10-K 1 f10kmiddleburg.htm f10kmiddleburg.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2009
 
Commission file number 0-24159
 
MIDDLEBURG FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
 
Virginia
(State or other jurisdiction
of incorporation or organization)
54-1696103
(I.R.S. Employer
Identification No.)
111 West Washington Street
Middleburg, Virginia
(Address of principal executive offices)
 
20117
(Zip Code)
Registrant’s telephone number, including area code (703) 777-6327
 
Securities registered pursuant to Section 12(b) of the Act:
 
 
Title of each class
Name of each exchange
on which registered
None
n/a
Securities registered pursuant to Section 12(g) of the Act:
 
Common Stock, par value $2.50 per share
(Title of class)
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  ¨    No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section  15(d) of the Act.  Yes  ¨    No  x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web side, if any every interactive data file required toe be submitted and posted pursuant to Rule 405 of Regulation S-T(§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  ¨   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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ¨   
Accelerated filer  x
   
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)
Smaller reporting company  ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  ¨    No  x
 
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.  $68,707,051
 
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.  6,917,738 shares of Common Stock as of March 4, 2010
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Proxy Statement for the 2010 Annual Meeting of Shareholders – Part III

 
 

 

TABLE OF CONTENTS



PART I
 
   
Page
ITEM 1.
BUSINESS
3
ITEM 1A.
RISK FACTORS
17
ITEM 1B.
UNRESOLVED STAFF COMMENTS
23
ITEM 2.
PROPERTIES
24
ITEM 3.
LEGAL PROCEEDINGS
25
ITEM 4.
RESERVED
26
 
   
PART II
 
     
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
 
   
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
 
   
EQUITY SECURITIES
27
ITEM 6.
SELECTED FINANCIAL DATA
29
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
 
   
CONDITION AND RESULTS OF OPERATION
30
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
 
   
MARKET RISK
55
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
56
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
 
   
ON ACCOUNTING AND FINANCIAL DISCLOSURE
57
ITEM 9A.
CONTROLS AND PROCEDURES
57
ITEM 9B.
OTHER INFORMATION
58
     
PART III
 
     
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
 
   
GOVERNANCE
58
ITEM 11.
EXECUTIVE COMPENSATION
58
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
 
   
OWNERS AND MANAGEMENT AND RELATED
 
   
STOCKHOLDER MATTERS
58
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
 
   
AND DIRECTOR INDEPENDENCE
59
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
59
     
PART IV
 
     
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
59

 
 

 

PART I

ITEM 1.
BUSINESS

General

Middleburg Financial Corporation (the “Company”) is a bank holding company that was incorporated under Virginia law in 1993.  The Company conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc., both of which are chartered under Virginia law.  The Company has one other wholly owned subsidiary, MFC Capital Trust II, which is a Delaware Business Trust that the Company formed in connection with the issuance of trust preferred debt in December 2003.

Middleburg Bank

Middleburg Bank opened for business on July 1, 1924 and has continuously offered banking products and services to surrounding communities since that date.  Middleburg Bank has seven full service facilities and two limited service facilities.  The main office is located at 111 West Washington Street, Middleburg, Virginia 20117.  Middleburg Bank has two full service facilities and one limited service facility in Leesburg, Virginia.  Other full service facilities are located in Ashburn, Purcellville, Reston and Warrenton, Virginia.  Middleburg Bank has a limited service facility located in Marshall, Virginia.

Middleburg Bank serves the Virginia counties of Loudoun, Fairfax and Fauquier.  Loudoun County is in northwestern Virginia and included in the Washington-Baltimore metropolitan statistical area.  According to the Loudoun County Department of Economic Development, the county’s estimated population was approximately 288,556 as of January 1, 2010.  The local economy is driven by service industries, including but not limited to, professional and technical services requiring a high skill level; federal, state and local government; construction; and retail trade.  Fairfax County is in northern Virginia and is included in the Washington-Baltimore metropolitan statistical area.  According to the latest data on Fairfax County government’s Web Site, the county’s population exceeds 1.0 million residents as of January 1, 2010.  The local economy is driven by service industries and federal, state and local governments.  Fauquier County is in northern Virginia and is included in the Washington-Baltimore metropolitan statistical area.  Fauquier County’s estimated population on January 1, 2010 was 72,685.  The local economy is driven by service industries and agriculture.

Middleburg Bank has one wholly owned subsidiary, Middleburg Bank Service Corporation.  Middleburg Bank Service Corporation is a partner in two limited liability companies, Bankers Title Shenandoah, LLC, which sells title insurance through its members, and Bankers Insurance, LLC, which acts as a broker for insurance sales for its member banks.  In the first quarter of 2008, Middleburg Bank Service Corporation was a partner in Bank Investment Group, LLC.  In April 2008, Bankers Investment Group was acquired by Infinex Financial Group.  As part of the acquisition, Middleburg Bank Service Corporation received an ownership interest in Infinex Financial Group.  Infinex Financial Group acts as a broker dealer for sales of investment products to clients of its member banks.

Middleburg Bank owns 57.1% of the issued and outstanding membership interest units of Southern Trust Mortgage, LLC.  The remaining 42.9% of issued and outstanding membership interest units are owned by other partners.  The ownership of these partners is represented in the financial statements as “Non-controlling interest in consolidated subsidiary.”  Southern Trust Mortgage is a regional mortgage lender headquartered in Virginia Beach, Virginia and has offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.

Middleburg Investment Group

Middleburg Investment Group is a non-bank holding company that was formed in the fourth quarter of 2005.  It has one wholly-owned subsidiary, Middleburg Trust Company which in turn wholly owns Middleburg Investment Advisors, Inc.

 
3

 


Middleburg Trust Company is chartered under Virginia law and opened for business in January 1994.  Its main office is located at 821 East Main Street, Richmond, Virginia, 23219.  Middleburg Trust Company serves primarily the greater Richmond area including the counties of Henrico, Chesterfield, Hanover, Goochland and Powhatan.  Richmond is the capital of the Commonwealth of Virginia, and the greater Richmond area had an estimated population in excess of 1.2 million in 2008 based on the 2000 U.S. Census.  In 2008, Middleburg Trust Company opened a new office in Williamsburg, Virginia.  According to the 2000 U.S. Census, Williamsburg and the surrounding counties had an estimated population of 135,000 in 2008.  Middleburg Trust Company also serves the counties of Fairfax, Fauquier and Loudoun with staff available to several of Middleburg Bank’s facilities.

Middleburg Investment Advisors, Inc. is an investment advisor registered with the Securities and Exchange Commission (the “SEC”).  Its main office is located at 1901 North Beauregard Street, Alexandria, Virginia, 22311.  Middleburg Investment Advisors primarily serves the District of Columbia metropolitan area including contingent markets in Virginia and Maryland but also has clients in 24 other states.

Prior to December of 2009, Middleburg Investment Advisors, Inc. was a wholly owned subsidiary of Middleburg Investment Group. In December of 2009, Middleburg Investment Group transferred its ownership in Middleburg Investment Advisors to Middleburg Trust Company and Middleburg Investment Advisors became a wholly owned subsidiary of Middleburg Trust Company.

Products and Services

The Company, through its subsidiaries, offers a wide range of banking, fiduciary and investment management services to both individuals and small businesses.  Middleburg Bank’s services include various types of checking and savings deposit accounts, and the making of business, real estate, development, mortgage, home equity, automobile and other installment, demand and term loans.  Also, Middleburg Bank offers ATMs at eight facilities and at two offsite locations.  Additional banking services available to the Company’s clients include, but are not limited to, internet banking, travelers’ checks, money orders, safe deposit rentals, collections, notary public and wire services.  Southern Trust Mortgage offers mortgage banking services to residential borrowers in six states within the southeastern United States.  Southern Trust Mortgage operates as Middleburg Mortgage within all of the Company’s financial service centers to provide mortgage banking services for the Company’s clients.

Middleburg Investment Group offers wealth management services through its two subsidiaries and through the investment services department of Middleburg Bank.  Middleburg Trust Company provides a variety of investment management and fiduciary services including trust and estate settlement.  Middleburg Trust Company can also serve as escrow agent, attorney-in-fact, and guardian of property or trustee of an IRA.  Middleburg Investment Advisors provides fee based investment management services for the Company’s clients.  The investment services department of Middleburg Bank provides investment brokerage services for the Company’s clients.

Employees

As of December 31, 2009, the Company and its subsidiaries had a total of 340 full time equivalent employees, including 162 employees at Southern Trust Mortgage.  The Company considers relations with its employees to be excellent.  The Company’s employees are not represented by a collective bargaining unit.

U.S. Securities and Exchange Commission Filings

The Company maintains an internet website at www.middleburgbank.com.  Shareholders of the Company and the public may access the Company’s periodic and current reports (including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports) filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of

 
4

 

1934, as amended, through the “Shareholder Relations” section of the Company’s website. The reports are made available on this website as soon as practicable following the filing of the reports with the SEC. The information is free of charge and may be reviewed, downloaded and printed from the website at any time.

Segment Reporting

The Company operates in a decentralized fashion in three principal business activities: commercial and retail banking services; wealth management services; and mortgage banking services.  Revenue from commercial and retail banking activities consists primarily of interest earned on loans and investment securities and service charges on deposit accounts.

Revenue from the wealth management activities is comprised mostly of fees based upon the market value of the accounts under administration as well as commissions on investment transactions. The wealth management services are conducted by Middleburg Trust Company, Middleburg Investment Advisors, Inc. and the investment services department of Middleburg Bank.

Revenue from the mortgage banking activities is comprised of interest earned on loans and fees received as a result of the mortgage origination process.  The Company recognizes gains on the sale of mortgages as part of Other Income.  The mortgage banking services are conducted by Southern Trust Mortgage.

Middleburg Bank and the Company have assets in custody with Middleburg Trust Company and accordingly pay Middleburg Trust Company a monthly fee.  Middleburg Bank also pays interest to Middleburg Trust Company, Middleburg Investment Advisors and Southern Trust Mortgage on deposit accounts that each company has at Middleburg Bank.  Southern Trust Mortgage has an outstanding line of credit for which it pays interest to Middleburg Bank.  Middleburg Bank provides office space and data processing services to Southern Trust Mortgage for which it receives rental and fee income.  Middleburg Investment Advisors pays the Company a management fee each month for accounting and other services provided.  Transactions related to these relationships are eliminated to reach consolidated totals.

The following tables present segment information for the years ended December 31, 2009, 2008 and 2007.

 
2009
 
Retail
 
Wealth
 
Mortgage
 
Inter-company
   
(In Thousands)
Banking
 
Management
 
Banking
 
Eliminations
 
Consolidated
Revenues:
                                   
Interest income
$
  49,143
 
$
8
   
$
8,855
   
$
(1,260)
   
$
     56,746
 
Wealth management fees
 
         --
   
3,873
     
--
     
(76)
     
      3,797
 
Other income
 
       3,965
   
--
     
13,228
     
(78)
     
    17,115
 
Total operating income
$
  53,108
 
$
3,881
   
$
22,083
   
$
(1,414)
   
$
      77,658
 
Expenses:
                                   
Interest expense
$
   18,495
 
$
--
   
$
1,846
   
$
  (1,260)
   
$
19,081
 
Salaries and employee benefits
 
    12,560
   
       2,895
     
12,560
     
29
     
28,044
 
Provision for loan losses
 
    4,564
   
--
     
(13)
     
--
     
4,551
 
Other
 
    15,491
   
       1,500
     
4,011
     
(183)
     
      20,819
 
Total operating expenses
$
  51,110
 
$
       4,395
   
$
18,404
   
$
  (1,414)
   
$
      72,495
 
Income before income taxes
$
       1,998
 
$
        (514)
   
$
3,679
   
$
--
   
$
       5,163
 
Provision for income taxes
 
       255
   
       (191)
     
--
     
--
     
            64
 
Net income
$
       1,743
 
$
 (323)
   
$
3,679
   
$
     --
   
$
       5,099
 
Non-controlling interest in
                                   
 consolidated subsidiary
 
        --
   
--
     
--
     
1,577
     
       1,577
 
Net income attributable to
                                   
 Middleburg Financial Corporation
$
       1,743
 
$
 (323)
   
$
3,679
   
$
(1,577)
   
$
3,522
 
Total assets
$
966,004
 
$
6,293
   
$
56,978
   
$
(52,902)
   
$
  976,373
 
Capital expenditures
$
1,922
 
$
11
   
$
47
   
$
--
   
$
1,980
 
Goodwill and identified intangibles
$
        --
 
$
4,664
   
$
1,867
   
$
--
   
$
6,531
 
 
2008
 
Retail
 
Wealth
 
Mortgage
 
Inter-company
   
(In Thousands)
Banking
 
Management
 
Banking
 
Eliminations
 
Consolidated
Revenues:
                                   
Interest income
$
  50,103
 
$
29
   
$
5,990
   
$
(200)
   
$
55,922
 
Wealth management fees
 
         --
   
4,253
     
--
     
(83)
     
4,170
 
Other income
 
       2,357
   
95
     
10,412
     
(130)
     
12,734
 
Total operating income
$
  52,460
 
$
4,377
   
$
16,402
   
$
(413)
   
$
72,826
 
Expenses:
                                   
Interest expense
$
   21,128
 
$
--
   
$
1,791
   
$
  (200)
   
$
22,719
 
Salaries and employee benefits
 
    12,065
   
2,795
     
10,516
     
--
     
25,376
 
Provision for loan losses
 
    3,621
   
--
     
1,640
     
--
     
5,261
 
Other
 
    11,644
   
1,560
     
4,232
     
(213)
     
17,223
 
Total operating expenses
$
  48,458
 
$
4,355
   
$
18,179
   
$
  (413)
   
$
70,579
 
Income before income taxes
$
       4,002
 
$
22
   
$
(1,777)
   
$
--
   
$
2,247
 
Provision for income taxes
 
       362
   
   82
     
--
     
--
     
         444
 
Net income
$
       3,640
 
$
 (60)
   
$
(1,777)
   
$
     --
   
$
1,803
 
Non-controlling interest in
                                   
 consolidated subsidiary
 
        --
   
--
     
--
     
757
     
757
 
Net income attributable to
                                   
 Middleburg Financial Corporation
$
       3,640
 
$
 (60)
   
$
(1,777)
   
$
757
   
$
2,560
 
Total assets
$
  933,652
 
$
6,514
   
$
51,709
   
$
(6,684)
   
$
  985,191
 
Capital expenditures
$
       3,162
 
$
282
   
$
275
   
$
--
   
$
3,719
 
Goodwill and identified intangibles
$
        --
 
$
4,877
   
$
1,867
   
$
--
   
$
6,744
 

 
2007
 
Retail
 
Wealth
 
Mortgage
 
Inter-company
   
(In Thousands)
Banking
 
Management
 
Banking
 
Eliminations
 
Consolidated
Revenues:
                                   
Interest income
$
  49,599
 
$
58
   
$
   --
   
$
(29)
   
$
49,628
 
Wealth management fees
 
         --
   
4,979
     
--
     
(89)
     
4,890
 
Other income
 
       2,853
   
--
     
--
     
(41)
     
2,812
 
Total operating income
$
  52,452
 
$
5,037
   
$
--
   
$
(159)
   
$
57,330
 
Expenses:
                                   
Interest expense
$
   22,470
 
$
--
   
$
--
   
$
  (29)
   
$
22,441
 
Salaries and employee benefits
 
    10,829
   
2,728
     
--
     
--
     
13,557
 
Provision for loan losses
 
    1,786
   
--
     
--
     
--
     
1,786
 
Other
 
    14,481
   
1,547
     
--
     
(130)
     
15,898
 
Total operating expenses
$
  49,566
 
$
4,275
   
$
--
   
$
  (159)
   
$
53,682
 
Income before income taxes
$
       2,886
 
$
762
   
$
--
   
$
--
   
$
3,648
 
Provision for income taxes
 
       251
   
   333
     
--
     
--
     
         584
 
Net income
$
       2,635
 
$
 429
   
$
--
   
$
     --
   
$
3,064
 
Non-controlling interest in
                                   
 consolidated subsidiary
 
        --
   
--
     
--
     
--
     
--
 
Net income attributable to
                                   
 Middleburg Financial Corporation
$
       2,635
 
$
 429
   
$
--
   
$
--
   
$
3,064
 
Total assets
$
  836,899
 
$
6,900
   
$
--
   
$
(2,399)
   
$
  841,400
 
Capital expenditures
$
       3,734
 
$
35
   
$
--
   
$
--
   
$
3,769
 
Goodwill and identified intangibles
$
        --
 
$
5,215
   
$
--
   
$
--
   
$
5,215
 


Competition

The Company’s commercial and retail banking segment faces significant competition for both loans and deposits.  Competition for loans comes from commercial banks, savings and loan associations and savings banks, mortgage banking subsidiaries of regional commercial banks, subsidiaries of national mortgage bankers, insurance companies, and other institutional lenders.  Its most direct competition for deposits has historically come from commercial banks, credit unions, savings banks, savings and loan associations and other financial institutions.  Based upon total deposits at June 30, 2009, as reported to the Federal Deposit Insurance Corporation (the “FDIC”), the Company has the largest share of deposits with 19.2% market share among banking organizations operating in Loudoun County, Virginia.  The Company’s Reston location, as of the latest FDIC report, has 0.08% of the $43.0 billion in deposits in the Fairfax County market.  The Company’s market share among banking organizations operating in Fauquier County, as of the latest FDIC report, is 5.9% of the

 
5

 

$1.2 billion in deposits.  The Company also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds.

The Company’s wealth management segment faces competition on several fronts.  Middleburg Trust Company competes for clients and accounts with banks, other financial institutions and money managers.  Even though many of these institutions have been engaged in the trust or investment management business for a considerably longer period of time than Middleburg Trust Company and have significantly greater resources, Middleburg Trust Company has grown through its commitment to quality trust and investment management services and a local community approach to business.  Middleburg Investment Advisors competes for its clients and accounts with other money managers and investment brokerage firms.  Like the rest of the Company, Middleburg Investment Advisors is dedicated to quality service and high investment performance for its clients.  Middleburg Investment Advisors has successfully operated in its markets for 28 years.  The investment services department of Middleburg Bank competes with local and on-line investment brokerage firms.

Competition for the Company’s mortgage banking segment, Southern Trust Mortgage is largely from other mortgage banking entities.  Traditional financial institutions, investment banking companies and internet sources for mortgages also add to the competitive market for mortgages.

Lending Activities

Credit Policies

The principal risk associated with each of the categories of loans in Middleburg Bank’s portfolio is the creditworthiness of its borrowers.  Within each category, such risk is increased or decreased, depending on prevailing economic conditions.  In an effort to manage the risk, Middleburg Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position and level of experience.  The risk associated with real estate mortgage loans, commercial and consumer loans varies, based on market employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness.  The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

Middleburg Bank has written policies and procedures to help manage credit risk.  Middleburg Bank utilizes an outside third party loan review process that includes regular portfolio reviews to establish loss exposure and to ascertain compliance with Middleburg Bank’s loan policy.

Middleburg Bank has three levels of lending authority.  Individual loan officers are the first level and are limited to their lending authority.  The second level is the Officers Loan Committee, which is composed of four officers of Middleburg Bank, including the Company’s Chairman, the President and Chief Executive Officer, and the Senior Lending Officer.  The Officers Loan Committee approves loans that exceed the individual loan officers’ lending authority and reviews loans to be presented to the Directors Loan Committee.  The Directors Loan Committee is composed of seven Directors, of which five are independent Directors.  The Directors Loan Committee approves new, modified and renewed credits that exceed Officer Loan Committee authorities.  The Chairman of the Directors Loan Committee is the Chairman of the Company.   A quorum is reached when four committee members are present, of which at least three must be independent Directors.  An application requires four votes to receive approval by this committee.  In addition, the Directors Loan Committee reports all new loans reviewed and approved to Middleburg Bank’s Board of Directors monthly.  Monthly reports shared with the Directors Loan Committee include names and monetary amounts of all new credits in excess of $12,500 or which had been extended; a watch list including names, monetary amounts, risk rating and payment status; non accruals and charge offs as recommended and a list of overdrafts in excess of $1,500 and which have been overdrawn more than four days.  The Directors Loan Committee also reviews lending policies proposed by management.

 
6

 

In the normal course of business, Middleburg Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its annual financial statements including commitments to extend credit.  At December 31, 2009, commitments to extend credit totaled $84.6 million.

Construction Lending

Middleburg Bank makes local construction loans, primarily residential, and land acquisition and development loans.  The construction loans are primarily secured by residential houses under construction and the underlying land for which the loan was obtained.  At December 31, 2009, construction, land and land development loans outstanding were $72.9 million, or 11.3%, of total loans.  Approximately 71.9% of these loans are concentrated in the Loudoun, Fairfax and Fauquier County, Virginia markets.  The average life of a construction loan is approximately 12 months and will reprice monthly to meet the market, typically the prime interest rate plus one percent.  Because the interest rate charged on these loans floats with the market, the construction loans help the Company in managing its interest rate risk.  Construction lending entails significant additional risks, compared with residential mortgage lending.  Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Another risk involved in construction lending is attributable to the fact that loan funds are advanced upon the security of the land or home under construction, which value is estimated prior to the completion of construction.  Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios.  To mitigate the risks associated with construction lending, Middleburg Bank generally limits loan amounts to 75% to 85% of appraised value, in addition to analyzing the creditworthiness of its borrowers.  Middleburg Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrowing entity’s principal owners.

Commercial Business Loans

Commercial business loans generally have a higher degree of risk than residential mortgage loans, but have higher yields.  To manage these risks, Middleburg Bank generally obtains appropriate collateral and personal guarantees from the borrowing entity’s principal owners and monitors the financial condition of its business borrowers.  Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from his employment and other income and are secured by real estate whose value tends to be readily ascertainable.  In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory.  As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself.  Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.  Middleburg Bank has an outside third party loan review and monitoring process to regularly assess the repayment ability of commercial borrowers.  At December 31, 2009, commercial loans totaled $43.4 million, or 6.7% of total loans.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in Middleburg Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches.  At December 31, 2009, commercial real estate loans aggregated $240.7 million, or 37.4%, of Middleburg Bank’s total loans.
 
 
In its underwriting of commercial real estate, Middleburg Bank may lend, under internal policy, up to 80% of the secured property’s appraised value. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending.  Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy generally. Middleburg Bank’s commercial real estate loan underwriting criteria

 
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require an examination of debt service coverage ratios and the borrower’s creditworthiness, prior credit history and reputation.  Middleburg Bank also evaluates the location of the security property and typically requires personal guarantees or endorsements of the borrowing entity’s principal owners.

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by Middleburg Bank’s loan originator solicitation, referrals by real estate professionals, existing or new bank clients and purchases of whole loans from Southern Trust Mortgage.  Loan applications are taken by a Bank loan officer.  As part of the application process, information is gathered concerning income, employment and credit history of the applicant.  Loan originations are underwritten using Middleburg Bank’s underwriting guidelines.  Security for the majority of Middleburg Bank’s residential lending is in the form of owner occupied one-to-four-family dwellings. The valuation of residential collateral is provided by independent fee appraisers who have been approved by Middleburg Bank’s Board of Directors.

Middleburg Bank also originates a non-conforming adjustable rate product (“ARM”) with a higher entry level rate and margin than that of the conforming adjustable rate products.  This non-conforming loan provides yet another outlet for loans not meeting secondary market guidelines.  Middleburg Bank keeps these loans in its loan portfolio.  Interest rates on ARM products offered by Middleburg Bank are tied to fixed rates issued by the Federal Home Loan Bank of Atlanta plus a spread.  Middleburg Bank’s ARM products contain interest rate caps at adjustment periods and rate ceilings based on a cap over and above the original interest rate.

At December 31, 2009, $267.7 million, or 41.6%, of Middleburg Bank’s loan portfolio consisted of one-to four-family residential real estate loans and home equity lines.  Of the $267.7 million, $181.3 million were fixed rate mortgages while the remaining $86.4 million were adjustable rate mortgages.   The fixed rate loans are typically 3, 5, 7 or 10 year balloon loans amortized over a 30 year period.  Middleburg Bank has about $91.4  million in fixed rate loans that have maturities of 15 years or greater.  Approximately $45.2 million of fixed rate loans have maturities of 5 years or less.

In connection with residential real estate loans, Middleburg Bank requires title insurance, hazard insurance and if required, flood insurance.  Flood determination letters with life of loan tracking are obtained on all federally related transactions with improvements serving as security for the transaction.

Consumer Lending

Middleburg Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans.  At December 31, 2009, Middleburg Bank had consumer loans of $16.9 million or 2.6% of gross loans.  Such loans are generally made to customers with whom Middleburg Bank has a pre-existing relationship.  Middleburg Bank currently originates all of its consumer loans in its geographic market area.  Most of the consumer loans are tied to the prime lending rate and reprice monthly.

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

 
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which it has against the seller of the underlying collateral.  Consumer loan delinquencies often increase over time as the loans age.

The underwriting standards employed by Middleburg Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.  Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Supervision and Regulation

General

As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System.  As a state-chartered commercial bank, Middleburg Bank is subject to regulation, supervision and examination by the Virginia State Corporation Commission’s Bureau of Financial Institutions.  It is also subject to regulation, supervision and examination by the Federal Reserve Board.  Other federal and state laws, including various consumer and compliance laws, govern the activities of Middleburg Bank, the investments that it makes and the aggregate amount of loans that it may grant to one borrower.

The following description summarizes the significant federal and state laws applicable to the Company and its subsidiaries.  To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.

The Bank Holding Company Act

Under the Bank Holding Company Act, the Company is subject to periodic examination by the Federal Reserve and required to file periodic reports regarding its operations and any additional information that the Federal Reserve may require.  Activities at the bank holding company level are limited to:

 
·
banking, managing or controlling banks;
 
·
furnishing services to or performing services for its subsidiaries; and
 
·
engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.

Some of the activities that the Federal Reserve Board has determined by regulation to be proper incidents to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.

With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

 
·
acquiring substantially all the assets of any bank;
 
·
acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or
 
·
merging or consolidating with another bank holding company.

In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company.  Control is conclusively presumed to exist if an individual or

 
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company acquires 25% or more of any class of voting securities of a bank holding company.  Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and either has registered securities under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or no other person owns a greater percentage of that class of voting securities immediately after the transaction.  The regulations provide a procedure for challenging this rebuttable control presumption.

In November 1999, Congress enacted the Gramm-Leach-Bliley Act (the “GLBA”), which made substantial revisions to the statutory restrictions separating banking activities from other financial activities.  Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.”  As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities.  Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries.  For example, insurance activities would be subject to supervision and regulation by state insurance authorities.  Although the Company has not elected to become a financial holding company in order to exercise the broader activity powers provided by the GLBA, the Company will likely elect do so in the future.

Payment of Dividends

The Company is a legal entity separate and distinct from its banking and non-banking subsidiaries.  The majority of the Company’s revenues are from dividends paid to the Company by its subsidiaries.  Middleburg Bank is subject to laws and regulations that limit the amount of dividends it can pay.  In addition, both the Company and Middleburg Bank are subject to various regulatory restrictions relating to the payment of dividends, including requirements to maintain capital at or above regulatory minimums.  Banking regulators have indicated that banking organizations should generally pay dividends only if the organization’s net income available to common shareholders over the past year has been 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 Company does not expect that any of these laws, regulations or policies will materially affect the ability of Middleburg Bank to pay dividends.  During the year ended December 31, 2009, Middleburg Bank paid $3.2 million in dividends to the Company.  No dividends were paid to the Company from the non-banking subsidiaries.

The FDIC has the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice.  The FDIC has indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.

In addition, during most of 2009 the Company was subject to restrictions on its ability to pay dividends on common stock as a result of the Company’s participation in the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”).  In connection with that program, the Company issued preferred stock and a warrant to purchase common stock to the Treasury on January 30, 2009.  The preferred stock was in a superior ownership position compared to common stock, and dividends were required to be paid on the preferred stock before they could be paid on the common stock.  In addition, the consent of the Treasury generally was required for the Company to increase its common stock dividend or repurchase its stock common or other equity or capital securities prior to January 30, 2012.  If the Company did not pay dividends on the preferred stock for an aggregate of six (6) quarterly dividend periods or more, whether or not consecutive, the Company’s authorized number of directors automatically would increase by two (2) and the holders of the Preferred Stock would have the right to elect those directors at the Company’s next annual meeting or at a special meeting called for that purpose; these two directors would be elected annually and would serve until all accrued and unpaid dividends for all past dividend periods had been declared and paid in full.  As a result of the Company’s redemption of the preferred stock in December 2009, the Company is no longer subject to these restrictions or requirements.

 
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Insurance of Accounts, Assessments and Regulation by the FDIC

The deposits of Middleburg Bank are insured by the FDIC up to the limits set forth under applicable law.  The deposits of Middleburg Bank subsidiary are subject to the deposit insurance assessments of the Deposit Insurance Fund (“DIF”) of the FDIC.

The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations.  In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks.  The FDIC has authority to impose special assessments from time to time.

The maximum deposit insurance amount per depositor has been increased from $100,000 to $250,000 until December 31, 2013.  On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except for individual retirement accounts and other certain retirement accounts which will remain at $250,000 per depositor.

In May 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured financial institution’s total assets minus its tier 1 capital as of June 30, 2009 to be paid on September 30, 2009.  This special assessment assisted the FDIC in the replenishment of the DIF as a result of the increase in financial institution failures during 2008 and 2009.  The special assessment imposed on Middleburg Bank was $480,000.  In November 2009, the FDIC adopted a final rule to require insured financial institutions to prepay three years of estimated insurance assessments.  This prepayment allows the FDIC to strengthen the cash position of the DIF immediately without immediately impacting earnings of the industry.  The payment of the prepaid assessment was due on December 30, 2009.  Middleburg Bank’s prepaid assessment was $6.9 million.

The FDIC is authorized to prohibit any DIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund.  Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital.  If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC.  The Company is not aware of any existing circumstances that could result in termination of any of Middleburg Bank’s deposit insurance.

Capital Requirements

The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises.  Under the risk-based capital requirements, the Company and Middleburg Bank are each generally required to maintain a minimum ratio of total risk-based capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%.  At least half of the total risk-based capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles and ineligible deferred tax assets.  The remainder may consist of “Tier 2 Capital,” which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance.  In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations.  Under these requirements, banking organizations must maintain a minimum ratio of Tier

 
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1 capital to adjusted average quarterly assets equal to 4%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  In sum, the capital measures used by the federal banking regulators are:

 
·
the Total Capital ratio, which includes Tier 1 Capital and Tier 2 Capital;

 
·
the Tier 1 Capital ratio; and

 
·
the leverage ratio.

Under these regulations, a bank will be:

 
·
“well capitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1 Capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;

 
·
“adequately capitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1 Capital ratio of 4% or greater, and a leverage ratio of 4% or greater – or 3% in certain circumstances – and is not well capitalized;

 
·
“undercapitalized” if it has a Total Capital ratio of less than 8%, a Tier 1 Capital ratio of less than 4% - or 3% in certain circumstances;

 
·
“significantly undercapitalized” if it has a Total Capital ratio of less than 6%, a Tier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%; or

 
·
“critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets.

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

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

Other Safety and Soundness Regulations

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent.  For example, under the requirements of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit

 
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resources to support such institutions in circumstances where it might not do so otherwise.  In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the insolvency of commonly controlled insured depository institutions or for any assistance provided by the FDIC to commonly controlled insured depository institutions in danger of failure.  The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in the best interests of the deposit insurance funds.  The FDIC’s claim for reimbursement under the cross guarantee provisions is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and nonaffiliated holders of subordinated debt of the commonly controlled insured depository institutions.

Monetary Policy

The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board.  The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowing and changes in reserve requirements against deposits held by all federally insured banks.  The Federal Reserve Board’s monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.  In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary fiscal authorities, including the Federal Reserve Board, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand of Middleburg Bank or the business and earnings of the Company.

Federal Reserve System

In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits.  NOW accounts, money market deposit accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements, as are any non-personal time deposits at an institution.  For net transaction accounts in 2010, the first $10.7 million will be exempt from reserve requirements, compared to $9.3 million in 2009.  A three percent reserve ratio will be assessed on net transaction accounts over $10.7 million up to and including $44.5 million, compared to $9.3 million up to and including $34.6 million in 2009.  A ten percent reserve ratio will be applied above $44.5 million in 2010, compared to $34.6 million in 2009.  These percentages are subject to adjustment by the Federal Reserve Board.  Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets.

Transactions with Affiliates

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act.  An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank.  Generally, Sections 23A and 23B:

 
·
limit the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus; and
 
·
require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a non-affiliate.

The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.

 
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Loans to Insiders

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks.  Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one borrower limit.  Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100,000,000, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus.  Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting.  The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000).  Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

Community Reinvestment Act

Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice.  The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs.  Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard.  Banking regulators consider a depository institution’s Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution.  An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiaries.

The Gramm-Leach-Bliley Act and federal bank regulators have made various changes to the Community Reinvestment Act.  Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulator.  A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a “satisfactory” rating in its latest Community Reinvestment Act examination.

Fair Lending; Consumer Laws

In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business.  Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers experience discrimination in their efforts to obtain loans from depository and other lending institutions.  These agencies have brought litigation against depository institutions alleging discrimination against borrowers.  Many of these suits have been settled, in some cases for material sums, short of a full trial.

These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence

 
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that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations.  These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.

Gramm-Leach-Bliley Act of 1999

The GLBA covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies.  The following description summarizes some of its significant provisions.

The GLBA permits unrestricted affiliations between banks and securities firms.  It also permits bank holding companies to elect to become financial holding companies.  A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities.  In order to become a financial holding company, a bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating.

The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities.  Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law.  Under the new law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.

The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the SEC for securities affiliates, and state insurance regulators for insurance affiliates.  It repeals the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Exchange Act, as amended.  It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a set of activities in which a bank may engage without being deemed a “dealer.”  Additionally, the new law makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.

The GLBA contains extensive customer privacy protection provisions.  Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information.  The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure.  An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes.  The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.

 
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Bank Secrecy Act

Under the Bank Secrecy Act, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction.  Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury.  In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.  The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution’s compliance with the BSA when reviewing applications from a financial institution.  As part of its BSA program, the USA PATRIOT Act also requires a financial institution to follow customer identification procedures when opening accounts for new customers and to review lists of individuals who and entities which are prohibited from opening accounts at financial institutions.

Emergency Economic Stabilization Act of 2008

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008 (“ESSA”) was signed into law on October 3, 2008.  Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, Treasury Secretary Paulson, after consulting with the Federal Reserve and the FDIC, announced that the Department of the Treasury would purchase equity stakes in certain banks and thrifts.  Under this program, known as the Capital Purchase Program, the Treasury would make $250 billion of capital available to U.S. financial institutions in the form of preferred stock (from the $700 billion authorized by the EESA).  In conjunction with the purchase of preferred stock, the Treasury would receive warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment.  Participating financial institutions would be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the Capital Purchase Program.  On January 30, 2009, the Company opted to participate in the Capital Purchase Program and issued $22 million of preferred stock to the Treasury.  As a result, the Company was subject to the executive compensation and corporate governance requirements of Section III of EESA.  In December 2009, the Company redeemed the preferred stock in full and, as a result, is no longer subject to these requirements.

Future Regulatory Uncertainty

Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, the Company cannot forecast how federal regulation of financial institutions may change in the future and impact its operations.  Although Congress in recent years has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, the Company fully expects that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.

Middleburg Trust Company

Middleburg Trust Company operates as a trust subsidiary of Middleburg Investment Group, which is a subsidiary of the Company.  It is subject to supervision and regulation by the Virginia State Corporation Commission’s Bureau of Financial Institutions and the Federal Reserve Board.

State and federal regulators have substantial discretion and latitude in the exercise of their supervisory and regulatory authority over Middleburg Trust Company, including the statutory authority to promulgate regulations affecting the conduct of business and the operations of Middleburg Trust Company.  They also have

 
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the ability to exercise substantial remedial powers with respect to Middleburg Trust Company in the event that it determines that Middleburg Trust Company is not in compliance with applicable laws, orders or regulations governing its operations, is operating in an unsafe or unsound manner, or is engaging in any irregular practices.

Middleburg Investment Advisors

Middleburg Investment Advisors operates as a subsidiary of Middleburg Trust Company, which is a subsidiary of Middleburg Investment Group, which in turn is a subsidiary of the Company.  It is subject to supervision and regulation by the Securities and Exchange Commission under the Investment Advisors Act of 1940.  The Investment Advisors Act of 1940 requires registered investment advisers to comply with numerous and pervasive obligations, including, among other things, record-keeping requirements, operational procedures, registration and reporting and disclosure obligations.  State regulatory authorities also provide similar oversight and regulation.


ITEM 1A.                      RISK FACTORS

The Company is subject to various risks, including the risks described below.  The Company’s (“We” or “Our”) operations, financial condition and performance and, therefore, the market value of our securities  could be materially adversely affected by any of these risks or additional risks not presently known or that we currently deem immaterial.

We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.

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

 
·
open new financial service centers;
 
·
attract deposits to those locations; and
 
·
identify attractive loan and investment opportunities.

We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future.  Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth, maintain cost controls and asset quality and successfully integrate any new financial service centers into our organization.

As we continue to implement our growth strategy by opening new financial service centers, we expect to incur construction costs and increased personnel, occupancy and other operating expenses.  We generally must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets.  Thus, our plans to grow could depress our earnings in the short run, even if we efficiently execute this growth.

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

Our banking subsidiary faces vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area.  A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services.  Our non-banking subsidiary faces competition from money managers and investment brokerage firms.

 
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To a limited extent, our banking subsidiary also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can.  Many of our non-bank competitors are not subject to the same extensive regulations that govern us.  As a result, these non-bank competitors have advantages over us in providing certain services.  This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.

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

Our profitability will depend in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities.  Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, the volume of loan originations in our mortgage banking business and the value we can recognize on the sale of mortgage and home equity loans in the secondary market.  We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it.  Based on our asset/liability position at December 31, 2009, a rise in interest rates would reduce our net interest income in the short term.  Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.

Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.
 
 
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans.  Many of our loans are secured by real estate (both residential and commercial) in our market area.  At December 31, 2009, approximately 37.4% and 41.6% of our $644.3 million total loan portfolio were secured by commercial and residential real estate, respectively.  A major change in the real estate market, such as deterioration in the value of this collateral, or in the local or national economy, could adversely affect our clients’ ability to pay these loans, which in turn could negatively impact us.  While we are in one of the fastest growing real estate markets in the United States, risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully.  We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

We may be adversely affected by economic conditions in our market area.

Our banking operations are located primarily in the Virginia counties of Loudoun, Fairfax and Fauquier.  Because our lending is concentrated in this market, we will be affected by the general economic conditions in the greater Washington, D.C. metropolitan area.  Changes in the economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing.  A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control would impact the demand for banking products and services generally, which could negatively affect our financial condition and performance.

A loss of our senior officers could impair our relationship with our customers and adversely affect our business.

Many community banks attract customers based on the personal relationships that the banks’ officers and customers establish with each other and the confidence that the customers have in the officers.  We depend on the performance of our senior officers.  These officers have many years of experience in the banking industry and have numerous contacts in our market area.  The loss of the services of any of our senior officers, or the failure of any of them to perform management functions in the manner anticipated by our board of directors, could have a material adverse effect on our business.  Our success will be dependent upon the board’s ability to

 
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attract and retain quality personnel, including these individuals.  We do not carry key man life insurance on our senior officers.

Many of the loans in our loan portfolio are too new to show any sign of problems.

Due to the economic growth in our market area and the opening of new financial service centers, a significant portion of our loans have been originated in the past several years.  In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process known as ‘seasoning.”  As a result, a portfolio of older loans will usually behave more predictably than a newer portfolio.  Although we believe we have conservative underwriting standards, it is more difficult to assess the future performance of the loan portfolio due to the recent origination of many of the loans.  Thus, there can be no assurance that charge-offs in the future periods will not exceed the allowance for loan losses or that additional increases in the allowance for loan losses will not be required.

If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.

Our business strategy calls for continued growth.  We anticipate that we will be able to support this growth through the generation of additional deposits at new branch locations as well as investment opportunities.  However, we may need to raise additional capital in the future to support our continued growth and to maintain our capital levels.  Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time.  We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.

Our profitability and the value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels.  Recently enacted, proposed and future banking legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry.  These regulations, which are intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence our earnings and growth.  Our success depends on our continued ability to maintain compliance with these regulations.  Some of these regulations may increase our costs and thus place other financial institutions that are not subject to similar regulation in stronger, more favorable competitive positions.

Revenue from our mortgage lending investment is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market or higher interest rates and may adversely impact our profits.

Maintaining our revenue stream from our mortgage banking subsidiary, Southern Trust Mortgage, is dependent upon its ability to originate loans and sell them to investors.  Loan production levels are sensitive to changes in economic conditions and can suffer from decreased economic activity, a slowdown in the housing market or higher interest rates.  Generally, any sustained period of decreased economic activity or higher interest rates could adversely affect Southern Trust Mortgage’s mortgage originations and, consequently, reduce its income from mortgage lending activities.  As a result, these conditions may ultimately adversely affect our net income.

 
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Banking regulators have broad enforcement power, but regulations are meant to protect depositors, and not investors.

The Company is subject to supervision by several governmental regulatory agencies.  Bank regulations, and the interpretation and application of them by regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence earnings and growth.  In addition, these regulations may limit the Company’s growth and the return to investors by restricting activities such as the payment of dividends, mergers with, or acquisitions by, other institutions, investments, loans and interest rates, interest rates paid on depositors and the creation of financial service centers.  Information on the regulations that impact the Company are included in Item 1., “Business – Supervision and Regulation,” above.  Although these regulations impose costs on the Company, they are intended to protect depositors, and should not be assumed to protect the interest of shareholders.  The regulations to which we are subject may not always be in the best interest of investors.

Trading in our common stock has been sporadic and volume has been light.  As a result, shareholders may not be able to quickly and easily sell their common stock.

Although our common stock trades on the Nasdaq Capital Market and a number of brokers offer to make a market in common stock on a regular basis, trading volume to date has been limited and there can be no assurance that an active and liquid market for the common stock will develop.

Our directors and officers have significant voting power.

Our directors and officers beneficially own 11.73% of our common stock and may purchase additional shares of our common stock by exercising vested stock options.  By voting against a proposal submitted to shareholders, the directors and officers may be able to make approval more difficult for proposals requiring the vote of shareholders such as mergers, share exchanges, asset sales and amendment to the Company’s articles of incorporation.

An inadequate allowance for loan losses would reduce our earnings.

Our earnings are significantly affected by our ability to properly originate, underwrite and service loans.  We maintain an allowance for loan losses based upon many factors, including the following:

 
·
actual loan loss history;
 
·
volume, growth, and composition of the loan portfolio;
 
·
the amount of non-performing loans and the value of their related collateral;
 
·
the effect of changes in the local real estate market on collateral values;
 
·
the effect of current economic conditions on a borrower’s ability to pay; and
 
·
other factors deemed relevant by management.

These determinations are based upon estimates that are inherently subjective, and their accuracy depends on the outcome of future events; therefore, realized losses may differ from current estimates.  Changes in economic, operating, and other conditions, including changes in interest rates, which are generally beyond our control, could increase actual loan losses significantly.  As a result, actual losses could exceed our current allowance estimate.  We cannot provide assurance that our allowance for loan losses is sufficient to cover actual loan losses should such losses differ significantly from the current estimates.

In addition, there can be no assurance that our methodology for assessing our asset quality will succeed in properly identifying impaired loans or calculating an appropriate loan loss allowance.  We could sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to deterioration in asset quality in a timely manner.  If our assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if bank regulatory authorities require us to increase the

 
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allowance for loan losses as a part of their examination process, our earnings and capital could be significantly and adversely affected.

Difficult market conditions have adversely affected our industry.

Dramatic declines in the housing market, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values by financial institutions.  These write-downs, initially of asset-backed securities but spreading to other securities and loans, have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail.  Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions.  This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally.  The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected our business and results of operations.  Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses.  A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.

Current levels of market volatility are unprecedented.

The capital and credit markets have been experiencing volatility and disruption for more than 12 months.  Recently, the volatility and disruption has reached unprecedented levels.  In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we 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 soundness of other financial institutions could adversely affect us.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions.  Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships.  We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry.  As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions.  Many of these transactions expose us to credit risk in the event of default of our counterparty or client.  In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us.  There is no assurance that any such losses would not materially and adversely affect our results of operations.
 
Regulation of the financial services industry is undergoing major changes, and future legislation could increase our cost of doing business or harm our competitive position.
 
 
In 2009, many emergency government programs enacted in 2008 in response to the financial crisis and the recession slowed or wound down, and global regulatory and legislative focus has generally moved to a second phase of broader reform and a restructuring of financial institution regulation. Legislators and regulators in the United States are currently considering a wide range of proposals that, if enacted, could result in major changes to the way banking operations are regulated. Some of these major changes may take effect as early as 2010, and could materially impact the profitability of our business, the value of assets we hold or the collateral
 

 
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available for our loans, require changes to business practices or force us to discontinue businesses and expose us to additional costs, taxes, liabilities, enforcement actions and reputational risk.
 
                Certain reform proposals under consideration could result in our becoming subject to stricter capital requirements and leverage limits, and could also affect the scope, coverage, or calculation of capital, all of which could require us to reduce business levels or to raise capital, including in ways that may adversely impact our shareholders or creditors. In addition, we anticipate the enactment of certain reform proposals under consideration that would introduce stricter substantive standards, oversight and enforcement of rules governing consumer financial products and services, with particular emphasis on retail extensions of credit and other consumer-directed financial products or services. We cannot predict whether new legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, financial condition, or results of operations.
 
 
Our ability to pay dividends is limited and we may be unable to pay future dividends.  
 
Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient capital in the Company and in our subsidiaries. The ability of our bank subsidiary to pay dividends to us is limited by the bank’s obligations to maintain sufficient capital, earnings and liquidity and by other general restrictions on their dividends under federal and state bank regulatory requirements. In July 2009, we announced that we had cut the regular quarterly dividend to $0.10 per share, from $0.19 per share, in light of continued weak economic conditions. We cannot be certain as to when, if ever, the dividend may be increased, nor can we be certain that further reductions of the dividend will not be made.
 
In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Board of Governors of the Federal Reserve System, or the Federal Reserve, regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) on our financial condition. These guidelines also require that we review our net income for the current and past four quarters, and the level of dividends on common stock and other Tier 1 capital instruments for those periods, as well as our projected rate of earnings retention.
 
Under the Federal Reserve’s policy, the board of directors of a bank holding company should also consider different factors to ensure that its dividend level is prudent relative to the organization’s financial position and is not based on overly optimistic earnings scenarios such as any potential events that may occur before the payment date that could affect its ability to pay while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce the bank holding company’s dividends if: (i) its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) its prospective rate of earnings retention is not consistent with the its capital needs and overall current and prospective financial condition; or (iii) it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. If we do not satisfy these regulatory requirements or the Federal Reserve’s policies, we will be unable to pay dividends on our common stock.

Further, we cannot pay any dividends on the common stock, or acquire any shares of common stock, if any distributions on our trust preferred securities are in arrears.
 
A substantial decline in the value of our Federal Home Loan Bank of Atlanta common stock may result in an other than temporary impairment charge.
 
We are a member of the Federal Home Loan Bank of Atlanta, or FHLB, which enables us to borrow funds under the Federal Home Loan Bank advance program. As a FHLB member, we are required to own FHLB common stock, the amount of which increases with the level of our FHLB borrowings. The carrying value of our FHLB common stock was $5.1 million as of December 31, 2009. The FHLB has suspended daily

 
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repurchases of FHLB common stock, which adversely affects the liquidity of these shares. Consequently, there is a risk that our investment could be deemed other-than-temporarily impaired at some time in the future.
 
Increases in FDIC insurance premiums may cause our earnings to decrease.
 
The limit on FDIC coverage has been temporarily increased to $250,000 for all accounts through December 31, 2013.  In addition, the costs association with bank resolutions or failures have substantially depleted the Deposit Insurance Fund.  As a result, the FDIC has been implementing and considering different methodologies by which it may increase premium amounts.  The FDIC almost doubled its assessment rate on well-capitalized institutions by raising the assessment rate 7 basis points at the beginning of 2009.  In May 2009, the FDIC issued a final rule regarding a special assessment of 5 basis points on an institution’s total assets minus its Tier 1 capital as of June 30, 2009.  The FDIC adopted another final rule effective April 1, 2009, to change the way that the FDIC’s assessment system differentiates for risk, make corresponding changes to assessment rates beginning with the second quarter of 2009, as well as other changes to the deposit insurance assessment rules.  In November 2009, the FDIC voted to require insured depository institutions to prepay slightly over three years of estimated insurance assessments. Additionally, the FDIC has proposed using executive compensation as a factor in assessing the premiums paid by insured depository institutions to the Deposit Insurance Fund.  These actions could significantly increase our noninterest expense for the foreseeable future.

Revenue from our mortgage lending investment is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates or new legislation and may adversely impact our profits.
 
Our mortgage banking subsidiary, Southern Trust Mortgage, has provided a significant portion of our consolidated business and maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors. For the fiscal year ended December 31, 2009, Southern Trust Mortgage produced net income of approximately $2.1 million attributable to Middleburg. Loan production levels are sensitive to changes in economic conditions and can suffer from decreased economic activity, a slowdown in the housing market or higher interest rates. Generally, any sustained period of decreased economic activity or higher interest rates could adversely affect Southern Trust Mortgage’s mortgage originations and, consequently, reduce its income from mortgage lending activities. In addition, new legislation, including proposed legislation that would require Southern Trust Mortgage to retain five percent of the credit risk of securitized exposures, could adversely affect its operations.
 
We could also experience a reduction in the carrying value of our equity investment in Southern Trust Mortgage if Southern Trust Mortgage operations are negatively impacted. The carrying value for Southern Trust Mortgage at December 31, 2009 was approximately $6.4 million. A reduction in our carrying value could negatively impact our net income through an impairment expense.
 
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain of these cases where Southern Trust Mortgage has originated loans and sold them to investors, it may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would also adversely affect our net income.



ITEM 1B.
UNRESOLVED STAFF COMMENTS

None.


 
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ITEM 2.
PROPERTIES

The Company has adopted a business model whereby all of its financial services will be available at each branch, known as a financial service center location.  The financial service centers are larger than most traditional retail branches in order to allow commercial, retail, wealth management and mortgage personnel and services to be readily available to serve clients.

The headquarters building of the Company and Middleburg Bank, which also serves as a financial service center, was completed in 1981 and is a two-story building of brick construction, with approximately 18,000 square feet of floor space, located at 111 West Washington Street, Middleburg, Virginia 20117.  The office operates nine teller windows, including three drive-up facilities and one stand-alone automatic teller machine.  Middleburg Bank owns the headquarters building.

The Purcellville facility was purchased in 1994.  Renovations to double the size of the facility for the conversion into a financial service center were completed during 2005.  The new facility is a one-story building of brick construction with a basement.  The facility has approximately 6,400 square feet of floor space and is located at 431 East Main Street, Purcellville, Virginia 20132.  The office operates five teller windows, a client service desk, two drive-up facilities and one drive-up automatic teller machine.  Middleburg Bank owns this building.

The Catoctin Circle, Leesburg facility was completed in 1997 and is a two-story building of brick construction, with approximately 6,000 square feet of floor space, located at 102 Catoctin Circle, S.E., Leesburg, Virginia 20175.  The office operates five teller windows, including three drive-up facilities and one drive-up automatic teller machine.  Middleburg Bank also owns this building.

The Fort Evans Road, Leesburg facility was relocated in July 2008 to 538 Fort Evans Road, NE, Leesburg, Virginia 20176 and is commonly referred to by the Company as “Fort Evans II.”  The facility is a one-story building of brick construction with approximately 4,000 square feet of floor space.  Fort Evans II is a financial service center with three drive-up facilities and a drive-up automated teller machine.  Middleburg Bank owns the building, but leases the land upon which it resides.  The initial term of the lease is 25 years, expiring July 31, 2033, with two five-year renewal options.  The annual lease expense associated with this location is $300,000.  Middleburg Bank retains ownership of the former Fort Evans Road, Leesburg facility with the intention of selling this property.  This facility was not active at December 31, 2009.

The Leesburg limited service facility, located at 200 North King Street, was leased beginning April 1999.  The leased space consists of 200 square feet with one teller window and a stand-alone automated teller machine.  Transactions in this location are limited to paying and receiving teller functions.  The initial term of this lease was five years, with two additional renewal periods of five years each.  The lease is in the second renewal period and will expire March 31, 2013.  The annual lease expense associated with this location is $5,400.

The Ashburn facility was relocated to 43325 Junction Plaza, Ashburn, Virginia 20147 in January 2008 and is a one-story building of brick construction with approximately 4,000 square feet of floor space.  The office is a financial service center with three drive-up facilities and a drive-up automated teller machine.  Middleburg Bank owns this building, but leases the land upon which it resides.  The initial term of the lease is 25 years, expiring October 5, 2032, with two five-year renewal options.  The annual lease expense associated with this location is $325,000.  Middleburg Bank is considering sub-leasing the original Ashburn office location at 20955 Professional Plaza, Suite 100, Ashburn, Virginia 20147.  The initial term of this lease is 15 years, expiring May 31, 2014, with two five-year renewal options.  The annual lease expense associated with this location is $90,000.

The Reston facility opened in November 2004 and consists of a one-story building of brick construction with approximately 3,500 square feet of floor space, located at 1779 Fountain Drive, Reston, Virginia, 20190.  The office is a financial service center with three double-stack drive-up facilities and a drive-up automated teller machine.  Middleburg Bank owns this building but leases the land upon which it resides.  The initial term of the

 
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lease is 15 years, expiring October 31, 2019, with two five-year renewal options.  The annual lease expense associated with this location is $220,000.

The Warrenton facility opened in October 2005 and consists of a one-story building of brick construction with approximately 3,500 square feet of floor space, located at 530 Blackwell Road, Warrenton, Virginia, 20186.  The office is a financial service center with a non-visible teller line, a client service desk, a remote teller station with four tellers, two drive-up lanes and a drive-up automated teller machine.  Middleburg Bank leases this office.  The initial term of the lease is 20 years, expiring February 28, 2025, with four five-year renewal options.  The annual lease expense associated with this location is $141,000.

The Leesburg Operations Center building was completed June 2002.  The building is Class A office space and is home to the deposit operations, loan operations, credit administration, mortgage banking and data processing departments of Middleburg Bank and the information technology, human resources, training, and marketing departments of the Company.  This building is a two story building with 18,000 square feet of floor space, located at 106 Catoctin Circle, SE, Leesburg, Virginia 20175.  Middleburg Bank owns this building.

Middleburg Trust Company leases its main office at 821 East Main Street in Richmond, Virginia.  The lease is for a term of 15 years and will expire November 30, 2015, with no renewal options.  The annual lease expense associated with this location is $203,000.

Middleburg Trust Company opened an office at 5372 Discovery Park Boulevard, Williamsburg, Virginia 23188 in February 2008.  The office is approximately 2,250 square feet.  The lease is for a term of five years, expiring January 14, 2012, with a five-year renewal option.  The annual lease expense associated with this location is $63,000.

Middleburg Investment Advisors leases its main office at 1901 North Beauregard Avenue, Alexandria, Virginia, 22311.  The lease, which was entered into in May 2008, is for a term of 8 years, with no renewal options.   The space includes approximately 3,500 square feet of office space and 900 square feet of storage.   The annual lease expense associated with this location is $121,000.

The Marshall limited service facility, located at 8383 West Main Street, was leased beginning December 1, 2006.  The leased space consists of 328 square feet.  Transactions in this location are limited to paying and receiving teller functions.  The initial term of this lease is three years, with two additional renewal periods of one year each.  The lease is in its initial term and will expire November 30, 2011.  The annual lease expense associated with this location is $12,000.

Southern Trust Mortgage, LLC leases its main office location at 4433 Corporation Lane, Virginia Beach, Virginia as well as eleven other service locations in Virginia, Maryland, and South Carolina with long-term leases.  Lease expiration dates for these office locations range from April, 2010 to August, 2018 with annual lease expenses ranging from $9,000 for the Summerville, SC location to $336,000 for the main office location in Virginia Beach, Virginia.  Southern Trust Mortgage also leases additional facilities on a month-to-month basis.  Total rental and lease expense for Southern Trust Mortgage was $902,548 and $1,113,476 for the years ended December 31, 2009 and 2008 respectively.  Rental and lease expenses for Sothern Trust Mortgage are included in the Company’s financial statements for the years ended December 31, 2009 and 2008.

All of the Company’s properties are well maintained, are in good operating condition and are adequate for the Company’s present and anticipated future needs.


ITEM 3.
LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.

 
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ITEM 4.
RESERVED

 
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PART II

ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Shares of the Company’s Common Stock trade on the Nasdaq Capital Market under the symbol “MBRG.”  The high and low sale prices per share for the Company’s Common Stock for each quarter of 2008 and 2009, and the amount of cash dividends per share in each quarter, are set forth in the table below.

Market Price and Dividends

 
Sales Price ($)
Dividends ($)
 
High
Low
 
2008:
1st quarter
2nd quarter
3rd quarter
4th quarter 
 
25.93
24.97
20.00
17.50
 
19.25
19.00
16.25
13.25
 
0.19
0.19
0.19
0.00
2009:
1st quarter
2nd quarter
3rd quarter
4th quarter 
 
14.91
15.70
14.19
13.10
 
10.25
11.25
10.68
11.65
 
0.19
0.19
0.10
0.10

As of March 5, 2010, the Company had approximately 491 shareholders of record and at least 2,231 additional beneficial owners of shares of Common Stock.

The Company historically has paid cash dividends on a quarterly basis.  In the fourth quarter of 2008, the Company changed its policy for declaring dividends from declaring them prior to the end of a quarter to declaring them after the quarter has ended.  The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiaries, principally Middleburg Bank, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies as discussed in Item 1., “Business – Supervision and Regulation – Payment of Dividends,” above.  
 
The Company did not repurchase any shares of Common Stock during the fourth quarter of 2009.  On June 16, 1999, the Company adopted a repurchase plan, which authorized management to purchase up to $5 million of the Company’s common stock from time to time.  Subsequently, the plan was amended to authorize management to purchase up to 100,000 shares and to eliminate the $5 million limit.  As of March 16, 2010, the Company has 24,084 shares eligible for repurchase under the plan.


 
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The following graph compares the cumulative total return to the shareholders of the Company for the last five fiscal years with the total return on the NASDAQ Composite Index and the SNL $500M-$1B Bank Index as reported by SNL Financial LC, assuming an investment of $100 in shares of Common Stock on December 31, 2004 and the reinvestment of dividends.
 
 
   
Period Ending
 
Index
12/31/04
12/31/05
12/31/06
12/31/07
12/31/08
12/31/09
Middleburg Financial Corporation
100.00
84.41
103.82
61.47
43.30
37.57
NASDAQ Composite
100.00
101.37
111.03
121.92
72.49
104.31
SNL Bank $500M-$1B
100.00
104.29
118.61
95.04
60.90
58.00

 
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ITEM 6.                      SELECTED FINANCIAL DATA

The following consolidated summary sets forth the Company’s selected financial data for the periods and at the dates indicated.  The selected financial data have been derived from the Company’s audited financial statements for each of the five years that ended December 31, 2009, 2008, 2007, 2006 and 2005.

   
Years Ended December 31,
 
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
(In thousands, except ratios and per share data)
 
Balance Sheet Data:
                             
   Assets (1)
  $ 976,374     $ 985,191     $ 841,400     $ 772,305     $ 739,911  
   Loans, net (2)
    680,104       702,651       638,692       564,750       520,511  
   Securities
    178,924       181,312       129,142       135,435       149,591  
   Deposits
    805,648       744,782       588,769       570,599       551,432  
   Shareholders’ equity
    100,312       75,677       77,904       77,898       53,476  
   Average shares outstanding, basic
    5,629       4,528       4,506       4,132       3,803  
   Average shares outstanding, diluted
    5,630       4,554       4,578       4,223       3,906  
                                         
Income Statement Data:
                                       
   Interest income
  $ 56,746     $ 55,922     $ 49,628     $ 45,398     $ 36,212  
   Interest expense
    19,082       22,719       22,441       18,487       11,596  
   Net interest income
    37,664       33,203       27,187       26,911       24,616  
   Provision for loan losses
    4,551       5,261       1,786       499       1,744  
   Net interest income after
                                       
     provision for loan losses
    33,113       27,942       25,401       26,412       22,872  
   Non-interest income
    19,914       17,817       7,832       8,420       8,945  
   Securities gains (losses)
    998       (913 )     (130 )     (305 )     76  
   Non-interest expense
    48,862       42,599       29,455       23,210       21,920  
   Income before income taxes and non-controlling interest in consolidated
                                       
subsidiary (3)
    5,163       2,247       3,648       11,317       9,973  
   Income taxes
    64       444       584       3,299       2,799  
   Non-controlling interest in consolidated subsidiary
    (1,577 )     757       --       --       --  
   Net income
    3,522       2,560       3,064       8,018       7,174  
                                         
Per Share Data:
                                       
   Net income, basic
  $ 0.37     $ 0.57     $ 0.68     $ 1.94     $ 1.89  
   Net income, diluted
    0.37       0.56       0.67       1.90       1.84  
   Cash dividends
    0.58       0.57       0.76       0.76       0.76  
   Book value at period end
    14.52       16.69       17.21       17.29       14.05  
   Tangible book value at period end
    13.57       15.20       16.06       16.06       12.50  
 
                                       
Asset Quality Ratios:
                                       
   Non-performing loans to total portfolio loans
    1.80 %     1.19 %     1.03 %     0.00 %     0.02 %
   Non-performing loans to total assets
    1.19       0.81       0.79       0.00       0.00  
   Net charge-offs (recoveries) to average loans
    0.76       0.51       0.04       0.01       0.00  
   Allowance for loan losses to loans
                                       
      outstanding at end of period (2)
    1.33       1.41       1.10       0.98       0.98  
                                         
Selected Ratios:
                                       
   Return on average assets
    0.35 %     0.28 %     0.38 %     1.05 %     1.05 %
   Return on average equity
    3.21       3.37       3.83       12.25       13.65  
   Dividend payout
    145.00       100.79       111.76       39.41       40.21  
   Efficiency ratio (4)
    82.63       80.53       81.25       63.85       63.32  
   Net interest margin (5)
    4.17       4.02       3.80       3.97       4.11  
   Equity to assets
    10.59       7.68       9.26       10.09       7.23  
   Tier 1 risk-based capital
    13.86       10.25       11.55       12.79       11.10  
   Total risk-based capital
    15.06       11.50       12.59       13.70       12.00  
    Leverage
    10.40       8.40       9.44       10.26       8.70  

(1)
Amounts have been adjusted to reflect the application of Accounting Standards Codification (“ASC”) Topic 810.  The common equity portion of the Trust Preferred entities has been deconsolidated and is included in Assets for all years reported.
(2)
Includes mortgages held for sale
(3)
Consolidated Southern Trust Mortgage, LLC in 2009 and 2008 based on the Company’s 57.1% ownership at year end.
(4)
The efficiency ratio is a key performance indicator in the Company’s industry.  The Company monitors this ratio in tandem with other key indicators for signals of potential trends that should be considered when making decisions regarding strategies related to such areas as asset liability management, business line development, and growth and expansion planning.  The ratio is computed by dividing non-interest expense by the sum of net interest income on a tax equivalent basis and non-interest income, net of any securities gains or losses.  It is a measure of the relationship between operating expenses to earnings.  Net interest income on a tax equivalent basis for the years ended December 31, 2009, 2008, 2007, 2006, and 2005 were $39,180,000, $34,463,000, $28,378,000, $27,705,000, and $25,435,000.  See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Critical Accounting Policies,” below for additional information.
(5)
Net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets.

 
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ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of the Company.  This discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and Notes to Consolidated Financial Statements.  It should also be read in conjunction with the “Caution About Forward Looking Statements” section at the end of this discussion.

Overview

           The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc and a majority owned subsidiary, Southern Trust Mortgage, LLC.  Middleburg Bank is a community bank serving the Virginia counties of Loudoun, Fairfax and Fauquier with seven financial service centers and two limited service facilities.  Middleburg Investment Group is a non-bank holding company with one wholly owned subsidiary, Middleburg Trust Company, which in turn wholly owns Middleburg Investment Advisors, Inc.  Middleburg Trust Company is a trust company headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank’s facilities.  Middleburg Investment Advisors is a registered investment advisor headquartered in Alexandria, Virginia serving clients in 24 states.  Southern Trust Mortgage is a regional mortgage company headquartered in Virginia Beach, Virginia and maintains offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.  During 2010, we will open a new Financial Service Center in Gainesville and open a Middleburg Bank office in Williamsburg, adding to our Trust and Investment services in that community.  Both of these communities allow us to offer our suite of financial services to new individuals, families and businesses.

The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank.  Net interest income is the difference between interest income and interest expense.  Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon.  Middleburg Bank’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon.  The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses or potential other-than-temporary impairment of securities  Middleburg Investment Group’s subsidiaries, Middleburg Trust Company and Middleburg Investment Advisors, generate fee income by providing investment management and trust services to its clients.  Investment management and trust fees are generally based upon the value of assets under management, and, therefore can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets.  Southern Trust Mortgage generates fees from the origination and sale of mortgages loans.  Southern Trust Mortgage also maintains a real estate construction portfolio and receives interest and fee income from these loans, which, net of interest expense, is included in net interest income.

At December 31, 2009, total assets were $976.4 million, a decrease of 0.9% from $985.2 million.  Total loans, including mortgages held for sale decreased $23.4 million from $712.7 million at December 31, 2008 to $689.3

 
30

 

million at December 31, 2009.  Total deposits increased $60.8 million from $744.8 million at December 31, 2008 to $805.6 million at December 31, 2009.  Lower cost deposits, including demand checking, interest checking and savings increased $85.7 million or 20.5% from the year ended December 31, 2008 to $504.2 million for the year ended December 31, 2009.  Higher cost time deposits, excluding brokered certificates of deposit, increased 5.4% or $12.1 million from the year ended December 31, 2008 to $238.9 million for the year ended December 31, 2009.  The shift in the mix of deposits as well as lower interest rates paid on deposits during 2009 contributed to the 57 basis point decrease in the overall cost of deposits from 2008 to 2009.  The net interest margin, a non-GAAP measure more fully described in the “Results of Operations” section below, increased from 4.02% for the year ended December 31, 2008 to 4.17% for the year ended December 31, 2009.  The increase is attributed to the 71 basis point decrease in yield of total interest bearing liabilities as compared to the 47 basis point decrease, on a tax equivalent basis, in yield of total interest bearing assets.  The provision for loan losses decreased $710,000 for the year ended December 31, 2009 to $4.5 million compared to $5.3 million for the same period in 2008.  The Company recognized other-than-temporary impairment on trust preferred securities of $1.1 million for the year ended December 31, 2009 compared to $1.6 million for the same period in 2008.  Total non-interest income increased $4.0 million for the year ended December 31, 2009, compared to same period in 2008.  The increase is largely due to gains on the sale of loans by the Company’s mortgage banking subsidiary, Southern Trust Mortgage.  Non-interest expense in 2009 increased $6.26 million, up 14.7% from 2008, driven primarily by commissions related to the increased production at Southern Trust Mortgage, increased FDIC insurance expense and increased legal and OREO expenses.

Total non-interest expenses for the year ended December 31, 2009 includes the consolidated expenses of Southern Trust Mortgage, while the same period in 2007 include a one-time impairment charge of $5.0 million.  Although, the Company is focused on keeping growth in non-interest expense low in the future, because of the Company’s plans to engage in growth and expansion, it is expected that non-interest expense will continue to grow in the future at a rate similar to previous years, excluding the impairment charge of 2007.  The Company remains well capitalized with risk-adjusted core capital and total capital ratios well above the regulatory minimums.

With the creation of Middleburg Investment Group, the Company has expanded the integration of Middleburg Trust Company, Middleburg Investment Advisors and Middleburg Bank’s investment services department into a more focused wealth management program for all of the Company’s clients.  The Company intends to make each of its wealth management services available within all of its financial service centers.  Also, through the affiliation with Southern Trust Mortgage, Middleburg Bank plans to continue to increase its loan portfolio by purchasing high credit quality, low loan to value first deeds of trusts on residential property.  Middleburg Bank plans to continue its focus on low cost deposit growth with advertising campaigns and product development.

The Company is not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on the registrant’s liquidity, capital resources or results of operations.


Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to some degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of Middleburg Bank’s financial condition and results of operations.  The Critical Accounting Policies require management’s most difficult,

 
31

 

subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting guidance.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  If a loan evaluated individually is not impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics.

For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans losses.  This estimate of losses is compared to the allowance for loan losses of Middleburg Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.

Intangibles and Goodwill

The Company has approximately $6.5 million in intangible assets and goodwill at December 31, 2009, a decrease of $213,000 since December 31, 2008 which was attributable to regular amortization of intangible assets. On April 1, 2002, the Company acquired Middleburg Investment Advisors, a registered investment advisor, for $6.0 million. Approximately $5.9 million of the purchase price was allocated to intangible assets and goodwill.  In connection with this investment, a purchase price valuation was completed to determine the appropriate

 
32

 

allocation to identified intangibles.  The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years.  Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of 7 years.  The remainder of the purchase price has been allocated to goodwill.  Approximately $1.0 million of the $6.5 million in intangible assets and goodwill at December 31, 2009 is attributable to the Company’s investment in Middleburg Trust Company.  With the consolidation of Southern Trust Mortgage, the Company recognized $1.9 million in goodwill as part of its equity investment.

The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of management add to the success of the Company.  For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future.  If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the Consolidated Financial Statements could result in a possible impairment of the intangible assets and goodwill or require acceleration in the amortization expense.

In addition, accounting standards require that goodwill be tested annually using a two-step process.  The first step is to identify a potential impairment.  The second step measures the amount of the impairment loss, if any.  Processes and procedures have been identified for the two-step process.

When the Company completes its ongoing review of the recoverability of intangible assets and goodwill, factors that are considered important to determining whether impairment might exist include loss of customers acquired or significant withdrawals of the assets currently under management and/or early retirement or termination of key members of management.  Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company’s financial condition and results of operations.

Tax-Equivalent Interest Income

Tax-equivalent interest income is gross interest income adjusted for the non-taxable interest income earned on loans, municipal securities and corporate securities, which are dividend-received deduction eligible.  The effective tax rate of 34% is used in calculating tax equivalent income related to loans, municipal securities and corporate securities.  A dividend-received deduction of 70% is used in determining tax-equivalent income related to corporate securities, as well.
 
Other-Than-Temporary Impairment (OTTI)
 
Approximately $1.1 million in losses related to other-than-temporary impairment on trust-preferred securities was recognized in 2009. At December 31, 2009, the Company had $2.5 million in trust-preferred securities in its portfolio.

In accordance with applicable accounting guidance, we determine other-than-temporary impairment for the trust preferred securities in the securities portfolio based on an evaluation of the underlying collateral. We developed cash flow projections based upon assumptions of default/deferral rates, recovery rates and prepayment rates for the collateral. The present value of the projected cash flows was calculated by discounting the projected cash flows using the effective yield at purchase in accordance with applicable accounting guidance. Finally, the present values of the projected cash flows were compared to the carrying values of the securities. If the present values were less than the carrying value, we determined that the security had an other-than-temporary impairment equal to the difference between the present value and the carrying value of the bond.

The Company may need to recognize additional other-than-temporary impairments related to trust preferred securities in 2010. We evaluate our default assumptions and cash flow projections in relation to the credit performance of the collateral that underlies the trust preferred securities. Should additional deferrals/defaults occur on the collateral, projected cash flows from the collateral could be reduced which could result in other-than-temporary impairments in 2010.

Results of Operations

Net Income

Net income for 2009 was $3.5 million, an increase of 37.5% from the 2008 net income of $2.56 million.  Net income for 2008 decreased 16.4% from 2007’s net income of $3.1 million.  For 2009, earnings per diluted share were $0.37 compared to $0.56 and $0.67 for 2008 and 2007, respectively.

Return on average assets (“ROA”) measures how effectively the Company employs its assets to produce net income.  The ROA for the Company increased to 0.35% for the year ended December 31, 2009 from 0.28% for the same period in 2008.  ROA for 2007 was 0.38%. Return on average equity (“ROE”), another measure of earnings performance, indicates the amount of net income earned in relation to the total average equity capital invested.  ROE decreased to 3.21% for the year ended December 31, 2009.   ROE was 3.37% and 3.83% for the years ended December 31, 2008 and 2007, respectively.

The following table reflects an analysis of the Company’s net interest income using the daily average balances of the Company’s assets and liabilities as of December 31.  Non-accrual loans are included in the loan average balances.

 
33

 

Average Balances, Income and Expenses, Yields and Rates
(Years Ended December 31)

         
2009
               
2008
               
2007
       
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
               
(Dollars in thousands)
                   
Assets :
                                                     
Securities:
                                                     
   Taxable
  $ 105,765     $ 4,830       4.57 %   $ 108,482     $ 5,483       5.05 %   $ 86,776     $ 4,713       5.43 %
   Tax-exempt (1) (2)
    64,305       4,461       6.94 %     47,975       3,306       6.89 %     41,524       2,947       7.10 %
       Total securities
  $ 170,070     $ 9,291       5.46 %   $ 156,457     $ 8,789       5.62 %   $ 128,300     $ 7,660       5.97 %
Loans
                                                                       
   Taxable
  $ 710,745     $ 48,834       6.87 %   $ 689,210     $ 48,088       6.98 %   $ 615,198     $ 42,958       6.98 %
   Tax-exempt (1)
    1       -       0.00 %     8       1       12.50 %     27       3       11.11 %
       Total loans
  $ 710,746     $ 48,834       6.87 %   $ 689,218     $ 48,089       6.98 %   $ 615,225     $ 42,961       6.98 %
Federal funds sold
    20,607       42       0.20 %     7,604       139       1.83 %     3,195       159       4.98 %
Interest bearing deposits in
                                                                       
      other financial institutions
    38,485       95       0.25 %     4,097       165       4.03 %     730       39       5.34 %
       Total earning assets
  $ 939,908     $ 58,262       6.20 %   $ 857,376     $ 57,182       6.67 %   $ 747,450     $ 50,819       6.80 %
Less: allowances for credit losses
    (9,160 )                     (9,251 )                     (6,005 )                
Total nonearning assets
    83,698                       77,029                       70,433                  
Total assets
  $ 1,104,446                     $ 925,154                     $ 811,878                  
                                                                         
Liabilities:
                                                                       
Interest-bearing deposits:
                                                                       
    Checking
  $ 251,781     $ 3,091       1.23 %   $ 188,886     $ 3,755       1.99 %   $ 140,045     $ 3,427       2.45 %
    Regular savings
    59,095       749       1.27 %     54,891       951       1.73 %     54,194       1,036       1.91 %
    Money market savings
    42,985       473       1.10 %     39,267       465       1.18 %     54,558       618       1.13 %
    Time deposits:
                                                                       
       $100,000 and over
    135,149       4,342       3.21 %     127,398       5,021       3.94 %     118,964       5,958       5.01 %
       Under $100,000
    187,115       6,959       3.72 %     127,114       5,299       4.17 %     84,056       3,758       4.47 %
       Total interest-bearing deposits
  $ 676,125     $ 15,614       2.31 %   $ 537,556     $ 15,491       2.88 %   $ 451,817     $ 14,797       3.27 %
                                                                         
Short-term borrowings
    19,424       593       3.05 %     44,983       1,988       4.42 %     51,659       2,825       5.47 %
Securities sold under agreements
                                                                       
    to repurchase
    21,122       40       0.19 %     40,924       831       2.03 %     43,769       1,868       4.27 %
Long-term debt
    69,407       2,835       4.08 %     100,308       4,398       4.38 %     60,018       2,926       4.88 %
Federal funds purchased
    -       -       - %     397       11       2.77 %     447       25       5.59 %
    Total interest-bearing liabilities
  $ 786,078     $ 19,082       2.43 %   $ 724,168     $ 22,719       3.14 %   $ 607,710     $ 22,441       3.69 %
Non-interest bearing liabilities
                                                                       
    Demand deposits
    107,936                       114,466                       117,942                  
    Other liabilities
    10,620                       7,328                       6,128                  
Total liabilities
  $ 904,634                     $ 845,961                     $ 731,780                  
Non-controlling interest in consolidated
    Subsidiary
    2,774                       3,232                       --                  
Shareholders’ equity
    107,038                       75,961                       80,098                  
  Total liabilities and
         Shareholders’ equity
  $ 1,104,446                     $ 925,154                     $ 811,878                  
                                                                         
Net interest income
          $ 39,180                     $ 34,463                     $ 28,378          
                                                                         
Interest rate spread
                    3.77 %                     3.53 %                     3.11 %
Interest expense as a percent of
                                                                       
    average earning assets
                    2.03 %                     2.65 %                     3.00 %
Net interest margin
                    4.17 %                     4.02 %                     3.80 %


(1)      Income and yields are reported on tax equivalent basis assuming a federal tax rate of 34%.
(2)      Income and yields include dividends on preferred securities that are 70% excludable for tax purposes.



 
34

 



Net Interest Income

Net interest income represents the principal source of earnings of the Company.  Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets.  Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income on a fully tax-equivalent basis was $39.2 million for the year ended December 31, 2009.  This is an increase of 13.8% over the $34.5 million reported for the same period in 2008.  Net interest income for 2008 increased 21.4% over the $28.4 million reported for 2007.  The net interest margin increased 15 basis points to 4.17% in 2009.  The net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets.  Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio.  Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense.  The tax rate utilized in calculating the tax benefit for each of 2009, 2008 and 2007 is 34%.  The reconciliation of tax equivalent net interest income, which is not a measurement under accounting principles generally accepted in the United States, to net interest income is reflected in the table below.
 
 
Reconciliation of Net Interest Income to
Tax Equivalent Net Interest Income

   
For the Year Ended December 31,
 
(in thousands)
 
2009
   
2008
   
2007
 
GAAP measures:
                 
  Interest Income – Loans
  $ 48,834     $ 48,088     $ 42,960  
  Interest Income - Investments & Other
    7,912       7,834       6,668  
  Interest Expense – Deposits
    15,614       15,492       14,797  
  Interest Expense - Other Borrowings
    3,468       7,227       7,644  
Total Net Interest Income
  $ 37,664     $ 33,203     $ 27,187  
Plus:
                       
NON-GAAP measures:
                       
  Tax Benefit Realized on Non-Taxable Interest Income – Loans
  $ -     $ 1     $ 1  
  Tax Benefit Realized on Non-Taxable Interest Income - Municipal Securities
    1,516       1,259       1,190  
Total Tax Benefit Realized on Non-Taxable Interest Income
  $ 1,516     $ 1,260     $ 1,191  
Total Tax Equivalent Net Interest Income
  $ 39,180     $ 34,463     $ 28,378  


The increase in net interest income in 2009 resulted from growth in earning assets and reduced funding costs. Average earning assets increased $82.5 million or 9.6% to $939.9 million during 2009.  The increase in average earning assets resulted primarily from overall deposit growth during 2009.  Interest income and fees from loans and investments increased 1.47% during 2009. The cost of interest bearing liabilities in 2009 decreased to 2.43%, down 71 basis points relative to 2008.    The average balance in the securities portfolio increased by $13.6 million, while the tax-equivalent yield decreased 16 basis points to 5.46%.  The average loan portfolio volume increased 3.1% during 2009.  The yield on the loan portfolio declined 11 basis points to 6.87%.

The average yield on the loan portfolio decreased 11 basis points in 2009.  On average, the loan portfolio increased by $21.5 million or 3.1% over the year ended December 31, 2008. Interest income from loans increased $746,000 or 1.5% over the year ended December 31, 2008. The average balance in the securities portfolio increased by $13.6 million in 2009, while the tax-equivalent yield decreased 14 basis points to 5.46%.

 
35

 

The average balance of interest bearing accounts (interest bearing checking, savings and money market accounts) increased 25.0% to $353.9 million at December 31, 2009.  The cost of such funding decreased 61 basis points over the year ended December 31, 2008.  The average balance of interest bearing checking increased 33.3% with a corresponding cost decrease of 76 basis points.  The average balances in time deposits increased 26.6%, while the cost of those deposits decreased 55 basis points.  The increase in the average balance of deposits greater than $100,000 was $7.8 million.  These deposits typically have a higher cost when compared to all other interest bearing deposits and do not include brokered certificates of deposit.

During 2009, non-deposit interest bearing liabilities decreased on average by $76.7 million.  The Company decreased its average short-term borrowings by $25.5 million or 56.8% over the year ended December 31, 2008.  The Company decreased its average long term debt by $30.9 million or 30.8% over the year ended December 31, 2008. Much of the decrease in borrowings was offset by the increases in deposits as the Company focused its efforts on deposit generation.  Total interest expense for 2009 was $19.1 million, a decrease of $3.6 million compared to the total interest expense for 2008. The cost of interest-bearing liabilities decreased 71 basis points over the year ended December 31, 2008.

Management believes that the net interest margin could compress during 2010.  Based on conservative internal interest rate risk models and the assumption of a sustained low rate environment, the Company expects net interest income to trend downward slightly throughout the next 12 months as loan related assets reprice and the decline in funding costs slows.  The expected decrease to net interest income could be 5.5% or $1.8 million in a 12 month period of rising rates of 100 basis points.  It is anticipated that targeted growth in earning assets and liability repricing opportunities will help mitigate the above mentioned impact to the Company’s net interest margin.  The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.

The average balances in certificates of deposit increased 26.6%, while the interest expense associated with these deposits increased 9.5% or $981 thousand.

 
36

 

The following table analyzes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates.  The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.  Non-accruing loans are included in the average outstanding loans.


Volume and Rate Analysis
(Tax Equivalent Basis)
(Years Ended December 31)

   
2009 vs. 2008
         
2008 vs. 2007
       
   
Increase (Decrease) Due
         
Increase (Decrease) Due
       
   
to Changes in: