10-K 1 hbiform10k033017.htm


 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2016


Commission File Number 000-27622

HIGHLANDS BANKSHARES, INC.
(Exact name of registrant as specified in its charter)

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

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


Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.625 par value
(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes     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 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 Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 Yes [ 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 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.  [ X ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. (See definition of "large accelerated filer, accelerated filer and smaller reporting company" in Rule 12b-2 of the Act). Large Accelerated Filer  [  ]   Accelerated Filer  [  ]    Non-Accelerated Filer [  ]  Smaller Reporting Company  [X]

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter.  $ 39,475,266.

Indicate the number of shares outstanding of each of the registrant's classes of common stock as of the latest practicable date.  As of March 22, 2017, there were 8,199,228 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE
 Consolidated Financial Report for year ended December 31, 2016 – Part II
Proxy Statement for the 2017 Annual Meeting of Shareholders—Part III

 

 
Table of Contents
 
   
Page Number
Part I
   
     
Item 1.
Business
2
Item 1A.
Risk Factors
13
Item 1B.
Unresolved Staff Comments
13
Item 2.
Properties
13
Item 3.
Legal Proceedings
13
Item 4.
Mine Safety Disclosures
14
     
     
Part II
   
     
Item 5.
Market for Registrant's Common Equity, Related Stockholder    Matters and Issuer Purchases of Equity Securities
14
Item 6.
Selected Financial Data
15
Item 7.
Management's Discussion and Analysis of Financial Condition
  and Results of Operations
15
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
32
Item 8.
Financial Statements and Supplementary Data
32
Item 9.
Changes in and Disagreements with Accountants on
  Accounting and Financial Disclosure
32
Item 9A.
Controls and Procedures
32
Item 9B.
Other Information
32
     
     
Part III
   
     
Item 10.
Directors, Executive Officers and Corporate Governance
32
Item 11.
Executive Compensation
32
Item 12.
Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters
33
Item 13.
Certain Relationships and Related Transactions, and Director Independence
33
Item 14.
Principal Accounting Fees and Services
34
     
     
Part IV
   
     
Item 15.
Exhibits, Financial Statement Schedules
34
     
     




i

Part I.

Item 1.  Business

History and Business
Highlands Bankshares, Inc. (the "Company") is a one-bank holding company organized under the laws of Virginia in 1995 and registered as a bank holding company under the Bank Holding Company Act of 1956 ("BHCA"). The Company conducts the majority of its business operations through its wholly-owned bank subsidiary, Highlands Union Bank (the "Bank"). The Company has one direct subsidiary as of December 31, 2016: the Bank, which was formed in 1985.
 Highlands Union Bank
The Bank is a Virginia state chartered bank that was incorporated in 1985. The Bank operates a commercial banking business from its headquarters in Abingdon, Virginia, and its thirteen area full service branch offices. The Bank offers general retail and commercial banking services to individuals, businesses and local government unit customers. These products and services include accepting deposits in the form of checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts and time deposits; making residential 1-4 family loans, owner occupied and non owner occupied commercial real estate loans, second mortgages and equity lines, consumer, commercial and industrial, credit card and agricultural loans; offering letters of credit; providing other consumer financial services, such as automatic funds transfer, collections, night depository, safe deposit, travelers checks and savings bond sales; and providing other miscellaneous services normally offered by commercial banks.
Highlands Union Insurance Services, Inc.
Highlands Union Insurance Services, Inc., ("HUIS") a wholly owned subsidiary of the Bank, was formed in 1999. The Bank, through HUIS, joined a consortium of approximately forty-seven other financial institutions to form Bankers' Insurance, LLC. Bankers' Insurance, LLC, as of December 31, 2016, had purchased twelve full service insurance agencies across the state of Virginia. HUIS sells insurance products and services through Bankers' Insurance, LLC.  The number of owner banks involved with Bankers' Insurance, LLC was twenty-nine as of December 31, 2016.
Highlands Union Financial Services, Inc.
 Highlands Union Financial Services, Inc., ("HUFS") a wholly-owned subsidiary of the Bank, was created to offer third party mutual funds and other financial services to its customers in all market areas served by the Bank.  The only activity in Highlands Union Financial Services Inc. now relates to commissions from the sale of life insurance.
Russell Road Properties, LLC
Russell Road Properties, LLC, formed in March 2015 is also an entity in which the Bank has a significant interest and was created to hold and manage certain properties acquired by the Bank through foreclosure or deed in lieu of foreclosure.


2

Highlands Home Mortgage
Highlands Home Mortgage Division, formed in June 2016, is a division of the bank.  It was created to offer secondary market loans which are sold to investors during the course of the business year on a servicing released basis. This division originated and sold approximately $16 million of loans in 2016 and is located in Raleigh, North Carolina.

Lending Activities- In House

The Bank has written policies and procedures to help manage credit risk.   The Bank's policy provides for three levels of lending authority.  The first level of authority is granted to individual loan officers who have various levels of approval based upon their position and experience.  The second level is the Senior Officers Loan Committee, which is comprised of senior officers of the Bank from all market areas.  The Senior Officers Loan Committee considers loans that exceed the individual loan officers' lending authority and reviews loans to be presented to the Directors Loan Committee.  The Directors Loan Committee is comprised of five Directors, four of which are independent Directors.  The Directors Loan Committee approves new, modified and renewed credits that exceed the Senior Officer Loan Committee authorities.  The Chairman of the Directors Loan Committee is the Chairman of the Company.   A quorum is reached when four committee members are present, of which at least three must be independent Directors.  An application requires four votes to receive approval by the Committee.  In addition, monthly, the Directors Loan Committee reports all new loans reviewed and approved to the Bank's Board of Directors.  Monthly reports shared by the Directors Loan Committee include names and amounts of all new credits extended; a watch list including names, amounts, risk rating; past due and non- accrual loans and recommended loans to be charged off and a list of overdrafts.  The Directors Loan Committee also reviews changes to lending policies as proposed by management prior to submission to the Board of Directors for approval.

The Bank has an internal Credit Review Department that reviews the Bank's loan portfolio to identify loss exposure and to monitor compliance with the Bank's loan policy.  An analysis of loss exposure and reports on policy compliance are presented to the Directors Loan Committee of the Board for approval on a quarterly basis.

One-to-Four-Family Residential Real Estate Lending

Residential loan opportunities may be generated by the Bank's loan officers, referrals by real estate professionals, and by existing or new bank clients.  Loan applications are taken by a Bank loan officer.  As part of the application process, information is gathered concerning income, employment and credit history of the applicant and originations are underwritten using policy including a loan to value ("LTV") of 80% of appraised value.  Security for the majority of one to four family residential loans is owner occupied single family dwellings. Values of residential real estate collateral are provided by independent appraisers who have been approved by the Bank's Board of Directors.

Second mortgages and Home Equity Lines of Credit are generated, underwritten and secured like single family residential real estate loans discussed above.  However, both second mortgages and Home Equity Lines of Credit are made at higher interest rates than residential mortgages.  Second mortgages are typically made for no more than fifteen years and equity lines mature in 20 years or less.

The Bank also originates adjustable rate products ("ARM") secured by one to four family residential properties with a repricing interval of three and five years.  These products provide another outlet instead of secondary market loans and are generated, underwritten and secured the same as single family residential real estate loans discussed above.  The Bank retains these loans in its loan portfolio.   Senior Management adjusts the ARM rates based on competitive rates within the Bank's market area.   The ARM products contain interest rate caps at adjustment periods and rate ceilings based on a cap over and above the original interest rate. Adjustable rate mortgages are underwritten based on payment amounts at the interest rate reaching the lifetime cap.

At December 31, 2016, $208 million, or 50%, of the Bank's loan portfolio consisted of one-to four-family residential real estate loans, second mortgages, and home equity lines.  Of the $208 million, $121 million were fixed rate mortgages while the remaining $87 million were adjustable rate mortgages.   The fixed rate loans are typically 3, 5, and 7 year balloon loans amortized over a 30 year period. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance, and if required, flood insurance.  

Multifamily Residential Real Estate Lending

Loan applications for loans to be secured by multi-family residential properties are taken by a loan officer.  As part of the application process, information is gathered concerning income, employment and credit history of the applicant, as well as rent rolls, operating costs and occupancy rates of the property to be financed.  At December 31, 2016, $23 million, or 6%, of the Bank's loan portfolio consisted of multi-family residential properties. Loan originations are underwritten using the Bank's underwriting guidelines of a LTV of 80% and a cash flow coverage ratio of 1.25 or better.   The valuation of multifamily residential collateral is provided by independent fee appraisers who have been approved by the Bank's Board of Directors.

The Bank originates fixed rate and adjustable rate loans secured by multi-family properties, which are retained in the Bank's portfolio. Adjustable rate mortgages are underwritten based on payment amounts at the interest rate reaching the lifetime cap.

3

Commercial, Construction, Farmland, Other Land Loans and Land Development Lending

The Bank makes commercial, construction, farmland and land acquisition and development loans.  These loans generally have a higher degree of risk than residential mortgage loans, but also have higher yields.  To minimize these risks, the Bank normally obtains appropriate collateral and requires the personal guarantees from the borrower's principal owners and monitors the financial condition of its business borrowers.  Commercial business loans typically are made on the basis of the borrower's ability to make repayment from cash flow from its business.  As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself.  Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as historically been the case with residential real estate.  

At December 31, 2016, commercial real estate loans aggregated $101 million, or 25%, of the Bank's total loans.  In its underwriting of commercial real estate, the Bank may lend, under its policy, up to 75% of the secured property's appraised value.  The Bank's commercial real estate loan underwriting criteria require an examination of debt service coverage ratios and the borrower's creditworthiness, prior credit history and reputation.  The Bank also evaluates the location of the secured property, and as noted above, typically requires personal guarantees or endorsements of the borrowing entity's principal owners.

Construction and Land Development loans, including acquisition and development loans, are primarily those secured by residential houses and commercial structures under construction and the underlying land for which the loan was obtained.  Over the past two years the Bank has significantly reduced the number of originations of construction and land development loans in all of its market areas in an effort to reduce portfolio risk.

At December 31, 2016, construction, farmland, and other land loans outstanding were $28 million, or 7%, of total loans. Construction lending entails significant additional risks and often involves larger loan balances concentrated with single borrowers or groups of related borrowers.  Another risk involved in construction lending is attributable to the fact that loan funds are advanced to fund construction, the value of which is estimated prior to the completion of construction on an "as built" basis.  Therefore, it is difficult to accurately estimate the total loan funds required to complete the project and the completed loan-to-value ratios.  To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 75% of as built appraised value, in addition to analyzing the creditworthiness of its borrowers.  The Bank obtains a first lien on the property as security for construction loans, monitors the construction and advance process and, if a business entity, typically requires personal guarantees from the borrowing entity's principal owners.

Commercial and Agricultural Lending-- Non-Real Estate Secured and Unsecured

The Bank makes local commercial and agricultural unsecured and non-real estate secured loans.  These loans generally have a higher degree of risk than other loans and to manage these risks, the Bank generally obtains collateral, such as inventories, accounts receivable, equipment and personal guarantees from the borrowing entity's principal owners. In its underwriting of commercial and agricultural non-real estate secured loans, the Bank may lend, under internal policy, up to 80% of the secured collateral appraised value. The Bank's commercial and agricultural non-real estate secured and unsecured underwriting criteria require adequate debt service coverage ratios and the borrower's creditworthiness, prior credit history and reputation.  As commercial business and agricultural non-real estate secured loans typically are made on the basis of the borrower's ability to make repayment from cash flow, the availability of funds for the repayment  is substantially dependent on the success of the business itself.  

At December 31, 2016, commercial and agricultural non-real estate secured loans including unsecured loans aggregated $33 million, or 8%, of the Bank's total loans.

Consumer Lending-Non Real Estate Secured and Unsecured

The Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans made on both an installment and demand basis.  At December 31, 2016, the Bank had consumer loans of $18 million or 4% of gross loans.  Such loans are generally made to customers with whom the Bank has a pre-existing relationship, often deposit and residential mortgage relationships. The Bank only originates its consumer loans in its geographic market area. The underwriting standards employed by the Bank for consumer loans include a determination of the applicant's payment history on other debts and an assessment of the ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant's monthly income may be determined by the verification of gross monthly income from primary employment and additionally from any verifiable secondary source.  The applicant's FICO scores are also analyzed with the credit report analysis.  Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the available collateral, if applicable.

Consumer loans may entail significant risk, particularly if unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles.  In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance.  The remaining deficiency often does not warrant further substantial collection efforts against the borrower.  In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.  Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.  Such loans may also give rise to claims and defenses by a consumer borrower against an assignee of collateral securing the loan such as the Bank and a borrower may raise claims which it has against the seller of the underlying collateral to prevent collection.
 

 
4

Participation Loans
The Bank will occasionally buy or sell all or a portion of a loan. The Bank will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan to a single borrower will exceed the Bank's legal lending limit, which is 15 percent of the unimpaired capital and unimpaired surplus of the Bank; (ii) the full amount of the loan, when combined with a borrower's previously outstanding loans, will exceed the Bank's legal lending limit to a single borrower; (iii) the Board of Directors or the Senior Officer Loan Committee believes that a particular borrower has a sufficient level of debt with the Bank; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by Bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location, one industry or in one particular type of loan. The Bank will consider purchasing a participation in a loan from another financial institution if the loan meets all applicable credit quality standards; (i) the Bank's loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase.
The following table sets forth, for the two fiscal years ended December 31, 2016 and 2015, the percentage of total operating revenue contributed by each class of similar services which contributed 15% or more of total operating revenues of the Company during such periods.
Year Ended
Class of Service
Percentage of Total Revenues
     
December 31, 2016
Interest and Fees on Loans
79.21%
December 31, 2015
Interest and Fees on Loans
78.40%
Market Area
Highlands Union Bank Market Area
The Bank's primary market area consists of:
 
•    all of Washington County, Virginia
•    portions of Smyth County, Virginia
•   the City of Bristol, Virginia
•   the City of Bristol, Tennessee and adjacent portions of Sullivan County, Tennessee
•   the Town of Rogersville, Tennessee and adjacent portions of Hawkins County,  Tennessee
•   the City of Sevierville, Tennessee and adjacent portions of Sevier County, Tennessee,
•   the City of Knoxville, Tennessee and adjacent portions of Knox County, Tennessee
•   the Town of Banner Elk and adjacent portions of Avery County, North Carolina
•   the Town of Boone and adjacent portions of Watauga County, North Carolina
 
   The independent city of Bristol, Virginia is located in far southwestern Virginia and lies directly on the Virginia-Tennessee state line. Washington County surrounds Bristol to the west, north and east. In the Bristol/Washington County community, educational/health care services, manufacturing, and retail trade sectors are the largest industries, in terms of total number of jobs in 2016.  These sectors contribute in total 51.8% of the total employment. The latest unemployment figures reflect an unemployment rate of 4.5% in the Bristol/Washington County, Virginia area.

The Bank has a branch office located in Marion which is the county seat of Smyth County, Virginia. Marion is approximately 30 miles northeast of Abingdon, Virginia.  The latest unemployment figures reflect an unemployment rate of 5.7% reported. In Smyth County, educational/health care services, manufacturing, and retail trade sectors are the largest industries, in terms of total number of jobs in 2016.  These sectors contribute in total 59.7% of the total employment.

Bristol, Tennessee is located in Sullivan County, Tennessee and is Bristol, Virginia's twin city. Bristol, Tennessee's three largest employment sectors are educational/health care services, manufacturing, and retail trade which make up 50.5% of all jobs throughout the Sullivan County. The latest unemployment figures reflect an unemployment rate of 5.2%.

Rogersville, Tennessee is located in Hawkins County approximately 45 miles southwest of Bristol, Tennessee. Rogersville is the county seat for Hawkins County.  Rogersville's and Hawkins County's largest employment sectors are educational/health care services, manufacturing, and retail trade. These sectors combined make up 57.7% of all jobs throughout the County. The latest unemployment figures for Hawkins County reflect an unemployment rate of 5.2%.

Sevierville, Tennessee is located in Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20 miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is the largest city located in Sevier County. Major employers for the County include entertainment/recreation, retail trade, and educational/health care services, which make up 55.4% of all jobs throughout the County. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses. The latest unemployment figures for Sevier County reflect an unemployment rate of 4.2%.

Knoxville, Tennessee is located in Knox County, Tennessee.  Knoxville, Tennessee is located approximately 20 miles west of Sevierville, Tennessee.  Knoxville serves as the county seat and is the third largest city in the state of Tennessee.  Major employers for the County include educational/health care services, retail trade, and professional services.  These sectors contribute to 54.3% of all jobs in the County.  The latest unemployment figures reflect an unemployment rate of 3.9% for Knox County.  Knoxville's central location to two major interstate highways which link the eastern half of the United States continues to provide many opportunities for economic growth in the future.

Banner Elk, North Carolina is located in Avery County in the northwestern mountains of North Carolina.  In Banner Elk, educational/health care services, retail trade, and arts/entertainment are the largest industries or 49.7% of total number of jobs in 2016. The latest unemployment figures for Avery County reflect an unemployment rate of 4.8%.

Boone, North Carolina is located in Watauga County in the northwestern mountains of North Carolina.  Boone's three largest employment sectors are educational/health care services, entertainment/recreation services, and retail trade, which make up 63.4% of the total number of jobs in Boone as of 2016.  The latest unemployment figures for Watauga County reflect an unemployment rate of 3.9%.


5

Competition

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


Certain Regulatory Considerations

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

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

Highlands Bankshares, Inc.

The Company is a bank holding company within the meaning of the BHCA and a financial institution holding company within the meaning of Chapter 7 of the Virginia Banking Act, as amended (the Virginia Banking Act). The activities of the Company also are governed by the Gramm-Leach-Bliley Act of 1999.

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

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

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

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

6

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

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

Dodd-Frank Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), made significant changes in the regulation of financial institutions and the financial services industry.  The Dodd-Frank Act included several provisions that will affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future.  Among other things, these provisions abolished the Office of Thrift Supervision and transferred its functions to the other federal banking agencies, relaxed rules regarding interstate branching, allowed financial institutions to pay interest on business checking accounts, changed the scope of federal deposit insurance coverage, and imposed new capital requirements on bank and thrift holding companies.  The Dodd-Frank Act also established the Bureau of Consumer Financial Protection, which is given the authority to promulgate consumer protection regulations applicable to all entities offering consumer financial services or products, including banks.  


   The Dodd-Frank Act also required the Consumer Financial Protection Bureau to issue regulations requiring lenders to make a reasonable good faith determination as to a prospective borrower's ability to repay a residential mortgage loan. The final "Ability to Repay" rules, which were effective January 4, 2013, established a "qualified mortgage" safe harbor for loans whose terms and features are deemed to make the loan less risky. In addition, on October 3, 2015, the new TILA-RESPA Integrated Disclosure (TRID) rules for mortgage closings took effect for new loan applications.
Some provisions of the Dodd-Frank Act involved delayed effective dates and/or require implementing regulations or have not been issued in final form. Their full impact on our operations cannot yet fully be assessed. However, the Dodd-Frank Act has resulted in increased compliance and operating expense for the Company.

7

Highlands Union Bank.

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

 Under the provisions of federal law, federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, these banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service. The Virginia State Corporation Commission and the Federal Reserve Board conduct regular examinations of the Bank reviewing the adequacy of the loan loss reserves, quality of the loans and investments, propriety of management practices, compliance with laws and regulations and other aspects of the bank's operations. In addition to these regular examinations, Virginia chartered banks must furnish to the Federal Reserve Board quarterly reports containing detailed financial statements and schedules.

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

Federal Deposit Insurance Corporation Improvement Act of 1991. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other operational and managerial standards as the agency determines to be appropriate.  The compensation standards prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that provide excessive compensation, fees or benefits or could lead to material financial loss.  In addition, each federal banking regulatory agency must prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency determines to be appropriate.  If an insured institution fails to meet any of the standards promulgated by regulation, then such institution will be required to submit a plan to its federal regulatory agency specifying the steps it will take to correct the deficiency.

8

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

The Bank met the requirements at December 31, 2016 to be classified as "well-capitalized."  This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Bank's overall financial condition.

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

Section 36 of FDICIA requires insured depository institutions with at least $500 million but less than $1 billion in total assets to file annual reports that must include the following:

1.
Audited comparative annual financial statements.
2.
The independent public accountant's report on the audited financial statements.
3.
A management report that contains a statement of management's responsibilities for preparing the financial statement, establishing and maintaining an adequate internal control structure over financial reporting and complying with the laws and regulations designed by the FDIC and appropriate banking regulators.
4.
An assessment by management of the institution's compliance with the designated laws and regulations during the year.

These amendments do not relieve public companies of their obligations to comply with the SOX Act and the SEC's rules on internal control reporting and audit committee independence.

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

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

Deposit Insurance.  The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC. Pursuant to the Dodd-Frank Act, FDIC insurance coverage limits on deposits were permanently increased to $250,000.

The FDIC has adopted a risk-based assessment system to determine assessment rates to be paid by member institutions, such as the Bank.  The amount of the assessment is a function of the institution's assessment rate and its assessment base.  Under this system, an institution's supervisory ratings, combined with certain other risk measures, including certain financial ratios.  In February 2011, the FDIC revised the risk-based assessment system to set new assessment rates that were effective on April 1, 2011.  The initial base assessment rates currently range from 3 to 30 basis points, subject to potential adjustments based on the amount of the institution's long-term unsecured debt.  After the effect of potential base-rate adjustments, the total base assessment rate can range from 1.5 to 30 basis points.  As the DIF reserve ratio grows, the rate schedule will be adjusted downward.  Also effective April 1, 2011, the assessment base is an institution's average consolidated total assets less its average tangible equity.

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

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

9

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

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

Limits on Dividends and Other Payments. The Company is a legal entity separate and distinct from the Bank; virtually all of the Company's cash reserves, and its ability to pay dividends to the Company's shareholders, are dependent on the ability of the Bank to upstream dividends to it. As a state member bank subject to the regulations of the Federal Reserve Board, the Bank must obtain the approval of the Federal Reserve Board for any dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits, as defined by the Federal Reserve Board, for that year, combined with its retained net profits for the preceding two years. In addition, the Federal Reserve Board is authorized to determine, under certain circumstances relating to the financial condition of a state member bank, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The payment of dividends that depletes a bank's capital base could be deemed to constitute such an unsafe or unsound practice.

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

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements. The Federal Reserve Board has indicated that banking organizations, including bank holding companies, should generally pay dividends only out of current operating earnings. Federal regulators also have indicated that bank holding companies generally should pay dividends only if the organization's net income available to company shareholders is sufficient to fully fund the dividends as well as maintaining sufficient capital levels.

Capital Requirements

The federal banking agencies adopted new regulations that implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act.
Effective January 1, 2015, the Bank became subject to new capital requirements adopted by the Federal Reserve (with some changes transitioned into full effectiveness over two to four years). The new requirements created a new required ratio for common equity Tier 1 ("CETI") capital, increased the leverage and Tier 1 capital ratios, changed the risk weight of certain assets for purposes of the risk-based capital ratios, created an additional capital conservation buffer over the required capital ratios and changed what qualifies as capital for purposes of meeting these various capital requirements. Beginning in 2016, failure to maintain the required capital conservation buffer will limit the ability of the Bank to pay dividends or pay discretionary bonuses. The Company is exempt from consolidated capital requirements as those requirements do not apply to certain small bank holding companies with assets under $1 billion.

Under the new capital regulations, the minimum capital ratios are as follows:

·
CETI capital ratio of 4.5% of risk-weighted assets (new);
·
Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from 4%);
·
Total capital ratio of 8.0% of risk-weighted assets (unchanged); and,
·
Leverage ratio of 4.0% (unchanged).

CETI generally consists of common stock and retained earnings, subject to applicable regulatory adjustments and deductions.

10

There are a number of changes in what constitutes regulatory capital, some of which are subject to transition periods. These changes include the phasing-out of certain instruments as qualifying capital. The Bank does not use any of these instruments. Under the new requirements for total capital, Tier 2 capital is no longer limited to the amount of Tier 1 capital included in total capital. Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of CETI will be deducted from capital. The Bank has elected to permanently opt-out of the inclusion of accumulated other comprehensive income in our capital calculations, as permitted by the regulations. This opt-out will reduce the impact of market volatility on our regulatory capital levels.


The new requirements also include changes in the risk-weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (increased from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and for non-residential mortgage loans that are 90 days past due or otherwise in non-accrual status; a 20% (increased from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable; a 250% risk weight (increased from 100%) for mortgage servicing and deferred tax assets that are not deducted from capital; and increased risk weights (0% to 600%) for equity exposures.

In addition to the minimum CETI, Tier 1 and total capital ratios, the Bank will have to maintain a capital conservation buffer consisting of additional CETI capital greater than 2.5% of risk-weighted assets above the required minimum levels in order to avoid limitations on paying dividends or paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. This new capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented in January 2019.

The Federal Reserve's prompt corrective action standards changed effective January 1, 2015. Under the new standards, in order to be considered well-capitalized, the Bank must have a CETI ratio of 6.5% (new), a Tier 1 ratio of 8.0% (increased from 6.0%), a total risk-based capital ratio of 10.0% (unchanged), and a leverage ratio of 5.0% (unchanged).

At December 31, 2016, the Bank's capital exceeded all applicable requirements and is considered "well-capitalized".
The risk-based capital standards of the Federal Reserve explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution's ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution's overall capital adequacy.  The capital guidelines also provide that an institution's exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization's capital adequacy.

The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FDIC.  These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers.  The Company and the Bank presently maintain sufficient capital to remain in compliance with these capital requirements.


11


Other Legislative and Regulatory Concerns

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


Formal Written Agreement

On October 13, 2010, the Company and Bank entered into a written agreement ("Written Agreement") with the Federal Reserve Bank of Richmond (the "Reserve Bank").  Under the terms of the Written Agreement, the Bank has agreed to develop and submit to the Reserve Bank for approval within the time periods specified therein written plans or programs to:

·
strengthen board oversight of the management and operations of the Bank;
·
strengthen credit risk management and administration;
·
provide for the effective grading of the Bank's loan portfolio;
·
summarize the findings of its review of the adequacy of the staffing of its loan review function;
·
improve the Bank's position with respect to loans, relationships, or other assets in excess of $500,000 that currently are or in the future become past due more than 90 days, on the Bank's problem loan list, or adversely classified in any report of examination of the Bank;
·
review and revise the Bank's methodology for determining the allowance for loan and lease losses ("ALLL") and maintain an adequate ALLL;
·
maintain sufficient capital at the Company and the Bank;
·
establish a revised written contingency funding plan;
·
establish a revised written strategic and capital plan;
·
establish a revised investment policy;
·
improve the Bank's earnings and overall condition;
·
revise the Bank's information technology program;
·
establish a disaster recovery and business continuity program; and,
·
establish a committee to monitor compliance with all aspects of the written agreement.

Further, both the Company and the Bank have agreed to refrain from declaring or paying dividends without prior regulatory approval.  The Company has agreed that it will not take any other form of payment representing a reduction in Bank's capital or make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior regulatory approval.  The Company also has agreed not to incur, increase or guarantee any debt or not to purchase or redeem any shares of its stock without prior regulatory approval.

The following summarizes the Company's progress to comply with the items in the Written Agreement as of December 31, 2016.


·
A new board oversight policy has been approved and implemented;
·
Completed revising the Bank's loan grading system and ALLL methodology;
·
Improved credit administration policies have been established and increased the staffing in the Loan Review area
·
Implemented Problem Loan Action reports and Problem Asset reports for all assets over $500,000. These are reviewed with the Board and forwarded to the Federal Reserve Bank on a quarterly basis;
·
Completed revising the written contingency funding plan;
·
Implemented stress testing of the loan portfolio;
·
Completed revising the investment policy;
·
Completed a three year capital plan targeted to improve the Company's and Bank's capital levels to include strategically reducing the risk weighted assets of the Company and improving earnings;
·
Completed a Business Continuity Plan and Disaster Recovery Plan; and,
·   
Formed a Directors' compliance committee to monitor the progress of each item in the written agreement. The committee meets at least quarterly and files a report with the Federal Reserve Bank.

 
12

Organization and Employment

The Company, the Bank, HUFS, HUIS, and Russell Road, LLC, are organized in a holding company/subsidiary structure. As of December 31, 2016, the Company had no employees, except for officers, and it conducted substantially all of its operations through its subsidiaries. All cash compensation paid to the Company's officers is paid by the subsidiary bank, including fees paid to its directors. At December 31, 2016, the Bank employed 211 full time equivalent employees at its main office, operations center, support centers and branch offices. The Company's relationship with its employees is considered to be good. An employment contract was entered into with the Company's CEO Timothy Schools in December 2015. The Company filed a Form 8-K discussing the agreement on December 14, 2015. This is the only employment agreement in effect at December 31, 2016.

Company Website

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

Item 1A.  Risk Factors

Not applicable

Item 1B.  Unresolved Staff Comments

Not applicable

Item 2. Properties

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

The Bank also owns the land and three buildings used for its Customer Call Center, Computer Operations, Loan and Deposit Operations, IRA Operations and Facilities departments in Abingdon, Virginia.

The Bank currently has 5 properties held for sale that were previously used for or purchased for banking operations.

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

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

13

Item 3.  Legal Proceedings

On December 23, 2015, James M. Brock and Jean W. Brock (together, "Brock") filed a complaint in the Circuit Court of Grayson County, Virginia, alleging that the Bank acted negligently when it foreclosed on property adjacent to the Brock's property and allegedly failed to remediate the foreclosed property, allegedly causing damage to Brock's property. Brock seeks damages of $200,000 plus prejudgment interest, attorneys' fees, and costs.  The Bank denies any wrongdoing in this matter and intends to vigorously defend itself.  No trial date has yet been set.  The Company is unable to estimate the likelihood of an unfavorable outcome or the amount or range of potential loss.


Item 4.  Mine Safety Disclosures

Not Applicable

Part II

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

Common Stock Information and Dividends

Trades in the Company's common stock are reported on the OTCQX marketplace. In addition, the Company maintains a list of individuals who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Company. The Company's stock transfer agent is Computershare.  Please refer to the table below entitled Common Stock Performance for a summary of sales prices known to the Company for each of the four quarters of 2016 and 2015.




Common Stock Performance – 2016
 
                         
   
High
   
Low
   
Quarterly Average
   
Dividends per Share
 
                         
First Quarter
 
$
6.25
   
$
4.85
   
$
5.31
   
$
-
 
                                 
Second Quarter
 
$
7.00
   
$
5.15
   
$
5.89
   
$
-
 
                                 
Third Quarter
 
$
5.70
   
$
4.55
   
$
5.18
   
$
-
 
                                 
Fourth Quarter
 
$
5.95
   
$
4.90
   
$
5.03
   
$
-
 
                                 
                                 
Common Stock Performance – 2015
 
                                 
   
High
   
Low
   
Quarterly Average
   
Dividends per Share
 
                                 
First Quarter
 
$
4.39
   
$
3.50
   
$
3.74
   
$
-
 
                                 
Second Quarter
 
$
4.50
   
$
3.67
   
$
3.95
   
$
-
 
                                 
Third Quarter
 
$
4.37
   
$
3.95
   
$
4.20
   
$
-
 
                                 
Fourth Quarter
 
$
4.95
   
$
4.22
   
$
4.61
   
$
-
 
 

 
14

 The Company is currently prohibited from paying dividends without regulatory approval under the terms of the Written Agreement dated October 13, 2010. For additional information regarding regulatory restrictions on the Company's ability to pay dividends, see "Certain Regulatory Considerations - Highlands Union Bank – Limits on Dividend and Other Payments" in Item 1 above.

In connection with its capital raise in 2014, the Company issued shares of Series A Convertible Perpetual Preferred Stock (the "Series A Preferred Stock").  Holders of Series A Preferred Stock are entitled to receive when, as and if declared by the Board of Directors or a duly authorized committee of the Board of Directors, out of funds legally available therefore, non-cumulative dividends in the same per share amount as the dividends paid on a share of common stock.  The Company will not pay any dividends with respect to its common stock unless an equivalent dividend also is paid to the holders of the Series A Preferred Stock.

In January of 2016, the Company's CEO, Timothy K. Schools purchased 235,294 shares of the Company's common stock at a price of $4.25 per share in a private placement as disclosed on Form 4 on January 12, 2016.  In February 2016, two of the private placement purchasers participating in the capital raise in 2014, MFP Partners LP and Deerhill Pond Investment Partners, LP, each purchased another 12,744 shares of common stock at $4.25 per share which allowed them to maintain the same ownership percentage that was held immediately prior to the Mr. Schools' purchase.

Effective September 6, 2016, the Company and Timothy K. Schools, the Company's President and Chief Executive Officer, executed an amendment to Mr. Schools' employment agreement. The amendment provides for the grant of 86,667 restricted shares of the Company's common stock. The Restricted Shares will vest 50% on the first anniversary of the Award Date and 50% on the second anniversary of the Award Date. The restricted shares will be expensed over the 2 year vesting period based on the grant date fair value of the shares.

As of March 22, 2017, the Company had approximately 1,403 shareholders of record.

Issuer Repurchases of Equity Securities

The Company had no repurchases of common stock during the twelve months ended December 31, 2016.  The Company does not anticipate any repurchases during 2017 as the Company currently is prohibited from repurchasing its common stock without regulatory approval under the terms of the Written Agreement dated October 13, 2010.
The Company currently has 8,199,229 shares of common stock outstanding as of March 22, 2017.

Item 6. Selected Financial Data

Not Applicable

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

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

15

Caution About Forward-Looking Statements

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

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

·
adverse economic conditions in the market area and the impact on credit quality and risks inherent in the loan portfolio such as repayment risk and fluctuating collateral values;
·
our inability to manage, dispose of and properly value non-performing assets and other real estate owned;
·
further deterioration in the housing market and collateral values;
·
our inability to assess the creditworthiness of our loan portfolio and maintain a sufficient allowance for loan losses;
·
our inability to maintain adequate sources of funding and liquidity, including secondary sources such as Federal Home Loan Bank advances;
·
our ability to attract and maintain capital levels adequate to support our asset levels and risk profile;
·
our inability to comply with the written agreement, dated October 13, 2010, with the Federal Reserve Bank of Richmond;
·
our successful management of interest rate risk and changes in interest rates and interest rate policies;
·
reliance on our management team, including our ability to attract and retain key personnel;
·
our ability to successfully manage our strategic plan;
·
difficult market conditions in our industry;
·
problems with technology utilized by us;
·
our ability to successfully manage third-party vendors upon whom we are dependent;
·
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
·
potential impact on us of recently enacted legislation and future regulation;
·
changes in accounting policies or standards;
·
demand, development and acceptance of new products and services; and,
·
changing trends in customer profiles and behavior.

Overview

At December 31, 2016, the Bank separately (on a non-consolidated basis) had total assets of $613.07 million. Total deposits at this date were $490.70 million. The Bank's net income for 2016 was $96 thousand which produced a return on average assets of 0.02% and a return on average stockholders' equity of 0.18%. Refer to Note 21 of the Notes to Consolidated Financial Statements for the Bank's risk-based capital ratios.

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

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

 

16

Critical Accounting Policies
 
General

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

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



Allowance for Loan Losses

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

Performance Summary

The following table shows certain of the Company's key performance ratios for the years ended December 31, 2016 and 2015:

 
           2016
           2015
     
Return on Average Assets
0.00%
0.22%
Return on Average Equity
0.02%
2.48%
Basic Earnings Per Share
$   0.00
$   0.17
Fully Diluted Earnings per share
$   0.00
$   0.13
Net Interest Margin (1)
3.60%
3.41%
Average Equity to Average Assets Ratio
9.07%
8.78%

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


17

Balance Sheet Summary

The following table shows the Company's key balance sheet indicators at December 31, 2016 and 2015:

(dollar amounts in thousands)


   
2016
   
2015
 
             
Securities
 
$
95,073
   
$
79,860
 
Loans, net
 
$
404,838
   
$
426,429
 
Deposits
 
$
489,869
   
$
494,912
 
Assets
 
$
612,678
   
$
616,982
 

Asset Quality

The following table shows the Company's key asset quality indicators at December 31, 2016 and 2015:

      (dollar amounts in thousands)

   
2016
   
2015
 
 
Non-accrual loans
 
$
3,999
   
$
9,456
 
Loans past due over 90 days and still accruing interest
   
2,210
     
-
 
 
Other real estate owned, net
   
2,768
     
5,694
 
Allowance for loan losses to total loans
   
1.18
%
   
1.31
%
 
Net charge-off ratio
   
0.57
%
   
0.31
%

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

 
18

Results of Operations

Net Interest Income
(dollar amounts in thousands)

Net interest income for 2016 was $19,219 or an increase of $1,013 from 2015. During 2016 interest income increased by $631. This was a result of existing interest earning assets re-pricing at higher rates, and new loans made and securities purchased with higher yields. Average interest earning assets decreased approximately $722 from 2015. Interest-bearing liabilities re-priced downward, causing a decrease in interest expense of $382. The net result of these changes was an increase in the Company's net interest margin from 3.41% in 2015 to 3.60% in 2016. During 2015 and 2016, the Federal Reserve Board began increasing the federal funds rate after being at historic lows for 9 years.

The tax equivalent yield on earning assets for 2016 was 4.38%, increasing 12 basis points as compared to 2015. During the same period, the yield on interest bearing liabilities was 0.98%, which was a decrease of 6 basis points. Average interest bearing liabilities decreased $9,888 from 2015. The Company continued to lower time deposit rates throughout the year in an effort to reduce its cost of funds.

Analysis of Net Interest Earnings

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




 
Year Ended December 31,
 
 
2016
2015
2014
 
 
(Dollars in Thousands)
 
 
Average
Balance
Interest Income/ Expense
 
Yield/
Rate
 
Average
Balance
Interest Income/ Expense
 
Yield/
Rate
 
Average
Balance
Interest Income/ Expense
 
Yield/
Rate
 
ASSETS
                 
Interest earning assets
  (taxable-equivalent basis):
                 
 
Loans (net of unearned
  discount (1)
 
 
$419,670
 
 
$ 21,327
 
 
5.08%
 
 
$416,584
 
 
$ 20,930
 
 
5.02%
 
 
$405,751
 
 
$ 21,332
 
 
5.26%
Securities (2)(3)
98,364
1,968
  2.18
90,835
1,748
  2.13
73,486
1,703
  2.66
Federal funds sold
      20,589
99
  0.48
      31,926
85
  0.27
      59,065
136
  0.23
 
Total interest-earning
  assets
 
 
$ 538,623
 
 
$  23,394
 
 
4.38%
 
 
$ 539,345
 
 
$  22,763
 
 
4.26%
 
 
$ 538,302
 
 
$  23,171
 
 
4.35%
 
LIABILITIES
                 
Interest bearing
  liabilities:
                 
 
Interest bearing deposits
 
$359,556
 
$ 1,794
 
 .50%
 
$369,389
 
$ 2,169
 
 .59%
 
$374,049
 
$ 2,539
 
 .68%
 
Other interest bearing
  liabilities
 
 
67,725
 
 
    2,381
 
 
     3.52
 
 
67,780
 
 
    2,388
 
 
     3.52
 
 
70,827
 
 
    2,685
 
 
     3.79
 
Total interest-bearing
  liabilities
 
 
$427,281
 
 
$  4,175
 
 
0.98%
 
 
$437,169
 
 
$  4,557
 
 
1.04%
 
 
$444,876
 
 
$  5,224
 
 
1.17%
 
Net interest income
 
 
$ 19,219
   
 
$ 18,206
   
 
$ 17,947
 
Net margin on interest
  earning assets on a
  tax equivalent basis
   
 
 
3.60%
   
 
 
3.41%
   
 
 
3.38%
 
Average interest spread
   
 
  3.40%
   
 
  3.22%
   
 
  3.18%
                   
(1)  For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
 
(2) Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax.
 
(3) The yield on securities classified as available – for - sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by ASC 320.
 

19


Analysis of Changes in Interest Income and Interest Expense

The Company's primary source of revenue is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other funds. The Company's net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities and by changes in yields earned on interest-earning assets and rates paid on interest-bearing liabilities. The following table sets forth, for the years indicated, a summary of the changes in interest income and interest expense resulting from changes in average asset and liability balances (volume) and changes in average interest rates (rate).  The increase (decrease) due to change in volume is computed using the change in the average balances between 2016 and 2015, and 2015 and 2014 multiplied by the corresponding current year average rates. The remaining increase or decrease in net interest income is allocated to the change in rate.
Increase/(Decrease) Due to Volume and Rate

   
2016 Compared to 2015
   
 
 
 
Increase (Decrease) in
 
Increase (decrease) due to change in volume
   
Increase (decrease) due to change in rate
   
Net increase
(decrease)
   
   
(Dollars in Thousands)
   
 
INTEREST INCOME
Securities
 
$
164
   
$
56
   
$
220
   
Federal funds sold
   
(55)
 
   
69
     
14
   
Loans
   
157
     
240
     
397
   
 
Total Income Change
 
$
266
   
$
365
   
$
631
   
 
INTEREST EXPENSE
Savings and time deposits
 
$
(49)
 
 
$
(326)
 
 
$
(375)
 
 
Other interest-bearing
  liabilities
   
(2)
 
   
(5)
 
   
(7)
 
 
 
Total Expense Change
 
$
( 51)
 
 
$
(331)
 
 
$
(382)
 
 
 
Increase (Decrease) in
  Net Interest Income
 
$
317
   
$
696
   
$
1,013
   
 

 
   
2015 Compared to 2014
   
 
 
 
Increase (Decrease) in
 
Increase (decrease) due to change in volume
   
Increase (decrease) due to change in rate
   
Net increase
(decrease)
   
   
(Dollars in Thousands)
   
 
INTEREST INCOME
Securities
 
$
369
   
$
(324)
 
 
$
45
   
Federal funds sold
   
(72)
 
   
21
     
(51)
 
 
Loans
   
544
     
(946)
 
   
(402)
 
 
 
Total Income Change
 
$
841
   
$
(1,249)
 
 
$
(408)
 
 
 
INTEREST EXPENSE
Savings and time deposits
 
$
(27)
 
 
$
(343)
 
 
$
(370)
 
 
Other interest-bearing
  liabilities
   
(108)
 
   
(189)
 
   
(297)
 
 
 
Total Expense Change
 
$
(135)
 
 
$
(532)
 
 
$
(667)
 
 
 
Increase (Decrease) in
  Net Interest Income
 
$
976
   
$
(717)
 
 
$
259
   

20

Non-interest Income
(dollar amounts in thousands)

The Company's non-interest income increased by $936 from 2015 to 2016. This was in large part to the gains on loans held for sale that were originated by Highlands Home Mortgage, a new division of the Bank that began selling loans in the second quarter of 2016. Gains on sales of loans held for sale totaled $525 in 2016. Service charges on deposit accounts, primarily overdraft fees, increased $101 from 2015. Earnings related to the Company's holdings of Bank Owned Life Insurance totaled $396 and $402 for 2016 and 2015, respectively.  Visa debit card interchange income totaled $1,355 and $1,312 for 2016 and 2015, respectively.

Non-interest Expense
(dollar amounts in thousands)

   Non-interest expense is comprised of salaries and employee benefit costs, occupancy expenses, furniture and equipment expenses, other operating expenses, and expenses related to foreclosed assets. Non-interest expense for 2016 was $22,909, an increase of $2,372 compared to 2015. Salaries and employee benefits increased by 17.21%, or $1,763, primarily due to staffing related to Highlands Home Mortgage. The Company also paid and/or accrued severance throughout 2016 totaling approximately $795 as part of its strategy to reduce the number of its employees. OREO (other real estate owned) write-downs, net losses on sales and OREO expenses totaled $1,883 in 2016 compared to $1,745 in 2015.

Also during the third quarter of 2015, the Bank settled a lawsuit for $425 which is reflected in other losses (non-interest expense) for the year ended December 31, 2015. The Company received an insurance settlement totaling $148 related to this matter in March 2016. The $148 is included in other operating income for the year ended December 31, 2016.


Income Taxes
(dollar amounts in thousands)

Income tax benefits in 2016 totaled $360 compared to $1,205 in 2015. In the second quarter of 2015, the Company reversed the remaining balance of the valuation allowance that was established against the deferred tax assets ("DTA") during the fourth quarter of 2011. The valuation allowance was established during 2011 due to uncertainty at the time regarding the ability to generate sufficient future taxable income to fully realize the benefit of the net DTA. Subsequent to 2011, earnings performance and asset quality have improved resulting in greater expected realization of the DTA. In addition, the Company raised $16,123 in net proceeds of new capital in 2014 which allowed the Company to payoff two high rate debt instruments (the Company's Community Bankers Bank note and Trust Preferred Securities) improving future earnings potential.  As a result of these factors, the Company reversed $1,000 of the DTA in the second quarter of 2014, and due to the continued improvements in asset quality and earnings performance the remaining $1,000 of the DTA valuation allowance was reversed in the second quarter of 2015. In assessing the realizability of DTA, management considers whether it is more likely than not that some portion or all of the DTA will not be realized. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 ("ASC 740"), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict.  If the Company's forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Management considers the reversal of deferred tax liabilities (including the impact of available carry-back and carry-forward periods), projected future taxable income and tax-planning strategies in making this assessment.

Management, in conjunction with the board of directors, will continue to evaluate the carrying value of the Company's DTA on a quarterly basis, in accordance with ASC 740, and will determine any need for a valuation allowance based upon circumstances and expectations then in existence. 


Provision and Allowance for Loan Losses
(dollar amounts in thousands)

The adequacy of the allowance for loan losses is based on management's judgment and analysis of current and historical loss experience, risk characteristics of the loan portfolio, concentrations of credit and asset quality, as well as other internal and external factors, such as general economic conditions.  The internal credit review department performs pre-approval analyses of large credits and also conducts credit review activities that provide management with an early warning of loan deterioration. The senior credit review officer and chief credit officer prepare quarterly analyses of the adequacy of the allowance for loans losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are based upon historical losses and other factors, as adjusted, for various loan types. To calculate the anticipated loan loss in each call report category for ASC 450 loans, the Bank begins with the net loss in each category for each of the last twelve quarters. The Bank uses a rolling twelve quarter weighted historical loss average where the most recent quarters are weighted heavier than the earlier quarters so that the calculation reflects current risk trends within the portfolio.  The weighting used by the Bank is similar to the Rule of 78's with the net losses of the most recent quarter weighted at 12/78ths and those in the first quarter in the twelve quarter period weighted at 1/78th. Therefore, the net losses of the most recent year represent approximately 54% of the calculation compared with 33% if a simple average of losses over the three-year period was used.  The total of weighted factors for each call report category is applied to the current outstanding loan balance in each category to calculate expected loss based on historical data for a group of loans with similar risk characteristics.  The same weighting is applied to all loan types.  In addition to the change in the period of historical losses included in the calculation, additional amounts were allocated based upon internal and external factors such as changing trends in the loan mix, the effects of changes in business conditions in our market areas, unemployment trends, the effects of any changes in loan policies, competition, regulatory factors, and environmental factors related to our loan portfolio. The calculation for allowance for loan losses is reviewed by both the Credit Administration Committee and the Board of Directors. There can be no assurance however that additional provisions for loan losses will not be required in the future as a result of adverse changes in the economy, or further decreases in real estate values which will affect management's future assumptions and allowance methodology.The Company's allowance for loan losses includes an unallocated portion totaling $1,258 primarily due to factors such as the Company's level of non-performing loans.

The Company's allowance for loan losses to total loans was 1.18% and 1.31%, respectively at December 31, 2016 and December 31, 2015.

At December 31, 2016 and 2015, the internal credit review department as well as management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of US generally accepted accounting principles.

21

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

   
Years Ended December 31,
(Dollars in Thousands)
 
   
2016
   
2015
   
2014
   
2013
   
2012
 
Allowance for loan losses at  beginning of year
 
$
5,654
   
$
5,477
   
$
6,825
   
$
7,449
   
$
9,024
 
 
Loans charged off:
                                       
  Residential 1-4 Family
   
249
     
360
     
258
     
452
     
584
 
  Multifamily
   
-
     
-
     
-
     
-
     
246
 
  Construction and Land Loans
   
28
     
12
     
18
     
127
     
518
 
  Commercial, Owner Occupied
   
1,245
     
407
     
345
     
52
     
686
 
  Commercial, Non-owner occupied
   
-
     
12
     
1,239
     
408
     
183
 
  Second Mortgages
   
4
     
3
     
25
     
134
     
90
 
  Equity Lines of Credit
   
8
     
-
     
116
     
3
     
23
 
  Farmland
   
2
     
-
     
-
     
40
     
4
 
                                         
Secured (other ) and unsecured
                                       
   Personal
   
899
     
662
     
315
     
274
     
300
 
  Commercial
   
164
     
257
     
177
     
408
     
592
 
  Agricultural
   
-
     
-
     
230
     
12
     
2
 
 
  Overdrafts
   
147
     
134
     
229
     
170
     
153
 
          Total
   
2,746
     
1,847
     
2,952
     
2,080
     
3,381
 
 
Recoveries of loans previously
  charged off:
                                       
                                         
  Residential 1-4 Family
   
32
     
3
     
1
     
19
     
161
 
  Multifamily
   
-
     
-
     
-
     
-
     
-
 
  Construction and Land Loans
   
14
     
41
     
17
     
5
     
453
 
  Commercial, Owner Occupied
   
7
     
376
     
132
     
-
     
5
 
  Commercial, Non-owner occupied
   
8
     
6
     
1
     
-
     
2
 
  Second Mortgages
   
-
     
-
     
-
     
-
     
3
 
  Equity Lines of Credit
   
2
     
41
     
-
     
-
     
-
 
  Farmland
   
-
     
3
     
-
     
-
     
2
 
                                         
  Secured (other ) and unsecured
                                       
  Personal
   
195
     
76
     
90
     
75
     
74
 
 Commercial
   
137
     
9
     
39
     
31
     
144
 
 Agricultural
   
-
     
-
     
-
     
6
     
4
 
 Overdrafts
   
-
     
-
     
-
     
-
     
-
 
                                         
            Total
   
395
     
555
     
280
     
136
     
848
 
                                         
Net loans charged off
   
2,351
     
1,292
     
2,672
     
1,944
     
2,533
 
Provision for loan losses
   
1,526
     
1,469
     
1,324
     
1,320
     
958
 
 
Allowance for loan losses end of year
 
$
4,829
   
$
5,654
   
$
5,477
   
$
6,825
   
$
7,449
 
 
Average total loans (net of deferred fees)
 
$
419,670
   
$
416,584
   
$
405,751
   
$
398,055
   
$
400,361
 
 
Total loans (net of deferred fees) at year-end
 
$
409,667
   
$
432,083
   
$
406,997
   
$
403,786
   
$
390,498
 
 
Ratio of net charge-offs to average loans
   
0.56
%
   
0.31
%
   
0.66
%
   
0.49
%
   
0.63
%
 
Ratio of provision for loan losses to average loans
   
0.36
%
   
0.35
%
   
0.33
%
   
0.33
%
   
0.24
%
 
Ratio of provision for loan losses to net charge-off
   
64.91
%
   
113.70
%
   
49.55
%
   
67.90
%
   
37.82
%
 
Allowance for loan losses to year-end loans
   
1.18
%
   
1.31
%
   
1.35
%
   
1.69
%
   
1.91
%
                                         



22

Non-performing loans
(dollar amounts in thousands)

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

Management's review of commercial and other loans may result in a determination that a loan should be placed on non-accrual. It is the policy of the Bank to discontinue the accrual of interest on any loan on which full repayment of principal and / or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt or a reduction of the  principal balance if the collection of all principal is not certain. Placing a loan on non-accrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and the financial condition of the borrower serve as more reliable indicators of potential loss of principal.
The policy of the Bank is that non-performing loans consist of loans accounted for on a non-accrual basis and loans which are contractually past due 90 days or more in regards to interest and/or principal payments. The following table presents non-performing loans at December 31.

   
2016
   
2015
   
2014
   
2013
   
2012
 
   
(Amounts in thousands)
 
                               
Non-performing loans
 
$
3,999
   
$
9,456
   
$
11,666
   
$
10,986
   
$
10,550
 
                                         
Non-accrual loans
 
$
3,999
   
$
9,456
   
$
11,644
   
$
10,984
   
$
10,544
 
                                         
Loans past-due 90 days and more and still accruing
 
$
2,210
   
$
-
   
$
22
   
$
2
   
$
6
 
                                         
Interest income lost on non-accruing loans
 
$
356
   
$
449
   
$
618
   
$
620
   
$
725
 
                                         

 The allowance for loan losses to total loans decreased from 1.31% to 1.18% during 2016. This was primarily due to loans being transferred into OREO and/or liquidated and subsequently written down to current market values out of specific reserves allocated to such loans. Additionally it was due to two large loans in the Company's Southwest VA market that were charged off in the second quarter of 2016. The Company foreclosed and sold its largest non-performing loan in December of 2016. This relationship totaling $2,210 is reflected above as 90 days past due and accruing. The property was sold at foreclosure and the Company received payoff funds including interest on January 19, 2017.

It is management's opinion that at December 31, 2016, the allowance for loan losses was determined to be in accordance with US generally accepted accounting principles and is adequate. The allowance for loan losses is reviewed and approved quarterly by the Board of Directors.
23

Allocation of the allowance for loan losses

The following table provides an allocation of the allowance for loan losses at December 31, 2016, 2015, 2014, 2013 and 2012.


   
December 31,
Percent of Loans on each Category
(Dollars in Thousands)
 
   
2016
   
2015
   
2014
 
   
Allowance for
Loan Loss
   
Percentage of Total Allowance
   
Percentage of
Total Loans
   
Allowance for
Loan Loss
   
Percentage of Total Allowance
   
Percentage of
Total Loans
   
Allowance for
Loan Loss
   
Percentage of Total Allowance
   
Percentage of
Total Loans
 
 
Residential 1-4 Family
 
$
371
     
7.68
%
   
45.49
%
 
$
654
     
11.57
%
   
44.88
%
 
$
995
     
18.17
%
   
45.83
%
Multifamily
           
0.00
     
5.51
             
0.00
     
5.52
     
20
     
0.37
     
5.18
 
Construction and Land Loans
   
21
     
0.44
     
3.89
     
37
     
0.66
     
4.43
     
87
     
1.59
     
4.54
 
Commercial – Owner Occupied
   
1,339
     
27.73
     
17.64
     
1,012
     
17.90
     
16.87
     
409
     
7.47
     
17.35
 
Commercial  Non Owner Occupied
   
445
     
9.21
     
7.02
     
748
     
13.23
     
8.78
     
1,063
     
19.41
     
7.89
 
Second Mortgages
   
15
     
0.31
     
1.69
     
43
     
0.76
     
1.89
     
67
     
1.22
     
1.98
 
Equity Line of Credit
   
27
     
0.56
     
3.27
     
20
     
0.35
     
1.39
     
74
     
1.35
     
1.60
 
 Farmland
   
16
     
0.33
     
2.97
     
7
     
0.12
     
2.61
     
12
     
0.22
     
2.02
 
                                                                         
Personal
   
802
     
16.61
     
4.32
     
704
     
12.45
     
4.80
     
665
     
12.14
     
5.13
 
Commercial
   
484
     
10.02
     
7.31
     
798
     
14.11
     
8.12
     
852
     
15.55
     
7.75
 
Agricultural
   
51
     
1.06
     
0.85
     
88
     
1.56
     
0.68
     
130
     
2.37
     
0.66
 
                                                                         
Overdrafts
   
-
     
-
     
0.04
     
-
     
-
     
0.03
     
-
     
-
     
0.07
 
Unallocated
   
1,258
     
26.05
     
-
     
1,543
     
27.29
     
-
     
1,103
     
20.14
     
-
 
                                                                         
 
Total
 
$
4,829
     
100.00
%
   
100.00
%
 
$
5,654
     
100.00
%
   
100.00
%
 
$
5,477
     
100.00
%
   
100.00
%





                                     
   
December 31,
Percent of Loans on each Category
(Dollars in Thousands)
       
   
2013
   
2012
 
   
Allowance for
Loan Loss
   
Percentage of Total Allowance
   
Percentage of
Total Loans
   
Allowance for
Loan Loss
   
Percentage of Total Allowance
   
Percentage of
Total Loans
 
 
Residential 1-4 Family
 
$
975
     
14.29
%
   
43.49
%
 
$
1,242
     
16.67
%
   
42.90
%
Multifamily
   
143
     
2.09
     
5.09
     
280
     
3.76
     
4.44
 
Construction and Land Loans
   
230
     
3.37
     
4.58
     
823
     
11.05
     
4.90
 
Commercial – Owner Occupied
   
1,029
     
15.08
     
17.66
     
1,039
     
13.95
     
16.50
 
Commercial  Non Owner Occupied
   
1,415
     
20.73
     
9.18
     
1,075
     
14.43
     
9.09
 
Second Mortgages
   
153
     
2.24
     
1.96
     
161
     
2.16
     
2.38
 
Equity Line of Credit
   
50
     
0.73
     
1.95
     
30
     
0.40
     
2.12
 
 Farmland
   
65
     
0.95
     
2.31
     
97
     
1.30
     
2.86
 
                                                 
Personal
   
483
     
7.08
     
5.06
     
486
     
6.53
     
5.72
 
Commercial
   
1,193
     
17.48
     
7.81
     
1,530
     
20.54
     
20.54
 
Agricultural
   
71
     
1.04
     
0.83
     
-
     
-
     
-
 
                                                 
Overdrafts
   
-
     
-
     
0.08
     
-
     
-
     
-
 
Unallocated
   
1,018
     
14.92
     
-
     
686
     
9.21
     
9.21
 
                                                 
 
Total
 
$
6,825
     
100.00
%
   
100.00
%
 
$
7,449
     
100.00
%
   
100.00
%


24

Financial Condition

Balance Sheet
(dollar amounts in thousands)

Total assets of the Company decreased slightly by $4,304 or 0.70% in 2016.  Average interest earning assets decreased approximately $722 from 2015. The Company's current strategy over the next couple of years is to moderately grow loans using existing federal funds sold, cash on hand or new deposits. Average interest bearing liabilities decreased by $9,888 from 2015. The Company plans on paying off three high rate FHLB borrowings that mature in 2017 from existing cash on hand and / or new deposits. Total deposits decreased $5,043 or 1.02% as the Company continued to see a decline in time deposits.

Loans
(dollar amounts in thousands)

Loans net of unearned income and deferred fees decreased by $22,416 or 5.19% in 2016. The majority of this decrease was due to the Company's transition to more stringent underwriting standards as well as its focus to reduce its non-performing loans. Non-accrual loans declined $5,457 during 2016.

Prior to the economic downturn, the Company's portfolio of commercial, construction and land development loans had experienced significant growth. As construction and commercial lending has slowed significantly in the last seven years, a diligent effort has been made to concentrate on permanent financing for residential mortgages and home equity lines of credit.

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

Loan Portfolio

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


25

   
December 31,
(Dollars in thousands)
 
   
2016
   
2015
   
2014
   
2013
   
2012
 
   
Amount
   
Percentage
   
Amount
   
Percentage
   
Amount
   
Percentage
   
Amount
   
Percentage
   
Amount
   
Percentage
 
Real Estate Secured:
                                                           
  Residential 1-4 family
 
$
186,695
     
45.49
%
 
$
194,287
     
44.88
%
 
$
186,829
     
45.83
%
 
$
175,860
     
43.49
%
 
$
167,777
     
42.90
%
  Multi-family
   
22,630
     
5.51
     
23,895
     
5.52
     
21,131
     
5.18
     
20,592
     
5.09
     
17,348
     
4.44
 
 Construction and Land          Loans
   
15,978
     
3.89
     
19,163
     
4.43
     
18,518
     
4.54
     
18,509
     
4.58
     
19,161
     
4.90
 
 Commercial, Owner Occ.
   
72,383
     
17.64
     
73,031
     
16.87
     
70,748
     
17.35
     
71,459
     
17.66
     
64,504
     
16.50
 
Commercial, Non Owner   Occupied
   
28,818
     
7.02
     
38,025
     
8.78
     
32,173
     
7.89
     
37,117
     
9.18
     
35,536
     
9.09
 
Second Mortgages
   
6,934
     
1.69
     
8,169
     
1.89
     
8,075
     
1.97
     
7,934
     
1.96
     
9,298
     
2.38
 
Equity Lines of Credit
   
13,395
     
3.27
     
6,000
     
1.39
     
6,499
     
1.60
     
7,884
     
1.95
     
8,287
     
2.12
 
Farmland
   
12,194
     
2.97
     
11,283
     
2.61
     
8,246
     
2.02
     
9,322
     
2.31
     
11,180
     
2.86
 
   
$
359,027
     
87.48
%
 
$
373,853
     
86.37
%
 
$
352,219
     
86.39
%
 
$
347,677
     
86.22
%
 
$
333,091
     
85.19
%
                                                                                 
 
Secured, Other and Unsecured
                                                                               
  Personal
 
$
17,745
     
4.32
   
$
20,775
     
4.80
%
 
$
20,901
     
5.13
%
 
$
20,472
     
5.06
%
 
$
22,358
     
5.72
%
  Commercial
   
29,977
     
7.31
     
35,144
     
8.12
     
31,586
     
7.75
     
31,575
     
7.81
     
31,927
     
8.15
 
  Agricultural
   
3,490
     
0.85
     
2,959
     
0.68
     
2,683
     
0.66
     
3,376
     
0.83
     
3,372
     
0.86
 
   
$
51,212
     
12.48
   
$
58,878
     
13.60
%
 
$
55,170
     
13.54
%
 
$
55,423
     
13.70
%
 
$
57,657
     
14.73
%
                                                                                 
Overdrafts
 
$
142
     
0.04
   
$
139
     
0.03
%
 
$
285
     
0.07
%
 
$
304
     
0.08
%
 
$
297
     
0.08
%
                                                                                 
Loans, gross
 
$
410,381
     
100.00
%
 
$
432,870
     
100.00
%
 
$
407,674
     
100.00
%
 
$
404,404
     
100.00
%
 
$
391,045
     
100.00
%
                                                                                 




 
26



The following table shows the maturity of loans outstanding, inclusive of expected prepayments and contractual amortization, at December 31,
2016:

   
December 31, 2016
(Amounts in Thousands)
 
 
   
Within One Year
   
After One Year But Within Five Years
   
After Five Years
       
   
Fixed
   
Floating
   
Fixed
   
Floating
   
Fixed
   
Floating
   
Total
 
                                           
Real Estate Secured:
                                         
Residential 1-4 Family
 
$
33,229
   
$
12,165
   
$
73,621
   
$
31,441
   
$
22,092
   
$
14,147
   
$
186,695
 
Multi-family
   
3,361
     
1,256
     
9,089
     
3,299
     
3,804
     
1,821
     
22,630
 
Construction and Land Loans
   
5,593
     
1,190
     
4,716
     
1,156
     
1,509
     
1,815
     
15,979
 
Commercial , Owner Occupied
   
15,592
     
4,430
     
32,037
     
5,243
     
6,846
     
8,236
     
72,384
 
Commercial, Non-Owner      Occupied
   
7,879
     
1,931
     
10,904
     
2,091
     
2,730
     
3,284
     
28,819
 
Second Mortgages
   
2,283
     
1,069
     
2,603
     
711
     
-
     
267
     
6,933
 
Equity Line of Credit
   
-
     
2,890
     
-
     
8,180
     
-
     
2,325
     
13,395
 
Farmland
   
1,314
     
1,966
     
5,196
     
1,385
     
-
     
2,334
     
12,195
 
Secured, Other and Unsecured
                                                       
Personal
   
5,794
     
3,003
     
6,620
     
1,643
     
-
     
685
     
17,745
 
Commercial
   
9,707
     
4,167
     
15,657
     
347
     
-
     
99
     
29,977
 
Agricultural
   
1,128
     
484
     
1,826
     
40
     
-
     
11
     
3,489
 
Overdrafts
   
140
     
-
     
-
     
-
     
-
     
-
     
140
 
                                                         
                                                         
Loans, Gross
 
$
86,020
   
$
34,551
   
$
162,269
   
$
55,536
   
$
36,981
   
$
35,024
   
$
410,381
 
                                                         
                                                         
                                                         
                                                         






27

Foreclosed Assets (Other Real Estate Owned)
(dollar amounts in thousands)

At December 31, 2016 OREO balances were $2,768 and consisted of 22 relationships. At December 31, 2015 OREO balances were $5,694 and consisted of 28 relationships. The following chart details each category type, number of relationships and balance.
 
 
 
 
OREO Property at 12/31/2016
           
             
OREO Description
 
Number
   
Balance at 12/31/16
 
         
(in thousands)
 
Land Development  - Vacant Land
   
9
   
$
597
 
1-4 Family
   
6
     
340
 
Commercial Real Estate
   
7
     
1,831
 
                 
Total
   
22
   
$
2,768
 
                 
 
 
 
OREO Property at 12/31/2015
           
             
OREO Description
 
Number
   
Balance at 12/31/15
 
         
(in thousands)
 
Land Development  - Vacant Land
   
11
   
$
1,287
 
1-4 Family
   
10
     
1,295
 
Commercial Real Estate
   
7
     
3,112
 
                 
Total
   
28
   
$
5,694
 
                 

The following table shows the activity related to OREO for the periods ended December 31, 2016 and 2015.

             
             
OREO Description
 
2016
   
2015
 
             
Beginning balance, January 1
 
$
5,694
   
$
6,685
 
Additions
   
1,632
     
4,131
 
Deletions
   
(4,558)
 
   
(5,122)
 
Ending Balance, December 31
 
$
2,768
   
$
5,694
 
                 

The Company's major markets are Southwestern Virginia, Tri-city Tennessee, Sevierville and Knoxville, Tennessee, and Boone and Banner Elk, North Carolina. The following table provides information about properties owned in each geographic area, the number of individual properties and book value.




   
December 31, 2016
   
December 31, 2015
 
                         
Geographic Area
 
Number
   
Value (in thousands)
   
Number
   
Value (in thousands)
 
                         
Sevierville and Knoxville TN Area
   
4
   
$
153
     
8
   
$
1,179
 
Southwest VA and Tri-city TN Area
   
16
     
2,525
     
17
     
4,248
 
Boone and Banner Elk NC Area
   
2
     
90
     
3
     
267
 
                                 
Total
   
22
   
$
2,768
     
28
   
$
5,694
 

The Company formed a special assets committee to focus directly on selling OREO properties and reducing other non-performing assets. The committee is comprised of lending officers from all of the Bank's three market areas. The ability to sell OREO which has been negatively affected by the current economic climate and the resulting reduction of non-performing assets, will to a large degree, depend upon continued saturation in specific market areas and strengthened local economies. Management has allocated significant resources to facilitate sales of OREO to reduce the Company's non-performing assets.


28

Securities
(dollar amounts in thousands)

Investment securities available for sale and other investments increased $15,213 (market value) from December 31, 2015 to December 31, 2016.  The Company made a significant number of purchases during 2016 primarily due to the Company's strategy to invest existing overnight funds into higher yielding securities. During 2016, the Company purchased a mix of Municipals, CMOs and MBS. As shown in the table below, for 2016, the average taxable equivalent yield on fixed rate mortgage backed securities was approximately 2.13% versus earning an average yield of 0.48% on overnight funds at the Federal Reserve.

Investment Portfolio

The following tables present the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2016 and December 31, 2015.

 
December 31, 2016
 
(Dollars in Thousands)
 
 
 
Within One
Year
   
One Year
Through
Five Years
   
Five Years
Through
Ten Years
   
After Ten
Years
   
Yield
   
Market
Value
     Amortized
Cost
 
Mortgage-backed Sec – fixed rate
 
$
-
   
$
-
   
$
9,716
   
$
61,666
     
2.13
%
 
$
71.387
   
$
72,481
 
Mtg.-backed Sec – variable rate
   
-
     
-
     
2
     
2,904
     
1.50
     
2.906
     
2,903
 
State & Municipals–  tax exempt
   
562
     
358
     
-
     
7,134
     
4.07
     
8.054
     
8,375
 
State & Municipals –  taxable
   
-
     
1,068
     
-
     
3,328
     
2.61
     
4.396
     
4,639
 
SBA bonds – fixed rate
           
846
     
-
     
7,484
     
2.23
     
8,330
     
8,529
 
SBA bonds – variable rate
   
-
     
-
     
3
     
-
     
1.12
     
3
     
3
 
 
TOTAL
   
562
   
$
2,272
   
$
9,721
   
$
82,516
           
$
95,073
   
$
96,930
 
Total fixed rate securities
 
$
562
   
$
2,272
   
$
9,716
   
$
79,612
           
$
92,164
   
$
94,024
 
 
Total variable rate securities
 
$
-
   
$
-
   
$
5
   
$
2,904
           
$
2,909
   
$
2,906
 
 

 
December 31, 2015
 
(Dollars in Thousands)
 
 
 
 
Within One
Year
   
One Year
Through
Five Years
   
Five Years
Through
Ten Years
   
After Ten
Years
   
Yield
   
Market
Value
     Amortized
Cost
 
Mortgage-backed Sec – fixed rate
 
$
-
   
$
-
   
$
6,877
   
$
49,250
     
1.84
%
 
$
56,127
   
$
56,395
 
Mtg.-backed Sec – variable rate
   
-
     
-
     
3
     
6,464
     
1.03
     
6,467
     
6,517
 
State & Municipals –  tax exempt
   
-
     
376
     
-
     
4,973
     
6.46
     
5,349
     
5,239
 
State & Municipals –  taxable
   
-
     
1,096
     
-
     
512
     
2.00
     
1,608
     
1,594
 
SBA bonds – fixed rate
           
1,192
     
-
     
9,110
     
1.94
     
10,302
     
10,487
 
SBA bonds – variable rate
   
-
     
-
     
7
     
-
     
0.83
     
7
     
7
 
 
TOTAL
   
-
   
$
2,664
   
$
6,887
   
$
70,309
           
$
79,860
   
$
80,239
 
Total fixed rate securities
 
$
-
   
$
2,664
   
$
6,887
   
$
63,845
           
$
73,386
   
$
73,715
 
 
Total variable rate securities
 
$
-
   
$
-
   
$
10
   
$