10-K 1 v456574_10k.htm FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

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

For the fiscal year ended December 31, 2016

or

 

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

For the transition period from ________ to __________

 

Commission file number 000-23565

 

EASTERN VIRGINIA BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

 

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

 

10900 Nuckols Road, Suite 325

Glen Allen, Virginia 23060

(Address of principal executive offices) (Zip Code)

 

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

 

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

 

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

 

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

NONE

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ¨ No x

 

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

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes x  No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

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

 

The aggregate market value of common stock held by non-affiliates of the registrant as of June 30, 2016 was $94.6 million.

 

There were 13,116,600 shares of common stock, par value $2.00 per share, outstanding as of March 10, 2017.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Not applicable.

 

 

 

 

TABLE OF CONTENTS

 

Part I    
     
Item 1. Business 3
     
Item 1A. Risk Factors 14
     
Item 1B. Unresolved Staff Comments 25
     
Item 2. Properties 25
     
Item 3. Legal Proceedings 25
     
Item 4. Mine Safety Disclosures 25
     
Part II    
     
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 27
     
Item 6. Selected Financial Data 30
     
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 31
     
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 70
     
Item 8. Financial Statements and Supplementary Data 72
     
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 72
     
Item 9A. Controls and Procedures 72
     
Item 9B. Other Information 73
     
Part III    
     
Item 10. Directors, Executive Officers and Corporate Governance 73
     
Item 11. Executive Compensation 74
     
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 74
     
Item 13. Certain Relationships and Related Transactions, and Director Independence 74
     
Item 14. Principal Accountant Fees and Services 74
     
Part IV    
     
Item 15. Exhibits, Financial Statement Schedules 75
     
Item 16. Form 10-K Summary 77
     
Signatures   77

 

 

 

 

Part I

 

Item 1. Business

 

General

 

Eastern Virginia Bankshares, Inc. (the “Company”) is a bank holding company that was organized and chartered under the laws of the Commonwealth of Virginia on September 5, 1997 and commenced operations on December 29, 1997. The Company was headquartered in Tappahannock, Virginia until October 2016 at which time it was relocated to Glen Allen, Virginia. Through our wholly-owned bank subsidiary, EVB (the “Bank”) which is headquartered in Tappahannock, Virginia, we operate twenty-four full service branches and two drive-in facilities in eastern Virginia, and one loan production office in Chesterfield County, Virginia. Two of EVB’s three predecessor banks, Bank of Northumberland, Inc. and Southside Bank, were established in 1910. The third bank, Hanover Bank, was established as a de novo bank in 2000. In April 2006, these three banks were merged and the surviving bank was re-branded as EVB. Additionally, the Company acquired Virginia Company Bank (“VCB”) on November 14, 2014 and merged VCB with and into the Bank with the Bank surviving, thereby adding to the Bank three additional branches located in Hampton, Newport News and Williamsburg. On December 13, 2016, the Company entered into an Agreement and Plan of Merger to merge with and into Southern National Bancorp of Virginia, Inc. (“Southern National”), with Southern National surviving (such transaction, the “Pending Merger”). The Pending Merger, which is expected to be completed by the third quarter of 2017, is subject to regulatory approvals and the approval of the shareholders of both companies, as well as customary closing conditions.

 

EVB is a community bank targeting small to medium-sized businesses and consumers in our traditional coastal plain markets and the emerging suburbs outside of the Richmond, Tidewater, and southern Virginia areas. Our mission is to enable our customers, teammates and shareholders to achieve their financial dreams and goals, making our communities better places to live.

 

The accompanying consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, at times collectively referred to as the “Company”, “we”, “our”, or “us.”

 

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

 

The Bank owns EVB Financial Services, Inc., which in turn has a 100% ownership interest in EVB Investments, Inc. EVB Investments, Inc. offers a comprehensive range of investment services through Infinex Investments, Inc. On May 15, 2014, the Bank acquired a 4.9% ownership interest in Southern Trust Mortgage, LLC. Pursuant to an independent contractor agreement with Southern Trust Mortgage, LLC, the Company advises and consults with Southern Trust Mortgage, LLC and facilitates the marketing and brand recognition of their mortgage business. In addition, the Company provides Southern Trust Mortgage, LLC with offices at two retail branches in the Company’s market area and access to office equipment at these locations during normal business hours. For its services, the Company receives fixed monthly compensation from Southern Trust Mortgage, LLC in the amount of $2 thousand, which is adjustable on a quarterly basis.

 

The Bank has a 6.0% ownership interest in Bankers Title, LLC. Bankers Title, LLC is a multi-bank owned title agency providing a full range of title insurance settlement and related financial services. The Bank has a 2.94% ownership in Bankers Insurance, LLC, which primarily sells insurance products to customers of the Bank, and other financial institutions that have an equity interest in the agency. The Bank also has 100% ownership interests in Dunston Hall LLC and POS LLC, which were formed to hold the title to real estate acquired by the Bank upon foreclosure on property of real estate secured loans. The financial position and operating results of all the subsidiaries of the Bank are not significant to the Company as a whole and are not considered principal activities of the Company at this time.

 

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

 

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Market Areas

 

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

 

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

 

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

 

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

 

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

 

Business Strategy

 

As a result of over 100 years of experience serving the Northern Neck and Middle Peninsula regions, we have a stable, loyal customer base and a high deposit market share in these regions. Due to the lower projected population growth of these markets, we expanded in Chesterfield, Hanover, Henrico, Gloucester, New Kent and King William Counties and the city of Colonial Heights to target the higher potential growth in these existing and emerging suburban markets. The deposit market share we have accumulated in our Northern Neck, Middle Peninsula and Southern regions has helped fund our loan growth in the emerging suburban areas in the Capital region. Additionally, in 2014 we expanded into our Tidewater region through the acquisition of VCB. This acquisition added three branches and expanded our footprint along the U.S. Interstate 64 corridor into the attractive and growing markets of the Virginia Peninsula.

 

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We believe that economic growth and bank consolidation have created a growing number of businesses and consumers in need of a broad range of products and services, as well as the high level of personal service that we provide. We look at 2017 as a year to strengthen our existing markets. Our long-term business plan is to capitalize on the growth opportunity in our markets by further developing our branch network and augmenting our market area, including through the Pending Merger with Southern National.

 

Competition

 

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

 

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

 

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

 

Employees

 

As of December 31, 2016, the Company had 315 full-time equivalent employees. Management of the Company considers its relations with employees to be excellent. No employees are represented by a union or any similar group, and the Company has never experienced any strike or labor dispute.

 

Regulation and Supervision

 

General

 

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

 

Regulatory Reform

 

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

 

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The Company continues to experience a period of rapidly changing regulatory requirements and an environment of constant regulatory reform. These regulatory changes could have a significant effect on how the Company conducts its business. The full extent of the Dodd-Frank Act and other potential regulatory reforms cannot yet be fully predicted and will depend to a large extent on the specific regulations that are adopted.

 

Regulation of the Company

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Capital Requirements

 

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

 

The Basel III Capital Rules were effective January 1, 2015, and the Basel III Capital Rules capital conservation buffer will be phased in from 2016 to 2019.

 

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

 

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

 

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

 

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

 

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Under the Basel III Capital Rules, the minimum capital ratios as of December 31, 2016 were as follows (including the impact of the capital conservation buffer):

 

·5.1250% CET1 to risk-weighted assets.
·6.6250% Tier 1 capital to risk-weighted assets.
·8.6250% Total capital to risk-weighted assets.

 

The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories to a much larger and more risk-sensitive number of categories than has been historically applied, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes that impacted the Company’s determination of risk-weighted assets included, among other things:

 

·Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.

 

·Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.

 

·Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%).

 

Management believes that, as of December 31, 2016, the Company would have met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were then in effect.

 

Limits on Dividends

 

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

 

Reporting Obligations

 

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

 

The Dodd-Frank Act

 

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

 

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

 

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

 

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

 

·Debit Card Interchange Fees. The Dodd-Frank Act imposed limits for debit card interchange fees for issuers that have over $10 billion in assets, which could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets.

 

In addition, the Dodd-Frank Act implements other changes to financial regulations, including provisions that:

 

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

 

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

 

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

 

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

 

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

 

Source of Strength Doctrine

 

The Dodd-Frank Act codifies and expands the existing Federal Reserve Board policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under the Dodd-Frank Act, the term “source of financial strength” is defined to mean the “ability of a company that directly or indirectly controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.” As of March 2017, implementing regulations of the Dodd-Frank Act source of strength provisions, however, have not yet been promulgated. It is the Federal Reserve Board’s existing policy that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. Consistent with this, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.

 

Incentive Compensation

 

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

 

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In 2016, the SEC and the federal banking agencies proposed rules that prohibit covered financial institutions (including bank holding companies and banks) from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk taking by providing covered persons (consisting of senior executive officers and significant risk takers, as defined in the rules) with excessive compensation, fees or benefits that could lead to material financial loss to the financial institution. The proposed rules outline factors to be considered when analyzing whether compensation is excessive and whether an incentive-based compensation arrangement encourages inappropriate risks that could lead to material loss to the covered financial institution, and establishes minimum requirements that incentive-based compensation arrangements must meet to be considered to not encourage inappropriate risks and to appropriately balance risk and reward. The proposed rules also impose additional corporate governance requirements on the boards of directors of covered financial institutions and imposes additional record-keeping requirements. The comment period for these proposed rules has closed and a final rule has not yet been published.

 

Regulation of the Bank

 

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

 

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

 

FDIC Insurance, Assessments and Regulation

 

The Bank’s deposits are insured by the DIF of the FDIC up to the standard maximum insurance amount for each deposit ownership category. As of March 2017, the basic limit on FDIC deposit insurance coverage was $250,000 per depositor. Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC, subject to administrative and potential judicial hearing and review processes.

 

The DIF is funded by assessments on banks and other depository institutions calculated based on average consolidated total assets minus average tangible equity (defined as Tier 1 capital). As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment scheme, set a target “designated reserve ratio” (described in more detail below) of 2% for the DIF and established a lower assessment rate schedule when the reserve ratio reaches 1.15% and, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2% and 2.5%. An institution's assessment rate is based on a statistical analysis of financial ratios that estimates the likelihood of failure over a three year period, which considers the institution’s weighted average CAMELS component rating, and is subject to further adjustments including related to levels of unsecured debt and brokered deposits (not applicable to banks with less than $10 billion in assets). At December 31, 2016 total base assessment rates for institutions that have been insured for at least five years range from 1.5 to 40 basis points, with rates of 1.5 to 30 basis points applying to banks with less than $10 billion in assets.

 

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The Dodd-Frank Act transferred to the FDIC increased discretion with regard to managing the required amount of reserves for the DIF, or the “designated reserve ratio.” Among other changes, the Dodd-Frank Act (i) raised the minimum designated reserve ratio to 1.35% and removed the upper limit on the designated reserve ratio, (ii) requires that the designated reserve ratio reach 1.35% by September 2020, and (iii) requires the FDIC to offset the effect on institutions with total consolidated assets of less than $10 billion of raising the designated reserve ratio from 1.15% to 1.35% – which requirement was met through rules adopted by the FDIC during 2016. The FDIA requires that the FDIC consider the appropriate level for the designated reserve ratio on at least an annual basis. On October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. On June 30, 2016 the designated reserve ratio rose to 1.17 percent, which triggered three major changes to deposit insurance assessments for the third quarter of 2016: (i) the range of initial assessment rates for all institutions declined from 5 to 35 basis points to 3 to 30 basis points (which are included in the total base assessment rates in the above paragraph); (ii) surcharges equal to an annual rate of 4.5 basis points began for insured depository institutions with total consolidated assets of $10 billion or more; and (iii) the revised assessment method described above was implemented.

 

FDIC insurance expense totaled $707 thousand, $821 thousand and $921 thousand in 2016, 2015 and 2014, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. The FICO assessment rate for the DIF ranged between a high of 0.58 basis points for 2016, with a low of 0.56 basis points for the second, third and fourth quarters of 2016. For the first quarter of 2017, the FICO assessment rate for the DIF is 0.54 basis points resulting in a premium of $0.0054 per $100 of DIF-eligible deposits.

 

Prompt Corrective Action

 

The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities. The Company believes that, as of December 31, 2016, its bank subsidiary, EVB, was “well capitalized” based on the applicable ratios.

 

Mortgage Banking Regulation

 

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

 

Compliance with the requirements of TILA, RESPA, and other federal and state laws and regulations (including regulations adopted by the CFPB) may require substantial investments in mortgage lending systems and processes and implementation efforts to respond to regulatory developments, all of which may impose significant costs on the Bank.  For example, compliance with the CFPB’s Integrated Mortgage Disclosure Rules under TILA and RESPA (or “TRID”), which became effective in October 2015, requires the Bank to implement at significant cost new systems and processes that will apply to most closed-end mortgage loans originated by the Bank.

 

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

 

Consumer Protection

 

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

 

As a smaller institution (i.e., with assets of $10 billion or less), most consumer protection aspects of the Dodd-Frank Act will continue to be applied to the Company and the Bank by the Federal Reserve Board. However, the CFPB may include its own examiners in regulatory examinations by a small institution’s prudential regulators and may require smaller institutions to comply with certain CFPB reporting requirements. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the Federal Reserve Board applies consumer protection laws and regulations to financial institutions that are not directly supervised by the CFPB. The precise impact of the CFPB’s consumer protection activities on the Company and the Bank cannot be determined with certainty. In 2016, the CFPB proposed rules that provide an exception to the requirement to deliver an annual privacy notice if a financial institution only provides nonpublic personal information to unaffiliated third parties under limited exceptions under the Gramm-Leach-Bliley Act and related regulations, and has not changed its policies and practices regarding disclosure of nonpublic personal financial information from those disclosed in the most recent privacy notice provided to the customer.

 

Confidentiality and Required Disclosures of Customer Information

 

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

 

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

 

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

 

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Community Reinvestment Act

 

The Community Reinvestment Act (“CRA”) imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs are assessed based on specified factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Following the Bank’s most recent scheduled compliance examination in July 2016, it received a CRA performance evaluation of “satisfactory.”

 

Federal Home Loan Bank of Atlanta

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, which is one of 12 regional FHLBs that provide funding to their members for making housing loans as well as for affordable housing and community development loans. Each FHLB serves as a reserve, or central bank, for the members within its assigned region. Each is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. Each FHLB makes loans to members in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank must purchase and maintain stock in the FHLB of Atlanta. In 2004, the FHLB converted to its new capital structure, which established the minimum capital stock requirement for member banks as an amount equal to the sum of a membership requirement and an activity-based requirement. At December 31, 2016, the Bank held $8.5 million of FHLB of Atlanta stock.

 

Volcker Rule

 

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

 

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

 

Future Regulation

 

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

 

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Available Information

 

The Company’s SEC filings are filed electronically and are available to the public over the Internet at the SEC’s web site at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company’s SEC filings also are available through our web site at http://www.evb.org under “SEC Filings” as soon as reasonably practicable after they are filed with the SEC. Copies of documents also can be obtained free of charge by writing to the Company’s Corporate Secretary at 10900 Nuckols Road, Suite 325, Glen Allen, VA 23060 or by calling 804-443-8400. The information on the Company’s website is not, and shall not be deemed to be, a part of this Annual Report on Form 10-K or incorporated into any other filings the Company makes with the SEC.

 

Item 1A. Risk Factors

 

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

 

Deterioration in economic conditions could adversely affect us.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Castle Creek holds approximately 8.1% of our common stock and approximately 27.8% of our combined common stock and Series B Preferred Stock. GCP Capital holds approximately 8.6% of our common stock and approximately 12.6% of our combined common stock and Series B Preferred Stock. Pursuant to the terms of the securities purchase agreements entered into with Castle Creek and GCP Capital, Castle Creek and GCP Capital each have a right to appoint a representative on our Board of Directors and on the Bank’s board of directors. Boris M. Gutin serves on the Boards of Directors of the Company and the Bank at the request of an affiliate of GCP Capital. Castle Creek and GCP Capital may have individual economic interests that are different from the other’s interests and different from the interests of our other shareholders.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Our regulatory compliance burden and associated costs could continue to increase, which could place restrictions on certain products and services, and limit our future capital strategies.

 

A wide range of regulatory initiatives directed at the financial services industry have been proposed in recent years. One of those initiatives, the Dodd-Frank Act, represents a sweeping overhaul of the financial services industry within the United States and mandates significant changes in the financial regulatory landscape that has impacted and will continue to impact all financial institutions, including the Company and the Bank. The federal regulatory agencies, and particularly bank regulatory agencies, are given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations, and certain of the implementing rules and regulations have not yet been proposed or approved; consequently the full details and impact of the Dodd-Frank Act will depend on the final implementing rules and regulations. Accordingly, it remains too early to fully assess the full impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on our business, financial condition or results of operations.

 

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

 

The Basel III Capital Rules require higher levels of capital and liquid assets, which could adversely affect our net income and return on equity.

 

The Basel III Capital Rules, which began to apply to the Company and the Bank on January 1, 2015, represent the most comprehensive overhaul of the U.S. banking capital framework in over two decades. These rules require bank holding companies and their subsidiaries, such as the Company and the Bank, to dedicate more resources to capital planning and regulatory compliance, and maintain substantially more capital as a result of higher required capital levels and more demanding regulatory capital risk-weightings and calculations. The rules also require all banks to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and likely increase risk-weighted assets at many banking organizations as a result of applying higher risk-weightings to certain types of loans and securities. As a result, we may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio, or change the way we manage past-due exposures.

 

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

 

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

 

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Most of our loans are secured by real estate (both residential and commercial) in our market areas. At December 31, 2016, approximately 80.5% of our $1.0 billion loan portfolio was secured by residential and commercial real estate. Changes in the real estate market, such as a deterioration in market value of collateral, or a decline in local employment rates or economic conditions, could adversely affect our customers’ ability to pay these loans, which in turn could impact our profitability. Repayment of our commercial loans is often dependent on the cash flow of the borrower, which may be unpredictable. If the value of real estate serving as collateral for the loan portfolio materially declines, a significant portion of the loan portfolio could become under-collateralized. If the loans that are secured by real estate become troubled when real estate market conditions are declining or have declined, in the event of foreclosure we may not be able to realize the amount of collateral that was anticipated at the time of originating the loan.  In that event, we may have to increase the provision for loan losses, which could have a material adverse effect on our operating results and financial condition.

 

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

 

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

 

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

 

At December 31, 2016, we had approximately $108.7 million in loans for the acquisition and development of real estate and for construction of improvements to real estate, representing approximately 10.5% of our total loans outstanding as of that date. These loans are to developers, builders and individuals. Project types financed include acquisition and development of residential subdivisions and commercial developments, builder lines for one to four family home construction and loans to individuals for primary and secondary residence construction. These types of loans are generally viewed as having more risk of default than residential real estate loans. Completion of development projects and sale of developed properties may be affected significantly by general economic conditions, and further downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains acquisition and development loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

 

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

 

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

 

 17 

 

 

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

 

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

 

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

 

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

 

Changes in interest rates also affect the value of our loans.  An increase in interest rates could adversely affect our borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money.  This may lead to an increase in nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our results of operations.

 

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

 

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. We may face a competitive disadvantage as a result of our smaller size, smaller asset base, lack of geographic diversification and inability to spread our marketing costs across a broader market. If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected. Failure to compete effectively to attract new or to retain existing clients may reduce or limit our margins and our market share and may adversely affect our results of operations, financial condition and growth.

 

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

 

From time to time we may pursue, develop, and implement strategic business initiatives. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such opportunities or that such opportunities, if pursued, will be successful.

 

 18 

 

 

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

 

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

 

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

 

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

 

Cyber-attacks or other security breaches could have a material adverse effect on our business.

 

As a financial institution, our operations rely heavily on the secure data processing, storage and transmission of confidential and other information on our computer systems and networks. Any failure, interruption or breach in security or operational integrity of these systems could result in failures or disruptions in our online banking system, customer relationship management, general ledger, deposit and loan servicing and other systems. The security and integrity of our systems and the technology we use could be threatened by a variety of interruptions or information security breaches, including those caused by computer hacking, cyber-attacks, electronic fraudulent activity or attempted theft of financial assets. We may fail to promptly identify or adequately address any such failures, interruptions or security breaches if they do occur. While we have certain protective policies and procedures in place, the nature and sophistication of the threats continue to evolve. We may be required to expend significant additional resources in the future to modify and enhance our protective measures.

 

The nature of our business may make it an attractive target and potentially vulnerable to cyber-attacks, computer viruses, physical or electronic break-ins or similar disruptions. The technology-based platform we use processes sensitive data from our borrowers and investors. While we have taken steps to protect confidential information that we have access to, our security measures and the security measures employed by the owners of the technology in the platform that we use could be breached. Any accidental or willful security breaches or other unauthorized access to our systems could cause confidential customer, borrower and investor information to be stolen and used for criminal purposes. Security breaches or unauthorized access to confidential information could also expose us to liability related to the loss of the information, time-consuming and expensive litigation and negative publicity. If security measures are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in the technology-based platform that we use are exposed and exploited, our relationships with borrowers and investors could be severely damaged, and we could incur significant liability.

 

Because techniques used to sabotage or obtain unauthorized access to systems change frequently and generally are not recognized until they are launched against a target, we and our collaborators may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, federal regulators and many federal and state laws and regulations require companies to notify individuals of data security breaches involving their personal data. These mandatory disclosures regarding a security breach are costly to implement and often lead to widespread negative publicity, which may cause customers, borrowers and investors to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, would harm our reputation and could cause us to lose customers, borrowers, investors and partners and adversely affect our business and operations.

 

 19 

 

 

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

 

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

 

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

 

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

 

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

 

Our disclosure controls and procedures and internal controls may not prevent or detect all errors or acts of fraud.

 

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

 

Our operations rely on certain external vendors.

 

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

 

 20 

 

 

Our communication and information systems may experience an interruption in service.

 

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

 

We continually encounter technological change.

 

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

 

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

 

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

 

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

 

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

 

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

 

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

 

 21 

 

 

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

 

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

 

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

 

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

 

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

 

The Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis are discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company has elected to bypass the preliminary assessment and conduct a full goodwill impairment analysis on an annual basis through the use of an independent third party specialist. As of December 31, 2016, we had $17.1 million of goodwill related to branch acquisitions in 2003 and 2008 and the acquisition of VCB in 2014. To date, we have not recorded any impairment charges on our goodwill, however there is no guarantee that we may not be forced to recognize impairment charges in the future as operating and economic conditions change. Any material impairment charge would have a negative effect on the Company’s financial results and shareholders’ equity.

 

Other-than-temporary impairment could reduce our earnings.

 

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

 

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

 

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

 

 22 

 

 

Our common stock and Series B Preferred Stock are not insured deposits.

 

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

 

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

 

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

 

Risks Related to the Pending Merger with Southern National

 

Because of the fixed exchange ratio and the fluctuation of the market price of Southern National common stock, the market value of the merger consideration to be paid by Southern National to our shareholders will fluctuate.

 

On December 13, 2016, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) to merge with and into Southern National Bancorp of Virginia, Inc. ( or “Southern National”), with Southern National surviving (such transaction, the “Pending Merger”). In the Pending Merger, each share of our common stock and of our Series B Preferred Stock will be converted into the right to receive 0.6313 shares of common stock of the combined company, the value of which will depend upon the price of Southern National common stock at the effective date of the Pending Merger, and cash in lieu of any fractional shares. Upon the effective date of the Pending Merger, Southern National common stock, including the shares issued to former holders of our common stock and our Series B Preferred Stock, will be the common stock of the combined company. The price of Southern National common stock as of the effective date of the Pending Merger may vary significantly from its price at the date the fixed exchange ratio was established. There will be no adjustment to the merger consideration for changes in the market price of either shares of Southern National common stock or shares of our common stock. There also is no maximum or minimum closing price of Southern National common stock at which we or Southern National may unilaterally terminate the Merger Agreement. Variations in the price of Southern National common stock may result from changes in the business, operations or prospects of Southern National, regulatory considerations, general market and economic conditions, and other factors, many of which are outside of the control of Southern National.

 

Termination of the Merger Agreement could negatively impact us.

 

If the Merger Agreement is terminated, our business may have been adversely affected by the failure to pursue other beneficial opportunities due to the focus of management on the Pending Merger, without realizing any of the anticipated benefits of completing the Pending Merger. Additionally, if the Merger Agreement is terminated, the market price of our common stock could decline to the extent that the current market price reflects a market assumption that the Pending Merger will be completed. Furthermore, costs relating to the Pending Merger, such as legal, accounting and financial advisory fees, must be paid even if the Pending Merger is not completed. Failure to complete the Pending Merger could also result in reputational harm to us. If the Merger Agreement is terminated under certain circumstances, including circumstances involving a change in recommendation by our Board of Directors, the Company may be required to pay to Southern National a termination fee of $7.5 million. If the Merger Agreement is terminated and our Board of Directors seeks another merger or business combination, our shareholders cannot be certain that we will be able to find a party willing to pay the equivalent or greater consideration than that which Southern National has agreed to pay with respect to the Pending Merger.

 

 23 

 

 

We are subject to business uncertainties and contractual restrictions related to the Pending Merger.

 

Uncertainty about the effect of the Pending Merger on employees and customers may have an adverse effect on us and our business. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Pending Merger is completed, and could cause customers and others that deal with the Company and the Bank to seek to change existing business relationships. Retention of certain employees by the Company and the Bank may be challenging until the Pending Merger is completed, as certain employees may experience uncertainty about their future roles with the Bank. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with our organization, our business before or following completion of the Pending Merger could be harmed. Southern National may be subject to similar risks and uncertainties related to the Pending Merger, and the negative consequences of risk and uncertainties encountered by the Company and Southern National may negatively affect the business, financial condition or results of operations of the combined company. In addition, subject to certain exceptions, we have agreed to operate our business in the ordinary course prior to closing and to refrain from taking certain specified actions until the Pending Merger occurs, which may prevent us from pursuing attractive business opportunities that may arise prior to completion of the Pending Merger.

 

Combining Southern National and the Company may be more difficult, costly or time-consuming than we expect.

 

Southern National and the Company have operated and, until the completion of the Pending Merger, will continue to operate independently. The success of the Pending Merger will depend, in part, on our ability to successfully combine the businesses of Southern National with ours. It is possible that the integration process could result in the loss of key employees, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the Pending Merger. The loss of key employees could adversely affect the combined company’s ability to successfully conduct its business in the markets in which we now operate, which could have an adverse effect on the combined company’s financial results and the value of Southern National’s common stock after the Pending Merger is completed. If the combined company experiences difficulties with the integration process, the anticipated benefits of the Pending Merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause the Bank to lose customers or cause customers to remove their accounts from the Bank and move their business to competing financial institutions. Integration efforts between Southern National and the Company will also divert management attention and resources. These integration matters could have an adverse effect on each of the Company, the Bank, Southern National and Sonabank during this transition period and for an undetermined period after consummation of the Pending Merger.

 

Our ability to complete the Pending Merger is subject to the receipt of consents and approvals from regulatory agencies which may impose conditions that could adversely affect us or cause the Merger to be abandoned.

 

Before the Pending Merger may be completed, we must obtain various approvals or consents from the Federal Reserve Board and the Bureau. These regulators may impose conditions on the completion of the Pending Merger. Although we do not currently expect that any significant conditions would be imposed, there can be no assurance that they will not be, and such conditions could have the effect of delaying completion of the Pending Merger or imposing additional costs on or limiting the revenues of the combined company following completion of the Pending Merger. There can be no assurance as to whether the regulatory approvals will be received, the timing of those approvals, or whether any conditions will be imposed.

 

The Merger Agreement limits our ability to pursue alternatives to the Pending Merger and might discourage competing offers for a higher price or premium.

 

The Merger Agreement contains “no-shop” provisions that, subject to limited exceptions, limit our ability to discuss, facilitate or commit to competing third-party proposals to acquire all or a significant part of our Company. In addition, under certain circumstances, if the Merger Agreement is terminated and we, subject to certain restrictions, consummate a similar transaction other than the Pending Merger, we must pay to Southern National a termination fee of $7.5 million. These provisions might discourage a potential competing acquiror that might have an interest in acquiring all or a significant percentage of ownership of us from considering or proposing the acquisition even if it were prepared to pay consideration with a higher per share market price than that proposed in the Pending Merger.

 

 24 

 

 

The Pending Merger may distract our management from their other responsibilities.

 

The Pending Merger could cause our management to focus their time and energies on matters related to the transaction that otherwise would be directed to our business and operations. Any such distraction on the part of our management could affect our ability to service existing business and develop new business and adversely affect our business and earnings before the completion of the Pending Merger, or the business and earnings of the combined company after completion of the Pending Merger.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

Our principal executive offices (and corporate headquarters) are leased and located at 10900 Nuckols Road, Suite 325, Glen Allen, Virginia 23060 where we relocated to in October 2016. At the end of 2016, the Company owned twenty-one full service branch buildings including the land on which eighteen of those buildings are located and two remote drive-in facilities. The Company currently has long-term leases for six of its branches, one loan production office and its corporate headquarters in Glen Allen, Virginia. Three of the leases are for branch buildings, three of the leases are for the land on which Company owned branches are located, one lease is for a loan production office building in Chesterfield, Virginia and one lease is for the corporate headquarters. All leases are under long-term non-cancelable operating lease agreements with renewal options, at total annual rentals of approximately $788 thousand as of December 31, 2017. The counties of Northumberland and Middlesex are each the home to three of our branches. The counties of Essex and Gloucester are each home to two branch offices. In addition, Essex County houses an operations center that formerly served as our corporate headquarters. Henrico County houses one branch office and the Company’s corporate headquarters. Hanover County houses three branch offices and the Bank’s loan administration center, while King William County, Lancaster, New Kent, Southampton, Surry, Sussex Counties and the cities of Colonial Heights, Hampton, Newport News and Williamsburg each have one full service branch office. In addition, the city of Newport News houses a commercial/administrative center. Southampton County and Sussex County also each have a stand-alone drive-in/automated teller machine location.

 

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

 

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

 

Item 3. Legal Proceedings

 

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

 

Item 4. Mine Safety Disclosures

 

None.

 

Executive Officers of the Registrant

 

Following are the persons who are currently executive officers of the Company, their ages as of December 31, 2016, their current titles and positions held during the last five years:

 

Joe A. Shearin, 60, joined the Company in 2001 as the President and Chief Executive Officer of Southside Bank. Mr. Shearin served in that capacity until 2006 when he became President and Chief Executive Officer of the Bank. Mr. Shearin became the President and Chief Executive Officer of the Company in 2002.

 

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J. Adam Sothen, 40, joined the Company in June 2010 as Vice President and Corporate Controller of the Bank. In September 2011, Mr. Sothen was appointed as the Company’s Chief Financial Officer and the Bank’s Executive Vice President and Chief Financial Officer. Mr. Sothen served as the Corporate Controller until October 2012.

 

James S. Thomas, 62, joined the Company in 2003 as Senior Vice President and Retail Banking Manager of Southside Bank. In 2005, he became Executive Vice President and Chief Operating Officer of Southside Bank. In April 2006, Mr. Thomas became Executive Vice President of Retail Banking for the Bank. In June 2007, Mr. Thomas was promoted to Executive Vice President and Chief Credit Officer of the Bank.

 

Douglas R. Taylor, 60, joined the Company in April 2010 as Executive Vice President and Chief Risk Officer of the Bank.

 

Ann-Cabell Williams, 55, joined the Company in July 2011 as Executive Vice President and Retail Executive of the Bank.  From January 2007 until joining the Company, Ms. Williams served as Chief Operation Officer and Retail Executive for Bank of Virginia.  In April 2016, she became Executive Vice President and Chief Channel Distribution Officer of the Bank.

 

Bruce T. Brockwell, 51, joined the Company in April 2011 as Senior Vice President and Senior Commercial Lending Officer of the Bank. In May 2012, he became Senior Vice President and Director of Commercial Banking of the Bank. In August 2013, Mr. Brockwell was promoted to Executive Vice President and Director of Commercial Banking of the Bank. In April 2016, he became Executive Vice President and Chief Banking Officer of the Bank.

 

Mark C. Hanna, 48, joined the Company in November 2014 as Executive Vice President and Regional Executive of the Bank. From November 2006 until joining the Company, Mr. Hanna served as President and Chief Executive Officer for Virginia Company Bank. From September 2005 to November 2006, Mr. Hanna served as President of Virginia Company Bank.

 

Dianna B. Emery, 58, joined the Company in December 2007 as Cash Management Sales Officer of the Bank and later transitioned to Senior Business Analyst of the Bank.  In March 2011, she became Vice President and Operations Manager of the Bank.  In July 2015, she became Senior Vice President and Chief Operations Officer of the Bank.  In November 2015, Ms. Emery was promoted to Executive Vice President and Chief Operations Officer of the Bank.

 

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Part II

 

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

 

Common Stock Performance and Dividends

 

The Company’s common stock is traded on the NASDAQ Global Market under the symbol “EVBS.” As of March 10, 2017, there were approximately 2,684 shareholders of record. As of that date, the closing price of our common stock on the NASDAQ Global Market was $10.66. Set forth in the table below is the high and low sales prices of our common stock as reported by the NASDAQ Stock Market during each quarter for 2016 and 2015, along with the dividends that were declared quarterly in 2016 and 2015.

 

   2016   2015 
Quarter  High   Low   Dividends   High   Low   Dividends 
First  $7.10   $6.60   $0.02   $6.50   $6.12   $0.01 
Second   7.75    6.60    0.02    6.57    5.80    0.01 
Third   8.69    7.16    0.02    7.24    6.12    0.02 
Fourth   10.50    7.60    0.03    7.24    6.25    0.02 

 

Payment of dividends is at the discretion of the Company’s board of directors and is subject to various federal and state regulatory limitations. For further information regarding payment of dividends refer to Item 1, “Business,” under the heading “Limits on Dividends” of this Annual Report on Form 10-K.

 

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Stock Performance Graph

 

The graph below presents five-year cumulative total return comparisons through December 31, 2016, in stock price appreciation and dividends for the Company’s common stock, the NASDAQ Composite and the SNL $1 billion - $5 billion Bank Index. Returns assume an initial investment of $100 at the market close on December 31, 2011 and reinvestment of dividends. Values as of each year end of the $100 initial investment are shown in the table and graph below.

 

 

   Cumulative Total Return as of Period Ending 
Index  12/31/11   12/31/12   12/31/13   12/31/14   12/31/15   12/31/16 
Eastern Virginia Bankshares, Inc.   100.00    268.66    348.26    321.89    360.60    531.19 
NASDAQ Composite   100.00    117.45    164.57    188.84    201.98    219.89 
SNL Bank $1B - $5B Bank Index   100.00    123.31    179.31    187.48    209.86    301.92 

 

Dividend Reinvestment and Stock Purchase Plan

 

The Company has a Dividend Reinvestment and Stock Purchase Plan (the “DRSPP”), which provides for the automatic conversion of dividends into common stock for enrolled shareholders. The DRSPP also permits participants to make voluntary cash payments of up to $20 thousand per shareholder per calendar quarter for the purchase of additional shares of the Company’s common stock. When the administrator of the DRSPP purchases shares of common stock from the Company, the purchase price will generally be the market value of the common stock on the purchase date as defined by the Nasdaq Stock Market. When the administrator purchases shares of common stock in the open market, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. When the administrator purchases shares of common stock in privately negotiated transactions, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses.

 

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Beginning on August 15, 2012, the issuance of common stock under the DRSPP was temporarily suspended. In July 2016 the Company reinitiated the Company’s DRSPP. Of the 353,473 shares reserved for issuance under the Company’s DRSPP, there were 128,670 shares available for issuance under the plan as of December 31, 2016.

 

Purchases of Equity Securities by the Issuer

 

In January 2001, the Company announced a stock repurchase program by which management was authorized to repurchase up to 300,000 shares of the Company’s common stock. This plan was amended in 2003 and the number of shares by which management is authorized to repurchase is up to 5% of the outstanding shares of the Company’s common stock on January 1 of each year. There is no stated expiration date for the program. During 2016, 2015 and 2014, the Company did not repurchase any of its common stock under the program.

 

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Item 6. Selected Financial Data

 

SELECTED FINANCIAL DATA                    
(dollars in thousands, except per share data)                    
   Year Ended December 31, 
   2016   2015   2014   2013   2012 
Operating Statement Data:                         
Interest and dividend income  $51,462   $47,964   $41,918   $42,024   $45,071 
Interest expense   6,662    5,589    4,428    8,045    11,568 
Net interest income   44,800    42,375    37,490    33,979    33,503 
Provision for loan losses   17    -    250    1,850    5,658 
Net interest income after provision for loan losses   44,783    42,375    37,240    32,129    27,845 
Noninterest income   6,796    6,453    6,675    7,748    9,898 
Noninterest expense   40,410    39,040    35,804    44,901    33,346 
Income (loss) before income taxes   11,169    9,788    8,111    (5,024)   4,397 
Income tax expense (benefit)   3,410    2,494    2,447    (2,392)   945 
Net income (loss)   7,759    7,294    5,664    (2,632)   3,452 
Effective dividend on preferred stock   -    386    1,948    1,504    1,500 
Net income (loss) available to common shareholders  $7,759   $6,908   $3,716   $(4,136)  $1,952 
                          
Per Share Data:                         
Basic and Diluted net income (loss) per common share  $0.42   $0.38   $0.22   $(0.45)  $0.32 
Cash dividends paid per share, common stock  $0.09   $0.06   $-   $-   $- 
Dividend payout ratio   21.26%   15.86%   n/a    n/a    n/a 
Book value per common share  $8.47   $8.11   $7.67   $7.41   $12.56 
                          
Balance Sheet Data:                         
Assets  $1,398,593   $1,270,384   $1,181,972   $1,027,074   $1,075,553 
Loans, net of unearned income   1,033,231    880,778    820,569    657,197    684,668 
Investment securities   259,145    269,600    253,707    275,979    286,164 
Deposits   1,051,361    988,719    939,254    834,462    838,373 
Total shareholders' equity   131,200    126,275    134,274    132,949    99,711 
Average common shares outstanding - basic   13,089    13,017    12,015    9,205    6,051 
Average common shares outstanding - diluted   18,329    18,257    17,255    9,205    6,051 
                          
Performance Ratios:                         
Return on average assets   0.60%   0.57%   0.35%   -0.39%   0.18%
Return on average common shareholders' equity   7.00%   6.76%   3.96%   -4.98%   2.66%
Efficiency ratio (1)   78.71%   78.93%   80.99%   79.46%   79.09%
Average equity to average assets   10.16%   10.53%   12.85%   11.13%   9.13%
Asset Quality Ratios:                         
Allowance for loan losses to period end loans   1.09%   1.29%   1.59%   2.25%   2.97%
Allowance for loan losses to nonaccrual loans   217.53%   183.43%   196.63%   134.03%   171.29%
Nonperforming assets to period end loans and other real estate owned   0.89%   0.89%   1.04%   1.80%   2.41%
Net charge-offs to average loans   0.01%   0.20%   0.28%   1.11%   1.32%
                          
Capital Ratios:                         
Leverage capital ratio   9.2748%   9.2029%   10.7632%   12.0624%   8.1262%
CET1 risk-based capital   8.8000%   9.8050%   n/a    n/a    n/a 
Tier 1 risk-based capital   11.5129%   12.6637%   14.0562%   18.2174%   12.6392%
Total risk-based capital   14.4449%   16.1737%   15.3097%   19.4793%   13.8767%

 

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

 

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

 

This commentary provides an overview of the Company’s financial condition as of December 31, 2016 and 2015, and changes in financial condition and results of operations for the years 2014 through 2016. This section of the Form 10-K should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included under Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.

 

Forward Looking Statements

 

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

 

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

 

qfactors that adversely affect our strategic and business initiatives, including, without limitation, changes in the economic or business conditions in the Company’s markets;
qthe possibility that any of the anticipated benefits of the Pending Merger will not be realized or will not be realized within the expected time period; the risk that integration of the operations of Southern National and the Company will be materially delayed or will be more costly or difficult than expected; the inability to complete the Pending Merger due to the failure to obtain the required shareholder approvals; the failure to satisfy other conditions to completion of the Pending Merger, including receipt of required regulatory and other approvals; the failure of the Pending Merger to close for any other reason; the effect of the announcement of the Pending Merger on customer relationships and operating results; the possibility that the Pending Merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events; changes in interest rates; general economic conditions and those in the market areas of Southern National and the Company;
qour ability and efforts to assess, manage and improve asset quality;
qthe strength of the economy in the Company’s target market area, as well as general economic, market, political, or business factors;
qchanges in the quality or composition of our loan or investment securities portfolios, including adverse developments in borrower industries or in the repayment ability of individual borrowers or issuers;
qconcentrations in segments of the loan portfolio or declines in real estate values in the Company’s markets;
qthe effects of our adjustments to the composition of our investment securities portfolio;
qthe strength of the Company’s counterparties;
qan insufficient allowance for loan losses;
qour ability to meet the capital requirements of our regulatory agencies;

 

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qchanges in laws, regulations and the policies of federal or state regulators and agencies, including the Basel III Capital Rules;
qchanges in the interest rates affecting our deposits and loans;
qthe loss of any of our key employees;
qfailure, interruption or breach of any of the Company’s communication or information systems, including those provided by external vendors;
qthe effects of cyber-attacks or other security breaches;
qour potential growth, including our entrance or expansion into new markets, the opportunities that may be presented to and pursued by us and the need for sufficient capital to support that growth;
qchanges in government monetary policy, interest rates, deposit flow, the cost of funds, and demand for loan products and financial services;
qour ability to maintain internal control over financial reporting;
qour ability to realize our deferred tax assets, including in the event the Company experiences an ownership change as defined by section 382 of the Code;
qour ability to raise capital as needed by our business;
qour reliance on secondary sources, such as FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks to meet our liquidity needs; and
qother circumstances, many of which are beyond our control.

 

Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions and projections within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance, actions or achievements of the Company will not differ materially from any future results, performance, actions or achievements expressed or implied by such forward-looking statements. Readers should not place undue reliance on such statements. Forward-looking statements speak only as of the date of this report. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. The reader should refer to risks detailed under Item 1A. “Risk Factors” included above in this Form 10-K and in our periodic and current reports filed with the SEC for specific factors that could cause our actual results to be significantly different from those expressed or implied by our forward-looking statements.

 

Critical Accounting Policies

 

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

 

Allowance for Loan Losses

 

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

 

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Impairment of Loans

 

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

 

Loans Acquired in a Business Combination

 

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

 

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

 

Impairment of Securities

 

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

 

Other Real Estate Owned (“OREO”)

 

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

 

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Goodwill

 

With the adoption of FASB Accounting Standards Update (“ASU”) 2011-08, “Intangible-Goodwill and Other-Testing Goodwill for Impairment,” the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis were discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company chose to bypass the preliminary assessment of qualitative impairment factors and completed its annual goodwill impairment test during the fourth quarter of 2016 through the use of an independent third party specialist and determined there was no impairment to be recognized in 2016. If the underlying estimates and related assumptions change in the future, the Company may be required to record impairment charges.

 

Retirement Plan

 

The Company historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense. The Company intends to terminate the plan effective May 1, 2017 in connection with the Pending Merger.

 

Accounting for Income Taxes

 

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

 

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

 

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

 

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Business Overview

 

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

 

The Company is committed to delivering strong long-term earnings using a prudent allocation of capital, in business lines where we have demonstrated the ability to compete successfully. During 2016, the national and local economies continued to show slow, but measured signs of recovery with the main challenges continuing to be underemployment above historical levels and uneven economic growth. Macro-economic and political issues continue to temper the global economic outlook and, as such, the Company remains cautiously optimistic regarding the improvements seen in our local markets. Despite this, the Company believes that our local markets are poised for stronger growth in the coming months and years than the economic recovery has provided in our markets in recent periods.

 

Since 2013 the Company has completed strategic initiatives that have significantly improved the Company’s financial condition. These initiatives represent significant progress toward the Company’s long-term goal of growing a more robust community banking business. These initiatives include:

 

·Raising in 2013 an aggregate of $50.0 million of gross proceeds from sales of the Company’s common stock and Series B Preferred Stock in private placements to certain institutional investors ($45.0 million in gross proceeds) and a rights offering to existing shareholders ($5.0 million in gross proceeds) (collectively, the “2013 Capital Initiative”);
·Using a portion of the proceeds from the 2013 Capital Initiative to prepay long-term, higher-rate FHLB advances and to accelerate the disposition of adversely classified assets;
·Paying all current and previously deferred interest and all current and previously deferred, but accumulated, dividends on the Company’s Junior Subordinated Debt and Series A Preferred Stock (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K), respectively;
·Redeeming all of the Company’s Series A Preferred Stock, which eliminated one of the Company’s most expensive sources of capital;
·Acquiring VCB effective November 14, 2014, thus adding three branches to the Bank’s branch network and an aggregate of $128.9 million of assets to the Company’s balance sheet. All former VCB branches have been fully integrated into the Bank’s branch network and operate as branches of the Bank, expanding the Bank’s branch network into the Virginia cities of Hampton, Newport News and Williamsburg;
·Opening a loan production office in Chesterfield County, Virginia to increase the Bank’s presence in the Richmond metropolitan area and contribute to loan portfolio growth and diversification;
·Declaring dividends to holders of both the Company’s common stock and Series B Preferred Stock. Beginning in March 2015, dividends of $0.01 per share were declared and paid quarterly. The Company increased the quarterly dividends to $0.02 per share starting August 2015 through August 2016, and again increased the quarterly dividends in November 2016 to $0.03 per share;
·Raising in the second quarter of 2015 an aggregate of $20.0 million in gross proceeds from sales of Senior Subordinated Debt (defined in Item 8. “Financial Statements and Supplementary Data” under the heading “Note 9. Junior and Senior Subordinated Debt”) in private placements to certain institutional investors. A portion of these proceeds were used to redeem the remainder of the Company’s Series A Preferred Stock and to repurchase the Warrant (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K) that was issued to the Treasury through the Capital Purchase Program;
·On October 11, 2016 the Company’s corporate headquarters was relocated to the Innsbrook business park in Glen Allen, Virginia in order to increase collaboration and productivity, while gaining operating efficiencies throughout the Company;

 

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·On December 13, 2016, the Company and Southern National jointly announced the signing of a definitive agreement to merge. The combination brings together two banking companies with complementary business lines creating one of the premier banking institutions headquartered in the Commonwealth of Virginia. The combined company will use the name Southern National Bancorp of Virginia, Inc. The Pending Merger, which is expected to be completed by the third quarter of 2017, is subject to regulatory approvals and the approval of the shareholders of both companies, as well as customary closing conditions; and
·In connection with the Pending Merger, the Company intends to terminate its defined benefit pension plan effective May 1, 2017.

 

The Company expects to recognize the continued benefits of these initiatives during 2017, including through lower interest expense related to the extinguished FHLB advances in 2013, elimination of the Series A Preferred Stock dividend as of June 15, 2015, additional interest income and cost savings related to the acquisition of VCB, and positive contributions to the Company’s loan portfolio generated by the three branches acquired from VCB and the Chesterfield County, Virginia loan production office.

 

As previously disclosed, the Company engaged an independent consultant to conduct a comprehensive assessment of its operations during the first half of 2015. The assessment identified operating efficiencies and revenue enhancement opportunities. The Company has leveraged the assessment’s findings, and since the second half of 2015, has continued to realize targeted increases in revenues and declines in certain noninterest expenses, particularly certain salaries and employee benefits expense. However, increases in group insurance costs due to claims and in incentive compensation have largely offset the aforementioned realized declines in salaries and employee benefits expense. Related to the Company’s continued commitment to drive operating efficiencies and reduce noninterest expenses, during the fourth quarter of 2016 the Company implemented a hiring freeze.  In connection with this hiring freeze, through attrition and other job eliminations, the Company reduced the number of its full-time equivalent employees by 10 during the month of December 2016 and by an additional 14 during the month of January 2017.  The Company currently expects this initiative to reduce salaries and employee benefits expense by approximately $1.3 million on an annualized basis.

 

Summary of 2016 Operating Results and Financial Condition

 

Table 1: Performance Summary

 

   Years Ended December 31, 
(dollars in thousands, except per share data)  2016   2015 
Net income (1)  $7,759   $7,294 
Net income available to common shareholders (1)  $7,759   $6,908 
Basic and diluted net income per common share  $0.42   $0.38 
Return on average assets   0.60%   0.57%
Return on average common shareholders' equity   7.00%   6.76%
Net interest margin (tax equivalent basis) (2)   3.72%   3.84%

 

(1)The difference between net income and net income available to common shareholders is the effective dividend to holders of the Company’s Series A Preferred Stock paid during the year ended December 31, 2015.
(2)For more information on the calculation of net interest margin on a tax equivalent basis, see the average balance sheet and net interest margin analysis for the years ended December 31, 2016 and 2015 contained in "Results of Operations" in this Item 7.

 

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For the year ended December 31, 2016, the following were significant factors in our reported results:

 

·Increase in net interest income of $2.4 million from the same period in 2015, principally due to an increase in interest and fees on loans driven primarily by loan growth, partially offset by an increase in interest expense associated with our short-term borrowings and the issuance of $20.0 million in Senior Subordinated Debt during the second quarter of 2015;
·Net interest margin (tax equivalent basis) decreased 12 basis points to 3.72% during the twelve months ended December 31, 2016 as compared to 3.84% for the same period of 2015 primarily due to a decline in yields on our investment securities and loan portfolio and the impact of interest incurred on our short-term borrowings and Senior Subordinated Debt;
·Net accretion attributable to accounting adjustments related to the VCB acquisition was $293 thousand, as compared to $479 thousand in the same period of 2015;
·A decrease in net charge-offs of $1.6 million from 2015 primarily due to the collection of charged-off principal on a previously restructured loan. Even though there was significant loan growth during 2016, this recovery primarily offset the need for any additional loan loss provision during 2016;
·Nonperforming assets at December 31, 2016 increased $1.4 million from December 31, 2015 due to a $2.1 million increase in OREO and a $224 thousand increase in loans 90 days past due and accruing interest, partially offset by a decrease of $994 thousand in nonaccrual loans. The increase in OREO was primarily due to the foreclosure on a property that secured a single PCI loan which had been past due 90 days and accruing interest;
·Performing TDRs decreased from December 31, 2015 by $5.1 million primarily due to collection of principal on two previously restructured loans. Nonperforming TDRs increased from December 31, 2015 by $909 thousand primarily due to the execution of two new loan restructuring agreements;
·Net gain on sale of available for sale securities of $701 thousand as compared to $224 thousand in the same period of 2015 was higher due to the adjustments of the composition of the investment securities portfolio as part of our overall asset/liability management strategy;
·Consultant fees decreased $416 thousand from the same period in 2015, primarily due to expenses incurred during 2015 related to the aforementioned comprehensive assessment of our operations that were not repeated during 2016;
·Collection, repossession and other real estate owned expense increased $153 thousand from the same period of 2015 due to an increase in foreclosure activity;
·Marketing and advertising expenses increased $160 thousand as compared to the same period in 2015 primarily due to costs associated with advertising campaigns and other initiatives;
·Merger and merger related expenses of $617 thousand were incurred during 2016 in connection with the Pending Merger. Merger and merger related expenses of $224 thousand were incurred during 2015 in connection with the VCB acquisition;
·Other operating expenses increased $329 thousand as compared to the same period in 2015 primarily due to increases in director fees and internet banking expense; and
·No effective dividend on preferred stock for the twelve months ended December 31, 2016 as compared to $386 thousand from the same period of 2015. This was due to the redemption of the remaining 14,000 shares of the Company’s Series A Preferred Stock in transactions completed during the first half of 2015.

 

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Results of Operations

 

The table below lists our quarterly performance for the years ended December 31, 2016 and 2015.

 

Table 2: Summary Of Financial Results By Quarter

 

   Three Months Ended   Three Months Ended 
   2016   2015 
(dollars in thousands, except per share data)  Dec. 31   Sep. 30   June 30   Mar. 31   Dec. 31   Sep. 30   June 30   Mar. 31 
Interest and dividend income  $13,493   $12,696   $12,619   $12,654   $12,280   $11,984   $11,935   $11,765 
Interest expense   1,721    1,648    1,654    1,639    1,585    1,484    1,329    1,191 
Net interest income   11,772    11,048    10,965    11,015    10,695    10,500    10,606    10,574 
Provision for loan losses   -    -    -    17    -    -    -    - 
Net interest income after provision for loan losses   11,772    11,048    10,965    10,998    10,695    10,500    10,606    10,574 
Noninterest income   1,707    1,866    1,672    1,551    1,678    1,724    1,532    1,519 
Noninterest expenses   10,934    10,100    9,957    9,419    9,357    9,517    10,199    9,967 
Income before income taxes   2,545    2,814    2,680    3,130    3,016    2,707    1,939    2,126 
Income tax expense   922    815    770    903    848    697    432    517 
Net income  $1,623   $1,999   $1,910   $2,227   $2,168   $2,010   $1,507   $1,609 
Less:  Effective dividend on preferred stock   -    -    -    -    -    -    166    220 
Net income available to common shareholders  $1,623   $1,999   $1,910   $2,227   $2,168   $2,010   $1,341   $1,389 
                                         
Income per common share: basic and diluted  $0.09   $0.10   $0.11   $0.12   $0.12   $0.11   $0.07   $0.08 

 

Net Interest Income and Net Interest Margin

 

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

 

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

 

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

 

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Table 3: Average Balance Sheet and Net Interest Margin Analysis

 

   Year Ended December 31, 
(dollars in thousands)  2016   2015   2014 
   Average   Income/   Yield/   Average   Income/   Yield/   Average   Income/   Yield/ 
   Balance   Expense   Rate (1)   Balance   Expense   Rate (1)   Balance   Expense   Rate (1) 
Assets:                                             
Securities                                             
Taxable  $254,690   $5,753    2.26%  $224,159   $4,934    2.20%  $232,639   $5,171    2.22%
Restricted securities   9,240    483    5.23%   7,965    427    5.36%   7,075    387    5.47%
Tax exempt (2)   5,285    196    3.71%   33,079    1,315    3.98%   28,466    1,133    3.98%
Total securities   269,215    6,432    2.39%   265,203    6,676    2.52%   268,180    6,691    2.49%
Interest bearing deposits in other banks   10,324    45    0.44%   7,574    18    0.24%   7,354    18    0.24%
Federal funds sold   227    -    0.00%   180    -    0.00%   191    -    0.00%
Loans, net of unearned income (3)   925,009    45,045    4.87%   840,814    41,672    4.96%   706,812    35,555    5.03%
Total earning assets   1,204,775    51,522    4.28%   1,113,771    48,366    4.34%   982,537    42,264    4.30%
Less allowance for loan losses   (10,955)             (12,327)             (14,547)          
Total non-earning assets   109,460              113,691              100,162           
Total assets  $1,303,280             $1,215,135             $1,068,152           
                                              
Liabilities & Shareholders' Equity:                                             
Interest-bearing deposits                                             
Checking  $308,121   $1,170    0.38%  $291,955   $1,067    0.37%  $262,765   $949    0.36%
Savings   103,652    192    0.19%   93,645    131    0.14%   90,015    120    0.13%
Money market savings   163,913    773    0.47%   162,360    748    0.46%   120,541    498    0.41%
Large dollar certificates of deposit (4)   123,726    1,297    1.05%   117,991    1,040    0.88%   99,521    1,187    1.19%
Other certificates of deposit   113,911    914    0.80%   118,509    1,071    0.90%   126,274    1,156    0.92%
Total interest-bearing deposits   813,323    4,346    0.53%   784,460    4,057    0.52%   699,116    3,910    0.56%
Federal funds purchased and repurchase agreements   5,819    27    0.46%   8,065    46    0.57%   4,698    28    0.60%
Short-term borrowings   119,366    514    0.43%   89,580    194    0.22%   72,565    151    0.21%
Junior subordinated debt   10,310    370    3.59%   10,310    329    3.19%   10,310    339    3.29%
Senior subordinated debt   19,071    1,405    7.37%   13,361    963    7.21%   -    -    0.00%
Total interest-bearing  liabilities   967,889    6,662    0.69%   905,776    5,589    0.62%   786,689    4,428    0.56%
Noninterest-bearing liabilities                                             
Demand deposits   195,543              174,150              139,991           
Other liabilities   7,474              7,265              4,171           
Total liabilities   1,170,906              1,087,191              930,851           
Shareholders' equity   132,374              127,944              137,301           
Total liabilities and shareholders' equity  $1,303,280             $1,215,135             $1,068,152           
Net interest income (2)       $44,860             $42,777             $37,836      
                                              
Interest rate spread (2)(5)             3.59%             3.72%             3.74%
Interest expense as a percent of  average earning assets             0.55%             0.50%             0.45%
Net interest margin (2)(6)             3.72%             3.84%             3.85%

 

Notes:

(1)Yields are based on average daily balances.
(2)Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%, with an adjustment of $60, $402 and $346 in 2016, 2015 and 2014, respectively.
(3)Nonaccrual loans have been included in the computations of average loan balances.
(4)Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.
(5)Interest rate spread is the average yield on earning assets, calculated on a fully taxable basis, less the average rate incurred on interest-bearing liabilities.
(6)Net interest margin is the net interest income, calculated on a fully taxable basis, expressed as a percentage of average earning assets.

 

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2016 compared with 2015

 

Net interest income and net interest margin

 

Net interest income for the year ended December 31, 2016 increased $2.4 million, or 5.7%, as compared to the same period in 2015.  The Company's net interest margin (tax equivalent basis) decreased to 3.72% for the year ended December 31, 2016, representing a 12 basis point decrease over the Company's net interest margin (tax equivalent basis) for the year ended December 31, 2015.  The decline in the net interest margin (tax equivalent basis) was primarily driven by lower loan yields as compared to 2015 as a result of competitive pressures in the historically low rate environment and lower accretion of fair value adjustments related to the VCB acquisition as well as increased interest expense as a result of the private placement of $20.0 million of Senior Subordinated Debt in April 2015. Additionally, the average balance of and rates paid on our short-term borrowings increased as compared to 2015. These margin pressures were largely offset by increases in average loan balances in the Company’s results for the year ended December 31, 2016, as compared to the same period in 2015. The most significant factors impacting net interest income during the year ended December 31, 2016 were as follows:

 

Positive Impact:

 

·Increases in average loan balances, primarily due to organic loan growth and loan purchases, partially offset by lower loan yields.

 

Negative Impacts:

 

·Decreases in average yields earned on investment securities, primarily tax exempt investment securities due to changes in the composition of the investment securities portfolio;
·Private placement of $20.0 million of Senior Subordinated Debt during the second quarter of 2015 resulting in increases to total average interest-bearing liabilities and related interest expense for the year ended December 31, 2016;
·Increases in average short-term borrowings balances and rates paid, primarily due to loan growth outpacing deposit growth and other strategic initiatives; and
·The Company experienced higher average interest-bearing deposit balances during the year ended December 31, 2016 over 2015, primarily due to customer growth. The result was an increase in interest expense.

 

Total interest and dividend income

 

Total interest and dividend income increased 7.3% for the year ended December 31, 2016 as compared to the same period in 2015.  The increase in total interest and dividend income was primarily driven by an increase in average loan and investment securities balances, partially offset by decreases in average loan and investment securities yields.

 

Loans

 

Average loan balances increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to organic loan growth and the purchase of $30.8 million in performing commercial and consumer loans during 2016. Loan growth during 2016 outpaced our internal targets. However, loan growth in our rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and we expect will continue to be intense given the historically low rate environment.  The Company’s average loan balances increased $84.2 million for the year ended December 31, 2016, as compared to average loan balances for the same period in 2015.  Total average loans were 76.8% of total average interest-earning assets for the year ended December 31, 2016, compared to 75.5% for the year ended December 31, 2015.

 

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Investment securities

 

Average total investment securities balances increased 1.5% for the year ended December 31, 2016, as compared to the same period in 2015.  This overall increase was the result of management of the Company’s liquidity needs to support operations, along with funds provided by deposit growth and loan demand in the Company’s markets, partially offset by a lack of investment opportunities with acceptable risk-adjusted rates of return. The Company remains committed to its long-term target of managing the investment securities portfolio to comprise 20% of the Company’s total assets.  The yields on total average investment securities decreased 13 basis points for the year ended December 31, 2016, as compared to the same period in 2015. The decrease in yields on average total investment securities during the year ended December 31, 2016, as compared to the same period of 2015, was driven by a lower allocation of the total investment securities portfolio to SBA Pool securities and tax exempt municipal securities, both of which also tend to be higher-yielding segments of the Company’s investment securities portfolio. These decreases were partially offset by higher interest rates and a greater allocation of the total investment securities portfolio to higher yielding Agency CMBS securities and taxable municipal securities.

 

Interest-bearing deposits

 

Average total interest-bearing deposit balances increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to organic deposit growth that was in part driven by the Company’s marketing and advertising initiatives as well as new products and services.

 

Borrowings

 

Average total borrowings increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to the issuance of $20.0 million in Senior Subordinated Debt in April 2015 and increased short-term borrowings.  Average short-term borrowings increased for the year ended December 31, 2016, as compared to the same period in 2015, due to additional short-term FHLB advances taken to fund loan growth and other strategic initiatives.

 

2015 compared with 2014

 

Net interest income and net interest margin

 

Net interest income for the year ended December 31, 2015 increased $4.9 million, or 13.0%, as compared to the same period in 2014. The Company’s net interest margin (tax equivalent basis) decreased to 3.84% for the year ended December 31, 2015, representing a 1 basis point decrease over the Company’s net interest margin (tax equivalent basis) for the year ended December 31, 2014. The most significant factors impacting net interest income during the year ended December 31, 2015 were as follows:

 

Positive Impacts:

 

·Average loan balances increased primarily due to the acquisition of VCB, organic loan growth and the purchase of $21.6 million in loans between June 2015 and December 2015; and
·Average rates paid on total interest-bearing deposits decreased for the year ended December 31, 2015 over the comparable period of 2014. However, the Company experienced higher average interest-bearing deposit balances during the year ended December 31, 2015 over the comparable 2014 period, primarily due to interest-bearing deposits assumed from the VCB acquisition. This drove a slight increase in interest expense attributable to the Company’s deposit portfolio.

 

Negative Impact:

 

·Private placement of $20.0 million of Senior Subordinated Debt in April 2015 resulted in increases to total average interest-bearing liabilities and related interest expense.

 

Total interest and dividend income

 

Total interest and dividend income increased 14.4% for the year ended December 31, 2015, as compared to the same period in 2014. The increase in total interest and dividend income was primarily driven by an increase in average loan balances and was partially offset by a decrease in average loan yields.

 

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Loans

 

Average loan balances increased for the year ended December 31, 2015, as compared to the same period in 2014, due primarily to the acquisition of VCB loans totaling $101.5 million as of November 14, 2014, net of fair value adjustments, the purchase of $21.6 million in performing one-to-four family residential mortgage loans, consumer loans and government guaranteed loans between June 2015 and December 2015, organic loan growth and the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014. Despite a 2.3% increase in loans during the fourth quarter of 2015 which was in line with internal targets, loan growth came in slightly below our expectations for the year. Loan growth in our rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and we expect will continue to be intense given the historically low rate environment. The Company’s average loan balances increased $134.0 million for the year ended December 31, 2015, as compared to average loan balances for the same period in 2014. Total average loans were 75.5% of total average interest-earning assets for the year ended December 31, 2015, compared to 71.9% for the year ended December 31, 2014.

 

Investment securities

 

Average total investment securities balances declined 1.1% for the year ended December 31, 2015, as compared to the same period in 2014. The overall decline during 2015 was the result of the Company moving toward its long term target of the investment securities portfolio comprising 20% of the Company’s total assets, the lack of investment opportunities with acceptable risk-adjusted rates of return and liquidity needs to support our operations and strategic initiatives. The yields on average investment securities increased 3 basis points for the year ended December 31, 2015, as compared to the same period of 2014.

 

Interest-bearing deposits

 

Average total interest-bearing deposit balances increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the assumption of VCB’s interest-bearing deposit liabilities, which totaled $85.6 million as of November 14, 2014, and organic deposit growth that was in part driven by the Company’s marketing and advertising initiatives.

 

Borrowings

 

Average total borrowings increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the issuance of $20.0 million in Senior Subordinated Debt in April 2015 and increased short-term borrowings. Average short-term borrowings increased for the year ended December 31, 2015, as compared to the same period of 2014, due to the assumption of $8.7 million in short-term FHLB advances as a result of the VCB acquisition, as well as additional short-term FHLB advances totaling $28.9 million during 2015 to fund loan growth and other strategic initiatives. The issuance of the Senior Subordinated Debt was a significant driver of higher interest expense and a lower net interest margin during the second half of 2015.

 

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Table 4: Volume and Rate Analysis (1)

 

   2016 from 2015   2015 from 2014 
   Increase (Decrease)   Increase (Decrease) 
   Due to Changes in:   Due to Changes in: 
(dollars in thousands)  Volume   Rate   Total   Volume   Rate   Total 
Interest income:                              
Securities:                              
Taxable  $681   $138   $819   $(191)  $(46)  $(237)
Restricted securities   67    (11)   56    48    (8)   40 
Tax exempt (2)   (1,035)   (84)   (1,119)   182    -    182 
Total securities   (287)   43    (244)   39    (54)   (15)
Interest bearing deposits in other banks   8    19    27    -    -    - 
Loans, net of unearned income   4,113    (740)   3,373    6,604    (487)   6,117 
Total interest income   3,834    (678)   3,156    6,643    (541)   6,102 
                               
Interest expense:                              
Interest-bearing deposits:                              
Checking   73    30    103    91    27    118 
Savings   10    51    61    2    9    11 
Money market savings   9    16    25    184    66    250 
Large dollar certificates of deposit (3)   49    208    257    361    (508)   (147)
Other certificates of deposit   (42)   (115)   (157)   (60)   (25)   (85)
Total interest-bearing deposits   99    190    289    578    (431)   147 
Federal funds purchased and repurchase agreements   (11)   (8)   (19)   19    (1)   18 
Short-term borrowings   85    235    320    35    8    43 
Junior subordinated debt   -    41    41    -    (10)   (10)
Senior subordinated debt   421    21    442    963    -    963 
Total interest expense   594    479    1,073    1,595    (434)   1,161 
Change in net interest income  $3,240   $(1,157)  $2,083   $5,048   $(107)  $4,941 

 

Notes:

(1)Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.
(2)Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.
(3)Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.

 

Interest Sensitivity

 

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

 

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

 

 43 

 

 

The Company believes that it will be a challenge for the Company to maintain its net interest margin at its current level given competitive rate pressures surrounding loan originations coupled with the rising cost of wholesale funding used to fund loan growth in the absence of significant core deposit growth. With uncertainty surrounding rate expectations in 2017, the Company will continue to reinvest investment securities portfolio cash flows with a focus on investment securities that provide steady cash flow at a low risk weighting to provide earnings and liquidity. In 2017, the Company will continue to focus on attracting and retaining core deposits to reduce our reliance on wholesale funding and offset the compression of our net interest margin.

 

Noninterest Income

 

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

 

The following table depicts the components of noninterest income for the years ended December 31, 2016 and 2015:

 

Table 5: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2016   2015   Change $   Change % 
Service charges and fees on deposit accounts  $2,966   $2,845   $121    4.3%
Debit card/ATM fees   1,699    1,728    (29)   -1.7%
Gain on sale of available for sale securities, net   701    224    477    212.9%
Gain on sale of held to maturity securities, net   -    10    (10)   -100.0%
Gain (loss) on sale of bank premises and equipment   14    (58)   72    124.1%
Earnings on bank owned life insurance policies   635    636    (1)   -0.2%
Other operating income   781    1,068    (287)   -26.9%
Total noninterest income  $6,796   $6,453   $343    5.3%

 

2016 Compared to 2015

 

Key changes in the components of noninterest income for the year ended December 31, 2016, as compared to the same period in 2015, are discussed below:

 

·Service charges and fees on deposit accounts increased primarily due to growth in deposits and increases in overdraft and NSF fees on checking accounts;
·Gain on sale of available for sale securities, net increased primarily as a result of the Company adjusting the composition of the investment securities portfolio as part of the Company’s overall asset/liability management strategy;
·Gain (loss) on sale of bank premises and equipment increased due to the receipt of insurance proceeds for damaged equipment in 2016 as compared to losses on the sale of our former Heathsville branch and the disposal of other assets in 2015; and
·Other operating income decreased primarily due to lower earnings from the Bank’s subsidiaries. Additionally, other operating income includes earnings from the Bank’s investment in Bankers Title, LLC and losses from the Bank’s investment in housing equity funds.

 

 44 

 

 

The following table depicts the components of noninterest income for the years ended December 31, 2015 and 2014:

 

Table 5A: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2015   2014   Change $   Change % 
Service charges and fees on deposit accounts  $2,845   $3,257   $(412)   -12.6%
Debit card/ATM fees   1,728    1,416    312    22.0%
Gain on sale of available for sale securities, net   224    538    (314)   -58.4%
Gain on sale of held to maturity securities, net   10    -    10    100.0%
(Loss) gain on sale of bank premises and equipment   (58)   6    (64)   -1066.7%
Earnings on bank owned life insurance policies   636    562    74    13.2%
Other operating income   1,068    896    172    19.2%
Total noninterest income  $6,453   $6,675   $(222)   -3.3%

 

2015 Compared to 2014

 

Key changes in the components of noninterest income for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:

 

·Service charges and fees on deposit accounts declined due to decreases in service charge and overdraft fees on checking accounts;
·Debit card/ATM fees increased primarily due to an increase in debit card fees driven by the acquisition of VCB and a higher utilization rate of debit cards by our customer base;
·Gain on sale of available for sale securities, net decreased primarily due to the sale of a portion of its previously impaired agency preferred securities (FNMA & FHLMC) that generated gains during the first quarter of 2014, and because the Company did not generate comparable gains during 2015;
·(Loss) gain on sale of bank premises and equipment during 2015 was primarily due to the sale of our former Heathsville branch building as operations were relocated to a new facility and the disposal of certain office equipment, with no similar losses occurring in 2014; and
·Other operating income increased primarily due to higher earnings from the Bank’s subsidiaries, its investment in Bankers Insurance, LLC and bank owned life insurance policies, partially offset by higher losses from the Bank’s investments in housing equity funds. Additionally, other operating income includes earnings from the Bank’s investments in Southern Trust Mortgage, LLC and Bankers Title, LLC.

 

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Noninterest Expense

 

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

 

The following table depicts the components of noninterest expense for the years ended December 31, 2016 and 2015:

 

Table 6: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2016   2015   Change $   Change % 
Salaries and employee benefits  $22,497   $21,649   $848    3.9%
Occupancy and equipment expenses   5,861    5,762    99    1.7%
Telephone   846    933    (87)   -9.3%
FDIC expense   707    821    (114)   -13.9%
Consultant fees   727    1,143    (416)   -36.4%
Collection, repossession and other real estate owned   672    519    153    29.5%
Marketing and advertising   1,519    1,359    160    11.8%
Loss on sale of other real estate owned   1    25    (24)   -96.0%
Impairment losses on other real estate owned   34    5    29    580.0%
Merger and merger related expenses   617    224    393    175.4%
Other operating expenses   6,929    6,600    329    5.0%
Total noninterest expenses  $40,410   $39,040   $1,370    3.5%

 

2016 Compared to 2015

 

Key changes in the components of noninterest expense for the year ended December 31, 2016, as compared to the same period in 2015, are discussed below:

 

·Salaries and employee benefits increased primarily due to an increase in group insurance expense (which was driven by an increase in claims during 2016);
·Occupancy and equipment expenses increased primarily due to rent expense related to the relocation of the Company’s corporate headquarters to Glen Allen, Virginia;
·FDIC expense decreased due to lower assessments beginning with the third quarter of 2016;
·Consultant fees decreased primarily due to expenses incurred related to the aforementioned comprehensive assessment of our operations that was completed in 2015;
·Collection, repossession and other real estate owned expenses increased due to an increase in foreclosure activity, particularly related to delinquent real estate taxes paid to secure the Company’s interest in properties subject to foreclosure;
·Marketing and advertising expenses increased due to the timing and size of advertising campaigns and other initiatives;
·Merger and merger related expenses incurred during 2016 in connection with the Pending Merger were higher as compared to expenses incurred during 2015 which were related to the VCB acquisition; and
·Other operating expenses increased primarily due to increases in director fees, data processing expense and internet banking expense.

 

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The following table depicts the components of noninterest expense for the years ended December 31, 2015 and 2014:

 

Table 6A: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2015   2014   Change $   Change % 
Salaries and employee benefits  $21,649   $18,982   $2,667    14.1%
Occupancy and equipment expenses   5,762    5,109    653    12.8%
Telephone   933    992    (59)   -5.9%
FDIC expense   821    921    (100)   -10.9%
Consultant fees   1,143    1,395    (252)   -18.1%
Collection, repossession and other real estate owned   519    323    196    60.7%
Marketing and advertising   1,359    1,005    354    35.2%
Loss on sale of other real estate owned   25    78    (53)   -67.9%
Impairment losses on other real estate owned   5    24    (19)   -79.2%
Merger and merger related expenses   224    1,831    (1,607)   -87.8%
Other operating expenses   6,600    5,144    1,456    28.3%
Total noninterest expenses  $39,040   $35,804   $3,236    9.0%

 

2015 Compared to 2014

 

Key changes in the components of noninterest expense for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:

 

·Salaries and employee benefits increased primarily due to the increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB. Additionally, salaries and employee benefits were higher in 2015 due to annual merit salary increases, increased restricted stock compensation expense, increased bonuses, commissions and other incentive compensation and valuation adjustments related to pension plan liabilities, partially offset by an increase in deferred compensation on loan originations, lower group insurance expenses and reductions in staff levels during the second half of 2015 that were driven by operating efficiencies gained through a previously completed comprehensive assessment of our operations;
·Occupancy and equipment expenses increased primarily due to depreciation expense associated with certain acquired VCB assets and increased rent, building repairs and maintenance and real estate tax expenses related to the acquired VCB branch locations;
·FDIC expense decreased due to lower base insurance assessment rates resulting from the improvement in the Bank’s overall composite rating in connection with the termination of the Company’s regulatory memorandum of understanding in March 2014;
·Consultant fees decreased as higher costs related to compliance, loan operations and outsourcing of the Bank’s core information technology processing were incurred during 2014, as compared to 2015. This decrease was partially offset by costs incurred related to the Company’s engagement of an independent consultant during the first half of 2015 to conduct a comprehensive assessment of its operations;
·Collection, repossession and other real estate owned expenses increased due to increases in average carrying balances of and costs associated with OREO and classified assets during certain periods of the second and third quarters of 2015;
·Marketing and advertising expenses increased due to expenses related to marketing and advertising initiatives;
·Merger and merger related expenses decreased due to certain costs associated with the acquisition of VCB in 2014 that were not repeated in 2015; and
·Other operating expenses increased due to elevated costs associated with outsourcing of the Bank’s core information technology processing, higher franchise taxes, loan closing costs, internet banking expenses and core deposit intangible amortization expense.

 

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Income Taxes

 

The Company recorded income tax expense of $3.4 million in 2016, $2.5 million in 2015 and $2.4 million in 2014.  The increase in income tax expense from 2015 to 2016 was primarily due to the Company’s pre-tax income increasing by $1.4 million, the recognition of nondeductible merger expenses and a reduction in tax-exempt interest income from the Company’s investment securities portfolio.  The decrease in tax-exempt interest income was primarily a result of the Company decreasing the percentage of tax-exempt investment securities that comprised its overall investment securities portfolio.

 

The Company’s effective tax rate for the years ended December 31, 2016, 2015 and 2014 was 30.5%, 25.5% and 30.1%, respectively.  The increase in the effective tax rate from 2015 to 2016 was primarily due to a decrease in tax-exempt interest income from the Company’s investment securities portfolio, as discussed above, and the recognition of $617 thousand in nondeductible expenses related to the Pending Merger with Southern National.  The decrease in the effective tax rate from 2014 to 2015 was primarily related to increased tax-exempt interest income on the Company’s investment securities portfolio, increased tax-exempt bank owned life insurance income as a percentage of pre-tax income and the recognition of $1.4 million in nondeductible expenses related to the acquisition of VCB in 2014.  The effective tax rate differs from the statutory income tax rate of approximately 34% due to the Company’s investment in tax-exempt loans and investment securities, income from bank owned life insurance, and community/housing development tax credits.  For further information concerning Income Taxes, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”

 

Asset Quality

 

Provision and Allowance for Loan Losses

 

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

 

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

 

Pass Grades

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

 

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Special Mention

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

 

Classified Grades

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

 

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

 

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

 

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

 

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

 

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

 

Table 7: Allowance for Loan Losses

 

   Years Ended December 31, 
(dollars in thousands)  2016   2015   2014   2013   2012 
Average loans outstanding*  $925,009   $840,814   $706,812   $669,520   $714,254 
Allowance for loan losses, January 1  $11,327   $13,021   $14,767   $20,338   $24,102 
Charge-offs:                         
   Commercial, industrial and agricultural   96    336    340    635    1,219 
   Real estate - one to four family residential:                         
      Closed end first and seconds   1,042    1,113    483    1,529    2,664 
      Home equity lines   497    160    444    184    1,112 
   Real estate - construction:                         
      One to four family residential   -    129    118    57    98 
      Other construction, land development and other land   -    -    -    1,196    1,622 
   Real estate - non-farm, non-residential:                         
      Owner occupied   353    139    292    2,370    2,337 
       Non-owner occupied   90    -    389    1,944    1,506 
       Consumer   151    33    190    153    391 
       Other   84    68    293    138    99 
           Total loans charged-off   2,313    1,978    2,549    8,206    11,048 
Recoveries:                         
   Commercial, industrial and agricultural   98    51    75    319    774 
   Real estate - one to four family residential:                         
       Closed end first and seconds   477    116    265    85    61 
       Home equity lines   24    31    15    34    11 
   Real estate - construction:                         
       One to four family residential   6    4    7    61    55 
       Other construction, land development and other land   7    1    9    69    2 
   Real estate - non-farm, non-residential:                         
       Owner occupied   63    1    27    1    100 
       Non-owner occupied   1,432    -    13    57    409 
       Consumer   95    49    96    108    179 
       Other   37    31    46    51    35 
          Total recoveries   2,239    284    553    785    1,626 
Net charge-offs   74    1,694    1,996    7,421    9,422 
Provision for loan losses   17    -    250    1,850    5,658 
Allowance for loan losses, December 31  $11,270   $11,327   $13,021   $14,767   $20,338 
Ratios:                         
Ratio of allowance for loan losses to                         
    total loans outstanding, end of year   1.09%   1.29%   1.59%   2.25%   2.97%
Ratio of net charge-offs to average loans                         
    outstanding during the year   0.01%   0.20%   0.28%   1.11%   1.32%

 

* Net of unearned income and includes nonaccrual loans.

 

The Company made a provision for loan losses of $17 thousand in 2016, as compared to no provision for loan losses in 2015, $250 thousand in 2014, $1.9 million in 2013 and $5.7 million in 2012. The allowance for loan losses totaled approximately $11.3 million at both December 31, 2016 and 2015. The ratio of the allowance for loan losses to total loans outstanding declined from December 31, 2015 to December 31, 2016 due to loan growth, improvements in the Company’s asset quality and the resolution of certain classified or problem assets during 2016. In addition to these factors, the decline in the ratio of the allowance for loan losses to total loans outstanding from December 31, 2015 to December 31, 2016 was also driven by improvements in economic and financial conditions in the Company’s markets.

 

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Impaired loans decreased approximately $3.2 million from December 31, 2015, primarily due to the payoff of two previously restructured loans, the upgraded credit quality of a large commercial borrower, the partial charge-off and foreclosure of two other large one to four family loan relationships and partially offset by the addition of two large commercial relationships to impaired loans as a result of a deterioration in the financial condition of the borrowers. Additionally, due to acquisition accounting related to the Company’s acquisition of VCB, the Company recorded loans acquired from VCB at fair value at the time of the acquisition, and any allowance for loan losses previously established by VCB was not recorded on the Company’s financial statements. 

 

Net charge-offs in 2016 were $74 thousand compared to $1.7 million in 2015, $2.0 million in 2014, $7.4 million in 2013 and $9.4 million in 2012. This represents 0.01% of average loans outstanding in 2016, 0.20% in 2015, 0.28% in 2014, 1.11% in 2013 and 1.32% in 2012. Net charge-offs decreased $1.6 million from the year ended December 31, 2015 to the same period of 2016 primarily due to the recovery of charged-off principal on a previously restructured loan. Even though there was significant loan growth during 2016, this recovery and its contribution to the allowance for loan losses principally offset the need for additional loan loss provisions during 2016.

 

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

 

Table 8: Allocation of Allowance for Loan Losses

 

   At December 31, 
   2016   2015   2014   2013   2012 
(dollars in thousands)  Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent 

Commercial, industrial

and agricultural

  $3,035    14.42%  $1,894    11.22%  $1,168    10.37%  $1,787    8.17%  $2,340    7.58%
Real estate - one to four family                                                  
residential:                                                  
Closed end first and seconds   1,487    20.85%   1,609    26.43%   1,884    28.86%   2,859    33.25%   2,876    34.91%
Home equity lines   653    11.85%   795    13.20%   1,678    13.42%   1,642    15.19%   720    14.56%

Real estate - multifamily

residential

   71    3.14%   78    3.37%   89    3.07%   79    2.75%   62    2.31%
Real estate - construction:                                                  
One to four family residential   197    1.57%   295    2.21%   235    2.40%   364    2.46%   419    2.96%
Other construction, land                                                  
development and other land   2,632    8.95%   2,423    5.32%   2,670    4.34%   1,989    3.30%   3,897    5.04%
Real estate - farmland   157    1.09%   272    1.30%   144    1.15%   116    1.24%   41    1.25%
Real estate - non-farm, non-residential:                                                  
Owner occupied   1,267    19.48%   1,964    21.27%   2,416    19.22%   3,236    19.26%   5,092    17.50%
Non-owner occupied   584    13.52%   1,241    11.86%   1,908    12.77%   1,770    11.39%   4,093    10.48%
Consumer   459    4.10%   287    2.27%   305    1.94%   387    2.55%   215    2.94%
Other   728    1.03%   469    1.55%   524    2.46%   538    0.44%   583    0.47%
Total allowance for loan losses  $11,270    100.00%  $11,327    100.00%  $13,021    100.00%  $14,767    100.00%  $20,338    100.00%

 

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

 

 51 

 

 

The following table presents commercial loans by credit quality indicator at December 31, 2016:

 

Table 9: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass   Special
Mention
   Substandard   Impaired   Acquired
Loans -
Purchased
Credit
Impaired
   Total 
Commercial, industrial and agricultural  $136,533   $9,839   $531   $1,640   $420   $148,963 
Real estate - multifamily residential   32,400    -    -    -    -    32,400 
Real estate - construction:                              
One to four family residential   15,624    319    91    170    -    16,204 
Other construction, land development                              
 and other land   84,832    -    212    7,170    252    92,466 
Total real estate - construction   100,456    319    303    7,340    252    108,670 
Real estate - farmland   7,270    3,504    -    515    -    11,289 
Real estate - non-farm, non-residential:                              
Owner occupied   179,400    9,359    1,892    7,645    2,988    201,284 
Non-owner occupied   127,817    2,222    689    7,446    1,475    139,649 
   Total real estate - non-farm, non-                              
   residential   307,217    11,581    2,581    15,091    4,463    340,933 
Total commercial loans  $583,876   $25,243   $3,415   $24,586   $5,135   $642,255 

 

 52 

 

 

The following table presents commercial loans by credit quality indicator at December 31, 2015:

 

Table 9A: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass  

Special

Mention

   Substandard   Impaired   Acquired
Loans -
Purchased
Credit
Impaired
   Total 
Commercial, industrial and agricultural  $95,440   $1,709   $291   $839   $549   $98,828 
Real estate - multifamily residential   29,672    -    -    -    -    29,672 
Real estate - construction:                              
One to four family residential   19,000    220    89    186    -    19,495 
Other construction, land development                              
 and other land   38,013    1,785    1,242    5,562    275    46,877 
Total real estate - construction   57,013    2,005    1,331    5,748    275    66,372 
Real estate - farmland   10,396    318    165    539    -    11,418 
Real estate - non-farm, non-residential:                              
Owner occupied   162,103    12,206    2,283    6,336    4,296    187,224 
Non-owner occupied   86,894    2,130    1,040    12,792    1,600    104,456 
Total real estate - non-farm, non-                              
residential   248,997    14,336    3,323    19,128    5,896    291,680 
Total commercial loans  $441,518   $18,368   $5,110   $26,254   $6,720   $497,970 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2016:

 

Table 10: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:               
Closed end first and seconds  $204,847   $10,615   $215,462 
Home equity lines   121,912    594    122,506 
 Total real estate - one to four family residential   326,759    11,209    337,968 
Consumer   42,077    326    42,403 
Other   10,605    -    10,605 
Total consumer loans  $379,441   $11,535   $390,976 

 

 53 

 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2015:

 

Table 10A: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:            
Closed end first and seconds  $220,016   $12,810   $232,826 
Home equity lines   115,434    875    116,309 
 Total real estate - one to four family residential   335,450    13,685    349,135 
Consumer   19,655    338    19,993 
Other   13,678    2    13,680 
Total consumer loans  $368,783   $14,025   $382,808 

 

Nonperforming Assets

 

The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. As of December 31, 2016, management is not aware of any potential problem loans to place immediately on nonaccrual status.

 

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

 

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

 

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

 

 54 

 

 

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

 

Table 11: Nonperforming Assets

 

   December 31, 
(dollars in thousands)  2016   2015   2014   2013   2012 
Nonaccrual loans*  $5,181   $6,175   $6,622   $11,018   $11,874 
Loans past due 90 days and accruing interest   1,341    1,117    53    -    - 
    Total nonperforming loans   6,522    7,292    6,675    11,018    11,874 
Other real estate owned   2,656    520    1,838    800    4,747 
    Total nonperforming assets  $9,178   $7,812   $8,513   $11,818   $16,621 
                          
Nonperforming assets to total loans and other real estate owned   0.89%   0.89%   1.04%   1.80%   2.41%
Allowance for loan losses to nonperforming loans   172.80%   155.34%   195.07%   134.03%   171.29%
Allowance for loan losses to nonaccrual loans   217.53%   183.43%   196.63%   134.03%   171.29%
Net charge-offs to average loans for the year   0.01%   0.20%   0.28%   1.11%   1.32%
Allowance for loan losses to year end loans   1.09%   1.29%   1.59%   2.25%   2.97%
Foregone interest income on nonaccrual loans  $383   $290   $124   $413   $335 

 

*Includes $2.2 million, $1.3 million, $3.4 million, $4.2 million and $5.1 million in nonaccrual TDRs at December 31, 2016, 2015, 2014, 2013 and 2012, respectively.

 

The following table presents the change in the OREO balance for 2016 and 2015:

 

Table 12: OREO Changes

 

(dollars in thousands)  2016   2015   Change $   Change % 
Balance at the beginning of year, gross  $522   $1,914   $(1,392)   -72.7%
Transfers from loans   3,969    1,966    2,003    101.9%
Capitalized costs   26    1    25    2500.0%
Sales proceeds   (1,824)   (3,255)   1,431    44.0%
Previously recognized impairment losses on disposition   -    (79)   79    100.0%
Loss on disposition   (1)   (25)   24    96.0%
Balance at the end of year, gross   2,692    522    2,170    415.7%
Less valuation allowance   (36)   (2)   (34)   -1700.0%
Balance at the end of year, net  $2,656   $520   $2,136    410.8%

 

The following table presents the change in the valuation allowance for OREO for 2016, 2015 and 2014:

 

Table 13: OREO Valuation Allowance Changes

 

(dollars in thousands)  2016   2015   2014 
Balance at the beginning of year  $2   $76   $254 
Valuation allowance   34    5    24 
Charge-offs   -    (79)   (202)
Balance at the end of year  $36   $2   $76 

 

 55 

 

 

Nonperforming assets were $9.2 million, or 0.89%, of total loans and OREO at December 31, 2016 compared to $7.8 million or 0.89% at December 31, 2015. The slow and measured economic recovery has prompted the Company to maintain the heightened level of the allowance for loan losses which was 217.53% of nonaccrual loans at December 31, 2016, compared to 183.43% at December 31, 2015. Nonperforming loans decreased $770 thousand, or 10.6%, during the year ended December 31, 2016 to $6.5 million, primarily due to a decrease in nonaccrual loans.

 

Nonaccrual loans were $5.2 million at December 31, 2016, a decrease of $994 thousand, or 16.1%, from $6.2 million at December 31, 2015. Of the current $5.2 million in nonaccrual loans, $4.4 million, or 84.5%, is secured by real estate in our market area. Of these real estate secured loans, $3.8 million are one to four family residential real estate, $578 thousand are commercial properties and $15 thousand are real estate construction. Loans past due 90 days and accruing interest were $1.3 million at December 31, 2016, an increase of $224 thousand, or 20.1%, from $1.1 million at December 31, 2015.

 

OREO, net of valuation allowance at December 31, 2016 was $2.7 million, an increase of approximately $2.1 million from December 31, 2015. The balance of OREO at December 31, 2016 was comprised of seventeen properties of which $1.4 million were one to four family residential properties, $52 thousand were real estate construction properties and $1.3 million were nonfarm, nonresidential properties. During the year ended December 31, 2016, new foreclosures consisted of thirty-three properties totaling $4.0 million transferred from loans, including a commercial property totaling $1.3 million that had previously secured a PCI loan. Sales of twenty-six OREO properties for the year ended December 31, 2016 resulted in a net loss of $1 thousand. Subsequent to December 31, 2016, three properties totaling $524 thousand were foreclosed on and transferred from loans. The remaining properties are being actively marketed and the Company does not anticipate any material losses associated with these properties. The Company recorded losses of $34 thousand in its consolidated statements of income for the year ended December 31, 2016, due to valuation adjustments on OREO properties as compared to $5 thousand for the same period of 2015. Asset quality continues to be a top priority for the Company. The Company continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets.

 

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

 

 56 

 

 

The following table presents loans individually evaluated for impairment, excluding PCI loans, by class of loans as of December 31, 2016:

 

Table 14: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $1,640   $1,640   $668   $972   $865   $1,094   $70 
Real estate - one to four family residential:                                   
    Closed end first and seconds   7,110    7,712    3,760    3,350    416    6,893    393 
  Home equity lines   225    225    175    50    50    453    2 
  Total real estate - one to four family                                   
  residential   7,335    7,937    3,935    3,400    466    7,346    395 
Real estate - construction:                                   
  One to four family residential   170    170    17    153    55    178    8 
  Other construction, land development and                                   
  other land   7,170    7,170    1,745    5,425    1,368    5,885    317 
  Total real estate - construction   7,340    7,340    1,762    5,578    1,423    6,063    325 
Real estate - farmland   515    517    261    254    40    525    34 
Real estate - non-farm, non-residential:                                   
   Owner occupied   7,645    7,647    6,195    1,450    321    6,176    407 
   Non-owner occupied   7,446    7,446    6,166    1,280    177    11,509    380 
   Total real estate - non-farm, non-                                   
   residential   15,091    15,093    12,361    2,730    498    17,685    787 
Consumer   309    322    3    306    63    323    17 
Total loans  $32,230   $32,849   $18,990   $13,240   $3,355   $33,036   $1,628 

 

 57 

 

 

The following table presents loans individually evaluated for impairment, excluding PCI loans, by class of loans as of December 31, 2015:

 

Table 14A: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $839   $839   $-   $839   $562   $753   $49 
Real estate - one to four family residential:                                   
  Closed end first and seconds   8,163    8,530    3,981    4,182    517    8,386    416 
  Home equity lines   625    625    175    450    265    521    16 
  Total real estate - one to four family                                   
  residential   8,788    9,155    4,156    4,632    782    8,907    432 
Real estate - construction:                                   
  One to four family residential   186    186    20    166    67    235    8 
  Other construction, land development and                                   
  other land   5,562    5,562    -    5,562    1,263    5,611    260 
  Total real estate - construction   5,748    5,748    20    5,728    1,330    5,846    268 
Real estate - farmland   539    541    -    539    210    167    36 
Real estate - non-farm, non-residential:                                   
  Owner occupied   6,336    6,336    3,506    2,830    824    8,995    292 
  Non-owner occupied   12,792    12,792    7,686    5,106    810    11,312    595 
  Total real estate - non-farm, non-                                   
  residential   19,128    19,128    11,192    7,936    1,634    20,307    887 
Consumer   338    350    12    326    88    352    19 
Other   2    2    2    -    -    4    - 
Total loans  $35,382   $35,763   $15,382   $20,000   $4,606   $36,336   $1,691 

 

The Company’s balance of impaired loans remains elevated over historical levels primarily due to performing TDRs, against which there are no required valuation allowances.

 

The following table presents the balances of TDRs at December 31, 2016, 2015, 2014, 2013 and 2012:

 

Table 15: Troubled Debt Restructurings (TDRs)

 

   December 31, 
(dollars in thousands)  2016   2015   2014   2013   2012 
Performing TDRs  $10,441   $15,535   $15,223   $16,026   $4,433 
Nonperforming TDRs*   2,209    1,300    3,438    4,188    5,089 
Total TDRs  $12,650   $16,835   $18,661   $20,214   $9,522 

 

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

 

At the time of a TDR, the loan is placed on nonaccrual status. A loan (including a TDR) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. Performing TDRs decreased by $5.1 million from December 31, 2015 primarily due to collection of principal on two previously restructured loans. Nonperforming TDRs increased by $909 thousand from December 31, 2015 primarily due to the execution of two new loan restructuring agreements. These two loans are classified as nonperforming due to their recent restructurings. However, they may be returned to accrual status after a sustained period of repayment performance (typically six months).

 

 58 

 

 

Financial Condition

 

Summary

 

At December 31, 2016, the Company had total assets of $1.40 billion, an increase of approximately $128.2 million or 10.1% from $1.27 billion at December 31, 2015. The increase in total assets was principally the result of increases in loans, primarily funded by cash and due from banks, interest bearing deposits with banks, short term borrowings and continued deposit growth. Major categories and changes in our balance sheet are as detailed in the following schedule:

 

Table 16: Balance Sheet Changes

 

   December 31,   December 31,         
(dollars in thousands)  2016   2015   Change $   Change % 
Total assets  $1,398,593   $1,270,384   $128,209    10.1%
Cash and due from banks   4,997    13,451    (8,454)   -62.9%
Interest bearing deposits with banks   11,919    18,304    (6,385)   -34.9%
Securities available for sale, at fair value   219,632    230,943    (11,311)   -4.9%
Securities held to maturity, at carrying value   27,956    29,698    (1,742)   -5.9%
Total loans   1,033,231    880,778    152,453    17.3%
Total deposits   1,051,361    988,719    62,642    6.3%
Total borrowings   208,225    148,760    59,465    40.0%
Total shareholders' equity   131,200    126,275    4,925    3.9%

 

Loan Portfolio

 

The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. A substantial portion of the loan portfolio is comprised of commercial and residential mortgage loans in our market area. The ability of our debtors to honor their contracts is dependent upon the real estate and general economic conditions in our market area. The loan portfolio is the largest component of earning assets and accounts for the greatest portion of total interest and dividend income. Total loans were $1.03 billion at December 31, 2016, an increase of $152.5 million, or 17.3%, from $880.8 million at December 31, 2015. As discussed previously, loans increased in 2016 primarily due to organic loan growth and the purchase of $30.8 million in performing commercial and consumer loans. Commercial, industrial and agricultural loans increased primarily as a result of the continued efforts of our loan production office in Chesterfield, Virginia. Closed end first and second loans decreased primarily due to weak demand in our rural markets and refinancing activity in a competitive mortgage lending market driven by the low interest rate environment. Other construction, land development and other land loans increased as the Company has renewed its focus and efforts on this loan segment. Non-farm, non-residential real estate loans increased due to the addition of a new commercial loan officer, as well as focused efforts of our commercial lending team in our Richmond and Tidewater markets. Consumer loans increased primarily due to the purchase of $19.7 million in performing student and recreational vehicle loans. Loan growth in the Company’s rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and is expected to continue to be intense given the historically low rate environment and increased competition among banks and other financial institutions.

 

 59 

 

 

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

 

Table 17: Summary of Loans

 

   December 31, 
   2016   2015   2014   2013   2012 
(dollars in thousands)  Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
Commercial, industrial and                                                  
agricultural  $148,963    14.42%  $98,828    11.22%  $85,119    10.37%  $53,673    8.17%  $51,881    7.58%
Real estate - one to four family                                                  
residential:                                                  
Closed end first and seconds   215,462    20.85%   232,826    26.43%   236,761    28.86%   218,472    33.25%   239,002    34.91%
Home equity lines   122,506    11.85%   116,309    13.20%   110,100    13.42%   99,839    15.19%   99,698    14.56%
Total real estate - one to                                                  
four family residential   337,968    32.70%   349,135    39.63%   346,861    42.28%   318,311    48.44%   338,700    49.47%
Real estate - multifamily                                                  
residential   32,400    3.14%   29,672    3.37%   25,157    3.07%   18,077    2.75%   15,801    2.31%
Real estate - construction:                                                  
One to four family residential   16,204    1.57%   19,495    2.21%   19,698    2.40%   16,169    2.46%   20,232    2.96%
Other construction, land                                                  
development and other land   92,466    8.95%   46,877    5.32%   35,591    4.34%   21,690    3.30%   34,555    5.04%
Total real                                                  
estate - construction   108,670    10.52%   66,372    7.53%   55,289    6.74%   37,859    5.76%   54,787    8.00%
Real estate - farmland   11,289    1.09%   11,418    1.30%   9,471    1.15%   8,172    1.24%   8,558    1.25%
Real estate - non-farm,                                                  
non-residential:                                                  
Owner occupied   201,284    19.48%   187,224    21.27%   157,745    19.22%   126,569    19.26%   119,824    17.50%
Non-owner occupied   139,649    13.52%   104,456    11.86%   104,827    12.77%   74,831    11.39%   71,741    10.48%
Total real estate -                                                  
non-farm, non-residential   340,933    33.00%   291,680    33.13%   262,572    31.99%   201,400    30.65%   191,565    27.98%
Consumer   42,403    4.10%   19,993    2.27%   15,919    1.94%   16,782    2.55%   20,173    2.94%
Other   10,605    1.03%   13,680    1.55%   20,181    2.46%   2,923    0.44%   3,203    0.47%
Total loans   1,033,231    100.00%   880,778    100.00%   820,569    100.00%   657,197    100.00%   684,668    100.00%
Less allowance for loan losses   (11,270)        (11,327)        (13,021)        (14,767)        (20,338)     
Loans, net  $1,021,961        $869,451        $807,548        $642,430        $664,330      

 

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The following table presents the changes in the loans held in the portfolio from December 31, 2015 to December 31, 2016, and from December 31, 2014 to December 31, 2015:

 

Table 17A: Changes in Loans Held

 

   2016 vs. 2015   2015 vs. 2014 
(dollars in thousands)  $ Change   % Change   $ Change   % Change 
Commercial, industrial and agricultural  $50,135    50.7%  $13,709    16.1%
Real estate - one to four family residential:                    
Closed end first and seconds   (17,364)   -7.5%   (3,935)   -1.7%
Home equity lines   6,197    5.3%   6,209    5.6%
Total real estate - one to four family residential   (11,167)   -3.2%   2,274    0.7%
Real estate - multifamily residential   2,728    9.2%   4,515    17.9%
Real estate - construction:                    
One to four family residential   (3,291)   -16.9%   (203)   -1.0%
Other construction, land development and other land   45,589    97.3%   11,286    31.7%
Total real estate - construction   42,298    63.7%   11,083    20.0%
Real estate - farmland   (129)   -1.1%   1,947    20.6%
Real estate - non-farm, non-residential:                    
Owner occupied   14,060    7.5%   29,479    18.7%
Non-owner occupied   35,193    33.7%   (371)   -0.4%
Total real estate - non-farm, non-residential   49,253    16.9%   29,108    11.1%
Consumer   22,410    112.1%   4,074    25.6%
Other   (3,075)   -22.5%   (6,501)   -32.2%
 Total loans  $152,453    17.3%  $60,209    7.3%

 

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The following table presents the estimated remaining maturities of loans held in the portfolio at December 31, 2016:

 

Table 18: Remaining Maturities of Loans

 

   December 31, 2016 
   Variable Rate   Fixed Rate     
(dollars in thousands)  Within 1 year   1 to 5 years   After 5 years   Total   Within 1 year   1 to 5 years   After 5 years   Total   Total Maturities 
Commercial, industrial and agricultural  $56,722   $2,801   $8,510   $68,033   $2,942   $56,129   $21,859   $80,930   $148,963 
Real estate - one to four family residential:                                             
Closed end first and seconds   46,229    100,831    8,224    155,284    2,772    23,767    33,639    60,178    215,462 
Home equity lines   104,614    406    17,319    122,339    -    145    22    167    122,506 
Real estate - multifamily residential   2,118    12,233    -    14,351    242    9,140    8,667    18,049    32,400 
Real estate - construction:                                             
One to four family residential   6,758    5,611    851    13,220    1,240    1,538    206    2,984    16,204 
Other construction, land development and other                                             
land   41,275    2,798    -    44,073    37,882    10,426    85    48,393    92,466 
Real estate - farmland   2,683    3,364    820    6,867    10    3,507    905    4,422    11,289 
Real estate - non-farm, non-residential:                                             
Owner occupied   16,142    61,828    16,291    94,261    15,261    47,603    44,159    107,023    201,284 
Non-owner occupied   9,452    24,624    13,576    47,652    9,453    39,313    43,231    91,997    139,649 
Consumer   3,641    14    -    3,655    971    6,304    31,473    38,748    42,403 
Other   1,318    98    -    1,416    9,063    126    -    9,189    10,605 
Total loans  $290,952   $214,608   $65,591   $571,151   $79,836   $197,998   $184,246   $462,080   $1,033,231 

 

The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of our borrowers. Within each category, such risk may increase or decrease depending on various factors. The risks associated with real estate mortgage loans, commercial loans and consumer loans vary based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies based on the supply and demand for the type of real estate under construction. In an effort to manage these risks, we have loan approval limits for individual loan officers based on their position and level of experience.

 

We have written policies and procedures to help manage credit risk. We use a loan review process that includes a portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular independent third party portfolio reviews to establish loss exposure and to monitor compliance with policies. Third party reviews are done on an annual basis by a consulting firm that is comprised of experienced commercial lenders who understand the laws, regulations and critical areas of portfolio management. They provide management with an unbiased opinion of our credits and actions needed to strengthen them or protect the Company.

 

Our loan approval process includes our Management Loan Committee, Directors Loan Committee and, for larger loans, the Board of Directors. Our Chief Credit Officer is responsible for reporting to the Directors Loan Committee monthly on the activities of the Management Loan Committee and on the status of various delinquent and nonperforming loans. The Directors Loan Committee also reviews lending policies proposed by management. Our Board of Directors establishes our total lending limit policy which is less than the legal lending limit.

 

At December 31, 2016, loans secured by real estate were $831.3 million, or 80.5%, of the portfolio, compared to $748.3 million, or 85.0%, of the portfolio at December 31, 2015.

 

Consistent with our focus on providing community-based financial services, we generally do not make loans outside of our principal market region. We may, from time to time, invest in high quality loans that were originated by banks outside our core geographic markets, including by purchasing pools of performing loans. We do not engage in foreign lending activities and consequently the loan portfolio is not exposed to the sometimes volatile risk from foreign credits. We further maintain a policy not to originate or purchase loans classified by regulators as highly leveraged transactions or loans to foreign entities or individuals. Historically, our loan collateral has been primarily real estate because of the nature of our market region; however, in our newer markets, we are encountering other collateral options in lieu of real estate, which are booked based on strong credit guidelines and controls to monitor the status and value of the collateral.

 

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Investment Securities

 

The investment securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity. In addition, the investment securities portfolio serves as a source of liquidity and is used as needed to meet collateral requirements, such as those related to secure public deposits, balances with the Reserve Bank and repurchase agreements. The investment securities portfolio consists of held to maturity and available for sale investment securities. We classify investment securities as available for sale or held to maturity based on our investment strategy and management’s assessment of our intent and ability to hold the investment securities until maturity. Management determines the appropriate classification of investment securities at the time of purchase, subject to any subsequent change in our intent and ability to hold the investment securities until maturity. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Investment securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at fair value. Total investment securities were $247.6 million at December 31, 2016, reflecting a decrease of approximately $13.1 million, or 5.0%, from $260.6 million at December 31, 2015. The valuation allowance for the available for sale investment securities portfolio had an unrealized (loss), net of tax benefit, of ($3.4) million at December 31, 2016 compared with an unrealized (loss), net of tax benefit, of ($1.7) million at December 31, 2015. These unrealized (losses) as of December 31, 2016 are principally due to financial market conditions for these types of investments, particularly related to changes in interest rates, which rose during late 2016 causing bond prices to decline, and are not attributable to credit deterioration.

 

During 2016, the Company either sold or had called its remaining investments in obligations of U.S. Government agencies and decreased its investments in state and political subdivisions (primarily tax exempt) while increasing its investments in Agency residential and commercial mortgage-backed securities in an effort to enhance the portfolio’s overall structure and provide more consistent cash flows and reinvestment opportunities. As part of our overall asset/liability management strategy, we are targeting our investment securities portfolio to be approximately 20% of our total assets. As of December 31, 2016 and 2015, our investment securities portfolio was 17.7% and 20.5%, respectively, of total assets.

 

There are no investment securities classified as “Trading” at December 31, 2016 or 2015. During the fourth quarter of 2013, the Company transferred investment securities with an amortized cost of $35.5 million, previously designated as “Available for Sale,” to “Held to Maturity” classification. The fair value of those investment securities as of the date of the transfer was $34.5 million, reflecting a gross unrealized loss of $994 thousand. The gross unrealized loss net of tax at the time of transfer remained in Accumulated Other Comprehensive (Loss) and is being amortized over the remaining life of the investment securities as an adjustment to interest income. During the third quarter of 2015, the Company sold a State and political subdivisions security that was classified as “Held to Maturity” due to the significant deterioration in the issuer’s financial condition. The carrying value of this investment security was $521 thousand and a gain of $10 thousand was recognized as a result of the sale.

 

The Company’s mortgage-backed securities consist of commercial and residential mortgage-backed securities. The Company’s mortgage-backed securities are all guaranteed by an agency (including a government-sponsored entity) of the U.S. Government and rated Aaa and AA+ by Moody and S&P, respectively, with no subprime issues. The Company follows a policy of not investing in instruments considered to be derivative in nature such as options, futures, swaps or forward commitments.

 

The Company’s pooled trust preferred securities previously included one senior issue of Preferred Term Securities XXVII which remained current on all payments and on which the Company took an impairment charge in the third quarter of 2009 to reduce the Company’s book value to the market value at September 30, 2009. On December 9, 2014 the Company sold this security resulting in a gain on sale of $82 thousand, and the Company reversed the related impairment reserve. During the second quarter of 2010, the Company recognized an impairment charge in the amount of $77 thousand on the Company’s investment in Preferred Term Securities XXIII mezzanine tranche, thus reducing the book value of this investment to $0. On September 22, 2014 the Company sold this security resulting in a gain on sale of $2 thousand and the Company subsequently reversed the related impairment reserve.

 

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The following tables present the amortized cost or carrying value and estimated fair value of investment securities at the dates indicated:

 

Table 19: Investment Securities Available for Sale

 

(dollars in thousands)  December 31, 2016 &nb