10-K 1 d311317d10k.htm 10-K 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

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

for the fiscal year ended: December 31, 2011

Commission File Number: 000-32561

 

 

Middlefield Banc Corp.

(Exact name of registrant as specified in its charter)

 

Ohio   34-1585111

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

 

LOGO

15985 East High Street, Middlefield, Ohio 44062-0035

(440) 632-1666

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

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

none

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

common stock, without par value

 

 

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

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

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).     Yes   ¨     No   ¨

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

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 definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨      Smaller reporting company   x

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

The aggregate market value on June 30, 2011 of common stock held by non-affiliates of the registrant was approximately $28.9 million. As of March 20, 2012, there were 1,771,687 shares of common stock issued and outstanding.

 

 

Documents Incorporated by Reference

Portions of the registrant’s definitive proxy statements for the 2012 Annual Meeting of Shareholders are incorporated by reference in Part III of this report. Portions of the Annual Report to Shareholders for the year ended December 31, 2011 are incorporated by reference into Part I and Part II of this report.


Item 1 — Business

Middlefield Banc Corp. Incorporated in 1988 under the Ohio General Corporation Law, Middlefield Banc Corp. (“Company”) is a two-bank and a one non-bank holding company registered under the Bank Holding Company Act of 1956. The Company’s three subsidiaries are:

 

  1. The Middlefield Banking Company (“MBC”), an Ohio-chartered commercial bank that began operations in 1901. MBC engages in a general commercial banking business in northeastern Ohio. The principal executive office is located at 15985 East High Street, Middlefield, Ohio 44062-0035, and its telephone number is (440) 632-1666.

 

  2. Emerald Bank (“EB”), an Ohio-chartered commercial bank headquartered in Dublin, Ohio. EB engages in a general commercial banking business in central Ohio. The principal executive office is located at 6215 Perimeter Drive, Dublin Ohio 43017, and its telephone number is (614) 793-4631.

 

  3. EMORECO Inc., an Ohio asset resolution corporation headquartered in Middlefield, Ohio. EMORECO engages in the resolution and disposition of troubled assets in central Ohio. The principal executive office is located at 15985 East High Street, Middlefield, Ohio 44062-0035, and its telephone number is (440) 632-1666.

The Middlefield Banking Company. MBC was chartered under Ohio law in 1901. The Company became the holding company for MBC in 1988. MBC offers its customers a broad range of banking services, including checking, savings, and negotiable order of withdrawal (NOW) accounts; money market accounts; time certificates of deposit, commercial loans, real estate loans, and various types of consumer loans; safe deposit facilities, and travelers’ checks. MBC offers online banking and bill payment services to individuals and online cash management services to business customers through its website at www.middlefieldbank.com.

Engaged in a general commercial banking business in northeastern Ohio, MBC offers commercial banking services principally to small and medium-sized businesses, professionals and small business owners, and retail customers. MBC has developed and continues to monitor and update a marketing program to attract and retain consumer accounts, and to offer banking services and facilities compatible with the needs of its customers.

MBC’s loan products include operational and working capital loans; loans to finance capital purchases; term business loans; residential construction loans; selected guaranteed or subsidized loan programs for small businesses; professional loans; residential mortgage and commercial mortgage loans, and consumer installment loans to purchase automobiles, boats, and for home improvement and other personal expenditures. Although the bank makes agricultural loans, it currently has no significant agricultural loans.

Emerald Bank. The Company acquired EB on April 19, 2007 for a combination of cash and stock. EB operates as a separate commercial bank subsidiary of the Company, offering essentially the same range of products and services in central Ohio as MBC does in northeastern Ohio.

EMORECO. EMORECO was incorporated in Ohio as a de novo asset resolution company on November 2, 2009. The Company is the sole stockholder. On October 23, 2009 the Company received from the Federal Reserve Bank of Cleveland approval to establish an asset resolution subsidiary. Organized as an Ohio corporation under the name EMORECO, Inc. and wholly owned by the Company, the purpose of the asset resolution subsidiary is to maintain, manage, and ultimately dispose of nonperforming loans and real estate acquired by subsidiary banks as the result of borrower default on real-estate-secured loans. At December 31, 2011, EMORECO’s assets consist of 17 nonperforming loans and six OREO properties. EMORECO has paid approximately $5.6 million to Emerald Bank for the nonperforming loans and other real estate, using funds contributed by the Company, which were borrowed under lines of credit of the Company. According to Federal law governing bank holding companies the real estate must be disposed of within two years after the properties were originally acquired by EB, which occurred in May and June of 2008, although limited extensions may be granted by the Federal Reserve Bank. Federal law governing bank holding companies also provides that a holding company subsidiary has limited real estate investment powers. EMORECO may only manage and maintain property and may not improve or develop property without advance approval of the Federal Reserve Bank.

Market Area. MBC’s market area consists principally of Geauga, Portage, Trumbull, and Ashtabula Counties. Benefiting from the area’s proximity both to Cleveland and Warren, population and income levels have maintained steady growth over the years. EB’s two offices are located in Franklin County, serving the central Ohio market. EMORECO’s market area is the same as the Banks.

Competition. The banking industry has been changing for many reasons, including continued consolidation within the banking industry, legislative and regulatory changes, and advances in technology. To deliver banking products and services more effectively and efficiently, banking institutions are opening in-store branches, installing more automated teller machines (ATMs) and investing in technology to permit telephone, personal computer, and internet banking. While all banks are experiencing the effects of the changing competitive and technological environment, the manner in which banks choose to compete is increasing the gap between large national and super-regional banks, on one hand, and community banks on the other. Large institutions are committed to becoming national or regional “brand names,” providing a broad selection of products at low cost and with advanced technology, while community banks provide most of the same products but with a commitment to personal service and with local ties to the customers and communities they serve. The Company seeks to take competitive advantage of its local orientation and community banking profile. It competes for loans principally through responsiveness to customers and its ability to communicate effectively with them and understand and address their needs. The Company competes for deposits principally by offering customers personal attention, a


variety of banking services, attractive rates, and strategically located banking facilities. The Company seeks to provide high quality banking service to professionals and small and mid-sized businesses, as well as individuals, emphasizing quick and flexible responses to customer demands.

Forward-looking Statements. This document contains forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) about The Company and subsidiaries. Information incorporated in this document by reference, future filings by the Company on Form 10-Q and Form 8-K, and future oral and written statements by the Company and its management may also contain forward-looking statements. Forward-looking statements include statements about anticipated operating and financial performance, such as loan originations, operating efficiencies, loan sales, charge-offs and loan loss provisions, growth opportunities, interest rates, and deposit growth. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “project,” “plan,” and similar expressions are intended to identify these forward-looking statements.

Forward-looking statements are necessarily subject to many risks and uncertainties. A number of things could cause actual results to differ materially from those indicated by the forward-looking statements. These include the factors we discuss immediately below, those addressed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” other factors discussed elsewhere in this document or identified in our filings with the Securities and Exchange Commission, and those presented elsewhere by our management from time to time. Many of the risks and uncertainties are beyond our control. The following factors could cause our operating and financial performance to differ materially from the plans, objectives, assumptions, expectations, estimates, and intentions expressed in forward-looking statements:

 

 

the strength of the United States economy in general and the strength of the local economies in which we conduct our operations; general economic conditions, either nationally or regionally, may be less favorable than we expect, resulting in a deterioration in the credit quality of our loan assets, among other things

 

 

the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest-rate policies of the Federal Reserve Board

 

 

inflation, interest rate, market, and monetary fluctuations

 

 

the development and acceptance of new products and services of the Company and subsidiaries and the perceived overall value of these products and services by users, including the features, pricing, and quality compared to competitors’ products and services

 

 

the willingness of users to substitute our products and services for those of competitors

 

 

the impact of changes in financial services laws and regulations (including laws concerning taxes, banking, securities, and insurance)

 

 

changes in consumer spending and saving habits

Forward-looking statements are based on our beliefs, plans, objectives, goals, assumptions, expectations, estimates, and intentions as of the date the statements are made. Investors should exercise caution because the Company cannot give any assurance that its beliefs, plans, objectives, goals, assumptions, expectations, estimates, and intentions will be realized. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise.

LendingLoan Portfolio Composition and Activity. The Company makes residential mortgage and commercial mortgage loans, home equity loans, secured and unsecured consumer installment loans, commercial and industrial loans, and real estate construction loans for owner-occupied and rental properties. The Company’s loan policy aspires to a loan composition mix consisting of approximately 50% to 60% residential real estate loans, 35% to 40% commercial loans, consumer loans of 5% to 15%, and credit card accounts of up to 5%. The lending policies of MBC and EB are essentially identical.

Although Ohio Bank law imposes no material restrictions on the kinds of loans the Company may make, real estate-based lending has historically been the Banks’ primary focus. For prudential reasons, the Banks avoid lending on the security of real estate located in regions in which the Bank is not familiar, and as a consequence almost all of the MBC’s real-estate secured loans are secured by real property in northeastern Ohio. EB’s lending is also predominantly real-estate secured lending. EB’s lending currently is concentrated in its Central Ohio market area, although previously EB had extended a number of real-estate secured loans in the southwestern Ohio market. Ohio Bank law does restrict the amount of loans an Ohio-chartered bank such as the Banks may make, however, providing generally that loans and extensions of credit to any one borrower may not exceed 15% of capital. An additional margin of 10% of capital is allowed for loans fully secured by readily marketable collateral. This 15% legal lending limit has not been a material restriction on the Banks’ lending. The Banks can accommodate loan volumes exceeding the legal lending limit by selling loan participations to other banks. MBC’s and EB’s internal policy is to maintain its credit exposure to any one borrower at less than $3.0 million and $1.2 million respectively, which is comfortably within the range of the Banks’ legal lending limit. As of December 31, 2011, MBC’s 15%-of-capital limit on loans to a single borrower was approximately $7.3 million and EB’s 15%-of-capital limit on loans to a single borrower was approximately $2.0 million.

The Company offers specialized loans for business and commercial customers, including equipment and inventory financing, real estate construction loans and Small Business Administration loans for qualified businesses. A substantial portion of the Banks’ commercial loans are designated as real estate loans for regulatory reporting purposes because they are secured by mortgages on real


property. Loans of that type may be made for purpose of financing commercial activities, such as accounts receivable, equipment purchases and leasing, but they are secured by real estate to provide the Bank with an extra measure of security. Although these loans might be secured in whole or in part by real estate, they are treated in the discussions to follow as commercial and industrial loans. The Company’s consumer installment loans include secured and unsecured loans to individual borrowers for a variety of purposes, including personal, home improvements, revolving credit lines, autos, boats, and recreational vehicles.

The following table shows on a consolidated basis the composition of the loan portfolio in dollar amounts and in percentages at December 31, 2011, 2010, 2009, 2008 and 2007, along with a reconciliation to loans receivable, net.

 

     2011     2010     2009     2008     2007  
(Dollars in thousands)    Amount      Percent     Amount      Percent     Amount      Percent     Amount      Percent     Amount      Percent  

Type of loan:

                         

Commercial and industrial

   $ 59,185         14.73      $ 57,501         15.44      $ 56,969         16.11      $ 66,524         20.69      $ 67,010         21.65   

Real estate construction

     21,545         5.36        15,845         4.25        7,837         2.22        7,965         2.48        6,704         2.17   

Mortgage:

                         

Residential

     208,139         51.79        209,863         56.34        205,074         58.00        199,354         61.99        193,514         62.53   

Commercial

     108,502         27.00        84,304         22.63        78,763         22.27        42,789         13.31        36,818         11.90   

Consumer installment

     4,509         1.12        4,985         1.34        4,954         1.40        4,943         1.53        5,400         1.75   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total loans

     401,880         100.00     372,498         100.00     353,597         100.00     321,575         100.00     309,446         100.00
     

 

 

      

 

 

      

 

 

      

 

 

      

 

 

 

Less:

                         

Allowance for loan losses

     6,819           6,221           4,937           3,557           3,299      
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

Net loans

   $ 395,061         $ 366,277         $ 348,660         $ 318,018         $ 306,147      
  

 

 

      

 

 

      

 

 

      

 

 

      

 

 

    

The following table presents on an consolidated basis maturity information for the loan portfolio at December 31, 2011. The table does not include prepayments or scheduled principal repayments. All loans are shown as maturing based on contractual maturities.

 

     Loan Portfolio Maturity at December 31, 2011  
     Commercial                                     
     and      Real Estate      Mortgage      Consumer         
(Dollars in thousands)    Industrial      Construction      Residential      Commercial      Installment      Total  

Amount due:

                 

In one year or less

   $ 12,571       $ 5,796       $ 1,933       $ 3,556       $ 1,252       $ 25,108   

After one year through five years

     17,272         1,809         16,524         6,395         2,755         44,755   

After five years

     29,342         13,940         189,682         98,551         502         332,017   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total amount due

   $ 59,185       $ 21,545       $ 208,139       $ 108,502       $ 4,509       $ 401,880   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Loans due on demand and overdrafts are included in the amount due in one year or less. The Company has no loans without a stated schedule of repayment or a stated maturity.


The following table shows on a consolidated basis the dollar amount of all loans due after December 31, 2011 that has pre-determined interest rates and the dollar amount of all loans due after December 31, 2011 that has floating or adjustable rates.

 

(Dollars in thousands)    Fixed
Rate
     Adjustable
Rate
     Total  

Commercial and industrial

   $ 26,135       $ 33,050       $ 59,185   

Real estate construction

     3,540         18,005         21,545   

Mortgage:

        

Residential

     21,794         186,345         208,139   

Commercial

     9,198         99,304         108,502   

Consumer installment

     4,387         122         4,509   
  

 

 

    

 

 

    

 

 

 
   $ 65,054       $ 336,826       $ 401,880   
  

 

 

    

 

 

    

 

 

 

Residential Mortgage Loans. A significant portion of the Company’s lending consists of origination of conventional loans secured by 1-4 family real estate located in Franklin, Geauga, Portage, Trumbull, and Ashtabula Counties. Residential mortgage loans approximated $208.1 million or 51.8% of the Company’s total loan portfolio at December 31, 2011.

The Company makes loans of up to 80% of the value of the real estate and improvements securing a loan (the “loan-to-value” or “LTV” ratio) on 1-4 family real estate. The Company generally does not lend in excess of 80% of the appraised value or sales price (whichever is less) of the property unless additional collateral is obtained, thereby lowering the total LTV. The Company offers residential real estate loans with terms of up to 30 years.

Before 1996, nearly all residential mortgage loans originated by MBC were written on a balloon-note basis. During 1996, the Company began to originate fixed-rate mortgage loans for maturities up to 20 years. In late 1998, MBC began originating adjustable-rate mortgage loans and de-emphasized balloon-note mortgages. Approximately 89.5% of the portfolio of conventional mortgage loans secured by 1-4 family real estate at December 31, 2011 was adjustable rate. The Company’s mortgage loans are ordinarily retained in the loan portfolio. The Company’s residential mortgage loans have not been originated with loan documentation that would permit their sale to Fannie Mae and Freddie Mac.

The Company’s home equity loan policy generally allows for a loan of up to 85% of a property’s appraised value, less the principal balance of the outstanding first mortgage loan. The Company’s home equity loans generally have terms of 10 years.

At December 31, 2011, residential mortgage loans of approximately $10.9 million were over 90 days delinquent or non-accruing on that date, representing 5.2% of the residential mortgage loan portfolio.

Commercial and Industrial Loans and Commercial Real Estate Loans. The Company’s commercial loan services include —

 

   accounts receivable, inventory       short-term notes
   and working capital loans       selected guaranteed or subsidized loan programs
   renewable operating lines of credit       for small businesses
   loans to finance capital equipment       loans to professionals
   term business loans       commercial real estate loans

Commercial real estate loans include commercial properties occupied by the proprietor of the business conducted on the premises, and income-producing or farm properties. Although the Company makes agricultural loans, it currently does not have a significant amount of agricultural loans. The primary risk of commercial real estate loans is loss of income of the owner or occupier of the property and the inability of the market to sustain rent levels. Although commercial and commercial real estate loans generally bear somewhat more risk than single-family residential mortgage loans, commercial and commercial real estate loans tend to be higher yielding, tend to have shorter terms and commonly provide for interest-rate adjustments as prevailing rates change. Accordingly, commercial and commercial real estate loans enhance a lender’s interest rate risk management and, in management’s opinion, promote more rapid asset and income growth than a loan portfolio comprised strictly of residential real estate mortgage loans.

Although a risk of nonpayment exists for all loans, certain specific types of risks are associated with various kinds of loans. One of the primary risks associated with commercial loans is the possibility that the commercial borrower will not generate income sufficient to repay the loan. The Company’s loan policy provides that commercial loan applications must be supported by documentation indicating that there will be cash flow sufficient for the borrower to service the proposed loan. Financial statements or tax returns for at least three years must be submitted, and annual reviews are undertaken for loans of $150,000 or more. The fair market value of collateral for collateralized commercial loans must exceed the Company’s loan exposure. For this purpose fair market value is determined by independent appraisal or by the loan officer’s estimate employing guidelines established by the loan policy. Term loans not secured by real estate generally have terms of five years or less, unless guaranteed by the U.S. Small Business Administration or other governmental agency, and terms loans secured by collateral having a useful life exceeding five years may have longer terms. The Company’s loan policy allows for terms of up to 15 years for loans secured by commercial real estate, and one year for business lines of credit. The maximum loan-to-value ratio for commercial real estate loans is 75% of the appraised value or cost, whichever is less.


Real estate is commonly a material component of collateral for the Company’s loans, including commercial loans. Although the expected source of repayment of these loans is generally the operations of the borrower’s business or personal income, real estate collateral provides an additional measure of security. Risks associated with loans secured by real estate include fluctuating land values, changing local economic conditions, changes in tax policies, and a concentration of loans within a limited geographic area.

At December 31, 2011, commercial and commercial real estate loans totaled $167.7 million, or 41.7% of the Company’s total loan portfolio. At December 31, 2011, commercial and commercial real estate loans of approximately $5.5 million were over 90 days delinquent or non-accruing on that date, and represented 3.4% of the commercial and commercial real estate loan portfolios.

Real Estate Construction. The Company originates several different types of loans that it categorizes as construction loans, including —

 

   

residential construction loans to borrowers who will occupy the premises upon completion of construction,

 

   

residential construction loans to builders,

 

   

commercial construction loans, and

 

   

real estate acquisition and development loans.

Because of the complex nature of construction lending, these loans are generally recognized as having a higher degree of risk than other forms of real estate lending. The Company’s fixed-rate and adjustable-rate construction loans do not provide for the same interest rate terms on the construction loan and on the permanent mortgage loan that follows completion of the construction phase of the loan. It is the norm for the Company to make residential construction loans without an existing written commitment for permanent financing. The Company’s loan policy provides that the Company may make construction loans with terms of up to one year, with a maximum loan-to-value ratio for residential construction of 80%.

At December 31, 2011, real estate construction loans totaled $21.6 million, or 5.4% of the Company’s total loan portfolio. Real estate construction loans of approximately $663,000 were over 90 days delinquent or non-accruing on that date, representing 3.2% of the real estate construction loan portfolio.

Consumer Installment Loan. The Company’s consumer installment loans include secured and unsecured loans to individual borrowers for a variety of purposes, including personal, home improvement, revolving credit lines, autos, boats, and recreational vehicles. The Company does not currently do any indirect lending. Unsecured consumer loans carry significantly higher interest rates than secured loans. The Company maintains a higher loan loss allowance for consumer loans, while maintaining strict credit guidelines when considering consumer loan applications.

According to the Company’s loan policy, consumer loans secured by collateral other than real estate generally may have terms of up to five years, and unsecured consumer loans may have terms up to two and one-half years. Real estate security generally is required for consumer loans having terms exceeding five years.

At December 31, 2011, the Company had approximately $4.5 million in its consumer installment loan portfolio, representing 1.1% of total loans. At December 31, 2011, no consumer installment loans were over 90 days delinquent or non-accruing.

Loan Solicitation and Processing. Loan originations are developed from a number of sources, including continuing business with depositors, other borrowers and real estate builders, solicitations by Company personnel and walk-in customers.

When a loan request is made, the Company reviews the application, credit bureau reports, property appraisals or evaluations, financial information, verifications of income, and other documentation concerning the creditworthiness of the borrower, as applicable to each loan type. The Company’s underwriting guidelines are set by senior management and approved by the Board of Directors. The loan policy specifies each individual officer’s loan approval authority. Loans exceeding an individual officer’s approval authority are submitted to a committee consisting of loan officers, which has authority to approve loans up to $500,000. The full Board of Directors acts as a loan committee for loans exceeding that amount.

Income from Lending Activities. The Company earns interest and fee income from its lending activities. Net of origination costs, loan origination fees are amortized over the life of a loan. The Company also receives loan fees related to existing loans, including late charges. Income from loan origination and commitment fees and discounts varies with the volume and type of loans and commitments made and with competitive and economic conditions. Note 1 to the Consolidated Financial Statements included herein contains a discussion of the manner in which loan fees and income are recognized for financial reporting purposes.

Nonperforming Loans. Late charges on residential mortgages and consumer loans are assessed if a payment is not received by the due date plus a grace period. When an advanced stage of delinquency appears on a single-family loan and if repayment cannot be expected within a reasonable time or a repayment agreement is not entered into, a required notice of foreclosure or repossession proceedings may be prepared by the Company’s attorney and delivered to the borrower so that foreclosure proceedings may be initiated promptly, if necessary. The Company also collects late charges on commercial loans.


When the Company acquires real estate through foreclosure, voluntary deed, or similar means, it is classified as other real estate owned until it is sold. When property is acquired in this manner, it is recorded at the lower of cost (the unpaid principal balance at the date of acquisition) or fair value. Any subsequent write-down is charged to expense. All costs incurred from the date of acquisition to maintain the property are expensed. “Other real estate owned” is appraised during the foreclosure process, before acquisition. Losses are recognized for the amount by which the book value of the related mortgage loan exceeds the estimated net realizable value of the property.

The Company undertakes regular review of the loan portfolio to assess its risks, particularly the risks associated with the commercial loan portfolio. This includes annual review of every commercial loan representing credit exposure of $150,000 or more. An independent firm performs semi-annual loan reviews for the Company.

Classified Assets. FDIC regulations governing classification of assets require nonmember commercial banks — including the Company — to classify their own assets and to establish appropriate general and specific allowances for losses, subject to FDIC review. The regulations are designed to encourage management to evaluate assets on a case-by-case basis, discouraging automatic classifications. Under this classification system, problem assets of insured institutions are classified as “substandard,” “doubtful,” or “loss.” An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as “doubtful” have all the weaknesses inherent in those classified substandard, with the added characteristic that the weaknesses make collection of principal in full — on the basis of currently existing facts, conditions, and values — highly questionable and improbable. Assets classified as “loss” are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets that do not expose the Company to risk sufficient to warrant classification in one of the above categories, but that possess some weakness, are required to be designated “special mention” by management.

When an insured institution classifies assets as either “substandard” or “doubtful,” it may establish allowances for loan losses in an amount deemed prudent by management. When an insured institution classifies assets as “loss,” it is required either to establish an allowance for losses equal to 100% of that portion of the assets so classified or to charge off that amount. An FDIC-insured institution’s determination about classification of its assets and the amount of its allowances is subject to review by the FDIC, which may order the establishment of additional loss allowances. Management also employs an independent third party to semi-annually review and validate the internal loan review process and loan classifications.

The Company has experienced a decrease in substandard loans. While it appears as though economic conditions within our defined market area have stabilized and may be improving, it is not yet evident that the improvement will be sustained. While the housing market appears to have stabilized, there is no evidence of a recovery to date. In addition, appraisal values are still below expectations. Loans secured by residential real estate and commercial real estate account for $14.5 million and $7.5 million of the substandard loans respectively. These amounts represent 81.4% of the Company’s substandard loans.

As of December 31, 2011, 2010, 2009, 2008, and 2007 consolidated classified assets were as follows:

 

     Classified Assets at December 31,  
     2011     2010     2009     2008     2007  
(Dollars in thousands)    Amount      Percent
of total
loans
    Amount      Percent
of total
loans
    Amount      Percent
of total
loans
    Amount      Percent
of total
loans
    Amount      Percent
of total
loans
 

Classified loans:

                         

Special mention

   $ 2,653         0.66   $ 2,868         0.77   $ 4,322         1.22   $ 5,134         1.60   $ 5,302         1.71

Substandard

     27,061         6.73     28,178         7.56     18,928         5.35     5,350         1.66     1,029         0.33

Doubtful

     73         0.02     224         0.06     277         0.08     420         0.13     835         0.27

Loss

     —           —          —           —          —           —          —           —          —           —     
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total amount

   $ 29,787         7.41   $ 31,270         8.39   $ 23,527         6.65   $ 10,904         3.39   $ 7,166         2.31
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Other than those disclosed above, the Company does not believe there are any loans classified for regulatory purposes as loss, doubtful, substandard, special mention or otherwise, which will result in losses or have a material impact on future operations, liquidity or capital reserves are not aware of any other information that causes us to have serious doubts as to the ability of borrowers in general to comply with repayment terms.


Investments. Investment securities provide a return on residual funds after lending activities. Investments may be in federal funds sold, corporate securities, U.S. Government and agency obligations, state and local government obligations and government-guaranteed, mortgage-backed securities. The Company generally does not invest in securities that are rated less than investment grade by a nationally recognized statistical rating organization. Ohio Bank law prescribes the kinds of investments an Ohio-chartered bank may make. Permitted investments include local, state, and federal government securities, mortgage-backed securities, and securities of federal government agencies. An Ohio-chartered bank also may invest up to 10% of its assets in corporate debt and equity securities, or a higher percentage in certain circumstances. Similar to the legal lending limit on loans to any one borrower, Ohio bank law also limits to 15% of capital the amount an Ohio-chartered bank may invest in the securities of any one issuer, other than local, state, and federal government and federal government agency issuers and mortgage-backed securities issuers. These Ohio bank law provisions have not been a material constraint upon the Company’s investment activities.

All securities-related activity is reported to the Company’s board of directors. General changes in investment strategy are required to be reviewed and approved by the board. Senior management can purchase and sell securities in accordance with the Company’s stated investment policy.

Management determines the appropriate classification of securities at the time of purchase. At this time the Company has no securities that are classified as held-to-maturity. Securities to be held for indefinite periods and not intended to be held to maturity or on a long-term basis are classified as available-for-sale. Available-for-sale securities are reflected on the balance sheet at their fair value.

The following table sets forth on a consolidated basis the amortized cost and fair value of the Company’s investment portfolio at the dates indicated.

 

     Investment Portfolio Amortized Cost and Fair Value at December 31,  
     2011      2010      2009  
(Dollars in thousands)    Amortized
cost
     Fair value      Amortized
cost
     Fair value      Amortized
cost
     Fair value  

Available for Sale:

                 

U.S. Government agency securities

   $ 31,520       $ 31,933       $ 33,332       $ 32,603       $ 18,657       $ 18,330   

Obligations of states and political subdivisions:

                 

Taxable

     8,207         8,973         7,371         7,417         3,451         3,375   

Tax-exempt

     75,807         79,427         69,363         69,463         52,752         53,346   

Mortgage-backed securities in government sponsored entities

     63,808         65,573         73,390         74,043         39,387         40,369   

Private-label mortgage-backed securities

     7,005         7,321         16,636         17,326         20,668         20,372   

Equity securities in financial institutions

     750         750         944         920         944         919   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Investment Securities

   $ 187,097       $ 193,977       $ 201,036       $ 201,772       $ 135,859       $ 136,711   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The contractual maturity of investment debt securities at December 31, 2011 is shown below.

 

     December 31, 2011  
     One year or less     More than one to five     More than five to ten     More than ten years     Total investment securities  
(Dollars in thousands)    Amortized
cost
     Average
yield
    Amortized
cost
     Average
yield
    Amortized
cost
     Average
yield
    Amortized
cost
     Average
yield
    Amortized
cost
     Average
yield
    Fair value  

U.S. Government agency securities

   $ —           —     $ —           —     $ 2,000         2.42   $ 29,520         2.05   $ 31,520         2.07   $ 31,933   

Obligations of states and political subdivisions:

                           

Taxable

     —           —          —           —          820         5.00        7,387         5.49        8,207         5.44        8,973   

Tax-exempt **

     1,964         5.78        4,671         5.70        13,025         5.95        56,147         5.82        75,807         5.83        79,427   

Mortgage-backed securities in government sponsored entities

     120         5.46        131         4.13        409         4.94        63,148         3.26        63,808         3.27        65,573   

Private-label mortgage-backed securities

     —           —          —           —          833         5.57        6,172         5.06        7,005         5.12        7,321   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total

   $ 2,084         5.76   $ 4,802         5.66   $ 17,087         5.45   $ 162,374         4.09   $ 186,347         4.28   $ 193,227   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

** Tax equivalent yield


Expected maturities of investment securities could differ from contractual maturities because the borrower, or issuer, could have the right to call or prepay obligations with or without call or prepayment penalties. The average yields in the above table are not calculated on a tax equivalent basis.

As of December 31, 2011, the Company also held 18,872 shares of $100 par value Federal Home Loan Bank of Cincinnati stock, which is a restricted security. FHLB stock represents an equity interest in the FHLB, but it does not have a readily determinable market value. The stock can be sold at its par value only, and only to the FHLB or to another member institution. Member institutions are required to maintain a minimum stock investment in the FHLB, based on total assets, total mortgages, and total mortgage-backed securities. The Company’s minimum investment in FHLB stock at December 31, 2011 was $1,887,200.

Sources of FundsDeposit Accounts. Deposit accounts are a major source of funds for the Company. The Company offers a number of deposit products to attract both commercial and regular consumer checking and savings customers, including regular and money market savings accounts, NOW accounts, and a variety of fixed-maturity, fixed-rate certificates with maturities ranging from seven days to 60 months. These accounts earn interest at rates established by management based on competitive market factors and management’s desire to increase certain types or maturities of deposit liabilities. The Company also provides travelers’ checks, official checks, money orders, ATM services, and IRA accounts.

The following table shows on a consolidated basis the amount of time deposits of $100,000 or more as of December 31, 2011, including certificates of deposit, by time remaining until maturity.

 

(Dollar amounts in thousands)    Amount      Percent of Total  

Within three months

   $ 5,940         6.84

Beyond three but within six months

     5,622         6.48   

Beyond six but within twelve months

     9,073         10.45   

Beyond one year

     66,158         76.23   
  

 

 

    

 

 

 

Total

   $ 86,793         100.00
  

 

 

    

 

 

 

Borrowings. Deposits and repayment of loan principal are the Company’s primary sources of funds for lending activities and other general business purposes. However, when the supply of lendable funds or funds available for general business purposes cannot satisfy the demand for loans or general business purposes, the Company can obtain funds from the FHLB of Cincinnati. Interest and principal are payable monthly, and the line of credit is secured by a pledge collateral agreement. At December 31, 2011, MBC had $8.6 million of FHLB borrowings outstanding. The Company also has access to credit through the Federal Reserve Bank of Cleveland and other funding sources.

The outstanding balances and related information about short-term borrowings as of December 31, which includes securities sold under agreements to repurchase, lines of credit with other banks and Federal Funds purchased are summarized on a consolidated basis as follows:

 

(Dollar amounts in thousands)    2011     2010     2009  

Balance at year-end

   $ 7,392      $ 7,632      $ 6,800   

Average balance outstanding

     7,276        7,320        2,281   

Maximum month-end balance

     7,552        8,178        7,406   

Weighted-average rate at year-end

     3.14     3.10     3.47

Weighted-average rate during the year

     3.23     3.40     1.50

Personnel

As of December 31, 2011 the Company had 103 full-time equivalent employees. None of the employees is represented by a collective bargaining group. Management considers its relations with employees to be excellent.

Supervision and Regulation

The following discussion of bank supervision and regulation is qualified in its entirety by reference to the statutory and regulatory provisions discussed. Changes in applicable law or in the policies of various regulatory authorities could affect materially the business and prospects of the Company.

 


The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956. As such, the Company is subject to regulation, supervision, and examination by the Board of Governors of the Federal Reserve System, acting primarily through the Federal Reserve Bank of Cleveland. The Company is required to file annual reports and other information with the Federal Reserve. Both bank subsidiaries are Ohio-chartered commercial banks. As a state-chartered, nonmember banks, the banks are primarily regulated by the FDIC and by the Ohio Division of Financial Institutions.

The Company and its subsidiary Banks are subject to federal banking laws, and the Company is also subject also to Ohio bank law. These federal and state laws are intended to protect depositors, not stockholders. Federal and state laws applicable to holding companies and their financial institution subsidiaries regulate the range of permissible business activities, investments, reserves against deposits, capital levels, lending activities and practices, the nature and amount of collateral for loans, establishment of branches, mergers, dividends, and a variety of other important matters. The Company is subject to detailed, complex, and sometimes overlapping federal and state statutes and regulations affecting routine banking operations. These statutes and regulations include but are not limited to state usury and consumer credit laws, the Truth-in-Lending Act and Regulation Z, the Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Truth in Savings Act, and the Community Reinvestment Act. The Company must comply with Federal Reserve Board regulations requiring depository institutions to maintain reserves against their transaction accounts (principally NOW and regular checking accounts). Because required reserves are commonly maintained in the form of vault cash or in a noninterest-bearing account (or pass-through account) at a Federal Reserve Bank, the effect of the reserve requirement is to reduce an institution’s earning assets.

The Federal Reserve Board and the FDIC have extensive authority to prevent and to remedy unsafe and unsound practices and violations of applicable laws and regulations by institutions and holding companies. The agencies may assess civil money penalties, issue cease-and-desist or removal orders, seek injunctions, and publicly disclose those actions. In addition, the Ohio Division of Financial Institutions possesses enforcement powers to address violations of Ohio banking law by Ohio-chartered banks.

Effective February 11, 2010, the Board of Directors of the Company’s subsidiary, EB, entered into a Memorandum of Understanding (“MOU”) with the FDIC and the Ohio Division of Financial Institutions as a result of the joint examination by the FDIC and the Ohio Division of Financial Institutions completed in the fourth quarter of 2009. The MOU sets forth certain actions required to be taken by management of EB to rectify unsatisfactory conditions identified by the federal and state banking regulators that relate to EB’s concentration of credit for non-owner occupied 1—4 family residential mortgage loans. The MOU requires EB to reduce delinquent and classified loans and enhance credit administration for non-owner occupied residential real estate; to develop specific plans for the reduction of borrower indebtedness on classified and delinquent credits; to correct violations of laws and regulations listed in the joint examination report; to implement an earnings improvement plan; to maintain specified capital discussed below; to submit to the FDIC and the Ohio Division of Financial Institutions for review and comment a revised methodology for calculating and determining the adequacy of the allowance for loan losses; and to provide 30 days advance notification of proposed dividend payments.

The MOU requires that EB submit plans and report to the Ohio Division of Financial Institutions and the FDIC regarding EB’s loan portfolio and profit plan, among other matters. The MOU also requires that the Bank maintain its Tier I Leverage Capital ratio at not less than 9 percent.

The following table sets forth the capital requirements for EB under the FDIC regulations and EB’s capital ratios at December 31, 2011 and 2010:

FDIC Regulations

 

Capital    Adequately     Well     December 31,  

Ratios

   Capitalized     Capitalized     2011     2010  

Leverage

     4.00     5.00 % (1)      9.92     9.45

Risk-Based Capital:

        

Tier 1

     4.00     6.00     12.57     13.26

Total

     8.00     10.00     13.82     14.55

 

(1) 9 percent required by MOU.


Regulation of Bank Holding CompaniesBank and Bank Holding Company Acquisitions. The Bank Holding Company Act requires every bank holding company to obtain approval of the Federal Reserve before —

 

   

directly or indirectly acquiring ownership or control of any voting shares of another bank or bank holding company, if after the acquisition the acquiring company would own or control more than 5% of the shares of the other bank or bank holding company (unless the acquiring company already owns or controls a majority of the shares),

 

   

acquiring all or substantially all of the assets of another bank, or

 

   

merging or consolidating with another bank holding company.

The Federal Reserve will not approve an acquisition, merger, or consolidation that would have a substantially anticompetitive result, unless the anticompetitive effects of the proposed transaction are clearly outweighed by a greater public interest in satisfying the convenience and needs of the community to be served. The Federal Reserve also considers capital adequacy and other financial and managerial factors in its review of acquisitions and mergers.

Additionally, the Bank Holding Company Act, the Change in Bank Control Act and the Federal Reserve Board’s Regulation Y require advance approval of the Federal Reserve to acquire “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of a class of voting securities of the bank holding company. If the holding company has securities registered under Section 12 of the Securities Exchange Act of 1934, as the Company does, or if no other person owns a greater percentage of the class of voting securities, control is presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities. Approval of the Ohio Division of Financial Institutions is also necessary to acquire control of an Ohio-chartered bank.

Nonbanking Activities. With some exceptions, the Bank Holding Company Act has for many years also prohibited a bank holding company from acquiring or retaining direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve non-bank activities that, by statute or by Federal Reserve Board regulation or order, are held to be closely related to the business of banking or of managing or controlling banks. In making its determination that a particular activity is closely related to the business of banking, the Federal Reserve considers whether the performance of the activities by a bank holding company can be expected to produce benefits to the public — such as greater convenience, increased competition, or gains in efficiency in resources — that will outweigh the risks of possible adverse effects such as decreased or unfair competition, conflicts of interest, or unsound banking practices. Some of the activities determined by Federal Reserve Board regulation to be closely related to the business of banking are: making or servicing loans or leases; engaging in insurance and discount brokerage activities; owning thrift institutions; performing data processing services; acting as a fiduciary or investment or financial advisor; and making investments in corporations or projects designed primarily to promote community welfare.

Financial Holding Companies. On November 12, 1999 the Gramm-Leach-Bliley Act became law, repealing much of the 1933 Glass-Steagall Act’s separation of the commercial and investment banking industries. The Gramm-Leach-Bliley Act expands the range of nonbanking activities a bank holding company may engage in, while preserving existing authority for bank holding companies to engage in activities that are closely related to banking. The new legislation creates a new category of holding company called a “financial holding company.” Financial holding companies may engage in any activity that is —

 

   

financial in nature or incidental to that financial activity, or

 

   

complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.

Activities that are financial in nature include —

 

   

acting as principal, agent, or broker for insurance,

 

   

underwriting, dealing in, or making a market in securities, and

 

   

providing financial and investment advice.

The Federal Reserve Board and the Secretary of the Treasury have authority to decide that other activities are also financial in nature or incidental to financial activity, taking into account changes in technology, changes in the banking marketplace, competition for banking services, and so on. The Company is engaged solely in activities that were permissible for a bank holding company before enactment of the Gramm-Leach-Bliley Act. Federal Reserve Board rules require that all of the depository institution subsidiaries of a financial holding company be and remain well capitalized and well managed. If all depository institution subsidiaries of a financial holding company do not remain well capitalized and well managed, the financial holding company must enter into an agreement acceptable to the Federal Reserve Board, undertaking to comply with all capital and management requirements within 180 days. In the meantime the financial holding company may not use its expanded authority to engage in nonbanking activities without Federal Reserve Board approval and the Federal Reserve may impose other limitations on the holding company’s or affiliates’ activities. If a financial holding company fails to restore the well-capitalized and well-managed status of a depository institution


subsidiary, the Federal Reserve may order divestiture of the subsidiary. Until recently the Company was been entitled to engage in the expanded range of activities in which a financial holding company, as defined in Federal Reserve Board rules, may engage. However, the Company has not taken advantage of that expanded authority and has elected to rescind its financial holding company status. The Company continues to be entitled to engage in activities deemed permissible to a bank holding company, as defined by Federal Reserve Board rules and the applicable laws of the United States.

Holding Company Capital and Source of Strength. The Federal Reserve considers the adequacy of a bank holding company’s capital on essentially the same risk-adjusted basis as capital adequacy is determined by the FDIC at the bank subsidiary level. In general, bank holding companies are required to maintain a minimum ratio of total capital to risk-weighted assets of 8% and Tier 1 capital — consisting principally of stockholders’ equity — of at least 4%. Bank holding companies are also subject to a leverage ratio requirement. The minimum required leverage ratio for the very highest rated companies is 3%, but as a practical matter the minimum required leverage ratio for most bank holding companies is 4% or higher. It is also Federal Reserve Board policy that bank holding companies serve as a source of strength for their subsidiary banking institutions.

Under Bank Holding Company Act section 5(e), the Federal Reserve Board may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the Federal Reserve Board determines that the activity or control constitutes a serious risk to the financial safety, soundness or stability of a subsidiary bank. And with the Federal Deposit Insurance Corporation Improvement Act of 1991’s addition of the prompt corrective action provisions to the Federal Deposit Insurance Act, section 38(f)(2)(I) of the Federal Deposit Insurance Act now provides that a federal bank regulatory authority may require a bank holding company to divest itself of an undercapitalized bank subsidiary if the agency determines that divestiture will improve the bank’s financial condition and prospects.

Liability of Commonly Controlled Institutions. Adding subsection (e) to section 5 of the Federal Deposit Insurance Act, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 allows the FDIC to demand from one institution payment for losses incurred or to be incurred by the FDIC because of the default of another institution or because of assistance provided by the FDIC to the other institution in danger of default, if the institutions are commonly controlled.

CapitalRisk-Based Capital Requirements. The Federal Reserve Board and the FDIC employ similar risk-based capital guidelines in their examination and regulation of bank holding companies and financial institutions. If capital falls below the minimum levels established by the guidelines, the bank holding company or bank may be denied approval to acquire or establish additional banks or non-bank businesses or to open new facilities. Failure to satisfy capital guidelines could subject a banking institution to a variety of enforcement actions by federal bank regulatory authorities, including the termination of deposit insurance by the FDIC and a prohibition on the acceptance of “brokered deposits.”

In the calculation of risk-based capital, assets and off-balance sheet items are assigned to broad risk categories, each with an assigned weighting. Most loans are assigned to the 100% risk category, except for first mortgage loans fully secured by residential property, which carry a 50% rating. Most investment securities are assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% risk-weight, and direct obligations of or obligations guaranteed by the United States Treasury or United States Government agencies, which have a 0% risk-weight. Off-balance sheet items are also taken into account in the calculation of risk-based capital, with each class of off-balance sheet item being converted to a balance sheet equivalent according to established “conversion factors.” From these computations, the total of risk-weighted assets is derived. Risk-based capital ratios therefore state capital as a percentage of total risk-weighted assets and off-balance sheet items. The ratios established by guideline are minimums only.

Current risk-based capital guidelines require bank holding companies and banks to maintain a minimum risk-based total capital ratio equal to 8% and a Tier 1 capital ratio of 4%. Intangibles other than readily marketable mortgage servicing rights are generally deducted from capital. Tier 1 capital includes stockholders’ equity, qualifying perpetual preferred stock (within limits and subject to conditions, particularly if the preferred stock is cumulative preferred stock), and minority interests in equity accounts of consolidated subsidiaries, less intangibles, identified losses, investments in securities subsidiaries, and certain other assets. Tier 2 capital includes —

 

   

the allowance for loan losses, up to a maximum of 1.25% of risk-weighted assets,

 

   

any qualifying perpetual preferred stock exceeding the amount includable in Tier 1 capital,

 

   

mandatory convertible securities, and

 

   

subordinated debt and intermediate term preferred stock, up to 50% of Tier 1 capital.

The FDIC also employs a market risk component in its calculation of capital requirements for nonmember banks. The market risk component could require additional capital for general or specific market risk of trading portfolios of debt and equity securities and other investments or assets. The FDIC’s evaluation of an institution’s capital adequacy takes account of a variety of other factors as well, including interest rate risks to which the institution is subject, the level and quality of an institution’s earnings, loan and investment portfolio characteristics and risks, risks arising from the conduct of nontraditional activities, and a variety of other factors.


Accordingly, the FDIC’s final supervisory judgment concerning an institution’s capital adequacy could differ significantly from the conclusions that might be derived from the absolute level of an institution’s risk-based capital ratios. Therefore, institutions generally are expected to maintain risk-based capital ratios that exceed the minimum ratios discussed above. This is particularly true for institutions contemplating significant expansion plans and institutions that are subject to high or inordinate levels of risk. Moreover, although the FDIC does not impose explicit capital requirements on holding companies of institutions regulated by the FDIC, the FDIC can take account of the degree of leverage and risks at the holding company level. If the FDIC determines that the holding company (or another affiliate of the institution regulated by the FDIC) has an excessive degree of leverage or is subject to inordinate risks, the FDIC may require the subsidiary institution(s) to maintain additional capital or the FDIC may impose limitations on the subsidiary institution’s ability to support its weaker affiliates or holding company.

The banking agencies have also established a minimum leverage ratio of 3%, which represents Tier 1 capital as a percentage of total assets, less intangibles. However, for bank holding companies and financial institutions seeking to expand and for all but the most highly rated banks and bank holding companies, the banking agencies expect an additional cushion of at least 100 to 200 basis points. At December 31, 2011, the Company was in compliance with all regulatory capital requirements.

Prompt Corrective Action. To resolve the problems of undercapitalized institutions and to prevent a recurrence of the banking crisis of the 1980s and early 1990s, the Federal Deposit Insurance Corporation Improvement Act of 1991 established a system known as “prompt corrective action.” Under the prompt corrective action provisions and implementing regulations, every institution is classified into one of five categories, depending on its total risk-based capital ratio, its Tier 1 risk-based capital ratio, its leverage ratio, and subjective factors. The categories are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A financial institution’s operations can be significantly affected by its capital classification. For example, an institution that is not “well capitalized” generally is prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market, and the holding company of any undercapitalized institution must guarantee, in part, aspects of the institution’s capital plan. Financial institution regulatory agencies generally are required to appoint a receiver or conservator shortly after an institution enters the category of weakest capitalization. The Federal Deposit Insurance Corporation Improvement Act of 1991 also authorizes the regulatory agencies to reclassify an institution from one category into a lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. Undercapitalized institutions are required to take specified actions to increase their capital or otherwise decrease the risks to the federal deposit insurance funds.

The following table illustrates the capital and prompt corrective action guidelines applicable to the Company and its subsidiaries, as well as its total risk-based capital ratio, Tier 1 capital ratio and leverage ratio as of December 31, 2011.

 

     Middlefield Banc Corp.     The Middlefield Banking Co.     Emerald Bank  
(Dollar amounts in thousands)    December 31, 2011     December 31, 2011     December 31, 2011  
     Amount      Ratio     Amount      Ratio     Amount      Ratio  

Total Capital

               

(to Risk-weighted Assets)

               

Actual

   $ 49,915         12.06   $ 42,185         11.75   $ 7,456         13.82

For Capital Adequacy Purposes

     33,101         8.00        28,722         8.00        4,317         8.00   

To Be Well Capitalized

     41,376         10.00        35,903         10.00        5,396         10.00   

Tier I Capital

               

(to Risk-weighted Assets)

               

Actual

   $ 44,723         10.81   $ 37,697         10.50   $ 6,782         12.57

For Capital Adequacy Purposes

     16,551         4.00        14,361         4.00        2,158         4.00   

To Be Well Capitalized

     24,826         6.00        21,542         6.00        3,237         6.00   

Tier I Capital

               

(to Average Assets)

               

Actual

   $ 44,723         7.13   $ 37,697         6.75   $ 6,782         9.92

For Capital Adequacy Purposes

     25,079         4.00        22,325         4.00        2,734         4.00   

To Be Well Capitalized

     31,349         5.00        27,906         5.00        3,417         5.00   

Limits on Dividends and Other Payments. The Company’s ability to obtain funds for the payment of dividends and for other cash requirements depends on the amount of dividends that may be paid to it by the banks. Ohio bank law and FDIC policy are consistent, providing that banks generally may rely solely on current earnings for the payment of dividends. Under Ohio Revised Code section 1107.15(B) a dividend may be declared from surplus, meaning additional paid-in capital, with the approval of (x) the


Ohio Superintendent of Financial Institutions and (y) the holders of two thirds of the bank’s outstanding shares. Superintendent approval is also necessary for payment of a dividend if the total of all cash dividends in a year exceeds the sum of (x) net income for the year and (y) retained net income for the two preceding years. Relying on 12 U.S.C. 1818(b), the FDIC may restrict a bank’s ability to pay a dividend if the FDIC has reasonable cause to believe that the dividend would constitute an unsafe and unsound practice. A bank’s ability to pay dividends may be affected also by the FDIC’s capital maintenance requirements and prompt corrective action rules. A bank may not pay a dividend if the bank is undercapitalized or if payment would cause the bank to become undercapitalized.

A 1985 policy statement of the Federal Reserve Board declares that a bank holding company should not pay cash dividends on common stock unless the organization’s net income for the past year is sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality, and overall financial condition.

The Dodd-Frank Act. A landmark financial reform bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act became law on July 21, 2010, changing the Federal bank regulatory structure and affecting the lending, investment, trading, and other operating activities of financial institutions and holding companies. The Dodd-Frank Act includes corporate governance and executive compensation reforms, new registration requirements for hedge fund and private equity fund advisers, increased regulation of over-the-counter derivatives and asset-backed securities, and new rules for credit rating agencies. Over 2,000 pages long, the Dodd-Frank Act includes these provisions —

 

   

section 111 establishes a new Financial Stability Oversight Council to monitor systemic financial risks. The Board of Governors of the Federal Reserve is given extensive new authorities to impose strict controls on large bank holding companies with total consolidated assets equal to or exceeding $50 billion and systemically significant non-bank financial companies to limit the risk they might pose for the economy and to other large interconnected companies. The Dodd-Frank Act also grants to the Treasury Department, FDIC and the FRB broad new powers to seize, close and wind-down “too big to fail” financial institutions (including non-bank institutions) in an orderly fashion.

 

   

Title X establishes an independent Federal regulatory body within the Federal Reserve System. Dedicated exclusively to consumer protection and known as the Bureau of Consumer Financial Protection, this new regulatory body has responsibility for most consumer protection laws, with rulemaking, supervisory, examination, and enforcement authority. The Bureau of Consumer Financial Protection will also be in charge of setting appropriate consumer banking fees and caps. According to Dodd-Frank Act section 1025, the new regulatory body has examination and enforcement authority over banks with more than $10 billion in assets, but under section 1026 banks with assets of $10 billion or less will continue to be examined by their bank regulators for consumer law compliance. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are stricter than those regulations promulgated by the Consumer Financial Protection Bureau. Compliance with any such new regulations would increase our cost of operations and could as a result limit our ability to expand into these products and services.

 

   

section 171 restricts the amount of trust preferred securities that may be considered Tier 1 capital. For depository institution holding companies with total assets of less than $15 billion, trust preferred securities issued before May 19, 2010 may continue to be included in Tier 1 capital, but future issuances of trust preferred securities will no longer be eligible for treatment as Tier 1 capital.

 

   

under section 334 the FDIC’s minimum reserve ratio is to be increased from 1.15% to 1.35%, with the goal of attaining that 1.35% level by September 30, 2020; however, financial institutions with assets of less than $10 billion are to be exempt from the cost of the increase. The Dodd-Frank Act also removes the upper limit on the designated reserve ratio, which was formerly capped at 1.5%, removing the upper limit on the size of the insurance fund as a consequence. The Dodd-Frank Act gives the FDIC much greater discretion to manage its insurance fund reserves, including where to set the insurance fund’s designated reserve ratio.

 

   

the deposit insurance cover limit is increased to $250,000 by section 335.

 

   

section 343 extends until January 1, 2013 unlimited FDIC insurance for non-interest-bearing demand deposit accounts, more commonly known as checking accounts; and section 627 repeals the longstanding prohibition against financial institutions paying interest on checking accounts.

 

   

section 331 changes the way deposit insurance premiums are calculated by the FDIC as well. That is, deposit insurance premiums are calculated based upon an institution’s so-called assessment base. Until the Dodd-Frank Act became law, the assessment base consisted of an institution’s deposit liabilities. Section 331, however, makes clear that the assessment base shall now be the difference between total assets and tangible equity. In other words, the assessment base will take account of all liabilities, not merely deposit liabilities. This change is likely to have a greater impact on large banks, which tend to rely on a variety of funding sources, than on community banks, which tend to rely primarily on deposit funding.

 


   

the Office of the Comptroller of the Currency’s ability to preempt state consumer protection laws is constrained by section 1044, and because of section 1042 state attorneys general have greater authority to enforce state consumer protection laws against national banks and their operating subsidiaries.

 

   

section 604 requires the Federal bank regulatory agencies to take into account the risks to the stability of the U.S. banking or financial system associated with approval of an application for acquisition of a bank, for acquisition of a nonbank company, or for a bank merger transaction.

 

   

section 619 implements the so-called “Volcker rule,” prohibiting a banking entity from engaging in proprietary trading or from sponsoring or investing in a hedge fund or private equity fund.

 

   

imposing a 5% risk retention requirement on securitizers of asset-backed securities, section 941 could have an impact on financial institutions that originate mortgages for sale into the secondary market. Like other provisions of the Dodd-Frank Act, the scope and impact of section 941 will be determined by future rulemaking.

We are evaluating the potential impact of the Dodd-Frank Act on our business, financial condition, results of operations, and prospects. The Dodd-Frank Act could affect the profitability of community banking, require changes in the business practices of community banking organizations, lead to more stringent capital and liquidity requirements, and otherwise adversely affect the community banking business. However, because much of the Dodd-Frank Act will be phased in over time and will not become effective until Federal agency rulemaking initiatives are completed, we cannot predict with confidence precisely how the Dodd-Frank Act will affect community banking organizations. We are confident, however, that short- and long-term compliance costs for all financial organizations, both large and small, will be greater because of the Dodd-Frank Act.

Sarbanes-Oxley Act of 2002. The goals of the Sarbanes-Oxley Act enacted in 2002 are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures made under the securities laws. The proposed changes are intended to allow shareholders to monitor the performance of companies and directors more easily and efficiently.

The Sarbanes-Oxley Act generally applies to all companies that file or are required to file periodic reports with the SEC under the Securities Exchange Act of 1934. The Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC, securities exchanges, and Nasdaq to adopt extensive additional disclosure, corporate governance, and other related rules. The final scope of all of these new requirements is not yet clear. Some of the changes are effective already, but others will become effective in the future.

The Sarbanes-Oxley Act has an impact on a wide variety of corporate governance and disclosure issues, including the composition of audit committees, certification of financial statements by the chief executive officer and the chief financial officer, forfeiture of bonuses and profits made by directors and senior officers in the 12-month period covered by restated financial statements, a prohibition on insider trading during pension plan black-out periods, disclosure of off-balance sheet transactions, a prohibition on personal loans to directors and officers (excluding Federally insured financial institutions), expedited filing requirements for stock transaction reports by officers and directors, the formation of a public accounting oversight board, auditor independence, and various increased criminal penalties for violations of securities laws.

Deposit Insurance. The premium that banks pay for deposit insurance is based upon a risk classification system established by the FDIC. Banks with higher levels of capital and a low degree of supervisory concern are assessed lower premiums than banks with lower levels of capital or a higher degree of supervisory concern. We anticipate that deposit insurance assessment rates will continue to increase for the foreseeable future because of the significant cost of bank failures, because of the relatively large number of troubled banks, and because of the Dodd-Frank Act requirement that the FDIC increase its insurance fund reserves to no less than $1.35 for each $100 of insured deposits.

The $100,000 basic deposit insurance limit in place for many years was increased temporarily to $250,000 by the Emergency Economic Stabilization Act of 2008, which became law on October 3, 2008. On July 21, 2010, section 335 of the Dodd-Frank Act made the $250,000 insurance limit permanent.

Interstate Banking and Branching. Section 613 of the Dodd-Frank Act amends the interstate branching provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. The expanded de novo branching authority of the Dodd-Frank Act authorizes a state or national bank to open a de novo branch in another state if the law of the state where the branch is to be located would permit a state bank chartered by that state to open the branch. Under prior law, an out-of-state bank could open a de novo branch in another state only if the particular state permitted out-of-state banks to establish a de novo branch. Section 607 of the Dodd-Frank Act also increases the approval threshold for interstate bank acquisitions, providing that a bank holding company must be well capitalized and well managed as a condition to approval of an interstate bank acquisition, rather than being merely adequately capitalized and adequately managed, and that an acquiring bank must be and remain well capitalized and well managed as a condition to approval of an interstate bank merger.


Transactions with Affiliates. Although the banks are not member banks of the Federal Reserve System, they are required by the Federal Deposit Insurance Act to comply with section 23A and section 23B of the Federal Reserve Act — pertaining to transactions with affiliates — as if they were member banks. These statutes are intended to protect banks from abuse in financial transactions with affiliates, preventing federally insured deposits from being diverted to support the activities of unregulated entities engaged in nonbanking businesses. An affiliate of a bank includes any company or entity that controls or is under common control with the bank. Generally, section 23A and section 23B of the Federal Reserve Act —

 

   

limit the extent to which a bank or its subsidiaries may lend to or engage in various other kinds of transactions with any one affiliate to an amount equal to 10% of the institution’s capital and surplus, limiting the aggregate of covered transactions with all affiliates to 20% of capital and surplus,

 

   

impose restrictions on investments by a subsidiary bank in the stock or securities of its holding company,

 

   

impose restrictions on the use of a holding company’s stock as collateral for loans by the subsidiary bank, and

 

   

require that affiliate transactions be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate.

The Company’s authority to extend credit to insiders — meaning executive officers, directors and greater than 10% stockholders — or to entities those persons control, is subject to section 22(g) and section 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these laws require insider loans to be made on terms substantially similar to those offered to unaffiliated individuals, place limits on the amount of loans a bank may make to insiders based in part on the Company’s capital position, and require that specified approval procedures be followed. Loans to an individual insider may not exceed the legal limit on loans to any one borrower, which in general terms is 15% of capital but can be higher in some circumstances. And the aggregate of all loans to all insiders may not exceed the Company’s unimpaired capital and surplus. Insider loans exceeding the greater of 5% of capital or $25,000 must be approved in advance by a majority of the board, with any “interested” director not participating in the voting. Lastly, loans to executive officers are subject to special limitations. Executive officers may borrow in unlimited amounts to finance their children’s education or to finance the purchase or improvement of their residence, and they may borrow no more than $100,000 for most other purposes. Loans to executive officers exceeding $100,000 may be allowed if the loan is fully secured by government securities or a segregated deposit account. A violation of these restrictions could result in the assessment of substantial civil monetary penalties, the imposition of a cease-and-desist order or other regulatory sanctions.

Banking agency guidance for commercial real estate lending. In December 2006 the FDIC and other Federal banking agencies issued final guidance on sound risk management practices for concentrations in commercial real estate lending, including acquisition and development lending, construction lending, and other land loans, which recent experience has shown can be particularly high-risk lending. According to a 2009 FDIC publication, a majority of the community banks that became problem banks or failed in 2008 had similar risk profiles: the banks often had extremely high concentrations, relative to their capital, in residential acquisition, development, and construction lending, loan underwriting and credit administration functions at these institutions typically were criticized by examiners, and many of the institutions had exhibited rapid asset growth funded with brokered deposits.

The commercial real estate risk management guidance does not impose rigid limits on commercial real estate lending but does create a much sharper supervisory focus on the risk management practices of banks with concentrations in commercial real estate lending. According to the guidance, an institution that has experienced rapid growth in commercial real estate lending, has notable exposure to a specific type of commercial real estate, or is approaching or exceeds the following supervisory criteria may be identified for further supervisory analysis of the level and nature of its commercial real estate concentration risk —

 

   

total reported loans for construction, land development, and other land represent 100% or more of the institution’s total capital, or

 

   

total commercial real estate loans represent 300% or more of the institution’s total capital and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more during the prior 36 months.

These measures are intended merely to enable the banking agencies to quickly identify institutions that could have an excessive commercial real estate lending concentration, potentially requiring close supervision to ensure that the institutions have sound risk management practices in place. Conversely, these measures do not imply that banks are authorized by the December 2006 guidance to accumulate a commercial real estate lending concentration up to the 100% and 300% thresholds.

Corporate Governance and Compensation. The Federal banking agencies jointly published their final Guidance on Sound Incentive Compensation Policies in June of 2010. The goal of the guidance is to enable financial organizations to manage the safety and soundness risks of incentive compensation arrangements and to assist banks and bank holding companies with identification of improperly-structured compensation arrangements. To ensure that incentive compensation arrangements do not encourage employees to take excessive risks that undermine safety and soundness, the incentive compensation guidance sets forth these key principles —

 


   

incentive compensation arrangements should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose the organization to imprudent risk,

 

   

these arrangements should be compatible with effective controls and risk management, and

 

   

these arrangements should be supported by strong corporate governance, including active and effective oversight by the board of directors.

To implement the interagency guidance, a financial organization must regularly review incentive compensation arrangements for all executive and non-executive employees who, either individually or as part of a group, have the ability to expose the organization to material amounts of risk, also reviewing the risk-management, control, and corporate governance processes related to these arrangements. The organization must immediately correct any identified deficiencies in compensation arrangements or processes that are inconsistent with safety and soundness.

In addition to numerous provisions that affect the business of banks and bank holding companies, the recently enacted Dodd-Frank Act includes in Title IX a number of provisions affecting corporate governance and executive compensation, for example the requirements that stockholders be given the opportunity to consider and vote upon executive compensation disclosed in a company’s annual meeting proxy statement, that a company’s compensation committee be comprised entirely of independent directors and that the committee have stated minimum authorities, that annual meeting proxy statements disclose the ratio of CEO compensation to the median compensation of all other employees, that company policy provide for recovery of excess incentive compensation after an accounting restatement, and that stockholders have the ability to designate director nominees for inclusion in a company’s annual meeting proxy statement. Section 956 also provides for adoption of incentive compensation guidelines jointly by the Federal banking agencies and the SEC, the National Credit Union Administration, and the Federal Housing Finance Agency.

Overdraft Protection Practices. Federal Reserve rules regarding overdraft charges for debit card and ATM transactions became effective on July 1, 2010, eliminating the automatic overdraft protection arrangements that had been in common use and requiring instead that banks notify customers and obtain their consent before enrolling them in an overdraft protection plan. The rules limit a bank’s ability to charge fees for the payment of overdrafts for debit and ATM card transactions. On November 24, 2010, the FDIC issued final supervisory guidance on overdraft protection programs and related consumer protection issues. Applicable only to nonmember banks regulated by the FDIC, the guidance emphasizes that banks should be alert to consumers’ use of automated overdraft protection programs in a way that is harmful, as opposed to using the coverage as protection against occasional errors or funds shortages. Programs in which a bank employee exercises discretion over whether an overdraft should be paid as an accommodation to a customer and linked lines of credit are not covered. Effective July 1, 2011, FDIC-regulated nonmember banks like The Middlefield Banking Company or Emerald Bank must monitor their programs for “excessive or chronic customer use,” including a customer overdrawing an account and being charged a fee on more than six occasions in 12 months. In such a case, the bank should contact the customer to discuss better alternatives and give the customer the chance to decide whether to continue to use the automated overdraft protection program. FDIC-regulated nonmember banks must implement daily limits on customer costs.

The FDIC’s supervisory guidance concerning automated overdraft payment programs requires banks to consider whether to eliminate fees for transactions that result in significant overdrafts and requires banks to review check-clearing procedures to ensure that the order of clearing items does not operate to maximize fees. The FDIC suggests that clearing items in the order in which they are received or clearing checks by numerical order is appropriate. The supervisory guidance provides that FDIC-regulated banks, including all state-chartered banks that have chosen not to become members of the Federal Reserve System, should give customers an opportunity to opt out of overdraft coverage for paper checks and automated clearing house transactions just as customers can opt out of ATM and point of sale transactions, even though the Federal Reserve Board’s recent opt-out amendments to Regulation E–Electronic Fund Transfers did not apply to non-electronic transactions. The FDIC supervisory guidance imposes on state-chartered nonmember banks a burden that is not imposed by the OCC on national banks or by the Federal Reserve on state-chartered member banks.

In 2010, the FDIC created a new Division of Depositor and Consumer Protection to sharpen the agency’s focus on consumer protection issues. Although the FDIC does not have rulemaking authority over statutes proscribing unfair or deceptive acts or practices (“UDAP”) and other consumer laws, the FDIC does have examination and enforcement authority over state-chartered nonmember banks. Because of the FDIC’s public advocacy against fee-based overdraft protection services that are considered by the FDIC to be abusive, FDIC-regulated nonmember banks could be at greater risk than other banks for claimed UDAP violations involving fee-based overdraft protection.

Community Reinvestment Act. Under the Community Reinvestment Act of 1977 and implementing regulations of the banking agencies, a financial institution has a continuing and affirmative obligation — consistent with safe and sound operation — to address the credit needs of its entire community, including low- and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop the types of products


and services it believes are best suited to its particular community. The CRA requires that bank regulatory agencies conduct regular CRA examinations and provide written evaluations of institutions’ CRA performance. The CRA also requires that an institution’s CRA performance rating be made public. CRA performance evaluations are based on a four-tiered rating system: Outstanding, Satisfactory, Needs to Improve and Substantial Noncompliance.

Although CRA examinations occur on a regular basis, CRA performance evaluations have been used principally in the evaluation of regulatory applications submitted by an institution. CRA performance evaluations are considered in evaluating applications for such things as mergers, acquisitions, and applications to open branches.

MBC’s CRA performance evaluation dated June 7, 2011 states that MBC’s CRA rating is “Satisfactory.” EB’s CRA performance evaluation dated February 17, 2011 states that EB’s CRA rating is “Satisfactory.”

Federal Home Loan Bank. The Federal Home Loan Bank serves as a credit source for their members. As a member of the FHLB of Cincinnati, both MBC and EB are required to maintain an investment in the capital stock of the FHLB of Cincinnati in an amount calculated by reference to its amount of loans, and or “advances,” from the FHLB. The Company is in compliance with this requirement, with an investment in FHLB stock on MBC’s part of $1.6 million and on EB’s part of $261,000 at December 31, 2011.

Each FHLB is required to establish standards of community investment or service that its members must maintain for continued access to long-term advances from the FHLB. The standards take into account a member’s performance under the Community Reinvestment Act and its record of lending to first-time home buyers.

Anti-money laundering and anti-terrorism legislation. The Bank Secrecy Act of 1970 requires financial institutions to maintain records and report transactions to prevent the financial institutions from being used to hide money derived from criminal activity and tax evasion. The Bank Secrecy Act establishes (a) record keeping requirements to assist government enforcement agencies with tracing financial transactions and flow of funds, (b) reporting requirements for Suspicious Activity Reports and Currency Transaction Reports to assist government enforcement agencies with detecting patterns of criminal activity, (c) enforcement provisions authorizing criminal and civil penalties for illegal activities and violations of the Bank Secrecy Act and its implementing regulations, and (d) safe harbor provisions that protect financial institutions from civil liability for their cooperative efforts.

The Treasury’s Office of Foreign Asset Control administers and enforces economic and trade sanctions against targeted foreign countries, entities, and individuals based on U.S. foreign policy and national security goals. As a result, financial institutions must scrutinize transactions to ensure that they do not represent obligations of or ownership interests in entities owned or controlled by sanctioned targets.

Signed into law on October 26, 2001, the USA PATRIOT Act of 2001 is omnibus legislation enhancing the powers of domestic law enforcement organizations to resist the international terrorist threat to United States security. Title III of the legislation, the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, most directly affects the financial services industry, enhancing the Federal government’s ability to fight money laundering through monitoring of currency transactions and suspicious financial activities. The Act has significant implications for depository institutions and other businesses involved in the transfer of money —

 

   

a financial institution must establish due diligence policies, procedures, and controls reasonably designed to detect and report money laundering through correspondent accounts and private banking accounts,

 

   

no bank may establish, maintain, administer, or manage a correspondent account in the United States for a foreign shell bank,

 

   

financial institutions must abide by Treasury Department regulations encouraging financial institutions, their regulatory authorities, and law enforcement authorities to share information about individuals, entities, and organizations engaged in or suspected of engaging in terrorist acts or money laundering activities,

 

   

financial institutions must follow Treasury Department regulations setting forth minimum standards regarding customer identification. These regulations require financial institutions to implement reasonable procedures for verifying the identity of any person seeking to open an account, maintain records of the information used to verify the person’s identity, and consult lists of known or suspected terrorists and terrorist organizations provided to the financial institution by government agencies,

 

   

every financial institution must establish anti-money laundering programs, including the development of internal policies and procedures, designation of a compliance officer, employee training, and an independent audit function.

State Banking Regulation. As Ohio-chartered banks, the banks are subject to regular examination by the Ohio Division of Financial Institutions. State banking regulation affects the internal organization of the banks as well as their savings, lending, investment, and other activities. State banking regulation may contain limitations on an institution’s activities that are in addition to limitations imposed under federal banking law. The Ohio Division of Financial Institutions may initiate supervisory measures or formal enforcement actions, and if the grounds provided by law exist it may take possession and control of an Ohio-chartered bank.


Monetary Policy. The earnings of financial institutions are affected by the policies of regulatory authorities, including monetary policy of the Federal Reserve Board. An important function of the Federal Reserve System is regulation of aggregate national credit and money supply. The Federal Reserve Board accomplishes these goals with measures such as open market transactions in securities, establishment of the discount rate on bank borrowings, and changes in reserve requirements against bank deposits. These methods are used in varying combinations to influence overall growth and distribution of financial institutions’ loans, investments and deposits, and they also affect interest rates charged on loans or paid on deposits. Monetary policy is influenced by many factors, including inflation, unemployment, short-term and long-term changes in the international trade balance, and fiscal policies of the United States government. Federal Reserve Board monetary policy has had a significant effect on the operating results of financial institutions in the past, and it can be expected to influence operating results in the future.

Item 1.A — Risk Factors

Risks Related to the Company’s Business

Continued negative developments in the financial industry and the domestic credit market may adversely affect the Company’s operations and results. Negative developments starting in the latter half of 2007 and continuing through 2011 in the credit and securitization markets have resulted in uncertainty in financial markets with the expectation of the general economic sluggishness continuing in 2012. Business activity across a wide range of industries and regions is declining. Unemployment has been persistently high. During 2011 the financial services industry was materially and adversely affected by the continued reduced values of nearly all asset classes. These negative developments were initially triggered by declines in home prices and the values of subprime residential mortgage loans, but quickly spread to other asset classes. Market conditions have also led to the failure or merger of a number of formerly prominent and large financial institutions. More than 410 financial institutions had failed in the four-year period from January 1, 2008 through December 31, 2011, and there have been numerous additional financial institution failures in 2012. Furthermore, declining asset values on financial instruments, defaults on residential mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to decrease liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions. Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. If current levels of market disruption and volatility continue or worsen, there can be no assurance that the Company will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition, and results of operations.

The Company operates in a highly competitive industry and market area. The U.S. financial system has become highly concentrated and has moved into a barbell-type structure. This structure is characterized at one end by a handful of large financial conglomerates controlling a disproportionate share of deposits and industry assets, with thousands of community financial institutions spread across the U.S at the other end controlling the remainder of deposits and industry assets. While the nation’s largest banks have not been permitted to fail, community banks do fail with regularity. This policy disparity has entrenched an ongoing competitive inequity against community banks. In effect, government ownership of banks considered “too big to fail” may adversely impact the market for various bank products and services, many of which are considered the financial system’s most profitable.

The Company faces significant competition both in making loans and in attracting deposits. Competition is based on interest rates and other credit and service charges, the quality of services rendered, the convenience of banking facilities, the range and type of products offered and, in the case of loans to larger commercial borrowers, lending limits, among other factors. Competition for loans comes principally from commercial banks, savings banks, savings and loan associations, credit unions, mortgage banking companies, insurance companies, and other financial service companies. The Company’s most direct competition for deposits has historically come from commercial banks, savings banks, and savings and loan associations. Technology has also lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Larger competitors may be able to achieve economies of scale and, as a result, offer a broader range of products and services. The Company’s ability to compete successfully depends on a number of factors, including, among other things:

 

   

the ability to develop, maintain, and build long-term customer relationships based on top quality service, high ethical standards, and safe, sound assets;

 

   

the ability to expand the Company’s market position;

 

   

the scope, relevance, and pricing of products and services offered to meet customer needs and demands;

 

   

the rate at which the Company introduces new products and services relative to its competitors;

 

   

customer satisfaction with the Company’s level of service; and

 

   

industry and general economic trends.

 


Failure to perform in any of these areas could significantly weaken the Company’s competitive position, which could adversely affect growth and profitability.

The Company may not be able to attract and retain skilled people. The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of the services of key personnel of the Company could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel. The Company does not currently have employment agreements or non-competition agreements with any of its senior officers.

The Company does not have the financial and other resources that larger competitors have; this could affect its ability to compete for large commercial loan originations and its ability to offer products and services competitors provide to customers. The northeastern Ohio and central Ohio markets in which the Company operates have high concentrations of financial institutions. Many of the financial institutions operating in our markets are branches of significantly larger institutions headquartered in Cleveland or in other major metropolitan areas, with significantly greater financial resources and higher lending limits. In addition, many of these institutions offer services that the Company does not or cannot provide. For example, the larger competitors’ greater resources offer advantages such as the ability to price services at lower, more attractive levels, and the ability to provide larger credit facilities. Because the Company is currently smaller than many commercial lenders in its market, it is on occasion prevented from making commercial loans in amounts competitors can offer. The Company accommodates loan volumes in excess of its lending limits from time to time through the sale of loan participations to other banks.

The business of banking is changing rapidly with changes in technology, which poses financial and technological challenges to small and mid-sized institutions. With frequent introductions of new technology-driven products and services, the banking industry is undergoing rapid technological changes. In addition to enhancing customer service, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Financial institutions’ success is increasingly dependent upon use of technology to provide products and services that satisfy customer demands and to create additional operating efficiencies. Many of the Company’s competitors have substantially greater resources to invest in technological improvements, which could enable them to perform various banking functions at lower costs than the Company, or to provide products and services that the Company is not able to economically provide. The Company cannot assure you that we will be able to develop and implement new technology-driven products or services or that the Company will be successful in marketing these products or services to customers. Because of the demand for technology-driven products, banks increasingly rely on unaffiliated vendors to provide data processing services and other core banking functions. The use of technology-related products, services, delivery channels, and processes exposes banks to various risks, particularly transaction, strategic, reputation, and compliance risk. The Company cannot assure you that we will be able to successfully manage the risks associated with our dependence on technology.

The banking industry is heavily regulated; the compliance burden to the industry is considerable; the principal beneficiary of federal and state regulation is the public at large and depositors, not stockholders. The Company and its subsidiaries are and will remain subject to extensive state and federal government supervision and regulation. This supervision and regulation affect many aspects of the banking business, including permissible activities, lending, investments, payment of dividends, the geographic locations in which our services can be offered, and numerous other matters. State and federal supervision and regulation are intended principally to protect depositors, the public, and the deposit insurance fund administered by the FDIC. Protection of stockholders is not a goal of banking regulation.

The burdens of federal and state banking regulation place banks in general at a competitive disadvantage compared to less regulated competitors. Applicable statutes, regulations, agency and court interpretations, and agency enforcement policies have undergone significant changes, and could change significantly again. Federal and state banking agencies also require banks and bank holding companies to maintain adequate capital. Failure to maintain adequate capital or to comply with applicable laws, regulations, and supervisory agreements could subject a bank or bank holding company to federal or state enforcement actions, including termination of deposit insurance, imposition of fines and civil penalties, and, in the most severe cases, appointment of a conservator or receiver for a depositary institution. Changes in applicable laws and regulatory policies could adversely affect the banking industry generally or the Company in particular. The Company gives you no assurance that we will be able to adapt successfully to industry changes caused by governmental actions.

Success in the banking industry requires disciplined management of lending risks. There are many risks in the business of lending, including risks associated with the duration over which loans may be repaid, risks resulting from changes in economic conditions, risks inherent in dealing with individual borrowers, and risks resulting from changes in the value of loan collateral. We attempt to mitigate this risk by a thorough review of the creditworthiness of loan customers. Nevertheless, there is risk that our credit evaluations will prove to be inaccurate due to changed circumstances or otherwise.

A critical resource for maintaining the safety and soundness of banks so that they can fulfill their basic function of financial intermediation, the allowance for possible loan losses is a reserve established through a provision for possible loan losses charged to expense that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans.


Current accounting standards for loan loss provisioning are based on the so-called “incurred loss” model. Under this model, a bank can reserve against a loan loss through a provision to the loan loss reserve only if that loss has been “incurred,” which means a loss that is probable and can be reasonably estimated. To meet that standard, banks have to document why a loss is probable and reasonably estimable, and the easiest way to do that is to refer to historical loss rates and the bank’s own prior loss experience with the type of asset in question. Banks are not limited to using historical experience in deciding the appropriate level of the loan loss reserve. In making these determinations, management can use judgment that takes into account other, forward-leaning factors, such as changes in underwriting standards and changes in the economic environment that would have an impact on loan losses. It is changes in the current economic environment that have led us, and may continue to lead management, to take provisions that are higher than our historical experience.

The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires management to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for possible loan losses, the Company will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Company’s financial condition and results of operations.

Changing interest rates have a direct and immediate impact on financial institutions. The risk of nonpayment of loans — or credit risk — is not the only lending risk. Lenders are subject also to interest rate risk. Fluctuating rates of interest prevailing in the market affect a bank’s net interest income, which is the difference between interest earned from loans and investments, on one hand, and interest paid on deposits and borrowings, on the other. Changes in the general level of interest rates can affect our net interest income by affecting the difference between the weighted average yield earned on our interest-earning assets and the weighted average rate paid on our interest-bearing liabilities, or interest rate spread, and the average life of our interest-earning assets and interest-bearing liabilities. Changes in interest rates also can affect (i) our ability to originate loans, (ii) the value of our interest-earning assets, and our ability to realize gains from the sale of such assets, (iii) our ability to obtain and retain deposits in competition with other available investment alternatives, and (iv) the ability of our borrowers to repay adjustable or variable rate loans. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions, and other factors beyond our control. Although the Company believes that the estimated maturities of our interest-earning assets currently are well balanced in relation to the estimated maturities of our interest-bearing liabilities (which involves various estimates as to how changes in the general level of interest rates will impact these assets and liabilities), there can be no assurance that our profitability would not be adversely affected during any period of changes in interest rates.

A prolonged economic downturn in our market area would adversely affect our loan portfolio and our growth prospects. Our lending market area is concentrated in northeastern and central Ohio, particularly Franklin, Geauga, Portage, Trumbull, and Ashtabula Counties. A very significant percentage of our loan portfolio is secured by real estate collateral, primarily residential mortgage loans. Commercial and industrial loans to small and medium-sized businesses also represent a significant percentage of our loan portfolio. The asset quality of our loan portfolio is largely dependent upon the area’s economy and real estate markets. A prolonged economic downturn would likely contribute to the deterioration of the credit quality of our loan portfolio and reduce our level of customer deposits, which in turn would hurt our business. If the current economic downturn in the economy as a whole, or in the northeastern and central Ohio markets continues for a prolonged period, borrowers may be less likely to repay their loans as scheduled or at all. Moreover, the value of real estate or other collateral that may secure our loans could be adversely affected. Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies and geographic locations. A prolonged economic downturn could, therefore, result in losses that could materially and adversely affect our business.

The Company could incur liabilities under federal and state environmental laws if we foreclose on commercial properties. A high percentage of the Company’s loans are secured by real estate. Although the vast majority of these loans are residential mortgage loans with little associated environmental risk, some are commercial loans secured by property on which manufacturing and other commercial enterprises are carried on. The Company has in the past and could again acquire property by foreclosing on loans in default. Under federal and state environmental laws, a bank could face liability for some or all of the costs of removing hazardous substances, contaminants, or pollutants from properties acquired in this fashion. Although other persons might be primarily responsible for these costs, these persons might not be financially solvent or they might be unable to bear the full cost of clean-up. It is also possible that a lender exercising unusual influence over a borrower’s commercial activities could be required to bear a portion of the clean-up costs under federal or state environmental laws.


Changes in accounting standards could materially impact our consolidated financial statements. Our accounting policies and methods are fundamental to how the Company records and reports its financial condition and results of operations. The accounting standard setters, including the Financial Accounting Standards Board, the SEC, and other regulatory bodies, from time to time may change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes can be hard to predict and can materially impact how we record and report our 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. Management may be required to make difficult, subjective, or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions.

There are risks with respect to future expansion and acquisitions or mergers. The Company may seek in the future to acquire other financial institutions or parts of those institutions. The Company may also expand into new markets or lines of business or offer new products or services. These activities would involve a number of risks, including—

 

   

the time and expense associated with identifying and evaluating potential acquisitions and merger partners;

 

   

using inaccurate estimates and judgments to evaluate credit, operations, management, and market risks with respect to the target institution or assets;

 

   

diluting our existing shareholders in an acquisition;

 

   

the time and expense associated with evaluating new markets for expansion, hiring experienced local management, and opening new offices;

 

   

taking a significant amount of time negotiating a transaction or working on expansion plans, resulting in management’s attention being diverted from the operation of our existing business; and

 

   

the time and expense associated with integrating the operations and personnel of the combined businesses, creating an adverse short-term effect on our results of operations.

There is also a risk that any expansion effort will not be successful.

Compliance with Sarbanes-Oxley Act and the Dodd-Frank Act involves significant expenditures, and non-compliance may adversely affect us. The Sarbanes-Oxley Act of 2002 (“SOX”), the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), and the related rules and regulations promulgated by the SEC and the bank regulatory agencies that are now applicable to us have increased the scope, complexity, and cost of corporate governance, reporting, disclosure, and routine banking practices. The Company has experienced and expect to continue to experience greater compliance costs, including costs related to internal controls. We expect the applicability of these rules and regulations to us will continue to increase our accounting, legal, and other costs, and to make some activities more difficult, time consuming, and costly. In the event that the Company is unable to maintain or achieve compliance with SOX, the Dodd-Frank Act, and any related rules, it may be adversely affected.

The Company utilizes the Federal Home Loan Bank as an additional source of liquidity. The Middlefield Banking Company and Emerald Bank are members of the Federal Home Loan Bank (“FHLB”) of Cincinnati, which is one of the twelve regional banks comprising the FHLB System. The FHLB provides credit for member financial institutions. As a member of the FHLB, the Company is required to own stock in the FHLB in proportion to our borrowings. As of December 31, 2011, our investment in FHLB stock totaled $1.9 million. The Company is authorized to apply for advances from the FHLB, which are collateralized in the aggregate by loans, securities, FHLB stock, and by deposits with the FHLB. At December 31, 2011, the Company had approximately $8.6 million in FHLB advances. FHLB advances are only available to borrowers that meet certain conditions. If the Company were to cease meeting these conditions, our access to FHLB advances could be significantly reduced or eliminated.

The 12 FHLBs obtain their funding primarily through issuance of consolidated obligations of the FHLB System. The U.S. government does not guarantee these obligations, and each of the 12 FHLBs are jointly and severally liable for repayment of each other’s debt. Therefore, the Company’s investment in the equity stock of the FHLB of Cincinnati could be adversely impacted by the operations of the other FHLBs. Certain FHLBs, including Cincinnati, have experienced lower earnings from time to time and paid out lower dividends to their members. If a FHLB’s capital drops below 4% of its assets, restrictions on the redemption or repurchase of member banks’ FHLB stock are imposed by law. Should the FHLBs be restricted from redeeming or repurchasing member banks’ FHLB stock due to adverse financial conditions affecting either individual FHLBs or the FHLB System as a whole, member banks may be required to recognize an impairment charge on their FHLB equity stock investments. Future problems at the FHLBs may impact the collateral necessary to secure borrowings and limit the borrowings extended to member banks, as well as require additional capital contributions by member banks. Should this occur, the Company’s short term liquidity needs could be negatively impacted.


Should the Company be restricted from using FHLB advances due to weakness in the FHLB System or with the FHLB of Cincinnati, the Company may be forced to find alternative funding sources. These alternative funding sources may include seeking lines of credit with third party banks or the Federal Reserve Bank, borrowing under repurchase agreement lines, increasing deposit rates to attract additional funds, accessing brokered deposits, or selling certain investment securities categorized as available-for-sale in order to maintain adequate levels of liquidity.

Our deposit insurance premium could be substantially higher in the future which would have an adverse effect on future earnings. The escalating pace of bank failures that began in 2008 has significantly increased the Deposit Insurance Fund’s loss provisions, resulting in a decline in the reserve ratio. The FDIC expects continued insured institution failures in the next few years, which likely will result in a continued decline in the reserve ratio. Increases in the deposit insurance premium assessment rate applicable to us will adversely impact our earnings.

Government regulation could restrict our ability to pay cash dividends. Dividends from the banks are the only significant source of cash for the Company. Statutory and regulatory limits could prevent the banks from paying dividends or transferring funds to the Company. As of December 31, 2011, MBC could have declared dividends of approximately $3.4 million in the aggregate to Company without having to obtain advance regulatory approval. The Company cannot assure you that the Banks’ profitability will continue to allow dividends to the Company, and the Company therefore cannot assure you that the Company will be able to continue paying regular, quarterly cash dividends. Because of the MOU, EB may not pay dividends to the Company unless EB first gives notice to the FDIC and the Ohio Division of Financial Institutions. The Company anticipates that for as long as the MOU is in force EB will not pay dividends to the Company but will instead retain earnings, if any, for the purpose of maintaining capital.

Risks Associated with the Company’s Common Stock

An investment in the Company’s common stock is not an insured deposit. The Company’s common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. As a result, if you acquire the Company’s common stock, you could lose some or all of your investment.

The Company’s common stock is very thinly traded, and it is therefore susceptible to wide price swings. The Company’s common stock is not traded or authorized for quotation on any exchanges, including Nasdaq. However, bid prices for Company common stock appear from time to time in the OTCQB under the symbol “MBCN.” OTCQB is for domestic (U.S.) companies registered with and reporting to the Securities and Exchange Commission or a banking or insurance regulator. Thinly traded, illiquid stocks are more susceptible to significant and sudden price changes than stocks that are widely followed by the investment community and actively traded on an exchange. The liquidity of the Company’s common stock depends upon the presence in the marketplace of willing buyers and sellers. The Company cannot assure you that you will be able to find a buyer for your shares. Two regional broker/dealers facilitate trades of the company common stock, matching interested buyers and sellers. The Company currently does not intend to seek listing of the Company’s common stock on Nasdaq or on another securities exchange. Even if we successfully list the Company’s common stock on a securities exchange, the Company nevertheless could not assure you that an organized public market for the securities will develop or that there will be any private demand for the Company’ common stock. The Company could also fail subsequently to satisfy the standards for continued exchange listing, such as standards having to do with the minimum number of public shareholders or the aggregate market value of publicly held shares. A stock that is not listed on a securities exchange might not be accepted as collateral for loans. If accepted as collateral, the stock’s value could nevertheless be substantially discounted. Consequently, investors should regard the Company’s common stock as a long-term investment and should be prepared to bear the economic risk for an indefinite period. Investors who need or desire to dispose of all or a part of their investments in the Company’s common stock might not be able to do so except by private, direct negotiations with third parties.

We give no assurance that a planned capital infusion will be completed or that we will be able to make use of that additional capital as planned. In a press release included as an exhibit to a Form 8-K Current Report that we filed with the SEC on August 18, 2011, we announced that we had entered into a stock purchase agreement with Bank Opportunity Fund, an affiliate of Hovde Private Equity Advisors LLC. Including warrants accompanying shares to be sold to Bank Opportunity Fund under the agreement, Bank Opportunity Fund would own 24.9% of our stock after completion of the sale transaction. We intend to use the proceeds from the sale of common stock to make capital contributions to and strengthen the balance sheets of our subsidiary banks and for other general corporate purposes, possibly seeking to take advantage of any acquisition or other expansion opportunities that could arise.

Completion of the transactions under the stock purchase agreement is subject to satisfaction of numerous conditions, including receipt of stockholder approval and receipt of regulatory approval. We give no assurance that regulatory approval and stockholder approval will be obtained by the June 30, 2012 deadline established by the stock purchase agreement or that the other conditions to completion of the transaction also will be satisfied by that deadline. We currently are optimistic that all conditions to completion of the transaction will be satisfied and that the transaction will be completed before the end of the second quarter of 2012.


Item 2 — Properties

The Company’s offices are:

 

Location

  

County

  

Owned/Leased

  

Other Information

Main Office:         
15985 East High Street    Geauga    Owned   
Middlefield, Ohio         
Branches :         
West Branch    Geauga    Owned   
15545 West High Street         
Middlefield, Ohio         
Garrettsville Branch    Portage    Owned   
8058 State Street         
Garrettsville, Ohio         
Mantua Branch    Portage    Leased    three-year lease renewed in November 2010, with option to renew for five additional consecutive three-year terms
10519 South Main Street         
Mantua, Ohio         
Chardon Branch    Geauga    Owned   
348 Center Street         
Chardon, Ohio         
Orwell Branch    Ashtabula    Owned   
30 South Maple Avenue         
Orwell, Ohio         
Newbury Branch    Geauga    Leased    ten-year lease dated December 2006, with option to renew for four additional consecutive five-year terms
11110 Kinsman Road         
Newbury, Ohio         
Cortland Branch    Trumbull    Owned   
3450 Niles Cortland
Road
        
Cortland, Ohio         
Emerald Bank    Franklin    Leased    twenty-year lease dated Febuary 2004, with the option to purchase after the tenth year
6215 Perimeter Drive         
Dublin, OH         
Westerville Branch
(Emerald
   Franklin    Owned   
17 North State Street         
Westerville, OH         

At December 31, 2011 the net book value of the Company’s investment in premises and equipment totaled $8.3 million.

Item 3 — Legal Proceedings

From time to time the Company and the banks are involved in various legal proceedings that are incidental to its business. In the opinion of management, no current legal proceedings are material to the financial condition of Company or the Banks, either individually or in the aggregate.

Item 4 — Mine Safety Disclosures

None


Part II

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

Information relating to the market for Middlefield’s common equity and related shareholder matters appears under “Market for the Companies’ Common Equity and Related Stockholder Matters” in the Companies’ 2011 Annual Report to Shareholders and is incorporated herein by reference. Information relating to dividend restrictions for Registrant’s common stock appears under” Supervision and Regulation.”

Equity Compensation Plan information

The following table provides information as of December 31, 2011 with respect to shares of common stock that may be issued under the Company’s existing equity plans which have been previously approved by the stockholders.

 

Plan Category

   Number of
Securities
to be Issued Upon
Exercise of
Outstanding
Options or Rights
     Weighted-Average
Exercise Price of
Outstanding
Options or Rights
 

Equity compensation plans approved by security holders:

     

1999 Stock Option Plan

     58,274       $ 29.64   

2007 Omnibus Equity Plan

     30,500         21.39   
  

 

 

    

 

 

 

Total

     88,774       $ 26.81   

Unregistered Sales of Equity Securities and Use of Proceeds

In 2011 we sold a total of 138,150 shares of common stock in a private offering at $16 per share, for total gross proceeds of $2.2 million. The shares were sold to purchasers qualifying as accredited investors under SEC Rule 501(a), including directors and officers and an institutional purchaser. Conducted without the use of advertising or other general solicitation, the private offering was exempt from registration under the Securities Act of 1933 by section 4 of that statute and by Rule 506 of the SEC’s Regulation D. Shares sold in the offering are subject to the resale limitations of the Securities Act of 1933 and the SEC’s Regulation D. The approximate dates of sale were —

 

approximate date of sale

   number of
shares sold
 

January 19, 2011

     15,625   

January 31, 2011

     24,000   

March 9, 2011

     5,125   

August 9, 2011

     1,500   

August 11, 2011

     3,125   

August 12, 2011

     88,775   

total

     138,150   

As part of the private offering we also entered into a Stock Purchase Agreement with Bank Opportunity Fund LLC. When all conditions specified in the Stock Purchase Agreement are satisfied, we will sell to Bank Opportunity Fund at the cash purchase price


of $16 per share a number of shares and warrants to acquire shares such that Bank Opportunity Fund will own or have the right to acquire ownership of 24.9% of our stock outstanding. The number of shares acquirable by exercise of warrants to be issued to Bank Opportunity Fund is 15% of the total number of common shares issued to Bank Opportunity Fund.

Bank Opportunity Fund LLC is a Delaware limited liability company, established by its managing member Bank Acquisitions LLC, also a Delaware limited liability company. Bank Opportunity Fund was formed to invest primarily in U. S. banks, thrifts, and their holding companies. Bank Opportunity Advisors LLC, another Delaware limited liability company, is the investment adviser for Bank Opportunity Fund. Bank Acquisitions LLC as managing member and Bank Opportunity Advisors LLC as investment adviser manage the day-to-day operations and investment activities of Bank Opportunity Fund. Bank Acquisitions LLC controls Bank Opportunity Fund. Mr. Eric D. Hovde controls both Bank Acquisitions LLC and Bank Opportunity Advisors LLC. Bank Opportunity Fund expects to terminate within ten years.

The exact number of shares and warrants to be issued to Bank Opportunity Fund will be determined at closing of the transaction, but the number is expected to exceed 500,000 shares and warrants to acquire an additional 75,000 shares. Completion of the transaction is subject to numerous conditions specified in the Stock Purchase Agreement, including but not limited to receipt of regulatory approval and receipt of stockholder approval under the Ohio Control Share Acquisition Act.

An agreement we entered into with the institutional investor that purchased 85,200 shares on August 12, 2011 requires the institutional investor to buy more shares so that the institutional investor maintains its ownership interest at 4.9%, although the investor may purchase the shares on the open market if it can acquire the shares on the open market at a lesser price than the $16 price applicable to the purchase of additional shares from us. Accordingly, completion of the transaction with Bank Opportunity Fund will entitle the institutional investor to purchase additional shares at the $16 purchase price. Donnelly Penman & Partners, an investment banking firm in Grosse Point, Michigan, served as sole placement agent for the transaction with Bank Opportunity Fund.

Additional details concerning the private offering and the proposed sale of shares to Bank Opportunity Fund LLC are included in the Form 8-K Current Report, including exhibits, that we filed with the SEC on August 18, 2011.

Item 6 — Selected Financial Data

Not required as the Company is a smaller reporting company.

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

The above-captioned information appears under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s 2012 Annual Report to Shareholders and is incorporated herein by reference.

Item 7A — Quantitative and Qualitative Disclosures About Market Risk

The above-captioned information appears under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the section “ Interest Rate Sensitivity Simulation Analysis” in the Company’s 2012 Annual Report to Shareholders and is incorporated herein by reference.

Item 8 — Financial Statements and Supplementary Data

The Consolidated Financial Statements of the Company and its subsidiaries, together with the report thereon by S.R. Snodgrass, A.C. appears in the Company’s 2012 Annual Report to Shareholders and are incorporated herein by reference.

Item 9 — Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None

Item 9A – Controls and Procedures

 

(a) Disclosure Controls and Procedures

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized


and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

 

(b) Internal Controls Over Financial Reporting

Management’s annual report on internal control over financial reporting is incorporated herein by reference to Item 8 - the Company’s audited Consolidated Financial Statements in this Annual Report on Form 10-K.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

 

(c) Changes to Internal Control Over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the three months ended December 31, 2012 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

Item 9b — Other Information

None

Part III

Item 10 — Directors and Executive Officers of the Registrant

Incorporated by reference to the definitive proxy statement for the 2012 annual meeting of shareholders, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2011.

Item 11 — Executive Compensation

Incorporated by reference to the definitive proxy statement for the 2012 annual meeting of shareholders, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2011.

Item 12 — Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Incorporated by reference to the definitive proxy statement for the 2012 annual meeting of shareholders, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2011. The information required by this item concerning Equity Compensation Plan information is presented under the caption “EQUITY COMPENSATION PLAN INFORMATION” contained in Part II, Item 5. “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”.

Item 13 — Certain Relationships and Related Transactions

Incorporated by reference to the definitive proxy statement for the 2012 annual meeting of shareholders, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2011.

Item 14 — Principal Accountant Fees and Services

Incorporated by reference to the definitive proxy statement for the 2012 annual meeting of shareholders, which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2011.


PART IV

Item 15 — Exhibits, Financial Statement Schedules

(a)(1) Financial Statements

Index to Consolidated Financial Statements :

Consolidated Financial Statements as of December 31, 2011 and 2010 and for each of the three years in the period ended December 31, 2011:

Report of Independent Registered Public Accounting firm

Consolidated Balance Sheets

Consolidated Statements of Income

Consolidated Statements of Changes in Stockholders’ Equity

Consolidated Statements of Cash Flows

Notes to Consolidated Financial Statements

(a)(2) Financial Statement Schedules

Financial Statement Schedules have been omitted because they are not applicable or the required information is shown elsewhere in the document in the Financial Statements or Notes thereto, or in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

(a)(3) Exhibits

See the list of exhibits below

(b) Exhibits Required by Item 601 of Regulation S-K

 

exhibit
number
   description    location
3.1    Second Amended and Restated Articles of Incorporation of Middlefield Banc Corp., as amended    Incorporated by reference to Exhibit 3.1 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2005, filed on March 29, 2006
3.2    Regulations of Middlefield Banc Corp.    Incorporated by reference to Exhibit 3.2 of Middlefield Banc Corp.’s registration statement on Form 10 filed on April 17, 2001
4.0    Specimen stock certificate    Incorporated by reference to Exhibit 4 of Middlefield Banc Corp.’s registration statement on Form 10 filed on April 17, 2001
4.1    Amended and Restated Trust Agreement, dated as of December 21, 2006, between Middlefield Banc Corp., as Depositor, Wilmington Trust Company, as Property trustee, Wilmington Trust Company, as Delaware Trustee, and Administrative Trustees    Incorporated by reference to Exhibit 4.1 of Middlefield Banc Corp.’s Form 8-K Current Report filed on December 27, 2006
4.2    Junior Subordinated Indenture, dated as of December 21, 2006, between Middlefield Banc Corp. and Wilmington Trust Company    Incorporated by reference to Exhibit 4.2 of Middlefield Banc Corp.’s Form 8-K Current Report filed on December 27, 2006


exhibit
number
   description    location
4.3    Guarantee Agreement, dated as of December 21, 2006, between Middlefield Banc Corp. and Wilmington Trust Company    Incorporated by reference to Exhibit 4.3 of Middlefield Banc Corp.’s Form 8-K Current Report filed on December 27, 2006
10.1.0*    1999 Stock Option Plan of Middlefield Banc Corp.    Incorporated by reference to Exhibit 10.1 of Middlefield Banc Corp.’s registration statement on Form 10 filed on April 17, 2001
10.1.1*    2007 Omnibus Equity Plan    Incorporated by reference to Middlefield Banc Corp.’s definitive proxy statement for the 2008 Annual Meeting of Shareholders, Appendix A, filed on April 7, 2008
10.2*    Severance Agreement between Middlefield Banc Corp. and Thomas G. Caldwell, dated January 7, 2008    Incorporated by reference to Exhibit 10.2 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.3*    Severance Agreement between Middlefield Banc Corp. and James R. Heslop, II, dated January 7, 2008    Incorporated by reference to Exhibit 10.3 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.4.0*    Severance Agreement between Middlefield Banc Corp. and Jay P. Giles, dated January 7, 2008    Incorporated by reference to Exhibit 10.4 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.4.1*    Severance Agreement between Middlefield Banc Corp. and Teresa M. Hetrick, dated January 7, 2008    Incorporated by reference to Exhibit 10.4.1 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.4.2    [reserved]   
10.4.3*    Severance Agreement between Middlefield Banc Corp. and Donald L. Stacy, dated January 7, 2008    Incorporated by reference to Exhibit 10.4.3 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.4.4*    Severance Agreement between Middlefield Banc Corp. and Alfred F. Thompson Jr., dated January 7, 2008    Incorporated by reference to Exhibit 10.4.4 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.5    Federal Home Loan Bank of Cincinnati Agreement for Advances and Security Agreement dated September 14, 2000    Incorporated by reference to Exhibit 10.4 of Middlefield Banc Corp.’s registration statement on Form 10 filed on April 17, 2001
10.6*    Amended Director Retirement Agreement with Richard T. Coyne    Incorporated by reference to Exhibit 10.6 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.7*    Amended Director Retirement Agreement with Frances H. Frank    Incorporated by reference to Exhibit 10.7 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.8*    Amended Director Retirement Agreement with Thomas C. Halstead    Incorporated by reference to Exhibit 10.8 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.9*    Director Retirement Agreement with George F. Hasman    Incorporated by reference to Exhibit 10.9 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2001, filed on March 28, 2002


exhibit
number
   description    location
10.10*    Director Retirement Agreement with Donald D. Hunter    Incorporated by reference to Exhibit 10.10 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2001, filed on March 28, 2002
10.11*    Director Retirement Agreement with Martin S. Paul    Incorporated by reference to Exhibit 10.11 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2001, filed on March 28, 2002
10.12*    Amended Director Retirement Agreement with Donald E. Villers    Incorporated by reference to Exhibit 10.12 of Middlefield Banc Corp.’s Form 8-K Current Report filed on January 9, 2008
10.13*    Executive Survivor Income Agreement (aka DBO agreement [death benefit only]) with Donald L. Stacy    Incorporated by reference to Exhibit 10.14 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.14*    DBO Agreement with Jay P. Giles    Incorporated by reference to Exhibit 10.15 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.15*    DBO Agreement with Alfred F. Thompson Jr.    Incorporated by reference to Exhibit 10.16 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.16    [reserved]   
10.17*    DBO Agreement with Theresa M. Hetrick    Incorporated by reference to Exhibit 10.18 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.18*    Executive Deferred Compensation Agreement with Jay P. Giles    filed herewith
10.19*    DBO Agreement with James R. Heslop, II    Incorporated by reference to Exhibit 10.20 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.20*    DBO Agreement with Thomas G. Caldwell    Incorporated by reference to Exhibit 10.21 of Middlefield Banc Corp.’s Annual Report on Form 10-K for the Year Ended December 31, 2003, filed on March 30, 2004
10.21*    Form of Indemnification Agreement with directors of Middlefield Banc Corp. and with executive officers of Middlefield Banc Corp. and The Middlefield Banking Company    Incorporated by reference to Exhibit 99.1 of Middlefield Banc Corp.’s registration statement on Form 10, Amendment No. 1, filed on June 14, 2001
10.22*    Annual Incentive Plan Summary    Incorporated by reference to the summary description of the annual incentive plan included as Exhibit 10.22 of Middlefield Banc Corp.’s Form 8-K Current Report filed on December 16, 2005
10.23*    Amended Executive Deferred Compensation Agreement with Thomas G. Caldwell    Incorporated by reference to Exhibit 10.23 of Middlefield Banc Corp.’s Form 8-K Current Report filed on May 9, 2008


exhibit
number
   description    location
10.24*    Amended Executive Deferred Compensation Agreement with James R. Heslop, II    Incorporated by reference to Exhibit 10.24 of Middlefield Banc Corp.’s Form 8-K Current Report filed on May 9, 2008
10.25*    Amended Executive Deferred Compensation Agreement with Donald L. Stacy    Incorporated by reference to Exhibit 10.25 of Middlefield Banc Corp.’s Form 8-K Current Report filed on May 9, 2008
10.26*    Stock Purchase Agreement dated August 15, 2011 between Bank Opportunity Fund LLC and Middlefield Banc Corp.    Incorporated by reference to Exhibit 10.26 of Middlefield Banc Corp.’s Form 8-K Current Report filed on August 18, 2011
10.26.1    Amendment 1 of the Stock Purchase Agreement with Bank Opportunity Fund LLC (amendment dated September 29, 2011)    filed herewith
10.26.2    Amendment 2 of the Stock Purchase Agreement with Bank Opportunity Fund LLC (amendment dated October 20, 2011)    filed herewith
10.26.3    Amendment 3 of the Stock Purchase Agreement with Bank Opportunity Fund LLC (amendment dated November 28, 2011)    filed herewith
10.26.4    Amendment 4 of the Stock Purchase Agreement with Bank Opportunity Fund LLC (amendment dated December 21, 2011)    filed herewith
10.27    Form of warrant to be issued to Bank Opportunity Fund LLC under the Stock Purchase Agreement    Incorporated by reference to Exhibit 10.27 of Middlefield Banc Corp.’s Form 8-K Current Report filed on August 18, 2011
10.28    Purchaser’s Rights and Voting Agreement dated August 15, 2011 among Bank Opportunity Fund LLC, Middlefield Banc Corp., and directors and officers of Middlefield Banc Corp.    Incorporated by reference to Exhibit 10.28 of Middlefield Banc Corp.’s Form 8-K Current Report filed on August 18, 2011
21    Subsidiaries of Middlefield Banc Corp.    filed herewith
23    Consent of S.R. Snodgrass, A.C., independent auditors of Middlefield Banc Corp.    filed herewith
31.1    Rule 13a-14(a) certification of Chief Executive Officer    filed herewith
31.2    Rule 13a-14(a) certification of Chief Financial Officer    filed herewith
32    Rule 13a-14(b) certification    filed herewith

 

* management contract or compensatory plan or arrangement


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Middlefield Banc Corp.
By:  

/s/ Thomas G. Caldwell

  Thomas G. Caldwell
  President and Chief Executive Officer
  Date: March 20, 2012

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.


/s/ Thomas G. Caldwell

   March 20, 2012

Thomas G. Caldwell

  

President, Chief Executive Officer, and Director

  

/s/ Donald L. Stacy

   March 20, 2012

Donald L. Stacy, Treasurer and Chief Financial Officer

  

(Principal accounting and financial officer)

  

/s/ Richard T. Coyne

   March 20, 2012

Richard T. Coyne, Chairman of the Board

  

/s/ Eric W. Hummel

   March 20, 2012

Eric W. Hummel, Director

  

/s/ James R. Heslop, II

   March 20, 2012

James R. Heslop, II, Executive Vice President,

  

Chief Operating Officer, and Director

  

/s/ Kenneth E. Jones

   March 20, 2012

Kenneth E Jones, Director

  

/s/ James J. McCaskey

   March 20, 2012

James J. McCaskey, Director

  

/s/ Carolyn J. Turk

   March 20, 2012

Carolyn J. Turk, Director

  

/s/ William J. Skidmore

   March 20, 2012

William J. Skidmore, Director

  

/s/ Robert W. Toth

   March 20, 2012

Robert W. Toth, Director

  


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Middlefield Banc Corp.

We have audited the accompanying consolidated balance sheet of Middlefield Banc Corp. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Middlefield Banc Corp. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ending December 31, 2011, in conformity with U.S. generally accepted accounting principles.

 

Wexford, Pennsylvania

March 20, 2012


MIDDLEFIELD BANC CORP.

CONSOLIDATED BALANCE SHEET

(Dollar amounts in thousands)

     December 31,  
     2011     2010  

ASSETS

    

Cash and due from banks

   $ 15,730      $ 10,473   

Federal funds sold

     18,660        20,162   
  

 

 

   

 

 

 

Cash and cash equivalents

     34,390        30,635   

Investment securities available for sale

     193,977        201,772   

Loans

     401,880        372,498   

Less allowance for loan losses

     6,819        6,221   
  

 

 

   

 

 

 

Net loans

     395,061        366,277   

Premises and equipment

     8,264        8,179   

Goodwill

     4,559        4,559   

Bank-owned life insurance

     8,257        7,979   

Accrued interest and other assets

     10,043        12,796   
  

 

 

   

 

 

 

TOTAL ASSETS

   $ 654,551      $ 632,197   
  

 

 

   

 

 

 

LIABILITIES

    

Deposits:

    

Noninterest-bearing demand

   $ 63,348      $ 53,391   

Interest-bearing demand

     55,853        48,869   

Money market

     75,621        71,105   

Savings

     167,207        146,993   

Time

     218,933        244,893   
  

 

 

   

 

 

 

Total deposits

     580,962        565,251   

Short-term borrowings

     7,392        7,632   

Other borrowings

     16,831        19,321   

Accrued interest and other liabilities

     2,113        1,971   
  

 

 

   

 

 

 

TOTAL LIABILITIES

     607,298        594,175   
  

 

 

   

 

 

 

STOCKHOLDERS' EQUITY

    

Common stock, no par value; 10,000,000 shares authorized, 1,951,868 and 1,780,553 shares issued

     31,240        28,429   

Retained earnings

     18,206        15,840   

Accumulated other comprehensive income

     4,541        487   

Treasury stock, at cost; 189,530 shares

     (6,734     (6,734
  

 

 

   

 

 

 

TOTAL STOCKHOLDERS' EQUITY

     47,253        38,022   
  

 

 

   

 

 

 

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

   $ 654,551      $ 632,197   
  

 

 

   

 

 

 

See accompanying notes to the consolidated financial statements.


MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF INCOME

(Dollar amounts in thousands, except per share data)

 

     Year Ended December 31,  
     2011     2010     2009  

INTEREST INCOME

      

Interest and fees on loans

   $ 21,854      $ 21,084      $ 20,271   

Interest-bearing deposits in other institutions

     14        15        15   

Federal funds sold

     12        52        20   

Investment securities:

      

Taxable interest

     4,862        5,185        3,794   

Tax-exempt interest

     2,883        2,650        1,882   

Dividends on stock

     102        108        69   
  

 

 

   

 

 

   

 

 

 

Total interest income

     29,727        29,094        26,051   
  

 

 

   

 

 

   

 

 

 

INTEREST EXPENSE

      

Deposits

     7,467        9,504        10,296   

Short-term borrowings

     235        249        34   

Other borrowings

     400        642        919   

Trust preferred securities

     550        550        534   
  

 

 

   

 

 

   

 

 

 

Total interest expense

     8,652        10,945        11,783   
  

 

 

   

 

 

   

 

 

 

NET INTEREST INCOME

     21,075        18,149        14,268   

Provision for loan losses

     3,085        3,580        2,578   
  

 

 

   

 

 

   

 

 

 

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

     17,990        14,569        11,690   
  

 

 

   

 

 

   

 

 

 

NONINTEREST INCOME

      

Service charges on deposit accounts

     1,512        1,784        1,905   

Investment securities gains (losses), net

     (173     11        (14

Earnings on bank-owned life insurance

     278        273        266   

Other income

     620        555        511   
  

 

 

   

 

 

   

 

 

 

Total noninterest income

     2,237        2,623        2,668   
  

 

 

   

 

 

   

 

 

 

NONINTEREST EXPENSE

      

Salaries and employee benefits

     7,233        6,411        5,938   

Occupancy expense

     953        946        928   

Equipment expense

     556        626        509   

Data processing costs

     693        743        917   

Ohio state franchise tax

     461        348        493   

Federal deposit insurance expense

     966        1,166        707   

Professional fees

     800        678        673   

Losses on other real estate owned

     497        783        183   

Other expense

     3,342        3,062        2,302   
  

 

 

   

 

 

   

 

 

 

Total noninterest expense

     15,501        14,763        12,650   
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     4,726        2,429        1,708   

Income taxes (benefit)

     596        (88     (73
  

 

 

   

 

 

   

 

 

 

NET INCOME

   $ 4,130      $ 2,517      $ 1,781   
  

 

 

   

 

 

   

 

 

 

EARNINGS PER SHARE

      

Basic

   $ 2.45      $ 1.60      $ 1.15   

Diluted

     2.45        1.60        1.15   

DIVIDENDS DECLARED PER SHARE

   $ 1.04      $ 1.04      $ 1.04   

See accompanying notes to the consolidated financial statements.


MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(Dollar amounts in thousands, except dividend per share amount)

 

                         Accumulated                    
                         Other           Total        
     Common Stock      Retained     Comprehensive     Treasury     Stockholders’     Comprehensive  
     Shares      Amount      Earnings     Income (Loss)     Stock     Equity     Income  

Balance, December 31, 2008

     1,725,381       $ 27,301       $ 14,786      $ (295   $ (6,734   $ 35,058     

Net income

           1,781            1,781      $ 1,781   

Other comprehensive income:

                

Unrealized gain on available for sale securities, net of reclasification adjustment,net of taxes of $445

             857          857        857   
                

 

 

 

Comprehensive income

                 $ 2,638   
                

 

 

 

Expense related to stock options

        61               61     

Dividend reinvestment and purchase plan

     28,731         557               557     

Cash dividends ($1.04 per share)

           (1,607         (1,607  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

Balance, December 31, 2009

     1,754,112       $ 27,919       $ 14,960      $ 562      $ (6,734   $ 36,707     

Net income

           2,517            2,517      $ 2,517   

Other comprehensive income:

                

Unrealized loss on available for sale securities, net of reclasification adjustment,net of taxes of ($39)

             (75       (75     (75
                

 

 

 

Comprehensive income

                 $ 2,442   
                

 

 

 

Dividend reinvestment and purchase plan

     26,441         510               510     

Cash dividends ($1.04 per share)

           (1,637         (1,637  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

Balance, December 31, 2010

     1,780,553       $ 28,429       $ 15,840      $ 487      $ (6,734   $ 38,022     

Net income

           4,130            4,130      $ 4,130   

Other comprehensive income:

                

Unrealized gain on available for sale securities, net of reclasification adjustment,net of taxes of $2,088

             4,054          4,054        4,054   
                

 

 

 

Comprehensive income

                 $ 8,184   
                

 

 

 

Stock based compensation expense recognized in earnings

     2,400         59               59     

Common stock issuance (138,150 shares)

     138,150         2,210               2,210     

Dividend reinvestment and purchase plan

     30,765         542               542     

Cash dividends ($1.04 per share)

           (1,764         (1,764  
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

Balance, December 31, 2011

     1,951,868       $ 31,240       $ 18,206      $ 4,541      $ (6,734   $ 47,253     
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   
             2011        2010        2009     
          

 

 

   

 

 

   

 

 

   

Components of comprehensive income (loss):

                

Change in net unrealized gain (loss)on investments available for sale

           $ 3,940      $ (68   $ 848     

Realized losses (gains) included in net income,net of taxes of $59, ($4) and $5

             114        (7     9     
          

 

 

   

 

 

   

 

 

   

Total

           $ 4,054      $ (75   $ 857     
          

 

 

   

 

 

   

 

 

   

See accompanying notes to the consolidated financial statements.


MIDDLEFIELD BANC CORP.

CONSOLIDATED STATEMENT OF CASH FLOWS

(Dollar amounts in thousands)

 

     Year Ended December 31,  
     2011     2010     2009  

OPERATING ACTIVITIES

      

Net income

   $ 4,130      $ 2,517      $ 1,781   

Adjustments to reconcile net income to net cash provided by operating activities:

      

Provision for loan losses

     3,085        3,580        2,578   

Depreciation and amortization

     731        740        680   

Amortization of premium and discount on investment securities

     451        6        (483

Amortization of deferred loan fees, net

     (170     (58     (68

Investment securities (gains) losses, net

     173        (11     14   

Earnings on bank-owned life insurance

     (278     (273     (266

Deferred income taxes

     (97     (777     (469

Stock based compensation expense

     59        —          61   

Loss on other real estate owned

     497        783        183   

Decrease (increase) in accrued interest receivable

     25        (847     35   

Decrease in accrued interest payable

     (145     (115     (394

Decrease (increase) in prepaid federal deposit insurance

     707        727        (2,499

Other, net

     (22     (538     (19
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     9,146        5,734        1,134   
  

 

 

   

 

 

   

 

 

 

INVESTING ACTIVITIES

      

Investment securities available for sale:

      

Proceeds from repayments and maturities

     69,264        42,815        20,674   

Purchases

     (80,078     (113,860     (52,163

Proceeds from sale of securities

     24,127        5,874        816   

Increase in loans, net

     (32,956     (22,992     (34,493

Purchase of Federal Home Loan Bank stock

     —          —          (14

Purchase of premises and equipment

     (583     (327     (467

Proceeds from the sale of other real estate owned

     866        932        100   
  

 

 

   

 

 

   

 

 

 

Net cash used for investing activities

     (19,360     (87,558     (65,547
  

 

 

   

 

 

   

 

 

 

FINANCING ACTIVITIES

      

Net increase in deposits

     15,711        78,145        92,286   

(Decrease) increase in short-term borrowings, net

     (240     832        4,913   

Repayment of other borrowings

     (2,490     (6,544     (8,038

Common stock issued

     2,210        —          —     

Proceeds from dividend reinvestment and purchase plan

     542        510        557   

Cash dividends

     (1,764     (1,637     (1,607
  

 

 

   

 

 

   

 

 

 

Net cash provided by financing activities

     13,969        71,306        88,111   
  

 

 

   

 

 

   

 

 

 

Increase (decrease) in cash and cash equivalents

     3,755        (10,518     23,698   

CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR

     30,635        41,153        17,455   
  

 

 

   

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS AT END OF YEAR

   $ 34,390      $ 30,635      $ 41,153   
  

 

 

   

 

 

   

 

 

 

SUPPLEMENTAL INFORMATION

      

Cash paid during the year for:

      

Interest on deposits and borrowings

   $ 8,797      $ 11,060      $ 12,177   

Income taxes

     615        850        275   

Non-cash investing transactions:

      

Transfers from loans to other real estate owned

   $ 1,257      $ 2,110      $ 1,872   

Loans to facilitate the sale of other real estate owned

     —          257        531   

See accompanying notes to the consolidated financial statements.


MIDDLEFIELD BANC CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting and reporting policies applied in the presentation of the accompanying financial statements follows:

Nature of Operations and Basis of Presentation

Middlefield Banc Corp. (the “Company”) is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (“MBC”). MBC is a state-chartered bank located in Ohio. On April 19, 2007, Middlefield Banc Corp. acquired Emerald Bank (“EB”), an Ohio-chartered commercial bank headquartered in Dublin, Ohio. On October 23, 2009, the Company established an asset resolution subsidiary named EMORECO, Inc. The Company and its subsidiaries derive substantially all of their income from banking and bank-related services, which includes interest earnings on residential real estate, commercial mortgage, commercial and consumer financings as well as interest earnings on investment securities and deposit services to its customers through ten locations. The Company is supervised by the Board of Governors of the Federal Reserve System, while MBC and EB are subject to regulation and supervision by the Federal Deposit Insurance Corporation and the Ohio Division of Financial Institutions.

The consolidated financial statements of the Company include its wholly owned subsidiaries, MBC, EB, and EMORECO, Inc. (the “Banks”). Significant intercompany items have been eliminated in preparing the consolidated financial statements.

The financial statements have been prepared in conformity with U.S. generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ significantly from those estimates.

Investment Securities

Investment securities are classified at the time of purchase, based on management’s intention and ability, as securities held to maturity or securities available for sale. Debt securities acquired with the intent and ability to hold to maturity are stated at cost adjusted for amortization of premium and accretion of discount, which are computed using a level yield method and recognized as adjustments of interest income. Certain other debt securities have been classified as available for sale to serve principally as a source of liquidity. Unrealized holding gains and losses for available-for-sale securities are reported as a separate component of stockholders’ equity, net of tax, until realized. Realized security gains and losses are computed using the specific identification method. Interest and dividends on investment securities are recognized as income when earned.

Common stock of the Federal Home Loan Bank (“FHLB”) represents ownership in an institution that is wholly owned by other financial institutions. This equity security is accounted for at cost and classified with other assets. While the FHLBs have been negatively impacted by economic conditions of the past several years, the FHLB of Cincinnati has reported profits for 2011 and 2010, remains in compliance with regulatory capital and liquidity requirements, and continues to pay dividends on the stock and make redemptions at the par value. With consideration given to these factors, management concluded that the stock was not impaired at December 31, 2011 or 2010.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Securities are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value is other than temporary. For debt securities, management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the investor does not intend to sell the security, and it is more-likely-than-not that it will not be required to sell the security, before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings.

Loans

Loans are reported at their principal amount net of the allowance for loan losses. Interest income is recognized as income when earned on the accrual method. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of principal and interest is doubtful. Payments received on nonaccrual loans are applied against principal according to management’s shadow accounting system.

Loan origination fees and certain direct loan origination costs are being deferred and the net amount amortized as an adjustment of the related loan’s yield. Management is amortizing these amounts over the contractual life of the related loans.

Allowance for Loan Losses

The allowance for loan losses represents the amount which management estimates is adequate to provide for probable loan losses inherent in its loan portfolio. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses which is charged to operations. The provision is based on management’s periodic evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term.

A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the Company expects to collect all amounts due, including interest accrued, at the contractual interest rate for the period of delay. All loans identified as impaired are evaluated independently by management. The Company estimates credit losses on impaired loans based on the present value of expected cash flows or the fair value of the underlying collateral if the loan repayment is expected to come from the sale or operation of such collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until such time, an allowance for loan losses is maintained for estimated losses. Cash receipts on impaired loans are applied first to accrued interest receivable unless otherwise required by the loan terms, except when an impaired loan is also a nonaccrual loan, in which case the portion of the payment related to interest is recognized as income.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Mortgage loans secured by one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. Management determines the significance of payment delays on a case-by-case basis, taking into consideration all circumstances concerning the loan, the creditworthiness and payment history of the borrower, the length of the payment delay, and the amount of shortfall in relation to the principal and interest owed.

Premises and Equipment

Premises and equipment are stated at cost net of accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, which range from 3 to 20 years for furniture, fixtures, and equipment and 3 to 40 years for buildings and leasehold improvements. Expenditures for maintenance and repairs are charged against income as incurred. Costs of major additions and improvements are capitalized.

Goodwill

The Company accounts for goodwill using a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company’s reported net income because impairment losses, in any, could occur irregularly and in varying amounts. The Company performs an annual impairment analysis of goodwill. No impairment of goodwill was recognized in any of the periods presented.

Intangible Assets

Intangible assets include core deposit intangibles, which are a measure of the value of consumer demand and savings deposits acquired in business combinations accounted for as purchases. The core deposit intangibles are being amortized to expense over a 10 year life on a straight-line basis. The recoverability of the carrying value of intangible assets is evaluated on an ongoing basis, and permanent declines in value, if any, are charged to expense.

Bank-Owned Life Insurance (“BOLI”)

The Company owns insurance on the lives of a certain group of key employees. The policies were purchased to help offset the increase in the costs of various fringe benefit plans including healthcare. The cash surrender value of these policies is included as an asset on the Consolidated Balance Sheet and any increases in the cash surrender value are recorded as noninterest income on the Consolidated Statements of Income. In the event of the death of an insured individual under these policies, the Company would receive a death benefit, which would be recorded as noninterest income.

Other Real Estate Owned

Real estate properties acquired through foreclose are initially recorded at the lower of cost or fair values at the date of foreclosure, establishing a new cost basis. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of cost or fair value less estimated cost to sell. Revenue and expenses from operations of the properties, gains or losses on sales and additions to the valuation allowance are included in operating results.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Income Taxes

The Company and its subsidiaries file a consolidated federal income tax return. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Earnings Per Share

The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share are calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options, warrants, and convertible securities are adjusted in the denominator.

Stock-Based Compensation

The Company accounts for stock compensation based on the grant date fair value of all share-based payment awards that are expected to vest, including employee share options to be recognized as employee compensation expense over the requisite service period.

The cash flows from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for stock-based awards (excess tax benefits) are classified as financing cash flows. There were no excess tax benefits recognized in 2011, 2010 and 2009.

For purposes of computing results, the Company estimated the fair values of stock options using the Black-Scholes option-pricing model. The model requires the use of subjective assumptions that can materially affect fair value estimates. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. The fair value of each stock option granted was estimated using the following weighted-average assumptions:

 

Grant

Year

   Expected
Dividend
Yield
    Risk-Free
Interest Rate
    Expected
Volatility
     Expected
Life (in years)
 

2011

     5.82     3.00     21.78         9.96   

During the years ended December 31, 2011, 2010, and 2009, the Company recorded $16,000, $0, and $61,000 of compensation cost related to vested share-based compensation awards granted in 2011 and 2008. As of December 31, 2011, there was no unrecognized compensation cost related to unvested share-based compensation awards granted in 2011 that is expected to be recognized in 2012.

The weighted-average fair value of each stock option granted for 2011 was $1.75.

The company also issued 2,400 shares of stock-based compensation recorded at $43,000 in 2011.

Cash Flow Information

The Company has defined cash and cash equivalents as those amounts included in the Consolidated Balance Sheet captions as “Cash and due from banks” and “Federal funds sold” with original maturities of less than 90 days.

Advertising Costs

Advertising costs are expensed as incurred. Advertising expenses amounted to $439,000, $401,000, and $371,000, for 2011, 2010, and 2009, respectively.

Reclassification of Comparative Amounts

Certain comparative amounts for prior years have been reclassified to conform to current-year presentations. Such reclassifications did not affect net income or retained earnings.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Recent Accounting Pronouncements:

In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The amendments in this Update provide additional guidance or clarification to help creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The amendments in this Update are effective for the first interim or annual reporting period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company has provided the necessary disclosures in Note 4.

In April 2011, the FASB issued ASU 2011-03, Transfers and Services (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. The main objective in developing this Update is to improve the accounting for repurchase agreements (repos) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this Update apply to all entities, both public and nonpublic. The amendments affect all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The guidance in this Update is effective for the first interim or annual period beginning on or after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. This ASU is not expected to have a significant impact on the Company’s financial statements.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments in this Update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. This ASU is not expected to have a significant impact on the Company’s financial statements.

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. The amendments in this Update improve the comparability, clarity, consistency, and transparency of financial reporting and increase the prominence of items reported in other comprehensive income. To increase the prominence of items reported in other comprehensive income and to facilitate convergence of U.S. GAAP and IFRS, the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity was eliminated. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income, and the total of comprehensive income. All entities that report items of comprehensive income, in any period presented, will be affected by the changes in this Update. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2012, and interim and annual periods thereafter. The amendments in this Update should be applied retrospectively, and early adoption is permitted. This ASU is not expected to have a significant impact on the Company’s financial statements.

In September 2011, the FASB issued ASU 2011-08, Intangibles—Goodwill and Other Topics (Topic 350); Testing Goodwill for Impairment. The objective of this Update is to simplify how entities, both public and nonpublic, test goodwill for impairment. The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Under the amendments in this Update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments in this Update apply to all entities, both public and nonpublic, that have goodwill reported in their financial statements and are effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. This ASU is not expected to have a significant impact on the Company’s financial statements.


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

In September 2011, the FASB issued ASU 2011-09, Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80): Disclosures about an Employer’s Participation in a Multiemployer Plan. The amendments in this Update will require additional disclosures about an employer’s participation in a multiemployer pension plan to enable users of financial statements to assess the potential cash flow implications relating to an employer’s participation in multiemployer pension plans. The disclosures also will indicate the financial health of all of the significant plans in which the employer participates and assist a financial statement user to access additional information that is available outside the financial statements. For public entities, the amendments in this Update are effective for annual periods for fiscal years ending after December 15, 2011, with early adoption permitted. For nonpublic entities, the amendments are effective for annual periods of fiscal years ending after December 15, 2012, with early adoption permitted. The amendments should be applied retrospectively for all prior periods presented. This ASU is not expected to have a significant impact on the Company’s financial statements.

In December 2011, the FASB issued ASU 2011-10, Property, Plant, and Equipment (Topic 360): Derecognition of in Substance Real Estate-a Scope Clarification. The amendments in this Update affect entities that cease to have a controlling financial interest in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt. Under the amendments in this Update, when a parent (reporting entity) ceases to have a controlling financial interest in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt, the reporting entity should apply the guidance in Subtopic 360-20 to determine whether it should derecognize the in substance real estate. Generally, a reporting entity would not satisfy the requirements to derecognize the in substance real estate before the legal transfer of the real estate to the lender and the extinguishment of the related nonrecourse indebtedness. That is, even if the reporting entity ceases to have a controlling financial interest under Subtopic 810-10, the reporting entity would continue to include the real estate, debt, and the results of the subsidiary’s operations in its consolidated financial statements until legal title to the real estate is transferred to legally satisfy the debt. The amendments in this Update should be applied on a prospective basis to deconsolidation events occurring after the effective date. Prior periods should not be adjusted even if the reporting entity has continuing involvement with previously derecognized in substance real estate entities. For public entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning on or after June 15, 2012. For nonpublic entities, the amendments are effective for fiscal years ending after December 15, 2013, and interim and annual periods thereafter. Early adoption is permitted. This ASU is not expected to have a significant impact on the Company’s financial statements.

In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. The amendments in this Update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. This information will enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. This ASU is not expected to have a significant impact on the Company’s financial statements.

In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. In order to defer only those changes in Update 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this Update supersede certain pending paragraphs in Update 2011-05. Entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before Update 2011-05. All other requirements in Update 2011-05 are not affected by this Update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. Nonpublic entities should begin applying these requirements for fiscal years ending after December 15, 2012, and interim and annual periods thereafter. This ASU is not expected to have a significant impact on the Company’s financial statements.


2. EARNINGS PER SHARE

There are no convertible securities that would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income will be used as the numerator. The following table sets forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.

 

     2011     2010     2009  

Weighted average common shares outstanding

     1,872,582        1,764,743        1,736,769   

Average treasury stock shares

     (189,530     (189,530     (189,530
  

 

 

   

 

 

   

 

 

 

Weighted average common shares and common stock equivalents used to calculate basic earnings per share

     1,683,052        1,575,213        1,547,239   

Additional common stock equivalents (stock options) used to calculate diluted earnings per share

     —          608        740   
  

 

 

   

 

 

   

 

 

 

Weighted average common shares and common stock equivalents used to calculate diluted earnings per share

     1,683,052        1,575,821        1,547,979   
  

 

 

   

 

 

   

 

 

 

Options to purchase 88,774 shares of common stock at prices ranging from $17.55 to $40.24 were outstanding during the year ended December 31, 2011, but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price being greater than the average market price as of December 31, 2011. Options to purchase 89,077 shares of common stock at prices ranging from $22.33 to $40.24 were outstanding during the year ended December 31, 2010, but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price being greater than the average market price as of December 31, 2010. Options to purchase 89,077 shares of common stock at prices ranging from $22.33 to $40.24 were outstanding during the year ended December 31, 2009, but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price being greater than the average market price as of December 31, 2009.


3. INVESTMENT SECURITIES AVAILABLE FOR SALE

The amortized cost and fair values of securities available for sale are as follows:

 

     December 31, 2011  
            Gross      Gross        
     Amortized      Unrealized      Unrealized     Fair  
(Dollar amounts in thousands)    Cost      Gains      Losses     Value  

U.S. government agency securities

   $ 31,520       $ 427       $ (14     31,933   

Obligations of states and political subdivisions:

          

Taxable

     8,207         766         —          8,973   

Tax-exempt

     75,807         3,681         (61     79,427   

Mortgage-backed securities in government sponsored-entities

     63,808         1,819         (54     65,573   

Private-label mortgage-backed securities

     7,005         411         (95     7,321   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total debt securities

     186,347         7,104         (224     193,227   

Equity securities in financial institutions

     750         —           —          750   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 187,097       $ 7,104       $ (224   $ 193,977   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

     December 31, 2010  
            Gross      Gross        
     Amortized      Unrealized      Unrealized     Fair  
     Cost      Gains      Losses     Value  

U.S. government agency securities

   $ 33,332       $ 111       $ (840 )$      32,603   

Obligations of states and political subdivisions:

          

Taxable

     7,371         80         (34     7,417   

Tax-exempt

     69,363         1,058         (958     69,463   

Mortgage-backed securities in government sponsored-entities

     73,390         2,270         (654     74,043   

Private-label mortgage-backed securities

     16,636         55         (328     17,326   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total debt securities

     200,092         3,574         (2,814     200,852   

Equity securities in financial institutions

     944         80         (104     920   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 201,036       $ 3,654       $ (2,918   $ 201,772   
  

 

 

    

 

 

    

 

 

   

 

 

 

The amortized cost and fair value of debt securities at December 31, 2011, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.


3. INVESTMENT SECURITIES AVAILABLE FOR SALE (Continued)

 

     Amortized      Fair  
(Dollar amounts in thousands)    Cost      Value  

Due in one year or less

   $ 2,084       $ 2,140   

Due after one year through five years

     4,802         5,113   

Due after five years through ten years

     17,087         18,053   

Due after ten years

     162,374         167,921   
  

 

 

    

 

 

 

Total

   $ 186,347       $ 193,227   
  

 

 

    

 

 

 

Investment securities with an approximate carrying value of $53,724,000 and $51,734,000 at December 31, 2011 and 2010, respectively, were pledged to secure deposits and other purposes as required by law.

Proceeds from sales of investment securities available for sale were $24,127,000 during 2011. Gross gains and gross losses realized were $830,000 and $809,000, respectively, during 2011. Proceeds from sales of investment securities available for sale were $5,874,000 during 2010. Gross gains and gross losses realized were $74,000 and $29,000, respectively, during 2010. Proceeds from sales of investment securities available for sale were $816,000 during 2009. Gross gains and gross losses realized were $74,000 and $0, respectively, during 2009.

The following table shows the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2011 and 2010.

 

     December 31, 2011  
     Less than Twelve Months     Twelve Months or Greater     Total  
            Gross            Gross            Gross  
     Fair      Unrealized     Fair      Unrealized     Fair      Unrealized  
(Dollar amounts in thousands)    Value      Losses     Value      Losses     Value      Losses  

U.S. government agency securities

   $ 1,986       $ (14   $ —         $ —        $ 1,986       $ (14

Obligations of states and political subdivisions

     2,707         (40     919         (21     3,626         (61

Mortgage-backed securities in government-sponsored entities

     8,992         (54     —           —          8,992         (54

Private-label mortgage-backed securities

     1,628         (42     398         (53     2,026         (95
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 15,313       $ (150   $ 1,317       $ (74   $ 16,630       $ (224
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

     December 31, 2010  
     Less than Twelve Months     Twelve Months or Greater     Total  
            Gross            Gross            Gross  
     Fair      Unrealized     Fair      Unrealized     Fair      Unrealized  
     Value      Losses     Value      Losses     Value      Losses  

U.S. government agency securities

   $ 24,406       $ (840   $ —         $ —        $ 24,406       $ (840

Obligations of states and political subdivisions

     35,846         (940     439         (52     36,285         (992

Mortgage-backed securities in government-sponsored entities

     27,792         (654     —           —          27,792         (654

Private-label mortgage-backed securities

     510         (11     2,480         (317     2,990         (328

Equity securities in financial institutions

     —           —          590         (104     590         (104
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 88,554       $ (2,445   $ 3,509       $ (473   $ 92,063       $ (2,918
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

There were 19 and 138 securities that were considered temporarily impaired at December 31, 2011 and 2010.


3. INVESTMENT SECURITIES AVAILABLE FOR SALE (Continued)

On a quarterly basis, the Company performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment (“OTTI”) pursuant to FASB ASC Topic 320 Investments — Debt and Equity Securities. A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. The accounting literature requires the Company to assess whether the unrealized loss is other-than-temporary. Prior to the adoption of FSP FAS 115-2, which was subsequently incorporated into FASB ASC Topic 320 Investments — Debt and Equity Securities, unrealized losses that were determined to be temporary were recorded, net of tax, in other comprehensive income for available for sale securities, whereas unrealized losses related to held-to-maturity securities determined to be temporary were not recognized. Regardless of whether the security was classified as available for sale or held to maturity, unrealized losses that were determined to be other than temporary were recorded to earnings. An unrealized loss was considered other than temporary if (i) it was probable that the holder would not collect all amounts due according to the contractual terms of the debt security, or (ii) the fair value was below the amortized cost of the debt security for a prolonged period of time and the Company did not have the positive intent and ability to hold the security until recovery or maturity.

OTTI losses are recognized in earnings when the Company has the intent to sell the debt security or it is more likely than not that it will be required to sell the debt security before recovery of its amortized cost basis. However, even if the Company does not expect to sell a debt security, it must evaluate expected cash flows to be received and determine if a credit loss has occurred.

Under this ASC, an unrealized loss is generally deemed to be other than temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result the credit loss component of an OTTI is recorded as a component of investment securities gains (losses) in the accompanying Consolidated Statement of Income, while the remaining portion of the impairment loss is recognized in other comprehensive income, provided the Company does not intend to sell the underlying debt security and it is “more likely than not” that the Company will not have to sell the debt security prior to recovery.

Debt securities issued by U.S. government agencies, U.S. government-sponsored enterprises, and state and political subdivisions accounted for more than 96.2 percent of the total available-for-sale portfolio as of December 31, 2011, and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government and the lack of significant unrealized loss positions within the obligations of state and political subdivisions security portfolio. The Company’s assessment was concentrated mainly on private-label collateralized mortgage obligations of approximately $7.0 million, for which the Company evaluates credit losses on a quarterly basis. Gross unrealized gain and loss positions related to these private-label collateralized mortgage obligations amounted to $411,000 and $95,000, respectively. The Company considered the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

 

   

The length of time and the extent to which the fair value has been less than the amortized cost basis.

 

   

Changes in the near term prospects of the underlying collateral of a security such as changes in default rates, loss severity given default and significant changes in prepayment assumptions.

 

   

The level of cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities.

 

   

Any adverse change to the credit conditions and liquidity of the issuer, taking into consideration the latest information available about the overall financial condition of the issuer, credit ratings, recent legislation and government actions affecting the issuer’s industry and actions taken by the issuer to deal with the present economic climate.

The Company determined equity securities in financial institutions to be other than temporarily impaired and recognized a loss of $194,000 in 2011. In 2010, investment in a private-label collateralized mortgage obligation was deemed impaired, resulting in a loss of $35,000. OTTI of $88,000 was also taken in 2009. These figures represent a before-tax, non-cash charge, and were recorded as reductions to noninterest income.


4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES

Major classifications of loans at December 31 are summarized as follows (in thousands):

 

     2011     2010  

Commercial and industrial

   $ 59,185      $ 57,501   

Real estate—construction

     21,545        15,845   

Real estate—mortgage:

    

Residential

     208,139        209,863   

Commercial

     108,502        84,304   

Consumer installment

     4,509        4,985   
  

 

 

   

 

 

 
     401,880        372,498   

Less allowance for loan losses

     (6,819     (6,221
  

 

 

   

 

 

 

Net loans

   $ 395,061      $ 366,277   
  

 

 

   

 

 

 

The Company’s primary business activity is with customers located within its local trade area, eastern Geauga County, and contiguous counties to the north, east, and south. The Company also serves the central Ohio market with offices in Dublin and Westerville, Ohio. Commercial, residential, consumer, and agricultural loans are granted. Although the Company has a diversified loan portfolio at December 31, 2011 and 2010, loans outstanding to individuals and businesses are dependent upon the local economic conditions in its immediate trade area.

The following table summarizes the primary segments of the loan portfolio as of December 31, 2011 and 2010 (in thousands):

 

                   Real Estate- Mortgage                
     Commercial      Real estate-                    Consumer         
December 31, 2011    and industrial      construction      Residential      Commercial      installment      Total  

Total loans

   $ 59,185       $ 21,545       $ 208,139       $ 108,502       $ 4,509       $ 401,880   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Individually evaluated for impairment

   $ 4,492       $ 867       $ 4,882       $ 6,491       $ —         $ 16,732   

Collectively evaluated for impairment

     54,693         20,678         203,257         102,011         4,509         385,148   
                   Real estate- Mortgage                
     Commercial      Real estate-                    Consumer         
December 31, 2010    and industrial      construction      Residential      Commercial      installment      Total  

Total loans

   $ 57,501       $ 15,845       $ 209,863       $ 84,304       $ 4,985       $ 372,498   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Individually evaluated for impairment

   $ 5,477       $ 1,299       $ 4,329       $ 6,266       $ 17       $ 17,388   

Collectively evaluated for impairment

     52,024         14,546         205,534         78,038         4,968         355,110   

The Company’s loan portfolio is segmented to a level that allows management to monitor risk and performance. The portfolio is segmented into Commercial and Industrial (“C & I”), Real Estate Construction, Real Estate – Mortgage, which is further segmented into Residential and Commercial real estate, and Consumer Installment Loans. The C&I loan segment consists of loans made for the purpose of financing the activities of commercial customers. The residential mortgage loan segment consists of loans made for the purpose of financing the activities of residential homeowners. The commercial mortgage loan segment consists of loans made for the purposed of financing the activities of commercial real estate owners and operators. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.


4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES (Continued)

Management evaluates individual loans in all of the commercial segments for possible impairment if the loan is greater than $150,000 and if the loan is either in nonaccrual status or is risk-rated Special Mention or Substandard and is greater than 90 days past due. Loans are considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. The Company does not separately evaluate individual consumer and residential mortgage loans for impairment, unless such loans are part of larger relationship that is impaired.

Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan with the fair value of the loan using one of three methods: (a) the present value of expected future cash flows discounted at the loan’s effective interest rate; (b) the loan’s observable market price; or (c) the fair value of the collateral less selling costs. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. The evaluation of the need and amount of a specific allocation of the allowance and whether a loan can be removed from impairment status is made on a quarterly basis. The Company’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.

The following tables present impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary as of December 31, 2011 and 2010 (in thousands):


4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES (Continued)

For the Year Ended December 31, 2011

Impaired Loans

 

      Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment
     Interest
Income
Recognized
 

With no related allowance recorded:

              

Commercial and industrial

   $ 1,172       $ 1,172       $ —         $ 2,079       $ 57   

Real estate—construction

     4,250         4,250         —           1,462         201   

Real estate—mortgage:

              

Residential

     3,188         3,193         —           1,153         157   

Commercial

     2,528         2,536         —           2,403         76   

Consumer installment

     24         24         —           13         2   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

With an allowance recorded:

              

Commercial and industrial

   $ 465       $ 465       $ 196       $ 1,062       $ 1   

Real estate—construction

     271         271         125         137         15   

Real estate—mortgage:

              

Residential

     —           —           —           287         —     

Commercial

     2,555         2,560         551         2,258         21   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total:

              

Commercial and industrial

   $ 1,637       $ 1,637       $ 196       $ 3,141       $ 58   

Real estate—construction

     4,521         4,521         125         1,599         216   

Real estate—mortgage:

              

Residential

     3,188         3,193         —           1,440         157   

Commercial

     5,083         5,096         551         4,660         97   

Consumer installment

     24         24         —           13         2   

 

For the Year Ended December 31, 2010                                   

Impaired Loans

 

 
      Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment
     Interest
Income
Recognized
 

With no related allowance recorded:

              

Commercial and industrial

   $ 2,494       $ 2,503       $ —         $ 2,157       $ 13   

Real estate—construction

     618         614         —           543         1   

Real estate—mortgage:

              

Residential

     —           —           —           —           —     

Commercial

     1,764         1,758         —           1,372         17   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

With an allowance recorded:

              

Commercial and industrial

   $ 655       $ 657       $ 203       $ 629       $ —     

Real estate—construction

     —           —           —           —           —     

Real estate—mortgage:

              

Residential

     594         594         221         594         —     

Commercial

     1,556         1,556         188         663         52   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total:

              

Commercial and industrial

   $ 3,149       $ 3,160       $ 203       $ 2,786       $ 13   

Real estate—construction

     618         614         —           543         1   

Real estate—mortgage:

              

Residential

     594         594         221         594         —     

Commercial

     3,320         3,314         188         2,035         69   

The table above includes troubled debt restructuring totaling $10.0 million and $1.6 million and as of December 31, 2011 and 2010, respectively.

For the year ended December 31, 2009, average recorded investment in impaired loans was $3.8 million and the interest income recognized on those loans was $33,000.


4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES (Continued)

The following table summarizes the troubled debt restructurings as of December 31, 2011 and 2010 (in thousands):

Modifications

As of December 31, 2011

 

               

Troubled Debt Restructurings

   Number of
Contracts
     Pre-Modification
Outstanding
Recorded Investment
     Post-Modification
Outstanding
Recorded Investment
 

Commercial and industrial

     8       $ 586       $ 586   

Real estate—construction

     2         3,883         3,883   

Real estate—mortgage:

        

Residential

     10         1,639         1,639   

Commercial

     2         1,625         1,625   

Consumer Installment

     2         24         24   

 

Troubled Debt Restructurings

subsequently defaulted

   Number of
Contracts
     Recorded Investment  

Commercial and industrial

     —           —     

Real estate—construction

     —           —     

Real estate—mortgage:

     

Residential

     —           —     

Commercial

     —           —     

Consumer Installment

     —           —     

 

As of December 31, 2010

 

 

Troubled Debt Restructurings

   Number of
Contracts
     Pre-Modification
Outstanding
Recorded Investment
     Post-Modification
Outstanding
Recorded Investment
 

Commercial and industrial

     7       $ 668       $ 668   

Real estate—construction

     —           —           —     

Real estate—mortgage:

        

Residential

     8         1,230         1,230   

Commercial

     3         2,025         2,025   

Consumer Installment

     3         43         43   

 

Troubled Debt Restructurings

subsequently defaulted

   Number of
Contracts
     Recorded Investment  

Commercial and industrial

     1         15   

Real estate—construction

     —           —     

Real estate—mortgage:

     

Residential

     1         98   

Commercial

     —           —     

Consumer Installment

     —           —     

Management uses a nine-point internal risk-rating system to monitor the credit quality of the overall loan portfolio. The first five categories are considered not criticized and are aggregated as Pass-rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification. Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due are considered Substandard. Any portion of a loan that has been charged off is placed in the Loss category.


4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES (Continued)

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Company has a structured loan-rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as bankruptcy, repossession, or death, occurs to raise awareness of a possible credit event. The Company’s Commercial Loan Officers are responsible for the timely and accurate risk rating of the loans in their portfolios at origination and on an ongoing basis. The Credit Department performs an annual review of all commercial relationships $200,000 or greater. Confirmation of the appropriate risk grade is included in the review on an ongoing basis. The Company has an experienced Loan Review Department that continually reviews and assesses loans within the portfolio. The Company engages an external consultant to conduct loan reviews on a semiannual basis. Generally, the external consultant reviews commercial relationships greater than $250,000 and/or criticized relationships greater than $125,000. Detailed reviews, including plans for resolution, are performed on loans classified as Substandard on a quarterly basis. Loans in the Special Mention and Substandard categories that are collectively evaluated for impairment are given separate consideration in the determination of the allowance.

The following table presents the classes of the loan portfolio summarized by the aggregate Pass rating and the criticized categories of Special Mention, Substandard, and Doubtful within the internal risk rating system as of December 31, 2011 and 2010 (in thousands):

 

      Pass      Special
Mention
     Substandard      Doubtful      Total
Loans
 

December 31, 2011

              

Commercial and industrial

   $ 53,645       $ 1,104       $ 4,363       $ 73       $ 59,185   

Real estate—construction

     20,883         —           662         —           21,545   

Real estate—mortgage:

              

Residential

     192,534         1,100         14,505         —           208,139   

Commercial

     100,536         443         7,523         —           108,502   

Consumer installment

     4,495         6         8         —           4,509   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 372,093       $ 2,653       $ 27,061       $ 73       $ 401,880   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
      Pass      Special
Mention
     Substandard      Doubtful      Total
Loans
 

December 31, 2010

              

Commercial and industrial

   $ 52,008       $ 903       $ 4,366       $ 224       $ 57,501   

Real estate—construction

     14,481