Item 1. Business
General
Eastern Virginia Bankshares, Inc. (the “Company”) is a bank holding company that was organized and chartered under the laws of the Commonwealth of Virginia on September 5, 1997 and commenced operations on December 29, 1997. The Company was headquartered in Tappahannock, Virginia until October 2016 at which time it was relocated to Glen Allen, Virginia. Through our wholly-owned bank subsidiary, EVB (the “Bank”) which is headquartered in Tappahannock, Virginia, we operate twenty-four full service branches and two drive-in facilities in eastern Virginia, and one loan production office in Chesterfield County, Virginia. Two of EVB’s three predecessor banks, Bank of Northumberland, Inc. and Southside Bank, were established in 1910. The third bank, Hanover Bank, was established as a de novo bank in 2000. In April 2006, these three banks were merged and the surviving bank was re-branded as EVB. Additionally, the Company acquired Virginia Company Bank (“VCB”) on November 14, 2014 and merged VCB with and into the Bank with the Bank surviving, thereby adding to the Bank three additional branches located in Hampton, Newport News and Williamsburg. On December 13, 2016, the Company entered into an Agreement and Plan of Merger to merge with and into Southern National Bancorp of Virginia, Inc. (“Southern National”), with Southern National surviving (such transaction, the “Pending Merger”). The Pending Merger, which is expected to be completed by the third quarter of 2017, is subject to regulatory approvals and the approval of the shareholders of both companies, as well as customary closing conditions.
EVB is a community bank targeting small to medium-sized businesses and consumers in our traditional coastal plain markets and the emerging suburbs outside of the Richmond, Tidewater, and southern Virginia areas. Our mission is to enable our customers, teammates and shareholders to achieve their financial dreams and goals, making our communities better places to live.
The accompanying consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, at times collectively referred to as the “Company”, “we”, “our”, or “us.”
We provide a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.
The Bank owns EVB Financial Services, Inc., which in turn has a 100% ownership interest in EVB Investments, Inc. EVB Investments, Inc. offers a comprehensive range of investment services through Infinex Investments, Inc. On May 15, 2014, the Bank acquired a 4.9% ownership interest in Southern Trust Mortgage, LLC. Pursuant to an independent contractor agreement with Southern Trust Mortgage, LLC, the Company advises and consults with Southern Trust Mortgage, LLC and facilitates the marketing and brand recognition of their mortgage business. In addition, the Company provides Southern Trust Mortgage, LLC with offices at two retail branches in the Company’s market area and access to office equipment at these locations during normal business hours. For its services, the Company receives fixed monthly compensation from Southern Trust Mortgage, LLC in the amount of $2 thousand, which is adjustable on a quarterly basis.
The Bank has a 6.0% ownership interest in Bankers Title, LLC. Bankers Title, LLC is a multi-bank owned title agency providing a full range of title insurance settlement and related financial services. The Bank has a 2.94% ownership in Bankers Insurance, LLC, which primarily sells insurance products to customers of the Bank, and other financial institutions that have an equity interest in the agency. The Bank also has 100% ownership interests in Dunston Hall LLC and POS LLC, which were formed to hold the title to real estate acquired by the Bank upon foreclosure on property of real estate secured loans. The financial position and operating results of all the subsidiaries of the Bank are not significant to the Company as a whole and are not considered principal activities of the Company at this time.
The Company also owns one non-operating subsidiary, EVB Statutory Trust I (the “Trust”), that was formed in September 2003. The Trust was formed for the purpose of issuing $10.0 million of trust preferred capital securities. The Trust is an unconsolidated subsidiary of the Company and its principal asset is $10.3 million of the Company’s junior subordinated deferrable interest debentures (the “Junior Subordinated Debt”) that is reported as a liability of the Company.
Market Areas
The Company currently conducts business through twenty-four full service branches and two drive-in facilities, primarily in the eastern portion of the state. Our markets are located east of U.S. Route 250 and extend from northeast of Richmond to the Chesapeake Bay and Hampton in central Virginia and across the James River from Colonial Heights to southeastern Virginia. Geographically, we have five primary market areas: Northern Neck, Middle Peninsula, Capital (suburbs of Richmond), Tidewater (Williamsburg, Newport News and Hampton), and Southern.
Our Northern Neck and Middle Peninsula regions are in the eastern coastal plain of Virginia, often referred to as River Country. A number of the branches in this locale have been in business for over one hundred years and have strong customer ties going back over multiple generations. According to the Virginia Economic Development Partnership, the region’s industries have traditionally been associated with abundant natural resources that include five rivers and the Chesapeake Bay. The diversified economy includes seafood harvesting, light manufacturing, agriculture, leisure, marine services and service sectors dedicated to many upscale retirement communities.
Our Capital region is currently comprised of Chesterfield, Hanover, Henrico and King William counties and Colonial Heights, which are largely emerging suburbs of Richmond. Hanover County is approximately 10 miles from downtown Richmond and eighty-six miles south of Washington, DC. Hanover County is the largest county by area in the Richmond metropolitan area. The county provides residents and businesses the geographic advantages of a growing metropolitan area coupled with substantial acreage for expansion in a suburban setting. With a branch and our corporate headquarters in the adjacent county of Henrico, which is closer to Richmond, we have the advantage of an established economic setting with many small business prospects. Our location in Colonial Heights puts us in the south Richmond suburbs and allows us to capitalize on economic activity related to the U.S. Army facility at Fort Lee. The other county, King William, offers us growth opportunities as the Richmond suburbs expand farther east of their current boundaries.
Our Tidewater region is currently comprised of Williamsburg, Newport News and Hampton. This area, located approximately 60 miles east of Richmond along the U.S. Interstate 64 corridor, is part of the Hampton Roads MSA and is a densely populated and well-established area. This major metropolitan area is the second largest metropolitan area in Virginia behind the Northern Virginia area and is home to the third largest harbor in the U.S., which supports extensive military and commercial shipping operations. In addition to being home to several Fortune 500 companies, the region has a high value customer base, such as entrepreneurs, small businesses, and professionals, which often are not well served by our larger competitors. The banking facilities in this region offer a wide range of banking products and services, including mortgage, investment and insurance products.
Our Southern region is comprised of New Kent, Surry, Sussex, and Southampton counties. New Kent has shown continued population growth over the past several years. Our Southern Region is located southeast of Richmond and north of Williamsburg placing us in the growth zone of U.S. Interstate 64 that runs from Richmond to the Virginia Beach area of the Virginia Tidewater region. The other three counties are approximately fifty miles southeast of Richmond along or just off the state U.S. Route 460 corridor and are adjacent to the Greater Tidewater area. The ports of Hampton Roads are approximately fifty miles to the east of our Southern region. The region’s close proximity to major military, naval and research centers and transportation infrastructure make this an attractive location for contractors and service and manufacturing companies.
Business Strategy
As a result of over 100 years of experience serving the Northern Neck and Middle Peninsula regions, we have a stable, loyal customer base and a high deposit market share in these regions. Due to the lower projected population growth of these markets, we expanded in Chesterfield, Hanover, Henrico, Gloucester, New Kent and King William Counties and the city of Colonial Heights to target the higher potential growth in these existing and emerging suburban markets. The deposit market share we have accumulated in our Northern Neck, Middle Peninsula and Southern regions has helped fund our loan growth in the emerging suburban areas in the Capital region. Additionally, in 2014 we expanded into our Tidewater region through the acquisition of VCB. This acquisition added three branches and expanded our footprint along the U.S. Interstate 64 corridor into the attractive and growing markets of the Virginia Peninsula.
We believe that economic growth and bank consolidation have created a growing number of businesses and consumers in need of a broad range of products and services, as well as the high level of personal service that we provide. We look at 2017 as a year to strengthen our existing markets. Our long-term business plan is to capitalize on the growth opportunity in our markets by further developing our branch network and augmenting our market area, including through the Pending Merger with Southern National.
Competition
The Bank encounters strong competition for its banking services within its primary market areas. The sources of competition vary based on the particular market of operation, which can range from a small rural town to part of a large urban market. The Bank competes with large national and regional financial institutions, savings associations and other independent community banks, as well as credit unions, mutual funds and life insurance companies. The banking business in the Bank’s primary market areas is highly competitive for both loans and deposits, and is dominated by a relatively small number of large banks with many offices operating over a wide geographic area. Among the advantages such large banks have over the Bank are their ability to offer banking products and services at large branch networks, to launch and finance wide-ranging advertising campaigns and, by virtue of their greater total capitalization, to have substantially higher lending limits than the Bank. In addition, large banks may more easily comply with certain regulations applicable to banking activities and consumer financial products and services.
Factors such as interest rates offered, the number and location of branches and the types of products offered, as well as the reputation of the institution, affect competition for deposits and loans. The Bank competes by emphasizing customer service and technology, establishing long-term customer relationships, building customer loyalty, and providing products and services to address the specific needs of its customers. The Bank targets individuals and small to medium sized business customers. No material part of the Bank’s business is dependent upon a single or a few customers, and the loss of any single customer would not have a material adverse effect upon the Bank’s business.
Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot foresee how federal regulation of financial institutions may change in the future. However, it is possible that current and future governmental regulatory and economic initiatives could impact the competitive landscape in the Bank’s markets.
Employees
As of December 31, 2016, the Company had 315 full-time equivalent employees. Management of the Company considers its relations with employees to be excellent. No employees are represented by a union or any similar group, and the Company has never experienced any strike or labor dispute.
Regulation and Supervision
General
Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of shareholders and creditors. The following summary briefly describes significant provisions of currently applicable federal and state laws and certain regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because regulation of financial institutions changes regularly and is the subject of constant legislative and regulatory debate, we cannot forecast how federal and state regulation and supervision of financial institutions may change in the future and affect the Company’s and the Bank’s operations.
Regulatory Reform
The financial crisis of 2008, including the downturn of global economic, financial and money markets and the threat of collapse of numerous financial institutions, and other related events led to the adoption of numerous laws and regulations that apply to financial institutions. The most significant of these laws is the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), adopted on July 21, 2010 to implement significant structural reforms to the financial services industry. The Dodd-Frank Act is discussed in more detail below.
The Company continues to experience a period of rapidly changing regulatory requirements and an environment of constant regulatory reform. These regulatory changes could have a significant effect on how the Company conducts its business. The full extent of the Dodd-Frank Act and other potential regulatory reforms cannot yet be fully predicted and will depend to a large extent on the specific regulations that are adopted.
Regulation of the Company
As a public company, the Company is subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As a result, the Company must file annual, quarterly, current and other reports with the Securities and Exchange Commission (the “SEC”), and also comply with other laws and regulations of the SEC applicable to public companies.
As a bank holding company, the Company is also subject to the Bank Holding Company Act of 1956 (the “BHCA”) and supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Generally, a bank holding company is required to obtain the approval of the Federal Reserve Board before acquiring direct or indirect ownership or control of more than five percent of the voting shares of a bank or bank holding company, including through a bank or bank holding company merger or acquisition, completing a non-bank acquisition, or engaging in an activity considered to be a banking activity, either directly or through a subsidiary. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.
Pursuant to the BHCA, the Federal Reserve Board has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the Federal Reserve Board has reasonable grounds to believe that continuation of such activity or ownership constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.
The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking or to managing or controlling banks, and permits interstate banking acquisitions subject to certain conditions, including national and state concentration limits. The Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. A bank holding company must be well capitalized and well managed to engage in an interstate acquisition or merger, and banks may branch across state lines provided that the law of the state in which the branch is to be located would permit establishment of the branch if the bank were a state bank chartered by such state.
A bank holding company is prohibited from engaging in or acquiring, either directly or indirectly through a subsidiary, ownership or control of more than five percent of the voting shares of any company engaged in non-banking activities. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Federal Reserve Board has determined by regulation or order are so closely related to banking as to be a proper incident to banking. A bank holding company also may become eligible to engage in activities that are financial in nature or complimentary to financial activities by qualifying as a financial holding company under the Gramm-Leach-Bliley Act of 1999 (the “GLBA”). To qualify as a financial holding company, each insured depository institution controlled by the bank holding company must be well-capitalized, well-managed and have at least a satisfactory rating under the Community Reinvestment Act. To date, the Company has not qualified as a financial holding company, and the qualification as such by other bank holding companies has not had a material impact on the business of the Company.
Each of the Bank’s depository accounts is insured by the Federal Deposit Insurance Corporation (the “FDIC”) against loss to the depositor to the maximum extent permitted by applicable law, and federal law and regulatory policy impose a number of obligations and restrictions on the Company and the Bank to reduce potential loss exposure to the depositors and to the FDIC insurance funds. For example, pursuant to the Dodd-Frank Act and Federal Reserve Board policy, a bank holding company must commit resources to support its subsidiary depository institutions, which is referred to as serving as a “source of strength.” In addition, insured depository institutions under common control must reimburse the FDIC for any loss suffered or reasonably anticipated by the Deposit Insurance Fund (the “DIF”) as a result of the default of a commonly controlled insured depository institution. The FDIC may decline to enforce the provisions if it determines that a waiver is in the best interest of the DIF. An FDIC claim for damage is superior to claims of stockholders of an insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt, other than affiliates, of the commonly controlled insured depository institution.
The Federal Deposit Insurance Act (the “FDIA”) provides that amounts received from the liquidation or other resolution of any insured depository institution must be distributed, after payment of secured claims, to pay the deposit liabilities of the institution before payment of any other general creditor or stockholder of that institution - including that institution’s parent holding company. This provision would give depositors a preference over general and subordinated creditors and stockholders if a receiver is appointed to distribute the assets of the Bank.
The Company also is subject to regulation and supervision by the Virginia State Corporation Commission Bureau of Financial Institutions (the “Bureau”).
Capital Requirements
The Federal Reserve Board and the FDIC have adopted rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision and standards for calculating risk-weighted assets and risk-based capital measurements (collectively, the “Basel III Capital Rules”) that apply to banking organizations they supervise. For the purposes of these capital rules, (i) common equity tier 1 capital (“CET1”) consists principally of common stock (including surplus) and retained earnings; (ii) Tier 1 capital consists principally of CET1 plus non-cumulative preferred stock and related surplus, and certain grandfathered cumulative preferred stocks and trust preferred securities; and (iii) Tier 2 capital consists principally of Tier 1 capital plus qualifying subordinated debt and preferred stock, and limited amounts of the allowance for loan losses. Each regulatory capital classification is subject to certain adjustments and limitations, as implemented by the Basel III Capital Rules. The Basel III Capital Rules also establish risk weightings that are applied to many classes of assets held by community banks, importantly including applying higher risk weightings to certain commercial real estate loans.
The Basel III Capital Rules were effective January 1, 2015, and the Basel III Capital Rules capital conservation buffer will be phased in from 2016 to 2019.
When fully phased in, the Basel III Capital Rules require banks to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).
The Basel III Capital Rules provide deductions from and adjustments to regulatory capital measures, primarily to CET1, including deductions and adjustments that were not applied to reduce CET1 under historical regulatory capital rules. For example, mortgage servicing rights, deferred tax assets, dependent upon future taxable income, and significant investments in non-consolidated financial entities must be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. These deductions from and adjustments to regulatory capital will generally be phased in beginning in 2015 through 2018.
The Basel III Capital Rules permanently includes in Tier 1 capital trust preferred securities issued prior to May 19, 2010 by bank holding companies with less than $15 billion in total assets, subject to a limit of 25% of Tier 1 capital. The Company expects that its trust preferred securities will be included in the Company’s Tier 1 capital until their maturity.
The Basel III Capital Rules also implement a “countercyclical capital buffer,” generally designed to absorb losses during periods of economic stress and to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk. This buffer is a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).
Under the Basel III Capital Rules, the minimum capital ratios as of December 31, 2016 were as follows (including the impact of the capital conservation buffer):
·5.1250% CET1 to risk-weighted assets.
·6.6250% Tier 1 capital to risk-weighted assets.
·8.6250% Total capital to risk-weighted assets.
The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories to a much larger and more risk-sensitive number of categories than has been historically applied, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes that impacted the Company’s determination of risk-weighted assets included, among other things:
·Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.
·Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.
·Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%).
Management believes that, as of December 31, 2016, the Company would have met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were then in effect.
Limits on Dividends
The Company is a legal entity that is separate and distinct from the Bank, and the ability of the Company to pay dividends depends upon the amount of dividends declared by the Bank, if any. In addition, the ability of the Company to pay dividends is subject to various laws and regulations, including limits on the sources of dividends and requirements to maintain capital at or above regulatory minimums. Regulatory restrictions also exist with respect to the Bank’s ability to pay dividends. Banking regulators have indicated that Virginia banking organizations should generally pay dividends only (1) from net undivided profits of the bank, after providing for all expenses, losses, interest and taxes accrued or due by the bank, and (2) if the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. In addition, Federal Reserve Board supervisory guidance indicates that the Federal Reserve Board may have safety and soundness concerns if a bank holding company pays dividends that exceed earnings for the period in which the dividend is being paid. Further, the FDIA prohibits insured depository institutions such as the Bank from making capital distributions, including paying dividends, if after making such distribution the institution would become undercapitalized as defined in the statute.
Reporting Obligations
As a bank holding company, the Company must file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require pursuant to the BHCA. The Bank must submit to federal and state regulators annual audit reports prepared by independent auditors. The Company’s annual report, which includes the report of the Company’s independent auditors, can be used to satisfy this requirement. The Bank must submit quarterly, to the FDIC, Reports of Condition and Income (referred to in the banking industry as a Call Report). The Company must submit quarterly, to the Federal Reserve Board, Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) and Parent Company Only Financial Statements for Large Bank Holding Companies (FR Y-9LP).
The Dodd-Frank Act
The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including changes that have affected all bank holding companies and banks, including the Company and the Bank. Provisions that significantly affect the business of the Company and the Bank include the following:
·Insurance of Deposit Accounts. The Dodd-Frank Act changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital. The Dodd-Frank Act also made permanent the $250,000 limit for federal deposit insurance and increased the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000.
·Payment of Interest on Demand Deposits. The Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
·Creation of the Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act centralized significant aspects of consumer financial protection by creating a new agency, the CFPB, which is discussed in more detail below.
·Debit Card Interchange Fees. The Dodd-Frank Act imposed limits for debit card interchange fees for issuers that have over $10 billion in assets, which could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets.
In addition, the Dodd-Frank Act implements other changes to financial regulations, including provisions that:
·Restrict the preemption of state law by federal law and disallow subsidiaries and affiliates of national banks from availing themselves of such preemption.
·Impose comprehensive regulation of the over-the-counter derivatives market, subject to significant rulemaking processes, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself.
·Require loan originators to retain 5 percent of any loan sold or securitized, unless it is a "qualified residential mortgage," subject to certain exceptions.
·Implement corporate governance revisions that apply to all public companies not just publicly-traded financial institutions.
The Dodd-Frank Act contains many other provisions, and federal regulators continue to draft implementing regulations which may affect the Company or the Bank. Accordingly, the topics discussed above are only a representative sample of the types of new or increasing regulatory issues in the Dodd-Frank Act that may have an impact on the Company and the Bank.
Source of Strength Doctrine
The Dodd-Frank Act codifies and expands the existing Federal Reserve Board policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under the Dodd-Frank Act, the term “source of financial strength” is defined to mean the “ability of a company that directly or indirectly controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.” As of March 2017, implementing regulations of the Dodd-Frank Act source of strength provisions, however, have not yet been promulgated. It is the Federal Reserve Board’s existing policy that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. Consistent with this, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.
Incentive Compensation
The Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC have issued regulatory guidance (the “Incentive Compensation Guidance”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination and incorporated into the organization’s supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies. The federal banking agencies emphasize that all banking organizations must carefully design and oversee incentive compensation policies to ensure such policies do not undermine the safety and soundness of such organizations.
In 2016, the SEC and the federal banking agencies proposed rules that prohibit covered financial institutions (including bank holding companies and banks) from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk taking by providing covered persons (consisting of senior executive officers and significant risk takers, as defined in the rules) with excessive compensation, fees or benefits that could lead to material financial loss to the financial institution. The proposed rules outline factors to be considered when analyzing whether compensation is excessive and whether an incentive-based compensation arrangement encourages inappropriate risks that could lead to material loss to the covered financial institution, and establishes minimum requirements that incentive-based compensation arrangements must meet to be considered to not encourage inappropriate risks and to appropriately balance risk and reward. The proposed rules also impose additional corporate governance requirements on the boards of directors of covered financial institutions and imposes additional record-keeping requirements. The comment period for these proposed rules has closed and a final rule has not yet been published.
Regulation of the Bank
The Bank, as a state-chartered member bank of the Federal Reserve System, is subject to regulation and examination by the Bureau and the Federal Reserve Board. The various laws and regulations issued and administered by the regulatory agencies (including the CFPB) affect corporate practices, such as the payment of dividends, the incurrence of debt and the acquisition of financial institutions and other companies, and affect business practices and operations, such as the payment of interest on deposits, the charging of interest on loans, and the types of business conduct, the products and terms offered to customers. In addition, the Bank is subject to the rules and regulations of the FDIC, which currently insures substantially all of the Bank’s deposits up to applicable limits of the DIF, and is subject to deposit insurance assessments to maintain the DIF.
Prior approval of the applicable primary federal regulatory and the Bureau is required for a Virginia chartered bank or a bank holding company to merge with another bank or bank holding company, or purchase the assets or assume the deposits of another bank or bank holding company, or acquire control of another bank or bank holding company. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the financial condition and capital position of, and any asset concentrations (including commercial real estate loan concentrations) of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant’s performance record under the Community Reinvestment Act and fair housing initiatives, the data security and cybersecurity infrastructure of the constituent organizations and the combined organization, and the applicant’s compliance with and the effectiveness of the subject organizations in combating money laundering activities and complying with Bank Secrecy Act requirements.
FDIC Insurance, Assessments and Regulation
The Bank’s deposits are insured by the DIF of the FDIC up to the standard maximum insurance amount for each deposit ownership category. As of March 2017, the basic limit on FDIC deposit insurance coverage was $250,000 per depositor. Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC, subject to administrative and potential judicial hearing and review processes.
The DIF is funded by assessments on banks and other depository institutions calculated based on average consolidated total assets minus average tangible equity (defined as Tier 1 capital). As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment scheme, set a target “designated reserve ratio” (described in more detail below) of 2% for the DIF and established a lower assessment rate schedule when the reserve ratio reaches 1.15% and, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2% and 2.5%. An institution's assessment rate is based on a statistical analysis of financial ratios that estimates the likelihood of failure over a three year period, which considers the institution’s weighted average CAMELS component rating, and is subject to further adjustments including related to levels of unsecured debt and brokered deposits (not applicable to banks with less than $10 billion in assets). At December 31, 2016 total base assessment rates for institutions that have been insured for at least five years range from 1.5 to 40 basis points, with rates of 1.5 to 30 basis points applying to banks with less than $10 billion in assets.
The Dodd-Frank Act transferred to the FDIC increased discretion with regard to managing the required amount of reserves for the DIF, or the “designated reserve ratio.” Among other changes, the Dodd-Frank Act (i) raised the minimum designated reserve ratio to 1.35% and removed the upper limit on the designated reserve ratio, (ii) requires that the designated reserve ratio reach 1.35% by September 2020, and (iii) requires the FDIC to offset the effect on institutions with total consolidated assets of less than $10 billion of raising the designated reserve ratio from 1.15% to 1.35% - which requirement was met through rules adopted by the FDIC during 2016. The FDIA requires that the FDIC consider the appropriate level for the designated reserve ratio on at least an annual basis. On October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. On June 30, 2016 the designated reserve ratio rose to 1.17 percent, which triggered three major changes to deposit insurance assessments for the third quarter of 2016: (i) the range of initial assessment rates for all institutions declined from 5 to 35 basis points to 3 to 30 basis points (which are included in the total base assessment rates in the above paragraph); (ii) surcharges equal to an annual rate of 4.5 basis points began for insured depository institutions with total consolidated assets of $10 billion or more; and (iii) the revised assessment method described above was implemented.
FDIC insurance expense totaled $707 thousand, $821 thousand and $921 thousand in 2016, 2015 and 2014, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. The FICO assessment rate for the DIF ranged between a high of 0.58 basis points for 2016, with a low of 0.56 basis points for the second, third and fourth quarters of 2016. For the first quarter of 2017, the FICO assessment rate for the DIF is 0.54 basis points resulting in a premium of $0.0054 per $100 of DIF-eligible deposits.
Prompt Corrective Action
The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities. The Company believes that, as of December 31, 2016, its bank subsidiary, EVB, was “well capitalized” based on the applicable ratios.
Mortgage Banking Regulation
In connection with making mortgage loans, the Bank is subject to rules and regulations that, among other things, establish standards for loan origination, prohibit discrimination, require certain disclosures, provide for inspections and appraisals of property, require credit reports on prospective borrowers and, in some cases, restrict certain loan features and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act (“TILA”), Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act (“RESPA”), and Home Ownership Equity Protection Act, and the regulations promulgated under these acts. These laws prohibit discrimination, require the disclosure of certain information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level. The Dodd-Frank Act has transferred rulemaking authority under many of these laws to the CFPB.
Compliance with the requirements of TILA, RESPA, and other federal and state laws and regulations (including regulations adopted by the CFPB) may require substantial investments in mortgage lending systems and processes and implementation efforts to respond to regulatory developments, all of which may impose significant costs on the Bank. For example, compliance with the CFPB’s Integrated Mortgage Disclosure Rules under TILA and RESPA (or “TRID”), which became effective in October 2015, requires the Bank to implement at significant cost new systems and processes that will apply to most closed-end mortgage loans originated by the Bank.
The Bank’s mortgage origination activities are also subject to Regulation Z, which implements TILA. As amended and effective in January 2014, certain provisions of Regulation Z require mortgage lenders to make a reasonable and good faith determination, based on verified and documented information, that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Alternatively, a mortgage lender can originate “qualified mortgages”, which are generally defined as mortgage loans without negative amortization, interest-only payments, balloon payments, terms exceeding 30 years, and points and fees paid by a consumer equal to or less than 3% of the total loan amount. Higher-priced qualified mortgages (e.g., subprime loans) receive a rebuttable presumption of compliance with ability-to-repay rules, and other qualified mortgages (e.g., prime loans) are deemed to comply with the ability-to-repay rules. The Bank predominately originates mortgage loans that comply with Regulation Z’s “qualified mortgage” rules.
Consumer Protection
The Dodd-Frank Act created the CFPB, a federal regulatory agency that is responsible for implementing, examining and enforcing compliance with federal consumer financial laws for institutions with more than $10 billion of assets and, to a lesser extent, smaller institutions. The Dodd-Frank Act gives the CFPB authority to supervise and regulate providers of consumer financial products and services, establishes the CFPB’s power to act against unfair, deceptive or abusive practices and gives the CFPB rulemaking authority in connection with numerous federal consumer financial protection laws (for example, but not limited to, TILA and RESPA).
As a smaller institution (i.e., with assets of $10 billion or less), most consumer protection aspects of the Dodd-Frank Act will continue to be applied to the Company and the Bank by the Federal Reserve Board. However, the CFPB may include its own examiners in regulatory examinations by a small institution’s prudential regulators and may require smaller institutions to comply with certain CFPB reporting requirements. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the Federal Reserve Board applies consumer protection laws and regulations to financial institutions that are not directly supervised by the CFPB. The precise impact of the CFPB’s consumer protection activities on the Company and the Bank cannot be determined with certainty. In 2016, the CFPB proposed rules that provide an exception to the requirement to deliver an annual privacy notice if a financial institution only provides nonpublic personal information to unaffiliated third parties under limited exceptions under the Gramm-Leach-Bliley Act and related regulations, and has not changed its policies and practices regarding disclosure of nonpublic personal financial information from those disclosed in the most recent privacy notice provided to the customer.
Confidentiality and Required Disclosures of Customer Information
The Company and the Bank are subject to various laws and regulations that address the privacy of nonpublic personal financial information of consumers. The GLBA and certain regulations issued thereunder protect against the transfer and use by financial institutions of consumer nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. These privacy provisions generally prohibit a financial institution from providing a customer's personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.
The Company and the Bank are also subject to various laws and regulations that attempt to combat money laundering and terrorist financing. The Bank Secrecy Act requires all financial institutions to, among other things, create a system of controls designed to prevent money laundering and the financing of terrorism, and imposes recordkeeping and reporting requirements. The USA Patriot Act facilitates information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering, and requires financial institutions to establish anti-money laundering programs. The Federal Bureau of Investigation (“FBI”) sends banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities, and requests banks to search their records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report with the U.S. Department of the Treasury (the “Treasury”) and contact the FBI. The Office of Foreign Assets Control (“OFAC”), which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. If the Bank finds a name of an “enemy” of the United States on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account or place transferred funds into a blocked account, file a suspicious activity report with the Treasury and notify the FBI.
Although these laws and programs impose compliance costs and create privacy obligations and, in some cases, reporting obligations, and compliance with all of the laws, programs and privacy and reporting obligations may require significant resources of the Company and the Bank, these laws and programs do not materially affect the Bank’s products, services or other business activities.
Community Reinvestment Act
The Community Reinvestment Act (“CRA”) imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs are assessed based on specified factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Following the Bank’s most recent scheduled compliance examination in July 2016, it received a CRA performance evaluation of “satisfactory.”
Federal Home Loan Bank of Atlanta
The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, which is one of 12 regional FHLBs that provide funding to their members for making housing loans as well as for affordable housing and community development loans. Each FHLB serves as a reserve, or central bank, for the members within its assigned region. Each is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. Each FHLB makes loans to members in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank must purchase and maintain stock in the FHLB of Atlanta. In 2004, the FHLB converted to its new capital structure, which established the minimum capital stock requirement for member banks as an amount equal to the sum of a membership requirement and an activity-based requirement. At December 31, 2016, the Bank held $8.5 million of FHLB of Atlanta stock.
Volcker Rule
The Dodd-Frank Act prohibits bank holding companies and their subsidiary banks from engaging in proprietary trading except in limited circumstances, and places limits on ownership of equity investments in private equity and hedge funds (the “Volcker Rule”). On December 10, 2013, the U.S. financial regulatory agencies (including the Federal Reserve Board, the FDIC and the SEC) adopted final rules to implement the Volcker Rule. In relevant part, these final rules would have prohibited banking entities from owning collateralized debt obligations (“CDOs”) backed by trust preferred securities, effective July 21, 2015. However, subsequent to these final rules the U.S. financial regulatory agencies issued an interim rule effective April 1, 2014 to exempt CDOs backed by trust preferred securities from the Volcker Rule and the final rule, provided that (a) the CDO was established prior to May 19, 2010, (b) the banking entity reasonably believes that the CDO’s offering proceeds were used to invest primarily in trust preferred securities issued by banks with less than $15 billion in assets, and (iii) the banking entity acquired the CDO investment on or before December 10, 2013.
Smaller banks, with total consolidated assets of $10 billion or less, engaged in modest proprietary trading activities for their own accounts are subject to a simplified compliance program under the final rules. Several portions of the Volcker Rule remain subject to regulatory rulemaking and legislative activity, including to further delay effectiveness of some provisions of the Volcker Rule. The Company believes that its financial condition will not be significantly impacted by the Volcker Rule, and does not expect that any delays in the effectiveness of the Volcker Rule will significantly impact its financial condition.
Future Regulation
Including and in addition to the specific proposals described above, from time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations, regulatory policies or regulatory guidance or interpretative positions applicable to the Company or any of its subsidiaries could have a material effect on the business of the Company.
Available Information
The Company’s SEC filings are filed electronically and are available to the public over the Internet at the SEC’s web site at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company’s SEC filings also are available through our web site at http://www.evb.org under “SEC Filings” as soon as reasonably practicable after they are filed with the SEC. Copies of documents also can be obtained free of charge by writing to the Company’s Corporate Secretary at 10900 Nuckols Road, Suite 325, Glen Allen, VA 23060 or by calling 804-443-8400. The information on the Company’s website is not, and shall not be deemed to be, a part of this Annual Report on Form 10-K or incorporated into any other filings the Company makes with the SEC.
Item 1A.
Item 1A. Risk Factors
An investment in our common stock involves significant risks inherent to the Company’s business. Like other bank holding companies, we are subject to a number of risks, many of which are outside of our control. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition, results of operations and prospects could be harmed. These risks are not the only ones that we may face. Other risks of which we are not aware, including those which relate to the banking and financial services industry in general and us in particular, or those which we do not currently believe are material, may harm our future business, financial condition, results of operations and prospects. Readers should consider carefully the following important risks, in conjunction with the other information in this Annual Report on Form 10-K including our consolidated financial statements and related notes, in evaluating us, our business and an investment in our securities.
Deterioration in economic conditions could adversely affect us.
Deterioration in economic and market conditions, such as the economic downturn and recession that resulted from the financial crisis of 2008, could hurt our business and our financial condition and results of operations. Our business is directly affected by general economic and market conditions, broad trends in industry and finance, and inflation, all of which are beyond our control. A deterioration in economic conditions, and in particular an economic slowdown within our markets, could result in increases in loan delinquencies, problem assets and foreclosures, and could result in decreases in demand for our products and services, and values of collateral supporting our loans. Declines in the housing market, including as experienced through falling home prices and rising foreclosures, can negatively impact the credit performance of real estate related loans. Declines in the employment markets, including as experienced through high unemployment and underemployment, can negatively impact the credit performance of consumer loans. Any of the foregoing effects could negatively impact our business, financial condition and results of operations.
We operate in a mixed market environment with influences from both rural and urban areas, and we will be affected by economic conditions in our Northern Neck, Middle Peninsula, Capital, Tidewater and Southern market areas. Changes in the local economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio, and loan and deposit pricing. Although we might not have significant credit exposure to all the businesses in our market areas, a downturn in any business sector of a market area or a downturn with respect to any significant business in a market area could have a negative impact on local economic conditions and real estate collateral values in that market area, which could negatively affect our profitability.
Offerings of our securities and other potential capital strategies or the conversion of shares of our non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) into common stock could dilute your investment or otherwise affect your rights as a shareholder.
In the future we may seek to raise additional capital through offerings of our common stock, preferred stock, securities convertible into common stock, or rights to acquire such securities or our common stock. Under our Articles of Incorporation, we have additional authorized shares of common stock that we can issue from time to time at the discretion of our Board of Directors, without further action by shareholders, except where shareholder approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The issuance of any additional shares of common stock or securities convertible into common stock in a subsequent offering could be substantially dilutive to holders of our common stock. Holders of our common stock have no preemptive rights as a matter of law that entitle them to purchase their pro-rata share of any offering or shares of any class or series. In addition, under our Articles of Incorporation, we can authorize and issue additional shares of our preferred stock, in one or more series the terms of which would be determined by our Board of Directors without shareholder approval, unless such approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The market price of our common stock could decline as a result of future sales of our securities or the perception that such sales could occur.
New investors, particularly with respect to newly authorized series of preferred stock, also may have rights, preferences, and privileges that are senior to, and that could adversely affect, our then current shareholders, and particularly holders of our common stock. For example, a new series of preferred stock could rank senior to shares of our common stock. As a result, we could be required to make any dividend payments on such preferred stock before any dividends can be paid on our common stock, and in the event of our bankruptcy, dissolution, or liquidation, we may have to pay the holders of this new series of preferred stock in full prior to any distributions being made to the holders of our common stock.
In addition, the conversion of shares of our Series B Preferred Stock into common stock would dilute the voting power of our then-outstanding shares of common stock.
We cannot predict or estimate the amount, timing, or nature of our future securities offerings or other capital initiatives or whether, when or how many shares of our Series B Preferred Stock will be converted into shares of common stock. Thus, our shareholders bear the risk of our future offerings or future conversions of shares of our Series B Preferred Stock diluting their stock holdings, adversely affecting their rights as shareholders, and/or reducing the market price of our common stock.
Affiliates of Castle Creek Capital Partners (“Castle Creek”) and GCP Capital Partners (“GCP Capital”) are substantial holders of our common stock.
Castle Creek holds approximately 8.1% of our common stock and approximately 27.8% of our combined common stock and Series B Preferred Stock. GCP Capital holds approximately 8.6% of our common stock and approximately 12.6% of our combined common stock and Series B Preferred Stock. Pursuant to the terms of the securities purchase agreements entered into with Castle Creek and GCP Capital, Castle Creek and GCP Capital each have a right to appoint a representative on our Board of Directors and on the Bank’s board of directors. Boris M. Gutin serves on the Boards of Directors of the Company and the Bank at the request of an affiliate of GCP Capital. Castle Creek and GCP Capital may have individual economic interests that are different from the other’s interests and different from the interests of our other shareholders.
Compliance with laws, regulations and supervisory guidance, both new and existing, may adversely impact our business, financial condition and results of operations.
We are subject to numerous laws, regulations and supervision from both federal and state agencies. During the past few years, there has been an increase in legislation related to and regulation of the financial services industry. We expect this increased level of oversight to continue. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase our costs and/or limit our ability to pursue certain business opportunities.
Laws and regulations, and any interpretations and applications with respect thereto, generally are intended to benefit consumers, borrowers and depositors, not shareholders. The legislative and regulatory environment is beyond our control, may change rapidly and unpredictably and may negatively influence our revenue, costs, earnings, and capital levels. Our success depends on our ability to maintain compliance with both existing and new laws and regulations.
Failure to comply with regulatory requirements could subject us to regulatory action.
The Company and the Bank are supervised by the Federal Reserve Board and the Bureau. As such, each is subject to extensive supervision and prudential regulation. Both the Company and the Bank must maintain certain risk-based and leverage capital ratios and operate in a safe and sound manner as required by the Federal Reserve Board and the Bureau. If the Company or the Bank fails to meet regulatory capital requirements or is deemed to be operating in an unsafe and unsound manner or in violation of law, it may be subject to a variety of informal or formal regulatory actions. Informal regulatory actions may include a memorandum of understanding which is initiated by the regulator and outlines an institution’s agreement to take specified actions within specified time periods to correct violations of law or unsafe and unsound practices. In addition, as part of the regular examination process, regulators may advise the Company or the Bank to operate under various restrictions as a prudential matter. Any of these restrictions, in whatever manner imposed, could have a material adverse effect on our business, financial condition and results of operations.
In addition to informal regulatory actions, we may also be subject to formal regulatory actions. Failure to comply with an informal regulatory action could lead to formal regulatory actions. Formal regulatory actions include written agreements, cease and desist orders, the imposition of substantial fines and other penalties. Furthermore, if the Bank became severely undercapitalized, it could become subject to the prompt corrective action framework which imposes progressively more restrictive constraints on operations, management and capital. A failure to meet regulatory capital requirements could also subject the Company to capital raising requirements. Additional capital raisings would be dilutive to holders of our common stock.
Any remedial measure or regulatory action, whether formal or informal, could impose restrictions on our ability to operate our businesses and adversely affect our prospects, financial condition or results of operations. In addition, any formal enforcement action could harm our reputation and our ability to retain and attract customers, and impact the trading price of our common stock.
Our regulatory compliance burden and associated costs could continue to increase, which could place restrictions on certain products and services, and limit our future capital strategies.
A wide range of regulatory initiatives directed at the financial services industry have been proposed in recent years. One of those initiatives, the Dodd-Frank Act, represents a sweeping overhaul of the financial services industry within the United States and mandates significant changes in the financial regulatory landscape that has impacted and will continue to impact all financial institutions, including the Company and the Bank. The federal regulatory agencies, and particularly bank regulatory agencies, are given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations, and certain of the implementing rules and regulations have not yet been proposed or approved; consequently the full details and impact of the Dodd-Frank Act will depend on the final implementing rules and regulations. Accordingly, it remains too early to fully assess the full impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on our business, financial condition or results of operations.
The Dodd-Frank Act creates a new financial consumer protection agency, the CFPB, that can impose new regulations on us and include its examiners in our routine regulatory examinations conducted by the Federal Reserve Bank of Richmond (the “Reserve Bank”), which could increase our regulatory compliance burden and costs and restrict the financial products and services we can offer to our customers. The CFPB, through the agency’s rulemaking and enforcement authority with respect to the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive business practices, may reshape the consumer financial protection laws and directly impact the business operations of financial institutions offering consumer financial products or services, including the Company and the Bank. This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service. The costs and limitations related to this additional regulatory agency and the limitations and restrictions that will be placed upon the Company with respect to its consumer product and service offerings have yet to be determined. However, these costs, limitations and restrictions may produce significant, material effects on our business, financial condition and results of operations.
The Basel III Capital Rules require higher levels of capital and liquid assets, which could adversely affect our net income and return on equity.
The Basel III Capital Rules, which began to apply to the Company and the Bank on January 1, 2015, represent the most comprehensive overhaul of the U.S. banking capital framework in over two decades. These rules require bank holding companies and their subsidiaries, such as the Company and the Bank, to dedicate more resources to capital planning and regulatory compliance, and maintain substantially more capital as a result of higher required capital levels and more demanding regulatory capital risk-weightings and calculations. The rules also require all banks to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and likely increase risk-weighted assets at many banking organizations as a result of applying higher risk-weightings to certain types of loans and securities. As a result, we may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio, or change the way we manage past-due exposures.
Due to the changes to bank capital levels and the calculation of risk-weighted assets, many banks could be required to access the capital markets on short notice and in relatively weak economic conditions, which could result in banks raising capital that significantly dilutes existing shareholders. Additionally, many community banks could be forced to limit banking operations and activities, and growth of loan portfolios and interest income, in order to focus on retention of earnings to improve capital levels. If the Basel III Capital Rules require the Company to access the capital markets in this manner, or similarly limit the Bank’s operations and activities, the Basel III Capital Rules would have a detrimental effect on our net income and return on equity and limit the products and services we provide to our customers.
We have a high concentration of loans secured by both residential and commercial real estate and a further downturn in either or both real estate markets, for any reason, may increase our credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Most of our loans are secured by real estate (both residential and commercial) in our market areas. At December 31, 2016, approximately 80.5% of our $1.0 billion loan portfolio was secured by residential and commercial real estate. Changes in the real estate market, such as a deterioration in market value of collateral, or a decline in local employment rates or economic conditions, could adversely affect our customers’ ability to pay these loans, which in turn could impact our profitability. Repayment of our commercial loans is often dependent on the cash flow of the borrower, which may be unpredictable. If the value of real estate serving as collateral for the loan portfolio materially declines, a significant portion of the loan portfolio could become under-collateralized. If the loans that are secured by real estate become troubled when real estate market conditions are declining or have declined, in the event of foreclosure we may not be able to realize the amount of collateral that was anticipated at the time of originating the loan. In that event, we may have to increase the provision for loan losses, which could have a material adverse effect on our operating results and financial condition.
Our small to medium-sized business target market may have fewer financial resources to weather a downturn in the economy.
We target our commercial development and marketing strategy primarily to serve the banking and financial services needs of small and medium-sized businesses. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact this major economic sector in the markets in which we operate, our results of operations and financial condition may be adversely affected.
We have a concentration of credit exposure in acquisition and development (or “ADC”) real estate loans.
At December 31, 2016, we had approximately $108.7 million in loans for the acquisition and development of real estate and for construction of improvements to real estate, representing approximately 10.5% of our total loans outstanding as of that date. These loans are to developers, builders and individuals. Project types financed include acquisition and development of residential subdivisions and commercial developments, builder lines for one to four family home construction and loans to individuals for primary and secondary residence construction. These types of loans are generally viewed as having more risk of default than residential real estate loans. Completion of development projects and sale of developed properties may be affected significantly by general economic conditions, and further downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains acquisition and development loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.
We may need to raise additional capital that may not be available to us.
We may need to or may otherwise be required to raise additional capital in the future, including if we incur losses or due to regulatory mandates. The ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, additional capital may not be raised, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to maintain our capital ratios could be materially impaired, and we could face additional regulatory challenges.
If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.
Making loans is an essential element of our business. The risk of nonpayment is affected by a number of factors, including but not limited to: the duration of the credit; credit risks of a particular customer; changes in economic and industry conditions; and, in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral. We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on those loans that are identified. Our allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, changes in the size and composition of the loan portfolio and industry information. Also included in our estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. Because any estimate of loan losses is necessarily subjective and the accuracy of any estimate depends on the outcome of future events, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income. We cannot be certain that our allowance for loan losses is adequate to absorb probable losses in our loan portfolio.
We may incur losses if we are unable to successfully manage interest rate risk.
Our profitability depends in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. These rates are normally in line with general market rates and rise and fall based on the asset liability committee’s view of our financing and liquidity needs. We may selectively pay above-market rates to attract deposits, as we have done in some of our marketing promotions in the past. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, which, in turn, may affect the growth in loan and retail deposit volume. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Fluctuations in market rates are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations.
Changes in interest rates also affect the value of our loans. An increase in interest rates could adversely affect our borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money. This may lead to an increase in nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our results of operations.
Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.
We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. We may face a competitive disadvantage as a result of our smaller size, smaller asset base, lack of geographic diversification and inability to spread our marketing costs across a broader market. If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected. Failure to compete effectively to attract new or to retain existing clients may reduce or limit our margins and our market share and may adversely affect our results of operations, financial condition and growth.
We face risks in connection with our strategic and other business initiatives and we may not be able to fully execute on these initiatives, which could have a material adverse effect on our financial condition or results of operations.
From time to time we may pursue, develop, and implement strategic business initiatives. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such opportunities or that such opportunities, if pursued, will be successful.
We remain focused on building a robust banking franchise and continue to evaluate and undertake various strategic activities and business initiatives. These initiatives may include products or services that are new to us. There can be no assurance that we will successfully identify appropriate initiatives, that we will be able to negotiate or finance such initiatives or that such initiatives, if undertaken, will be successful.
Our ability to execute strategic and other business initiatives successfully will depend on a variety of factors. These factors likely will vary based on the nature of the initiative but may include: overall market conditions, meeting applicable regulatory requirements and receiving approval of any regulatory applications or filings, hiring or retaining key employees, achieving anticipated business results and our success in operating effectively with any co-investor or partner with whom we elect to do business. Our ability to address these factors successfully cannot be assured. In addition, our strategic efforts may divert resources or management's attention from ongoing business operations and may subject us to additional regulatory scrutiny and potential liability. If we do not successfully execute a strategic initiative, it could adversely affect our business, financial condition, results of operations or reputation. In connection with executing any such initiative, we would expect to incur additional non-interest expense, and perhaps the initiative’s entire cost, in advance of realizing improved financial condition and results of operations as a result of the initiative.
Deterioration in the soundness of our counterparties could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could create another market-wide liquidity crisis similar to that experienced in late 2008 and early 2009 and could lead to losses or defaults by us or by other institutions. There is no assurance that the failure of our counterparties would not materially adversely affect the Company’s results of operations.
Cyber-attacks or other security breaches could have a material adverse effect on our business.
As a financial institution, our operations rely heavily on the secure data processing, storage and transmission of confidential and other information on our computer systems and networks. Any failure, interruption or breach in security or operational integrity of these systems could result in failures or disruptions in our online banking system, customer relationship management, general ledger, deposit and loan servicing and other systems. The security and integrity of our systems and the technology we use could be threatened by a variety of interruptions or information security breaches, including those caused by computer hacking, cyber-attacks, electronic fraudulent activity or attempted theft of financial assets. We may fail to promptly identify or adequately address any such failures, interruptions or security breaches if they do occur. While we have certain protective policies and procedures in place, the nature and sophistication of the threats continue to evolve. We may be required to expend significant additional resources in the future to modify and enhance our protective measures.
The nature of our business may make it an attractive target and potentially vulnerable to cyber-attacks, computer viruses, physical or electronic break-ins or similar disruptions. The technology-based platform we use processes sensitive data from our borrowers and investors. While we have taken steps to protect confidential information that we have access to, our security measures and the security measures employed by the owners of the technology in the platform that we use could be breached. Any accidental or willful security breaches or other unauthorized access to our systems could cause confidential customer, borrower and investor information to be stolen and used for criminal purposes. Security breaches or unauthorized access to confidential information could also expose us to liability related to the loss of the information, time-consuming and expensive litigation and negative publicity. If security measures are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in the technology-based platform that we use are exposed and exploited, our relationships with borrowers and investors could be severely damaged, and we could incur significant liability.
Because techniques used to sabotage or obtain unauthorized access to systems change frequently and generally are not recognized until they are launched against a target, we and our collaborators may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, federal regulators and many federal and state laws and regulations require companies to notify individuals of data security breaches involving their personal data. These mandatory disclosures regarding a security breach are costly to implement and often lead to widespread negative publicity, which may cause customers, borrowers and investors to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, would harm our reputation and could cause us to lose customers, borrowers, investors and partners and adversely affect our business and operations.
We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a customer-focused and relationship-driven organization. We expect our future success to be driven in a large part by the relationships maintained with our customers by our president and chief executive officer and other senior officers. We have entered into employment agreements with certain of our executive officers, including our chief executive officer. The existence of such agreements, however, does not necessarily assure that we will be able to continue to retain their services. The unexpected loss of any of our key employees could have an adverse effect on our business and possibly result in reduced revenues and earnings. The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. The market for these people is competitive, and we cannot assure you that we will be successful in attracting, hiring, motivating or retaining them.
Our deposit insurance premiums could increase in the future, which may adversely affect our future financial performance.
The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges insured financial institutions premiums to maintain the DIF at a certain level. The financial crisis of 2008 and the resulting recession increased the rate of bank failures and expectations for further bank failures, requiring the FDIC to make payments for insured deposits from the DIF - which depleted the DIF - and prepare for future payments from the DIF.
On April 1, 2011, final rules to implement changes required by the Dodd-Frank Act with respect to the FDIC assessment rules became effective. The rules provide that a depository institution’s deposit insurance assessment will be calculated based on the institution’s total assets less tangible equity, rather than the previous base of total deposits. These changes have not materially increased the Company’s FDIC insurance assessments for comparable asset and deposit levels. However, if the Bank’s asset size increases or the FDIC takes other actions to replenish the DIF, the Bank’s FDIC insurance premiums could increase.
Our disclosure controls and procedures and internal controls may not prevent or detect all errors or acts of fraud.
Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or omission. Additionally, controls can be circumvented by individual acts, by collusion by two or more people and/or by override of the established controls. Accordingly, because of the inherent limitations in our control systems and in human nature, misstatements due to error or fraud may occur and not be detected.
Our operations rely on certain external vendors.
We are reliant upon certain external vendors to provide products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. We maintain a system of comprehensive policies and a control framework designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition, (iii) changes in the vendor’s support for existing products and services and (iv) changes in the vendor’s strategic focus. While we believe these policies and procedures help to mitigate risk, the failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements could be disruptive to our operations, which could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
Our communication and information systems may experience an interruption in service.
We rely heavily on communications and information systems to conduct our business. Any failure or interruption of these systems could result in failures or disruptions in our customer relationship management, transaction processing systems and various accounting and data management systems. While we have policies and procedures designed to prevent and/or limit the effect of any failure or interruption of our communication and information systems, there can be no assurance that any such failures or interruptions will not occur, or, if they do occur, they will be adequately addressed on a timely basis. The occurrence of failures or interruptions of our communication and information systems could damage our reputation, result in a loss of customer business and subject us to additional regulatory scrutiny, which could have a material adverse effect on our financial condition and results of operations.
We continually encounter technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. Although recently we have significantly increased our focus on technological innovation and have introduced new, more technologically-advanced products and services, we may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
We are subject to environmental liability risk associated with lending activities.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact our business.
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. In addition, such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. The occurrence of any such event in the future could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially impact our financial statements.
From time to time the SEC and the Financial Accounting Standards Board (“FASB”) change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing our financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, the Company may experience unexpected material consequences.
Liquidity needs could adversely affect our results of operations and financial condition.
The Company relies on dividends from the Bank as its primary source of additional liquidity, and the payment of dividends by the Bank to the Company is restricted by applicable state and federal law. The primary sources of funds of the Bank are client deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to clients on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands.
We may be parties to certain legal proceedings that may impact our earnings.
We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.
We have goodwill that may become impaired, and thus result in a charge against earnings.
The Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis are discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company has elected to bypass the preliminary assessment and conduct a full goodwill impairment analysis on an annual basis through the use of an independent third party specialist. As of December 31, 2016, we had $17.1 million of goodwill related to branch acquisitions in 2003 and 2008 and the acquisition of VCB in 2014. To date, we have not recorded any impairment charges on our goodwill, however there is no guarantee that we may not be forced to recognize impairment charges in the future as operating and economic conditions change. Any material impairment charge would have a negative effect on the Company’s financial results and shareholders’ equity.
Other-than-temporary impairment could reduce our earnings.
We may be required to record other-than-temporary impairment (or “OTTI”) charges on our investment securities if they suffer a decline in value that is considered other-than-temporary. Numerous factors, including lack of liquidity for re-sales of certain investment securities, absence of reliable pricing information for certain investment securities, adverse changes in business climate, adverse actions by regulators, or unanticipated changes in the competitive environment could have a negative effect on our investment securities portfolio in future periods. An OTTI charge could have a material adverse effect on our results of operations and financial condition.
Our common stock trading volume may not provide adequate liquidity for investors.
Although shares of the Company’s common stock are listed on the NASDAQ Global Select Market, the average daily trading volume in the common stock is less than that of many other financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of a sufficient number of willing buyers and sellers of the common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the daily average trading volume of the Company’s common stock, significant sales of the common stock in a brief period of time, or the expectation of these sales, could cause a decline in the price of the Company’s common stock.
Our common stock and Series B Preferred Stock are not insured deposits.
Our common stock and Series B Preferred Stock are not bank deposits and, therefore, losses in their value are not insured by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in the Company’s common stock or Series B Preferred Stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this Form 10-K, and is subject to the same market forces and investment risks that affect the price of capital stock in any other company, including the possible loss of some or all principal invested.
Certain losses or other tax assets could be limited if we experience an ownership change, as defined in the Internal Revenue Code.
Our ability to use net operating loss carryforwards, built-in losses and certain other tax assets may be limited in the event of an “ownership change” as defined by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5% shareholders” (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period. If an “ownership change” occurs, Section 382 would impose an annual limit on the amount of losses or other tax assets we can use to reduce our taxable income equal to the product of the total value of our outstanding equity immediately prior to the “ownership change” and the applicable federal long-term tax-exempt interest rate. A number of special rules apply to calculating this limit. While stock issuances that we have completed since 2013 and other changes in ownership of certain of our shareholders may have increased the likelihood of an “ownership change,” we currently believe that an “ownership change” has not occurred. If such an ownership change has occurred or occurs in the future, we may not be able to use all of our net operating losses and other tax assets to offset taxable income, thus paying higher income taxes which would negatively impact our financial condition and results of operations.
Risks Related to the Pending Merger with Southern National
Because of the fixed exchange ratio and the fluctuation of the market price of Southern National common stock, the market value of the merger consideration to be paid by Southern National to our shareholders will fluctuate.
On December 13, 2016, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) to merge with and into Southern National Bancorp of Virginia, Inc. ( or “Southern National”), with Southern National surviving (such transaction, the “Pending Merger”). In the Pending Merger, each share of our common stock and of our Series B Preferred Stock will be converted into the right to receive 0.6313 shares of common stock of the combined company, the value of which will depend upon the price of Southern National common stock at the effective date of the Pending Merger, and cash in lieu of any fractional shares. Upon the effective date of the Pending Merger, Southern National common stock, including the shares issued to former holders of our common stock and our Series B Preferred Stock, will be the common stock of the combined company. The price of Southern National common stock as of the effective date of the Pending Merger may vary significantly from its price at the date the fixed exchange ratio was established. There will be no adjustment to the merger consideration for changes in the market price of either shares of Southern National common stock or shares of our common stock. There also is no maximum or minimum closing price of Southern National common stock at which we or Southern National may unilaterally terminate the Merger Agreement. Variations in the price of Southern National common stock may result from changes in the business, operations or prospects of Southern National, regulatory considerations, general market and economic conditions, and other factors, many of which are outside of the control of Southern National.
Termination of the Merger Agreement could negatively impact us.
If the Merger Agreement is terminated, our business may have been adversely affected by the failure to pursue other beneficial opportunities due to the focus of management on the Pending Merger, without realizing any of the anticipated benefits of completing the Pending Merger. Additionally, if the Merger Agreement is terminated, the market price of our common stock could decline to the extent that the current market price reflects a market assumption that the Pending Merger will be completed. Furthermore, costs relating to the Pending Merger, such as legal, accounting and financial advisory fees, must be paid even if the Pending Merger is not completed. Failure to complete the Pending Merger could also result in reputational harm to us. If the Merger Agreement is terminated under certain circumstances, including circumstances involving a change in recommendation by our Board of Directors, the Company may be required to pay to Southern National a termination fee of $7.5 million. If the Merger Agreement is terminated and our Board of Directors seeks another merger or business combination, our shareholders cannot be certain that we will be able to find a party willing to pay the equivalent or greater consideration than that which Southern National has agreed to pay with respect to the Pending Merger.
We are subject to business uncertainties and contractual restrictions related to the Pending Merger.
Uncertainty about the effect of the Pending Merger on employees and customers may have an adverse effect on us and our business. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Pending Merger is completed, and could cause customers and others that deal with the Company and the Bank to seek to change existing business relationships. Retention of certain employees by the Company and the Bank may be challenging until the Pending Merger is completed, as certain employees may experience uncertainty about their future roles with the Bank. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with our organization, our business before or following completion of the Pending Merger could be harmed. Southern National may be subject to similar risks and uncertainties related to the Pending Merger, and the negative consequences of risk and uncertainties encountered by the Company and Southern National may negatively affect the business, financial condition or results of operations of the combined company. In addition, subject to certain exceptions, we have agreed to operate our business in the ordinary course prior to closing and to refrain from taking certain specified actions until the Pending Merger occurs, which may prevent us from pursuing attractive business opportunities that may arise prior to completion of the Pending Merger.
Combining Southern National and the Company may be more difficult, costly or time-consuming than we expect.
Southern National and the Company have operated and, until the completion of the Pending Merger, will continue to operate independently. The success of the Pending Merger will depend, in part, on our ability to successfully combine the businesses of Southern National with ours. It is possible that the integration process could result in the loss of key employees, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the Pending Merger. The loss of key employees could adversely affect the combined company’s ability to successfully conduct its business in the markets in which we now operate, which could have an adverse effect on the combined company’s financial results and the value of Southern National’s common stock after the Pending Merger is completed. If the combined company experiences difficulties with the integration process, the anticipated benefits of the Pending Merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause the Bank to lose customers or cause customers to remove their accounts from the Bank and move their business to competing financial institutions. Integration efforts between Southern National and the Company will also divert management attention and resources. These integration matters could have an adverse effect on each of the Company, the Bank, Southern National and Sonabank during this transition period and for an undetermined period after consummation of the Pending Merger.
Our ability to complete the Pending Merger is subject to the receipt of consents and approvals from regulatory agencies which may impose conditions that could adversely affect us or cause the Merger to be abandoned.
Before the Pending Merger may be completed, we must obtain various approvals or consents from the Federal Reserve Board and the Bureau. These regulators may impose conditions on the completion of the Pending Merger. Although we do not currently expect that any significant conditions would be imposed, there can be no assurance that they will not be, and such conditions could have the effect of delaying completion of the Pending Merger or imposing additional costs on or limiting the revenues of the combined company following completion of the Pending Merger. There can be no assurance as to whether the regulatory approvals will be received, the timing of those approvals, or whether any conditions will be imposed.
The Merger Agreement limits our ability to pursue alternatives to the Pending Merger and might discourage competing offers for a higher price or premium.
The Merger Agreement contains “no-shop” provisions that, subject to limited exceptions, limit our ability to discuss, facilitate or commit to competing third-party proposals to acquire all or a significant part of our Company. In addition, under certain circumstances, if the Merger Agreement is terminated and we, subject to certain restrictions, consummate a similar transaction other than the Pending Merger, we must pay to Southern National a termination fee of $7.5 million. These provisions might discourage a potential competing acquiror that might have an interest in acquiring all or a significant percentage of ownership of us from considering or proposing the acquisition even if it were prepared to pay consideration with a higher per share market price than that proposed in the Pending Merger.
The Pending Merger may distract our management from their other responsibilities.
The Pending Merger could cause our management to focus their time and energies on matters related to the transaction that otherwise would be directed to our business and operations. Any such distraction on the part of our management could affect our ability to service existing business and develop new business and adversely affect our business and earnings before the completion of the Pending Merger, or the business and earnings of the combined company after completion of the Pending Merger.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Our principal executive offices (and corporate headquarters) are leased and located at 10900 Nuckols Road, Suite 325, Glen Allen, Virginia 23060 where we relocated to in October 2016. At the end of 2016, the Company owned twenty-one full service branch buildings including the land on which eighteen of those buildings are located and two remote drive-in facilities. The Company currently has long-term leases for six of its branches, one loan production office and its corporate headquarters in Glen Allen, Virginia. Three of the leases are for branch buildings, three of the leases are for the land on which Company owned branches are located, one lease is for a loan production office building in Chesterfield, Virginia and one lease is for the corporate headquarters. All leases are under long-term non-cancelable operating lease agreements with renewal options, at total annual rentals of approximately $788 thousand as of December 31, 2017. The counties of Northumberland and Middlesex are each the home to three of our branches. The counties of Essex and Gloucester are each home to two branch offices. In addition, Essex County houses an operations center that formerly served as our corporate headquarters. Henrico County houses one branch office and the Company’s corporate headquarters. Hanover County houses three branch offices and the Bank’s loan administration center, while King William County, Lancaster, New Kent, Southampton, Surry, Sussex Counties and the cities of Colonial Heights, Hampton, Newport News and Williamsburg each have one full service branch office. In addition, the city of Newport News houses a commercial/administrative center. Southampton County and Sussex County also each have a stand-alone drive-in/automated teller machine location.
The Company believes its facilities are in good operating condition, are suitable and adequate for its operational needs and are adequately insured.
See Item 13. “Certain Relationships and Related Transactions, and Director Independence” and Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 23. Former Related Party Lease” of this Form 10-K for more information on the Company’s former related party lease.
Item 3.
Item 3. Legal Proceedings
The Company is not a party to, nor is any of its property the subject of, any material pending legal proceedings incidental to its businesses other than those arising in the ordinary course of business. Although the amount of any ultimate liability with respect to such matters cannot be determined, in the opinion of management, any such liability from legal proceedings incidental to the Company’s business will not have a material adverse effect on the consolidated financial position or results of operations of the Company.
Item 4.
Item 4. Mine Safety Disclosures
None.
Executive Officers of the Registrant
Following are the persons who are currently executive officers of the Company, their ages as of December 31, 2016, their current titles and positions held during the last five years:
Joe A. Shearin, 60, joined the Company in 2001 as the President and Chief Executive Officer of Southside Bank. Mr. Shearin served in that capacity until 2006 when he became President and Chief Executive Officer of the Bank. Mr. Shearin became the President and Chief Executive Officer of the Company in 2002.
J. Adam Sothen, 40, joined the Company in June 2010 as Vice President and Corporate Controller of the Bank. In September 2011, Mr. Sothen was appointed as the Company’s Chief Financial Officer and the Bank’s Executive Vice President and Chief Financial Officer. Mr. Sothen served as the Corporate Controller until October 2012.
James S. Thomas, 62, joined the Company in 2003 as Senior Vice President and Retail Banking Manager of Southside Bank. In 2005, he became Executive Vice President and Chief Operating Officer of Southside Bank. In April 2006, Mr. Thomas became Executive Vice President of Retail Banking for the Bank. In June 2007, Mr. Thomas was promoted to Executive Vice President and Chief Credit Officer of the Bank.
Douglas R. Taylor, 60, joined the Company in April 2010 as Executive Vice President and Chief Risk Officer of the Bank.
Ann-Cabell Williams, 55, joined the Company in July 2011 as Executive Vice President and Retail Executive of the Bank. From January 2007 until joining the Company, Ms. Williams served as Chief Operation Officer and Retail Executive for Bank of Virginia. In April 2016, she became Executive Vice President and Chief Channel Distribution Officer of the Bank.
Bruce T. Brockwell, 51, joined the Company in April 2011 as Senior Vice President and Senior Commercial Lending Officer of the Bank. In May 2012, he became Senior Vice President and Director of Commercial Banking of the Bank. In August 2013, Mr. Brockwell was promoted to Executive Vice President and Director of Commercial Banking of the Bank. In April 2016, he became Executive Vice President and Chief Banking Officer of the Bank.
Mark C. Hanna, 48, joined the Company in November 2014 as Executive Vice President and Regional Executive of the Bank. From November 2006 until joining the Company, Mr. Hanna served as President and Chief Executive Officer for Virginia Company Bank. From September 2005 to November 2006, Mr. Hanna served as President of Virginia Company Bank.
Dianna B. Emery, 58, joined the Company in December 2007 as Cash Management Sales Officer of the Bank and later transitioned to Senior Business Analyst of the Bank. In March 2011, she became Vice President and Operations Manager of the Bank. In July 2015, she became Senior Vice President and Chief Operations Officer of the Bank. In November 2015, Ms. Emery was promoted to Executive Vice President and Chief Operations Officer of the Bank.
Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Performance and Dividends
The Company’s common stock is traded on the NASDAQ Global Market under the symbol “EVBS.” As of March 10, 2017, there were approximately 2,684 shareholders of record. As of that date, the closing price of our common stock on the NASDAQ Global Market was $10.66. Set forth in the table below is the high and low sales prices of our common stock as reported by the NASDAQ Stock Market during each quarter for 2016 and 2015, along with the dividends that were declared quarterly in 2016 and 2015.
Payment of dividends is at the discretion of the Company’s board of directors and is subject to various federal and state regulatory limitations. For further information regarding payment of dividends refer to Item 1, “Business,” under the heading “Limits on Dividends” of this Annual Report on Form 10-K.
Stock Performance Graph
The graph below presents five-year cumulative total return comparisons through December 31, 2016, in stock price appreciation and dividends for the Company’s common stock, the NASDAQ Composite and the SNL $1 billion - $5 billion Bank Index. Returns assume an initial investment of $100 at the market close on December 31, 2011 and reinvestment of dividends. Values as of each year end of the $100 initial investment are shown in the table and graph below.
Dividend Reinvestment and Stock Purchase Plan
The Company has a Dividend Reinvestment and Stock Purchase Plan (the “DRSPP”), which provides for the automatic conversion of dividends into common stock for enrolled shareholders. The DRSPP also permits participants to make voluntary cash payments of up to $20 thousand per shareholder per calendar quarter for the purchase of additional shares of the Company’s common stock. When the administrator of the DRSPP purchases shares of common stock from the Company, the purchase price will generally be the market value of the common stock on the purchase date as defined by the Nasdaq Stock Market. When the administrator purchases shares of common stock in the open market, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. When the administrator purchases shares of common stock in privately negotiated transactions, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses.
Beginning on August 15, 2012, the issuance of common stock under the DRSPP was temporarily suspended. In July 2016 the Company reinitiated the Company’s DRSPP. Of the 353,473 shares reserved for issuance under the Company’s DRSPP, there were 128,670 shares available for issuance under the plan as of December 31, 2016.
Purchases of Equity Securities by the Issuer
In January 2001, the Company announced a stock repurchase program by which management was authorized to repurchase up to 300,000 shares of the Company’s common stock. This plan was amended in 2003 and the number of shares by which management is authorized to repurchase is up to 5% of the outstanding shares of the Company’s common stock on January 1 of each year. There is no stated expiration date for the program. During 2016, 2015 and 2014, the Company did not repurchase any of its common stock under the program.
Item 6.
Item 6. Selected Financial Data
Note: (1) Efficiency ratio is computed by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, net of gains or losses.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This commentary provides an overview of the Company’s financial condition as of December 31, 2016 and 2015, and changes in financial condition and results of operations for the years 2014 through 2016. This section of the Form 10-K should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included under Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.
Forward Looking Statements
Certain statements contained in this Annual Report on Form 10-K that are not historical facts may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Exchange Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, income or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to products or services, the performance of portions of the Company’s asset portfolio, employee initiatives and the anticipated financial impact of those initiatives, and the payment of dividends; (iii) statements of future financial performance and economic conditions; (iv) statements regarding the adequacy of the allowance for loan losses; (v) statements regarding the Company’s liquidity; (vi) statements of management’s expectations regarding future trends in interest rates, real estate values, business opportunities and economic conditions generally and in the Company’s markets; (vii) statements regarding future asset quality, including expected levels of charge-offs; (viii) statements regarding potential changes to laws, regulations or administrative guidance; (ix) statements regarding strategic initiatives of the Company or the Bank and the results of these initiatives, including the Pending Merger of the Company and Southern National; and (x) statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” “continue,” “remain,” “will,” “should,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
qfactors that adversely affect our strategic and business initiatives, including, without limitation, changes in the economic or business conditions in the Company’s markets;
qthe possibility that any of the anticipated benefits of the Pending Merger will not be realized or will not be realized within the expected time period; the risk that integration of the operations of Southern National and the Company will be materially delayed or will be more costly or difficult than expected; the inability to complete the Pending Merger due to the failure to obtain the required shareholder approvals; the failure to satisfy other conditions to completion of the Pending Merger, including receipt of required regulatory and other approvals; the failure of the Pending Merger to close for any other reason; the effect of the announcement of the Pending Merger on customer relationships and operating results; the possibility that the Pending Merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events; changes in interest rates; general economic conditions and those in the market areas of Southern National and the Company;
qour ability and efforts to assess, manage and improve asset quality;
qthe strength of the economy in the Company’s target market area, as well as general economic, market, political, or business factors;
qchanges in the quality or composition of our loan or investment securities portfolios, including adverse developments in borrower industries or in the repayment ability of individual borrowers or issuers;
qconcentrations in segments of the loan portfolio or declines in real estate values in the Company’s markets;
qthe effects of our adjustments to the composition of our investment securities portfolio;
qthe strength of the Company’s counterparties;
qan insufficient allowance for loan losses;
qour ability to meet the capital requirements of our regulatory agencies;
qchanges in laws, regulations and the policies of federal or state regulators and agencies, including the Basel III Capital Rules;
qchanges in the interest rates affecting our deposits and loans;
qthe loss of any of our key employees;
qfailure, interruption or breach of any of the Company’s communication or information systems, including those provided by external vendors;
qthe effects of cyber-attacks or other security breaches;
qour potential growth, including our entrance or expansion into new markets, the opportunities that may be presented to and pursued by us and the need for sufficient capital to support that growth;
qchanges in government monetary policy, interest rates, deposit flow, the cost of funds, and demand for loan products and financial services;
qour ability to maintain internal control over financial reporting;
qour ability to realize our deferred tax assets, including in the event the Company experiences an ownership change as defined by section 382 of the Code;
qour ability to raise capital as needed by our business;
qour reliance on secondary sources, such as FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks to meet our liquidity needs; and
qother circumstances, many of which are beyond our control.
Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions and projections within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance, actions or achievements of the Company will not differ materially from any future results, performance, actions or achievements expressed or implied by such forward-looking statements. Readers should not place undue reliance on such statements. Forward-looking statements speak only as of the date of this report. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. The reader should refer to risks detailed under Item 1A. “Risk Factors” included above in this Form 10-K and in our periodic and current reports filed with the SEC for specific factors that could cause our actual results to be significantly different from those expressed or implied by our forward-looking statements.
Critical Accounting Policies
The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.
Allowance for Loan Losses
The Company establishes the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. For more information see the section titled “Asset Quality” within Item 7.
Impairment of Loans
The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due, according to the contractual terms of the loan agreement. The Company does not consider a loan impaired during a period of insignificant payment shortfalls if we expect the ultimate collection of all amounts due. Impairment is measured on a loan by loan basis for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans, representing consumer, one to four family residential first and seconds and home equity lines, are collectively evaluated for impairment. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. Troubled debt restructurings (“TDRs”) are also considered impaired loans. A TDR occurs when the Company, for economic or legal reasons related to the borrower’s financial condition, grants a concession (including, without limitation, rate reductions to below-market rates, payment deferrals, forbearance and, in some cases, forgiveness of principal or interest) to the borrower that it would not otherwise consider. For more information see the section titled “Asset Quality” within this Item 7.
Loans Acquired in a Business Combination
The Company accounts for loans acquired in a business combination in accordance with the FASB Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations.” Accordingly, acquired loans are segregated between purchased credit-impaired (“PCI”) loans and purchased performing loans and are recorded at estimated fair value on the date of acquisition without the carryover of the related allowance for loan losses.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair market value, PCI loans are aggregated into pools of loans based on common characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income. Loans not designated PCI loans as of the acquisition date are designated purchased performing loans. The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing or PCI loans. A provision for loan losses is recorded for any deterioration in these loans subsequent to the acquisition.
Impairment of Securities
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income (loss). For equity securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company’s best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.
Other Real Estate Owned (“OREO”)
Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at fair value of the property, less estimated disposal costs, if any. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write-downs are charged against current earnings.
Goodwill
With the adoption of FASB Accounting Standards Update (“ASU”) 2011-08, “Intangible-Goodwill and Other-Testing Goodwill for Impairment,” the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis were discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company chose to bypass the preliminary assessment of qualitative impairment factors and completed its annual goodwill impairment test during the fourth quarter of 2016 through the use of an independent third party specialist and determined there was no impairment to be recognized in 2016. If the underlying estimates and related assumptions change in the future, the Company may be required to record impairment charges.
Retirement Plan
The Company historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense. The Company intends to terminate the plan effective May 1, 2017 in connection with the Pending Merger.
Accounting for Income Taxes
Determining the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company’s tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.
The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed. For more information, see Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”
For further information concerning accounting policies, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 1. Summary of Significant Accounting Policies.”
Business Overview
The Company provides a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.
The Company is committed to delivering strong long-term earnings using a prudent allocation of capital, in business lines where we have demonstrated the ability to compete successfully. During 2016, the national and local economies continued to show slow, but measured signs of recovery with the main challenges continuing to be underemployment above historical levels and uneven economic growth. Macro-economic and political issues continue to temper the global economic outlook and, as such, the Company remains cautiously optimistic regarding the improvements seen in our local markets. Despite this, the Company believes that our local markets are poised for stronger growth in the coming months and years than the economic recovery has provided in our markets in recent periods.
Since 2013 the Company has completed strategic initiatives that have significantly improved the Company’s financial condition. These initiatives represent significant progress toward the Company’s long-term goal of growing a more robust community banking business. These initiatives include:
·Raising in 2013 an aggregate of $50.0 million of gross proceeds from sales of the Company’s common stock and Series B Preferred Stock in private placements to certain institutional investors ($45.0 million in gross proceeds) and a rights offering to existing shareholders ($5.0 million in gross proceeds) (collectively, the “2013 Capital Initiative”);
·Using a portion of the proceeds from the 2013 Capital Initiative to prepay long-term, higher-rate FHLB advances and to accelerate the disposition of adversely classified assets;
·Paying all current and previously deferred interest and all current and previously deferred, but accumulated, dividends on the Company’s Junior Subordinated Debt and Series A Preferred Stock (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K), respectively;
·Redeeming all of the Company’s Series A Preferred Stock, which eliminated one of the Company’s most expensive sources of capital;
·Acquiring VCB effective November 14, 2014, thus adding three branches to the Bank’s branch network and an aggregate of $128.9 million of assets to the Company’s balance sheet. All former VCB branches have been fully integrated into the Bank’s branch network and operate as branches of the Bank, expanding the Bank’s branch network into the Virginia cities of Hampton, Newport News and Williamsburg;
·Opening a loan production office in Chesterfield County, Virginia to increase the Bank’s presence in the Richmond metropolitan area and contribute to loan portfolio growth and diversification;
·Declaring dividends to holders of both the Company’s common stock and Series B Preferred Stock. Beginning in March 2015, dividends of $0.01 per share were declared and paid quarterly. The Company increased the quarterly dividends to $0.02 per share starting August 2015 through August 2016, and again increased the quarterly dividends in November 2016 to $0.03 per share;
·Raising in the second quarter of 2015 an aggregate of $20.0 million in gross proceeds from sales of Senior Subordinated Debt (defined in Item 8. “Financial Statements and Supplementary Data” under the heading “Note 9. Junior and Senior Subordinated Debt”) in private placements to certain institutional investors. A portion of these proceeds were used to redeem the remainder of the Company’s Series A Preferred Stock and to repurchase the Warrant (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K) that was issued to the Treasury through the Capital Purchase Program;
·On October 11, 2016 the Company’s corporate headquarters was relocated to the Innsbrook business park in Glen Allen, Virginia in order to increase collaboration and productivity, while gaining operating efficiencies throughout the Company;
·On December 13, 2016, the Company and Southern National jointly announced the signing of a definitive agreement to merge. The combination brings together two banking companies with complementary business lines creating one of the premier banking institutions headquartered in the Commonwealth of Virginia. The combined company will use the name Southern National Bancorp of Virginia, Inc. The Pending Merger, which is expected to be completed by the third quarter of 2017, is subject to regulatory approvals and the approval of the shareholders of both companies, as well as customary closing conditions; and
·In connection with the Pending Merger, the Company intends to terminate its defined benefit pension plan effective May 1, 2017.
The Company expects to recognize the continued benefits of these initiatives during 2017, including through lower interest expense related to the extinguished FHLB advances in 2013, elimination of the Series A Preferred Stock dividend as of June 15, 2015, additional interest income and cost savings related to the acquisition of VCB, and positive contributions to the Company’s loan portfolio generated by the three branches acquired from VCB and the Chesterfield County, Virginia loan production office.
As previously disclosed, the Company engaged an independent consultant to conduct a comprehensive assessment of its operations during the first half of 2015. The assessment identified operating efficiencies and revenue enhancement opportunities. The Company has leveraged the assessment’s findings, and since the second half of 2015, has continued to realize targeted increases in revenues and declines in certain noninterest expenses, particularly certain salaries and employee benefits expense. However, increases in group insurance costs due to claims and in incentive compensation have largely offset the aforementioned realized declines in salaries and employee benefits expense. Related to the Company’s continued commitment to drive operating efficiencies and reduce noninterest expenses, during the fourth quarter of 2016 the Company implemented a hiring freeze. In connection with this hiring freeze, through attrition and other job eliminations, the Company reduced the number of its full-time equivalent employees by 10 during the month of December 2016 and by an additional 14 during the month of January 2017. The Company currently expects this initiative to reduce salaries and employee benefits expense by approximately $1.3 million on an annualized basis.
Summary of 2016 Operating Results and Financial Condition
Table 1: Performance Summary
(1)The difference between net income and net income available to common shareholders is the effective dividend to holders of the Company’s Series A Preferred Stock paid during the year ended December 31, 2015.
(2)For more information on the calculation of net interest margin on a tax equivalent basis, see the average balance sheet and net interest margin analysis for the years ended December 31, 2016 and 2015 contained in "Results of Operations" in this Item 7.
For the year ended December 31, 2016, the following were significant factors in our reported results:
·Increase in net interest income of $2.4 million from the same period in 2015, principally due to an increase in interest and fees on loans driven primarily by loan growth, partially offset by an increase in interest expense associated with our short-term borrowings and the issuance of $20.0 million in Senior Subordinated Debt during the second quarter of 2015;
·Net interest margin (tax equivalent basis) decreased 12 basis points to 3.72% during the twelve months ended December 31, 2016 as compared to 3.84% for the same period of 2015 primarily due to a decline in yields on our investment securities and loan portfolio and the impact of interest incurred on our short-term borrowings and Senior Subordinated Debt;
·Net accretion attributable to accounting adjustments related to the VCB acquisition was $293 thousand, as compared to $479 thousand in the same period of 2015;
·A decrease in net charge-offs of $1.6 million from 2015 primarily due to the collection of charged-off principal on a previously restructured loan. Even though there was significant loan growth during 2016, this recovery primarily offset the need for any additional loan loss provision during 2016;
·Nonperforming assets at December 31, 2016 increased $1.4 million from December 31, 2015 due to a $2.1 million increase in OREO and a $224 thousand increase in loans 90 days past due and accruing interest, partially offset by a decrease of $994 thousand in nonaccrual loans. The increase in OREO was primarily due to the foreclosure on a property that secured a single PCI loan which had been past due 90 days and accruing interest;
·Performing TDRs decreased from December 31, 2015 by $5.1 million primarily due to collection of principal on two previously restructured loans. Nonperforming TDRs increased from December 31, 2015 by $909 thousand primarily due to the execution of two new loan restructuring agreements;
·Net gain on sale of available for sale securities of $701 thousand as compared to $224 thousand in the same period of 2015 was higher due to the adjustments of the composition of the investment securities portfolio as part of our overall asset/liability management strategy;
·Consultant fees decreased $416 thousand from the same period in 2015, primarily due to expenses incurred during 2015 related to the aforementioned comprehensive assessment of our operations that were not repeated during 2016;
·Collection, repossession and other real estate owned expense increased $153 thousand from the same period of 2015 due to an increase in foreclosure activity;
·Marketing and advertising expenses increased $160 thousand as compared to the same period in 2015 primarily due to costs associated with advertising campaigns and other initiatives;
·Merger and merger related expenses of $617 thousand were incurred during 2016 in connection with the Pending Merger. Merger and merger related expenses of $224 thousand were incurred during 2015 in connection with the VCB acquisition;
·Other operating expenses increased $329 thousand as compared to the same period in 2015 primarily due to increases in director fees and internet banking expense; and
·No effective dividend on preferred stock for the twelve months ended December 31, 2016 as compared to $386 thousand from the same period of 2015. This was due to the redemption of the remaining 14,000 shares of the Company’s Series A Preferred Stock in transactions completed during the first half of 2015.
Results of Operations
The table below lists our quarterly performance for the years ended December 31, 2016 and 2015.
Table 2: Summary Of Financial Results By Quarter
Net Interest Income and Net Interest Margin
Net interest income, the fundamental source of the Company’s earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and investment securities, while deposits, short-term borrowings, Junior Subordinated Debt and Senior Subordinated Debt represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations and the yield of our interest earning assets compared to our cost of funding these assets.
Table 3 presents the average interest earning assets and average interest bearing liabilities, the average yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the indicated periods. The variance in interest income and expense caused by differences in average balances and rate is shown in Table 4.
For comparative purposes, income from tax-exempt investment securities is adjusted to a tax-equivalent basis using the federal statutory tax rate of 34% and adjusted by the Tax Equity and Fiscal Responsibility Act adjustment. This latter adjustment is for the disallowance as a deduction of a portion of total interest expense related to the ratio of average tax-exempt investment securities to average total assets. By making these adjustments, tax-exempt income and their yields are presented on a comparable basis with income and yields from fully taxable earning assets. The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets, and represents the Company’s net yield on its earning assets. Net interest margin is an indicator of the Company’s effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competitive pressures, Federal Reserve Board policies and the economy. The spread that can be earned between interest earning assets and interest bearing liabilities is also dependent to a large extent on the slope of the yield curve.
Table 3: Average Balance Sheet and Net Interest Margin Analysis
Notes:
(1)Yields are based on average daily balances.
(2)Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%, with an adjustment of $60, $402 and $346 in 2016, 2015 and 2014, respectively.
(3)Nonaccrual loans have been included in the computations of average loan balances.
(4)Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.
(5)Interest rate spread is the average yield on earning assets, calculated on a fully taxable basis, less the average rate incurred on interest-bearing liabilities.
(6)Net interest margin is the net interest income, calculated on a fully taxable basis, expressed as a percentage of average earning assets.
2016 compared with 2015
Net interest income and net interest margin
Net interest income for the year ended December 31, 2016 increased $2.4 million, or 5.7%, as compared to the same period in 2015. The Company's net interest margin (tax equivalent basis) decreased to 3.72% for the year ended December 31, 2016, representing a 12 basis point decrease over the Company's net interest margin (tax equivalent basis) for the year ended December 31, 2015. The decline in the net interest margin (tax equivalent basis) was primarily driven by lower loan yields as compared to 2015 as a result of competitive pressures in the historically low rate environment and lower accretion of fair value adjustments related to the VCB acquisition as well as increased interest expense as a result of the private placement of $20.0 million of Senior Subordinated Debt in April 2015. Additionally, the average balance of and rates paid on our short-term borrowings increased as compared to 2015. These margin pressures were largely offset by increases in average loan balances in the Company’s results for the year ended December 31, 2016, as compared to the same period in 2015. The most significant factors impacting net interest income during the year ended December 31, 2016 were as follows:
Positive Impact:
·Increases in average loan balances, primarily due to organic loan growth and loan purchases, partially offset by lower loan yields.
Negative Impacts:
·Decreases in average yields earned on investment securities, primarily tax exempt investment securities due to changes in the composition of the investment securities portfolio;
·Private placement of $20.0 million of Senior Subordinated Debt during the second quarter of 2015 resulting in increases to total average interest-bearing liabilities and related interest expense for the year ended December 31, 2016;
·Increases in average short-term borrowings balances and rates paid, primarily due to loan growth outpacing deposit growth and other strategic initiatives; and
·The Company experienced higher average interest-bearing deposit balances during the year ended December 31, 2016 over 2015, primarily due to customer growth. The result was an increase in interest expense.
Total interest and dividend income
Total interest and dividend income increased 7.3% for the year ended December 31, 2016 as compared to the same period in 2015. The increase in total interest and dividend income was primarily driven by an increase in average loan and investment securities balances, partially offset by decreases in average loan and investment securities yields.
Loans
Average loan balances increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to organic loan growth and the purchase of $30.8 million in performing commercial and consumer loans during 2016. Loan growth during 2016 outpaced our internal targets. However, loan growth in our rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and we expect will continue to be intense given the historically low rate environment. The Company’s average loan balances increased $84.2 million for the year ended December 31, 2016, as compared to average loan balances for the same period in 2015. Total average loans were 76.8% of total average interest-earning assets for the year ended December 31, 2016, compared to 75.5% for the year ended December 31, 2015.
Investment securities
Average total investment securities balances increased 1.5% for the year ended December 31, 2016, as compared to the same period in 2015. This overall increase was the result of management of the Company’s liquidity needs to support operations, along with funds provided by deposit growth and loan demand in the Company’s markets, partially offset by a lack of investment opportunities with acceptable risk-adjusted rates of return. The Company remains committed to its long-term target of managing the investment securities portfolio to comprise 20% of the Company’s total assets. The yields on total average investment securities decreased 13 basis points for the year ended December 31, 2016, as compared to the same period in 2015. The decrease in yields on average total investment securities during the year ended December 31, 2016, as compared to the same period of 2015, was driven by a lower allocation of the total investment securities portfolio to SBA Pool securities and tax exempt municipal securities, both of which also tend to be higher-yielding segments of the Company’s investment securities portfolio. These decreases were partially offset by higher interest rates and a greater allocation of the total investment securities portfolio to higher yielding Agency CMBS securities and taxable municipal securities.
Interest-bearing deposits
Average total interest-bearing deposit balances increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to organic deposit growth that was in part driven by the Company’s marketing and advertising initiatives as well as new products and services.
Borrowings
Average total borrowings increased for the year ended December 31, 2016, as compared to the same period in 2015, primarily due to the issuance of $20.0 million in Senior Subordinated Debt in April 2015 and increased short-term borrowings. Average short-term borrowings increased for the year ended December 31, 2016, as compared to the same period in 2015, due to additional short-term FHLB advances taken to fund loan growth and other strategic initiatives.
2015 compared with 2014
Net interest income and net interest margin
Net interest income for the year ended December 31, 2015 increased $4.9 million, or 13.0%, as compared to the same period in 2014. The Company’s net interest margin (tax equivalent basis) decreased to 3.84% for the year ended December 31, 2015, representing a 1 basis point decrease over the Company’s net interest margin (tax equivalent basis) for the year ended December 31, 2014. The most significant factors impacting net interest income during the year ended December 31, 2015 were as follows:
Positive Impacts:
·Average loan balances increased primarily due to the acquisition of VCB, organic loan growth and the purchase of $21.6 million in loans between June 2015 and December 2015; and
·Average rates paid on total interest-bearing deposits decreased for the year ended December 31, 2015 over the comparable period of 2014. However, the Company experienced higher average interest-bearing deposit balances during the year ended December 31, 2015 over the comparable 2014 period, primarily due to interest-bearing deposits assumed from the VCB acquisition. This drove a slight increase in interest expense attributable to the Company’s deposit portfolio.
Negative Impact:
·Private placement of $20.0 million of Senior Subordinated Debt in April 2015 resulted in increases to total average interest-bearing liabilities and related interest expense.
Total interest and dividend income
Total interest and dividend income increased 14.4% for the year ended December 31, 2015, as compared to the same period in 2014. The increase in total interest and dividend income was primarily driven by an increase in average loan balances and was partially offset by a decrease in average loan yields.
Loans
Average loan balances increased for the year ended December 31, 2015, as compared to the same period in 2014, due primarily to the acquisition of VCB loans totaling $101.5 million as of November 14, 2014, net of fair value adjustments, the purchase of $21.6 million in performing one-to-four family residential mortgage loans, consumer loans and government guaranteed loans between June 2015 and December 2015, organic loan growth and the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014. Despite a 2.3% increase in loans during the fourth quarter of 2015 which was in line with internal targets, loan growth came in slightly below our expectations for the year. Loan growth in our rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and we expect will continue to be intense given the historically low rate environment. The Company’s average loan balances increased $134.0 million for the year ended December 31, 2015, as compared to average loan balances for the same period in 2014. Total average loans were 75.5% of total average interest-earning assets for the year ended December 31, 2015, compared to 71.9% for the year ended December 31, 2014.
Investment securities
Average total investment securities balances declined 1.1% for the year ended December 31, 2015, as compared to the same period in 2014. The overall decline during 2015 was the result of the Company moving toward its long term target of the investment securities portfolio comprising 20% of the Company’s total assets, the lack of investment opportunities with acceptable risk-adjusted rates of return and liquidity needs to support our operations and strategic initiatives. The yields on average investment securities increased 3 basis points for the year ended December 31, 2015, as compared to the same period of 2014.
Interest-bearing deposits
Average total interest-bearing deposit balances increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the assumption of VCB’s interest-bearing deposit liabilities, which totaled $85.6 million as of November 14, 2014, and organic deposit growth that was in part driven by the Company’s marketing and advertising initiatives.
Borrowings
Average total borrowings increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the issuance of $20.0 million in Senior Subordinated Debt in April 2015 and increased short-term borrowings. Average short-term borrowings increased for the year ended December 31, 2015, as compared to the same period of 2014, due to the assumption of $8.7 million in short-term FHLB advances as a result of the VCB acquisition, as well as additional short-term FHLB advances totaling $28.9 million during 2015 to fund loan growth and other strategic initiatives. The issuance of the Senior Subordinated Debt was a significant driver of higher interest expense and a lower net interest margin during the second half of 2015.
Table 4: Volume and Rate Analysis (1)
Notes:
(1)Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.
(2)Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.
(3)Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.
Interest Sensitivity
Our primary goals in interest rate risk management are to minimize negative fluctuations in net interest margin as a percentage of earning assets and to increase the dollar amount of net interest income at a growth rate consistent with the growth rate of total assets. These goals are accomplished by managing the interest sensitivity gap, which is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. Interest sensitivity gap is managed by balancing the volume of floating rate liabilities with a similar volume of floating rate assets, by keeping the fixed rate average maturity of asset and liability contracts reasonably consistent and short, and by routinely adjusting pricing to market conditions on a regular basis.
The Company strives to maintain a position flexible enough to move to a balanced position between rate-sensitive assets and rate-sensitive liabilities, which may be desirable when there are wide and frequent fluctuations in interest rates. Matching the amount of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact on net interest income in periods of rising or falling interest rates. Interest rate gaps are managed through investments, loan pricing and deposit pricing strategies. When an unacceptable positive gap within a one-year time frame occurs, maturities can be extended by selling shorter-term investments and purchasing longer maturities. When an unacceptable negative gap occurs, variable rate loans can be increased (subject to customer demand for these loans) and greater investment in shorter-term investments can be made.
The Company believes that it will be a challenge for the Company to maintain its net interest margin at its current level given competitive rate pressures surrounding loan originations coupled with the rising cost of wholesale funding used to fund loan growth in the absence of significant core deposit growth. With uncertainty surrounding rate expectations in 2017, the Company will continue to reinvest investment securities portfolio cash flows with a focus on investment securities that provide steady cash flow at a low risk weighting to provide earnings and liquidity. In 2017, the Company will continue to focus on attracting and retaining core deposits to reduce our reliance on wholesale funding and offset the compression of our net interest margin.
Noninterest Income
Noninterest income is comprised of all sources of income other than interest and dividend income on our earning assets. Significant revenue items include fees collected on certain deposit account transactions, debit card and ATM fees, fees from other general services, earnings from other investments we own in part or in full and gains or losses on sales of investment securities, loans and fixed assets.
The following table depicts the components of noninterest income for the years ended December 31, 2016 and 2015:
Table 5: Noninterest Income
2016 Compared to 2015
Key changes in the components of noninterest income for the year ended December 31, 2016, as compared to the same period in 2015, are discussed below:
·Service charges and fees on deposit accounts increased primarily due to growth in deposits and increases in overdraft and NSF fees on checking accounts;
·Gain on sale of available for sale securities, net increased primarily as a result of the Company adjusting the composition of the investment securities portfolio as part of the Company’s overall asset/liability management strategy;
·Gain (loss) on sale of bank premises and equipment increased due to the receipt of insurance proceeds for damaged equipment in 2016 as compared to losses on the sale of our former Heathsville branch and the disposal of other assets in 2015; and
·Other operating income decreased primarily due to lower earnings from the Bank’s subsidiaries. Additionally, other operating income includes earnings from the Bank’s investment in Bankers Title, LLC and losses from the Bank’s investment in housing equity funds.
The following table depicts the components of noninterest income for the years ended December 31, 2015 and 2014:
Table 5A: Noninterest Income
2015 Compared to 2014
Key changes in the components of noninterest income for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:
·Service charges and fees on deposit accounts declined due to decreases in service charge and overdraft fees on checking accounts;
·Debit card/ATM fees increased primarily due to an increase in debit card fees driven by the acquisition of VCB and a higher utilization rate of debit cards by our customer base;
·Gain on sale of available for sale securities, net decreased primarily due to the sale of a portion of its previously impaired agency preferred securities (FNMA & FHLMC) that generated gains during the first quarter of 2014, and because the Company did not generate comparable gains during 2015;
·(Loss) gain on sale of bank premises and equipment during 2015 was primarily due to the sale of our former Heathsville branch building as operations were relocated to a new facility and the disposal of certain office equipment, with no similar losses occurring in 2014; and
·Other operating income increased primarily due to higher earnings from the Bank’s subsidiaries, its investment in Bankers Insurance, LLC and bank owned life insurance policies, partially offset by higher losses from the Bank’s investments in housing equity funds. Additionally, other operating income includes earnings from the Bank’s investments in Southern Trust Mortgage, LLC and Bankers Title, LLC.
Noninterest Expense
Noninterest expense includes all expenses with the exception of those paid for interest on borrowings and deposits. Significant expense items included in this component are salaries and employee benefits, occupancy and equipment expenses and other operating expenses.
The following table depicts the components of noninterest expense for the years ended December 31, 2016 and 2015:
Table 6: Noninterest Expense
2016 Compared to 2015
Key changes in the components of noninterest expense for the year ended December 31, 2016, as compared to the same period in 2015, are discussed below:
·Salaries and employee benefits increased primarily due to an increase in group insurance expense (which was driven by an increase in claims during 2016);
·Occupancy and equipment expenses increased primarily due to rent expense related to the relocation of the Company’s corporate headquarters to Glen Allen, Virginia;
·FDIC expense decreased due to lower assessments beginning with the third quarter of 2016;
·Consultant fees decreased primarily due to expenses incurred related to the aforementioned comprehensive assessment of our operations that was completed in 2015;
·Collection, repossession and other real estate owned expenses increased due to an increase in foreclosure activity, particularly related to delinquent real estate taxes paid to secure the Company’s interest in properties subject to foreclosure;
·Marketing and advertising expenses increased due to the timing and size of advertising campaigns and other initiatives;
·Merger and merger related expenses incurred during 2016 in connection with the Pending Merger were higher as compared to expenses incurred during 2015 which were related to the VCB acquisition; and
·Other operating expenses increased primarily due to increases in director fees, data processing expense and internet banking expense.
The following table depicts the components of noninterest expense for the years ended December 31, 2015 and 2014:
Table 6A: Noninterest Expense
2015 Compared to 2014
Key changes in the components of noninterest expense for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:
·Salaries and employee benefits increased primarily due to the increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB. Additionally, salaries and employee benefits were higher in 2015 due to annual merit salary increases, increased restricted stock compensation expense, increased bonuses, commissions and other incentive compensation and valuation adjustments related to pension plan liabilities, partially offset by an increase in deferred compensation on loan originations, lower group insurance expenses and reductions in staff levels during the second half of 2015 that were driven by operating efficiencies gained through a previously completed comprehensive assessment of our operations;
·Occupancy and equipment expenses increased primarily due to depreciation expense associated with certain acquired VCB assets and increased rent, building repairs and maintenance and real estate tax expenses related to the acquired VCB branch locations;
·FDIC expense decreased due to lower base insurance assessment rates resulting from the improvement in the Bank’s overall composite rating in connection with the termination of the Company’s regulatory memorandum of understanding in March 2014;
·Consultant fees decreased as higher costs related to compliance, loan operations and outsourcing of the Bank’s core information technology processing were incurred during 2014, as compared to 2015. This decrease was partially offset by costs incurred related to the Company’s engagement of an independent consultant during the first half of 2015 to conduct a comprehensive assessment of its operations;
·Collection, repossession and other real estate owned expenses increased due to increases in average carrying balances of and costs associated with OREO and classified assets during certain periods of the second and third quarters of 2015;
·Marketing and advertising expenses increased due to expenses related to marketing and advertising initiatives;
·Merger and merger related expenses decreased due to certain costs associated with the acquisition of VCB in 2014 that were not repeated in 2015; and
·Other operating expenses increased due to elevated costs associated with outsourcing of the Bank’s core information technology processing, higher franchise taxes, loan closing costs, internet banking expenses and core deposit intangible amortization expense.
Income Taxes
The Company recorded income tax expense of $3.4 million in 2016, $2.5 million in 2015 and $2.4 million in 2014. The increase in income tax expense from 2015 to 2016 was primarily due to the Company’s pre-tax income increasing by $1.4 million, the recognition of nondeductible merger expenses and a reduction in tax-exempt interest income from the Company’s investment securities portfolio. The decrease in tax-exempt interest income was primarily a result of the Company decreasing the percentage of tax-exempt investment securities that comprised its overall investment securities portfolio.
The Company’s effective tax rate for the years ended December 31, 2016, 2015 and 2014 was 30.5%, 25.5% and 30.1%, respectively. The increase in the effective tax rate from 2015 to 2016 was primarily due to a decrease in tax-exempt interest income from the Company’s investment securities portfolio, as discussed above, and the recognition of $617 thousand in nondeductible expenses related to the Pending Merger with Southern National. The decrease in the effective tax rate from 2014 to 2015 was primarily related to increased tax-exempt interest income on the Company’s investment securities portfolio, increased tax-exempt bank owned life insurance income as a percentage of pre-tax income and the recognition of $1.4 million in nondeductible expenses related to the acquisition of VCB in 2014. The effective tax rate differs from the statutory income tax rate of approximately 34% due to the Company’s investment in tax-exempt loans and investment securities, income from bank owned life insurance, and community/housing development tax credits. For further information concerning Income Taxes, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”
Asset Quality
Provision and Allowance for Loan Losses
The allowance for loan losses is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as probable credit losses inherent in the loan portfolio, and is based on periodic evaluations of the collectability and historical loss experience of loans. A provision for loan losses, which is a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in management’s judgment, is appropriate to absorb probable losses in the loan portfolio. Actual credit losses are deducted from the allowance for loan losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent. Subsequent recoveries, if any, are credited to the allowance for loan losses.
The allowance for loan losses is comprised of a specific allowance for identified problem loans and a general allowance representing estimations performed pursuant to either FASB ASC Topic 450 “Accounting for Contingencies”, or FASB ASC Topic 310 “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal may be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when deemed appropriate. The general component covers non-classified or performing loans and those loans classified as substandard, doubtful or loss that are not impaired. The general component is based on migration analysis adjusted for qualitative factors, such as economic conditions, interest rates and unemployment rates. The Company uses a risk grading system for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans. Loans are graded on a scale from 1 to 9. Non-impaired real estate and commercial loans are assigned an allowance factor which increases with the severity of risk grading. A general description of the characteristics of the risk grades is as follows:
Pass Grades
·Risk Grade 1 loans have little or no risk and are generally secured by cash or cash equivalents;
·Risk Grade 2 loans have minimal risk to well qualified borrowers and no significant questions as to safety;
·Risk Grade 3 loans are satisfactory loans with strong borrowers and secondary sources of repayment;
·Risk Grade 4 loans are satisfactory loans with borrowers not as strong as risk grade 3 loans but may exhibit a higher degree of financial risk based on the type of business supporting the loan; and
·Risk Grade 5 loans are loans that warrant more than the normal level of supervision and have the possibility of an event occurring that may weaken the borrower’s ability to repay.
Special Mention
·Risk Grade 6 loans have increasing potential weaknesses beyond those at which the loan originally was granted and if not addressed could lead to inadequately protecting the Company’s credit position.
Classified Grades
·Risk Grade 7 loans are substandard loans and are inadequately protected by the current sound worth or paying capacity of the obligor or the collateral pledged. These have well defined weaknesses that jeopardize the liquidation of the debt with the distinct possibility the Company will sustain some loss if the deficiencies are not corrected;
·Risk Grade 8 loans are doubtful of collection and the possibility of loss is high but pending specific borrower plans for recovery, its classification as a loss is deferred until its more exact status is determined; and
·Risk Grade 9 loans are loss loans which are considered uncollectable and of such little value that their continuance as a bank asset is not warranted.
The Company uses a past due grading system for consumer loans, including one to four family residential first and seconds and home equity lines. The past due status of a loan is based on the contractual due date of the most delinquent payment due. The past due grading of consumer loans is based on the following categories: current, 1-29 days past due, 30-59 days past due, 60-89 days past due and over 90 days past due. The consumer loans are segregated between performing and nonperforming loans. Performing loans are those that have made timely payments in accordance with the terms of the loan agreement and are not past due 90 days or more. Nonperforming loans are those that do not accrue interest, are greater than 90 days past due and accruing interest or considered impaired. Non-impaired consumer loans are assigned an allowance factor which increases with the severity of past due status. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio.
The Company's ALL Committee is responsible for assessing the overall appropriateness of the allowance for loan losses and monitoring the Company's allowance for loan losses methodology, particularly in the context of current economic conditions and a rapidly changing regulatory environment. The ALL Committee at least annually reviews the Company's allowance for loan losses methodology.
The allocation methodology applied by the Company includes management’s ongoing review and grading of the loan portfolio into criticized loan categories (defined as specific loans warranting either specific allocation, or a classified status of substandard, doubtful or loss). The allocation methodology focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, management’s ongoing review and grading of the loan portfolio, consideration of migration analysis and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of classified loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. In determining the allowance for loan losses, the Company considers its portfolio segments and loan classes to be the same.
Management believes that the level of the allowance for loan losses is appropriate in light of the credit quality and anticipated risk of loss in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses through increased provisions for loan losses or may require that certain loan balances be charged-off or downgraded into classified loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examinations.
The following table presents the Company’s loan loss experience for the past five years:
Table 7: Allowance for Loan Losses
* Net of unearned income and includes nonaccrual loans.
The Company made a provision for loan losses of $17 thousand in 2016, as compared to no provision for loan losses in 2015, $250 thousand in 2014, $1.9 million in 2013 and $5.7 million in 2012. The allowance for loan losses totaled approximately $11.3 million at both December 31, 2016 and 2015. The ratio of the allowance for loan losses to total loans outstanding declined from December 31, 2015 to December 31, 2016 due to loan growth, improvements in the Company’s asset quality and the resolution of certain classified or problem assets during 2016. In addition to these factors, the decline in the ratio of the allowance for loan losses to total loans outstanding from December 31, 2015 to December 31, 2016 was also driven by improvements in economic and financial conditions in the Company’s markets.
Impaired loans decreased approximately $3.2 million from December 31, 2015, primarily due to the payoff of two previously restructured loans, the upgraded credit quality of a large commercial borrower, the partial charge-off and foreclosure of two other large one to four family loan relationships and partially offset by the addition of two large commercial relationships to impaired loans as a result of a deterioration in the financial condition of the borrowers. Additionally, due to acquisition accounting related to the Company’s acquisition of VCB, the Company recorded loans acquired from VCB at fair value at the time of the acquisition, and any allowance for loan losses previously established by VCB was not recorded on the Company’s financial statements.
Net charge-offs in 2016 were $74 thousand compared to $1.7 million in 2015, $2.0 million in 2014, $7.4 million in 2013 and $9.4 million in 2012. This represents 0.01% of average loans outstanding in 2016, 0.20% in 2015, 0.28% in 2014, 1.11% in 2013 and 1.32% in 2012. Net charge-offs decreased $1.6 million from the year ended December 31, 2015 to the same period of 2016 primarily due to the recovery of charged-off principal on a previously restructured loan. Even though there was significant loan growth during 2016, this recovery and its contribution to the allowance for loan losses principally offset the need for additional loan loss provisions during 2016.
The following table shows the allocation of the allowance for loan losses at the dates indicated. Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loan.
Table 8: Allocation of Allowance for Loan Losses
(Percent is portfolio loans in category divided by total loans)
The following table presents commercial loans by credit quality indicator at December 31, 2016:
Table 9: Commercial Credit Quality Indicators
The following table presents commercial loans by credit quality indicator at December 31, 2015:
Table 9A: Commercial Credit Quality Indicators
The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2016:
Table 10: Consumer Payment Activity
The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2015:
Table 10A: Consumer Payment Activity
Nonperforming Assets
The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. As of December 31, 2016, management is not aware of any potential problem loans to place immediately on nonaccrual status.
When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across the Company’s loan portfolio.
A loan (including a TDR) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.
Real estate acquired through, or in lieu of, foreclosure (or “OREO”) is held for sale and is stated at the fair value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to the property are capitalized. Net operating income or expenses of such properties are included in collection, repossession and other real estate owned expenses.
The following table presents information concerning nonperforming assets for the periods indicated:
Table 11: Nonperforming Assets
*Includes $2.2 million, $1.3 million, $3.4 million, $4.2 million and $5.1 million in nonaccrual TDRs at December 31, 2016, 2015, 2014, 2013 and 2012, respectively.
The following table presents the change in the OREO balance for 2016 and 2015:
Table 12: OREO Changes
The following table presents the change in the valuation allowance for OREO for 2016, 2015 and 2014:
Table 13: OREO Valuation Allowance Changes
Nonperforming assets were $9.2 million, or 0.89%, of total loans and OREO at December 31, 2016 compared to $7.8 million or 0.89% at December 31, 2015. The slow and measured economic recovery has prompted the Company to maintain the heightened level of the allowance for loan losses which was 217.53% of nonaccrual loans at December 31, 2016, compared to 183.43% at December 31, 2015. Nonperforming loans decreased $770 thousand, or 10.6%, during the year ended December 31, 2016 to $6.5 million, primarily due to a decrease in nonaccrual loans.
Nonaccrual loans were $5.2 million at December 31, 2016, a decrease of $994 thousand, or 16.1%, from $6.2 million at December 31, 2015. Of the current $5.2 million in nonaccrual loans, $4.4 million, or 84.5%, is secured by real estate in our market area. Of these real estate secured loans, $3.8 million are one to four family residential real estate, $578 thousand are commercial properties and $15 thousand are real estate construction. Loans past due 90 days and accruing interest were $1.3 million at December 31, 2016, an increase of $224 thousand, or 20.1%, from $1.1 million at December 31, 2015.
OREO, net of valuation allowance at December 31, 2016 was $2.7 million, an increase of approximately $2.1 million from December 31, 2015. The balance of OREO at December 31, 2016 was comprised of seventeen properties of which $1.4 million were one to four family residential properties, $52 thousand were real estate construction properties and $1.3 million were nonfarm, nonresidential properties. During the year ended December 31, 2016, new foreclosures consisted of thirty-three properties totaling $4.0 million transferred from loans, including a commercial property totaling $1.3 million that had previously secured a PCI loan. Sales of twenty-six OREO properties for the year ended December 31, 2016 resulted in a net loss of $1 thousand. Subsequent to December 31, 2016, three properties totaling $524 thousand were foreclosed on and transferred from loans. The remaining properties are being actively marketed and the Company does not anticipate any material losses associated with these properties. The Company recorded losses of $34 thousand in its consolidated statements of income for the year ended December 31, 2016, due to valuation adjustments on OREO properties as compared to $5 thousand for the same period of 2015. Asset quality continues to be a top priority for the Company. The Company continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets.
As discussed earlier in Item 7, the Company measures impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. TDRs are considered impaired loans. TDRs occur when we agree to modify the original terms of a loan by granting a concession due to the deterioration in the financial condition of the borrower. These concessions can be temporary and are made in an attempt to avoid foreclosure and with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include, without limitation, rate reductions to below market rates, payment deferrals, forbearance, and, in some cases, forgiveness of principal or interest.
The following table presents loans individually evaluated for impairment, excluding PCI loans, by class of loans as of December 31, 2016:
Table 14: Impaired Loans
The following table presents loans individually evaluated for impairment, excluding PCI loans, by class of loans as of December 31, 2015:
Table 14A: Impaired Loans
The Company’s balance of impaired loans remains elevated over historical levels primarily due to performing TDRs, against which there are no required valuation allowances.
The following table presents the balances of TDRs at December 31, 2016, 2015, 2014, 2013 and 2012:
Table 15: Troubled Debt Restructurings (TDRs)
* Included in nonaccrual loans in Table 11: Nonperforming Assets.
At the time of a TDR, the loan is placed on nonaccrual status. A loan (including a TDR) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. Performing TDRs decreased by $5.1 million from December 31, 2015 primarily due to collection of principal on two previously restructured loans. Nonperforming TDRs increased by $909 thousand from December 31, 2015 primarily due to the execution of two new loan restructuring agreements. These two loans are classified as nonperforming due to their recent restructurings. However, they may be returned to accrual status after a sustained period of repayment performance (typically six months).
Financial Condition
Summary
At December 31, 2016, the Company had total assets of $1.40 billion, an increase of approximately $128.2 million or 10.1% from $1.27 billion at December 31, 2015. The increase in total assets was principally the result of increases in loans, primarily funded by cash and due from banks, interest bearing deposits with banks, short term borrowings and continued deposit growth. Major categories and changes in our balance sheet are as detailed in the following schedule:
Table 16: Balance Sheet Changes
Loan Portfolio
The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. A substantial portion of the loan portfolio is comprised of commercial and residential mortgage loans in our market area. The ability of our debtors to honor their contracts is dependent upon the real estate and general economic conditions in our market area. The loan portfolio is the largest component of earning assets and accounts for the greatest portion of total interest and dividend income. Total loans were $1.03 billion at December 31, 2016, an increase of $152.5 million, or 17.3%, from $880.8 million at December 31, 2015. As discussed previously, loans increased in 2016 primarily due to organic loan growth and the purchase of $30.8 million in performing commercial and consumer loans. Commercial, industrial and agricultural loans increased primarily as a result of the continued efforts of our loan production office in Chesterfield, Virginia. Closed end first and second loans decreased primarily due to weak demand in our rural markets and refinancing activity in a competitive mortgage lending market driven by the low interest rate environment. Other construction, land development and other land loans increased as the Company has renewed its focus and efforts on this loan segment. Non-farm, non-residential real estate loans increased due to the addition of a new commercial loan officer, as well as focused efforts of our commercial lending team in our Richmond and Tidewater markets. Consumer loans increased primarily due to the purchase of $19.7 million in performing student and recreational vehicle loans. Loan growth in the Company’s rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and is expected to continue to be intense given the historically low rate environment and increased competition among banks and other financial institutions.
The following table presents the composition of the loan portfolio at the dates indicated:
Table 17: Summary of Loans
The following table presents the changes in the loans held in the portfolio from December 31, 2015 to December 31, 2016, and from December 31, 2014 to December 31, 2015:
Table 17A: Changes in Loans Held
The following table presents the estimated remaining maturities of loans held in the portfolio at December 31, 2016:
Table 18: Remaining Maturities of Loans
The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of our borrowers. Within each category, such risk may increase or decrease depending on various factors. The risks associated with real estate mortgage loans, commercial loans and consumer loans vary based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies based on the supply and demand for the type of real estate under construction. In an effort to manage these risks, we have loan approval limits for individual loan officers based on their position and level of experience.
We have written policies and procedures to help manage credit risk. We use a loan review process that includes a portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular independent third party portfolio reviews to establish loss exposure and to monitor compliance with policies. Third party reviews are done on an annual basis by a consulting firm that is comprised of experienced commercial lenders who understand the laws, regulations and critical areas of portfolio management. They provide management with an unbiased opinion of our credits and actions needed to strengthen them or protect the Company.
Our loan approval process includes our Management Loan Committee, Directors Loan Committee and, for larger loans, the Board of Directors. Our Chief Credit Officer is responsible for reporting to the Directors Loan Committee monthly on the activities of the Management Loan Committee and on the status of various delinquent and nonperforming loans. The Directors Loan Committee also reviews lending policies proposed by management. Our Board of Directors establishes our total lending limit policy which is less than the legal lending limit.
At December 31, 2016, loans secured by real estate were $831.3 million, or 80.5%, of the portfolio, compared to $748.3 million, or 85.0%, of the portfolio at December 31, 2015.
Consistent with our focus on providing community-based financial services, we generally do not make loans outside of our principal market region. We may, from time to time, invest in high quality loans that were originated by banks outside our core geographic markets, including by purchasing pools of performing loans. We do not engage in foreign lending activities and consequently the loan portfolio is not exposed to the sometimes volatile risk from foreign credits. We further maintain a policy not to originate or purchase loans classified by regulators as highly leveraged transactions or loans to foreign entities or individuals. Historically, our loan collateral has been primarily real estate because of the nature of our market region; however, in our newer markets, we are encountering other collateral options in lieu of real estate, which are booked based on strong credit guidelines and controls to monitor the status and value of the collateral.
Investment Securities
The investment securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity. In addition, the investment securities portfolio serves as a source of liquidity and is used as needed to meet collateral requirements, such as those related to secure public deposits, balances with the Reserve Bank and repurchase agreements. The investment securities portfolio consists of held to maturity and available for sale investment securities. We classify investment securities as available for sale or held to maturity based on our investment strategy and management’s assessment of our intent and ability to hold the investment securities until maturity. Management determines the appropriate classification of investment securities at the time of purchase, subject to any subsequent change in our intent and ability to hold the investment securities until maturity. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Investment securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at fair value. Total investment securities were $247.6 million at December 31, 2016, reflecting a decrease of approximately $13.1 million, or 5.0%, from $260.6 million at December 31, 2015. The valuation allowance for the available for sale investment securities portfolio had an unrealized (loss), net of tax benefit, of ($3.4) million at December 31, 2016 compared with an unrealized (loss), net of tax benefit, of ($1.7) million at December 31, 2015. These unrealized (losses) as of December 31, 2016 are principally due to financial market conditions for these types of investments, particularly related to changes in interest rates, which rose during late 2016 causing bond prices to decline, and are not attributable to credit deterioration.
During 2016, the Company either sold or had called its remaining investments in obligations of U.S. Government agencies and decreased its investments in state and political subdivisions (primarily tax exempt) while increasing its investments in Agency residential and commercial mortgage-backed securities in an effort to enhance the portfolio’s overall structure and provide more consistent cash flows and reinvestment opportunities. As part of our overall asset/liability management strategy, we are targeting our investment securities portfolio to be approximately 20% of our total assets. As of December 31, 2016 and 2015, our investment securities portfolio was 17.7% and 20.5%, respectively, of total assets.
There are no investment securities classified as “Trading” at December 31, 2016 or 2015. During the fourth quarter of 2013, the Company transferred investment securities with an amortized cost of $35.5 million, previously designated as “Available for Sale,” to “Held to Maturity” classification. The fair value of those investment securities as of the date of the transfer was $34.5 million, reflecting a gross unrealized loss of $994 thousand. The gross unrealized loss net of tax at the time of transfer remained in Accumulated Other Comprehensive (Loss) and is being amortized over the remaining life of the investment securities as an adjustment to interest income. During the third quarter of 2015, the Company sold a State and political subdivisions security that was classified as “Held to Maturity” due to the significant deterioration in the issuer’s financial condition. The carrying value of this investment security was $521 thousand and a gain of $10 thousand was recognized as a result of the sale.
The Company’s mortgage-backed securities consist of commercial and residential mortgage-backed securities. The Company’s mortgage-backed securities are all guaranteed by an agency (including a government-sponsored entity) of the U.S. Government and rated Aaa and AA+ by Moody and S&P, respectively, with no subprime issues. The Company follows a policy of not investing in instruments considered to be derivative in nature such as options, futures, swaps or forward commitments.
The Company’s pooled trust preferred securities previously included one senior issue of Preferred Term Securities XXVII which remained current on all payments and on which the Company took an impairment charge in the third quarter of 2009 to reduce the Company’s book value to the market value at September 30, 2009. On December 9, 2014 the Company sold this security resulting in a gain on sale of $82 thousand, and the Company reversed the related impairment reserve. During the second quarter of 2010, the Company recognized an impairment charge in the amount of $77 thousand on the Company’s investment in Preferred Term Securities XXIII mezzanine tranche, thus reducing the book value of this investment to $0. On September 22, 2014 the Company sold this security resulting in a gain on sale of $2 thousand and the Company subsequently reversed the related impairment reserve.
The following tables present the amortized cost or carrying value and estimated fair value of investment securities at the dates indicated:
Table 19: Investment Securities Available for Sale
Table 19A: Investment Securities Held to Maturity
The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment that may result due to adverse economic conditions and associated credit deterioration. Based on the Company’s evaluation, and because management believes that unrealized losses are principally due to changes in interest rates, management does not believe any unrealized loss at December 31, 2016 represents an other-than-temporary impairment. At December 31, 2016, there were 155 debt securities with fair values totaling $195.6 million considered temporarily impaired. Of these debt securities, 132 with fair values totaling $166.5 million were in an unrealized loss position of less than 12 months and 23 with fair values totaling $29.1 million were in an unrealized loss position of 12 months or more. Because the Company intends to hold these investments in debt securities until recovery of the amortized cost basis and it is more likely than not that the Company will not be required to sell these investments before a recovery of unrealized losses, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2016 and no impairment has been recognized. At December 31, 2016, there were no equity securities in an unrealized loss position.
However, in the event that the Company is required or decides to use its investment securities portfolio in 2017 to manage its liquidity position, the Company may sell a portion of the investment securities in a temporary unrealized loss position before these investment securities recover their fair value, which would result in the Company recognizing losses on the sale of investment securities.
The following tables present the maturity and yields of investment securities at their amortized cost or carrying value at the date indicated:
Table 20: Maturity and Yields of Available for Sale Securities
* Yields on tax-exempt investment securities have been computed on a taxable-equivalent basis.
Table 20A: Maturity and Yields of Held to Maturity Securities
* Yields on tax-exempt investment securities have been computed on a taxable-equivalent basis.
Deposits
The Company’s predominant source of funds is depository accounts. The Company’s deposit base, which is provided by individuals and businesses located within the communities served, is comprised of demand deposits, savings and money market savings deposits and time deposits. The Company augments its deposit base through conservative use of brokered deposits, including through the Certificate of Deposit Account Registry Service program (“CDARS”). The Company’s balance sheet growth is largely determined by the availability of deposits in its markets, the cost of attracting the deposits and the prospects of profitably utilizing the available deposits by increasing the loan or investment securities portfolios.
The following table shows deposit balances for the years ended December 31, 2016 and 2015:
Table 21: Deposits
Total deposits were $1.05 billion as of December 31, 2016, an increase of approximately $62.6 million, or 6.3%, from $988.7 million as of December 31, 2015. During 2016, the Company’s deposits increased due to organic growth that was in part driven by the Company’s marketing and advertising initiatives as well as new products and services. The increase in our noninterest-bearing demand deposits was due to organic growth and as a result of customers seeking the liquidity and safety of demand deposit accounts in light of continuing economic uncertainty in general. Savings and money market savings deposits increased as a result of our new Kasasa products and related marketing and advertising initiatives. At December 31, 2016 and 2015, the Company had $57.6 million and $53.8 million in brokered certificates of deposits, respectively. The interest rates paid on these deposits are approximately consistent with the market rates offered in our local area. Included in these brokered certificates of deposits as of December 31, 2016 and 2015 are $24.7 million and $28.4 million, respectively, in deposits under the CDARS program.
Interest rates paid on specific deposit types are set by management through its Rate Committee and are determined based on (i) the interest rates offered by competitors, (ii) anticipated amount and timing of funding needs, (iii) availability of and cost of alternative sources of funding and (iv) anticipated future economic conditions and interest rates. Customer deposits are attractive sources of liquidity because of their stability, cost and the ability to generate fee income through the cross-sale of other services to the depositors. The Company will continue funding assets with deposit liability accounts and focus upon core deposit growth as its primary source of liquidity and stability.
The following table presents average deposit balances and average rates paid for the periods indicated:
Table 22: Average Deposits and Average Rates Paid
The following table presents the maturity schedule of time deposits $100 thousand and over at the date indicated:
Table 23: Maturities of Time Deposits $100 Thousand and Over
Borrowings
The Company’s ability to borrow funds through non-deposit sources provides additional flexibility in meeting the liquidity needs of customers while enhancing its funding position and cost of funds structure.
In addition to deposits, the Company utilizes short-term borrowings from the FHLB to fund its day to day operations. Short-term borrowings also include repurchase agreements, which are secured transactions with customers and generally mature the day following the day sold, and overnight unsecured fed funds lines with three correspondent banks. All FHLB advances are secured by a blanket floating lien on all of the Company’s qualifying closed-end and revolving open-end loans that are secured by one to four family residential properties. Total borrowings were $208.2 million at December 31, 2016, an increase of $59.5 million, or 40.0%, from $148.8 million at December 31, 2015. The increase in total borrowings was primarily due to an increase in short-term FHLB advances used to fund loan growth and other strategic initiatives. For further information concerning the Company’s borrowings, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 8. Borrowings.”
On September 17, 2003, $10 million of trust preferred securities were placed through EVB Statutory Trust I in a pooled underwriting totaling approximately $650 million. The trust issuer has invested the total proceeds from the sale of the trust preferred securities in Floating Rate Junior Subordinated Deferrable Interest Debentures (or “Junior Subordinated Debt”) issued by the Company. The trust preferred securities pay cumulative cash distributions quarterly at a variable rate per annum, reset quarterly, equal to the 3-month LIBOR plus 2.95%. As of December 31, 2016 and 2015, the interest rate was 3.94% and 3.48%, respectively. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities have a mandatory redemption date of September 17, 2033, and became subject to varying call provisions beginning September 17, 2008. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.
Capital Resources
The assessment of capital adequacy depends on such factors as asset quality, liquidity, earnings performance, and changing competitive conditions and economic forces. The Company regularly reviews the adequacy of the Company’s capital. The Company maintains a structure that it believes will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses. Refer to Item 1. “Business” under the heading “Regulation and Supervision” and to Item 8. “Financial Statements and Supplementary Data” under the heading “Note 18. Regulatory Matters” for additional information.
The Company’s capital position continues to exceed regulatory minimum requirements. The primary indicators relied on by bank regulators in measuring the capital position of the Company and the Bank at December 31, 2016 and 2015 are the CET1 capital, Tier 1 capital, total risk-based capital, and leverage ratios. The Company’s Tier 1 leverage ratio was 9.2748% at December 31, 2016, compared with 9.2029% at December 31, 2015. The Company’s CET1 capital to risk-weighted assets ratio was 8.8000% at December 31, 2016, compared to 9.8050% at December 31, 2015. The Company’s Tier 1 capital to risk-weighted assets ratio was 11.5129% at December 31, 2016, compared with 12.6637% at December 31, 2015. The Company’s total capital to risk-weighted assets ratio was 14.4449% at December 31, 2016, compared with 16.1737% at December 31, 2015. These ratios are in excess of the mandated minimum requirements that applied to the Company and the Bank at December 31, 2016 and 2015.
Total shareholders’ equity was $131.2 million at December 31, 2016, compared with $126.3 million at December 31, 2015. The increase in total shareholders’ equity during 2016 was primarily due to the net income recognized in 2016, partially offset by an increase in accumulated other comprehensive loss and dividends paid. During 2016, the Company paid $0.09 of cash dividends to common shareholders and the holders of the Company’s Series B Preferred Stock. During 2015, the Company paid $0.06 of cash dividends to common shareholders and the holders of the Company’s Series B Preferred Stock. The dividend payout ratio, based on net income allocated to common shareholders, was 21.3% in 2016, compared to 15.9% in 2015.
Off-Balance Sheet Arrangements
In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, standby letters of credit and guarantees of previously sold credit card accounts and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and guarantees of previously sold credit card accounts is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Unless otherwise noted, the Company does not require collateral or other security to support such financial instruments with credit risk.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include property, plant and equipment and income-producing commercial properties. Our unfunded loan commitments, excluding letters of credit, are used in large part to meet seasonal funding needs which are generally higher from spring through fall than at year end.
Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are usually uncollateralized and do not always contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed. The total amount of unused loan commitments was $223.1 million at December 31, 2016 and $174.0 million at December 31, 2015.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company has not incurred any losses on its commitments in either 2016 or 2015. The total amount of standby letters of credit was $8.7 million at December 31, 2016 and $6.5 million at December 31, 2015.
In connection with the sale of its credit card loan portfolio, the Company has guaranteed the credit card accounts of certain customers to the bank that issues the cards. At December 31, 2016 and 2015, the guarantees totaled $756 thousand and $763 thousand, of which the outstanding balance of the guarantees was $143 thousand and $212 thousand, respectively. As of December 31, 2016, the Company does not anticipate any significant or material losses as a result of the guaranteed credit card accounts.
Liquidity
Liquidity represents an institution’s ability to meet present and future financial obligations, including through the sale of existing assets or the acquisition of additional funds through short-term borrowings. Our liquidity is provided from cash and due from banks, interest bearing deposits with other banks, federal funds sold, repayments from loans, sales of loans, increases in deposits, lines of credit from the FHLB and three correspondent banks, sales of investments, interest and dividend payments received from investments and maturing investments. We also use other short and long-term borrowings to provide additional liquidity when available on terms favorable to the Company, including entering into repurchase agreements with customers and issuing subordinated debt and notes. Our ability to maintain sufficient liquidity may be affected by numerous factors, including economic conditions nationally and in our markets and available borrowing capacity under certain of our borrowing sources. Depending on our liquidity levels, our capital position, conditions in the capital markets and other factors, we may from time to time consider the issuance of debt, equity or other securities, or other possible capital market transactions, the proceeds of which could provide additional liquidity for operations.
As a result of our management of liquid assets and our ability to generate liquidity through liability funding, we believe that we maintain overall liquidity to satisfy our depositors’ requirements and to meet customers’ credit needs. We also take into account any liquidity needs generated by off-balance sheet transactions such as commitments to extend credit, commitments to purchase securities and standby letters of credit.
We monitor and plan our liquidity position for future periods. Liquidity strategies are implemented and monitored by our Asset/Liability Committee (“ALCO”).
Cash, cash equivalents and federal funds sold totaled $17.6 million as of December 31, 2016 compared to $32.0 million as of December 31, 2015. At December 31, 2016, cash, cash equivalents, federal funds sold and unpledged securities available for sale were $206.9 million, or 14.8%, of total assets, compared to $204.4 million, or 16.1%, of total assets at December 31, 2015.
As disclosed in the Company’s consolidated statements of cash flows, net cash provided by operating activities was $15.5 million, net cash used in investing activities was ($150.3) million and net cash provided by financing activities was $120.5 million for the year ended December 31, 2016. Combined, this contributed to a $14.3 million decrease in cash and cash equivalents for the year ended December 31, 2016.
The Company maintains access to short-term funding sources as well, including federal funds lines of credit with three correspondent banks up to $40.0 million and the ability to borrow from the FHLB up to $394.6 million. The Company has no reason to believe these arrangements will not be renewed at maturity. Additional loans and investment securities are available that can be pledged as collateral for future borrowings from the FHLB above the current lendable collateral value.
Certificates of deposit of $100,000 or more, maturing in one year or less, totaled $62.3 million at December 31, 2016. Certificates of deposit of $100,000 or more, maturing in more than one year, totaled $50.4 million at December 31, 2016.
The following table presents the Company’s contractual obligations and scheduled payment amounts, excluding interest, due at various intervals over the next five years and beyond as of December 31, 2016:
Table 24: Contractual Obligations
As of December 31, 2016, the Company was not aware of any other known trends, events or uncertainties that have or are reasonably likely to have a material impact on our liquidity. As of December 31, 2016, the Company has no material commitments or long-term debt for capital expenditures.
Impact of Inflation and Changing Prices
The Company’s financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). U.S. GAAP presently requires the Company to measure financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on the operations of the Company is reflected in increased operating costs. In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate because virtually all of the assets and liabilities are monetary in nature. While interest rates are greatly influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude as the inflation rate. Interest rates are highly sensitive to many factors that are beyond the control of the Company, including changes in the expected rate of inflation, the influence of general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.
In financial institutions, unlike most manufacturing companies, virtually all of the assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on a bank's performance than the effects of general levels of inflation. Interest rate movement is not necessarily tied to movements in the same direction or with the same magnitude as the prices of goods and services, since such prices are affected by inflation to a larger extent than interest rates.
Recent Accounting Pronouncements
For information regarding recent accounting pronouncements and their effect on the Company, see Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 1. Summary of Significant Accounting Policies-Recent Significant Accounting Pronouncements.”
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will impact the amount of interest income and expense the Company receives or pays on a significant portion of its assets and liabilities and the market value of its interest-earning assets and interest-bearing liabilities, excluding those which have a very short-term until maturity. The Company does not subject itself to foreign currency exchange rate risk or commodity price risk due to the current nature of its operations. As of December 31, 2016, the Company does not have any hedging transactions in place such as interest rate swaps or caps. In addition, the Company does not hold or issue financial instruments for trading purposes. The Company does hold in its loan and investment securities portfolios, investments that adjust or float according to changes in index rates, but the Company considers these assets to be necessary for good asset/liability management and not speculative in nature. Management is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. The Board of Directors reviews guidelines for managing the interest rate sensitivity position established by management.
Asset/Liability Risk Management
The primary goal of asset/liability risk management is to maximize the net interest income and the net value of our future cash flows within the interest rate limits set by ALCO. Risks may increase when changes in interest rates occur and produce shifts in the Company’s ability to generate earnings (“earnings risk”) and its overall value of equity (“equity risk”). These risks can be measured and monitored by employing management strategies which track the relationship between rate sensitive assets and liabilities so that the net effect of their ability to generate earnings and economic value can be evaluated in a variety of interest rate scenarios.
Interest Rate Risk
Interest rate risk is the risk to earnings or capital as a result of interest rate movement and is monitored through the use of three complementary measures: static gap analysis, earnings simulation modeling and economic value of equity. While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of our interest rate risk, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships.
Static Gap Analysis
Interest rate risk is measured and monitored by measuring the rate sensitivity of the balance sheet using static gap analysis. Gap analysis involves analyzing the dollar volume of interest rate sensitive assets and liabilities that will re-price during specific periods of time in the future. The “gap” refers to the difference from the total dollar volume of assets that re-price (or mature, prepay, or amortize) over a given period of time minus the total dollar volume of liabilities that re-price (or mature, prepay or amortize) during the same time period. At December 31, 2016, we are asset sensitive, which means our rate sensitive assets re-price faster than our rate sensitive liabilities, and our cumulative one year gap is 20.8%. An asset-sensitive company generally will be impacted favorably by increasing interest rates while a liability-sensitive company’s net interest margin and net interest income generally will be impacted favorably by declining interest rates.
Earnings Simulation
The earnings simulation model forecasts one-year net interest income on a static balance sheet under a variety of scenarios that incorporate changes in interest rates, changes in the shape of the yield curve and changes in interest rate relationships. Management evaluates the effects on income of alternative interest rate scenarios against earnings in a stable interest rate environment. This type of analysis is also most useful in determining the short-run earnings exposures to changes in customer behavior involving loan payments and deposit additions and withdrawals. The following table represents the interest rate sensitivity on net interest income for the Company for the twelve months following each of the years ended December 31, 2016 and December 31, 2015, using a static balance sheet and different rate scenarios:
Internally, we also perform earnings simulation model forecasts on a quarterly basis using the impact of an increase in interest rates by 300 basis points and 400 basis points, as well as a decrease in interest rates by 200 basis points and 300 basis points on a dynamic balance sheet. However, with the current fed funds target rate at a range of 75 - 100 basis points and in the current interest rate environment, we consider a rate decrease by more than 100 basis points or increases by more than 200 basis points to be very unlikely. This dynamic simulation model includes assumptions about how the balance sheet is likely to evolve through time, in different interest rate environments. Loan and deposit growth rate assumptions are derived from historical analysis and management’s outlook, as are the assumptions used to project yields and rates for new loans and deposits. All maturities, calls and prepayments in the investment securities portfolio are assumed to be reinvested in like instruments. Mortgage loan prepayment assumptions are developed from institution specific prepayment data. The sensitivities of key assumptions are analyzed at least annually through stress testing and are reviewed by management.
Economic Value of Equity
Economic value simulation is used to calculate the estimated fair value of assets and liabilities in different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. Economic value-based methodologies measure the degree to which the economic values of the Company’s positions change under different interest rate scenarios. The economic-value approach focuses on a longer-term time horizon, captures all future cash flows expected from existing assets and liabilities, and is more effective in considering embedded options in a typical institution’s balance sheet. The following table reflects the change in economic value of equity for the Company for each of the years ended December 31, 2016 and 2015, using different rate scenarios:
The Company believes that our current interest rate exposure is manageable and does not indicate any significant exposure to interest rate changes.
Item 8.
Item 8. Financial Statements and Supplementary Data
The following financial statements are filed as a part of this report following Item 15:
·Report of Independent Registered Public Accounting Firm
·Consolidated Balance Sheets as of December 31, 2016 and 2015
·Consolidated Statements of Income for the three years ended December 31, 2016
·Consolidated Statements of Comprehensive Income for the three years ended December 31, 2016
·Consolidated Statements of Changes in Shareholders’ Equity for the three years ended December 31, 2016
·Consolidated Statements of Cash Flows for the three years ended December 31, 2016
·Notes to Consolidated Financial Statements
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company’s management, with the participation of the Company’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of December 31, 2016 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that the Company’s disclosure controls and procedures will detect or uncover every situation involving the failure of persons within the Company or its subsidiary to disclose material information required to be set forth in the Company’s periodic reports.
Management’s Report on Internal Control over Financial Reporting
Management of the Company is also responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework (2013). Based on our assessment, we believe that, as of December 31, 2016, the Company’s internal control over financial reporting was effective based on those criteria.
The effectiveness of the Company’s internal control over financial reporting as of December 31, 2016 has been audited by Yount, Hyde & Barbour, P.C., the independent registered public accounting firm who also audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K. Yount, Hyde & Barbour, P.C.’s attestation report on the Company’s internal control over financial reporting, which states an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016, is incorporated by reference in Item 8 above, under the heading “Report of Independent Registered Public Accounting Firm.”
Changes in Internal Control
There were no changes in the Company’s internal control over financial reporting during the Company’s quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Except as provided below, the response to this Item will be included in an amendment to this Annual Report on Form 10-K to be filed with the SEC on or before May 1, 2017.
The Board of Directors has approved a Code of Ethics for all directors, officers and staff of our Company and its subsidiaries. The Code of Ethics is designed to promote honest and ethical conduct, proper disclosure of financial information in our periodic reports, and compliance with applicable laws, rules, and regulations by our senior officers who have financial responsibilities. The Code of Ethics is available on our web page at www.evb.org. The Company intends to provide any required disclosure of any amendment to or waiver from the Code that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, on www.evb.org promptly following the amendment or waiver. The Company may elect to disclose any such amendment or waiver in a report on Form 8-K filed with the SEC either in addition to or in lieu of the website disclosure. The information contained on or connected to our Internet website is not incorporated by reference into this report and should not be considered part of this or any other report that we file with or furnish to the SEC.
Item 11.
Item 11. Executive Compensation
The response to this Item will be included in an amendment to this Annual Report on Form 10-K to be filed with the SEC on or before May 1, 2017.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The response to this Item will be included in an amendment to this Annual Report on Form 10-K to be filed with the SEC on or before May 1, 2017.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The response to this Item will be included in an amendment to this Annual Report on Form 10-K to be filed with the SEC on or before May 1, 2017.
Item 14.
Item 14. Principal Accountant Fees and Services
The response to this Item will be included in an amendment to this Annual Report on Form 10-K to be filed with the SEC on or before May 1, 2017.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)(1) The response to this portion of Item 15 is included in Item 8 above.
(a)(2) The response to this portion of Item 15 is included in Item 8 above.
(a)(3) Exhibits
The following exhibits are filed as part of this Form 10-K and this list includes the Exhibit Index.
Exhibit
Number
2.1
Agreement and Plan of Reorganization, dated as of May 29, 2014, among Eastern Virginia Bankshares, Inc., EVB and Virginia Company Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed May 30, 2014).
2.2
Agreement and Plan of Merger, dated as of December 13, 2016, between Southern National Bancorp of Virginia, Inc. and Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed December 14, 2016).
2.2.1
Amendment to Agreement and Plan of Merger, dated as of March 8, 2017, by and between Southern National Bancorp of Virginia, Inc. and Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed March 9, 2017).
3.1
Amended and Restated Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective December 29, 2008 (incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K filed March 10, 2009).
3.1.1
Articles of Amendment to the Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective January 6, 2009 (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed January 13, 2009).
3.1.2
Articles of Amendment to the Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective June 10, 2013 (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed June 14, 2013).
3.2
Bylaws of Eastern Virginia Bankshares, Inc., as amended June 4, 2013 (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed June 14, 2013).
4.3
Indenture, dated April 22, 2015, by and between Eastern Virginia Bankshares, Inc. and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed April 24, 2015).
4.4
Forms of 6.50% Subordinated Note due 2025 (included as Exhibit A-1 and Exhibit A-2 in Exhibit 4.3 filed with, and incorporated herein by reference to, the Company’s Current Report on Form 8-K filed April 24, 2015).
Certain instruments relating to long-term debt as to which the total amount of securities authorized there under does not exceed 10% of the total assets of Eastern Virginia Bankshares, Inc. have been omitted in accordance with Item 601(b)(4)(iii) of Regulation S-K. The registrant will furnish a copy of any such instrument to the Securities and Exchange Commission upon its request.
10.1
Eastern Virginia Bankshares, Inc. 2003 Stock Incentive Plan (incorporated by reference to Exhibit A to the Company’s 2003 Proxy Statement filed March 24, 2003).*
10.2
Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit A to the Company’s 2007 Proxy Statement filed March 21, 2007.*
10.3
Amended and Restated Employment Agreement dated as of January 1, 2008 between Eastern Virginia Bankshares, Inc. and Joe A. Shearin (incorporated by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K filed March 10, 2009).*
10.3.1
Amendment to Amended and Restated Employment Agreement, dated as of March 19, 2015 between Eastern Virginia Bankshares, Inc. and Joe A. Shearin (incorporated by reference to Exhibit 10.3.1 to the Company’s Current Report on Form 8-K filed March 23, 2015).*
10.6
Amended and Restated Employment Agreement dated as of January 10, 2008, between Eastern Virginia Bankshares, Inc. and James S. Thomas (incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-K filed March 10, 2009).*
10.10
Form of TARP-compliant Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. Stock Incentive Plan (incorporated by reference to Exhibit 10.10 to the Company’s Current Report on Form 8-K filed November 19, 2010).*
10.13
Form of TARP-compliant Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit 10.13 to the Company’s Current Report on Form 8-K filed July 6, 2012).*
10.14
Securities Purchase Agreement, dated as of March 26, 2013, between Eastern Virginia Bankshares, Inc. and Castle Creek Capital Partners IV, LP (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.15
Securities Purchase Agreement, dated as of March 26, 2013, between Eastern Virginia Bankshares, Inc. and GCP III EVB LLC (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.16
Form of Securities Purchase Agreement between Eastern Virginia Bankshares, Inc. and certain institutional investors (incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.18
Base salaries for executive officers of Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q filed May 10, 2016).*
10.19
Non-employee directors’ annual compensation for Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 10.19 to the Company’s Quarterly Report on Form 10-Q filed August 9, 2016).*
10.20
Form of Time-Based and Performance-Based Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit 10.20 to the Company’s Current Report on Form 8-K filed October 16, 2014).*
10.21
Eastern Virginia Bankshares, Inc. Supplemental Executive Retirement Plan, effective January 1, 2008 (incorporated by reference to Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q filed May 16, 2011).*
10.21.1
First Amendment to Eastern Virginia Bankshares, Inc. Supplemental Executive Retirement Plan, effective as of November 20, 2014 (incorporated by reference to Exhibit 10.21.1 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.22
Employment Agreement, effective November 20, 2014, between Eastern Virginia Bankshares, Inc. and Mark C. Hanna (incorporated by reference to Exhibit 10.22 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.23
Form of Split Dollar Insurance Agreement between EVB and each of the executive officers of the Company (incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.24
Eastern Virginia Bankshares, Inc. Executive Severance Plan (incorporated by reference to Exhibit 10.24 to the Company’s Current Report on Form 8-K filed March 23, 2015).*
10.25
Description of Annual Bonus Plan for Key Executives.#*
10.26
Subordinated Note Purchase Agreement, dated April 22, 2015, by and among Eastern Virginia Bankshares, Inc. and the purchasers identified therein (incorporated by reference to Exhibit 10.26 to the Company’s Current Report on Form 8-K filed April 24, 2015).
10.27
Registration Rights Agreement, dated April 22, 2015, by and among Eastern Virginia Bankshares, Inc. and the purchasers identified therein (incorporated by reference to Exhibit 10.27 to the Company’s Current Report on Form 8-K filed April 24, 2015).
10.28
Eastern Virginia Bankshares, Inc. 2016 Equity Compensation Plan (incorporated by reference to Exhibit 10.28 to the Company’s Current Report on Form 8-K filed May 24, 2016). *
10.29
Form of Time-Based and Performance-Based Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2016 Equity Compensation Plan (incorporated by reference to Exhibit 10.29 to the Company’s Current Report on Form 8-K filed November 21, 2016).*
21.1
Subsidiaries of Eastern Virginia Bankshares, Inc.#
23.1
Consent of Yount, Hyde & Barbour, P.C.#
31.1
Rule 13a-14(a) Certification of Chief Executive Officer.#
31.2
Rule 13a-14(a) Certification of Chief Financial Officer.#
32.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.#
32.2
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.#
The following materials from Eastern Virginia Bankshares, Inc. Annual Report on Form 10-K for the year ended December 31, 2016, formatted in XBRL (Extensible Business Reporting Language), furnished herewith: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.#
* Management contract or compensatory plan or arrangement.
# Filed herewith.
(b)Exhibits - See exhibit index included in Item 15(a)(3) above.
(c)Financial Statement Schedules - See Item 15(a)(2) above.
Item 16. Form 10-K Summary
Not applicable.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EASTERN VIRGINIA BANKSHARES, INC.
(Registrant)
By: /s/ Joe A. Shearin Date: March 15, 2017
Joe A. Shearin
President and Chief Executive Officer
(Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 15, 2017.
/s/ W. Rand Cook
W. Rand Cook, Chairman, Director
/s/ Joe A. Shearin
Joe A. Shearin
President and Chief Executive Officer, Director
(Principal Executive Officer)
/s/ J. Adam Sothen
J. Adam Sothen
Executive Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ F.L. Garrett, III
F.L. Garrett, III, Vice Chairman, Director
/s/ John F. Biagas
John F. Biagas, Director
/s/ William G. Cox
William G. Cox, Director
/s/ Michael E. Fiore
Michael E. Fiore, Director
/s/ Boris M. Gutin
Boris M. Gutin, Director
/s/ Ira C. Harris
Ira C. Harris, Director
/s/ Eric A. Johnson
Eric A. Johnson, Director
/s/ W. Leslie Kilduff, Jr.
W. Leslie Kilduff, Jr., Director
/s/ Leslie E. Taylor
Leslie E. Taylor, Director
/s/ Jay T. Thompson, III
Jay T. Thompson, III, Director
EXHIBIT INDEX
Exhibit
Number
2.1
Agreement and Plan of Reorganization, dated as of May 29, 2014, among Eastern Virginia Bankshares, Inc., EVB and Virginia Company Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed May 30, 2014).
2.2
Agreement and Plan of Merger, dated as of December 13, 2016, between Southern National Bancorp of Virginia, Inc. and Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 2.2 to the Company’s Current Report on Form 8-K filed December 14, 2016).
2.2.1
Amendment to Agreement and Plan of Merger, dated as of March 8, 2017, by and between Southern National Bancorp of Virginia, Inc. and Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed March 9, 2017).
3.1
Amended and Restated Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective December 29, 2008 (incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K filed March 10, 2009).
3.1.1
Articles of Amendment to the Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective January 6, 2009 (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed January 13, 2009).
3.1.2
Articles of Amendment to the Articles of Incorporation of Eastern Virginia Bankshares, Inc., effective June 10, 2013 (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed June 14, 2013).
3.2
Bylaws of Eastern Virginia Bankshares, Inc., as amended June 4, 2013 (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed June 14, 2013).
4.3
Indenture, dated April 22, 2015, by and between Eastern Virginia Bankshares, Inc. and U.S. Bank National Association, as trustee (incorporated by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed April 24, 2015).
4.4
Forms of 6.50% Subordinated Note due 2025 (included as Exhibit A-1 and Exhibit A-2 in Exhibit 4.3 filed with, and incorporated herein by reference to, the Company’s Current Report on Form 8-K filed April 24, 2015).
Certain instruments relating to long-term debt as to which the total amount of securities authorized there under does not exceed 10% of the total assets of Eastern Virginia Bankshares, Inc. have been omitted in accordance with Item 601(b)(4)(iii) of Regulation S-K. The registrant will furnish a copy of any such instrument to the Securities and Exchange Commission upon its request.
10.1
Eastern Virginia Bankshares, Inc. 2003 Stock Incentive Plan (incorporated by reference to Exhibit A to the Company’s 2003 Proxy Statement filed March 24, 2003).*
10.2
Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit A to the Company’s 2007 Proxy Statement filed March 21, 2007.*
10.3
Amended and Restated Employment Agreement dated as of January 1, 2008 between Eastern Virginia Bankshares, Inc. and Joe A. Shearin (incorporated by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K filed March 10, 2009).*
10.3.1
Amendment to Amended and Restated Employment Agreement, dated as of March 19, 2015 between Eastern Virginia Bankshares, Inc. and Joe A. Shearin (incorporated by reference to Exhibit 10.3.1 to the Company’s Current Report on Form 8-K filed March 23, 2015).*
10.6
Amended and Restated Employment Agreement dated as of January 10, 2008, between Eastern Virginia Bankshares, Inc. and James S. Thomas (incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-K filed March 10, 2009).*
10.10
Form of TARP-compliant Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. Stock Incentive Plan (incorporated by reference to Exhibit 10.10 to the Company’s Current Report on Form 8-K filed November 19, 2010).*
10.13
Form of TARP-compliant Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit 10.13 to the Company’s Current Report on Form 8-K filed July 6, 2012).*
10.14
Securities Purchase Agreement, dated as of March 26, 2013, between Eastern Virginia Bankshares, Inc. and Castle Creek Capital Partners IV, LP (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.15
Securities Purchase Agreement, dated as of March 26, 2013, between Eastern Virginia Bankshares, Inc. and GCP III EVB LLC (incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.16
Form of Securities Purchase Agreement between Eastern Virginia Bankshares, Inc. and certain institutional investors (incorporated by reference to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed March 28, 2013).
10.18
Base salaries for executive officers of Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q filed May 10, 2016).*
10.19
Non-employee directors’ annual compensation for Eastern Virginia Bankshares, Inc. (incorporated by reference to Exhibit 10.19 to the Company’s Quarterly Report on Form 10-Q filed August 9, 2016).*
10.20
Form of Time-Based and Performance-Based Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (incorporated by reference to Exhibit 10.20 to the Company’s Current Report on Form 8-K filed October 16, 2014).*
10.21
Eastern Virginia Bankshares, Inc. Supplemental Executive Retirement Plan, effective January 1, 2008 (incorporated by reference to Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q filed May 16, 2011).*
10.21.1
First Amendment to Eastern Virginia Bankshares, Inc. Supplemental Executive Retirement Plan, effective as of November 20, 2014 (incorporated by reference to Exhibit 10.21.1 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.22
Employment Agreement, effective November 20, 2014, between Eastern Virginia Bankshares, Inc. and Mark C. Hanna (incorporated by reference to Exhibit 10.22 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.23
Form of Split Dollar Insurance Agreement between EVB and each of the executive officers of the Company (incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on Form 10-K filed March 31, 2015).*
10.24
Eastern Virginia Bankshares, Inc. Executive Severance Plan (incorporated by reference to Exhibit 10.24 to the Company’s Current Report on Form 8-K filed March 23, 2015).*
10.25
Description of Annual Bonus Plan for Key Executives.#*
10.26
Subordinated Note Purchase Agreement, dated April 22, 2015, by and among Eastern Virginia Bankshares, Inc. and the purchasers identified therein (incorporated by reference to Exhibit 10.26 to the Company’s Current Report on Form 8-K filed April 24, 2015).
10.27
Registration Rights Agreement, dated April 22, 2015, by and among Eastern Virginia Bankshares, Inc. and the purchasers identified therein (incorporated by reference to Exhibit 10.27 to the Company’s Current Report on Form 8-K filed April 24, 2015).
10.28
Eastern Virginia Bankshares, Inc. 2016 Equity Compensation Plan (incorporated by reference to Exhibit 10.28 to the Company’s Current Report on Form 8-K filed May 24, 2016). *
10.29
Form of Time-Based and Performance-Based Restricted Stock Agreement under Eastern Virginia Bankshares, Inc. 2016 Equity Compensation Plan (incorporated by reference to Exhibit 10.29 to the Company’s Current Report on Form 8-K filed November 21, 2016).*
21.1
Subsidiaries of Eastern Virginia Bankshares, Inc.#
23.1
Consent of Yount, Hyde & Barbour, P.C.#
31.1
Rule 13a-14(a) Certification of Chief Executive Officer.#
31.2
Rule 13a-14(a) Certification of Chief Financial Officer.#
32.1
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350.#
32.2
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350.#
The following materials from Eastern Virginia Bankshares, Inc. Annual Report on Form 10-K for the year ended December 31, 2016, formatted in XBRL (Extensible Business Reporting Language), furnished herewith: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.#
* Management contract or compensatory plan or arrangement.
# Filed herewith.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors
Eastern Virginia Bankshares, Inc.
Glen Allen, Virginia
We have audited the accompanying consolidated balance sheets of Eastern Virginia Bankshares, Inc. and Subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Eastern Virginia Bankshares, Inc. and Subsidiaries as of December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Eastern Virginia Bankshares, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated March 15, 2017 expressed an unqualified opinion on the effectiveness of Eastern Virginia Bankshares, Inc. and Subsidiaries’ internal control over financial reporting.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia
March 15, 2017
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors
Eastern Virginia Bankshares, Inc.
Glen Allen, Virginia
We have audited Eastern Virginia Bankshares, Inc. and Subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016 of Eastern Virginia Bankshares, Inc. and Subsidiaries, and our report dated March 15, 2017 expressed an unqualified opinion.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia
March 15, 2017
Eastern Virginia Bankshares, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 2016 and 2015
(dollars in thousands, except share and per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
Eastern Virginia Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands, except per share amounts)
The accompanying notes are an integral part of the consolidated financial statements.
Eastern Virginia Bankshares, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
For the Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
Eastern Virginia Bankshares, Inc. and Subsidiaries
Consolidated Statements of Shareholders’ Equity
For the Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands)
(1)For the purposes of this table, Preferred Stock Series A includes the effect of the warrant (prior to its repurchase by the Company during the second quarter of 2015) issued in connection with the sale of the Series A Preferred Stock and the discount on such preferred stock.
The accompanying notes are an integral part of the consolidated financial statements.
Eastern Virginia Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands)
The accompanying notes are an integral part of the consolidated financial statements.
Eastern Virginia Bankshares, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2016, 2015 and 2014
Note 1. Summary of Significant Accounting Policies
The accounting and reporting policies of Eastern Virginia Bankshares, Inc. (the “Company”) and its subsidiaries, EVB Statutory Trust I (the “Trust”), and EVB (the “Bank”) and its subsidiaries, are in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and conform to accepted practices within the banking industry. A summary of significant accounting policies is briefly described below.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. In addition, the Company owns the Trust which is an unconsolidated subsidiary. The subordinated debt owed to the Trust is reported as a liability of the Company.
Nature of Operations
Eastern Virginia Bankshares, Inc. is a bank holding company that was organized and chartered under the laws of the Commonwealth of Virginia on September 5, 1997 and commenced operations on December 29, 1997. The Company was headquartered in Tappahannock, Virginia until October 2016 at which time it was relocated to Glen Allen, Virginia. The Company conducts its primary operations through its wholly-owned bank subsidiary, EVB, which is headquartered in Tappahannock, Virginia. Two of EVB’s three predecessor banks, Bank of Northumberland, Inc. and Southside Bank, were established in 1910. The third bank, Hanover Bank, was established as a de novo bank in 2000. In April 2006, these three banks were merged and the surviving bank was re-branded as EVB. Additionally, the Company acquired Virginia Company Bank (“VCB”) (see Note 2 - Business Combinations) on November 14, 2014 and merged VCB with and into the Bank, with the Bank surviving, thus adding three additional branches to the Bank located in Newport News, Williamsburg and Hampton, respectively. The Bank provides a full range of banking and related financial services to individuals and businesses through its network of retail branches. With twenty-four retail branches, the Bank serves diverse markets that primarily are in the counties of Essex, Gloucester, Hanover, Henrico, King and Queen, King William, Lancaster, Middlesex, New Kent, Northumberland, Southampton, Surry, Sussex, and the cities of Colonial Heights, Hampton, Newport News, Richmond and Williamsburg. The Bank also operates a loan production office in Chesterfield County, Virginia, that the Bank opened during the second quarter of 2014. The Bank operates under a state bank charter and as such is subject to regulation by the Virginia State Corporation Commission Bureau of Financial Institutions (the “Bureau”) and the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).
On December 13, 2016, the Company entered into an Agreement and Plan of Merger to merge with and into Southern National Bancorp of Virginia, Inc. (“Southern National”), with Southern National surviving (such transaction, the “Pending Merger”). The Pending Merger, which is expected to be completed by the third quarter of 2017, is subject to regulatory approvals and the approval of the shareholders of both companies, as well as customary closing conditions.
The Bank owns EVB Financial Services, Inc., which in turn has a 100% ownership interest in EVB Investments, Inc. EVB Investments, Inc. offers a comprehensive range of investment services through Infinex Investments, Inc. On May 15, 2014, the Bank acquired a 4.9% ownership interest in Southern Trust Mortgage, LLC. Pursuant to an independent contractor agreement with Southern Trust Mortgage, LLC, the Company advises and consults with Southern Trust Mortgage, LLC and facilitates the marketing and brand recognition of their mortgage business. In addition, the Company provides Southern Trust Mortgage, LLC with offices at two retail branches in the Company’s market area and access to office equipment at these locations during normal business hours. For its services, the Company receives fixed monthly compensation from Southern Trust Mortgage, LLC in the amount of $2 thousand, which is adjustable on a quarterly basis.
The Bank had a 75% ownership interest in EVB Title, LLC, which primarily sold title insurance to the mortgage loan customers of the Bank and EVB Mortgage, LLC. Effective January 2014, the Bank ceased operations of EVB Title, LLC due to low volume and profitability. On October 1, 2014, the Bank acquired a 6.0% ownership interest in Bankers Title, LLC. Bankers Title, LLC is a multi-bank owned title agency providing a full range of title insurance settlement and related financial services. The Bank has a 2.94% ownership interest in Bankers Insurance, LLC, which primarily sells insurance products to customers of the Bank, and other financial institutions that have an equity interest in the agency. The Bank also has a 100% ownership interest in Dunston Hall LLC and POS LLC, which were formed to hold the title to real estate acquired by the Bank upon foreclosure on property of real estate secured loans. The Bank previously had a 100% ownership interest in Tartan Holdings LLC and ECU-RE LLC which were used in a similar capacity as Dunston Hall LLC and POS LLC, but they are now inactive with the Virginia State Corporation Commission and will no longer be used by the Bank. The financial position and operating results of all of these subsidiaries are not significant to the Company as a whole and are not considered principal activities of the Company at this time. The Company’s common stock trades on the NASDAQ Global Select Market under the symbol “EVBS.”
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, loans acquired in a business combination, impairment of loans, impairment of securities, the valuation of other real estate owned (or “OREO”), the projected benefit obligation under the defined benefit pension plan, the valuation of deferred taxes and goodwill impairment. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, which are necessary for a fair presentation of the results of operations in these financial statements, have been made.
Reclassifications
Certain prior year amounts have been reclassified to conform to the 2016 presentation. These reclassifications had no effect on previously reported net income.
Significant Group Concentrations of Credit Risk
Substantially all of the Company’s lending activities are with customers located in Virginia. At December 31, 2016 and 2015, respectively, 32.7% and 39.6% of the Company’s loan portfolio consisted of real estate loans secured by one to four family residential properties, which includes closed end first and second mortgages as well as home equity lines. In addition, at December 31, 2016 and 2015, the Company had $14.4 million and $20.0 million of loans to the hospitality industry (hotels, motels, inns, etc.). These amounts represent 3.1% and 5.4% of the Company’s total commercial real estate loans and 10.2% and 15.7% of the Bank’s total risk-based capital at December 31, 2016 and 2015, respectively. These concentrations of loans did not exceed established supervisory guidelines of 25% of the Bank’s total risk-based capital. The Company does not have any significant loan concentrations to any one customer. Note 4 - Loan Portfolio discusses the Company’s lending activities.
The Company invests in a variety of securities and does not have any significant securities concentrations in any one industry or to any one issuer. Note 3 - Investment Securities discusses the Company’s investment activities.
At December 31, 2016 and 2015, the Company’s cash and due from banks included three commercial bank deposit accounts that were in excess of the Federal Deposit Insurance Corporation (“FDIC”) insured limit of $250,000 per institution by approximately $164 thousand and $6.9 million, respectively.
Business Combination
On November 14, 2014, the Company acquired VCB. The acquisition was accounted for using the acquisition method of accounting. Under this method, assets and liabilities of VCB were recorded at their respective fair values as of November 14, 2014. These fair values were preliminary and subject to refinement for up to one year after the closing date of the acquisition (the “Measurement Period”), or until November 14, 2015, as information relative to the closing date fair values became available. The Company’s financial position and results of operations as of and for the years ended December 31, 2016 and 2015 include assets acquired and liabilities assumed from VCB that remain on the Company’s balance sheet as of December 31, 2016 and 2015 and results of operations generated by these assets and liabilities from November 14, 2014 forward. No adjustments were made to the preliminary fair values during the Measurement Period. See Note 2-Business Combinations for additional information regarding the acquisition of VCB.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and cash equivalents includes cash and due from banks, interest bearing deposits with banks and federal funds sold, which all mature within ninety days.
Restrictions on Cash and Due from Bank Accounts
The Company is required to maintain average reserve balances in cash with the Federal Reserve Bank of Richmond (the “Reserve Bank”). The Company had reserve requirements of $2.0 million and $1.4 million with the Reserve Bank for December 31, 2016 and 2015, respectively. These reserve requirements were covered by internal holdings.
Investment Securities
The accounting and measurement framework for our investment securities differs depending on the security classification. We classify investment securities as available for sale or held to maturity based on our investment strategy and management’s assessment of our intent and ability to hold the investment securities until maturity. Management determines the appropriate classification of investment securities at the time of purchase, subject to any subsequent change in our intent and ability to hold the securities until maturity. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Any decision to sell investment securities available for sale would be based on various factors, including, but not limited to, asset/liability management strategies, changes in interest rates or prepayment risks, liquidity needs, or regulatory capital considerations. Investment securities available for sale are carried at fair value, with unrealized gains and losses, net of related deferred income taxes, included in shareholders’ equity as a separate component of accumulated other comprehensive income (loss). Gains or losses are recognized in earnings on the trade date using the amortized cost of the specific security sold. Premiums and discounts are amortized or accreted into interest income using the interest method over the terms of the securities.
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive (loss) income.
For equity securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company’s best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.
Restricted Securities
As a requirement for membership, the Company invests in the stock of the Federal Home Loan Bank (“FHLB”) of Atlanta, Community Bankers Bank (“CBB”), and the Reserve Bank. These investments are carried at cost.
Loans
The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. A substantial portion of the loan portfolio is represented by mortgage loans in the Company’s market area. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market area. Loans that management has both the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are stated at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and net of any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment to the yield (interest income) of the related loans. The Company is amortizing these amounts over the contractual life of the related loans. The Company occasionally purchases loans outside of a business combination. These loans are reviewed with the same scrutiny as originated loans and any discounts or premiums are amortized as a yield adjustment over the remaining life of the loans.
The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due.
When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across the Company’s loan portfolio.
A loan (including a troubled debt restructuring or “TDR”) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Impaired loans are stated at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and net of any deferred fees or costs on originated loans (recorded investment). Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment shortfalls generally are not classified as impaired. The Company determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans, by either the present value of expected cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans, representing consumer, one to four family residential first and seconds and home equity lines, are collectively evaluated for impairment. Accordingly, the Company does not separately identify the individual consumer and one to four family residential loans for impairment disclosures, except for TDRs as noted below. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment.
A loan is accounted for as a TDR if the Company, for economic or legal reasons related to a deterioration in the borrower’s financial condition, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired loans. A TDR may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate, the forbearance of principal and interest payments for a specified period, the conversion from an amortizing loan to an interest-only loan for a specified period, or some combination of these concessions. These concessions can be temporary and are done in an attempt to avoid foreclosure and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. At the time of a TDR, the loan is placed on non-accrual status. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. As of December 31, 2016 and 2015, the Company had $12.7 million and $16.8 million of loans classified as TDRs.
Loans Acquired in a Business Combination
The Company accounts for loans acquired in a business combination, such as the Company’s acquisition of VCB, in accordance with the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations.” Accordingly, acquired loans are segregated between purchased credit-impaired (“PCI”) loans and purchased performing loans and are recorded at fair value on the date of acquisition without the carryover of the related allowance for loan losses.
PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair market value, PCI loans were aggregated into pools of loans based on common characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income. Loans not designated PCI loans as of the acquisition date are designated purchased performing loans. The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing or PCI loans. A provision for loan losses is recorded for any deterioration in these loans subsequent to the acquisition.
Allowance for Loan Losses
The allowance for loan losses is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the loan portfolio, and is based on periodic evaluations of the collectability and historical loss experience of loans. A provision for loan losses, which is a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in management’s judgment, is appropriate to absorb probable losses in the loan portfolio. Actual credit losses are deducted from the allowance for loan losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent. The following general charge-off guidelines apply:
·Management believes that the collectability of the principal is unlikely regardless of delinquency status.
·If unsecured, the loan will be charged-off in full no later than 120 days after its payment due date if a closed-end credit.
·If unsecured, the loan will be charged-off in full no later than 180 days after its payment due date if an open-ended credit.
·If secured, the outstanding principal balance of the loan will be charged-off generally after the collateral has been liquidated and sale proceeds applied to the balance.
Subsequent recoveries, if any, are credited to the allowance for loan losses.
The Company's ALL Committee is responsible for assessing the overall appropriateness of the allowance for loan losses and monitoring the Company's allowance for loan losses methodology, particularly in the context of current economic conditions and a rapidly changing regulatory environment. The ALL Committee at least annually reviews the Company's allowance for loan losses methodology.
The allocation methodology applied by the Company includes management’s ongoing review and grading of the loan portfolio into criticized loan categories (defined as specific loans warranting either specific allocation, or a classified status of substandard, doubtful or loss). The allocation methodology focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, management’s ongoing review and grading of the loan portfolio, consideration of migration analysis and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of classified loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. In determining the allowance for loan losses, the Company considers its portfolio segments and loan classes to be the same.
The allowance for loan losses is comprised of a specific allowance for identified problem loans and a general allowance representing estimations performed pursuant to either FASB ASC Topic 450 “Accounting for Contingencies,” or FASB ASC Topic 310 “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when deemed appropriate. The general component covers non-classified or performing loans and those loans classified as substandard, doubtful or loss that are not impaired. The general component is based on migration analysis adjusted for qualitative factors, such as economic conditions, interest rates and unemployment rates. The Company uses a risk grading system for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans. Loans are graded on a scale from 1 to 9. Non-impaired real estate and commercial loans are assigned an allowance factor which increases with the severity of risk grading. A general description of the characteristics of the risk grades is as follows:
Pass Grades
·Risk Grade 1 loans have little or no risk and are generally secured by cash or cash equivalents;
·Risk Grade 2 loans have minimal risk to well qualified borrowers and no significant questions as to safety;
·Risk Grade 3 loans are satisfactory loans with strong borrowers and secondary sources of repayment;
·Risk Grade 4 loans are satisfactory loans with borrowers not as strong as risk grade 3 loans but may exhibit a higher degree of financial risk based on the type of business supporting the loan; and
·Risk Grade 5 loans are loans that warrant more than the normal level of supervision and have the possibility of an event occurring that may weaken the borrower’s ability to repay.
Special Mention
·Risk Grade 6 loans have increasing potential weaknesses beyond those at which the loan originally was granted and if not addressed could lead to inadequately protecting the Company’s credit position.
Classified Grades
·Risk Grade 7 loans are substandard loans and are inadequately protected by the current sound worth or paying capacity of the obligor or the collateral pledged. These have well defined weaknesses that jeopardize the liquidation of the debt with the distinct possibility the Company will sustain some loss if the deficiencies are not corrected;
·Risk Grade 8 loans are doubtful of collection and the possibility of loss is high but pending specific borrower plans for recovery, its classification as a loss is deferred until its more exact status is determined; and
·Risk Grade 9 loans are loss loans which are considered uncollectable and of such little value that their continuance as a bank asset is not warranted.
The Company uses a past due grading system for consumer loans, including one to four family residential first and seconds and home equity lines. The past due status of a loan is based on the contractual due date of the most delinquent payment due. The past due grading of consumer loans is based on the following categories: current, 1-29 days past due, 30-59 days past due, 60-89 days past due and over 90 days past due. The consumer loans are segregated between performing and nonperforming loans. Performing loans are those that have made timely payments in accordance with the terms of the loan agreement and are not past due 90 days or more. Nonperforming loans are those that do not accrue interest, are greater than 90 days past due and accruing interest or considered impaired. Non-impaired consumer loans are assigned an allowance factor which increases with the severity of past due status. This component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio.
Management believes that the level of the allowance for loan losses is appropriate in light of the credit quality and anticipated risk of loss in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses through increased provisions for loan losses or may require that certain loan balances be charged-off or downgraded into classified loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examinations.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over financial assets is deemed to be surrendered when: 1) the assets have been isolated from the Company, so as to be presumptively beyond reach of the Company and its creditors, even in bankruptcy or other receivership; 2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and 3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, standby letters of credit and guarantees of previously sold credit card accounts. Such financial instruments are recorded in the financial statements when they become payable.
Other Real Estate Owned
Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at the fair value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to the property are capitalized. Net operating income or expenses of such properties are included in collection, repossession and other real estate owned expenses.
Bank Premises and Equipment
Land is carried at cost with no depreciation. Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is computed generally by the straight-line method for financial reporting purposes. Depreciation for tax purposes is computed based on accelerated methods. It is the Company’s policy for maintenance and repairs to be charged to expense as incurred and to capitalize major additions and improvements and depreciate the cost thereof over the estimated useful lives.
Upon sale or retirement of depreciable properties, the cost and related accumulated depreciation are netted against proceeds and any resulting gain or loss is reflected in income.
Goodwill and Intangible Assets
The excess of the cost of an acquisition over the fair value of the net assets acquired consists primarily of goodwill, core deposit intangibles, and other identifiable intangibles. Acquired intangible assets (such as core deposit intangibles) are separately recognized if the benefit of the asset can be sold, transferred, licensed, rented or exchanged, and are amortized over their useful life. Goodwill is not amortized but is subject to impairment tests if, based on an assessment of qualitative factors related to goodwill, the Company determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and may be required to record the impairment changes. In assessing the recoverability of the Company’s goodwill, which was recognized in connection with the acquisition of branches in 2003 and 2008 and the acquisition of VCB in 2014, the Company must make assumptions in order to determine the fair value of the respective assets. Any impairment of goodwill will be recognized as an expense in the period of impairment and such impairment could be material. The Company has elected to bypass the preliminary assessment and conduct a full goodwill impairment analysis on an annual basis through the use of an independent third party specialist. The Company has completed the annual goodwill impairment test during the fourth quarter of each year (as of September 30 of that year). Based on annual testing, there were no impairment charges in 2016, 2015 or 2014.
During the third quarter of 2010, the Company sold certain one to four family residential mortgage loans and retained the right to service the loans sold. Upon sale, a mortgage servicing rights asset was capitalized in the amount of $214 thousand, which represents the then current fair value of future net cash flows expected to be realized for performing servicing activities. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income, which is 4 years. As of December 31, 2014 the balance of mortgage servicing rights had been fully amortized. The Company earns fees for servicing these residential mortgage loans. These fees are generally calculated on the outstanding principal balance of the loans serviced and are recorded as income when earned. Total loan servicing income amounted to $16 thousand, $19 thousand and $37 thousand for the years ended December 31, 2016, 2015 and 2014, respectively, and is included in other operating income in the consolidated statements of income.
Income Taxes
The Company determines deferred income tax assets and liabilities using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Deferred taxes are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the consolidated balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the consolidated statements of income. The Company did not have any uncertain tax positions for the periods ending December 31, 2016, 2015 or 2014.
Retirement Plan
The Company has historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011, to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. See Note 10 - Employee Benefit Plans.
Stock Compensation Plans
At December 31, 2016, the Company had equity awards outstanding under two stock based compensation plans. The Company accounts for these plans under the provisions of FASB ASC Topic 718 “Compensation - Stock Compensation.” Compensation expense for grants of restricted shares is accounted for using the fair market value of the Company’s common stock on the date the restricted shares are awarded. Compensation expense for grants of stock options is accounted for at fair value as determined using the Black-Scholes option-pricing model. Compensation expense for restricted shares and stock options is charged to income ratably over the vesting period. Compensation expense recognized is included in salaries and employee benefits expense in the consolidated statements of income. See Note 14 - Stock Based Compensation Plans.
Fair Value Measurements
The Company follows the provisions of FASB ASC Topic 820 “Fair Value Measurements and Disclosures,” for financial assets and financial liabilities. FASB ASC Topic 820 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. See Note 20 - Fair Value Measurements.
Segment Reporting
Public business enterprises are required to report information about operating segments in annual financial statements and selected information about operating segments in financial reports issued to shareholders. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by management in deciding how to allocate resources and in assessing their performance. Generally, financial information is required to be reported on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments. The Company has determined that it has one significant operating segment, the providing of general commercial financial services to customers located in the geographic areas of the Company’s retail branch network.
Net Income Per Common Share
The Company applies the two-class method of computing basic and diluted net income per common share. Under the two-class method, net income per common share is determined for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Based on FASB guidance, the Company considers its Series B Preferred Stock to be a participating security. FASB guidance requires that all outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends participate in undistributed earnings with common shareholders. Accordingly, the weighted average number of shares of the Company’s common stock used in the calculation of basic and diluted net income per common share includes unvested shares of the Company’s common stock outstanding. Potential common shares that may be issued by the Company relate to outstanding stock options and the Company’s Series B Preferred Stock, and are determined using the treasury method. Net income per common share calculations are presented in Note 12 - Net Income Per Common Share.
Advertising Costs
The Company charges advertising costs to expense as incurred. Advertising expense totaled $1.1 million, $984 thousand and $748 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
Comprehensive Income
FASB ASC Topic 220 “Comprehensive Income” establishes standards for the reporting and presentation of comprehensive income and its components (revenues, expenses, gains and losses) within the Company’s consolidated financial statements. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale and pension liability adjustments, are reported as a separate component of the equity section of the consolidated balance sheet, such items, along with net income, are components of comprehensive income.
Recent Significant Accounting Pronouncements:
Adoption of New Accounting Standards:
In June 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-12, “Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period.” The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation - Stock Compensation (Topic 718)” should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted, and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2015, the FASB issued ASU 2015-01, “Income Statement-Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items.” The amendments in this ASU eliminate from U.S. GAAP the concept of extraordinary items. Subtopic 225-20, Income Statement - Extraordinary and Unusual Items, required that an entity separately classify, present, and disclose extraordinary events and transactions. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes and either present or disclose earnings-per-share data applicable to the extraordinary item. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In February 2015, the FASB issued ASU 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis.” The amendments in this ASU are intended to improve targeted areas of consolidation guidance for legal entities such as limited partnerships, limited liability corporations, and securitization structures (collateralized debt obligations, collateralized loan obligations, and mortgage-backed security transactions). In addition to reducing the number of consolidation models from four to two, the new standard simplifies the FASB ASC and improves current U.S. GAAP by placing more emphasis on risk of loss when determining a controlling financial interest, reducing the frequency of the application of related-party guidance when determining a controlling financial interest in a variable interest entity (“VIE”), and changing consolidation conclusions for public and private companies in several industries that typically make use of limited partnerships or VIEs. The amendments in this ASU are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. ASU 2015-02 may be applied retrospectively in previously issued financial statements for one or more years with a cumulative-effect adjustment to retained earnings as of the beginning of the first year restated. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In April 2015, the FASB issued ASU 2015-05, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” The amendments in this ASU provide guidance to customers regarding cloud computing arrangements that include a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The amendments do not change the accounting for a customer’s accounting for service contracts. As a result of the amendments, all software licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. The amendments in this ASU are effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. Early adoption is permitted. An entity can elect to adopt the amendments either: (1) prospectively to all arrangements entered into or materially modified after the effective date; or (2) retrospectively. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In July 2015, the FASB issued ASU 2015-12, “Plan Accounting: Defined Benefit Pension Plans (Topic 960), Defined Contribution Pension Plans (Topic 962), and Health and Welfare Benefit Plans (Topic 965) - 1. Fully Benefit-Responsive Investment Contracts, 2. Plan Investment Disclosures, and 3. Measurement Date Practical Expedient.” The amendments within this ASU are in 3 parts. Among other things, Part I amendments designate contract value as the only required measure for fully benefit-responsive investment contracts; Part II amendments eliminate the requirement that plans disclose: (a) individual investments that represent 5 percent or more of net assets available for benefits; and (b) the net appreciation or depreciation for investments by general type requirements for both participant-directed investments and nonparticipant-directed investments. Part III amendments provide a practical expedient to permit plans to measure investments and investment-related accounts (e.g., a liability for a pending trade with a broker) as of a month-end date that is closest to the plan’s fiscal year-end, when the fiscal period does not coincide with month-end. The amendments in Parts I and II of this ASU are effective on a retrospective basis and Part III is effective on a prospective basis, for fiscal years beginning after December 15, 2015. Early adoption is permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In August 2015, the FASB issued ASU 2015-15, “Interest - Imputation of Interest (Subtopic 835-30) - Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements (Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting).” On April 7, 2015, the FASB issued ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which requires entities to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability. The guidance in ASU 2015-03 (see paragraph 835-30-45-1A) does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to line-of-credit arrangements, the SEC staff stated that they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. ASU 2015-15 adds these SEC comments to the "S" section of the ASC. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
New Accounting Standards Not Yet Adopted:
In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” This update is intended to provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period. If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 to have a material impact on its consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, “Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The amendments in ASU 2016-01, among other things: 1) require equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; 2) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; 3) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables); and 4) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: 1) a lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and 2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is currently assessing the impact that ASU 2016-02 will have on its consolidated financial statements.
In March 2016, the FASB issued ASU 2016-07, “Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting.” The amendments in this ASU eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The amendments require that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. In addition, the amendments in this ASU require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income (loss) at the date the investment becomes qualified for use of the equity method. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-07 to have a material impact on its consolidated financial statements.
During March 2016, the FASB issued ASU 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting.” The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: a) income tax consequences; b) classification of awards as either equity or liabilities; and c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company does not expect the adoption of ASU 2016-09 to have a material impact on its consolidated financial statements.
During June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will be required to use additional forward-looking information when determining their credit loss estimates. It is anticipated that many of the loss estimation techniques currently applied will still be permitted, although the inputs to those techniques are expected to change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for public companies that file reports with the SEC for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements.
During August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments,” to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The amendments should be applied using a retrospective transition method to each period presented. If retrospective application is impractical for some of the issues addressed by the update, the amendments for those issues would be applied prospectively as of the earliest date practicable. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.
During January 2017, the FASB issued ASU 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business”. The amendments in this ASU clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. Under the current implementation guidance in Topic 805, there are three elements of a business-inputs, processes, and outputs. While an integrated set of assets and activities (collectively referred to as a “set”) that is a business usually has outputs, outputs are not required to be present. In addition, all the inputs and processes that a seller uses in operating a set are not required if market participants can acquire the set and continue to produce outputs. The amendments in this ASU provide a screen to determine when a set is not a business. If the screen is not met, the amendments (1) require that to be considered a business, a set must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output and (2) remove the evaluation of whether a market participant could replace missing elements. The ASU provides a framework to assist entities in evaluating whether both an input and a substantive process are present. The amendments in this ASU are effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. The amendments in this ASU should be applied prospectively on or after the effective date. No disclosures are required at transition. The Company does not expect the adoption of ASU 2017-01 to have a material impact on its consolidated financial statements.
During January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment”. The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Public business entities that are SEC filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Public business entities that are not SEC filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2020. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.
Note 2. Business Combinations
On November 14, 2014, the Company completed its acquisition of VCB. Pursuant to the Agreement and Plan of Reorganization dated May 29, 2014, VCB's common shareholders received for each share of VCB common stock they owned either (i) cash at a rate of $6.25 per share of VCB common stock, or approximately $2.4 million in the aggregate, or (ii) the Company’s common stock at a rate of 0.9259 shares of the Company’s common stock per share of VCB common stock, which totaled approximately $6.7 million based on the Company’s closing common stock price on November 14, 2014 of $6.27 per share. In addition, the Company purchased VCB’s Series A Preferred Stock for $4.3 million. VCB was established in 2005 and was headquartered in Newport News, Virginia. VCB operated three branches, one each in Hampton, Newport News and Williamsburg, Virginia.
The Company accounted for the acquisition using the acquisition method of accounting in accordance with FASB ASC 805, “Business Combinations.” Under the acquisition method of accounting, the assets and liabilities of VCB were recorded at their respective acquisition date fair values. Determining the fair value of assets and liabilities, particularly related to the loan portfolio, is a complicated process involving significant judgment regarding methods and assumptions used to calculate the estimated fair values. The fair values were preliminary and subject to refinement during the Measurement Period as additional information relative to the acquisition date fair values became available. No adjustments were made to the preliminary fair values during the Measurement Period. The Company recognized goodwill of $1.1 million in connection with the acquisition, none of which is deductible for income tax purposes.
The following table details the total consideration paid by the Company on November 14, 2014 in connection with the acquisition of VCB, the fair values of the assets acquired and liabilities assumed, and the resulting goodwill.
Fair values of the major categories of assets acquired and liabilities assumed were determined as follows:
Loans: The acquired loans were recorded at fair value at the acquisition date of $101.5 million without carryover of VCB's allowance for loan losses of $1.1 million. Where loans exhibited characteristics of performance, fair value was determined based on a discounted cash flow analysis which included default estimates; loans without such characteristics, fair value was determined based on the estimated values of the underlying collateral. While estimating the amount and timing of both principal and interest cash flows expected to be collected, a market-based discount rate was applied. In this regard, the acquired loans were segregated into pools based on loan type and credit risk. Loan type was determined based on collateral type and purpose, industry segment and loan structure. Credit risk characteristics included risk rating groups pass, special mention, substandard, and doubtful and lien position. For valuation purposes, these pools were further disaggregated by maturity and pricing characteristics (e.g., fixed-rate, adjustable-rate, balloon maturities).
At November 14, 2014, the gross contractual amounts receivable and the fair value for the purchased performing loans were $116.6 million and $93.7 million respectively, while the estimated cash flows not expected to be collected were approximately $2.0 million. Information about the PCI loan portfolio at November 14, 2014 is as follows:
Premises and Equipment: The fair value of VCB's premises, including land, buildings and improvements, was determined based upon appraisal by licensed appraisers. These appraisals were based upon the best and highest use of the property with final values determined based upon an analysis of the cost, sales comparison and income capitalization approaches for each property appraised. The fair value of bank-owned real estate resulted in a discount of $1.0 million. Land is not depreciated.
Core Deposit Intangible: The fair value of the core deposit intangible (“CDI”) was determined based on a combined discounted economic benefit and market approach. The economic benefit was calculated as the cost savings between maintaining the core deposit base and using an alternate funding source, such as FHLB advances. The life of the deposit base and projected deposit attrition rates was determined using VCB's historical deposit data. The CDI was estimated at $1.0 million or 1.25% of deposits. The CDI is being amortized over a weighted average life of 89 months using a sum-of-the-months method.
Time Deposits: The fair value adjustment of time deposits represents a premium over the value of the contractual repayments of fixed-maturity deposits using prevailing market interest rates for similar term certificates of deposit. The resulting estimated fair value adjustment of certificates of deposit ranging in maturity from one month to five years is a $149 thousand premium and is being amortized into income on a level-yield basis over the weighted average remaining life of approximately 61 months.
FHLB Advances: The fair value of FHLB advances was considered to be equivalent to VCB’s recorded book balance as the advances matured in 90 days or less.
Deferred Tax Assets and Liabilities: Certain deferred tax assets and liabilities were carried over to the Bank from VCB based on the Company’s ability to utilize them in the future. Additionally, deferred tax assets and liabilities were established for acquisition accounting fair value adjustments as the future amortization/accretion of these adjustments represent temporary differences between book income and taxable income.
The table below illustrates the unaudited pro forma revenue and net income of the combined entities had the acquisition taken place on January 1, 2013. The unaudited combined pro forma revenue and net income combines the historical results of VCB with the Company's consolidated statements of income for the periods listed below and, while certain adjustments were made for the estimated effect of certain fair value adjustments and other acquisition-related activity, they are not indicative of what would have occurred had the acquisition actually taken place on January 1, 2013. Acquisition related expenses of $224 thousand and $1.8 million were included in the Company's actual consolidated statements of income for the years ended December 31, 2015 and 2014, respectively, but were excluded from the unaudited pro forma information listed below. Additionally, the Company expects to achieve further operational cost savings and other efficiencies as a result of the acquisition which are not reflected in the unaudited pro forma amounts below:
The net effect of the amortization and accretion of premiums and discounts associated with the Company’s acquisition accounting adjustments to assets acquired and liabilities assumed from VCB had the following impact on the consolidated statements of income for the years ended December 31, 2016, 2015 and 2014:
(1)Loan discount accretion is included in the “Interest and fees on loans” section of “Interest and Dividend Income” in the consolidated statements of income.
(2)Core deposit intangible premium amortization is included in the “Other operating expenses” section of “Noninterest Expenses” in the consolidated statements of income.
(3)Time deposit premium amortization is included in the “Deposits” section of “Interest Expense” in the consolidated statements of income.
Note 3. Investment Securities
The amortized cost and estimated fair value, with gross unrealized gains and losses, of investment securities at December 31, 2016 and 2015 were as follows:
*The combined unrealized gains on these securities was less than $1.
* The combined unrealized gains on these securities was less than $1.
*Represents the unamortized net unrealized holding loss for securities transferred from available for sale to held to maturity, net of amortization or accretion.
*Represents the unamortized net unrealized holding loss for securities transferred from available for sale to held to maturity, net of amortization or accretion.
There are no securities classified as “Trading” at December 31, 2016 or 2015. During the fourth quarter of 2013, the Company transferred securities with an amortized cost of $35.5 million, previously designated as “Available for Sale,” to “Held to Maturity” classification. The fair value of those securities as of the date of the transfer was $34.5 million, reflecting a gross unrealized loss of $994 thousand. The gross unrealized loss net of tax at the time of transfer remained in Accumulated Other Comprehensive (Loss) and is being amortized over the remaining life of the securities as an adjustment to interest income. During the third quarter of 2015, the Company sold a State and political subdivisions security that was classified as “Held to Maturity” due to the significant deterioration in the issuer’s financial condition. The carrying value of this security was $521 thousand and a gain of $10 thousand was recognized as a result of the sale.
The Company’s mortgage-backed securities consist of commercial and residential mortgage-backed securities. The Company’s mortgage-backed securities are all backed by an agency of the U.S. government and rated Aaa and AA+ by Moody and S&P, respectively, with no subprime issues.
The Company’s pooled trust preferred securities previously included one senior issue of Preferred Term Securities XXVII which remained current on all payments and on which the Company took an impairment charge in the third quarter of 2009 to reduce the Company’s book value to the market value at September 30, 2009. On December 9, 2014 the Company sold this security resulting in a gain on sale of $82 thousand and the Company reversed the related impairment reserve. During the second quarter of 2010, the Company recognized an impairment charge in the amount of $77 thousand on the Company’s investment in Preferred Term Securities XXIII mezzanine tranche, thus reducing the book value of this investment to $0. On September 22, 2014 the Company sold this security resulting in a gain on sale of $2 thousand, and the Company reversed the related impairment reserve. The decision to recognize the other-than-temporary impairment had been based upon an analysis of the market value of the discounted cash flow for the security as provided by Moody’s at June 30, 2010, which indicated that the Company was unlikely to recover any of its remaining investment in these securities.
The amortized cost, carrying value and estimated fair values of investment securities at December 31, 2016, by the earlier of contractual maturity or expected maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without penalties.
The following table presents the gross realized gains and losses on the sale of investment securities available for sale and proceeds from the sales of investment securities available for sale during the twelve months ended December 31, 2016, 2015 and 2014:
Proceeds from maturities, calls and paydowns of investment securities available for sale for the years ended December 31, 2016, 2015 and 2014 were $30.4 million, $23.3 million and $36.0 million, respectively.
The following table presents the gross realized gains on the sale of investment securities held to maturity and proceeds from the sales of investment securities held to maturity during the twelve months ended December 31, 2016, 2015 and 2014:
Proceeds from maturities, calls and paydowns of investment securities held to maturity were $1.4 million, $1.6 million and $3.0 million for the years ended December 31, 2016, 2015 and 2014, respectively.
The Company pledges investment securities to secure public deposits, balances with the Reserve Bank and repurchase agreements. Investment securities with an aggregate book value of $57.9 million and an aggregate fair value of $58.1 million were pledged at December 31, 2016. Investment securities with both aggregate book and fair values of $88.0 million were pledged at December 31, 2015.
Investment securities in an unrealized loss position at December 31, 2016, by duration of the period of the unrealized loss, are shown below:
The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment that may result due to adverse economic conditions and associated credit deterioration. A determination as to whether a security’s decline in market value is other-than-temporary takes into consideration numerous factors and the relative significance of any single factor can vary by security. Some factors the Company may consider in the other-than-temporary impairment analysis include the length of time the security has been in an unrealized loss position, changes in security ratings, financial condition of the issuer, as well as security and industry specific economic conditions. In addition, the Company may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds, and the value of any underlying collateral. For certain securities in unrealized loss positions, the Company will enlist independent third-party firms to prepare cash flow analyses to compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.
Based on the Company’s evaluation, management does not believe any unrealized loss at December 31, 2016 represents an other-than-temporary impairment as these unrealized losses are primarily attributable to current financial market conditions for these types of investments, particularly related to changes in interest rates, which rose during late 2016 causing bond prices to decline, and are not attributable to credit deterioration. At December 31, 2016, there were 155 debt securities with fair values totaling $195.6 million considered temporarily impaired. Of these debt securities, 132 with fair values totaling $166.5 million were in an unrealized loss position of less than 12 months and 23 with fair values totaling $29.1 million were in an unrealized loss position of 12 months or more. Because the Company intends to hold these investments in debt securities until recovery of the amortized cost basis and it is more likely than not that the Company will not be required to sell these investments before a recovery of unrealized losses, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2016 and no impairment has been recognized. At December 31, 2016, there were no equity securities in an unrealized loss position.
Investment securities in an unrealized loss position at December 31, 2015, by duration of the period of the unrealized loss, are shown below:
The Company’s investment in FHLB stock totaled $8.5 million and $5.9 million at December 31, 2016 and 2015, respectively. FHLB stock is generally viewed as a long-term investment and as a restricted investment security, which is carried at cost, because there is no market for the stock other than the FHLBs or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Because the FHLB generated positive net income for each quarterly period beginning January 1, 2016, and ending December 31, 2016, the Company does not consider this investment to be other-than-temporarily impaired at December 31, 2016 and no impairment has been recognized. FHLB stock is included in a separate line item on the consolidated balance sheets (Restricted securities, at cost) and is not part of the Company’s investment securities portfolio. The Company’s restricted securities also include investments in the Reserve Bank and CBB totaling $3.0 million at both December 31, 2016 and 2015, which are carried at cost.
Note 4. Loan Portfolio
The following table sets forth the composition of the Company’s loan portfolio in dollar amounts and as a percentage of the Company’s total gross loans at the dates indicated:
Deferred fees and costs, net are included in the table above and totaled $1.8 million and $1.6 million for December 31, 2016 and 2015, respectively.
The following table presents the aging of the recorded investment in past due loans as of December 31, 2016 by class of loans:
*For purposes of this table only, the "Total Current" column includes loans that are 1-29 days past due.
The following table presents the aging of the recorded investment in past due loans as of December 31, 2015 by class of loans:
*For purposes of this table only, the "Total Current" column includes loans that are 1-29 days past due.
The following table presents nonaccrual loans, loans past due 90 days and accruing interest, and troubled debt restructurings (accruing) at December 31:
At December 31, 2016 and 2015, there were approximately $2.2 million and $1.3 million, respectively, in troubled debt restructurings (“TDRs”) included in nonaccrual loans.
The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due.
When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across our loan portfolio.
A loan (including a TDR) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.
Outstanding principal balance and the carrying amount of loans acquired pursuant to the Company’s acquisition of VCB (or “Acquired Loans”) that were recorded at fair value at the acquisition date and are included in the consolidated balance sheet at December 31, 2016 and 2015 were as follows:
The following table presents the recorded investment in nonaccrual loans and loans past due 90 days and accruing interest by class at December 31, 2016 and 2015:
If interest income had been recognized on nonaccrual loans at their stated rates during years 2016, 2015 and 2014, interest income would have increased by approximately $383 thousand, $290 thousand and $124 thousand, respectively.
The following table presents commercial loans by credit quality indicator at December 31, 2016:
The following table presents commercial loans by credit quality indicator at December 31, 2015:
At December 31, 2016 and 2015, the Company did not have any loans classified as Doubtful or Loss.
The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2016:
The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2015:
The following table presents a rollforward of the Company’s allowance for loan losses for the year ended December 31, 2016:
The following table presents a rollforward of the Company’s allowance for loan losses for the year ended December 31, 2015:
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio class based on impairment method as of December 31, 2016:
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio class based on impairment method as of December 31, 2015:
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2016:
*PCI loans are excluded from this table.
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2015:
*PCI loans are excluded from this table.
Determining the fair value of PCI loans at November 14, 2014 required the Company to estimate cash flows expected to result from those loans and to discount those cash flows at appropriate rates of interest. For such loans, the excess of the cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans and is called the accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is the nonaccretable difference and is not recorded. In accordance with U.S. GAAP, the Company did not “carry over” any allowances for loan losses that were reserved for the VCB loan portfolio prior to the Company’s acquisition of VCB. PCI loans had unpaid principal balances of $7.1 million and $8.8 million and recorded carrying values of $6.3 million and $7.9 million at December 31, 2016 and 2015, respectively.
Loans acquired from VCB that constituted PCI loans were recorded by the Company at fair value on the date of acquisition as follows:
The following table presents a summary of the changes in the accretable yield of the PCI loan portfolio, which was acquired at November 14, 2014, for the years ended December 31, 2016, 2015 and 2014:
The following table presents, by class of loans, information related to loans modified as TDRs during the years ended December 31, 2016 and 2015:
*The period end balances are inclusive of all partial paydowns and charge-offs since the modification date. Loans modified as TDRs that were fully paid down, charged-off, or foreclosed upon by period end are not reported.
The Company has no obligation to fund additional advances on its impaired loans.
The following table presents, by class of loans, information related to loans modified as TDRs that subsequently defaulted (i.e., 90 days or more past due following a modification) during the years ended December 31, 2016 and 2015 and were modified as TDRs within the 12 months prior to default:
At December 31, 2016, $869 thousand in foreclosed residential real estate properties were included in OREO, and $229 thousand in residential real estate loans were in the process of foreclosure.
Note 5. Bank Premises and Equipment
Bank premises and equipment are summarized as follows:
Depreciation and amortization of bank premises and equipment for the years ended December 31, 2016, 2015 and 2014 amounted to $2.5 million, $2.6 million and $2.2 million, respectively.
Note 6. Other Real Estate Owned (“OREO”)
At December 31, 2016 and 2015 OREO was $2.7 million and $520 thousand, respectively. OREO is primarily comprised of residential properties, residential lots, raw land and non-residential properties associated with commercial relationships, and is located primarily in the Commonwealth of Virginia.
Changes in the balance for OREO for the years ended December 31, 2016 and 2015 are as follows:
Changes in the valuation allowance for OREO for the years ended December 31, 2016, 2015 and 2014 are as follows:
Expenses applicable to OREO, other than the valuation allowance, were $323 thousand, $222 thousand and $114 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
Note 7. Deposits
Interest-bearing deposits consist of the following:
A summary of interest expense by deposit category for the years ended December 31, 2016, 2015 and 2014 is as follows:
At December 31, 2016, the scheduled maturities of time deposits are as follows:
Overdrawn demand deposit accounts totaling $121 thousand at December 31, 2016 and $97 thousand at December 31, 2015 were reclassified from deposits to loans.
Note 8. Borrowings
Federal funds purchased and repurchase agreements. The Company has unsecured lines of credit with SunTrust Bank, Community Bankers Bank and Pacific Coast Bankers Bank for the purchase of federal funds in the amount of $20.0 million, $15.0 million and $5.0 million, respectively. These lines of credit have a variable rate based on the lending bank’s daily federal funds sold rate and are due on demand. Repurchase agreements are secured transactions and generally mature the day following the day sold. Customer repurchases are standard transactions that involve a Bank customer instead of a wholesale bank or broker. The Company offers this product as an accommodation to larger retail and commercial customers that request safety for their funds beyond the FDIC deposit insurance limits. The Company does not use or have any open repurchase agreements with broker-dealers.
The tables below present selected information on federal funds purchased and repurchase agreements:
Short-term borrowings. Short-term borrowings consist of advances from the FHLB, which are secured by a blanket floating lien on all qualifying closed-end and revolving open-end loans that are secured by one to four family residential properties. Short-term advances from the FHLB at December 31, 2016 consisted of $6.8 million using a daily rate credit, which is due on demand, and $166.9 million in fixed rate one month advances. Short-term advances from the FHLB at December 31, 2015 consisted of $114.4 million in fixed rate one month advances. Outstanding accrued interest at December 31, 2016 and 2015 totaled $53 thousand and $28 thousand, respectively.
The table below presents selected information on short-term borrowings:
Long-term borrowings. From time to time, the Company may obtain long-term borrowings from the FHLB, which consist of advances from the FHLB that are secured by a blanket floating lien on all qualifying closed end and revolving open end loans that are secured by one to four family residential properties. At December 31, 2016 and 2015, the Company had no long-term FHLB advances outstanding.
The Company’s line of credit with the FHLB can equal up to 30% of the Company’s gross assets or approximately $394.6 million at December 31, 2016. This line of credit totaled $225.4 million with approximately $51.8 million available at December 31, 2016. As of December 31, 2016 and 2015, loans with a carrying value of $301.0 million and $307.2 million, respectively, are pledged to the FHLB as collateral for borrowings. Additional loans are available that can be pledged as collateral for future borrowings from the FHLB above the current lendable collateral value.
Note 9. Junior and Senior Subordinated Debt
On September 17, 2003, $10 million of trust preferred securities were placed through EVB Statutory Trust I in a pooled underwriting totaling approximately $650 million. The trust issuer has invested the total proceeds from the sale of the trust preferred securities in Floating Rate Junior Subordinated Deferrable Interest Debentures (the “Junior Subordinated Debt”) issued by the Company. The trust preferred securities pay cumulative cash distributions quarterly at a variable rate per annum, reset quarterly, equal to the 3-month LIBOR plus 2.95%. As of December 31, 2016 and 2015, the interest rate was 3.94% and 3.48%, respectively. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes. The trust preferred securities have a mandatory redemption date of September 17, 2033, and became subject to varying call provisions beginning September 17, 2008. The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the Junior Subordinated Debt and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.
The trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion. The portion of the securities not considered as Tier 1 capital will be included in Tier 2 capital. At December 31, 2016 and 2015, all of the trust preferred securities qualified as Tier 1 capital.
Subject to certain exceptions and limitations, the Company is permitted to elect from time to time to defer regularly scheduled interest payments on its outstanding Junior Subordinated Debt relating to its trust preferred securities. If the Company defers interest payments on the Junior Subordinated Debt for more than 20 consecutive quarters, the Company would be in default under the governing agreements for such notes and the amount due under such agreements would be immediately due and payable.
From June 2011 to March 2014, the Company deferred its regularly scheduled interest payments on its outstanding Junior Subordinated Debt relating to its trust preferred securities due to prohibitions on such payments under provisions of regulatory agreements, which have been subsequently terminated. The Company and the Bank were previously under a written agreement with the Reserve Bank and the Bureau until July 30, 2013, and thereafter, a memorandum of understanding with the Reserve Bank and the Bureau until March 13, 2014. On June 17, 2014, the Company paid all current and deferred interest on the outstanding Junior Subordinated Debt, and the Company has not deferred any subsequent interest payments through December 31, 2016.
On April 22, 2015, the Company entered in a Senior Subordinated Note Purchase Agreement with certain institutional accredited investors pursuant to which the Company sold $20.0 million in aggregate principal amount of its 6.50% Fixed-to-Floating Rate Subordinated Notes due 2025 (the "Senior Subordinated Debt") to the investors at a price equal to 100% of the aggregate principal amount of the Senior Subordinated Debt. The Senior Subordinated Debt bears interest at an annual rate of 6.50%, payable semi-annually in arrears on May 1 and November 1 of each year ending on May 1, 2020. From and including May 1, 2020 to, but excluding, the maturity date, the Senior Subordinated Debt will bear interest at an annual rate, reset quarterly, equal to LIBOR determined on the determination date of the applicable interest period plus 502 basis points, payable quarterly in arrears on February 1, May 1, August 1 and November 1 of each year, beginning on August 1, 2020. The Company may, at its option, redeem, in whole or in part, the Senior Subordinated Debt as early as May 1, 2020, and any partial redemption would be made pro rata among all of the holders. At December 31, 2016 and 2015, all of the Senior Subordinated Debt qualified as Tier 2 capital. At December 31, 2016, the remaining unamortized debt issuance costs related to the Senior Subordinated Debt totaled $875 thousand.
Note 10. Employee Benefit Plans
Pension Plan
The Company historically maintained a defined benefit pension plan covering substantially all of the Company’s employees. Benefits are based on years of service and the employee’s compensation during the last five years of employment. The Company’s funding policy has been to contribute annually the maximum amount that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributable to service to date but also for those expected to be earned in the future.
The plan was amended January 28, 2008 to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year.
The Company intends to terminate the plan effective May 1, 2017 in connection with the Pending Merger.
Information pertaining to the activity in the plan, using a measurement date of December 31, is as follows:
Expected Long-Term Rate of Return on Assets
In consultation with its investment advisors and actuary, the Company’s plan sponsor selects the expected long-term rate of return on assets assumption. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience that may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions. The discount rate used to calculate funding requirements and benefit expense was 3.85%, 3.55% and 4.35% in 2016, 2015 and 2014, respectively.
Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which the assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated with periodic cost). The Company made no contributions to the pension plan during 2016, 2015 and 2014. In connection with the Pending Merger, the Company expects to fully fund the pension plan and terminate it effective May 1, 2017.
Fair value is discussed in detail in Note 20 - Fair Value Measurements. The fair value of the Company’s pension plan assets at December 31, 2016 and 2015, by asset category are as follows:
(1)This category includes investments in mutual funds focused on equity securities with a diversified portfolio and includes investments in large cap and small cap funds, growth funds, international focused funds and value funds. The funds are valued using the net asset value method in which an average of the market prices for the underlying investments is used to value the funds.
(2)This category includes investments in mutual funds focused on fixed income securities with both short-term and long-term investments. The funds are valued using the net asset value method in which an average of the market prices for the underlying investments is used to value the funds.
The pension plan’s weighted-average asset allocations as of December 31, 2016 and 2015, by asset category are as follows:
The Company believes that the trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 74% fixed income and 26% equities. The investment manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance, for the implementation of the plan’s investment strategy. The investment manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.
It is the responsibility of the Company’s trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust. There is no Company common stock included in the plan assets.
Estimated future benefit payments, assuming that the pension plan is not terminated during 2017 in connection with the Pending Merger, which reflect expected future service, as appropriate, are as follows:
401(k) Plan
The Company maintains a defined contribution 401(k) profit sharing plan (the “401(k) Plan”). The 401(k) Plan allows for a maximum voluntary salary deferral up to the statutory limitations. All employees are eligible to participate on the first day of hire. The 401(k) Plan provides for a matching contribution, which equals 100% of the first 3% of the employee’s contributions and 50% of the next 3% of the employee’s contributions. At the option of the Compensation Committee, the Company may make an additional discretionary contribution after the end of each year to employees not previously grandfathered in the Pension Plan in an amount equal to 3% of the employee’s compensation (as described in plan documents). For matching and discretionary employer contributions, an employee is 100% vested after two years of service. The amounts charged to expense under the 401(k) Plan were $633 thousand, $610 thousand and $503 thousand for the years ended December 31, 2016, 2015 and 2014, respectively. The Company does not offer its stock as an investment option under the 401(k) Plan.
Deferred Compensation Plan
The Company has a Supplemental Executive Retirement Plan which is unfunded and maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. As of December 31, 2016, the Company has entered into a deferred supplemental compensation agreement with its Chief Executive Officer and one of its other executive officers. For the Chief Executive Officer, full vesting of benefits under the supplemental agreement occurs only at age 67, with partial vesting of approximately 5% for each year of service after age 52. Benefits are to be paid in equal monthly installments over a 15 year period. There is no pre-retirement benefit, but a beneficiary can be named to receive the remaining payments for the 15 year period after benefits have commenced. For the other executive officer, full vesting of benefits under the supplemental agreement occurs only at age 65, with partial vesting of approximately 5% for each year of service after age 46. Benefits are to be paid in equal monthly installments over a 200 month period. There is no pre-retirement benefit, but a beneficiary can be named to receive the remaining payments for the 200 month period after benefits have commenced. In connection with the Pending Merger, benefits for participants in the Supplemental Executive Retirement Plan will fully vest on an accelerated basis upon completing the Pending Merger.
The deferred compensation expense for the Company’s deferred supplemental compensation agreements for 2016, 2015 and 2014, based on the present value of the retirement benefits, was $142 thousand, $173 thousand and $105 thousand, respectively.
Note 11. Income Taxes
The current and deferred components of income tax expense are as follows:
A reconciliation between the provision for income taxes and the amount computed by multiplying income by the current statutory federal income tax rate of approximately 34% for the years ended December 31, 2016, 2015 and 2014, respectively, is as follows:
Deferred income taxes result from timing differences between taxable income and the income for financial reporting purposes. The most significant timing difference relates to the allowance for loan losses.
Cumulative net deferred tax assets consist of the following components at December 31, 2016 and 2015:
The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed. Management’s assessment is primarily dependent on historical taxable income and projections of future taxable income, which are directly related to the Company’s core earnings capacity and its prospects to generate core earnings in the future. Projections of core earnings and taxable income are inherently subject to uncertainty and estimates that may change given the uncertain economic outlook, banking industry conditions and other factors. Further, management has considered future reversals of existing taxable temporary differences and limited, prudent and feasible tax-planning strategies, such as changes in investment security income (tax-exempt to taxable), additional sales of loans and sales of branches/buildings with an appreciated asset value over the tax basis. Based upon an analysis of available evidence, management has determined that it is “more likely than not” that the Company’s deferred income tax assets as of December 31, 2016 and 2015 will be fully realized and therefore no valuation allowance to the Company’s deferred income tax assets was recorded. However, the Company can give no assurance that in the future its deferred income tax assets will not be impaired because such determination is based on projections of future earnings and the possible effect of certain transactions which are subject to uncertainty and based on estimates that may change due to changing economic conditions and other factors. Due to the uncertainty of estimates and projections, it is possible that the Company will be required to record adjustments to the valuation allowance in future reporting periods.
The Company’s ability to realize its deferred income tax assets may be limited if the Company experiences an ownership change as defined by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). For additional information see Part I, Item 1A. “Risk Factors” in this Annual Report on Form 10-K.
The Company files income tax returns in the U.S. federal jurisdiction and the Commonwealth of Virginia. With few exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2013.
Note 12. Net Income Per Common Share
The Company applies the two-class method of computing basic and diluted net income per common share. Under the two-class method, net income per common share is determined for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Based on FASB guidance, the Company considers its Series B Preferred Stock (defined below) to be a participating security. FASB guidance requires that all outstanding unvested share-based payment awards that contain voting rights and rights to nonforfeitable dividends participate in undistributed earnings with common shareholders. Accordingly, the weighted average number of shares of the Company’s common stock used in the calculation of basic and diluted net income per common share includes unvested shares of the Company’s outstanding restricted common stock.
The following table shows the computation of basic and diluted net income per common share for the periods presented:
Options to acquire 36,500, 67,525 and 110,487 shares of common stock were not included in computing diluted net income per common share for the years ended December 31, 2016, 2015 and 2014, respectively, because their effects were anti-dilutive.
On June 12, 2013, the Company issued 5,240,192 shares of non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) through private placements to certain investors. Each share of Series B Preferred Stock can, under certain limited circumstances as set forth in the Company’s articles of incorporation, be converted into one share of the Company’s common stock, and is therefore reflected in the dilutive weighted average common shares outstanding for 2016, 2015 and 2014. For more information related to the conversion rights of these preferred shares, see Note 22 - Preferred Stock and Warrant.
Additionally, the impact of warrants to acquire shares of the Company’s common stock that were issued to the U.S. Department of the Treasury (“Treasury”) in connection with the Company’s participation in the Capital Purchase Program is not included, as the warrants were anti-dilutive. As previously disclosed, these warrants were repurchased by the Company during May 2015. For additional information on preferred stock warrants, see Note 22 - Preferred Stock and Warrant.
Note 13. Related Party Transactions
During the year, officers, directors, principal shareholders, and their affiliates (related parties) were customers of and had transactions with the Company in the ordinary course of business. In management’s opinion, these transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable loans to non-related customers and did not involve more than the normal risk of collectability or present other unfavorable features.
Loan activity to related parties is as follows:
*Loans with a principal balance of $361 thousand and $2.5 million from two former directors who are no longer on the Company’s board.
At December 31, 2016 and 2015, there was approximately $3.6 million and $1.9 million in available credit that the related parties could draw upon, respectively.
Deposits from related parties held by the Company at December 31, 2016 and 2015 amounted to $4.7 million and $10.7 million, respectively.
Note 14. Stock Based Compensation Plans
On September 21, 2000, the Company adopted the Eastern Virginia Bankshares, Inc. 2000 Stock Option Plan (the “2000 Plan”) to provide a means for selected key employees and directors to increase their personal financial interest in the Company, thereby stimulating their efforts and strengthening their desire to remain with the Company. Under the 2000 Plan, up to 400,000 shares of Company common stock could be granted in the form of stock options. On April 17, 2003, the shareholders approved the Eastern Virginia Bankshares, Inc. 2003 Stock Incentive Plan, amending and restating the 2000 Plan (the “2003 Plan”) and still authorizing the issuance of up to 400,000 shares of common stock under the plan, but expanding the award types available under the plan to include stock options, stock appreciation rights, common stock, restricted stock and phantom stock. No additional awards may be granted under the 2003 Plan. Any awards previously granted under the 2003 Plan that were outstanding as of April 17, 2013 remain outstanding and will vest in accordance with their regular terms.
On April 19, 2007, the Company’s shareholders approved the Eastern Virginia Bankshares, Inc. 2007 Equity Compensation Plan (the “2007 Plan”) to enhance the Company’s ability to recruit and retain officers, directors, employees, consultants and advisors with ability and initiative and to encourage such persons to have a greater financial interest in the Company. Under the 2007 Plan, the Company could issue up to 400,000 additional shares of common stock pursuant to grants of stock options, stock appreciation rights, common stock, restricted stock, performance shares, incentive awards and stock units. No additional awards may be granted under the 2007 Plan. Any awards previously granted under the 2007 Plan that were outstanding as of May 19, 2016 remain outstanding and will vest in accordance with their regular terms.
On May 19, 2016, the Company’s shareholders approved the Eastern Virginia Bankshares, Inc. 2016 Equity Compensation Plan (the “2016 Plan”) to promote the success of the Company by providing incentives to key employees, non-employee directors, consultants and advisors to associate their personal interests with the long-term financial success of the Company and with growth in shareholder value consistent with the Company’s risk management practices. The 2016 Plan authorizes the Company to issue up to 500,000 additional shares of common stock pursuant to stock options, restricted stock units, stock appreciation rights, stock awards, performance units and performance cash awards. There were 484,232 shares still available to be granted as awards under the 2016 Plan as of December 31, 2016.
Accounting standards require companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options, based on the fair value of those awards at the date of grant.
Accounting standards also require that new awards to employees eligible for accelerated vesting at retirement prior to the awards becoming fully vested be recognized as compensation cost over the period through the date that the employee first becomes eligible to retire and is no longer required to provide service to earn the award. The Company’s stock options granted to eligible participants were recognized, as required, as compensation cost over the vesting period except in the instance where a participant reaches normal retirement age of 65 prior to the normal vesting date. For the years ended December 31, 2016, 2015 and 2014 there was no stock option compensation expense.
There were no stock options granted or exercised in the years ended December 31, 2016, 2015 and 2014. There was no remaining unrecognized compensation expense related to stock options.
A summary of the Company’s stock option activity and related information is as follows:
*Intrinsic value is the amount by which the fair value of the underlying common stock exceeds the exercise price of a stock option on exercise date.
The table below summarizes information concerning stock options outstanding and exercisable at December 31, 2016:
On April 29, 2016, the Company granted 6,500 shares of restricted stock under the 2007 Plan to various senior officers of the Bank. All of the shares are subject to time vesting over a one-year period and will vest on April 29, 2017. On March 24, 2016, the Company granted 65,000 shares of restricted stock under the 2007 Plan to its executive officers. Fifty percent (50%) of the shares are subject to time vesting in five equal annual installments beginning on March 31, 2017. The remaining fifty percent (50%) of the shares are subject to performance vesting and will vest on March 31, 2019 to the extent certain financial performance requirements for fiscal year 2018 are met. On March 19, 2015, the Company granted 45,000 shares of restricted stock under the 2007 Plan to its executive officers. Fifty percent (50%) of the shares are subject to time vesting in five equal annual installments beginning on March 31, 2016. The remaining fifty percent (50%) of the shares are subject to performance vesting and will vest on March 31, 2018 to the extent certain financial performance requirements for fiscal year 2017 are met. On October 15, 2014, the Company granted 42,500 shares of restricted stock under the 2007 Plan to its executive officers. Fifty percent (50%) of the shares are subject to time vesting in five equal annual installments beginning on March 31, 2015. The remaining fifty percent (50%) of the shares are subject to performance vesting and will vest on March 31, 2017 to the extent certain financial performance requirements for fiscal year 2016 are met. On November 20, 2014, the Company granted 3,242 shares of restricted stock under the 2007 Plan to one of its executive officers. All of these shares are subject to time vesting over a two year period, and generally vest fifty percent (50%) on the first and second anniversaries of the grant date. In connection with the Pending Merger, all outstanding time and performance based shares of restricted stock will vest on an accelerated basis upon completing the Pending Merger.
For the years ended December 31, 2016, 2015 and 2014, restricted stock compensation expense was $358 thousand, $248 thousand and $100 thousand, respectively, and was included in salaries and employee benefits expense in the consolidated statements of income. Restricted stock compensation expense is accounted for using the fair value of the Company’s common stock on the date the restricted shares were awarded, which was $7.00 per share for the April 29, 2016 awards, $6.80 per share for the March 24, 2016 awards, $6.28 per share for the March 19, 2015 awards, $6.10 per share for the October 15, 2014 awards and $6.17 per share for the November 20, 2014 award.
A summary of the status of the Company’s nonvested shares in relation to the Company’s restricted stock awards as of December 31, 2016, 2015 and 2014, and changes during the years ended December 31, 2016, 2015 and 2014, is presented below; the weighted average price is the weighted average fair value at the date of grant:
At December 31, 2016, there was $639 thousand of total unrecognized compensation expense related to restricted stock awards. This unearned compensation is being amortized over the remaining vesting period for the time and performance based shares. The total fair value of restricted stock awards vested during 2016, 2015 and 2014 was $190 thousand, $181 thousand and $97 thousand, respectively.
Note 15. Accumulated Other Comprehensive (Loss)
The balances in accumulated other comprehensive (loss) are shown in the following table:
Reclassifications of gains on securities available for sale are reported in the consolidated statements of income as “Gain on sale of available for sale securities, net” with the corresponding income tax effect being reflected as a component of income tax expense. Amortization of unrealized losses on securities transferred from available for sale to held to maturity is included in interest income on investments (taxable or non-taxable) in the Company’s consolidated statements of income.
During the years ended December 31, 2016, 2015 and 2014, the Company reported gains on the sale of available for sale and held to maturity securities and amortization of unrealized losses on securities transferred from available for sale to held to maturity as shown in the following table:
Note 16. Commitments and Contingent Liabilities
In the normal course of business there are various outstanding commitments and contingent liabilities, which are not reflected in the accompanying financial statements. The Company does not anticipate any material losses as a result of these transactions. See Note 21 - Financial Instruments with Off-Balance Sheet Risk.
Note 17. Dividend Limitations
Dividends may be paid to the Company by the Bank under formulas established by the appropriate regulatory authorities. Generally, the amount of dividends the Bank may pay to the Company at any time, without prior approval, is limited to current year to date earnings as of the dividend date plus earnings retained for the two preceding years.
Note 18. Regulatory Matters
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
The Basel III Capital Rules, a new comprehensive capital framework for U.S. banking organizations, became effective for the Company and the Bank on January 1, 2015 (subject to a phase-in period for certain provisions). Quantitative measures established by the Basel III Capital Rules to ensure capital adequacy require the maintenance of minimum amounts and ratios as presented in the table below of common equity tier 1 capital (“CET1”), Tier 1 capital and Total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).
·The Company and the Bank’s CET1 capital includes common stock and related surplus and retained earnings. In connection with the adoption of the Basel III Capital Rules, we elected to opt-out of the requirement to include components of accumulated other comprehensive income (loss) in CET1 capital. CET1 capital for both the Company and the Bank is reduced by, goodwill, deferred tax assets, and other intangible assets, net of associated deferred tax liabilities, and subject to transition provisions.
·Tier 1 capital includes CET1 capital and additional Tier 1 capital. For the Company, additional Tier 1 capital at December 31, 2016 and 2015 includes $21.6 million of Series B Preferred Stock (including related surplus). At December 31, 2016 and 2015, $10.0 million of qualified trust preferred securities were included in the Company’s additional Tier 1 capital. The Bank did not have any additional Tier 1 capital beyond CET1 capital as of December 31, 2016 and 2015.
·Total capital includes Tier 1 capital and Tier 2 capital. Tier 2 capital for both the Company and the Bank includes an allowable portion of the allowance for loan losses. Tier 2 capital for the Company at December 31, 2016 and 2015 also includes $20.0 million of qualified senior subordinated debt.
Risk-weighted assets for the Company and the Bank were both $1.1 billion at December 31, 2016 and $888.5 million and $889.6 million, respectively at December 31, 2015, as determined under then applicable regulations. Management believes, as of December 31, 2016 and 2015, that the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2016, the most recent notification from the Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized at December 31, 2016, an institution must maintain minimum total risk-based, CET1 risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Company’s and the Bank’s actual capital amounts and ratios, and minimum regulatory capital requirements, as of December 31, 2016 and 2015 are also presented in the table.
*Except with regard to the Company’s and the Bank’s Tier 1 capital to average assets ratio, includes the current phased-in portion of the Basel III Capital Rules capital conservation buffer (0.625%) which is added to the minimum capital requirements for capital adequacy purposes. The capital conservation buffer is being phased in through four equal annual installments of 0.625% from 2016 to 2019, with full implementation in January 2019 (2.5%). The Company’s and the Bank’s capital conservation buffer must consist of additional CET1 above regulatory minimum requirements. Failure to maintain the prescribed levels places limitations on capital distributions and discretionary bonuses to executives. As of December 31, 2016, the capital conservation buffer of the Company and the Bank was 4.3000% and 5.3055%, respectively.
Note 19. Dividend Reinvestment and Stock Purchase Plan
The Company has a Dividend Reinvestment and Stock Purchase Plan (the “DRSPP”), which provides for the automatic conversion of dividends into common stock for enrolled shareholders. The DRSPP also permits participants to make voluntary cash payments of up to $20 thousand per shareholder per calendar quarter for the purchase of additional shares of the Company’s common stock. When the administrator of the DRSPP purchases shares of common stock from the Company, the purchase price will generally be the market value of the common stock on the purchase date as defined by the Nasdaq Stock Market. When the administrator purchases shares of common stock in the open market, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. When the administrator purchases shares of common stock in privately negotiated transactions, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. Effective March 1, 2012, the DRSPP was amended and restated to effect certain design changes to the plan, but not to change the number of shares issuable thereunder. Beginning on August 15, 2012, the issuance of common stock under the DRSPP was temporarily suspended. In July 2016 the Company reinitiated the Company’s DRSPP. Of the 353,473 shares reserved for issuance under the Company’s DRSPP, there were 128,670 shares available for issuance under the plan as of December 31, 2016.
Note 20. Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. U.S. GAAP requires that valuation techniques maximize the use of observable inputs and minimize the use of unobservable inputs. U.S. GAAP also establishes a fair value hierarchy which prioritizes the valuation inputs into three broad levels. Based on the underlying inputs, each fair value measurement in its entirety is reported in one of the three levels. These levels are:
*Level 1 - Valuation is based upon quoted prices (unadjusted) for identical instruments traded in active markets.
*Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
*Level 3 - Valuation is determined using model-based techniques with significant assumptions not observable in the market.
U.S. GAAP allows an entity the irrevocable option to elect fair value (the fair value option) for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract basis. The Company has not made any fair value option elections as of December 31, 2016.
Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Assets Measured at Fair Value on a Recurring Basis
Securities Available For Sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s available for sale securities are considered to be Level 2 securities.
The following table summarizes financial assets measured at fair value on a recurring basis as of December 31, 2016 and 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:
Assets Measured at Fair Value on a Non-Recurring Basis
Certain assets are measured at fair value on a non-recurring basis in accordance with U.S. GAAP. These adjustments to fair value usually result from the application of fair value accounting or impairment write-downs of individual assets.
Impaired Loans. Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3.
The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a non-recurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.
Other Real Estate Owned. OREO is measured at fair value less cost to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a non-recurring basis. Any initial fair value adjustment is charged against the allowance for loan losses. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense on the consolidated statements of income.
The following table summarizes assets measured at fair value on a non-recurring basis as of December 31, 2016 and 2015, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:
The following table displays quantitative information about Level 3 Fair Value Measurements as of December 31, 2016 and 2015:
Fair Value of Financial Instruments
U.S. GAAP requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies and assumptions for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The methodologies and assumptions for other financial assets and financial liabilities are discussed below:
Cash and Short-Term Investments. For those short-term instruments, the carrying amount is a reasonable estimate of fair value.
Investment Securities. For securities and marketable equity securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. For other securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted prices for similar securities. All securities prices are provided by independent third party vendors.
Restricted Securities. The carrying amount approximates fair value based on the redemption provisions of the correspondent banks.
Loans. The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower’s creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note.
Bank Owned Life Insurance. Bank owned life insurance represents insurance policies on officers of the Company. The cash values of the policies are estimated using information provided by insurance carriers. The policies are carried at their cash surrender value, which approximates fair value.
Deposits. The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using market rates for deposits of similar remaining maturities.
Short-Term Borrowings. The carrying amounts of federal funds purchased and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the current incremental borrowing rates for similar types of borrowing arrangements.
Long-Term Borrowings. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.
Accrued Interest Receivable and Accrued Interest Payable. The carrying amounts of accrued interest approximate fair value.
Off-Balance Sheet Financial Instruments. The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.
The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. The fair value of guarantees of credit card accounts previously sold is based on the estimated cost to settle the obligations with the counterparty at the reporting date. At December 31, 2016 and 2015, the fair value of loan commitments, standby letters of credit and credit card guarantees are not significant and are not included in the table below.
The estimated fair value and the carrying value of the Company’s recorded financial instruments are as follows:
*Includes federal funds sold.
**Includes federal funds purchased and repurchase agreements.
***Net of unamortized debt issuance costs of $875.
*Includes federal funds sold.
**Includes federal funds purchased and repurchase agreements.
***Net of unamortized debt issuance costs of $978.
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of the Company’s normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. The Company attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. The Company monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
Note 21. Financial Instruments with Off-Balance Sheet Risk
In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, standby letters of credit, guarantees of credit card accounts previously sold and potential repurchase obligations related to previously sold loans, and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit and guarantees of credit card accounts previously sold is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Unless otherwise noted, the Company does not require collateral or other security to support financial instruments with credit risk.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include property, plant and equipment and income-producing commercial properties.
Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are usually uncollateralized and do not always contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company has not incurred any losses on its commitments in either 2016 or 2015.
The amounts of loan commitments and standby letters of credit are set forth in the following table as of December 31, 2016 and 2015:
In connection with the sale of its credit card loan portfolio, the Company has guaranteed credit card accounts of certain customers to the Bank that purchased the accounts. At December 31, 2016 and 2015, the guarantees totaled $756 thousand and $763 thousand, respectively, of which the outstanding balance of the guarantees was $143 thousand and $212 thousand, respectively. As of December 31, 2016, the Company does not anticipate any significant or material losses as a result of the guaranteed credit card accounts.
Note 22. Preferred Stock and Warrant
On January 9, 2009, the Company signed a definitive agreement with the Treasury under the Emergency Economic Stabilization Act of 2008 to participate in the Treasury’s Capital Purchase Program. Pursuant to this agreement, the Company sold 24,000 shares of its Series A fixed rate cumulative perpetual preferred stock, liquidation value $1,000 per share (the “Series A Preferred Stock”), to the Treasury for an aggregate purchase price of $24 million. The Series A Preferred Stock paid a cumulative dividend at a rate of 5% for the first five years, and effective January 9, 2014, paid a rate of 9%. As part of its purchase of the Series A Preferred Stock, the Treasury was also issued a warrant (the “Warrant”) to purchase, on its initial terms, up to 373,832 shares of the Company’s common stock at an initial exercise price of $9.63 per share. If not exercised, the Warrant would have expired after ten years. On October 21, 2013, the Treasury sold all 24,000 shares of Series A Preferred Stock that were held by Treasury to private investors. Capital stock transactions by the Company subsequent to the Warrant’s issuance adjusted the Warrant’s exercise price per share to $9.374 and increased the number of shares that could have been acquired upon exercise to 384,041.19 shares.
On May 13, 2015, the Company repurchased from the Treasury the Warrant for an aggregate repurchase price of $115 thousand, based on the fair value of the Warrant as agreed upon by the Company and the Treasury. Following the repurchase of the Warrant, the Treasury has no remaining equity investment in the Company. Additionally, on June 15, 2015, the Company redeemed the remaining $9.0 million of its Series A Preferred Stock.
In connection with its private placements, on June 12, 2013, the Company issued 5,240,192 shares of its Series B Preferred Stock for a gross purchase price of $23.8 million, or $4.55 per share. The Series B Preferred Stock has no maturity date. The holders of Series B Preferred Stock are entitled to receive dividends if, as and when declared by the Company’s Board of Directors, in an identical form of consideration and at the same time, as those dividends or distributions that would have been payable on the number of whole shares of the Company’s common stock that such shares of Series B Preferred Stock would be convertible into upon satisfaction of certain conditions. The Company will not pay any dividends with respect to its common stock unless an equivalent dividend also is paid to the holders of Series B Preferred Stock. The Series B Preferred Stock ranks junior with regard to dividends to any class or series of capital stock of the Company the terms of which expressly provide that such class or series will rank senior to the common stock or the Series B Preferred Stock as to dividend rights and/or as to rights on liquidation, dissolution or winding up of the Company.
Note 23. Former Related Party Lease
The Bank has entered into a long-term land lease with a former related party to provide for space for one branch located in Hartfield, Virginia. This lease has been classified as an operating lease for financial reporting purposes. The lease term expires on April 30, 2025 with annual lease payments of approximately $8 thousand. Future minimum lease payments required over the remaining term of this non-cancelable operating lease total $66 thousand. Under the terms of the lease, the Bank has two options to extend the lease term beyond April 30, 2025. Total lease expense was $8 thousand for each of the years 2016, 2015 and 2014, respectively.
Note 24. Lease Commitments
The Company currently has long-term leases for six of its branches, one loan production office and its corporate headquarters. Three of the leases are for branch buildings, three of the leases are for the land on which Company owned branches are located, one lease is for a loan production office building in Chesterfield, Virginia and one lease is for the corporate headquarters in Glen Allen, Virginia. Pursuant to the terms of these leases, the following is a schedule, by year, of future minimum lease payments required under the long-term non-cancelable lease agreements.
Rent expense for the years ended December 31, 2016, 2015 and 2014 was $752 thousand, $508 thousand and $315 thousand, respectively, and was included in occupancy and equipment expenses.
Note 25. Common Stock Repurchases
In January 2001, the Company announced a stock repurchase program by which management was authorized to repurchase up to 300,000 shares of the Company’s common stock. This program was amended in 2003 and the number of shares by which management is authorized to repurchase is up to 5% of the outstanding shares of the Company’s common stock on January 1 of each year. There is no stated expiration date for the program. During 2016, 2015 and 2014, the Company did not repurchase any of its common stock under the program.
Note 26. Condensed Parent Company Only Financial Information
The condensed financial position as of December 31, 2016 and 2015 and the condensed results of income and cash flows for each of the years in the three-year period ended December 31, 2016, of Eastern Virginia Bankshares, Inc., parent company only, are presented below:
Condensed Balance Sheets
December 31, 2016 and 2015
(dollars in thousands)
Condensed Statements of Income
Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands)
Condensed Statements of Cash Flows
Years Ended December 31, 2016, 2015 and 2014
(dollars in thousands)
Note 27. Low Income Housing Tax Credits
The Company had investments in four separate housing equity funds at December 31, 2016. The general purpose of these funds is to encourage and assist participants in investing in low-income residential rental properties located in the Commonwealth of Virginia, develop and implement strategies to maintain projects as low-income housing, deliver Federal Low Income Housing Credits to investors, allocate tax losses and other possible tax benefits to investors, and to preserve and protect project assets. The investments in these funds were recorded as other assets on the consolidated balance sheets and were $2.3 million and $2.8 million at December 31, 2016 and 2015, respectively. These investments and related tax benefits have expected terms through 2032, with the majority maturing by 2027. Tax credits and other tax benefits recognized related to these investments during the years ended December 31, 2016 and 2015 were $469 thousand and $478 thousand, respectively. Total projected tax credits to be received for 2016 are $318 thousand, which is based on the most recent quarterly estimates received from the funds. Additional capital calls expected for the funds totaled $984 thousand and $1.0 million at December 31, 2016 and 2015, respectively, and are included in other liabilities on the consolidated balance sheets.