10-K 1 a2017q410-k.htm 10-K Document


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, 2017
[   ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number:  000-27622

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.)
P.O. Box 1128
Abingdon, Virginia
(Address of principal executive offices)
 24212-1128
(Zip Code)

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

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, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,”and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [ ] Smaller Reporting Company [X] Emerging Growth Company [ ]
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
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. $49,735,450.
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 8,199,228 shares of common stock, par value $0.625 per share, outstanding as of April 2, 2018.
DOCUMENTS INCORPORATED BY REFERENCE
Consolidated Financial Report for year ended December 31, 2017 – Part II
Proxy Statement for the 2018 Annual Meeting of Shareholders—Part III




Highlands Bankshares, Inc.
Form 10-K
For the Year Ended December 31, 2017

Table of Contents

 
Page
 
 
 
 
 


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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's single direct subsidiary as of December 31, 2017 is 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 provides banking, insurance, wealth management, and other financial solutions through 14 banking offices, 3 loan production offices, and 160 full-time equivalent associates located in North Carolina, Tennessee, and Virginia.
The Bank offers retail and commercial banking products and services to individuals, businesses and local government customers. These products and services include traditional deposit and loan options, including checking accounts, money market deposit accounts, interest-bearing demand deposit accounts, savings accounts, time deposits, residential 1-4 family loans, owner occupied and non owner occupied commercial real estate loans, second mortgage loans, home equity lines of credit, consumer, commercial/industrial, credit card and agricultural loans. Other products and services offered include automatic funds transfer, night depository, safe deposit, and 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, 2017, had purchased multiple full service insurance agencies across the state of Virginia. HUIS sells insurance products and services through Bankers' Insurance, LLC.
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.

Lending Activities
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 Credit Committee, which is comprised of senior officers of the Bank from all market areas. The Credit Committee considers loans that exceed the individual loan officers' lending authority and reviews loans to be presented to the Board's Risk Committee or the Board of Directors. In addition to approving loans that exceed the Credit Committee's authority, the board's Risk Committee reviews portfolio concentrations and other credit quality metrics. All lending policies are reviewed and approved by the Board of Directors. .
The Bank has engaged an external third part to perform an independent review of the Bank's loan portfolio to identify loss exposure and to monitor compliance with the Bank's loan policy. The independent credit review seeks to review approximately 50 percent of outstanding loan balances each year.
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 guidelines. 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.

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Second mortgages and Home Equity Lines of Credit are generated, underwritten and secured like single family residential real estate loans discussed above. Second mortgage loans are typically originated at higher interest rates than residential mortgage loans. Home equity lines of credit are typically variable-rate instruments based on a market index, although some have been originated with a promotional interest rate that reverts to standard pricing following a specified period of time. Second mortgages are typically made for no more than fifteen years. Home equity lines of credit mature in ten years.
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, 2017, $214.0 million, or 49.5 percent, of the Bank's loan portfolio consisted of one-to four-family residential real estate loans, second mortgages, and home equity lines. 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 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, 2017, $19.5 million, or 4.5 percent, 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.
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, 2017, commercial real estate loans aggregated $115.9 million, or 26.8 percent, of the Bank's total loans. In its underwriting of commercial real estate, the Bank may lend, under its policy, up to 80% 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, 2017, construction, farmland, and other land loans outstanding were $29.1 million, or 6.7 percent, 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 80% 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.

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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. To manage these risks, the Bank generally obtains collateral, such as assignments of inventory or 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, 2017, commercial and agricultural non-real estate secured loans including unsecured loans aggregated $39.7 million, or 9.2 percent, 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, 2017, the Bank had consumer loans of $14.2 million or 3.3 percent 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.
Participation Loans
In addition to secondary marketing activities related to 1-4 family residential mortgage 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, 2017 and 2016, 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, 2017
Interest and Fees on Loans
81.83%
December 31, 2016
Interest and Fees on Loans
79.21%


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Market Area
The Bank operates five offices in Southwest Virginia, five offices in the Tri-Cities area straddling the Tennessee/Virginia border, three offices in the vicinity of Knoxville, Tennessee, and two offices in the High County region of Northwestern North Carolina

Southwest Virginia Market Area
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 2017.
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. In Smyth County, educational/health care services, manufacturing, and retail trade sectors are the largest industries.
Tri-Cities Market Area
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.
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.
Knoxville Market Area
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. There is some industrial base that mitigates some of the seasonal employment fluctuation from the tourism and related businesses.
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. 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.
High Country Market Area
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, tourism and arts/entertainment are the largest industries.
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.

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. 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.


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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.
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

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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.

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

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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.
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, 2017 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:
Audited comparative annual financial statements
The independent public accountant's report on the audited financial statements
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
An assessment by management of the institution's compliance with the designated laws and regulations during the year.
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

9



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.
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

10



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 ("CET1") 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. CET1 generally consists of common stock and retained earnings, subject to applicable regulatory adjustments and deductions.
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:
CET1 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).
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 CET1 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 CET1, Tier 1 and total capital ratios, the Bank will have to maintain a capital conservation buffer consisting of additional CET1 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. Phase-in of this new capital conservation buffer requirement commenced in January 2016 at 0.625% of risk-weighted assets and will increase each year until fully implemented in January 2019.

11



Under the new standards, which became effective January 1, 2015, in order to be considered well-capitalized, the Bank must have a CET1 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).
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.
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, 2017:
A new board oversight policy has been approved and implemented;
Revised the Bank's loan grading system and ALLL methodology;
Improved credit administration policies have been established; the Bank has engaged a third party to provide an independent credit review
Implemented problem loan action reports and problem asset reports for all assets over $500,000; these reports are reviewed with the Board and provided to the Federal Reserve Bank on a quarterly basis;

12



Revised the written contingency funding plan;
Implemented stress testing of the loan portfolio;
Revised 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.

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, 2017, the Company had no employees, although certain Bank employees are designated as officers of the Company. The Bank pays all employee and officer salaries and director fees. At December 31, 2017, the Bank employed 153 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.
The Company executed an employment agreement with CEO Timothy Schools in December 2015, which was reported on the Company's Form 8-K on December 14, 2015. This is the only employment agreement in effect at December 31, 2017.

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 located in Southwest Virginia, the Tri-Cities area that straddles Virginia and Tennessee, the Knoxville area and the High Country area of Northwestern North Carolina. 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, loan and deposit operations, and facilities departments in Abingdon, Virginia.

The Bank currently has four 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.

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.
The Company, the Bank and other subsidiaries are occasionally named as defendants in various legal actions arising from our normal business activities in which damages in various amounts are claimed. Although the amount of any ultimate liability with respect to those matters cannot be determined, in the opinion of management, no legal actions currently exist that are expected to have a material effect on the Company's consolidated financial statements.


Item 4.  Mine Safety Disclosures

Not Applicable

14




PART II.
FINANCIAL INFORMATION

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. These parties negotiate the per share price independent of the Company. The Company's transfer agent is Computershare. 

The following table provides market prices for trades in the Company's Common stock for each of the four quarters for 2017 and 2016.
Common Stock Performance – 2017
 
 
High
 
Low
 
Quarterly Average
 
Dividends per Share
First Quarter
 
$
7.28

 
$
5.95

 
$
6.86

 
$

Second Quarter
 
$
7.50

 
$
6.65

 
$
7.08

 
$

Third Quarter
 
$
7.25

 
$
6.86

 
$
7.04

 
$

Fourth Quarter
 
$
7.56

 
$
6.92

 
$
7.16

 
$

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

 
$


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 "Regulatory Considerations - Highlands Union Bank – Limits on Dividends 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 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.

As of April 2, 2018, the Company had approximately 1,347 shareholders of record.

Issuer Repurchases of Equity Securities

The Company had no repurchases of common stock during the twelve months ended December 31, 2017.  The Company does not anticipate any repurchases during 2018 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 April 2, 2018.

Item 6. Selected Financial Data

Not Applicable

15





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

The following discussion and analysis is provided to address information about the Company's financial condition and results of operations that is not otherwise apparent from the Consolidated Financial Statements and the notes thereto or included in this report. Reference should be made to those statements and the notes thereto for an understanding of the following discussion and analysis.

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 areas we serve and the impact on credit quality of risks inherent in the loan portfolio, including repayment risk and fluctuations collateral values;
our ability to manage, dispose of and properly value non-performing assets and other real estate owned;
further deterioration in housing market and collateral values;
our ability to assess the creditworthiness of our loan customers and to maintain an adequate allowance for loan losses;
our ability to maintain adequate sources of funding and liquidity, including customer deposits and access to 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 ability to comply with the October 13, 2010 written agreement with the Federal Reserve Bank of Richmond;
our ability to successfully manage 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 that exist now or may develop in future periods;
problems with technology utilized by us;
our ability to successfully manage third-party vendors upon whom we are dependent;
competition with other banks, non-bank financial institutions, and companies outside of the banking industry, including companies that have substantially greater access to capital and other resources;
potential impact on us of recently-enacted legislation and future regulations;
changes in accounting policies or standards;
demand, development and acceptance of new products an services; and
changing trends in customer profiles and behavior.


Critical Accounting Policies
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.
The Company monitors credit quality 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.

16




Performance Summary

The following table provides certain key performance ratios for the years ended December 31, 2017 and December 31, 2016.
 
2017
 
2016
Return on average assets
(0.07
)%
 

Return on average equity
(0.78
)%
 
0.02
%
Basic earnings (loss) per share
$
(0.05
)
 
$

Fully diluted earnings (loss) per share
$
(0.05
)
 
$

Net interest margin
3.54
 %
 
3.60
%
 
 
 
 


Results of Operations

The Company reported a consolidated net loss of $(437,000) for the year ended December 31, 2017, compared to net income of $12,000 for the year ended December 31, 2016. Income before income taxes totaled $5.3 million for 2017, compared to loss before income taxes of $(348,000) for 2016. The Company recorded income tax expense of $5.7 million during 2017, $4.0 million of which relates to the revaluation of the Company's net deferred tax asset resulting from enactment of the the Tax Cut and Jobs Act on December 22, 2017.

The following table provides summarized income statements for the years ended December 31, 2017 and December 31, 2016.
 
 
Year ended December 31,
 
(thousands)
 
2017
 
2016
 
Net interest income
 
$
18,928

 
$
19,219

 
Provision expense
 
120

 
1,526

 
Noninterest income
 
6,036

 
4,868

 
Noninterest expense
 
19,587

 
22,909

 
Income (loss) before income taxes
 
5,257

 
(348
)
 
Income tax expense (benefit)
 
5,694

 
(360
)
 
Net income (loss)
 
$
(437
)
 
$
12

 


Net interest income
Net interest income for the year ended December 31, 2017 decreased $291,000 or 1.5 percent compared to the year ended December 31, 2016 primarily due to a $4.1 million reduction in average interest-earning assets. While average loan balances increased slightly during 2017, average investment securities declined $3.2 million or 3.3 percent and average fed funds sold declined $2.1 million or 9.2 percent. The reductions in average investment securities and average fed funds sold occurred as existing liquidity was used to fund repayment of FHLB advances.

Average interest-bearing liabilities decreased $20.3 million during 2017 due to repayments of FHLB advances and a $7.7 million reduction in average interest-bearing deposits. The rate on average interest-bearing liabilities declined from 0.98 percent during 2016, to 0.94 percent for 2017 due to the repayment of $27.5 million of FHLB advances and change in deposit mix.


17



The following table shows the major categories of interest-earning assets and interest-bearing liabilities, the related interest income or expense, the average yield or rate on the average balance outstanding, net interest income, interest rate spread and net yield on average interest-earning assets for the periods indicated.
 
2017
 
2016
 
2015
($ thousands)
Average balance
Interest income/expense
Yield/rate
 
Average balance
Interest income/expense
Yield/rate
 
Average balance
Interest income/expense
Yield/rate
Loans
$
420,024

$
20,427

4.86
%
 
$
419,670

$
21,327

5.08
%
 
$
416,584

$
20,930

5.02
%
Investment securities available for sale
93,425

2,148

2.30
%
 
98,364

1,968

2.18
%
 
90,835

1,748

2.13
%
Fed funds sold
20,734

192

0.93
%
 
20,589

99

0.48
%
 
31,926

85

0.27
%
Total interest-earning assets
$
534,183

$
22,767

4.26
%
 
$
538,623

$
23,394

4.38
%
 
$
539,345

$
22,763

4.26
%
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing deposits
$
351,824

1,854

0.53
%
 
$
359,556

$
1,794

0.50
%
 
$
369,389

$
2,169

0.59
%
FHLB advances
55,164

1,985

3.60
%
 
67,725

2,381

3.52
%
 
67,780

2,388

3.52
%
Total interest-bearing liabilities
$
406,988

3,839

0.94
%
 
$
427,281

4,175

0.98
%
 
$
437,169

4,557

1.04
%
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
$
18,928

 
 
 
$
19,219

 
 
 
$
18,206

 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate spread
 
 
3.32
%
 
 
 
3.40
%
 
 
 
3.22
%
Net yield on interest-earning assets
3.54
%
 
 
 
3.60
%
 
 
 
3.41
%
 
 
 
 
 
 
 
 
 
 
 
 
Loans includes loans held for sale and nonaccrual loans.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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, FHLB borrowings and other interest-bearing liabilities. 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 the current and prior period, multiplied by the corresponding current year average yield/rate. The remaining increase or decrease in net interest income is allocated between yield and rate.

 
2017
 
2016
 
Increase (decrease) due to change in
 
Increase (decrease) due to change in
(thousands)
Volume
Rate
Total
 
Volume
Rate
Total
Loans
$
18

$
(918
)
$
(900
)
 
$
157

$
240

$
397

Investment securities available for sale
(108
)
288

180

 
164

56

220

Fed funds sold
1

92

93

 
(55
)
69

14

Total interest income
$
(194
)
$
(433
)
$
(627
)
 
$
266

$
365

$
631

 
 
 
 
 
 
 

Interest-bearing deposits
$
(39
)
$
99

$
60

 
$
(49
)
$
(326
)
$
(375
)
FHLB advances
(442
)
46

(396
)
 
(2
)
(5
)
(7
)
Total interest expense
$
(199
)
$
(137
)
$
(336
)
 
$
(51
)
$
(331
)
$
(382
)
 
 
 
 
 
 
 
 
Increase (decrease) in net interest income
$
5

$
(296
)
$
(291
)
 
$
317

$
696

$
1,013



18



Provision for loan losses
The provision for loan losses for the year ended December 31, 2017 totaled $120,000, compared to $1.5 million during 2016, primarily due to lower net charge-offs during 2017. The Company continually monitors the loan portfolio for signs of credit weaknesses or developing collection problems. Loan loss provisions for each period are determined after evaluating the loan portfolio and determining the level necessary to absorb current charge-offs and maintain the reserve at adequate levels. 

The Company's allowance for loan losses at December 31, 2017 decreased to 0.92 percent of total loans, compared to December 31, 2016, when the allowance for loan losses as a percentage of total loans was 1.18 percent.

Noninterest income
Noninterest income for 2017 totaled $6.0 million, compared to $4.9 million during 2016. The $1.2 million increase in noninterest income during 2017 primarily resulted from growth in mortgage banking income, which was launched during early 2016. The Company's mortgage division originates loans to be sold on a servicing-released basis through its branch footprint and through offices in Raleigh and Greensboro, North Carolina. Income from the gain on sale of loans totaled $1.9 million during 2017. Previously, underwriting and other operational responsibilities related to originating and marketing these mortgage loans were performed by bank personnel. During early 2018, in an effort to reduce the costs associated with the mortgage division, the Company initiated a plan to outsource the underwriting and other operational areas to a third party. This outsourced model will result in lower mortgage banking income in future periods.

Other service charges, commissions and fees increased $133,000 compared to 2016, primarily due to higher financial services income. Service charge income decreased $218,000 during 2017, compared to 2016, primarily due to lower NSF income, while other noninterest income declined $178,000 during 2017.

Noninterest expense
Total noninterest expense for 2017 decreased $3.3 million from 2016, primarily resulting from lower OREO-related expenses and a reduction in salaries and employee benefits. OREO-related expenses declined $1.6 million from 2016, resulting from significant reductions in OREO losses and writedowns during 2017.

Salaries and employee benefits decreased $1.1 million for 2017, compared to the prior year, resulting from the impact of earlier workforce reductions and deferred salary costs from current year loan originations, net of higher salary and benefit costs related to the expansion of the mortgage division during 2017. Salary and employee benefits expense related to the mortgage division will decline during 2018 due to the planned outsourcing of the underwriting and secondary marketing function to a third party.

Income tax expense
Income tax expense for 2017 totaled $5.7 million, compared to tax benefit of $(360,000) recorded during 2016. Income tax expense for 2017 reflected the impact of the significant increase in pre-tax income and also included $4.0 million of income tax expense resulting from revaluation of the Company's net deferred tax asset resulting from enactment of the Tax Cut and Jobs Act on December 22, 2017. The Tax Cut and Jobs Act reduced the Company's future federal income tax rate to 21.0 percent.


19




Financial Position

Loans
Total loans, net of deferred fees, totaled $431.6 million at December 31, 2017, compared to $409.7 million at December 31, 2016. The loan to deposit ratio was 86.5 percent at December 31, 2017 compared to 83.6 percent at December 31, 2016. During 2017, the Company experienced growth among home equity lines of credit, commercial real estate, both owner-occupied and non-owner-occupied, and commercial loans. Residential 1-4 family, multifamily and personal loans all declined during 2017.

The following table provides balance by loan class as of December 31 for past five years.
 
December 31, 2017
 
December 31, 2016
 
December 31, 2015
 
December 31, 2014
 
December 31, 2013
($ thousands)
Amount
Percent
 
Amount
Percent
 
Amount
Percent
 
Amount
Percent
 
Amount
Percent
Real estate secured:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
$
174,889

40.45
%
 
$
186,695

45.49
%
 
$
194,287

44.88
%
 
$
186,829

45.83
%
 
$
175,860

43.49
%
Multifamily
19,469

4.50
%
 
22,630

5.51
%
 
23,895

5.52
%
 
21,131

5.18
%
 
20,592

5.09
%
Construction and land loans
15,907

3.68
%
 
15,978

3.89
%
 
19,163

4.43
%
 
18,518

4.54
%
 
18,509

4.58
%
Commercial, owner occupied
82,121

19.00
%
 
72,383

17.64
%
 
73,031

16.87
%
 
70,748

17.35
%
 
71,459

17.67
%
Commercial, non-owner occupied
33,748

7.81
%
 
28,818

7.02
%
 
38,025

8.78
%
 
32,173

7.89
%
 
37,117

9.18
%
Second mortgages
4,684

1.08
%
 
6,934

1.69
%
 
8,169

1.89
%
 
8,075

1.97
%
 
7,934

1.96
%
Equity lines of credit
34,378

7.95
%
 
13,395

3.27
%
 
6,000

1.39
%
 
6,499

1.59
%
 
7,884

1.95
%
Farmland
13,188

3.05
%
 
12,194

2.97
%
 
11,283

2.61
%
 
8,246

2.02
%
 
9,322

2.31
%
Total real estate secured
378,384

87.53
%
 
359,027

87.48
%
 
373,853

86.37
%
 
352,219

86.40
%
 
348,677

86.22
%
Non-real estate secured:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Personal
14,192

3.28
%
 
17,887

4.36
%
 
20,914

4.83
%
 
21,186

5.20
%
 
20,776

5.14
%
Commercial
36,785

8.51
%
 
29,977

7.31
%
 
35,144

8.12
%
 
31,586

7.75
%
 
31,575

7.81
%
Agricultural
2,950

0.68
%
 
3,490

0.85
%
 
2,959

0.68
%
 
2,683

0.66
%
 
3,376

0.83
%
Total non-real estate secured
53,927

12.47
%
 
51,354

12.52
%
 
59,017

13.63
%
 
55,455

13.60
%
 
55,727

13.78
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
$
432,311

100.00
%
 
$
410,381

100.00
%
 
$
432,870

100.00
%
 
$
407,674

100.00
%
 
$
404,404

100.00
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


20



The following table provides loan maturity information as of December 31, 2017.

(thousands)
Within 1 year
 
1-5 years
 
After 5 years
 
 
Real estate secured:
Fixed
 
Variable
 
Fixed
 
Variable
 
Fixed
 
Variable
 
Total
Residential 1-4 family
$
26,359

 
$
12,923

 
$
67,796

 
$
34,111

 
$
20,665

 
$
13,035

 
$
174,889

Multifamily
3,722

 
2,120

 
6,601

 
4,911

 

 
2,115

 
19,469

Construction and land loans
5,187

 

 
10,720

 

 

 

 
15,907

Commercial, owner occupied
27,091

 
4,020

 
16,302

 
7,950

 
9,721

 
17,037

 
82,121

Commercial, non-owner occupied
 
 
 
 
33,748

 

 

 

 
33,748

Second mortgages
1,166

 
576

 
2,136

 
631

 

 
175

 
4,684

Equity lines of credit

 
8,040

 

 
19,110

 

 
7,228

 
34,378

Farmland
1,843

 
1,175

 
5,946

 
1,656

 

 
2,568

 
13,188

 
 
 
 
 
 
 
 
 
 
 
 
 

Non-real estate secured:
 
 
 
 
 
 
 
 
 
 
 
 

Personal
4,332

 
2,669

 
5,976

 
739

 

 
476

 
14,192

Commercial
14,784

 
4,013

 
20,164

 
611

 

 
163

 
39,735

Agricultural
 
 
 
 
 
 
 
 
 
 
 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total
$
84,484

 
$
35,536

 
$
169,389

 
$
69,719

 
$
30,386

 
$
42,797

 
$
432,311

 
 
 
 
 
 
 
 
 
 
 
 
 
 


Investment securities available for sale
Investment securities available for sale totaled $78.5 million at December 31, 2017, compared to $95.1 million at December 31, 2016. The $16.5 million reduction occurred as proceeds from maturing securities and proceeds from investment security sales were used to fund loan demand and to fund the repayment of FHLB advances during 2017.

Investment securities available for sale at December 31, 2017 included mortgage backed securities/CMOs (75.5 percent of the total securities portfolio), municipal issues (15.9 percent), and SBAs bonds (8.5 percent).  There were no investment securities held to maturity at December 31, 2017 or December 31, 2016.


21



The following table presents the maturity distribution, fair value, and taxable-equivalent yield of the investment portfolio at December 31, 2017 and December 31, 2016.
 
 
Fair value maturing:
 
 
($ thousands)
 
Within 1 year
 
1-5 years
 
5-10 years
 
Beyond 10 years
 
Total
 
Yield
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 
$

 
$

 
$
11,423

 
$
45,416

 
$
56,839

 
2.10
%
Variable rate
 

 

 
1

 
2,467

 
2,468

 
2.26
%
State and municipal securities:
 
 
 
 
 
 
 
 
 
 
 
 
Tax-exempt
 
125

 
230

 

 
6,602

 
6,957

 
3.58
%
Taxable
 

 
301

 
197

 
5,056

 
5,554

 
2.92
%
SBA bonds:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 

 
502

 
644

 
5,563

 
6,709

 
2.29
%
Variable rate
 

 

 

 

 

 
%
Total
 
$
125

 
$
1,033

 
$
12,265

 
$
65,104

 
$
78,527

 
2.31
%
Fixed rate
 
$
125

 
$
1,033

 
$
12,264

 
$
62,637

 
$
76,059

 
 
Variable rate
 

 

 
1

 
2,467

 
2,468

 
 
Total
 
$
125

 
$
1,033

 
$
12,265

 
$
65,104

 
$
78,527

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 
$

 
$

 
$
9,716

 
$
61,666

 
$
71,382

 
2.13
%
Variable rate
 

 

 
2

 
2,904

 
2,906

 
1.5
%
State and municipal securities:
 
 
 
 
 
 
 
 
 
 
 
 
Tax-exempt
 
562

 
358

 

 
7,135

 
8,055

 
4.07
%
Taxable
 

 
1,068

 

 
3,328

 
4,396

 
2.61
%
SBA bonds:
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 

 
846

 

 
7,485

 
8,331

 
2.23
%
Variable rate
 

 

 
3

 

 
3

 
1.12
%
Total
 
$
562

 
$
2,272

 
$
9,721

 
$
82,518

 
$
95,073

 
2.31
%
Fixed rate
 
$
562

 
$
2,272

 
$
9,716

 
$
79,614

 
$
92,164

 
 
Variable rate
 

 

 
5

 
2,904

 
2,909

 
 
Total
 
$
562

 
$
2,272

 
$
9,721

 
$
82,518

 
$
95,073

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

All of the mortgage-backed securities included above are agency-issued by FHLMC, FNMA or GNMA. The Company does not hold any non-agency mortgage-backed securities. All SBA bonds owned by the Company have the full faith and credit of the U.S. Government and carry a zero risk weighting.


22



The following table provides credit ratings for the Company's municipal securities assigned by Moody's and/or Standard & Poors as of December 31, 2017:
Moody's
 
Standard & Poor's
 
Fair value (thousands)
Aaa
 
AAA
 
$
629

Aa
 
AA
 
10,609

A
 
A
 
1,194

Baa
 
BBB
 
79

 
 
 
 
$
12,511

 
 
 
 
 

Other investments
Other investments include capital stock investments in the Federal Reserve, the Federal Home Loan Bank of Atlanta, Community Bankers Bank, and Pacific Coast Bankers Bank. These investments had a carrying value of $3.1 million at December 31, 2017, and are considered to be non-marketable as the Company is required to hold these investments and the only market for these investments is the issuing agency. Also included in other investments are certificates of deposit purchased from other FDIC-insured institutions. The balance of these CDs totaled $748,000 at December 31, 2017.

Deposits
Deposits at December 31, 2017 increased $8.9 million since December 31, 2016. Deposit growth during 2017 has been primarily among non-interest bearing deposits, which increased $14.1 million since December 31, 2016.

The following table provides a breakdown of deposits at December 31, 2017 and December 31, 2016, showing the amount and percent increase or decrease by deposit type.
(thousands)
December 31, 2017
 
December 31, 2016
 
Increase (decrease)
% increase (decrease)
Non-interest bearing demand
$
148,633

 
$
134,488

 
$
14,145

10.5
 %
Interest bearing demand
119,197

 
124,143

 
(4,946
)
(4.0
)%
Savings deposits
104,390

 
90,686

 
13,704

15.1
 %
Time deposits greater than $100,000
36,794

 
43,743

 
(6,949
)
(15.9
)%
Other time deposits
89,769

 
96,809

 
(7,040
)
(7.3
)%
Total deposits
$
498,783

 
$
489,869

 
$
8,914

1.8
 %
 
 
 
 
 
 
 

The following table provides the scheduled maturities of time deposits greater than or equal to $100,000 at December 31, 2017.
(thousands)
 
< 3 months
$
4,379

3-6 months
4,732

6-12 months
9,864

> 12 months
17,819

Total time deposits greater than $100,000
$
36,794

 
 

Short-term borrowings and long-term debt
As of December 31, 2017, the Company has $40.1 million in FHLB advances. No new advances were originated during 2017. The Company currently secures all FHLB advances with 1-4 family residential mortgage, commercial real estate and multifamily loans. As of December 31, 2017, short-term borrowings included $10.0 million of the outstanding FHLB advances, scheduled to mature within one year. The remaining $30.1 million is included in long-term debt with scheduled maturities beyond one year.



23



Nonperforming assets
Nonperforming assets include nonaccrual loans, loans contractually past due 90 days or more and still accruing interest, other real estate owned and repossessions. Nonperforming assets were $4.4 million or 1.02 percent of loans held for investment and OREO at December 31, 2017, compared to $6.8 million or 1.64 percent of loans held for investment and OREO at December 31, 2016.  As demonstrated by the reductions in non-performing assets over the past 12 months, the Company continues its efforts to reduce non-performing assets, primarily by reducing nonaccrual loans and selling OREO.
(thousands)
December 31, 2017
 
December 31, 2016
 
December 31, 2015
 
December 31, 2014
 
December 31, 2013
Nonaccrual loans
$
2,064

 
$
3,999

 
$
9,456

 
$
11,666

 
$
10,986

Loans 90+ days past due and still accruing
26

 
2,210

 

 
22

 
2

Total nonperforming loans
2,090

 
6,209

 
9,456

 
11,688

 
10,988

Other real estate owned
2,350

 
2,768

 
5,694

 

 

Total nonperforming assets
$
4,440

 
$
8,977

 
$
15,150

 
$
11,688

 
$
10,988


At December 31, 2017, other real estate owned totaled $2.4 million and consisted of 15 relationships. At December 31, 2016 OREO balances were $2.8 million and consisted of 22 relationships. The following chart details each category type, number of relationships, and balance.

 
 
December 31, 2017
 
December 31, 2016
 
($ thousands)
 
Number
 
Balance
 
Number
 
Balance
 
Construction and land loans
 
10

 
$
663

 
9

 
$
597

 
Residential 1-4 family
 
2

 
142

 
6

 
340

 
Commercial real estate
 
3

 
1,545

 
7

 
1,831

 
Total
 
15

 
$
2,350

 
22

 
$
2,768

 
 
 
 

 
 

 
 
 
 
 

The Company's major markets include: Southwestern Virginia, Tri-city Tennessee, Sevierville and Knoxville, Tennessee, and Boone/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, 2017
 
December 31, 2016
 
($ thousands)
 
Number
 
Balance
 
Number
 
Balance
 
Sevierville and Knoxville TN Area
 
1

 
$
71

 
4

 
$
153

 
Southwest VA and Tri-city TN Area
 
12

 
2,209

 
16

 
2,525

 
Boone and Banner Elk NC Area
 
2

 
70

 
2

 
90

 
Total
 
15

 
$
2,350

 
22

 
$
2,768

 

The Company focuses on selling OREO properties and reducing other non-performing assets. The ability to sell OREO continues to be somewhat negatively affected by limited demand.

As of December 31, 2017 and December 31, 2016, loan balances totaling $8.0 million and $12.7 million, respectively, were classified as troubled debt restructurings. Nonperforming TDRs totaled $881,000 and $1.6 million, respectively, as of December 31, 2017 and December 31, 2016.


Allowance for Loan Losses
The allowance for loan losses is calculated 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, including general economic conditions. The internal credit review function includes pre-approval analyses of large credits and credit review activities that provide early warnings of loan deterioration. The senior credit administration officer prepares quarterly analyses of the adequacy of the allowance for loan losses. These analyses include individual loans considered impaired for direct exposure. In addition, potential losses on loan pools and pool allocations are estimated based upon historical losses and other

24



factors, as adjusted, for various loan types. The calculation of the allowance for loan losses is reviewed by the senior credit officers, the chief risk officer, senior financial officers and the board of directors.

At December 31, 2017 and December 31, 2016, management determined that the Company's allowance for loan losses is sufficient and is appropriate based on the requirements of accounting principles generally accepted in the United States of America.

The following table provides an allocation of the allowance for loan losses as of the dates indicated.
 
 
December 31, 2017
 
December 31, 2016
 
December 31, 2015
 
December 31, 2014
 
December 31, 2013
($ thousands)
 
Allowance for loan losses
 
Percent of total loans
 
Allowance for loan losses
 
Percent of total loans
 
Allowance for loan losses
 
Percent of total loans
 
Allowance for loan losses
 
Percent of total loans
 
Allowance for loan losses
 
Percent of total loans
Residential 1-4 family
 
$
133

 
40.5
%
 
$
371

 
45.5
%
 
$
654

 
44.9
%
 
$
995

 
45.8
%
 
$
975

 
43.5
%
Multifamily
 

 
4.5
%
 

 
5.5
%
 

 
5.5
%
 
20

 
5.2
%
 
143

 
5.1
%
Construction and land loans
 
1

 
3.7
%
 
21

 
3.9
%
 
37

 
4.4
%
 
87

 
4.5
%
 
230

 
4.6
%
Commercial - owner-occupied
 
1,636

 
19.0
%
 
1,339

 
17.6
%
 
1,012

 
16.9
%
 
409

 
17.4
%
 
1,029

 
17.7
%
Commercial - non-owner-occupied
 
955

 
7.8
%
 
445

 
7.0
%
 
748

 
8.8
%
 
1,063

 
7.9
%
 
1,415

 
9.2
%
Second mortgages
 
12

 
1.1
%
 
15

 
1.7
%
 
43

 
1.9
%
 
67

 
2.0
%
 
153

 
2.0
%
Equity lines of credit
 

 
8.0
%
 
27

 
3.3
%
 
20

 
1.4
%
 
74

 
1.6
%
 
50

 
2.0
%
Farmland
 
54

 
3.1
%
 
16

 
3.0
%
 
7

 
2.6
%
 
12

 
2.0
%
 
65

 
2.3
%
Personal
 
265

 
3.3
%
 
802

 
4.4
%
 
704

 
4.8
%
 
665

 
5.2
%
 
483

 
5.1
%
Commercial/Agricultural
 
383

 
9.2
%
 
535

 
8.2
%
 
886

 
8.8
%
 
982

 
8.4
%
 
1,264

 
8.6
%
Unallocated
 
515

 

 
1,258

 
%
 
1,543

 
%
 
1,103

 
%
 
1,018

 
%
Total
 
$
3,954

 
100.0
%
 
$
4,829

 
100.0
%
 
$
5,654

 
100.0
%
 
$
5,477

 
100.0
%
 
$
6,825

 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


25



The following table presents the Company's loan loss experience for the past five years.
(thousands)
 
2017
 
2016
 
2015
 
2014
 
2013
Allowance for loan losses at January 1
 
$
4,829

 
$
5,654

 
$
5,477

 
$
6,825

 
$
7,449

Provision for loan losses
 
120

 
1,526

 
1,469

 
1,324

 
1,320

Loans charged off:
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
57

 
249

 
360

 
258

 
452

Multifamily
 

 

 

 

 

Construction and land loans
 

 
28

 
12

 
18

 
127

Commercial - owner-occupied
 
755

 
1,245

 
407

 
345

 
52

Commercial - non-owner-occupied
 

 

 
12

 
1,239

 
408

Second mortgages
 

 
4

 
3

 
25

 
134

Equity lines of credit
 

 
8

 

 
116

 
3

Farmland
 

 
2

 

 

 
40

Personal
 
321

 
1,046

 
796

 
544

 
444

Commercial/Agricultural
 
470

 
164

 
257

 
407

 
420

Total charge-offs
 
1,603

 
2,746

 
1,847

 
2,952

 
2,080

Recoveries of loans previously charged off:
 
 
 
 
 
 
 
 
 
 
Residential 1-4 family
 
39

 
32

 
3

 
1

 
19

Multifamily
 

 

 

 

 

Construction and land loans
 
4

 
14

 
41

 
17

 
5

Commercial - owner-occupied
 
27

 
7

 
376

 
132

 

Commercial - non-owner-occupied
 
1

 
8

 
6

 
1

 

Second mortgages
 
1

 

 

 

 

Equity lines of credit
 
1

 
2

 
41

 

 

Farmland
 
2

 

 
3

 

 

Personal
 
182

 
195

 
76

 
90

 
75

Commercial/Agricultural
 
448

 
137

 
9

 
39

 
37

Total recoveries
 
705

 
395

 
555

 
280

 
136

Net loan charge-offs
 
898

 
2,351

 
1,292

 
2,672

 
1,944

Establish reserve for unfunded commitments
 
97

 

 

 

 

Allowance for loan losses at December 31
 
$
3,954

 
$
4,829

 
$
5,654

 
$
5,477

 
$
6,825

 
 
 
 
 
 
 
 
 
 
 

Liquidity and Capital Resources

Total stockholders' equity of the Company was $53.8 million at December 31, 2017. Total stockholders' equity at December 31, 2016 was $53.8 million. While total stockholders' equity was unchanged, there were changes within additional paid-in capital, retained earnings and accumulated other comprehensive income.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total risk-based capital and tier 1 capital to risk-weighted assets (as defined in the regulations), and tier 1 capital to adjusted total assets (as defined). See Note 19 for a more detailed discussion of the Bank's regulatory capital ratios.

Liquidity is the ability to provide sufficient cash levels to meet financial commitments and to fund loan demand and deposit withdrawals. The Company and subsidiary Bank maintain a significant level of liquidity in the form of cash and cash equivalents ($30.8 million as of December 31, 2017) and unrestricted investment securities available for sale ($51.7 million as of December 31, 2017).  Cash and cash equivalents are immediately available for satisfaction of deposit withdrawals, customer credit needs, and operations of the Bank.  The Bank also maintains a significant amount of available credit with both the Federal Home Loan Bank and a correspondent financial institution. Unencumbered investment securities available for sale represent a secondary level of liquidity available for conversion to liquid funds in the event of extraordinary needs. The Company believes that it maintains sufficient liquidity to meet its current and projected requirements and needs.

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk  

Not Applicable

Item 8.  Financial Statements

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders
Highlands Bankshares, Inc. and Subsidiary
Abingdon, Virginia

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of Highlands Bankshares, Inc. and Subsidiary (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes (collectively referred to as the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audit, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
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CERTIFIED PUBLIC ACCOUNTANTS

We have been the Company’s auditor since 1995.

Blacksburg, Virginia
April 2, 2018


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Consolidated Balance Sheets
(Amounts in thousands) 
 
 
December 31, 2017
 
December 31, 2016
ASSETS
 
 
 
 
Cash and due from banks
 
$
15,179

 
$
27,391

Federal funds sold
 
15,618

 
22,994

Total cash and cash equivalents
 
30,797

 
50,385

Investment securities available for sale (amortized cost $79,990 at December 31, 2017, $96,930 at December 31, 2016)
 
78,527

 
95,073

Other investments, at cost
 
3,116

 
6,637

Loans held for sale
 
4,808

 
1,255

Loans
 
431,574

 
409,667

Allowance for loan losses
 
(3,954
)
 
(4,829
)
Net loans
 
427,620

 
404,838

Premises and equipment, net
 
18,332

 
17,814

Real estate held for sale
 
1,430

 
1,680

Deferred tax assets
 
7,161

 
12,989

Interest receivable
 
1,987

 
2,047

Bank-owned life insurance
 
14,679

 
14,314

Other real estate owned
 
2,350

 
2,768

Other assets
 
3,290

 
2,878

Total assets
 
$
594,097

 
$
612,678

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
LIABILITIES
 
 
 
 
Deposits:
 
 
 
 
Non-interest bearing
 
$
148,633