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 17: Dividend Limitations” of this Annual Report on Form 10-K.

 

Purchases of Equity Securities by the Issuer

 

In January 2001, the Company announced a stock repurchase program by which management was authorized to repurchase up to 300,000 shares of the Company’s common stock. This plan was amended in 2003 and the number of shares by which management is authorized to repurchase is up to 5% of the outstanding shares of the Company’s common stock on January 1 of each year. There is no stated expiration date for the program. During 2014, 2013 and 2012, the Company did not repurchase any of its common stock.

 

In connection with the Company’s sale to the Treasury of its Series A Preferred Stock under the Capital Purchase Program, as previously described, prior to January 9, 2012, the Company generally could not purchase any of its common stock without the consent of the Treasury.

 

In connection with the MOU with the Federal Reserve Board and the Bureau, as previously described, the Company was subject to additional limitations and regulatory restrictions and could not purchase or redeem shares of its stock without prior regulatory approval. The MOU was terminated effective March 13, 2014. For further information regarding repurchase of equity securities, refer to Item 7 under the heading “Capital Resources” of this Annual Report on Form 10-K.

 

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Item 6. Selected Financial Data

 

SELECTED FINANCIAL DATA

(dollars in thousands, except per share data)

 

       Year Ended December 31,     
Operating Statement Data:  2014   2013   2012   2011   2010 
Interest and dividend income  $41,918   $42,024   $45,071   $49,538   $53,510 
Interest expense   4,428    8,045    11,568    14,651    17,722 
Net interest income   37,490    33,979    33,503    34,887    35,788 
Provision for loan losses   250    1,850    5,658    8,800    28,930 
Net interest income after provision for loan losses   37,240    32,129    27,845    26,087    6,858 
Noninterest income   6,675    7,748    9,898    9,518    10,942 
Noninterest expense   35,804    44,901    33,346    34,039    35,521 
Income (loss) before income taxes   8,111    (5,024)   4,397    1,566    (17,721)
Income tax expense (benefit)   2,447    (2,392)   945    (211)   (6,962)
Net income (loss)   5,664    (2,632)   3,452    1,777    (10,759)
Effective dividend on preferred stock   1,948    1,504    1,500    1,496    1,492 
Net income (loss) available to common shareholders  $3,716   $(4,136)  $1,952   $281   $(12,251)
                          
Per Share Data:                         
Diluted income (loss) per common share  $0.22   $(0.45)  $0.32   $0.05   $(2.05)
Dividends per share, common   -    -    -    -    0.12 
Book value per common share   7.67    7.41    12.56    11.83    11.28 
                          
Balance Sheet Data:                         
Assets  $1,181,972   $1,027,074   $1,075,553   $1,063,034   $1,119,330 
Loans, net of unearned income   820,569    657,197    684,668    734,530    774,774 
Investment securities   246,174    275,979    286,164    246,582    256,464 
Deposits   939,254    834,462    838,373    829,951    868,146 
Total shareholders' equity   134,274    132,949    99,711    95,123    91,418 
Average shares outstanding - basic   12,015    9,205    6,051    6,008    5,978 
Average shares outstanding - diluted   17,255    9,205    6,051    6,008    5,978 
                          
Performance Ratios:                         
Return on average assets   0.35%   -0.39%   0.18%   0.03%   -1.11%
Return on average common shareholders' equity   3.96%   -4.98%   2.66%   0.40%   -15.36%
Efficiency ratio (1)   80.99%   79.46%   79.09%   76.63%   79.89%
Average equity to average assets   12.85%   11.13%   9.13%   8.79%   9.40%
Asset Quality Ratios:                         
Allowance for loan losses to period end loans   1.59%   2.25%   2.97%   3.28%   3.26%
Allowance for loan losses to nonaccrual loans   196.63%   134.03%   171.29%   79.56%   97.80%
Nonperforming assets to period end loans and other real estate owned   1.04%   1.80%   2.41%   5.09%   5.00%
Net charge-offs to average loans   0.28%   1.11%   1.32%   1.32%   1.89%
                          
Capital Ratios:                         
Leverage capital ratio   10.76%   12.06%   8.13%   7.67%   7.38%
Tier 1 risk-based capital   14.06%   18.22%   12.64%   11.23%   10.51%
Total risk-based capital   15.31%   19.48%   13.88%   12.47%   11.70%

 

Note:(1) Efficiency ratio is computed by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, net of gains or losses.

 

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

 

This commentary provides an overview of the Company’s financial condition as of December 31, 2014 and 2013, and changes in financial condition and results of operations for the years 2012 through 2014. This section of the Form 10-K should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included under Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.

 

Forward Looking Statements

 

Certain statements contained in this Annual Report on Form 10-K that are not historical facts may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to products or services, the performance or disposition of portions of the Company’s asset portfolio, future changes to the Bank’s branch network, and the payment of dividends; (iii) statements of future financial performance and economic conditions; (iv) statements regarding the adequacy of the allowance for loan losses; (v) statements regarding the effect of future sales of foreclosed properties; (vi) statements regarding the Company’s liquidity; (vii) statements of management’s expectations regarding future trends in interest rates, real estate values, and economic conditions generally and in the Company’s markets; (viii) statements regarding future asset quality, including expected levels of charge-offs; (ix) statements regarding potential changes to laws, regulations or administrative guidance; (x) statements regarding strategic initiatives of the Company or the Bank and the results of these initiatives, including the Company’s acquisition of VCB and transactions to redeem or refinance the Company’s Series A Preferred Stock; and (xi) statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” “continue,” “remain,” “will,” “should,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

 

qfactors that adversely affect our business initiatives, including the Company’s acquisition and integration of VCB, and other factors that could impact the business of the combined organization, including, without limitation, changes in the economic or business conditions in the Company’s markets;
qour ability and efforts to assess, manage and improve asset quality;
qthe strength of the economy in the Company’s target market area, as well as general economic, market, political, or business factors;
qchanges in the quality or composition of our loan or investment portfolios, including adverse developments in borrower industries, decline in real estate values in our markets, or in the repayment ability of individual borrowers or issuers;
qthe effects of our adjustments to the composition of our investment portfolio;
qthe impact of government intervention in the banking business;
qan insufficient allowance for loan losses;
qour ability to meet the capital requirements of our regulatory agencies;
qchanges in laws, regulations and the policies of federal or state regulators and agencies, including the Basel III Final Rules;
qchanges in the interest rates affecting our deposits and loans;
qthe loss of any of our key employees;
qchanges in our competitive position, competitive actions by other financial institutions and the competitive nature of the financial services industry and our ability to compete effectively against other financial institutions in our banking markets;
qour potential growth, including our entrance or expansion into new markets, the opportunities that may be presented to and pursued by us and the need for sufficient capital to support that growth;
qchanges in government monetary policy, interest rates, deposit flow, the cost of funds, and demand for loan products and financial services;
qour ability to maintain internal control over financial reporting;

 

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qour ability to realize our deferred tax assets, including in the event the Company experiences an ownership change as defined by section 382 of the Code;
qour ability to raise capital as needed by our business;
qour reliance on secondary sources, such as Federal Home Loan Bank advances, sales of securities and loans, federal funds lines of credit from correspondent banks and out-of-market time deposits, to meet our liquidity needs; and
qother circumstances, many of which are beyond our control.

 

Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. The reader should refer to risks detailed under Item 1A. “Risk Factors” included above in this Form 10-K and in our periodic and current reports filed with the SEC for specific factors that could cause our actual results to be significantly different from those expressed or implied by our forward-looking statements.

 

Critical Accounting Policies

 

The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.

 

Allowance for Loan Losses

 

The Company establishes the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. For more information see the section titled “Asset Quality” within Item 7.

 

Impairment of Loans

 

The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due, according to the contractual terms of the loan agreement. The Company does not consider a loan impaired during a period of insignificant payment shortfalls if we expect the ultimate collection of all amounts due. Impairment is measured on a loan by loan basis for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans, representing consumer, one to four family residential first and seconds and home equity lines, are collectively evaluated for impairment. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. Troubled debt restructurings (“TDRs”) are also considered impaired loans. A TDR occurs when the Company, for economic or legal reasons related to the borrower’s financial condition, grants a concession (including, without limitation, rate reductions to below-market rates, payment deferrals, forbearance and, in some cases, forgiveness of principal or interest) to the borrower that it would not otherwise consider. For more information see the section titled “Asset Quality” within this Item 7.

 

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Loans Acquired in a Business Combination

 

The Company accounts for loans acquired in a business combination, such as the Company’s acquisition of VCB, in accordance with the FASB Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations.” Accordingly, acquired loans are segregated between purchased credit-impaired (“PCI”) loans and purchased performing loans and are recorded at estimated fair value on the date of acquisition without the carryover of the related allowance for loan losses.

 

PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair market value, PCI loans were aggregated into pools of loans based on common characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income. Loans not designated PCI loans as of the acquisition date are designated purchased performing loans. The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing or PCI loans. A provision for loan losses is recorded for any deterioration in these loans subsequent to the acquisition.

 

Impairment of Securities

 

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company’s best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.

 

Other Real Estate Owned

 

Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at estimated fair market value of the property, less estimated disposal costs, if any. Any excess of cost over the estimated fair market value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings.

 

Goodwill

 

With the adoption of FASB Accounting Standards Update (“ASU”) 2011-08, “Intangible-Goodwill and Other-Testing Goodwill for Impairment,” the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis were discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company chose to bypass the preliminary assessment of qualitative impairment factors and completed its annual goodwill impairment test during the fourth quarter of 2014 through the use of a independent third party specialist and determined there was no impairment to be recognized in 2014. If the underlying estimates and related assumptions change in the future, the Company may be required to record impairment charges.

 

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Retirement Plan

 

The Company has historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.

 

Accounting for Income Taxes

 

Determining the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company’s tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

 

The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized.  “More likely than not” is defined as greater than a 50% chance.  Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed. For more information, see Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”

 

For further information concerning accounting policies, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 1. Summary of Significant Accounting Policies.”

 

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Business Overview

 

The Company provides a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.

 

The Company is committed to delivering strong long-term earnings using a prudent allocation of capital, in business lines where we have demonstrated the ability to compete successfully. During 2014, the national and local economies continued to show measured signs of recovery with the main challenges continuing to be persistent unemployment above historical levels and uneven economic growth. Macro-economic and political issues continue to temper the global economic outlook and as such the Company remains cautiously optimistic regarding the limited signs of improvement seen in our local markets. Despite this, the Company believes that our local markets are poised for stronger growth in the coming months and years than the economic recovery has provided in our markets in recent periods.

 

Since 2013 the Company has completed strategic initiatives that have significantly improved the Company’s financial condition. These initiatives represent significant progress toward the Company’s long-term goal of growing a more robust community banking business, and will provide the platform for continued growth and success in future periods. These initiatives include:

 

·Raising in 2013 an aggregate of $50.0 million of gross proceeds from sales of the Company’s common stock and Series B Preferred Stock in private placements to certain institutional investors ($45.0 million in gross proceeds) and a rights offering to existing shareholders ($5.0 million of gross proceeds) (collectively, the “2013 Capital Initiative”);
·Using a portion of the proceeds from the 2013 Capital Initiative to prepay long-term, higher-rate FHLB advances and to accelerate the disposition of adversely classified assets;
·Paying all current and previously deferred interest and all current and previously deferred, but accumulated, dividends on the Company’s trust preferred securities and Series A Preferred Stock, respectively;
·Redeeming 10,000 shares of the Company’s Series A Preferred Stock in October 2014, and redeeming an additional 5,000 shares of the Company’s Series A Preferred Stock in January 2015, which significantly reduced one of the Company’s most expensive sources of capital;
·Acquiring Virginia Company Bank (or “VCB”) effective November 14, 2014, thus adding three branches to the Bank’s branch network and an aggregate of $128.9 million of assets to the Company’s balance sheet. All former VCB branches have been fully integrated into EVB’s branch network and operate as branches of the Bank, expanding the Bank’s branch network into the Virginia cities of Hampton, Newport News and Williamsburg;
·Opening a loan production office in Chesterfield County, Virginia to increase the Bank’s presence in the Richmond metropolitan area; and
·Declaring a dividend of $0.01 per share to holders of the Company’s common stock and Series B Preferred Stock as of March 6, 2015, which was paid on March 20, 2015.

 

The Company expects to recognize the continued benefits of these initiatives during 2015, including through lower interest expense related to the extinguished FHLB advances, lower dividends paid on the Company’s Series A Preferred Stock, additional interest income and cost savings related to the acquisition of VCB, and positive contributions to the Company’s loan portfolio generated by the three branches acquired from VCB and the Chesterfield County, Virginia loan production office. During 2015 the Company also plans to continue its focus on developing online and mobile banking options and offering these products and services to the Bank’s customers.

 

While the Company has largely worked through the economic challenges of the past few years and believes that it is positioned for future success, in significant part due to the successful execution of the strategic initiatives summarized above, the Company will continue to evaluate business development and other strategic initiatives and opportunities it identifies during 2015. These opportunities and initiatives could include opportunities to grow the Company’s business or strengthen the Bank’s branch network in existing or new markets. The Company also intends to complete the repayment of its Series A Preferred Stock during the first half of 2015.

 

33
 

 

Summary of 2014 Operating Results and Financial Condition

 

Table 1: Performance Summary

 

   Years Ended December 31, 
(dollars in thousands, except per share data)  2014   2013 
Net income (loss) (1)  $5,664   $(2,632)
Net income (loss) available to common shareholders (1)  $3,716   $(4,136)
Basic income (loss) per common share  $0.31   $(0.45)
Diluted income (loss) per common share  $0.22   $(0.45)
Return on average assets   0.35%   -0.39%
Return on average common shareholders' equity   3.96%   -4.98%
Net interest margin (tax equivalent basis) (2)   3.85%   3.46%

 

(1) The difference between net income (loss) and net income (loss) available to common shareholders is the effective dividend to holders of the Company’s Series A Preferred Stock.

(2) For more information on the calculation of net interest margin on a tax equivalent basis, see the average balance sheet and net interest margin analysis for the years ended December 31, 2014 and 2013 contained in "Results of Operations" in this Item 7.

 

The Company’s results for the year ended December 31, 2014 were directly impacted by legal and professional fees and integration costs of $1.8 million related to the acquisition of VCB, which was effective on November 14, 2014. While the majority of these merger-related expenses have been recognized in 2014, the Company believes that additional legal and other transition expenses related to this acquisition will likely be incurred during the first half of 2015. Additionally, the Company’s results continue to be positively impacted by asset quality improvements and the extinguishment of long-term FHLB advances in the third quarter of 2013, as discussed in greater detail below. The prepayment of these advances has significantly improved the Company’s financial position and net interest margin for the twelve months ended December 31, 2014 as compared to the twelve months ended December 31, 2013.

 

For the year ended December 31, 2014, the following key points were significant factors in our reported results:

 

·Loss of $11.5 million on the extinguishment of $107.5 million in long-term FHLB advances in 2013 with no such prepayment or loss present in 2014;
·Increase in net interest income of $3.5 million compared to 2013, principally due to a $3.6 million decrease in interest expense, partially offset by a slight decrease in interest on investment securities;
·Net interest margin (tax equivalent basis) increased 39 basis points to 3.85% for 2014 as compared to 3.46% for 2013;
·Provision for loan losses of $250 thousand compared to $1.9 million in 2013, reflecting a reduction in net charge-offs to $2.0 million for 2014, from $7.4 million in 2013;
·Decrease in nonperforming assets of $3.3 million at December 31, 2014 as compared to December 31, 2013, due to the Company’s continued focus on credit quality initiatives to improve its asset quality and resolve nonperforming assets, which was principally reflected by a decline in nonaccrual loans;
·Operating results were impacted by accounting adjustments which were recorded in relation to the VCB acquisition. As a result, yields on loans acquired increased and were partially offset by amortization of the core deposit intangible and the time deposit premium. The net accretion attributable to these adjustments was $197 thousand;
·Gain of $538 thousand on the sale of available for sale securities during 2014 as compared to $1.5 million in 2013;
·Gain of $224 thousand on the sale of our former Bowling Green branch office in 2013 with no such gain present in 2014;
·Expenses related to FDIC insurance premiums of $921 thousand in 2014, compared to $1.8 million for 2013;
·Loss of $78 thousand on the sale of other real estate owned during 2014 as compared to $775 thousand in 2013;
·Impairment losses on other real estate owned of $24 thousand during 2014 as compared to $585 thousand in 2013;
·Other operating expenses increased $3.0 million during 2014 as compared to 2013 due to increases in marketing, consulting fees, franchise taxes, data processing and internet banking expenses, and the Company incurred legal and professional fees and integration costs of approximately $1.8 million associated with the acquisition of Virginia Company Bank during 2014; and
·Increase in the effective dividend on preferred stock of $444 thousand from 2013. This was due primarily to the dividend rate of the Company’s Series A Preferred Stock increasing from 5% to 9% in the first quarter of 2014, partially offset by the redemption of 10,000 shares of the Series A Preferred Stock on October 15, 2014.

 

34
 

 

Results of Operations

 

The table below lists our quarterly performance for the years ended December 31, 2014 and 2013.

 

TABLE 2: SUMMARY OF FINANCIAL RESULTS BY QUARTER

 

   Three Months Ended   Three Months Ended 
   2014   2013 
(dollars in thousands)  Dec. 31   Sep. 30   June 30   Mar. 31   Dec. 31   Sep. 30   June 30   Mar. 31 
Interest and dividend income  $11,261   $10,084   $10,197   $10,376   $10,262   $10,552   $10,633   $10,577 
Interest expense   1,085    1,121    1,107    1,115    1,179    1,821    2,505    2,540 
Net interest income   10,176    8,963    9,090    9,261    9,083    8,731    8,128    8,037 
Provision for loan losses   -    -    -    250    300    350    600    600 
Net interest income after provision for loan losses   10,176    8,963    9,090    9,011    8,783    8,381    7,528    7,437 
Noninterest income   1,539    1,605    1,639    1,892    2,555    1,795    1,450    1,948 
Noninterest expenses   10,479    8,628    8,519    8,178    8,185    20,555    8,205    7,956 
Income (loss) before income taxes   1,236    1,940    2,210    2,725    3,153    (10,379)   773    1,429 
Income tax expense (benefit)   505    658    555    729    892    (3,733)   100    349 
Net income (loss)  $731   $1,282   $1,655   $1,996   $2,261   $(6,646)  $673   $1,080 
Less:  Effective dividend on preferred stock   349    540    541    518    376    376    376    376 
Net income (loss) available to common shareholders  $382   $742   $1,114   $1,478   $1,885   $(7,022)  $297   $704 
                                         
Income (loss) per common share: basic  $0.03   $0.06   $0.10   $0.12   $0.16   $(0.60)  $0.04   $0.12 
Income (loss) per common share: diluted  $0.03   $0.04   $0.06   $0.09   $0.11   $(0.60)  $0.04   $0.12 

 

Net Interest Income and Net Interest Margin

 

Net interest income, the fundamental source of the Company’s earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and investment securities, while deposits, short-term borrowings, long-term borrowings and trust preferred debt represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations and the yield of our interest earning assets compared to our cost of funding these assets.

 

Table 3 presents the average interest earning assets and average interest bearing liabilities, the average yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the indicated periods. The variance in interest income and expense caused by differences in average balances and rate is shown in Table 4.

 

For comparative purposes, income from tax-exempt securities is adjusted to a tax-equivalent basis using the federal statutory tax rate of 34% and adjusted by the Tax Equity and Fiscal Responsibility Act adjustment. This latter adjustment is for the disallowance as a deduction of a portion of total interest expense related to the ratio of average tax-exempt securities to average total assets. By making these adjustments, tax-exempt income and their yields are presented on a comparable basis with income and yields from fully taxable earning assets. The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets, and represents the Company’s net yield on its earning assets. Net interest margin is an indicator of the Company’s effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competitive pressures, Federal Reserve Board policies and the economy. The spread that can be earned between interest earning assets and interest bearing liabilities is also dependent to a large extent on the slope of the yield curve, which in recent periods has been significantly impacted by initiatives of the Federal Reserve Board intended to lower interest rates.

 

35
 

 

Table 3: Average Balance Sheet and Net Interest Margin Analysis

 

   Year Ended December 31, 
  2014   2013   2012 
   Average   Income/   Yield/   Average   Income/   Yield/   Average   Income/   Yield/ 
(dollars in thousands)  Balance   Expense   Rate (1)   Balance   Expense   Rate (1)   Balance   Expense   Rate (1) 
Assets:                                             
Securities                                             
Taxable  $232,639   $5,171    2.22%  $250,474   $5,443    2.17%  $236,917   $4,656    1.97%
Restricted securities   7,075    387    5.47%   7,796    323    4.14%   9,590    333    3.47%
Tax exempt (2)   28,466    1,133    3.98%   23,857    959    4.02%   14,858    670    4.51%
Total securities   268,180    6,691    2.49%   282,127    6,725    2.38%   261,365    5,659    2.17%
Interest bearing deposits in other banks   7,354    18    0.24%   39,537    105    0.27%   23,123    56    0.24%
Federal funds sold   191    -    0.00%   162    -    0.00%   227    -    0.00%
Loans, net of unearned income (3)   706,812    35,555    5.03%   669,520    35,487    5.30%   714,254    39,561    5.54%
Total earning assets   982,537    42,264    4.30%   991,346    42,317    4.27%   998,969    45,276    4.53%
Less allowance for loan losses   (14,547)             (18,527)             (23,273)          
Total non-earning assets   100,162              97,047              92,332           
Total assets  1,068,152             1,069,866             1,068,028           
                                              
Liabilities & Shareholders' Equity:                               
Interest-bearing deposits                                             
Checking  $262,765   $949    0.36%  $248,675   $929    0.37%  $229,605   $1,205    0.52%
Savings   90,015    120    0.13%   90,065    142    0.16%   85,476    239    0.28%
Money market savings   120,541    498    0.41%   123,559    515    0.42%   124,724    613    0.49%
Large dollar certificates of deposit (4)   99,521    1,187    1.19%   120,852    1,574    1.30%   131,862    2,139    1.62%
Other certificates of deposit   126,274    1,156    0.92%   129,654    1,516    1.17%   144,975    2,203    1.52%
Total interest-bearing deposits   699,116    3,910    0.56%   712,805    4,676    0.66%   716,642    6,399    0.89%
Federal funds purchased and repurchase agreements   4,698    28    0.60%   3,489    21    0.60%   3,649    32    0.88%
Short-term borrowings   72,565    151    0.21%   16,963    38    0.22%   318    1    0.31%
Long-term borrowings   -    -    0.00%   73,278    2,958    4.04%   117,500    4,775    4.06%
Trust preferred debt   10,310    339    3.29%   10,310    352    3.41%   10,310    361    3.50%
Total interest-bearing liabilities   786,689    4,428    0.56%   816,845    8,045    0.98%   848,419    11,568    1.36%
Noninterest-bearing liabilities                                             
Demand deposits   139,991              127,211              114,597           
Other liabilities   4,171              6,732              7,538           
Total liabilities   930,851              950,788              970,554           
Shareholders' equity   137,301              119,078              97,474           
Total liabilities and shareholders' equity  $1,068,152             $1,069,866             $1,068,028           
                                              
Net interest income (2)       $37,836             $34,272             $33,708      
                                              
Interest rate spread  (2)(5)             3.74%             3.29%             3.17%
Interest expense as a percent of average earning assets             0.45%             0.81%             1.16%
Net interest margin (2)(6)             3.85%             3.46%             3.37%

 

Notes:

(1) Yields are based on average daily balances.

(2) Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%, with an

adjustment of $346, $293 and $205 in 2014, 2013 and 2012, respectively.

(3) Nonaccrual loans have been included in the computations of average loan balances.

(4) Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.

(5) Interest rate spread is the average yield on earning assets, calculated on a fully taxable basis, less the average

rate incurred on interest-bearing liabilities.

(6) Net interest margin is the net interest income, calculated on a fully taxable basis,

expressed as a percentage of average earning assets.

 

36
 

 

2014 compared with 2013

 

Net interest income

Net interest income for the year ended December 31, 2014 increased $3.5 million, or 10.3%, when compared to the same period in 2013. The Company’s net interest margin increased to 3.85% for the year ended December 31, 2014, representing a 39 basis point increase over the Company’s net interest margin for the year ended December 31, 2013. The most significant factors impacting net interest income during 2014 were as follows:

 

Positive Impacts:

·Acquisition of VCB and the related loans and deposits;
·Increasing average loan balances primarily due to the acquisition of VCB, the acquisition of $27.2 million of performing mortgage loans, the opening of a new loan production office in Chesterfield County, Virginia and the origination of a line of credit to fund originations through Southern Trust Mortgage, LLC;
·Extinguishment of higher-rate long-term FHLB advances during the third quarter of 2013, which drove declines in the Company’s interest expense and rate paid on average interest-bearing liabilities; and
·Decreases in the average balances of and average rates paid on total interest-bearing deposits for the year ended December 31, 2014.

 

Negative Impacts:

·Decreasing yields on the Company’s loan portfolio;
·Decreases in the average balances of total investment securities, but partially offset by higher average rates earned during 2014 as compared to 2013; and
·Decreases in average short-term investment balances for the year ended December 31, 2014.

 

Total interest and dividend income

 

Total interest and dividend income decreased 0.3% for the year ended December 31, 2014, as compared to the same period in 2013. The slight decrease in total interest was primarily driven by declines in the yield on the loan portfolio and a decrease in average investment securities. These declines were mostly offset by higher yields on investment securities and higher average loan balances.

 

Loans

 

Average loan balances increased for the year ended December 31, 2014, as compared to the same period in 2013, due primarily to the acquisition of VCB loans totaling $101.5 million, net of credit and liquidity marks, the purchase of $27.2 million in performing one-to-four family residential loans in the first quarter of 2014, the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014, and the origination of a line of credit to fund loan originations through Southern Trust Mortgage, LLC (balance of $10.9 million as of December 31, 2014) in the second quarter of 2014. These additions to the Company’s loan portfolio were partially offset by weak loan demand in the Company’s markets as a result of continuing challenging economic conditions, such that the Company’s average loan balances increased $37.3 million for the year ended December 31, 2014, as compared to the same period in 2013. In addition, due to the continuing low interest rate environment and competitive pressures, loans were originated during the full year 2014 at much lower yields than seasoned loans in the Company’s loan portfolio, which has contributed significantly to average yields on the loan portfolio declining 27 basis points for the year ended December 31, 2014, as compared to the same period in 2013. Total average loans were 71.9% of total average interest-earning assets for the year ended December 31, 2014, as compared to 67.5% for the same period in 2013.

 

Investment securities

 

Average investment securities balances declined 4.9% for the year ended December 31, 2014, as compared to the same period in 2013, due to the Company’s efforts to rebalance the securities portfolio and provide additional liquidity, while yields on investment securities increased 11 basis points for the year ended December 31, 2014, as compared to the same period in 2013. Increasing yields on the investment securities portfolio were driven by increases in interest rates from 2013 to 2014 and portfolio rebalancing efforts during late 2013 and the first half of 2014, which largely consisted of accelerated prepayments on lower yield Agency mortgage-backed and Agency CMO securities and allocating a greater proportion of the portfolio to SBA Pool securities and higher yielding, longer duration municipal securities. The decline in average investment securities was also driven by the Company’s decision, in light of the low rate environment, to permit the investment securities portfolio to run off during 2014 and deploy proceeds received from investment securities in other segments of the Company’s balance sheet.

 

37
 

 

Interest bearing deposits in other banks

 

Average interest bearing deposits in other banks decreased significantly for the year ended December 31, 2014, as compared to the same period in 2013, due to the overall decrease in our average total deposits, the purchase of $27.2 million in performing one-to-four family mortgage loans in the first quarter of 2014 and declines in average total borrowings that were largely due to extinguishing the Company’s long-term FHLB advances during the third quarter of 2013.

 

Interest bearing deposits

 

Average total interest bearing deposit balances and related rates paid decreased for the year ended December 31, 2014, as compared to the same period in 2013, contributing to the reduction in interest expense during 2014 compared to 2013. Retail deposits continued to shift from higher priced certificates of deposit and money market savings accounts to lower priced checking (“NOW”) accounts.

 

Borrowings

 

Average total borrowings and related rates paid decreased for the year ended December 31, 2014, as compared to the same period in 2013, significantly driving the reduction in interest expense in the full year 2014. Average total borrowings and related rates paid decreased primarily due to the extinguishment of higher rate long-term FHLB advances during the third quarter of 2013. The long-term FHLB advances were replaced with short-term FHLB advances at a significantly lower rate.

 

2013 compared with 2012

 

Net interest income

 

Net interest income for the year ended December 31, 2013 increased $476 thousand or 1.4% to $34.0 million, down from $33.5 million for the year ended December 31, 2012. The Company’s net interest margin increased by 9 basis points from 3.37% for the year ended December 31, 2012 to 3.46% for the same period of 2013. The most significant factors impacting net interest income during this period were as follows:

 

Positive Impacts:

·Decreases to the cost of all categories of interest-bearing liabilities and increases to the balances of low-yielding deposits and short-term FHLB advances as funding sources; and
·The Company’s expansion of its investment securities portfolio funded by excess liquidity, and increased yields on investment securities.

 

Negative Impacts:

·Declining loan balances, and decreasing yields on the Company’s loan portfolio.

 

Total interest and dividend income

 

Total interest and dividend income decreased 6.8% for the year ended December 31, 2013, as compared to the same period in 2012, primarily as the result of reduced yields on the loan portfolio, a significant decrease in average loan balances and a significant increase in average short term investments partially offset by higher average balances and yields on investment securities.

 

Loans

 

Average total loan balances decreased $44.7 million from $714.3 million for the year ended December 31, 2012, to $669.5 million for the same period in 2013, with a contemporary 24 basis point decline in the yield on the average loan portfolio resulting in a $4.1 million decline in interest income generated by the Company’s largest earning asset category. These declines were due primarily to weak loan demand in our markets as a result of the challenging economic conditions, adjustments to our variable rate loans in the low interest rate environment, charge-offs, payment curtailments on outstanding loans and the sale of our credit card portfolio in September 2012. In addition, due to the historically low interest rate environment, although slightly rising beginning in the latter portion of the second quarter of 2013 and through the end of 2013, and intensified loan competition in our markets, loans were originated during 2012 and 2013 at much lower yields which has contributed significantly to lower yields on the loan portfolio during 2013.

 

38
 

 

Investment securities

 

Average investment security balances increased 7.9% for the year ended December 31, 2013, as compared to the same period in 2012, due to the Company’s efforts to rebalance the securities portfolio and deploy excess liquidity, while yields on investment securities increased 21 basis points for the year ended December 31, 2013, as compared to the same period in 2012. The higher yield resulted from investment portfolio restructurings, accelerated prepayments on our Agency mortgage-backed and Agency CMO securities, principally due to the low rate environment and incentives for homeowners to refinance higher-rate mortgages, in the prior year compared to the current year, and our decision to invest in the second quarter of 2013 in higher yielding, longer duration municipal securities.

 

Interest bearing deposits in other banks

 

Average interest bearing deposits in other banks increased significantly for the year ended December 31, 2013, as compared to the same period in 2012, due to the overall increase in our average total deposits and difficulty strategically deploying excess liquidity, including a portion of the proceeds generated by the 2013 Capital Initiative, in the low interest rate environment, and in particular difficulty funding new loans to creditworthy borrowers and identifying investment securities with suitable rates of return.

 

Interest bearing deposits

 

Average total interest bearing deposit balances and related rates paid decreased for the year ended December 31, 2013, as compared to the same period in 2012, contributing to the reductions in interest expense. Retail deposits continued to shift from higher priced certificates of deposit to lower priced checking (or “NOW” accounts) and savings accounts.

 

Borrowings

 

Average total borrowings and related rates decreased for the year ended December 31, 2013, as compared to the same period in 2012, significantly driving the reduction in interest expense. Average total borrowings and related rates paid decreased primarily due to the extinguishment of higher rate long-term FHLB advances during the third quarter of 2013. The long-term FHLB advances were replaced with short-term FHLB advances at a significantly lower rate and lower principal balance.

 

As the largest component of income, net interest income represents the amount that interest and fees earned on loans and investments exceeds the interest costs of funds used to support these earning assets. Net interest income is determined by the relative levels, rates and mix of earning assets and interest bearing liabilities. The following table attributes changes in net interest income either to changes in average volume or to rate changes in proportion to the relationship of the absolute dollar amount of the change in each.

 

39
 

 

Table 4: Volume and Rate Analysis (1)

 

   2014 from 2013   2013 from 2012 
   Increase (Decrease)   Increase (Decrease) 
   Due to Changes in:   Due to Changes in: 
(dollars in thousands)  Volume   Rate   Total   Volume   Rate   Total 
Interest income:                              
Securities:                              
Taxable  $(402)  $130   $(272)  $296   $491   $787 
Restricted securities   (53)   117    64    (460)   450    (10)
Tax exempt (2)   183    (9)   174    352    (63)   289 
Total securities   (272)   238    (34)   188    878    1,066 
Interest bearing deposits in other banks   (76)   (11)   (87)   41    8    49 
Federal funds sold   -    -    -    -    -    - 
Loans, net of unearned income   797    (729)   68    (2,404)   (1,670)   (4,074)
Total interest income   449    (502)   (53)   (2,175)   (784)   (2,959)
                               
Interest expense:                              
Interest-bearing deposits:                              
Checking   44    (24)   20    109    (385)   (276)
Savings   5    (27)   (22)   12    (109)   (97)
Money market savings   (5)   (12)   (17)   (11)   (87)   (98)
Large dollar certificates of deposit (3)   (262)   (125)   (387)   (168)   (397)   (565)
Other certificates of deposit   (43)   (317)   (360)   (216)   (471)   (687)
Total interest-bearing deposits   (261)   (505)   (766)   (274)   (1,449)   (1,723)
Federal funds purchased and repurchase agreements   7    -    7    (1)   (10)   (11)
Short-term borrowings   115    (2)   113    37    -    37 
Long-term borrowings   (2,958)   -    (2,958)   (1,794)   (23)   (1,817)
Trust preferred debt   -    (13)   (13)   -    (9)   (9)
Total interest expense   (3,097)   (520)   (3,617)   (2,032)   (1,491)   (3,523)
Change in net interest income  $3,546   $18   $3,564   $(143)  $707   $564 

 

Notes:

(1) Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.

(2) Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.

(3) Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.

 

Interest Sensitivity

 

Our primary goals in interest rate risk management are to minimize negative fluctuations in net interest margin as a percentage of earning assets and to increase the dollar amount of net interest income at a growth rate consistent with the growth rate of total assets. These goals are accomplished by managing the interest sensitivity gap, which is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. Interest sensitivity gap is managed by balancing the volume of floating rate liabilities with a similar volume of floating rate assets, by keeping the fixed rate average maturity of asset and liability contracts reasonably consistent and short, and by routinely adjusting pricing to market conditions on a regular basis.

 

The Company strives to maintain a position flexible enough to move to a balanced position between rate-sensitive assets and rate-sensitive liabilities, which may be desirable when there are wide and frequent fluctuations in interest rates. Matching the amount of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact on net interest income in periods of rising or falling interest rates. Interest rate gaps are managed through investments, loan pricing and deposit pricing strategies. When an unacceptable positive gap within a one-year time frame occurs, maturities can be extended by selling shorter-term investments and purchasing longer maturities. When an unacceptable negative gap occurs, variable rate loans can be increased (subject to customer demand for these loans) and greater investment in shorter-term investments can be made.

 

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The Company believes that it will be a challenge for the Company to maintain its net interest margin at its current level if funds obtained from loan and investment security repayments, as well as any deposit growth, cannot be fully used to originate new loans and are instead reinvested in lower-yield earning assets, and if reductions in earning asset yields exceeds interest rate declines in interest-bearing liabilities. As the economy remains on an uneven recovery and with continued lack of quality loan demand in our markets coupled with competitive pressures, the Company has focused on restructuring the investment portfolio and recognized some gains on the disposition of securities held due to an increase in prices as rates have continued to fall. With the expectation that interest rates will not change significantly during 2015 and that they will likely remain low for an extended period of time, the Company continues to redeploy its excess funds in the investment portfolio with a focus on securities that provide steady cash flow at a low risk weighting to maximize earnings until loan demand returns. Given this limited earnings environment and the low yields on investment securities, the Company has continued to lower its deposit and other funding costs to offset the overall compression of our margins.

 

Noninterest Income

 

Noninterest income is comprised of all sources of income other than interest income on our earning assets. Significant revenue items include fees collected on certain deposit account transactions, debit and credit card fees, other general services, earnings from other investments we own in part or in full and gains or losses on sales of investments, loans, and fixed assets.

 

The following table depicts the components of noninterest income for the years ended December 31, 2014 and 2013:

 

Table 5: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2014   2013   Change $   Change % 
Service charges and fees on deposit accounts  $3,257   $3,286   $(29)   -0.9%
Debit/credit card fees   1,416    1,469    (53)   -3.6%
Gain on sale of available for sale securities, net   538    1,507    (969)   -64.3%
Gain on sale of bank premises and equipment   6    249    (243)   -97.6%
Other operating income   1,458    1,237    221    17.9%
Total noninterest income  $6,675   $7,748   $(1,073)   -13.8%

 

2014 Compared to 2013

 

Key changes in the components of noninterest income for the year ended December 31, 2014, as compared to the same period in 2013, are discussed below:

 

·Service charges and fees on deposit accounts decreased due to decreases in service charge and overdraft fees on checking accounts;
·Gain on sale of available for sale securities, net decreased as the Company recognized gains during the fourth quarter of 2013 primarily due to the sale of a portion of its previously impaired agency preferred securities (FNMA &FHLMC), and the Company did not generate comparable gains during 2014;
·Gain on sale of bank premises and equipment decreased as the Company sold its former Bowling Green branch office during the third quarter of 2013 (which generated a gain of $224 thousand) with no such gain being recognized during 2014; and
·Other operating income increased for the year ended December 31, 2014, as compared to the same period in 2013, primarily due to higher earnings from sales of insurance products through Bankers Insurance, LLC and higher earnings from bank owned life insurance policies during 2014. Additionally, other operating income for 2014 includes earnings from the Bank’s investments in Southern Trust Mortgage, LLC (acquired 4.9% ownership on May 15, 2014) and Bankers Title, LLC (acquired 6.0% ownership on October 1, 2014).

 

41
 

 

The following table depicts the components of noninterest income for the years ended December 31, 2013 and 2012:

 

Table 5A: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2013   2012   Change $   Change % 
Service charges and fees on deposit accounts  $3,286   $3,239   $47    1.5%
Debit/credit card fees   1,469    1,557    (88)   -5.7%
Gain on sale of available for sale securities, net   1,507    3,875    (2,368)   -61.1%
Gain (loss) on sale of bank premises and equipment   249    (1)   250    25000.0%
Gain on sale of loans   -    197    (197)   -100.0%
Other operating income   1,237    1,031    206    20.0%
Total noninterest income  $7,748   $9,898   $(2,150)   -21.7%

 

2013 Compared to 2012

 

Key changes in the components of noninterest income for the year ended December 31, 2013, as compared to the same period in 2012, are discussed below:

 

·Gain on sale of available for sale securities, net decreased in 2013 as compared to the same period in 2012. During 2012 the Company strategically adjusted the composition of its investment portfolio by reducing its holdings of tax-exempt securities in an effort to increase the Company’s source of taxable income. To implement this strategy the Company sold tax-exempt securities issued by state and political subdivisions during 2012, many of which were in an unrealized gain position at the time of sale due to the low interest rate environment during 2012, which was principally due to current economic conditions and monetary policies of the Federal Reserve to further reduce interest rates. During 2013, the Company sold a portion of its previously impaired agency preferred securities (FNMA & FHLMC). The Company sold these securities to remove classified assets from the balance sheet and increase the Company’s sources of taxable income;
·Gain (loss) on sale of bank premises and equipment increased $250 thousand in 2013 as compared to the same period in 2012 due to the sale of our former Bowling Green branch office during the third quarter of 2013 which generated a gain of $224 thousand;
·Gain on sale of loans was $197 thousand in 2012 as the result of the sale of our credit card loan portfolio, while no such sales occurred during 2013; and
·Other operating income increased by $206 thousand in 2013 as compared to 2012. This was driven by a 21.4% increase in investment services income, a 44.3% increase in income from bank owned life insurance due to our additional $10.0 million investment in bank owned life insurance in the second quarter of 2013, and a 26.4% decrease in write downs of our investments in community and housing development funds.

 

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Noninterest Expense

 

Noninterest expense includes all expenses with the exception of those paid for interest on borrowings and deposits. Significant expense items included in this component are salaries and employee benefits, occupancy and other operating expenses.

 

The following table depicts components of noninterest expense for the years ended December 31, 2014 and 2013:

 

Table 6: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2014   2013   Change $   Change % 
Salaries and employee benefits  $18,982   $17,156   $1,826    10.6%
Occupancy and equipment expenses   5,109    5,226    (117)   -2.2%
Telephone   992    1,142    (150)   -13.1%
FDIC expense   921    1,765    (844)   -47.8%
Consultant fees   1,395    1,051    344    32.7%
Collection, repossession and other real estate owned   323    540    (217)   -40.2%
Marketing and advertising   1,005    787    218    27.7%
Loss on sale of other real estate owned   78    775    (697)   -89.9%
Impairment losses on other real estate owned   24    585    (561)   -95.9%
Loss on extinguishment of debt   -    11,453    (11,453)   -100.0%
Merger and merger related expenses   1,831    -    1,831    100.0%
Other operating expenses   5,144    4,421    723    16.4%
Total noninterest expenses  $35,804   $44,901   $(9,097)   -20.3%

 

2014 Compared to 2013

 

Key changes in the components of noninterest expense for the year ended December 31, 2014, as compared to the same period in 2013, are discussed below:

 

·Salaries and employee benefits increased due to annual merit increases, increased restricted stock expense, lower deferred compensation on loan originations and higher group term insurance costs, partially offset by an increase in the actuarial pension benefit recognized. Additionally, the Bank incurred higher personnel costs in 2014 associated with increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB;
·Telephone decreased primarily due to changing vendors in 2014;
·FDIC insurance expense decreased due to lower base assessment rates resulting from the improvement in the Bank’s overall composite rating in connection with the termination of the Written Agreement in July 2013, and corresponding decreases in FDIC insurance assessment rates during 2014;
·Consultant fees increased due to additional services related to compliance and loan operations and outsourcing of the Bank’s core information technology processing;
·Collection, repossession and other real estate owned expenses decreased due to declines in carrying balances of and costs associated with other real estate owned and classified assets;
·Marketing and advertising increased due to expenditures related to the VCB acquisition, digital marketing initiatives and other local market events;
·Loss on the sale of other real estate owned declined primarily due to the Company’s strategic initiative to remove risk from its balance sheet by expediting the resolution and disposition of other real estate owned during the fourth quarter of 2013, lower other real estate owned balances during 2014 and stabilization of real estate prices in our markets;
·Impairment losses on other real estate owned decreased as other real estate owned balances have continued to decline and real estate prices in our markets have continued to stabilize;
·Loss on extinguishment of debt of $11.5 million was recognized in August 2013 due to the prepayment of $107.5 million in long-term FHLB advances with no such loss or prepayment present in 2014; and
·Other operating expenses increased primarily due to costs related to the Company’s acquisition of VCB (including legal, consulting and professional services, marketing and integration costs). Other operating expenses also increased due to higher franchise taxes, director expenses, and increased customer check and coupon incentives, partially offset by a decrease in ATM charge-off expense.

 

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The following table depicts components of noninterest expense for the years ended December 31, 2013 and 2012:

 

Table 6A: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2013   2012   Change $   Change % 
Salaries and employee benefits  $17,156   $15,770   $1,386    8.8%
Occupancy and equipment expenses   5,226    5,165    61    1.2%
Telephone   1,142    945    197    20.8%
FDIC expense   1,765    2,329    (564)   -24.2%
Consultant fees   1,051    754    297    39.4%
Collection, repossession and other real estate owned   540    1,115    (575)   -51.6%
Marketing and advertising   787    804    (17)   -2.1%
Loss on sale of other real estate owned   775    227    548    241.4%
Impairment losses on other real estate owned   585    1,723    (1,138)   -66.0%
Loss on extinguishment of debt   11,453    -    11,453    100.0%
Other operating expenses   4,421    4,514    (93)   -2.1%
Total noninterest expenses  $44,901   $33,346   $11,555    34.7%

 

2013 Compared to 2012

 

Key changes in the components of noninterest expense for the year ended December 31, 2013, as compared to the same period in 2012, are discussed below:

 

·Salaries and employee benefits expense increased due to annual merit increases, lower deferred compensation on loan originations and was partially offset by a decrease in group term insurance costs;
·Telephone expense increased primarily due to a credit received during 2012 from the Company’s data and telephone provider for repeated service interruptions including downtime and loss of connectivity that was not repeated during 2013;
·FDIC insurance expense decreased, driven by lower base assessment rates due to the improvement in the Bank’s overall composite rating in connection with the termination of the Written Agreement in July 2013;
·Consultant fees increased primarily due to additional loan review fees and consulting charges incurred related to compliance, loan operations and information technology;
·Collection, repossession and other real estate owned expenses decreased primarily due to the overall decrease in the carrying balances of OREO, nonperforming loans and classified assets;
·Losses on the sale of other real estate owned increased and was primarily due to the Company’s strategic initiative to remove risk from its balance sheet by expediting the resolution and disposition of OREO during 2013;
·Impairment losses related to valuation adjustments on OREO decreased as significant impairments on certain assets within the Company’s other real estate owned portfolio during 2012 related to the Company’s asset quality initiatives were not repeated during 2013; and
·Loss on the extinguishment of debt was $11.5 million during 2013 and was incurred due to the prepayment of $107.5 million in long-term FHLB advances, while no such losses occurred in 2012.

 

Income Taxes

 

The Company recorded an income tax expense of $2.4 million in 2014, compared to income tax benefit of $2.4 million in 2013 and income tax expense of $945 thousand in 2012. The increase in income tax expense from 2013 to 2014 was the result of the Company’s pretax income increasing by approximately $13.1 million, due substantially to the $11.5 million prepayment penalty on the long-term FHLB advances prepaid during the third quarter of 2013 that was not repeated during 2014, and partially offset by increases in the amount of tax-exempt income on investment securities (as the Company rebalanced its securities portfolio during 2013), increases in tax-exempt income from bank owned life insurance policies and partially offset by merger related expenses that are not tax deductible. The Company’s effective tax rate for the years ended December 31, 2014, 2013 and 2012 was 30.1%, 39.1% and 25.5%, respectively. The effective tax rate differs from the statutory income tax rate of 34% due to the Company’s investment in tax-exempt loans and securities, income from bank owned life insurance, and community/housing development tax credits. For further information concerning Income Taxes, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”

 

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Asset Quality

 

Provision and Allowance for Loan Losses

 

The allowance for loan losses is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the loan portfolio, and is based on periodic evaluations of the collectability and historical loss experience of loans. A provision for loan losses, which is a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in management’s judgment, is appropriate to absorb probable losses in the loan portfolio. Actual credit losses are deducted from the allowance for loan losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent. Subsequent recoveries, if any, are credited to the allowance for loan losses.

 

The allowance for loan losses is comprised of a specific allowance for identified problem loans and a general allowance representing estimations done pursuant to either FASB ASC Topic 450 “Accounting for Contingencies”, or FASB ASC Topic 310 “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when deemed appropriate. The general component covers non-classified or performing loans and those loans classified as substandard, doubtful or loss that are not impaired. The general component is based on migration analysis adjusted for qualitative factors, such as economic conditions, interest rates and unemployment rates. The Company uses a risk grading system for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans. Loans are graded on a scale from 1 to 9. Non-impaired real estate and commercial loans are assigned an allowance factor which increases with the severity of risk grading. A general description of the characteristics of the risk grades is as follows:

 

Pass Grades

·Risk Grade 1 loans have little or no risk and are generally secured by cash or cash equivalents;
·Risk Grade 2 loans have minimal risk to well qualified borrowers and no significant questions as to safety;
·Risk Grade 3 loans are satisfactory loans with strong borrowers and secondary sources of repayment;
·Risk Grade 4 loans are satisfactory loans with borrowers not as strong as risk grade 3 loans but may exhibit a higher degree of financial risk based on the type of business supporting the loan; and
·Risk Grade 5 loans are loans that warrant more than the normal level of supervision and have the possibility of an event occurring that may weaken the borrower’s ability to repay.

 

Special Mention

·Risk Grade 6 loans have increasing potential weaknesses beyond those at which the loan originally was granted and if not addressed could lead to inadequately protecting the Company’s credit position.

 

Classified Grades

·Risk Grade 7 loans are substandard loans and are inadequately protected by the current sound worth or paying capacity of the obligor or the collateral pledged. These have well defined weaknesses that jeopardize the liquidation of the debt with the distinct possibility the Company will sustain some loss if the deficiencies are not corrected;
·Risk Grade 8 loans are doubtful of collection and the possibility of loss is high but pending specific borrower plans for recovery, its classification as a loss is deferred until its more exact status is determined; and
·Risk Grade 9 loans are loss loans which are considered uncollectable and of such little value that their continuance as a bank asset is not warranted.

 

The Company uses a past due grading system for consumer loans, including one to four family residential first and seconds and home equity lines. The past due status of a loan is based on the contractual due date of the most delinquent payment due. The past due grading of consumer loans is based on the following categories: current, 1-29 days past due, 30-59 days past due, 60-89 days past due and over 90 days past due. The consumer loans are segregated between performing and nonperforming loans. Performing loans are those that have made timely payments in accordance with the terms of the loan agreement and are not past due 90 days or more. Nonperforming loans are those that do not accrue interest or are greater than 90 days past due and accruing interest or considered impaired. Non-impaired consumer loans are assigned an allowance factor which increases with the severity of past due status. This component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio.

 

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The Company's ALL Committee is responsible for assessing the overall appropriateness of the allowance for loan losses and monitoring the Company's allowance for loan losses methodology, particularly in the context of current economic conditions and a rapidly changing regulatory environment.  The ALL Committee reviews at least annually the Company's allowance for loan losses methodology.

 

During 2013, the ALL Committee reviewed, with input from and consultation with independent external parties, the allowance for loan losses methodology with a specific focus on whether the Company should use migration analysis instead of historical loan loss experience on balances collectively evaluated for impairment. Migration analysis tracks the movement of loans through various loan classifications in order to estimate the percentage of losses likely to be incurred in a loan portfolio. In addition to evaluating multiple scenarios using migration analysis over a period of time, the ALL Committee engaged an independent third party to audit the Company’s existing allowance for loan losses methodology and validate its migration analysis. After this review, the ALL Committee determined that the Company should modify its methodology to use migration analysis in the calculation of the allowance for loan losses, effective December 31, 2013.

 

For prior financial periods ending with the third quarter of 2013, historical loan loss experience was calculated using a rolling three year average of historical loan loss experience. Beginning with the quarter ended December 31, 2013, the Company calculated the allowance for loan losses based on a migration analysis of loans, segmented by an identical risk grading system or past due grading system, depending on type of loan as previously used with the historical loan loss experience methodology. Other adjustments may be made to the allowance for loan losses for pools of loans after an assessment of internal and external factors on credit quality that are not fully reflected in the past due or risk grading data. The Company believes this change in methodology provides a more accurate evaluation of the potential risk in our loan portfolio and establishes a stronger focus on areas of weakness and strength within the portfolio. A tabular presentation comparing the provision for loan losses for the year ended December 31, 2013 calculated using the current methodology, to the provision as would have been calculated for the same period using the former methodology, can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 under Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 3. Loan Portfolio.”

 

The allocation methodology applied by the Company includes management’s ongoing review and grading of the loan portfolio into criticized loan categories (defined as specific loans warranting either specific allocation, or a classified status of substandard, doubtful or loss). The allocation methodology focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, management’s ongoing review and grading of the loan portfolio, consideration of migration analysis and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of classified loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. In determining the allowance for loan losses, the Company considers its portfolio segments and loan classes to be the same.

 

Management believes that the level of the allowance for loan losses is appropriate in light of the credit quality and anticipated risk of loss in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses through increased provisions for loan losses or may require that certain loan balances be charged-off or downgraded into classified loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examinations.

 

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

 

Table 7: Allowance for Loan Losses

 

   Years Ended December 31, 
(dollars in thousands)  2014   2013   2012   2011   2010 
Average loans outstanding*  $706,812   $669,520   $714,254   $757,123   $835,502 
Allowance for loan losses, January 1  $14,767   $20,338   $24,102   $25,288   $12,155 
Charge-offs:                         
Commercial, industrial and agricultural   340    635    1,219    1,257    5,608 
Real estate - one to four family residential:                         
Closed end first and seconds   483    1,529    2,664    1,868    2,643 
Home equity lines   444    184    1,112    348    458 
Real estate - construction:                         
One to four family residential   118    57    98    309    162 
Other construction, land development and other land   -    1,196    1,622    2,987    3,491 
Real estate - non-farm, non-residential:                         
Owner occupied   292    2,370    2,337    2,107    2,178 
Non-owner occupied   389    1,944    1,506    1,119    580 
Consumer   190    153    391    683    990 
Other   293    138    99    113    - 
Total loans charged-off   2,549    8,206    11,048    10,791    16,110 
Recoveries:                         
Commercial, industrial and agricultural   75    319    774    303    94 
Real estate - one to four family residential:                         
Closed end first and seconds   265    85    61    162    19 
Home equity lines   15    34    11    -    - 
Real estate - construction:                         
One to four family residential   7    61    55    6    13 
Other construction, land development and other land   9    69    2    1    2 
Real estate - non-farm, non-residential:                         
Owner occupied   27    1    100    45    8 
Non-owner occupied   13    57    409    -    - 
Consumer   96    108    179    238    177 
Other   46    51    35    50    - 
Total recoveries   553    785    1,626    805    313 
Net charge-offs   1,996    7,421    9,422    9,986    15,797 
Provision for loan losses   250    1,850    5,658    8,800    28,930 
Allowance for loan losses, December 31  $13,021   $14,767   $20,338   $24,102   $25,288 
Ratios:                         
Ratio of allowance for loan losses to total loans outstanding, end of year   1.59%   2.25%   2.97%   3.28%   3.26%
Ratio of net charge-offs to average loans outstanding during the year   0.28%   1.11%   1.32%   1.32%   1.89%

 

*Net of unearned income and includes nonaccrual loans.

 

The Company made provisions for loan losses of $1.9 million in 2013, $5.7 million in 2012, $8.8 million in 2011 and $28.9 million in 2010. In light of improving economic and financial market conditions, both nationally and in the Company’s markets, and the Company’s improving asset quality, the Company reduced its provisions for loan losses to $250 thousand for 2014. Net charge-offs in 2014 were $2.0 million compared to $7.4 million in 2013, $9.4 million in 2012, $10.0 million in 2011 and $15.8 million in 2010. This represents 0.28% of average loans outstanding in 2014, 1.11% in 2013, 1.32% in 2012 and 2011 and 1.89% in 2010. Management believes that improvements in the economic and financial markets and the Company’s asset quality improvements indicate that credit quality issues are less likely to impact our loan portfolio and our operating results in future periods than in periods that more immediately followed the height of the financial crisis of 2008. Net charge-offs decreased $5.4 million, or 73.1%, from the year ended December 31, 2013 to the same period of 2014 due to improvements in some of the Company’s credit quality metrics, including nonperforming assets, and other factors, such as a decline in adversely rated credits which are reflective of slowly improving economic conditions. This decline in net charge-offs significantly contributed to the Company’s decision to reduce its provisions for loan losses from 2013 to 2014. The Company continues to focus on credit quality initiatives to improve its asset quality and resolve its remaining nonperforming assets, and such initiatives should further reduce net charge-offs in future periods.

 

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The following table shows the allocation of the allowance for loan losses at the dates indicated. Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loan.

 

Table 8: Allocation of Allowance for Loan Losses

 

   At December 31, 
   2014   2013   2012   2011   2010 
(dollars in thousands)  Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent 
Commercial, industrial and agricultural  $1,168    10.37%  $1,787    8.17%  $2,340    7.58%  $4,389    7.76%  $5,981    9.39%
Real estate - one to four family residential:                                                  
Closed end first and seconds   1,884    28.86%   2,859    33.25%   2,876    34.91%   2,856    34.51%   3,340    33.62%
Home equity lines   1,678    13.42%   1,642    15.19%   720    14.56%   278    13.93%   587    12.05%
Real estate - multifamily residential   89    3.07%   79    2.75%   62    2.31%   29    1.77%   23    1.51%
Real estate - construction:                                                  
One to four family residential   235    2.40%   364    2.46%   419    2.96%   382    2.89%   344    3.29%
Other construction, land development and other land   2,670    4.34%   1,989    3.30%   3,897    5.04%   6,861    5.75%   7,837    6.56%
Real estate - farmland   144    1.15%   116    1.24%   41    1.25%   15    0.80%   17    1.07%
Real estate - non-farm, non-residential:                                                  
Owner occupied   2,416    19.22%   3,236    19.26%   5,092    17.50%   4,831    18.42%   2,546    17.32%
Non-owner occupied   1,908    12.77%   1,770    11.39%   4,093    10.48%   3,172    10.11%   3,072    10.12%
Consumer   305    1.94%   387    2.55%   215    2.94%   776    3.86%   905    4.65%
Other   524    2.46%   538    0.44%   583    0.47%   513    0.20%   280    0.42%
Total allowance for balance sheet loans   13,021    100.00%   14,767    100.00%   20,338    100.00%   24,102    100.00%   24,932    100.00%
Unallocated   -         -         -         -         356      
Total allowance for loan losses  $13,021        $14,767        $20,338        $24,102        $25,288      

 

(Percent is portfolio loans in category divided by total loans)

 

The following table presents commercial loans by credit quality indicator at December 31, 2014:

 

Table 9: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass   Special
Mention
   Substandard   Doubtful   Impaired   Acquired
loans -
purchased
impaired
   Total 
Commercial, industrial and agricultural  $79,191   $2,779   $675        $1,451   $1,023   $85,119 
Real estate - multifamily residential   25,157    -    -    -    -    -    25,157 
Real estate - construction:                                   
One to four family residential   18,978    300    244    -    176    -    19,698 
Other construction, land development and other land   26,916    1,791    1,144    -    5,661    79    35,591 
  Total real estate - construction   45,894    2,091    1,388    -    5,837    79    55,289 
Real estate - farmland   9,471    -    -    -    -    -    9,471 
Real estate - non-farm, non-residential:                                   
Owner occupied   132,266    11,339    2,253    -    10,046    1,841    157,745 
Non-owner occupied   84,951    4,771    1,817    -    9,816    3,472    104,827 
  Total real estate - non-farm, non-residential   217,217    16,110    4,070    -    19,862    5,313    262,572 
     Total commercial loans  $376,930   $20,980   $6,133   $-   $27,150   $6,415   $437,608 

 

48
 

 

The following table presents commercial loans by credit quality indicator at December 31, 2013:

 

Table 9A: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass   Special
Mention
   Substandard   Doubtful   Impaired   Total 
Commercial, industrial and agricultural  $44,571   $3,851   $3,229   $22   $2,000   $53,673 
Real estate - multifamily residential   18,077    -    -    -    -    18,077 
Real estate - construction:                              
One to four family residential   14,890    235    738    -    306    16,169 
Other construction, land development and other land   6,638    7,104    4,634    -    3,314    21,690 
  Total real estate - construction   21,528    7,339    5,372    -    3,620    37,859 
Real estate - farmland   6,288    338    1,068    -    478    8,172 
Real estate - non-farm, non-residential:                              
Owner occupied   87,187    13,341    15,983    -    10,058    126,569 
Non-owner occupied   43,406    15,533    7,520    -    8,372    74,831 
  Total real estate - non-farm, non-residential   130,593    28,874    23,503    -    18,430    201,400 
     Total commercial loans  $221,057   $40,402   $33,172   $22   $24,528   $319,181 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2014:

 

Table 10: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:               
Closed end first and seconds  $226,801   $9,960   $236,761 
Home equity lines   109,565    535    110,100 
  Total real estate - one to four family residential   336,366    10,495    346,861 
Consumer   15,548    371    15,919 
Other   20,175    6    20,181 
     Total consumer loans  $372,089   $10,872   $382,961 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2013:

 

Table 10A: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:               
Closed end first and seconds  $205,860   $12,612   $218,472 
Home equity lines   99,311    528    99,839 
  Total real estate - one to four family residential   305,171    13,140    318,311 
Consumer   16,314    468    16,782 
Other   2,451    472    2,923 
     Total consumer loans  $323,936   $14,080   $338,016 

 

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Nonperforming Assets

 

The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. As of December 31, 2014, management is not aware of any potential problem loans to place immediately on nonaccrual status.

 

When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across the Company’s loan portfolio.

 

Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal.

 

Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at estimated fair market value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the estimated fair market value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The estimated fair market value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to property are capitalized. Net operating income or expenses of such properties are included in collection, repossession and other real estate owned expenses.

 

The following table presents information concerning nonperforming assets for the periods indicated:

 

Table 11:  Nonperforming Assets

 

   December 31, 
(dollars in thousands)  2014   2013   2012   2011   2010 
Nonaccrual loans*  $6,622   $11,018   $11,874   $30,293   $25,858 
Loans past due 90 days and accruing interest   53    -    -    168    1,836 
Total nonperforming loans   6,675    11,018    11,874    30,461    27,694 
Other real estate owned   1,838    800    4,747    7,326    11,617 
Total nonperforming assets  $8,513   $11,818   $16,621   $37,787   $39,311 
                          
Nonperforming assets to total loans and other real estate owned   1.04%   1.80%   2.41%   5.09%   5.00%
Allowance for loan losses to nonaccrual loans   196.63%   134.03%   171.29%   79.56%   97.80%
Net charge-offs to average loans for the year   0.28%   1.11%   1.32%   1.32%   1.89%
Allowance for loan losses to year end loans   1.59%   2.25%   2.97%   3.28%   3.26%
Foregone interest income on nonaccrual loans  $124   $413   $335   $1,347   $1,583 

 

* Includes $3.4 million, $4.2 million, $5.1 million, $13.4 million and $6.2 million in nonaccrual TDRs at December 31, 2014, 2013, 2012, 2011, and 2010 respectively.

 

50
 

 

The following table presents the change in the OREO balance for 2014 and 2013:

 

Table 12: OREO Changes

 

(dollars in thousands)  2014   2013 
Balance at the beginning of year, gross  $1,054   $5,558 
Transfers from loans   1,657    1,921 
Acquired from Virginia Company Bank   103    - 
Sales proceeds   (620)   (4,508)
Previously recognized impairment losses on disposition   (202)   (1,142)
(Loss) on disposition   (78)   (775)
Balance at the end of year, gross   1,914    1,054 
Less valuation allowance   (76)   (254)
Balance at the end of year, net  $1,838   $800 

 

The following table presents the change in the valuation allowance for OREO for 2014, 2013 and 2012:

 

Table 13: OREO Valuation Allowance Changes

 

(dollars in thousands)  2014   2013   2012 
Balance at the beginning of year  $254   $811   $1,403 
Valuation allowance   24    585    1,723 
Charge-offs   (202)   (1,142)   (2,315)
Balance at the end of year  $76   $254   $811 

 

Nonperforming assets were $8.5 million or 1.04% of total loans and other real estate owned at December 31, 2014 compared to $11.8 million or 1.80% at December 31, 2013. Nonperforming assets increased from 2007 through 2010 as a result of the challenging economic conditions which significantly increased unemployment, reduced profitability of local businesses, and reduced the ability of many of our customers to keep their loans current. Nonperforming assets began to trend downward during 2011, continued this trend throughout 2012 and 2013 and decreased by $3.3 million in 2014. The Company has maintained the heightened level of the allowance for loan losses as compared to historical levels, which is 196.63% of nonaccrual loans at December 31, 2014, compared to 134.03% at December 31, 2013, in light of uneven improvement in economic conditions in the Company’s markets, and to position the Company to continue its strategic initiative of aggressively resolving problem assets. Nonperforming loans have decreased $4.3 million or 39.4% during the year ended December 31, 2014 to $6.7 million.

 

Nonaccrual loans were $6.6 million at December 31, 2014, a decrease of $4.4 million or 39.9% from $11.0 million at December 31, 2013. Of the current $6.6 million in nonaccrual loans, $6.2 million or 86.0% is secured by real estate in our market area. Of these real estate secured loans, $3.9 million are residential real estate, $221 thousand are real estate construction, $590 thousand are farmland, and $1.5 million are commercial properties.

 

Other real estate owned, net of valuation allowance at December 31, 2014 was $1.8 million, an increase of $1.0 million or 129.8% from $800 thousand at December 31, 2013. The balance at December 31, 2014 was comprised of eleven properties of which $1.1 million are residential real estate, $219 thousand are real estate construction and $553 thousand are commercial properties. During the year ended December 31, 2014, new foreclosures included nine properties totaling $1.7 million transferred from loans. Sales of thirteen other real estate owned properties for the year ended December 31, 2014 resulted in a net loss of $78 thousand. At December 31, 2014, there were no properties under contract for sale. Subsequent to December 31, 2014, four properties were sold resulting in a net loss of approximately $53 thousand that will be recognized in the first quarter of 2015, and three properties totaling $218 thousand were placed under contracts for sale and are not expected to generate any material losses on sale. The remaining properties are being actively marketed and the Company does not anticipate any material losses associated with these properties. As a direct result of the generally depressed real estate market during 2014, the Company recorded losses of $24 thousand in its consolidated statement of operations for the year ended December 31, 2014, due to valuation adjustments on other real estate owned properties as compared to $585 thousand in 2013 and $1.7 million in 2012. Asset quality continues to be a top priority for the Company. The Company continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets, as demonstrated by the $3.3 million, or 28.0%, decrease in nonperforming assets from 2013 to 2014.

 

51
 

 

As discussed earlier in Item 7, the Company measures impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. TDRs are considered impaired loans. TDRs occur when we agree to modify the original terms of a loan by granting a concession due to the deterioration in the financial condition of the borrower. These concessions can be temporary and are made in an attempt to avoid foreclosure and with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include, without limitation, rate reductions to below market rates, payment deferrals, forbearance, and, in some cases, forgiveness of principal or interest.

 

The following table presents loans individually evaluated for impairment, excluding purchased credit impaired loans, by class of loans as of December 31, 2014:

 

Table 14: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment With
No Allowance
  

Recorded

Investment With

 Allowance

   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $1,451   $1,451   $1,451   $-   $-   $2,010   $128 
Real estate - one to four family residential:                                   
Closed end first and seconds   8,713    8,813    3,611    5,102    1,006    9,800    474 
Home equity lines   175    175    175    -    -    289    - 
Total real estate - one to four family residential   8,888    8,988    3,786    5,102    1,006    10,089    474 
Real estate - construction:                                   
One to four family residential   176    176    -    176    78    312    7 
Other construction, land development and other land   5,661    5,661    -    5,661    1,632    5,399    256 
Total real estate - construction   5,837    5,837    -    5,837    1,710    5,711    263 
Real estate - farmland   -    -    -    -    -    -    - 
Real estate - non-farm, non-residential:                                   
Owner occupied   10,046    10,146    3,734    6,312    1,240    12,056    534 
Non-owner occupied   9,816    9,816    4,262    5,554    1,262    9,356    456 
Total real estate - non-farm, non-residential   19,862    19,962    7,996    11,866    2,502    21,412    990 
Consumer   371    371    -    371    106    420    21 
Other   6    6    6    -         328    - 
Total loans  $36,415   $36,615   $13,239   $23,176   $5,324   $39,970   $1,876 

 

52
 

 

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2013:

 

Table 14A: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment With
No Allowance
   Recorded
Investment With 
Allowance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $2,000   $2,000   $-   $2,000   $612   $1,712   $97 
Real estate - one to four family residential:                                   
Closed end first and seconds   10,048    10,148    2,008    8,040    1,833    8,727    498 
Home equity lines   175    175    175    -    -    382    - 
Total real estate - one to four family residential   10,223    10,323    2,183    8,040    1,833    9,109    498 
Real estate - construction:                                   
One to four family residential   306    306    -    306    180    794    9 
Other construction, land development and other land   3,314    5,662    -    3,314    802    8,581    161 
Total real estate - construction   3,620    5,968    -    3,620    982    9,375    170 
Real estate - farmland   478    478    478    -    -    428    32 
Real estate - non-farm, non-residential:                                   
Owner occupied   10,058    11,544    6,730    3,328    1,223    10,472    506 
Non-owner occupied   8,372    8,372    4,357    4,015    617    9,353    348 
Total real estate - non-farm, non-residential   18,430    19,916    11,087    7,343    1,840    19,825    854 
Consumer   302    302    -    302    104    203    22 
Other   472    472    9    463    311    504    - 
Total loans  $35,525   $39,459   $13,757   $21,768   $5,682   $41,156   $1,673 

 

The Company’s impaired loans have declined when comparing 2014 to 2013, but impaired loans remain elevated over historical levels due to the uneven economic recovery and challenging economic conditions in portions of our markets, which have contributed to increased unemployment and underemployment, reduced profitability of local businesses, and reduced the ability of many of our customers to keep their loans current.

 

The following table presents the balances of TDRs at December 31, 2014, 2013, 2012, 2011 and 2010:

 

Table 15: Troubled Debt Restructurings (TDRs)

 

   December 31, 
(dollars in thousands)  2014   2013   2012   2011   2010 
Performing TDRs  $15,223   $16,026   $4,433   $5,517   $2,411 
Nonperforming TDRs*   3,438    4,188    5,089    13,378    6,177 
Total TDRs  $18,661   $20,214   $9,522   $18,895   $8,588 

 

* Included in nonaccrual loans in Table 11: Nonperforming Assets.

 

At the time of a TDR, the loan is placed on nonaccrual status. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.

 

53
 

 

Financial Condition

 

Summary

 

Total assets were $1.2 billion at December 31, 2014, an increase of $154.9 million or 15.1% from $1.0 billion at December 2013. This increase was primarily due to the addition of assets purchased in connection with the VCB acquisition, partially offset by lower investment securities. Major categories and changes in our balance sheet are as detailed in the following schedule.

 

Table 16: Balance Sheet Changes

 

   December 31,   December 31,         
(dollars in thousands)  2014   2013   Change $   Change % 
Total assets  $1,181,972   $1,027,074   $154,898    15.1%
Cash and short-term investments   14,024    13,944    80    0.6%
Interest bearing deposits with banks   5,272    5,402    (130)   -2.4%
Securities available for sale, at fair value   214,011    234,935    (20,924)   -8.9%
Securities held to maturity, at carrying value   32,163    35,495    (3,332)   -9.4%
Restricted securities, at cost   7,533    5,549    1,984    35.8%
Total loans   820,569    657,197    163,372    24.9%
Deferred income taxes, net   17,529    18,937    (1,408)   -7.4%
Other real estate owned, net   1,838    800    1,038    129.8%
Goodwill   17,085    15,970    1,115    7.0%
Bank owned life insurance   24,463    21,158    3,305    15.6%
Total deposits   939,254    834,462    104,792    12.6%
Total borrowings   102,013    55,259    46,754    84.6%
Total shareholders' equity   134,274    132,949    1,325    1.0%

 

Loan Portfolio

 

The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. A substantial portion of the loan portfolio is represented by commercial and residential mortgage loans in our market area. The ability of our debtors to honor their contracts is dependent upon the real estate and general economic conditions in our market area. The loan portfolio is the largest component of earning assets and accounts for the greatest portion of total interest income. Total loans were $820.6 million at December 31, 2014, an increase of $163.4 million or 24.9% from $657.2 million at December 31, 2013. As discussed previously, loans increased in 2014 primarily due to the acquisition of VCB and the addition of VCB’s loans to the Company’s loan portfolio, the purchase of performing one-to-four family residential mortgage loans, the opening of a new loan production office in Chesterfield County, Virginia and the origination of a line of credit to fund loan originations through Southern Trust Mortgage, LLC. These additions were partially offset by weak loan demand in the Company’s markets and the continuing challenging economic conditions.

 

54
 

 

The following table presents the composition of the loan portfolio at the dates indicated:

 

Table 17: Summary of Loans

 

   December 31, 
   2014   2013   2012   2011   2010 
(dollars in thousands)  Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
Commercial, industrial and agricultural  $85,119    10.37%  $53,673    8.17%  $51,881    7.58%  $57,021    7.76%  $72,790    9.39%
Real estate - one to four family residential:                                                  
Closed end first and seconds   236,761    28.86%   218,472    33.25%   239,002    34.91%   253,465    34.51%   260,442    33.62%
Home equity lines   110,100    13.42%   99,839    15.19%   99,698    14.56%   102,297    13.93%   93,387    12.05%
Total real estate - one to four family residential   346,861    42.28%   318,311    48.44%   338,700    49.47%   355,762    48.44%   353,829    45.67%
Real estate - multifamily residential   25,157    3.07%   18,077    2.75%   15,801    2.31%   13,035    1.77%   11,682    1.51%
Real estate - construction:                                                  
One to four family residential   19,698    2.40%   16,169    2.46%   20,232    2.96%   21,212    2.89%   25,454    3.29%
Other construction, land development and other land   35,591    4.34%   21,690    3.30%   34,555    5.04%   42,208    5.75%   50,841    6.56%
Total real estate - construction   55,289    6.74%   37,859    5.76%   54,787    8.00%   63,420    8.64%   76,295    9.85%
Real estate - farmland   9,471    1.15%   8,172    1.24%   8,558    1.25%   5,860    0.80%   8,304    1.07%
Real estate - non-farm, non-residential:                                                  
Owner occupied   157,745    19.22%   126,569    19.26%   119,824    17.50%   135,294    18.42%   134,186    17.32%
Non-owner occupied   104,827    12.77%   74,831    11.39%   71,741    10.48%   74,231    10.11%   78,396    10.12%
Total real estate - non-farm, non-residential   262,572    31.99%   201,400    30.65%   191,565    27.98%   209,525    28.53%   212,582    27.44%
Consumer   15,919    1.94%   16,782    2.55%   20,173    2.94%   28,355    3.86%   36,000    4.65%
Other   20,181    2.46%   2,923    0.44%   3,203    0.47%   1,553    0.20%   3,294    0.42%
Total loans   820,569    100.00%   657,197    100.00%   684,668    </