Item 1.
BUSINESS.
General
Virginia National Bankshares Corporation (the “Company”) was incorporated under the laws of the Commonwealth of Virginia on February 21, 2013 at the direction of the Board of Directors of Virginia National Bank (the “Bank”) for the purpose of acquiring all of the outstanding shares of the Bank and becoming the holding company of the Bank. On June 19, 2013, the shareholders of the Bank approved the Reorganization Agreement and Plan of Share Exchange, dated March 6, 2013, whereby the Bank would reorganize into a holding company structure (the “Reorganization”). On December 16, 2013, when the Reorganization became effective, the Bank became a wholly-owned subsidiary of the Company, and each share of the Bank’s common stock was exchanged for one share of the Company’s common stock.
The Company is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is subject to inspection, examination and supervision by the Federal Reserve. The Company is also under the jurisdiction of the Securities and Exchange Commission (“SEC”) and is subject to the disclosure and regulatory requirements of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) as administered by the SEC. Virginia National Bankshares Corporation is headquartered at 404 People Place, Charlottesville, Virginia.
Virginia National Bank, the principal operating subsidiary of the Company, was organized in 1998 under federal law as a national banking association to engage in a general commercial and retail banking business. The Bank received its charter from the Office of the Comptroller of the Currency (the “OCC”) and commenced operations on July 29, 1998. The Bank received fiduciary powers in January 2000. The Bank’s main office is in Charlottesville, Virginia. The Bank’s deposits are insured up to the maximum amount provided by the Federal Deposit Insurance Act by the Federal Deposit Insurance Corporation (“FDIC”). Prior to July 2018, the Bank had one wholly owned subsidiary, VNBTrust, National Association (“VNBTrust”), a national trust bank formed in 2007. Effective July 1, 2018, VNBTrust was merged into Virginia National Bank. The Bank continues to offer trust and estate administration services under the name of VNB Trust and Estate Services and offers wealth and investment advisory services under the name Sturman Wealth Advisors (“Sturman Wealth”), formerly known as VNB Investment Services. The Bank is subject to the supervision, examination and regulations of the OCC and is also subject to regulations of the FDIC, the Federal Reserve and the Consumer Financial Protection Bureau (“CFPB”).
During 2018, the Company formed Masonry Capital Management, LLC (“Masonry Capital”), a registered investment advisor, which offers investment advisory and management services to clients through separately managed accounts and a private investment fund. The Company believes the formation of Masonry Capital allows the Company to offer its investment strategy to a wider range of clients.
References to the Company’s subsidiaries in this document include both the Bank and Masonry Capital.
As of December 31, 2020, the Company and its subsidiaries occupied five full-service banking facilities in the cities of Charlottesville and Winchester and the County of Albemarle, Virginia, as well as a drive-through facility with additional office space for VNB Trust and Estate Services in Charlottesville. Refer to Item 2. Properties for additional information regarding locations.
The multi-story office building at 404 People Place, Charlottesville, Virginia, also serves as the Company’s corporate headquarters and operations center, as well as the offices for Masonry Capital and for Sturman Wealth. Additionally, the Company has a loan production location in Richmond, Virginia.
Proposed Mergers with Fauquier Bankshares, Inc. and The Fauquier Bank
On October 1, 2020, the Company announced the signing of a definitive merger agreement with Fauquier Bankshares, Inc., pursuant to which the companies are expected to combine in an all-stock merger with the Company as the surviving company. At or immediately following consummation of the merger, The Fauquier Bank, the wholly owned banking subsidiary of Fauquier, will be merged with and into the Bank, with the Bank as the surviving bank. Under the terms of the merger agreement, Fauquier shareholders will receive 0.675 shares of Company stock for each share of Fauquier common stock they own. Shareholders
of the Company will own approximately 51.4%, and Fauquier shareholders will own approximately 48.6% of the combined company. The combined company will operate under the Virginia National Bankshares Corporation name and the combined bank will operate under the Virginia National Bank name. Completion of the merger is subject to customary closing conditions, including receipt of the approval of the shareholders of the Company and Fauquier, respectively. The Company and Fauquier have each scheduled a special meeting of shareholders for March 25, 2021 to consider and vote on the merger and related matters. Additional information on the proposed merger can be found in the Company’s Current Reports on Form 8-K filed with the SEC on October 1, 2020 and October 2, 2020.
Products and Services
The Bank offers a full range of banking and related financial services, including checking accounts, NOW accounts, money market deposit accounts, certificates of deposit, individual retirement accounts, Certificate of Deposit Account Registry Service (CDARS™), Insured Cash Sweep® (ICS®) and other depository services. The Bank actively solicits such accounts from individuals, businesses and charitable organizations within its trade area. Other services offered by the Bank include automated teller machines (“ATMs”), internet banking, treasury and cash management services and merchant card services. In addition, the Bank is affiliated with Visa®, which is accepted worldwide and offers debit cards to consumer and business customers.
The Bank also offers short to long term commercial, real estate and consumer loans. The Bank is committed to being a reliable and consistent source of credit, providing loans that are priced based upon an overall banking relationship, easy access to the Bank’s local decision makers who possess strong local market knowledge, local delivery, fast response, and continuity in the banking relationship. The Bank originates residential mortgage loans and sells on the secondary market those loans which the Bank does not wish to retain for its own loan portfolio due to the interest rate risks that are inherent with long-term fixed rate loans.
Wealth and investment advisory services and products are offered under the name of Sturman Wealth Advisors, formerly known as VNB Investment Services, pursuant to networking agreements with a registered broker/dealer and a registered investment advisor to provide services through representatives who are also employees of the Company.
Trust and estate administration services are offered through VNB Trust and Estate Services.
Investment management services are offered through Masonry Capital Management, LLC, whose flagship product for separately managed accounts and a private investment fund employs a value-based, catalyst-driven investment strategy. The financial instruments used include common and preferred stock, corporate bonds, bank loans and other debt securities, convertible securities, Exchange Traded Funds, options, warrants and cash equivalents.
The Bank primarily serves the Virginia communities in and around the City of Charlottesville, Albemarle County and the City of Winchester. The Bank also has a loan production location in Richmond, Virginia. The Bank’s locations are well-positioned in attractive markets. Within its market area, there are various types of industry including higher education, medical and professional services, research and development companies and retail.
Competition
The Company engages in highly competitive activities. Each activity involves competition with other banks, as well as with non-banking enterprises that offer financial products and services that compete directly with the Company’s product and service offerings. The Company actively competes with other banks in its efforts to obtain deposits and make loans, in the scope and types of services offered, in interest rates paid on time deposits and charged on loans, and in other aspects of banking.
In addition to competing with other commercial banks within and outside its primary service areas, the Company competes with other financial institutions engaged in the business of making loans or accepting deposits, such as credit unions, insurance companies, small loan companies, finance companies, mortgage companies, certain governmental agencies and other enterprises. Competition for money market accounts with securities brokers and mutual funds is strong. Additional competition for deposits comes from government and private issuers of debt obligations and other investment alternatives for depositors such as money market funds.
The market areas served by the Company are highly competitive with respect to banking. Competition for loans to businesses and professionals is intense, and pricing is important. Many of the Company’s competitors have substantially greater resources and lending limits than the Company and offer certain services such as extensive and established branch networks that the Company does not expect to match. Deposit competition is also very strong. Management believes, however, that a market exists for the personal and customized financial services an independent, community bank can offer.
Environmental, Social and Governance
The Company is taking proactive steps to conserve resources and improve the environment. Most of our back-office operations exist in a paperless environment and customers are encouraged to utilize online banking, including paperless statements, mobile banking and remote deposit capture, in an effort to reduce individual and collective carbon footprints. The Company supports its customers who are actively engaged in “going-green” campaigns, including the use of renewable energy.
Near the onset of the COVID-19 pandemic, the Company was proactively involved in facilitating the delivery of personal protective equipment to local businesses and nonprofits. The Company also participated in the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) as described in detail later in this report.
The Company has also made a financial commitment to community partners and nonprofit organizations who support housing projects, kids in need, workforce readiness, health and wellness and the arts. Executive leadership and the Board of Directors of the Company are dynamically involved in the communities in which they serve, including serving on boards, making financial donations and volunteering time.
Almost immediately after the Tax Cut and Jobs Act of 2017 was signed into law on December 22, 2017, the Company made the decision to have an internal minimum wage of $15 per hour for all employees. This took effect on January 1, 2018. Also, since the onset of the COVID-19 pandemic, the Company has continued to pay its employees at 100% of their salaries and wages, even if the employees worked on a rotating, rather than a full-time, schedule. No benefits have been reduced for employees as a result of COVID-19 effects.
A portion of the Company’s Chief Executive Officer (“CEO”) compensation is based on his personal involvement on community nonprofit boards and his designing of programs that help the same nonprofits serve their constituents. Prior to the onset of the COVID-19 pandemic, the CEO helped design and launch the Financial Education Program for high school students, Driving Lives Forward program in conjunction with United Way and Carter Myers Car Dealership and a program that helps get individuals started in a banking career. The CEO is also responsible for launching the Company’s executive diversity, equity and inclusion program which was started before the COVID-19 pandemic onset. The Company has been involved for the past seven years in the Bank On lending program, operated by the Coalition for Economic Opportunity, whose mission is to enhance access to fair, reasonable and just financial services for low- and moderate- income members of the community. The CEO and members of the Company’s executive team are also involved in major fundraising activities for many of the community (local, state and national) nonprofits.
Employees
The Company has a shared vision of guiding principles, core values and strategies that work and have guided the Company through both good and challenging times. The Company strives to ensure that its constituents believe in it as well, including its shareholders, customers, board, executive management and high performing employees. The Company believes that the shared vision, when properly aligned and communicated to all constituents, will produce more than above average performance in key metrics. As part of the shared vision, the Company is dedicated and committed to its shareholders, customers, employees and communities. A critical part of this dedication and commitment is attracting and retaining high performing employees who desire to enrich the lives of customers and communities the Company
serves. To attract and retain high performing employees, the Company provides a competitive compensation and benefits program, including wellness benefits.
At December 31, 2020, the Company had 86 full time equivalent employees, of which 7 were part-time employees. None of its employees are represented by any collective bargaining unit. The Company considers relations with its employees to be good.
The Company owns Bank Owned Life Insurance (“BOLI”) policies on each executive officer and certain other senior officers of the Company. BOLI is a bank-eligible asset designed to recover costs of providing pre- and post-retirement benefits and/or to finance general employee benefit expenses. Under BOLI policies, each executive officer and certain other senior officers of the Company are the insured, and the Company is the owner and beneficiary of the policies. The insured has no claim to the insurance policy or to the policy’s cash value. Under separate split dollar agreements, a portion of any death benefit may be paid to the beneficiaries of the insured officer, subject to the terms and restrictions of the split dollar endorsement agreement between the insured officer and the Company.
Supervision and Regulation
The Company and the Bank are extensively regulated under both federal and state laws. The following description briefly addresses certain historic and current provisions of federal and state laws and certain regulations, proposed regulations and the potential impacts on the Company and the Bank. To the extent statutory or regulatory provisions or proposals are described in this report, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.
The Company
General. As a bank holding company registered under the BHC Act, the Company is subject to supervision, regulation, and examination by the Federal Reserve. The Company is also registered under the bank holding company laws of Virginia and is subject to supervision, regulation, and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission (the “Virginia BFI”).
Permitted Activities. The permitted activities of a bank holding company are limited to managing or controlling banks, furnishing services to or performing services for its subsidiaries, and engaging in other activities that the Federal Reserve determines by regulation or order to be so closely related to banking, or managing or controlling banks, as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity reasonably can be expected to produce benefits to the public that outweigh possible adverse effects. Possible benefits include greater convenience, increased competition, and gains in efficiency. Possible adverse effects include undue concentration of resources, decreased or unfair competition, conflicts of interest, and unsound banking practices. Despite prior approval, the Federal Reserve may order a bank holding company or its subsidiaries to terminate any activity or to terminate ownership or control of any subsidiary when the Federal Reserve has reasonable cause to believe that a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company may result from such an activity.
Banking Acquisitions; Changes in Control. The BHC Act and related regulations require, among other things, the prior approval of the Federal Reserve in any case where a bank holding company proposes to (i) acquire direct or indirect ownership or control of more than 5% of the outstanding voting stock of any bank or bank holding company (unless it already owns a majority of such voting shares), (ii) acquire all or substantially all of the assets of another bank or bank holding company, or (iii) merge or consolidate with any other bank holding company. In determining whether to approve a proposed acquisition, the Federal Reserve will consider, among other factors, the following: the effect of the acquisition on competition; the public benefits expected to be received from the acquisition; any outstanding regulatory compliance issues of any institution that is a party to the transaction; the projected capital ratios and levels on a post-acquisition basis; the financial condition of each institution that is a party to the transaction and of the combined institution after the transaction; the parties’ managerial resources, as well as risk management and governance processes and systems; the parties’ compliance with the Bank Secrecy Act and anti-money laundering requirements; and the acquiring institution’s performance under the Community Reinvestment Act of 1977 (“CRA”) and its compliance with fair housing and other consumer protection laws.
Subject to certain exceptions, the BHC Act and the Change in Bank Control Act, together with applicable regulations, require Federal Reserve approval (or, depending on the circumstances, no notice of disapproval) prior to any person or company’s acquiring “control” of a bank or bank holding company. A
conclusive presumption of control exists if an individual or company acquires the power, directly or indirectly, to direct the management or policies of an insured depository institution or to vote 25% or more of any class of voting securities of any insured depository institution. Under the Change in Bank Control Act, a rebuttable presumption of control exists if a person or company acquires 10% or more but less than 25% of any class of voting securities of an insured depository institution and either (i) the institution has registered its securities with the SEC under Section 12 of the Exchange Act or (ii) no other person will own a greater percentage of that class of voting securities immediately after the acquisition. The Company’s common stock is registered under Section 12 of the Exchange Act.
In addition, Virginia law requires the prior approval of the Virginia BFI for (i) the acquisition by a Virginia bank holding company of more than 5% of the voting shares of a Virginia bank or a Virginia bank holding company, or (ii) the acquisition by any other person of control of a Virginia bank holding company or a Virginia bank.
Source of Strength. Federal Reserve policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) codified this policy as a statutory requirement. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
Safety and Soundness. There are a number of obligations and restrictions imposed on bank holding companies and their subsidiary banks by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance fund in the event of a depository institution insolvency, receivership, or default. For example, under the Federal Deposit Insurance Company Improvement Act of 1991, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any subsidiary bank that may become “undercapitalized” with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.
Under the Federal Deposit Insurance Act (“FDIA”), the federal bank regulatory agencies have adopted guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to capital management, internal controls and information systems, internal audit systems, information systems, data security, loan documentation, credit underwriting, interest rate exposure and risk management, vendor management, corporate governance, and asset growth, as well as compensation, fees, and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines.
Capital Requirements. The Federal Reserve imposes certain capital requirements on bank holding companies under the BHC Act, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are described below under “The Bank - Capital Requirements.” Subject to its capital requirements and certain other restrictions, the Company is able to borrow money to make a capital contribution to the Bank, and such loans may be repaid from dividends paid by the Bank to the Company.
Limits on Dividends and Other Payments. The Company is a legal entity, separate and distinct from its subsidiaries. A significant portion of the revenues of the Company result from dividends paid to it by the Bank. There are various legal limitations applicable to the payment of dividends by the Bank to the Company and to the payment of dividends by the Company to its shareholders. The Bank is subject to various statutory and regulatory restrictions on its ability to pay dividends to the Company. The OCC has advised that a national bank should generally pay dividends only out of current operating earnings. Under current regulations, prior regulatory approval is required if cash dividends declared by the Bank in any given year exceed net income for that year, plus retained net profits of the two preceding years. The payment of dividends by the Bank or the Company may be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Bank or the Company from engaging in an unsafe or unsound practice in conducting its respective business. The payment of dividends, depending on the financial condition of the Bank or the Company, could be deemed to constitute such an unsafe or unsound practice.
Under the FDIA, insured depository institutions, such as the Bank, are prohibited from making capital distributions, including the payment of dividends, if, after making such distributions, the institution would become “undercapitalized” (as such term is used in the statute). Based on the Bank’s current financial condition, the Company does not expect that this provision will have any impact on its ability to receive dividends from the Bank.
In addition, the Company’s ability to pay dividends is limited by restrictions imposed by the Virginia Stock Corporation Act on Virginia corporations. In general, dividends paid by a Virginia corporation may be paid only if, after giving effect to the distribution, (i) the corporation is still able to pay its debts as they become due in the usual course of business, or (ii) the corporation’s total assets are greater than or equal to the sum of its total liabilities plus (unless the corporation’s articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights, upon the dissolution, of shareholders whose preferential rights are superior to those receiving the distribution.
The Bank
General. The Bank is supervised and regularly examined by the OCC. The various laws and regulations administered by the OCC and the other bank regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt, and acquisition of financial institutions and other companies; they also affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices. Certain of these laws and regulations are referenced above under “The Company.”
Capital Requirements. The OCC and the other federal bank regulatory agencies have issued risk-based and leverage capital guidelines applicable to U.S. banking organizations. Those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth.
The federal banking agencies have adopted final rules regarding capital requirements and calculations of risk-weighted assets to implement the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision (the “Basel Committee”) and certain provisions of the Dodd-Frank Act (the “Basel III Capital Rules”).
The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a 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 Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Company were 14.37%, 14.37%, 15.35% and 9.54%, respectively, as of December 31, 2020, thus exceeding the minimum requirements. The Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Bank were 14.24%, 14.24%, 15.22% and 9.46%, respectively, as of December 31, 2020, also exceeding the minimum requirements.
With respect to the Bank, the “prompt corrective action” regulations, to be “well capitalized” under the revised regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. The Bank exceeds the thresholds to be considered well capitalized as of December 31, 2020.
In December 2017, the Basel Committee published standards that it described as the finalization of the Basel III post-crisis regulatory reforms (the standards are commonly referred to as “Basel IV”). Among other things, these standards revise the Basel Committee’s standardized approach for credit risk (including by recalibrating risk weights and introducing new capital requirements for certain “unconditionally cancellable commitments,” such as unused credit card lines of credit) and provide a new standardized
approach for operational risk capital. Under the proposed framework, these standards will generally be effective on January 1, 2022, with an aggregate output floor phasing-in through January 1, 2027. Under the current capital rules, operational risk capital requirements and a capital floor apply only to advanced approaches institutions, and not to the Company. The impact of Basel IV on the Company and the Bank will depend on the manner in which it is implemented by the federal bank regulatory agencies.
On August 28, 2018, the Federal Reserve issued an interim final rule required by the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018, which was signed into law on May 24, 2018 (the “EGRRCPA”), that expands the applicability of the Federal Reserve’s small bank holding company policy statement (the “SBHC Policy Statement”) to bank holding companies with total consolidated assets of less than $3 billion (up from the prior $1 billion threshold). Under the SBHC Policy Statement, qualifying bank holding companies have additional flexibility in the amount of debt they can issue and are also exempt from the Basel III Capital Rules (subsidiary depository institutions of qualifying bank holding companies are still subject to capital requirements). The Company currently has less than $3 billion in total consolidated assets and qualifies under the revised SBHC Policy Statement. The Company will continue to have less than $3 billion in total consolidated assets immediately after the proposed merger with Fauquier. However, the Company does not currently intend to issue a material amount of debt or take any other action that would cause its capital ratios to fall below the minimum ratios required by the Basel III Capital Rules.
On September 17, 2019 the FDIC finalized a rule that introduced an optional simplified measure of capital adequacy for qualifying community banking organizations, referred to as, the community bank leverage ratio (“CBLR”) framework, as required by the EGRRCPA. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital.
The CBLR framework was made available for community banking organizations to use in their March 31, 2020 Call Report. These CBLR rules were modified in response to the COVID-19 pandemic. See “Coronavirus Aid, Relief, and Economic Security Act and Consolidated Appropriations Act, 2021” below. The Company has not opted into the CBLR framework.
Prompt Corrective Action. Federal banking regulators are authorized and, under certain circumstances, required to take certain actions against banks that fail to meet their capital requirements. The federal bank regulatory agencies have additional enforcement authority with respect to undercapitalized depository institutions. “Well capitalized” institutions may generally operate without additional supervisory restriction. With respect to “adequately capitalized” institutions, such banks (i) cannot normally pay dividends or make any capital contributions that would leave it undercapitalized, (ii) cannot pay a management fee to a controlling person if, after paying the fee, it would be undercapitalized, and (iii) cannot accept, renew, or roll over any brokered deposit unless the bank has applied for and been granted a waiver by the FDIC.
Immediately upon becoming “undercapitalized,” a depository institution becomes subject to the provisions of Section 38 of the FDIA, which: (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution’s assets; and (v) require prior approval of certain expansion proposals. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the DIF, subject in certain cases to specified procedures. These discretionary supervisory actions include: (a) requiring the institution to raise additional capital; (b) restricting transactions with affiliates; (c) requiring divestiture of the institution or the sale of the institution to a willing purchaser; and (d) any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly
undercapitalized and critically undercapitalized institutions. The Bank met the definition of being “well capitalized” as of December 31, 2020.
As described above in “The Bank - Capital Requirements,” the capital requirement rules issued by the OCC incorporate new requirements into the prompt corrective action framework.
Deposit Insurance. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments based on average total assets minus average tangible equity to maintain the DIF. The basic limit on FDIC deposit insurance coverage is $250,000 per depositor. Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations as an insured depository institution, 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. As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment structure, set a target “designated reserve ratio” of 2 percent for the DIF, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2 percent and 2.5 percent. 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. The CAMELS component is a supervisory rating system designed to reflect financial and operational risks that a bank may face, including capital adequacy, asset quality, management capability, earnings, liquidity and sensitivity to market risk (“CAMELS”). At December 31, 2020, 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. In 2020 and 2019, the Company expensed $187,000 and $36,000, respectively, in deposit insurance assessments. In 2019, the Company received a $155,000 FDIC small bank credit assessment award, which was used partially in 2019 with the residual amount applied toward the first quarter of 2020 assessments, as the deposit insurance fund reserve ratio exceeded 1.38%.
Transactions with Affiliates. Pursuant to Sections 23A and 23B of the Federal Reserve Act and Regulation W, the authority of the Bank to engage in transactions with related parties or “affiliates” or to make loans to insiders is limited. Loan transactions with an affiliate generally must be collateralized and certain transactions between the Bank and its affiliates, including the sale of assets, the payment of money or the provision of services, must be on terms and conditions that are substantially the same, or at least as favorable to the Bank, as those prevailing for comparable nonaffiliated transactions. In addition, the Bank generally may not purchase securities issued or underwritten by affiliates.
Loans to executive officers, directors, or to any person who directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote more than 10% of any class of voting securities of a bank (“10% Shareholders”), are subject to Sections 22(g) and 22(h) of the Federal Reserve Act and their corresponding regulations (Regulation O) and Section 13(k) of the Exchange Act relating to the prohibition on personal loans to executives (which exempts financial institutions in compliance with the insider lending restrictions of Section 22(h) of the Federal Reserve Act). Among other things, these loans must be made on terms substantially the same as those prevailing on transactions made to unaffiliated individuals and certain extensions of credit to those persons must first be approved in advance by a disinterested majority of the entire Board of Directors. Section 22(h) of the Federal Reserve Act prohibits loans to any of those individuals where the aggregate amount exceeds an amount equal to 15% of an institution’s unimpaired capital and surplus plus an additional 10% of unimpaired capital and surplus in the case of loans that are fully secured by readily marketable collateral, or when the aggregate amount on all of the extensions of credit outstanding to all of these persons would exceed the Bank’s unimpaired capital and unimpaired surplus. Section 22(g) of the Federal Reserve Act identifies limited circumstances in which the Bank is permitted to extend credit to executive officers.
Community Reinvestment Act. The Bank is subject to the requirements of the CRA. The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low- and moderate-income neighborhoods. The CRA requires the appropriate federal banking agency, in connection with its examination of a bank, to assess the bank’s record in meeting such credit needs. In addition, in order for a bank holding company, like the Company, to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC
Act, each insured depository institution subsidiary of the bank holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Under the CRA, institutions are assigned a rating of “outstanding,” “satisfactory,” “needs to improve,” or “substantial non-compliance.” The Bank received a “satisfactory” CRA rating in its most recent examination.
On June 5, 2020, the OCC published a final rule, effective October 1, 2020, to modernize the agency’s regulations under the CRA. The rule (i) clarifies which activities qualify for CRA credit and (ii) requires banks to identify an additional assessment area based on where they receive a significant portion of their domestic retail products, thus creating two assessment areas: a deposit-based assessment area and a facility-based assessment area. Further, on November 24, 2020, the OCC issued a proposed rule to establish the agency’s proposed approach to determine the CRA evaluation measure benchmarks, retail lending distribution test thresholds, and community development minimums under the general performance standards set forth in the June 2020 final rule. The Company is evaluating what impact this new rule will have on its operations.
LIBOR and Other Benchmark Rates. Following the announcement by the U.K.’s Financial Conduct Authority in July 2017 that it will no longer persuade or require banks to submit rates for the London InterBank Offered Rate (“LIBOR”) after 2021, central banks and regulators around the world have commissioned working groups to find suitable replacements for Interbank Offered Rates (“IBOR”) and other benchmark rates and to implement financial benchmark reforms more generally. These actions have resulted in uncertainty regarding the use of alternative reference rates (“ARRs”) and could cause disruptions in a variety of markets, as well as adversely impact the Company’s business, operations and financial results.
In November 2020, the administrator of LIBOR announced it will consult on its intention to extend the retirement date of certain offered rates whereby the publication of the one week and two month LIBOR offered rates will cease after December 31, 2021; but, the publication of the remaining LIBOR offered rates will continue until June 30, 2023. Given consumer protection, litigation, and reputation risks, federal bank regulators have indicated that entering into new contracts that use LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and that they will examine bank practices accordingly. Therefore, the agencies encouraged banks to cease entering into new contracts that use LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.
To facilitate an orderly transition from LIBOR, IBOR and other benchmark rates to ARRs, the Company has established a focus committee, which includes members of senior management, including the Chief Credit Officer and Chief Financial Officer, among others. The task of this committee is to identify, assess and monitor risks associated with the expected discontinuation or unavailability of benchmarks, including LIBOR, achieve operational readiness and engage impacted clients in connection with the transition to ARRs.
Confidentiality 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 customers. A financial institution must provide to its customers information regarding its policies and procedures with respect to the handling of customers’ personal information. Each institution must conduct an internal risk assessment of its ability to protect customer information. These privacy laws and regulations generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated parties without prior notice and approval from the customer.
Anti-Money Laundering Laws and Regulations. The Company is subject to several federal laws that are designed to combat money laundering, terrorist financing, and transactions with persons, companies or foreign governments designated by U.S. authorities (“AML laws”). This category of laws includes the Bank Secrecy Act of 1970, the Money Laundering Control Act of 1986, the USA PATRIOT Act of 2001, and the Anti-Money Laundering Act of 2020.
The AML laws and their implementing regulations require insured depository institutions, broker-dealers, and certain other financial institutions to have policies, procedures, and controls to detect, prevent, and report money laundering and terrorist financing. The AML laws and their regulations also provide for information sharing, subject to conditions, between federal law enforcement agencies and financial institutions, as well as among financial institutions, for counter-terrorism purposes. Federal banking
regulators are required, when reviewing bank holding company acquisition and bank merger applications, to take into account the effectiveness of the anti-money laundering activities of the applicants. To comply with these obligations, the Company has implemented appropriate internal practices, procedures, and controls.
Office of Foreign Assets Control. The Office of Foreign Assets Control (“OFAC”), which is a division of the U.S. 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, and report it to OFAC. Failure to comply with OFAC requirements could have serious legal, financial and reputational consequences for the Company.
Volcker Rule. The Dodd-Frank Act and regulations under that act prohibit insured depository institutions and their affiliates, except as permitted under certain limited circumstances, from (i) engaging in short-term proprietary trading for their own accounts and (ii) having certain ownership interests in, and relationships with, hedge funds or private equity funds. The Volcker Rule did not have a material impact on the Company's operations or financial position in 2020 and 2019.
Consumer Financial Protection. The Bank is subject to a number of other federal and state consumer protection laws that extensively govern its relationship with its customers. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Home Mortgage Disclosure Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Fair Debt Collection Practices Act, the Servicemembers’ Civil Relief Act, Secure and Fair Enforcement for Mortgage Licensing Act, laws governing flood insurance, federal and state laws prohibiting unfair and deceptive business practices, foreclosure laws, and various regulations that implement some or all of the foregoing. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, collecting loans, and providing other services. If the Bank fails to comply with these laws and regulations, it may be subject to various penalties. Failure to comply with consumer protection requirements may also result in failure to obtain any required bank regulatory approval for merger or acquisition transactions the Bank may wish to pursue or being prohibited from engaging in such transactions even if approval is not required.
The Dodd-Frank Act centralized responsibility for consumer financial protection by creating a new agency, the CFPB, and giving it responsibility for implementing, examining, and enforcing compliance with federal consumer protection laws. The CFPB focuses on (i) risks to consumers and compliance with the federal consumer financial laws; (ii) the markets in which firms operate and risks to consumers posed by activities in those markets; (iii) depository institutions that offer a wide variety of consumer financial products and services; and (iv) non-depository companies that offer one or more consumer financial products or services. The CFPB is responsible for implementing, examining and enforcing compliance with federal consumer financial laws for institutions with more than $10 billion of assets. While the Bank, like all banks, is subject to federal consumer protection rules enacted by the CFPB, because the Company and the Bank have total consolidated assets of $10 billion or less, the OCC oversees the application to the Bank of most consumer protection aspects of the Dodd-Frank Act and other laws and regulations.
The CFPB has broad rulemaking authority for a wide range of consumer financial laws that apply to all banks, including, among other things, the authority to prohibit “unfair, deceptive, or abusive” acts and practices. Abusive acts or practices are defined as those that materially interfere with a consumer’s ability to understand a term or condition of a consumer financial product or service or take unreasonable advantage of a consumer’s (i) lack of financial savvy, (ii) inability to protect himself in the selection or use of consumer financial products or services, or (iii) reasonable reliance on a covered entity to act in the consumer’s interests. The CFPB can issue cease-and-desist orders against banks and other entities that violate consumer financial laws. The CFPB may also institute a civil action against an entity in violation of federal consumer financial law in order to impose a civil penalty or injunction. Further, regulatory positions taken by the CFPB with respect to financial institutions with more than $10 billion in assets may influence how other regulatory agencies apply the subject consumer financial protection laws and regulations.
Mortgage Banking Regulation. In connection with making mortgage loans, the Company and the Bank are subject to rules and regulations that, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers, in some cases restrict certain loan features and fix maximum interest rates and fees, require the disclosure of certain basic 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 Company and the Bank are also subject to rules and regulations that require the collection and reporting of significant amounts of information with respect to mortgage loans and borrowers.
The Company’s and the Bank’s mortgage origination activities are subject to Regulation Z, which implements the Truth in Lending Act. Certain provisions of Regulation Z require creditors 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. Creditors are required to determine consumers’ ability to repay in one of two ways. The first alternative requires the creditor to consider the following eight underwriting factors when making the credit decision: (i) current or reasonably expected income or assets; (ii) current employment status; (iii) the monthly payment on the covered transaction; (iv) the monthly payment on any simultaneous loan; (v) the monthly payment for mortgage-related obligations; (vi) current debt obligations, alimony, and child support; (vii) the monthly debt-to-income ratio or residual income; and (viii) credit history. Alternatively, the creditor can originate “qualified mortgages,” which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage, the points and fees paid by a consumer cannot exceed 3% of the total loan amount, and the consumer’s debt-to-income ratio (“DTI”) must be below the prescribed threshold. Qualified mortgages that are “higher-priced” (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g. prime loans) are given a safe harbor of compliance. Small creditors, as described below, may originate qualified mortgages that are not restricted by the specific DTI threshold (however, the DTI must still be considered). Small creditors are those financial institutions that meet the following requirements: (i) have assets below $2 billion (adjustable annually by CFPB); (ii) originated no more than 2,000 first-lien, closed-end residential mortgages subject to the ability-to-repay requirements in the preceding calendar year; and (iii) hold the qualified mortgage loan in its portfolio after origination. The Company, as a small creditor, does comply with the “qualified mortgage rules” and the other applicable Truth in Lending requirements.
Incentive Compensation. In 2010, the federal bank regulatory agencies issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of financial institutions do not undermine the safety and soundness of such institutions by encouraging excessive risk-taking. The Interagency Guidance on Sound Incentive Compensation Policies, which covers all employees that have the ability to materially affect the risk profile of financial institutions, either individually or as part of a group, is based upon the key principles that a financial institution’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the institution’s ability to effectively identify and manage risks; (ii) be compatible with effective internal controls and risk management; and (iii) be supported by strong corporate governance, including active and effective oversight by the financial institution’s Board of Directors.
The Federal Reserve and the OCC will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of financial institutions, such as the Company and the Bank, that are not “large, complex banking organizations.” These reviews will be tailored to each financial institution based on the scope and complexity of the institution’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the institution’s supervisory ratings, which can affect the institution’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a financial institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the institution’s safety and soundness and the financial institution is not taking prompt and effective measures to correct the deficiencies.
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 (i) 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 (ii) 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 impose additional record-keeping requirements. The comment period for these proposed rules has closed, and final rules have not yet been published.
Cybersecurity. The federal bank regulatory agencies have adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards under the supervision of a financial institution’s board of directors. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial products and services. The federal bank regulatory agencies expect financial institutions to establish lines of defense and to ensure that their risk management processes address the risk posed by compromised customer credentials, and also expect financial institutions to maintain sufficient business continuity planning processes to ensure rapid recovery, resumption and maintenance of the institution’s operations after a cyberattack. If the Company or the Bank fails to meet the expectations set forth in this regulatory guidance, the Company or the Bank could be subject to various regulatory actions, including financial penalties. Risks and exposures related to cybersecurity attacks are expected to remain high for the foreseeable future due to the rapidly evolving nature and sophistication of these threats and the expanding use of technology-based products and services. The Company is, however, taking measures to combat these types of threats and manage risk to the Company and its customers.
In October 2016, the federal bank regulatory agencies issued proposed rules on enhanced cybersecurity risk-management and resilience standards that would apply to very large financial institutions and to services provided by third parties to these institutions. The comment period for these proposed rules has closed; however, the final rules have not been published. Although the proposed rules would apply only to bank holding companies and banks with $50 billion or more in total consolidated assets, these rules could influence the federal bank regulatory agencies’ expectations and supervisory requirements for information security standards and cybersecurity programs of financial institutions with less than $50 billion in total consolidated assets such as the Company.
In December 2020, the federal banking agencies issued a notice of proposed rulemaking that would require banking organizations to notify their primary regulator within 36 hours of becoming aware of a “computer-security incident” or a “notification incident.” The proposed rule also would require specific and immediate notifications by bank service providers that become aware of similar incidents.
Coronavirus Aid, Relief, and Economic Security Act and Consolidated Appropriations Act, 2021. In response to the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law on March 27, 2020 and the Consolidated Appropriations Act, 2021 (“Appropriations Act”) was signed into law on December 27, 2020. Among other things, the CARES Act and Appropriations Act include the following provisions impacting financial institutions:
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Community Bank Leverage Ratio. The CARES Act directed federal banking agencies to adopt interim final rules to lower the threshold under the CBLR from 9% to 8% and to provide a reasonable grace period for a community bank that falls below the threshold to regain compliance, in each case until the earlier of the termination date of the national emergency or December 31, 2020. In April 2020, the federal bank regulatory agencies issued two interim final rules implementing this directive. One interim final rule provides that, as of the second quarter 2020, banking organizations with leverage ratios of 8% or greater (and that meet the other existing qualifying criteria) may elect to use the CBLR framework. It also establishes a two-quarter grace period for qualifying community banking organizations whose leverage ratios fall below the 8% CBLR requirement, so long as the banking organization maintains a leverage ratio of 7% or greater. The second interim final rule provides a transition from the temporary 8% CBLR requirement to a 9% CBLR requirement. It establishes a minimum CBLR of 8% for the second through fourth quarters of 2020, 8.5% for 2021, and 9% thereafter, and maintains a two-quarter grace period for qualifying community banking organizations whose leverage ratios fall no more than 100 basis points below the applicable CBLR requirement.
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Temporary Troubled Debt Restructurings Relief. The CARES Act allowed banks to elect to suspend requirements under U.S. generally accepted accounting principles (“GAAP”) for loan modifications related to the COVID-19 pandemic (for loans that were not more than 30 days past due as of December 31, 2019) that would otherwise be categorized as a troubled debt restructuring (“TDR”), including impairment for accounting purposes, until the earlier of 60 days after the termination date of the national emergency or December 31, 2020. Federal banking agencies are required to defer to the determination of the banks making such suspension. The Appropriations Act extended this temporary relief until the earlier of 60 days after the termination date of the national emergency or January 1, 2022.
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Small Business Administration Paycheck Protection Program. The CARES Act created the SBA PPP and it was extended by the Appropriations Act. Under the PPP, money was authorized for small business loans to pay payroll and group health costs, salaries and commissions, mortgage and rent payments, utilities, and interest on other debt. The loans are provided through participating financial institutions, such as the Bank, that process loan applications and service the loans.
Future Regulation
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 and the Bank 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 or the Bank.
Effect of Governmental Monetary Policies
The Company’s operations are affected not only by general economic conditions but also by the policies of various regulatory authorities. In particular, the Federal Reserve uses monetary policy tools to impact money market and credit market conditions and interest rates to influence general economic conditions. These policies have a significant impact on overall growth and distribution of loans, investments, and deposits; they affect market interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks, including the Company, in the past and are expected to do so in the future.
Reporting Obligations under Securities Laws; Availability of Information
The Company is subject to the periodic and other reporting requirements of the Exchange Act, including the filing of annual, quarterly and other reports with the SEC. Prior to the Reorganization, the Bank filed the periodic and annual reports required under the Exchange Act with the OCC. Annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, plus any amendments to these reports, are available, free of charge, at www.vnbcorp.com. The Company’s SEC filings are posted and available as soon as reasonably practicable after the reports are filed electronically with the SEC. The information on the Company’s website is not incorporated into this report or any other filing the Company makes with the SEC. The SEC maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.
Item 1A.
Item 1A.
RISK FACTORS.
The Company’s business is subject to risk. The following discussion, along with management’s discussion and analysis and the financial statements and footnotes, sets forth the most significant risks and uncertainties that management believes could adversely affect the Company’s business, financial condition or results of operations. Additional risks and uncertainties that management is not aware of or that management currently deems immaterial may also have a material adverse effect on the Company’s business, financial condition or results of operations. There is no assurance that this discussion covers all potential risks that the Company faces.
Summary of Risk Factors
The following is a summary of the most significant risks and uncertainties that the Company believes could adversely affect its business, financial condition or results of operations.
Credit Risks
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The Company must effectively manage its credit risks, as credit standards and credit assessment processes might not protect it from significant losses.
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The Bank’s ALLL may be insufficient and any increases in the ALLL may have a material adverse effect on the Company’s financial condition and results of operations.
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Lending to small to mid-sized community-based businesses may increase the Company’s credit risk.
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The concentration in loans secured by real estate may increase the Company’s future credit losses.
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The Company has a moderate concentration of credit exposure in commercial real estate and loans with this type of collateral are viewed as having more risk of default.
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The ability of borrowers to repay their loans significantly affect the Company’s results of operations.
Liquidity Risks
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The Company must effectively manage its liquidity risk, as liquidity needs could adversely affect results of operations and financial condition.
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The Company may need to raise additional capital in the future and may not be able to do so on acceptable terms, or at all.
Market Risks
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The Company may be adversely impacted by changes in market conditions.
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Change in economic conditions, especially in the areas in which the Company conducts operations, could materially and negatively affect its business.
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The Company’s business is subject to interest rate risk, and variations in interest rates and inadequate management of interest rate risk may negatively affect financial performance.
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The Company may be adversely affected by changes in the method of determining LIBOR, or the replacement of LIBOR with an alternative reference rate, for variable rate loans.
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The Company relies upon independent appraisals to determine the value of the real estate that secures a significant portion of its loans and the value of any foreclosed properties that may be carried on its books, and the values indicated by such appraisals may not be realizable if it is forced to foreclose upon such loans or liquidate such foreclosed property.
Strategic Risks
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The Company faces strong and growing competition from financial services companies and other companies that offer banking and other financial services, which could negatively affect the Company’s business.
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The Company may not be able to successfully manage its long-term growth.
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The success of the Company’s strategy depends on its ability to identify and retain individuals with experience and relationships in its markets.
Operational Risks
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The Company must effectively manage its operational risks, as it is subject to a variety of operational risks, including reputational risk, legal and compliance risk, and the risk of fraud or theft by employees or outsiders.
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Changes in accounting standards could impact reported earnings.
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Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on the Company’s results of operation and financial condition.
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The Company depends on the accuracy and completeness of information about clients and counterparties.
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The Company’s success depends on its management team, and the unexpected loss of any of these personnel could adversely affect operations.
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The Company relies on other companies to provide key components of its business infrastructure.
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The soundness of other financial institutions could adversely affect the Company.
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The Company’s operations may be adversely affected by cybersecurity risks.
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Consumers may increasingly decide not to use banks to complete their financial transactions.
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The Company’s ability to operate profitably may be dependent on its ability to integrate or introduce various technologies into its operations.
Legal, Regulatory and Compliance Risks
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The Company operates in a highly regulated industry.
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Regulations issued by the CFPB could adversely impact earnings due to, among other things, increased compliance costs or costs due to noncompliance.
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The Company is subject to laws regarding the privacy, information security and protection of personal information and any violation of these laws or another incident involving personal, confidential or proprietary information of individuals could damage the Company’s reputation.
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The Company’s business and earnings are impacted by governmental, fiscal and monetary policy over which it has no control.
Risks Related to the Proposed Merger with Fauquier
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Failure of, or a significant delay in completing, the Company’s proposed merger with Fauquier could negatively impact the Company.
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Combining the Company and Fauquier may be more difficult, costly or time-consuming than expected.
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The Company may not be able to effectively integrate the operations of the two banks.
Risks Relating to the Company’s Common Stock
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The Company is not obligated to pay dividends and its ability to pay dividends is limited.
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Future issuances of the Company’s common stock could adversely affect the market price of the common stock and could be dilutive.
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The Company’s common stock currently has a limited trading market and is thinly traded.
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The Company’s governing documents and Virginia law contain provisions that may discourage or delay an acquisition of the Company.
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An investment in the Company’s common stock is not an insured deposit.
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The Company qualifies as a “smaller reporting company,” and the reduced disclosure obligations applicable to smaller reporting companies may make its common stock less attractive to investors.
General Risk Factors
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The ongoing COVID-19 pandemic and measures intended to prevent its spread may adversely affect the Company’s business, financial condition and operations; the extent of such impacts are highly uncertain and difficult to predict.
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As a participating lender in the PPP, the Company may be subject to additional risks regarding our Bank’s processing of PPP loans and are dependent on the federal government’s continuation and support of the program.
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The Company is exposed to environmental liabilities with respect to properties to which it takes title.
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Severe weather, earthquakes, other natural disasters, pandemics, acts of war or terrorism and other external events could significantly impact our business.
Risk Factors Associated with the Company’s Business
Credit Risks
The Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses.
The Company assumes credit risk by virtue of making loans and extending loan commitments and letters of credit. The Company manages credit risk through a program of underwriting standards, the review of certain credit decisions and a continuous quality assessment process of credit already extended. The Company’s exposure to credit risk is managed through the use of consistent underwriting standards that emphasize local lending while avoiding highly leveraged transactions, as well as excessive industry and other concentrations. The Company’s credit administration function employs risk management techniques to help ensure that problem loans are promptly identified. While these procedures are designed to provide the Company with the information needed to implement policy adjustments where necessary and to take appropriate corrective actions, there can be no assurance that such measures will be effective in avoiding undue credit risk.
The Bank’s ALLL may be insufficient and any increases in the ALLL may have a material adverse effect on the Company’s financial condition and results of operations.
The Bank maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents the Bank’s best estimate of probable losses that will be incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio.
The level of the allowance reflects management’s evaluation of the level of loans outstanding, the level of nonperforming loans, historical loan loss experience, delinquency trends, underlying collateral values, the amount of actual losses charged to the reserve in a given period and assessment of present and anticipated economic conditions. The determination of the appropriate level of the ALLL inherently involves a high degree of subjectivity and requires the Bank to make significant estimates of current credit risks and future trends, all of which may undergo material changes. The outbreak of COVID-19 and the unprecedented governmental response have made these subjective judgments even more difficult. Although the Bank believes the ALLL is a reasonable estimate of known and inherent losses in the loan portfolio, it cannot precisely predict such losses or be certain that the loan loss allowance will be adequate in the future. Deterioration of economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Bank’s control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies and the Bank’s auditors periodically review its ALLL and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Further, if charge-offs in future periods exceed the allowance for loan losses, the Bank will need additional provisions to increase the allowance for loan losses.
The Company’s focus on lending to small to mid-sized community-based businesses may increase its credit risk.
Most of the Company’s commercial business and commercial real estate loans are made to small and mid-sized businesses and non-profits. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the market areas in which the Company operates negatively impact this important customer sector, the Company’s results of operations and financial condition may be adversely affected. Moreover, a portion of these loans have been made by the Company in recent years and the borrowers may not have experienced a complete business or economic cycle. Any deterioration of the borrowers’ businesses may hinder their ability to repay their loans with the Company, which could have a material adverse effect on its financial condition and results of operations. Steps to mitigate such risks include underwriting multiple sources of repayment, including but not limited, to business cash flow, personal guarantees, collateral, and government guarantees, where applicable. Although the Company has taken these mitigation steps, there is no guarantee that such practices will be effective to prevent the increased credit risk.
The Company’s concentration in loans secured by real estate may increase its future credit losses, which would negatively affect the Company’s financial results.
The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Credit risk and credit losses can increase if its loans are concentrated to borrowers who, as a group, may be uniquely or disproportionately affected by economic or market conditions. As of December 31, 2020, approximately 67.3% of the Company’s loans are secured by real estate, both residential and commercial. The Company has established concentration limits that are regularly monitored by management and reported to the Board. A major change in the real estate market in the regions in which the Company operates, resulting in a deterioration in real estate values, or in the local or national economy, including changes caused by the COVID-19 pandemic, could adversely affect the Company’s customers’ ability to pay these loans, which in turn could adversely impact the Company. Risk of loan defaults and foreclosures are inherent in the banking industry, and the Company tries to limit its exposure to this risk by carefully underwriting and monitoring its extensions of credit. The Company cannot fully eliminate credit risk, and as a result, credit losses may occur in the future.
The Company has a moderate concentration of credit exposure in commercial real estate and loans with this type of collateral are viewed as having more risk of default.
As of December 31, 2020, the Company had approximately $204.1 million in loans secured by commercial real estate, which represented approximately 33.5% of total loans outstanding at that date. Such loans consist of non-owner occupied commercial real estate, construction, land development, multi-family and other land loans. These types of loans are generally viewed as having more risk of default than residential real estate loans. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. It may be more difficult for commercial real estate borrowers to repay their loans in a timely manner, as commercial real estate borrowers’ abilities to repay their loans frequently depends on the successful rental of their properties. Cash flows may be affected significantly by general economic conditions, and a sustained 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 the Company’s loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in its percentage of nonperforming loans. An increase in nonperforming 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 the Company’s financial condition. The Company’s banking regulators generally give commercial real estate lending greater scrutiny and may require banks with higher levels of commercial real estate loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital as a result of commercial real estate lending growth and exposures, which could have a material adverse effect on the Company’s results of operations. Steps to mitigate such risks include underwriting multiple sources of repayment, including but not limited, to business cash flow, personal guarantees, collateral, and government guarantees, where applicable. In addition, the Company has established concentration limits that are regularly monitored by management and reported to the Board. Although the Company has taken these mitigation steps, there is no guarantee that such practices will be effective to prevent the increased credit risk.
The Company’s results of operations are significantly affected by the ability of borrowers to repay their loans.
A significant source of risk for the Company is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most of the Company’s loans are secured but some loans are unsecured. With respect to the secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in economic, environmental and other conditions, including the impacts of the COVID-19 pandemic, declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, terrorist activity, environmental contamination and other external events. In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a
loan is adequately collateralized when it is not. The Company has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss. An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.
Liquidity Risks
The Company’s liquidity needs could adversely affect results of operations and financial condition.
The Company’s primary sources of funds are 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, but not limited to, changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, availability of, and/or access to, sources of refinancing, business closings or lay-offs, pandemics or endemics, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including, but not limited to, rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to customers on alternative investments and general economic conditions. Accordingly, the Company 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 Federal Home Loan Bank of Atlanta (“FHLB”) advances, sales of securities and loans, federal funds lines of credit from correspondent banks and borrowings from the Federal Reserve Discount Window, as well as additional out-of-market time deposits and brokered deposits. While the Company believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands, particularly if the Company continues to grow and experiences increasing loan demand. The Company may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.
The Company may need to raise additional capital in the future and may not be able to do so on acceptable terms, or at all.
Access to sufficient capital is critical in order to enable the Company to implement its business plan, support its business, expand its operations and meet applicable capital requirements. The inability to have sufficient capital, whether internally generated through earnings or raised in the capital markets, could adversely impact the Company’s ability to support and to grow its operations. If the Company grows its operations faster than it generates capital internally, it will need to access the capital markets. The Company may not be able to raise additional capital in the form of additional debt or equity on acceptable terms, or at all. The Company’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, the Company’s financial condition and its results of operations. Economic conditions and a loss of confidence in financial institutions may increase the Company’s cost of capital and limit access to some sources of capital. Further, if the Company needs to raise capital in the future, it may have to do so when many other financial institutions are also seeking to raise capital and would then have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a material adverse impact on the Company’s business, financial condition and results of operations.
Market Risks
The Company may be adversely impacted by changes in market conditions.
The Company is directly and indirectly affected by changes in market conditions. Market risk generally represents the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions. As a financial institution, market risk is inherent in the financial instruments associated with the Company’s operations and activities, including loans, deposits, securities, and short-term borrowings. A few of the market conditions that may shift from time to time, thereby exposing the Company to market risk, include fluctuations in interest rates, equity and futures prices, and price deterioration or changes in value due to changes in market perception or actual credit quality of issuers. The Company’s investment securities portfolio, in particular, may be impacted by market conditions beyond its control, including rating agency downgrades of the securities, defaults of the issuers of the securities, lack of market pricing of the securities, and inactivity or instability in the credit markets. Any changes in these conditions, in current accounting principles or interpretations of these principles could impact the Company’s assessment of fair value and thus the determination of other-than-temporary impairment of the securities in the investment securities portfolio, which could adversely affect the Company’s earnings and capital ratios.
Asset values also directly impact revenues in the Company’s wealth management businesses. The Company receives asset-based management fees based on the value of clients’ portfolios or investments in funds managed by the Company and, in some cases, the Company may also receive performance fees based on increases in the value of such investments. Declines in asset values can reduce the value of clients’ portfolios or fund assets, which in turn can result in lower fees earned for managing such assets.
Changes in economic conditions, especially in the areas in which the Company conducts operations, could materially and negatively affect its business.
The Company’s business is directly impacted by economic conditions, legislative and regulatory changes, changes in government monetary and fiscal policies, and inflation, all of which are beyond its control. A deterioration in economic conditions, whether caused by global, national or local concerns (including the COVID-19 pandemic), especially within the Company’s market area, could result in the following potentially material consequences: loan delinquencies increasing; problem assets and foreclosures increasing; demand for products and services decreasing; low cost or noninterest bearing deposits decreasing; and collateral for loans, especially real estate, declining in value, in turn reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans. A continued economic downturn could result in losses that materially and adversely affect the Company’s business.
The Company’s business is subject to interest rate risk, and variations in interest rates and inadequate management of interest rate risk may negatively affect financial performance.
Changes in the interest rate environment may reduce the Company’s profits. It is expected that the Company will continue to realize income from the differential or “spread” between the interest earned on loans, securities, and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and the current interest rate environment encourages extreme competition for new loan originations from qualified borrowers. The Company’s management cannot ensure that it can minimize interest rate risk. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Accordingly, changes in levels of market interest rates could materially and adversely affect the net interest spread, asset quality, loan origination volume and the Company’s overall profitability.
Following the COVID-19 outbreak, market interest rates have declined significantly. These reductions in interest rates may adversely affect the Company’s financial condition and results of operations.
The Company may be adversely affected by changes in the method of determining LIBOR, or the replacement of LIBOR with an alternative reference rate, for variable rate loans.
The Company has certain variable-rate loans indexed to LIBOR to calculate the loan interest rate. The United Kingdom Financial Conduct Authority, which regulates LIBOR, has proposed to extend publication of the most commonly used U.S. dollar LIBOR settings to June 30, 2023 and to cease publishing other LIBOR settings on December 31, 2021. The U.S. federal banking agencies have issued guidance strongly encouraging banking organizations to cease using U.S. dollar LIBOR as a reference rate in new contracts as soon as practicable and in any event by December 31, 2021. It is not possible to know whether LIBOR will continue to be viewed as an acceptable market benchmark, what rates or rates may become accepted alternatives to LIBOR, or what the effect of any such changes in views or alternative may have on the financial markets for LIBOR-linked financial instruments.
The implementation of a substitute index or indices for the calculation of interest rates under the Company’s loan agreements with borrowers or other financial arrangements may cause the Company to incur significant expenses in effecting the transition, may result in reduced loan balances if borrowers do not accept the substitute index or indices, and may result in disputes or litigation with customers or other counter-parties over the appropriateness or comparability to LIBOR of the substitute index or indices, any of which could have a material adverse effect on the Company’s results of operations.
The Company relies upon independent appraisals to determine the value of the real estate that secures a significant portion of its loans and the value of any foreclosed properties that may be carried on its books, and the values indicated by such appraisals may not be realizable if it is forced to foreclose upon such loans or liquidate such foreclosed property.
As indicated above, a significant portion of the Company’s loan portfolio consists of loans secured by real estate and it may also hold foreclosed properties from time to time. The Company relies upon independent appraisers to estimate the value of such real estate. Appraisals are only estimates of value and the independent appraisers may make mistakes of fact or judgment that adversely affect the reliability of their appraisals. In addition, events occurring after the initial appraisal may cause the value of the real estate to increase or decrease. As a result of any of these factors, the real estate securing some of the Company’s loans and any foreclosed properties that may be held by the Company may be more or less valuable than anticipated. If a default occurs on a loan secured by real estate that is less valuable than originally estimated, the Company may not be able to recover the outstanding balance of the loan. It may also be unable to sell any foreclosed properties for the values estimated by their appraisals.
Strategic Risks
The Company faces strong and growing competition from financial services companies and other companies that offer banking and other financial services, which could negatively affect the Company’s business.
The Company encounters substantial competition from other financial institutions in its market area and competition is increasing. Ultimately, the Company may not be able to compete successfully against current and future competitors. Many competitors offer the same banking services that the Company offers in its service area. These competitors include national, regional and community banks. The Company also faces competition from many other types of financial institutions, including finance companies, mutual and money market fund providers, brokerage firms, insurance companies, credit unions, financial subsidiaries of certain industrial corporations, financial technology companies and mortgage companies. Increased competition may result in reduced business for the Company.
Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain loans and deposits, and range and quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking customers,
it may be unable to continue to grow loan and deposit portfolios and its results of operations and financial condition may otherwise be adversely affected.
The Company may not be able to successfully manage its long-term growth, which may adversely affect its results of operations and financial condition.
A key aspect of the Company’s long-term business strategy is its continued growth and expansion. The Company’s ability to continue to grow depends, in part, upon its ability to (i) open new branch offices or acquire existing branches or other financial institutions, such as Fauquier, (ii) attract deposits to those locations, and (iii) identify attractive loan and investment opportunities.
The Company may not be able to successfully implement its growth strategy if it is unable to identify attractive markets, locations or opportunities to expand in the future, or if the Company is subject to regulatory restrictions on growth or expansion of its operations. The Company’s ability to manage its growth successfully also will depend on whether it can maintain capital levels adequate to support its growth, maintain cost controls and asset quality and successfully integrate any businesses the Company acquires into its organization. As the Company identifies opportunities to implement its growth strategy by opening new branches or acquiring branches or other banks, it may incur increased personnel, occupancy and other operating expenses. In the case of new branches, the Company must absorb those higher expenses while it begins to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding assets.
The Company may consider acquiring other businesses or expanding into new product lines that it believes will help it fulfill its strategic objectives. The Company expects that other banking and financial companies, some of which have significantly greater resources, will compete with it to acquire financial services businesses. This competition could increase prices for potential acquisitions that the Company believes are attractive. Acquisitions may also be subject to various regulatory approvals. If the Company fails to receive the appropriate regulatory approvals, it will not be able to consummate acquisitions that it believes are in its best interests.
When the Company enters into new markets or new lines of business, its lack of history and familiarity with those markets, clients and lines of business may lead to unexpected challenges or difficulties that inhibit its success. The Company’s plans to expand could depress earnings in the short run, even if it efficiently executes a growth strategy leading to long-term financial benefits.
The success of the Company’s strategy depends on its ability to identify and retain individuals with experience and relationships in its markets.
In order to be successful, the Company must identify and retain experienced key management members and sales staff with local expertise and relationships. Competition for qualified personnel is intense and there is a limited number of qualified persons with knowledge of and experience in the community banking and mortgage industry in the Company’s chosen geographic market. Even if the Company identifies individuals that it believes could assist it in building its franchise, it may be unable to recruit these individuals away from their current employers. In addition, the process of identifying and recruiting individuals with the combination of skills and attributes required to carry out the Company’s strategy is often lengthy. The Company’s inability to identify, recruit and retain talented personnel could limit its growth and could materially adversely affect its business, financial condition and results of operations.
Operational Risks
The Company is subject to a variety of operational risks, including reputational risk, legal and compliance risk, and the risk of fraud or theft by employees or outsiders.
The Company is exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees, operational errors, clerical or record-keeping errors, and errors resulting from faulty or disabled computer or communications systems.
Reputational risk, or the risk to the Company’s earnings and capital from negative public opinion, could result from the Company’s actual or alleged conduct in any number of activities, including lending practices, corporate governance, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect the Company’s ability to attract and keep customers and employees and can expose it to litigation and regulatory action.
Further, if any of the Company’s financial, accounting, or other data processing systems fail or have other significant issues, the Company could be adversely affected. The Company depends on internal systems and outsourced technology to support these data storage and processing operations. The Company’s inability to use or access these information systems at critical points in time could unfavorably impact the timeliness and efficiency of the Company’s business operations. It could be adversely affected if one of its employees causes a significant operational break-down or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates its operations or systems. The Company is also at risk of the impact of natural disasters, terrorism and international hostilities on its systems and from the effects of outages or other failures involving power or communications systems operated by others. The Company may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (for example, computer viruses or electrical or communications outages), which may give rise to disruption of service to customers and to financial loss or liability. In addition, there have been instances where financial institutions have been victims of fraudulent activity in which criminals pose as customers to initiate wire and automated clearinghouse transactions out of customer accounts. Although the Company has policies and procedures in place to verify the authenticity of its customers, it cannot guarantee that such policies and procedures will prevent all fraudulent transfers. Such activity can result in financial liability and harm to the Company’s reputation. If any of the foregoing risks materialize, it could have a material adverse effect on the Company’s business, financial condition and results of operations.
Changes in accounting standards could impact reported earnings.
The authorities that promulgate accounting standards, including the Financial Accounting Standards Board (“FASB”), the SEC and other regulatory authorities, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes are difficult 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 the restatement of financial statements for prior periods. Such changes could also require the Company to incur additional personnel or technology costs.
Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on the Company’s results of operation and financial condition.
Effective internal and disclosure controls are necessary for the Company to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. The Bank is also required to establish and maintain an adequate internal control structure over financial reporting pursuant to regulations of the FDIC. As a public company, the Company is required by the Sarbanes-Oxley Act to design and maintain a system of internal control over financial reporting and include management’s assessment regarding internal control over financial reporting. If the Company cannot provide reliable financial reports or prevent fraud, its reputation and operating results would be harmed. As part of the Company’s ongoing monitoring of internal control, it may discover material weaknesses or significant deficiencies in its internal control that require remediation. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.
The Company’s inability to maintain the operating effectiveness of the controls described above could result in a material misstatement to the Company’s financial statements or other disclosures, which could have an adverse effect on its business, financial condition or results of operations. In addition, any failure to maintain effective controls or to timely effect any necessary improvement of the Company’s internal and disclosure controls could, among other things, result in losses from fraud or error, harm the Company’s
reputation or cause investors to lose confidence in its reported financial information, all of which could have a material adverse effect on its results of operation and financial condition.
The Company depends on the accuracy and completeness of information about clients and counterparties, and the Company’s financial condition could be adversely affected if it relies on misleading or incorrect information.
In deciding whether to extend credit or to enter into other transactions with clients and counterparties, the Company may rely on information furnished to it by or on behalf of clients and counterparties, including financial statements and other financial information, which it does not independently verify. The Company also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, the Company may assume that a client’s audited financial statements conform with GAAP and present fairly, in all material respects, the financial condition, results of operations and cash flows of that client. The Company’s financial condition and results of operations could be negatively impacted to the extent it relies on financial statements that do not comply with GAAP or are materially misleading.
The Company’s success depends on its management team, and the unexpected loss of any of these personnel could adversely affect operations.
The Company’s success is, and is expected to remain, highly dependent on its management team. This is particularly true because, as a community bank, the Company depends on the management team’s ties to the community and customer relationships to generate business. The Company’s growth will continue to place significant demands on management, and the loss of any such person’s services may have an adverse effect upon growth and profitability. If the Company fails to retain or continue to recruit qualified employees, growth and profitability could be adversely affected.
The Company relies on other companies to provide key components of its business infrastructure.
Third parties provide key components of the Company’s business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, internet connections and network access. While the Company has selected these third-party vendors carefully, it does not control their actions. Any problem caused by these third parties, including poor performance of services, failure to provide services, disruptions in communication services provided by a vendor and failure to handle current or higher volumes, could adversely affect the Company’s ability to deliver products and services to its customers and otherwise conduct its business, and may harm its reputation. Financial or operational difficulties of a third-party vendor could also hurt the Company’s operations if those difficulties interfere with the vendor’s ability to serve the Company. Replacing these third-party vendors could also create significant delay and expense. Accordingly, use of such third-parties creates an unavoidable inherent risk to the Company’s business operations.
The soundness of other financial institutions could adversely affect the Company.
The Company’s 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. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. In addition, credit risk may be exacerbated when the collateral held cannot be realized upon or is liquidated at prices insufficient to recover the full amount of the financial instrument exposure due. There is no assurance that any such losses would not materially and adversely affect results of operations.
The Company’s operations may be adversely affected by cybersecurity risks.
In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information (“PII”) related to its customers and employees in systems and on networks. The secure processing, maintenance, and use of this information is critical to operations and the Company’s business strategy. The Company has invested in accepted technologies, and continually reviews processes and practices that are designed to protect its networks, computers, and data from damage or unauthorized access. Despite these security measures, the Company’s computer systems and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. A breach of any kind could compromise systems and the information stored there could be accessed, damaged or disclosed. A breach in security could result in legal claims, regulatory penalties, disruption in operations, and damage to the Company’s reputation, which could adversely affect its business and financial condition. Furthermore, as cyber threats continue to evolve and increase, the Company may be required to expend significant additional financial and operational resources to modify or enhance its protective measures, or to investigate and remediate any identified information security vulnerabilities.
In addition, multiple major U.S. retailers have experienced data systems incursions reportedly resulting in the thefts of credit and debit card information, online account information and other financial or privileged data. Retailer incursions affect cards issued and deposit accounts maintained by many banks, including Virginia National Bank. Although the Company’s systems are not breached in retailer incursions, these events can cause it to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Company and its customers. In some cases, the Company may be required to reimburse customers for the losses they incur. Other possible points of intrusion or disruption not within the Company’s control include internet service providers, electronic mail portal providers, social media portals, distant-server (cloud) service providers, electronic data security providers, data processing service providers, telecommunications companies, and smart phone manufacturers.
Consumers may increasingly decide not to use banks to complete their financial transactions, which would have a material adverse impact on the Company’s financial condition and operations.
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s ability to operate profitably may be dependent on its ability to integrate or introduce various technologies into its operations.
The market for financial services, including banking and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, online banking and tele-banking. The Company’s ability to compete successfully in its market may depend on the extent to which it is able to implement or exploit such technological changes. If the Company is not able to afford such technologies, properly or timely anticipate or implement such technologies, or effectively train its staff to use such technologies, its business, financial condition or operating results could be adversely affected.
Legal, Regulatory and Compliance Risks
The Company operates in a highly regulated industry and the laws and regulations that govern the Company’s operations, corporate governance, executive compensation and financial accounting, or reporting, including changes in them or the Company’s failure to comply with them, may adversely affect the Company.
The Company is subject to extensive regulation and supervision that govern almost all aspects of its operations. These laws and regulations, among other matters, prescribe minimum capital requirements, impose limitations on the Company’s business activities, limit the dividends or distributions that it can pay, restrict the ability of institutions to guarantee its debt and impose certain specific accounting requirements that may be more restrictive and may result in greater or earlier charges to earnings or reductions in its capital than GAAP. Compliance with laws and regulations can be difficult and costly, and changes to laws and regulations often impose additional compliance costs.
The Company is currently facing increased regulation and supervision of its industry as a result of the financial crisis in the banking and financial markets. The Dodd-Frank Act instituted major changes to the banking and financial institutions regulatory regimes. Other changes to statutes, regulations or regulatory policies or supervisory guidance, including changes in interpretation or implementation of statutes, regulations, policies or supervisory guidance, could affect the Company in substantial and unpredictable ways. Such additional regulation and supervision has increased, and may continue to increase, the Company’s costs and limit its ability to pursue business opportunities. Further, the Company’s failure to comply with these laws and regulations, even if the failure was inadvertent or reflects a difference in interpretation, could subject it to restrictions on its business activities, fines and other penalties, any of which could adversely affect the Company’s results of operations, capital base and the price of its securities. Further, any new laws, rules and regulations could make compliance more difficult or expensive or otherwise adversely affect the Company’s business and financial condition.
Regulations issued by the CFPB could adversely impact earnings due to, among other things, increased compliance costs or costs due to noncompliance.
The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. The CFPB has also been directed to write rules identifying practices or acts that are unfair, deceptive or abusive in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. For example, the CFPB issued a final rule, effective January 10, 2014, requiring 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, or to originate “qualified mortgages” that meet specific requirements with respect to terms, pricing and fees. The rule also contains additional disclosure requirements at mortgage loan origination and in monthly statements. The requirements under the CFPB’s regulations and policies could limit the Company’s ability to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could adversely impact the Company’s profitability.
The Company is subject to laws regarding the privacy, information security and protection of personal information and any violation of these laws or another incident involving personal, confidential or proprietary information of individuals could damage the Company’s reputation and otherwise adversely affect its business.
The Company’s business requires the collection and retention of large volumes of customer data, including PII in various information systems that the Company maintains and in those maintained by third party service providers. The Company also maintains important internal company data such as PII about its employees and information relating to its operations. The Company is subject to complex and evolving laws and regulations governing the privacy and protection of PII of individuals (including customers, employees and other third-parties). For example, the Company’s business is subject to the Gramm-Leach-Bliley Act of 1999, which, among other things: (i) imposes certain limitations on the Company’s ability to share nonpublic
PII about its customers with nonaffiliated third parties; (ii) requires that the Company provides certain disclosures to customers about its information collection, sharing and security practices and affords customers the right to “opt out” of any information sharing by it with nonaffiliated third parties (with certain exceptions); and (iii) requires that the Company develops, implements and maintains a written comprehensive information security program containing appropriate safeguards based on the Company’s size and complexity, the nature and scope of its activities, and the sensitivity of customer information it processes, as well as plans for responding to data security breaches. Various federal and state banking regulators and states have also enacted data breach notification requirements with varying levels of individual, consumer, regulatory or law enforcement notification in the event of a security breach. Ensuring that the Company’s collection, use, transfer and storage of PII complies with all applicable laws and regulations can increase the Company’s costs. Furthermore, the Company may not be able to ensure that customers and other third parties have appropriate controls in place to protect the confidentiality of the information that they exchange with us, particularly where such information is transmitted by electronic means. If personal, confidential or proprietary information of customers or others were to be mishandled or misused, the Company could be exposed to litigation or regulatory sanctions under privacy and data protection laws and regulations. Concerns regarding the effectiveness of the Company’s measures to safeguard PII, or even the perception that such measures are inadequate, could cause the Company to lose customers or potential customers and thereby reduce its revenues. Accordingly, any failure, or perceived failure, to comply with applicable privacy or data protection laws and regulations may subject the Company to inquiries, examinations and investigations that could result in requirements to modify or cease certain operations or practices or in significant liabilities, fines or penalties, and could damage the Company’s reputation and otherwise adversely affect its operations, financial condition and results of operations.
The Company’s business and earnings are impacted by governmental, fiscal and monetary policy over which it has no control.
The Company is affected by domestic monetary policy. The Federal Reserve regulates the supply of money and credit in the United States, and its policies determine in large part the Company’s cost of funds for lending, investing and capital raising activities and the return it earns on those loans and investments, both of which affect the Company’s net interest margin. The actions of the Federal Reserve also can materially affect the value of financial instruments that the Company holds, such as loans and debt securities, and also can affect the Company’s borrowers, potentially increasing the risk that they may fail to repay their loans. The Company’s business and earnings also are affected by the fiscal or other policies that are adopted by various regulatory authorities of the United States. Changes in fiscal or monetary policy are beyond the Company’s control and hard to predict.
Risks Related to the Proposed Merger with Fauquier
Failure of the Company’s proposed merger with Fauquier to be completed, the termination of the merger agreement, or a significant delay in completing the merger could negatively impact the Company.
The merger agreement between the Company and Fauquier is subject to a number of conditions that must be fulfilled in order to complete the merger. These conditions to the consummation of the merger may not be fulfilled and, accordingly, the merger may not be completed. In addition, if the merger is not completed by September 30, 2021, either the Company or Fauquier may terminate the merger agreement at any time after that date if the failure of the effective time to occur on or before that date is not caused by any breach of the merger agreement by the party electing to terminate the merger agreement.
Any delay in completion of the merger may have a material adverse effect on the Company’s and Fauquier’s business during the pendency of the merger, and on the Company’s business and results of operations following the merger, due to potential diversion of management attention from other opportunities, constraints contained in the merger agreement on the Company’s business during the pendency of the merger, the incurrence of additional merger-related expenses, and negative reactions by markets and customers. If the merger is not completed, the ongoing business, financial condition and results of operations of the Company may be materially adversely affected and the market price of the Company’s
common stock may decline significantly, particularly to the extent that the current market price reflects a market assumption that the merger will be completed.
In addition, the Company’s business may have been adversely impacted by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger.
Combining the Company and Fauquier may be more difficult, costly or time-consuming than expected.
The success of the merger will depend, in part, on the Company’s ability to realize the anticipated benefits and cost savings from combining the businesses of the Company and Fauquier. To realize such anticipated benefits and cost savings, the Company must successfully combine the businesses of the Company and Fauquier in a manner that permits growth opportunities and cost savings to be realized without materially disrupting the existing customer relationships of Fauquier or the Company or decreasing revenues due to loss of customers. If the Company is not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully, or at all, or may take longer to realize than expected.
The Company and Fauquier have operated, and, until the completion of the merger, will continue to operate, independently. After the completion of the merger, the Company will integrate Fauquier’s business into its own. The integration process in the merger could result in one or more of the following: loss of key employees, disruption of each party’s ongoing business, and inconsistencies in standards, controls, procedures and policies that may adversely affect either party’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the merger. The loss of key employees could adversely affect the Company’s ability to successfully conduct its business in the markets in which Fauquier now operates, which could have an adverse effect on the Company’s financial results and the value of its common stock. If the Company experiences difficulties with the integration process, the anticipated benefits of the 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 disruptions that cause the Company and Fauquier to lose customers or cause customers to withdraw their deposits from the Company’s or Fauquier’s banking subsidiaries, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition after the merger. These integration matters could have an adverse effect on each of the Company and Fauquier during this transition period and for an undetermined period after consummation of the merger.
The Company may not be able to effectively integrate the operations of The Fauquier Bank and the Bank.
The future operating performance of the Bank will depend, in part, on the success of the merger of the Bank and The Fauquier Bank, which is expected to occur as soon as practicable after the merger of the Company and Fauquier. The success of the bank merger will, in turn, depend on a number of factors, including the Company’s ability to (i) integrate the operations and branches of the Bank and The Fauquier Bank, (ii) retain the deposits and customers of the Bank and The Fauquier Bank, (iii) control the incremental increase in noninterest expense arising from the merger in a manner that enables the continuing bank to improve its overall operating efficiencies and (iv) retain and integrate the appropriate personnel of The Fauquier Bank with the operations of the Bank. The integration of the Bank and The Fauquier Bank following the bank merger will require the dedication of the time and resources of the banks’ management teams and may temporarily distract the management teams’ attention from the day-to-day business of the banks. If the Bank and The Fauquier Bank are unable to successfully integrate, the Company may not be able to realize expected operating efficiencies and eliminate redundant costs.
Risks Related to the Company’s Common Stock
The Company is not obligated to pay dividends and its ability to pay dividends is limited.
The Company’s ability to make dividend payments on its common stock depends primarily on certain regulatory considerations and the receipt of dividends and other distributions from the Bank. There are various regulatory restrictions on the ability of banks, such as the Bank, to pay dividends or make other payments to their holding companies. The Company is currently paying a quarterly cash dividend to holders of its common stock at a rate of $0.30 per share. Although the Company has paid a quarterly cash dividend to the holders of its common stock since July 2013, holders of its common stock are not entitled to receive dividends, and the Company is not obligated to pay dividends in any particular amounts or at any particular times. Regulatory, economic and other factors may cause the Company’s Board to consider, among other things, the reduction of dividends paid on its common stock.
Future issuances of the Company’s common stock could adversely affect the market price of the common stock and could be dilutive.
The Company’s Board, without the approval of shareholders, could from time to time decide to issue additional shares of common stock or shares of preferred stock, which may adversely affect the market price of the shares of common stock and could be dilutive to the Company’s shareholders. Any sale of additional shares of the Company’s common stock may be at prices lower than the current market value of the Company’s shares. In addition, new investors may have rights, preferences and privileges that are senior to, and that could adversely affect, the Company’s existing shareholders. For example, preferred stock would be senior to common stock in right of dividends and as to distributions in liquidation. The Company cannot predict or estimate the amount, timing, or nature of its future offerings of equity securities. Thus, the Company’s shareholders bear the risk of future offerings diluting their stock holdings, adversely affecting their rights as shareholders, and/or reducing the market price of the Company’s common stock.
The Company’s common stock currently has a limited trading market and is thinly traded, and a more liquid market for its common stock may not develop, which may limit the ability of shareholders to sell their shares and may increase price volatility.
The Company’s common stock is quoted on the OTC Markets Group’s OTCQX marketplace under the symbol “VABK.” The Company’s common stock is thinly traded and has substantially less liquidity than the trading markets for many other bank holding companies. Although the Company has agreed to use its best efforts to list its common stock on a national stock exchange in connection with the proposed merger with Fauquier, the Company will be required to meet the initial listing requirements of such exchange to be listed. The Company may not be able to meet those initial listing requirements, and even if the Company’s common stock is so listed, the Company may be unable to maintain the listing of its common stock in the future. In addition, there can be no assurance that an active trading market for shares of the Company’s common stock will develop or if one develops, that it can be sustained. The development of a liquid public market depends on the existence of willing buyers and sellers, the presence of which is not within the Company’s control. Therefore, the Company’s shareholders may not be able to sell their shares at the volume, prices, or times that they desire. Shareholders should be financially prepared and able to hold shares for an indefinite period. In addition, thinly traded stocks can be more volatile than more widely traded stocks. the Company’s stock price has been volatile in the past and several factors could cause the price to fluctuate substantially in the future. These factors include, but are not limited to, changes in analysts’ recommendations or projections, developments related to the Company’s business and operations, stock performance of other companies deemed to be peers, news reports of trends, concerns, irrational exuberance on the part of investors, and other issues related to the financial services industry. The Company’s stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to its performance. General market declines or market volatility in the future, especially in the financial institutions sector of the economy, could adversely affect the price of the Company’s common stock, and the current market price may not be indicative of future market prices.
The Company’s governing documents and Virginia law contain provisions that may discourage or delay an acquisition of the Company even if such acquisition or transaction is supported by shareholders.
Certain provisions of the Company’s articles of incorporation could delay or make a merger, tender offer or proxy contest involving the Company more difficult, even in instances where the shareholders deem the proposed transaction to be beneficial to their interests. One provision, among others, provides that a plan of merger, share exchange, or sale of all or substantially all of the Company’s assets must be approved by the affirmative vote of more than two-thirds of the outstanding capital stock of the Company entitled to vote on the transaction if the transaction is not approved and recommended by at least two-thirds of the Company’s Board. In addition, certain provisions of state and federal law may also have the effect of discouraging or prohibiting a future takeover attempt in which the Company shareholders might otherwise receive a substantial premium for their shares over then-current market prices. To the extent that these provisions discourage or prevent takeover attempts, they may tend to reduce the market price for the Company’s common stock.
An investment in the Company’s common stock is not an insured deposit.
The Company’s common stock is not a bank deposit and, therefore, it is not insured against loss by the FDIC or by any other public or private entity. An investment in the Company’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company and, as a result, shareholders may lose some or all of their investment.
The Company qualifies as a “smaller reporting company,” and the reduced disclosure obligations applicable to smaller reporting companies may make its common stock less attractive to investors.
The Company is a “smaller reporting company” as defined in federal securities laws, and will remain a smaller reporting company until the fiscal year following the determination that the market value of its voting and non-voting common shares held by non-affiliates is more than $250 million measured on the last business day of its second fiscal quarter, or its annual revenues are less than $100 million during the most recently completed fiscal year and the market value of its voting and non-voting common shares held by non-affiliates is more than $700 million measured on the last business day of its second fiscal quarter. Smaller reporting companies have reduced disclosure obligations, such as an exemption from providing selected financial data and an ability to provide simplified executive compensation information and only two years of audited financial statements. If some investors find the Company’s common stock less attractive because the Company may rely on these reduced disclosure obligations, there may be a less active trading market for its common stock and its stock price may be more volatile.
General Risk Factors
The ongoing COVID-19 pandemic and measures intended to prevent its spread may adversely affect the Company’s business, financial condition and operations; the extent of such impacts are highly uncertain and difficult to predict.
Global health and economic concerns relating to the COVID-19 pandemic and government actions taken to reduce the spread of the virus have had a material adverse impact on the macroeconomic environment, and the outbreak has significantly increased economic uncertainty. The pandemic has resulted in federal, state and local authorities, including those who govern the markets in which it operates, implementing numerous measures to try to contain the virus. These measures, including shelter in place orders and business limitations and shutdowns, have significantly contributed to rising unemployment and negatively impacted consumer and business spending.
The COVID-19 pandemic has adversely impacted and is likely to continue to adversely impact the Company’s workforce and operations and the operations of its customers and business partners. In particular, the Company may experience adverse effects due to a number of operational factors impacting it or its customers or business partners, including but not limited to: (i) loan losses resulting from financial stress experienced by the Company’s borrowers, especially those operating in industries hardest hit by government measures to contain the spread of the virus; (ii) collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase; (iii) as a result of the decline in the Federal Reserve’s target federal funds rate, the yield on the Company’s assets may decline to a greater extent than the decline in its cost of interest-bearing liabilities, reducing net interest margin and spread, and reducing
net income; (iv) operational failures, disruptions or inefficiencies due to changes in the Company’s normal business practices necessitated by its internal measures to protect employees and government-mandated measures intended to slow the spread of the virus; (v) possible business disruptions experienced by the Company’s vendors and business partners in carrying out work that supports its operations; (vi) decreased demand for the Company’s products and services due to economic uncertainty, volatile market conditions and temporary business closures; (vii) potential financial liability, loan losses, litigation costs or reputational damage resulting from the Company’s origination of loans as a participating lender in the PPP as administered through the SBA; and (viii) heightened levels of cyber and payment fraud, as cyber criminals try to take advantage of the disruption and increased online activity brought about by the pandemic.
The extent to which the pandemic impacts the Company’s business, liquidity, financial condition and operations will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, its duration and severity, the actions to contain it or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. In addition, the rapidly changing and unprecedented nature of COVID-19 heightens the inherent uncertainty of forecasting future economic conditions and their impact on the Company’s loan portfolio, thereby increasing the risk that the assumptions, judgments and estimates used to determine the ALLL and other estimates are incorrect. Further, the Company’s loan deferral program could delay or make it difficult to identify the extent of asset quality deterioration during the deferral period. As a result of these and other conditions, the ultimate impact of the pandemic is highly uncertain and subject to change, and the Company cannot predict the full extent of the impacts on its business, its operations or the global economy as a whole. To the extent any of the foregoing risks or other factors that develop as a result of COVID-19 materialize, it could exacerbate the other risk factors discussed in this report or otherwise and materially and adversely affect the Company’s business, liquidity, financial condition and results of operations.
As a participating lender in the SBA’s PPP, the Company may be subject to additional risks regarding the Bank’s processing of PPP loans and are dependent on the federal government’s continuation and support of the program.
Due to the short timeframe between the passing of the CARES Act and the beginning of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP. Several large banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. The Company may be exposed to the risk of litigation, from both customers and non-customers who approached the Bank requesting PPP loans, regarding the process and procedures used by the Bank in processing applications for the PPP. Any such litigation filed against the Company or the Bank may be costly, regardless of the outcome, and result in significant financial liability or adversely affect our reputation. Any financial liability, litigation costs or reputational damage caused by PPP-related litigation could have a material adverse impact on the Company’s business, financial condition and results of operations.
In addition, while the PPP loans are fully guaranteed by the SBA and the majority of these loans will be forgiven, there can be no assurance that the borrowers will use or have used the funds appropriately or will have satisfied the staffing or payment requirements to qualify for forgiveness in whole or in part. Any portion of the loan that is not forgiven must be repaid by the borrower. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded or serviced by the Bank, which may or may not be related to an ambiguity in the laws, rules or guidance regarding operation of the PPP, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if the Bank has already been paid under the guaranty, seek recovery from the Bank of any loss related to the deficiency.
The Company is exposed to risk of environmental liabilities with respect to properties to which it takes title.
In the course of its business, the Company may foreclose and take title to real estate, potentially becoming subject to environmental liabilities associated with the properties. The Company may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs or the Company may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. Costs associated with investigation or remediation activities can be substantial. If the Company is the owner or former owner of a contaminated site, it may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. These costs and claims could adversely affect the Company’s business.
Severe weather, earthquakes, other natural disasters, pandemics, acts of war or terrorism and other external events could significantly impact our business.
Severe weather, earthquakes, other natural disasters, pandemics (such as the COVID-19 pandemic), acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. 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, results in loss of revenue and/or cause the Company to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such events could have a material adverse effect on our business, financial condition and results of operations.
Item 1B.
Item 1B.
UNRESOLVED STAFF COMMENTS.
None
Item 2.
Item 2.
PROPERTIES.
The Company and its subsidiaries currently occupy five full-service banking facilities in Charlottesville, Winchester, and Albemarle County. The Company’s main office, a full-service banking facility, operations, and offices of both Masonry Capital and Sturman Wealth Advisors are located at 404 People Place, Charlottesville, Virginia. Full-service banking facilities are also located at 222 East Main Street, Charlottesville, Virginia; 1580 Seminole Trail, Charlottesville, Virginia; 1900 Arlington Boulevard, Charlottesville, Virginia; and 3119 Valley Avenue, #102, Winchester, Virginia. VNB Trust and Estate Services is located at 112 Third Street, SE, Charlottesville, Virginia, which is part of the same leased space that the Company uses to operate a drive-through location at 301 East Water Street, Charlottesville, Virginia.
The five-story building located at 404 People Place, Charlottesville, Virginia (the “Pantops Building”), just east of the Charlottesville city limits on Pantops Mountain, was constructed by the Bank on a pad site leased in 2005 from Pantops Park, LLC for a term of twenty years, with seven five-year renewal options. William D. Dittmar, Jr., a director of the Company, is the manager and indirect owner of Pantops Park, LLC. Monthly rent for this space is a fair market rate as verified by an independent third-party appraisal. The building, consisting of approximately 43,000 square feet, was completed in early 2008, and the Bank opened this full-service office in April 2008. In addition to the Company’s use of this building as outlined in the preceding paragraph, a portion of the additional space is leased to tenants.
The drive-through location at 301 East Water Street, Charlottesville and the adjoining office space located at 112 Third Street, SE, Charlottesville Virginia (the “Water and Third Street Property”) is leased from East Main Investments, LLC. Hunter E. Craig, a director of the Company and the Bank, serves as manager of East Main Investments, LLC, which is owned by Mr. Craig and his spouse.
The property located at 1580 Seminole Trail, Charlottesville, Virginia has been fully owned by the Company since 2012. As of December 31, 2020, all of the other locations were leased from parties other than related parties other than the Pantops Building and the Water and Third Street Property. The banking facility located at 1900 Arlington Boulevard, Charlottesville, Virginia, was constructed by the Bank on a pad site which is leased by the Company; this facility has additional space not occupied by the banking facility that has been leased to tenants.
See Note 5 - Premises and Equipment and Note 6 - Leases in the Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data for information with respect to the
amounts at which the Company’s premises and equipment are carried and commitments under long-term leases.
Item 3.
Item 3.
LEGAL PROCEEDINGS.
In the ordinary course of its operations, the Company and/or its subsidiaries are parties to various legal proceedings from time to time. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome of such proceedings, in the aggregate, will not have a material adverse effect on the business or financial condition of the Company and its subsidiaries.
Item 4.
Item 4.
MINE SAFETY DISCLOSURES.
Not applicable
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
Virginia National Bankshares Corporation’s common stock is quoted on the OTC Markets Group’s OTCQX tier (“OTCQX”) under the symbol VABK. As of December 31, 2020, the Company had issued and outstanding 2,714,273 shares of common stock, which included 25,268 shares of restricted stock that have not yet vested. These shares were held by approximately 450 registered shareholders of record, not including beneficial holders of securities held in street name at a brokerage or other firm.
The payment of dividends is at the discretion of the Company’s Board of Directors and is subject to various federal and state regulatory limitations. As a bank holding company, the ability to pay dividends is dependent upon the overall performance and capital requirements of the Bank.
The data in the table below represents the high bid and low bid quotations that occurred for the periods shown, as reported by the OTCQX, for the years ended December 31, 2020 and December 31, 2019. These over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. Additionally, the table shows the dividends declared per quarter in 2020 and 2019.
On June 13, 2019, the Company’s Board of Directors declared a 5% stock dividend to be paid on July 5, 2019 to shareholders of record as of June 26, 2019. Shareholders received cash in lieu of fractional shares. American Stock Transfer and Trust Company is the Company’s stock transfer agent and registrar.
Recent Issuances of Unregistered Securities
During 2019, the Company issued 4,902 unregistered shares of the Company’s common stock at an exercise price of $16.56 in connection with the exercise of stock options by current directors, former directors and employees under the Company’s 2003 Stock Incentive Plan. These shares were not registered under the Securities Act and were issued in reliance upon the exemption from registration provided by Section 4(a)(2) of the Securities Act on the basis that such issuance did not involve any public offering. Shares issued prior to July 5, 2019 have been adjusted for the 5% stock dividend effective on such date. No unregistered shares were issued in 2018 or 2020.
Item 6.
Item 6.
SELECTED FINANCIAL DATA.
Not required.
Item 7.
Item 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of Virginia National Bankshares Corporation. This discussion and analysis should be read in conjunction with the consolidated financial statements and Notes to Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data.
Proposed Merger with Fauquier Bankshares, Inc. and The Fauquier Bank
On October 1, 2020, the Company announced the signing of a definitive merger agreement with Fauquier, pursuant to which the companies are expected to combine in an all-stock merger with the Company as the surviving company. At or immediately following consummation of the merger, The Fauquier Bank, the wholly owned banking subsidiary of Fauquier, will be merged with and into the Bank, with the Bank as the surviving bank. Under the terms of the merger agreement, Fauquier shareholders will receive 0.675 shares of Company stock for each share of Fauquier common stock they own. Shareholders of the Company will own approximately 51.4% and Fauquier shareholders will own approximately 48.6% of the combined company. The combined company will operate under the Virginia National Bankshares Corporation name and the combined bank will operate under the Virginia National Bank name. Completion of the merger is subject to customary closing conditions, including receipt of the approval of the shareholders of the Company and Fauquier, respectively. The Company and Fauquier have each scheduled a special meeting of shareholders for March 25, 2021 to consider and vote on the merger and related matters. Additional information on the proposed merger can be found in the Company’s Current Reports on Form 8-K filed with the SEC on October 1, 2020 and October 2, 2020.
Impact of COVID-19
The COVID-19 pandemic has caused, and will likely continue to cause, economic and social disruption, significantly affecting many industries, including many of our clients. Significant uncertainty exists regarding the magnitude of the impact and duration of this pandemic. Following are brief descriptions of areas within our Company that have been or may be impacted.
Financial Condition and Results of Operations
Allowance for loan losses (“ALLL”) - The Company’s consolidated financial statements include estimates and assumptions made by management which affect the reported amounts of assets and liabilities, including the level of the ALLL that is established. The ALLL calculation and resulting provision for loan losses are impacted by changes in economic conditions. As of March 31, 2020 and June 30, 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of the COVID-19 pandemic on the economy. No additional downgrades of such factors were taken during the quarters ended September 30, 2020 or December 31, 2020. If economic conditions improve or worsen, the Company could experience further changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of the COVID-19 pandemic are sustained.
Potential credit exposures - While most industries have been adversely impacted by the COVID-19 pandemic, the Company has exposures on its balance sheet as of December 31, 2020 in the following categories of loans that are considered to have higher risk of significant impact:
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Travel accommodations (hotels/motels/B&B) - $16.7 million, or 3.0% of loans
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Retail trade - $13.6 million, or 2.5% of loans
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Restaurants - $7.4 million, or 1.3% of loans
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Wholesale trade - $7.1 million, or 1.3% of loans
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Arts, entertainment and recreation - $6.7 million, or 1.2% of loans, and
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Caterers - $5.9 million, or 1.1% of loans
Note that the loan balances and percentages above do not include PPP loans made to entities within such categories.
Loan deferrals - In accordance with guidance from regulators and the CARES Act, we are working with borrowers who have been adversely affected by the COVID-19 pandemic to defer principal only, or principal and interest payments for a 90- to 180-day period. While interest will continue to accrue to income, in accordance with GAAP, if the Company ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively affected. Since the beginning of the pandemic, the Company has accommodated 193 deferrals on outstanding loan balances of $59.0 million (of which 131 deferrals on outstanding loan balances of $1.8 million were related to student loans). In accordance with interagency guidance issued in March 2020, these short-term deferrals are not considered TDRs. As of December 31, 2020, $55.7 million, or 94.3%, of the total loan deferments approved have returned to normal payment schedules and are now current. Therefore, only $3.3 million in loan deferrals were outstanding as of December 31, 2020, $2.8 million of which are guaranteed by the United States Department of Agriculture (“USDA”).
PPP Loans - During 2020, the Company devoted significant resources to accept PPP round 1 and round 2 applications, a program designed to provide a direct incentive for small businesses to keep employees on their payroll. As of December 31, 2020, the Company had closed 574 loans representing $86.9 million in funding, with average origination fees of 3.4%, assisting many nonprofits and local businesses through this program. The Company is participating in round 3 of the PPP program. Loans funded through the PPP are fully guaranteed by the U.S. government. The Company performed the required due diligence pursuant to the established SBA criteria; nonetheless, if a determination is made that certain loans did not meet the criteria established for the program, the Company may be required to establish additional ALLL through provision for loan loss expense which will negatively impact net income.
Credit quality standards - Throughout the onset of this pandemic, the Company has maintained its high standards of credit quality on organic loan funding to limit credit risk exposure.
Additional COVID-19 related expenses - During 2020, the Company incurred approximately $185,000 additional expense as a direct result of COVID-19. The additional expense was incurred in the following categories:
•
Air purifier depreciation, janitorial and other cleaning supplies - $57,000
•
Technology-related costs, such as depreciation for additional laptops, phones, phone service and licenses for remote meeting sites - $45,000;
•
Personnel costs, primarily related to overtime incurred in connection with the PPP lending - $44,000;
•
Personal protective equipment (“PPE”) - $25,000;
•
COVID-19 antibody and rapid tests - $12,000; and
•
Outdoor seating depreciation - $2,000.
Cash outlays in the amount of $80,000 were incurred related to COVID-19 for laptops, printers, outdoor furniture, air purifiers, sneeze guards and additional PPE, which are being depreciated or amortized over their estimated useful lives. Depreciation and amortization expense recognized in 2020 is included in the expenses noted above.
Capital and Liquidity
As of December 31, 2020, capital ratios of the Company were in excess of regulatory requirements. While currently included in the category of “well capitalized” by bank regulators, a prolonged economic recession could adversely impact reported and regulatory capital ratios.
The Company maintains access to multiple sources of liquidity. Management has also revisited its capital and liquidity stress tests, as well as capital and liquidity contingency plans to validate how the Company can react effectively to the economic downturn caused by this pandemic and to gauge the amount of SBA PPP loans the Company could and should accept.
Goodwill
As of December 31, 2020, the goodwill on our balance sheet was not deemed to be impaired. However, management may determine that goodwill is required to be evaluated for impairment in the future due to the presence of a triggering event, which may have a negative impact on the Company’s results of operations.
Operations, Processes, Controls and Business Continuity Plan
The Company reacted quickly to the COVID-19 pandemic. We began internal social distancing in mid-March 2020, as well as distancing from the public by keeping our drive-thru services available, and encouraging customers to conduct transactions at ATMs, through online banking and the mobile app. The Company also increased consumer and business mobile deposit limits to encourage customers to make deposits remotely from the safety of their home or business. The Company implemented a schedule whereby most staff members are working remotely at any given time, allowing the remaining essential staff to create more distance between each other within the offices. We temporarily increased the number of staff in the client service center to assist more customers by telephone and encourage them to utilize online and mobile banking. The client service center was also temporarily moved to a larger location to allow for appropriate social distancing. In addition, the Company enhanced disinfecting procedures to include hospital-grade cleaning solution and foggers, increased the frequency of cleaning and issued personal protective equipment, including N-95 and disposable face masks, face shields, sneeze guards, gloves and thermometers, to employees, along with specific instructions for use, to enhance their safety. The Company also installed disinfecting protective strips to high touch areas, placed free-standing air filter machines throughout our facilities, purchased COVID-19 instant test kits for on-site testing and provided antibody testing options to all employees. See above for expenses incurred during 2020 related to such measures, included in Financial Condition and Results of Operations. Management provides frequent email communications and social media updates regarding COVID-19, helpful tips and status of Company initiatives, as well as warning customers of potential scams during this pandemic.
The Company’s preparedness resulted in minimal impact to the Company’s operations as a result of the COVID-19 pandemic. Effective and thorough business continuity planning allowed for successful deployment of most of our employees to work in a remote environment. No material operational or internal control risks have been identified to date, and the Company has enhanced fraud-related controls.
Application of Critical Accounting Policies and Critical Accounting Critical Estimates
The accounting and reporting policies followed by the Company conform, in all material respects, to GAAP and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Company bases estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates.
The Company considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s financial statements. The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations.
Following are the accounting policies and estimates that the Company considers as critical:
•
Allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that are inherent in the loan portfolio. Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with Accounting Standards Codification (“ASC”) Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” The level
of the allowance reflects management’s continuing evaluation of: industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions; and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion and Note 3 - Loans and Note 4 - Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
•
Impaired loans are loans so designated when, based on current information and events, it is probable the Company will be unable to collect all amounts when due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net of the impairment, using either the present value of estimated future cash flows at the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. Additional information on impaired loans, which includes both TDRs and non-accrual loans, is included in Note 3 - Loans and Note 4 - Allowance for Loan Losses, in the Notes to Consolidated Financial Statements.
•
Fair value measurements are used by the Company to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realized value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Additional discussion of valuation methodologies is presented in Note 16 - Fair Value Measurements, in the Notes to Consolidated Financial Statements.
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Other-than-temporary impairment of securities accounting policies require a periodic review by management to determine if the decline in the fair value of any security appears to be other-than-temporary. Factors considered in determining whether the decline is other-than-temporary include, but are not limited to: the length of time and the extent to which fair value has been below cost; the financial condition and near-term prospects of the issuer; and the Company’s intent to sell. See Note 1 - Summary of Significant Accounting Policies and Note 2 - Securities, in the Notes to Consolidated Financial Statements, for further details on the accounting policies for other-than-temporary impairment of securities and the methodology used by management to make this evaluation.
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Intangible asset accounting policies require that goodwill and other intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually, or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 3 to 10 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company’s Consolidated Balance Sheets. See Note 1 - Summary of Significant Accounting Policies and Note 7 - Intangible Assets, in the Notes to Consolidated Financial Statements, for further detail on the accounting policies for intangible assets.
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Income tax accounting policies have the objective to recognize the amount of taxes payable or refundable for the current year and the deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations.
See Note 1 - Summary of Significant Accounting Policies and Note 10 - Income Taxes, in the Notes to Consolidated Financial Statements, for further detail on the accounting policies for income taxes and for components of the deferred tax assets and liabilities.
Non-GAAP Presentations
The Company, in referring to its net income and net interest income, is referring to income computed in accordance with GAAP, unless otherwise noted. Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations also refer to various calculations that are non-GAAP presentations. They include:
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Fully taxable-equivalent (“FTE”) adjustments - Net interest margin and efficiency ratios are presented on an FTE basis, consistent with SEC guidance in Industry Guide 3 which states that tax exempt income may be calculated on a tax-equivalent basis. This is a non-GAAP presentation. The FTE basis adjusts for the tax-exempt status of net interest income from certain investments using a federal tax rate of 21%, where applicable, to increase tax-exempt interest income to a taxable-equivalent basis.
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Net interest income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “FTE,” and the reconcilement below shows the fully taxable-equivalent adjustment to net interest income to aid the reader in understanding the computations of net interest margin and the efficiency ratio on a non-GAAP basis.
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Net interest margin - Net interest margin (FTE) is calculated as net interest income, computed on an FTE basis, expressed as a percentage of average earning assets. The Company believes this measure to be the preferred industry measurement of net interest margin and that it enhances comparability of net interest margin among peers in the industry.
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Efficiency ratio - One of the ratios the Company examines in its evaluation of net income is the efficiency ratio, which measures the cost to produce one dollar of revenue. The Company computes its efficiency ratio (FTE) by dividing noninterest expense by the sum of net interest income (FTE) and noninterest income. A lower ratio is an indicator of increased operational efficiency. This non-GAAP metric is used to assist investors in understanding how management assesses its ability to generate revenues from its non-funding-related expense base, as well as to align presentation of this financial measure with peers in the industry. The Company believes this measure to be the preferred industry measurement of operational efficiency, which is consistent with FDIC studies.
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Performance measures exclude nonrecurring merger expenses, which were incurred in connection with due diligence, legal and other professional fees associated with the proposed merger with Fauquier. Management believes that the exclusion of the significant one-time effect of merger expenses provides users of the Company’s financial information a presentation of the Company’s financial results that is representative of its ongoing operations. In this non-GAAP presentation, the merger expenses incurred is added to the Company’s net income.
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The allowance for loan loss measure excludes the impact of PPP loans. Management believes that the exclusion of impact of PPP loans provides users of the Company’s financial information a presentation of the Company’s allowance for loan loss percentage that is representative of its ongoing operations.
Management uses these non-GAAP measures to evaluate the Company’s operating performance on a basis comparable to other financial periods. Net income is discussed in Management’s Discussion and Analysis on a GAAP basis unless noted as “non-GAAP.”
The reconcilement below shows how these non-GAAP measures are computed from their respective GAAP measures (dollars in thousands):
Results of Operations
Consolidated Return on Assets and Equity and Other Key Ratios
The annualized ratio of net income to average total assets and average shareholders' equity and certain other ratios for the periods indicated are as follows:
Net income for the year ended December 31, 2020 was $8.0 million, or $2.94 per diluted share, a 19.3% increase compared to $6.7 million, or $2.49 per diluted share for the year ended December 31, 2019. This $1.3 million increase was primarily the result of an increase of $2.0 million in net interest income and $1.0 million in noninterest income. Negatively affecting net income for 2020 compared to 2019 was an $895,000 increase in noninterest expense, a $538,000 increase in provision for income taxes, and a $247,000 increase in the provision for loan losses.
The efficiency ratio (FTE) was 61.4% for the year ended December 31, 2020, compared to 64.9% for the same period of 2019, improving due to the higher level of revenue from net interest income and noninterest income.
The Company has four reportable segments: the Bank, VNB Trust and Estate Services, Sturman Wealth Advisors, and Masonry Capital.
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Bank - The Bank’s commercial banking activities involve making loans, taking deposits and offering related services to individuals, businesses and charitable organizations. Loan fee income, service charges from deposit accounts, and other non-interest-related revenue, such as fees for debit cards and ATM usage and fees for treasury management services, generate additional income for this segment.
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Sturman Wealth Advisors - This segment offers wealth and investment advisory services. Revenue for this segment is generated primarily from investment advisory and financial planning fees, with a small and decreasing portion attributable to brokerage commissions. During February 2016, the Company purchased the book of business, including interest in the client relationships, (“Purchased Relationships”), from a current officer (the “Seller”) of the Company pursuant to an employment and asset purchase agreement (the “Purchase Agreement”). Prior to becoming an employee of the Company and until the effective date of the sale, the Seller provided services to the Purchased Relationships as a sole proprietor. Under the terms of the Purchase Agreement, the Company will receive all future revenue for investment management, advisory, brokerage, insurance, consulting, and related services performed for the Purchased Relationships. More information on this purchase can be found under Intangible Assets in Note 7 of the Notes to Consolidated Financial Statements, which is found in Item 8. Financial Statements and Supplementary Data.
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VNB Trust and Estate Services - This segment offers corporate trustee services, trust and estate administration, IRA administration and custody services and, prior to January 1, 2020, offered in-house investment management services. Revenue for this segment is generated from administration, service and custody fees, as well as management fees which are derived from Assets Under Management. Investment management services currently are offered through affiliated and third-party managers. In addition, royalty income, in the form of fixed and/or incentive fees, from the sale of Swift Run Capital Management, LLC in 2013 is reported as income of VNB Trust and Estate Services. More information on royalty income and the related sale can be found under Summary of Significant Accounting Policies in Note 1 of the Notes to Consolidated Financial Statements, which is found in Item 8. Financial Statements and Supplementary Data.
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Masonry Capital - Masonry Capital offers investment management services for separately managed accounts and a private investment fund employing a value-based, catalyst-driven investment strategy. Revenue for this segment is generated from management fees which are derived from Assets Under Management and incentive income which is based on the investment returns generated on performance-based Assets Under Management.
The Bank segment earned net income of $8.3 million in 2020, a $1.5 million increase over the $6.8 million netted in 2019. Sturman Wealth Advisors earned $48,000 in 2020 compared to $11,000 in the prior year. VNB Trust and Estate Services realized a net loss of $52,000 in 2020, compared to net income of $90,000 in 2019. Masonry Capital realized net losses of $274,000 and $210,000 in 2020 and 2019, respectively.
Details of the changes in the various components of net income are further discussed below.
Net Interest Income
Net interest income is computed as the difference between the interest income on earning assets and the interest expense on deposits and other interest bearing liabilities. Net interest income represents the principal source of revenue for the Company and accounted for 78.4% of the total revenue in 2020. Net interest margin (FTE) is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income (FTE) and net interest margin (FTE).
The following table details the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest bearing liabilities, for the years ended December 31, 2020, 2019, and 2018.
Consolidated Average Balance Sheets and Analysis of Net Interest Income (FTE)
(1)
Tax-exempt income for investment securities has been adjusted to a fully tax-equivalent basis (FTE), using a Federal income tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations earlier in this section.
(2)
Interest rate spread is the average yield earned on earning assets less the average rate paid on interest-bearing liabilities.
(3)
Net interest margin (FTE) is net interest income expressed as a percentage of average earning assets.
The purpose of the volume and rate analysis below is to describe the impact on the net interest income (FTE) of the Company resulting from changes in average balances and average interest rates for the periods indicated. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Interest income is reported on a tax-equivalent basis.
Volume and Rate Analysis
2020 compared to 2019
(dollars in thousands)
2019 compared to 2018
(dollars in thousands)
For the twelve months of 2020, net interest income (FTE) of $24.0 million was recognized, an increase of $2.0 million or 9.1% over the same period in 2019. Net interest income (FTE) for 2019 totaled $22.0 million and was $985,000 lower than the 2018 total of $23.0 million. Average earning assets increased $140.6 million or 22.8% in 2020 compared to 2019 and increased $10.9 million or 1.8% in 2019 compared to 2018. The increases in volume of real estate and commercial loans from 2019 to 2020 were the primary contributing factors of the increase in net interest income. The declines in rates paid on deposits over the same period also positively impacted net interest income. The average balance for loans as a percentage of earnings assets for 2020 was 79.4%, compared to 85.1% and 87.3% in 2019 and 2018, respectively.
The 2020 net interest margin (FTE) declined 40 basis points to 3.17% from 3.57% in 2019. The 2019 net interest margin (FTE) declined 23 basis points from 3.80% in 2018. The tax-equivalent yield on average earning assets for 2020 of 3.62% was 65 basis points lower than the 2019 yield of 4.27%. The 2018 tax-equivalent yield on average earning assets of 4.26% was fairly comparable to the 2019 yield. Loan yields for 2020 were 4.15%, declining 47 basis points from the loan yield of 4.62% for 2019. Average loans for 2020 of $600.9 million were $77.1 million higher than the 2019 average of $523.8 million, primarily due to the origination of PPP loans during 2020. 2019’s average loan balances were $4.1 million lower than the 2018 average of $527.9 million.
Interest expense as a percentage of average earning assets declined to 44 basis points for 2020, compared to 69 and 46 basis points for 2019 and 2018, respectively. Net interest margin will be impacted by future changes in short-term and long-term interest rate levels on deposits, as well as the impact from the competitive environment. A continuing primary driver of the Company’s low cost of funds is the Company’s level of non-interest bearing demand deposits and low-cost deposit accounts. Following is a table illustrating the average balances of these accounts as a percentage of total deposit account balances.
Non-interest and low-cost deposit account analysis
Provision for Loan Losses
The level of the allowance reflects changes in the size of the portfolio or in any of its components, as well as management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, and economic, political and regulatory conditions. Additional information concerning management’s methodology in determining the adequacy of the allowance for loan losses is contained later in this section under Allowance for Loan Losses, in addition to Note 1 and Note 4 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.
Based on management’s continuing evaluation of the loan portfolio in 2020, the Company recorded a provision for loan losses of $1.6 million, compared to a provision of $1.4 million in 2019 and $1.9 million in 2018 The increase in the 2020 provision for loan losses was largely the result of worsening economic qualitative factors associated with the COVID-19 pandemic. The decrease in the 2019 provision for loan losses was primarily attributed to the recapture of a portion of the provision previously allocated to a shared national credit that was sold during the year and the decline in student loan balances year-over-year.
The allowance for loan losses as a percentage of total loans was 0.90% at December 31, 2020 compared to 0.78% at December 31, 2019.
The following is a summary of the changes in the allowance for loan losses for the years ended December 31, 2020, 2019, and 2018:
Noninterest Income
The major components of noninterest income are detailed below. Year-to-year variances are shown for each noninterest income category.
Noninterest income of $6.6 million for the year ended December 31, 2020 experienced a net increase over the prior year by $1.0 million, as a result of the following variances:
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Loan swap fee income increased $1.1 million, as a result of increased acceptance of the product by customers and lenders;
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Gains on sales and calls of securities increased $669,000, as more securities were sold in 2020 and at a time where the Federal Reserve was purchasing mortgage-backed securities at a premium, resulting in gains on sales of such securities;
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Fiduciary income decreased $545,000 due to lower fees charged to customer accounts; and
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Earnings from bank owned life insurance decreased $361,000 primarily as a result of a death benefit received following the death of a former employee in 2019.
Noninterest Expense
Noninterest expense of $18.8 million reported for 2020 increased $895,000 or 5.0% from the $17.9 million for the same period of 2019. The major components of noninterest expense are detailed below. Year-over-year variances are shown for each noninterest expense category.
Merger expenses accounted for the largest increase, amounting to $988,000 in 2020, compared to no merger expenses in the prior year.
Settlement of claims amounted to $460,000 in 2019 in connection with the final settlement of pending and threatened legal proceedings. No such expenses were incurred during 2020.
Salaries and employee benefits accounted for $217,000 of the increase from prior year to current year. This increase was due to an overall increase in salaries based on normal annual merit increases for employees, offset by a decrease in the number of employees year-over-year. At December 31, 2020, the Company had 86 full-time equivalent employees compared to 97 at year-end 2019.
Provision for Income Taxes
The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and the income tax bases of assets and liabilities using the applicable enacted marginal tax rate.
For 2020, the Company provided $2.1 million for Federal income taxes, resulting in an effective income tax rate of 20.6%. In 2019, the Company provided $1.5 million for Federal income taxes, resulting in an effective income tax rate of 18.6%. The effective income tax rates for 2020 and 2019 were lower than the U.S. statutory rate of 21% primarily due to the effect of tax-exempt income from municipal bonds and bank owned life insurance policies. The tax benefits from the tax-exempt income in 2020 and 2019 were $192,000 and $230,000, respectively. The lower effective tax rate for 2019 compared to 2020 and the statutory rate was primarily related to the non-taxability of the death proceeds from bank owned life insurance. The non-deductibility of certain merger-related expenses for tax purposes in 2020 caused the effective rate to increase compared to the prior year.
More information on income taxes, including net deferred taxes can be found in Note 10 - Income Taxes of the Notes to Consolidated Financial Statements which is found in Item 8. Financial Statements and Supplementary Data.
BALANCE SHEET ANALYSIS
Securities
The investment securities portfolio has a primary role in the management of the Company’s liquidity requirements and interest rate sensitivity, as well as generating significant interest income. Investment securities also play a key role in diversifying the Company’s balance sheet. In addition, a portion of the investment securities portfolio is pledged as collateral for public fund deposits. Changes in deposit and other funding balances and in loan production will impact the overall level of the investment portfolio.
As of December 31, 2020, the Company’s investment portfolio totaled $177.1 million, with obligations of U.S. government corporations and government-sponsored enterprises amounting to $106.4 million, or approximately 60% of the total. The Company’s investment portfolio totaled $115.7 million as of December 31, 2019.
For the year ended December 31, 2020, proceeds from the sales of securities amounted to $69.5 million, and gross realized gains on these securities were $742,000. An additional $1,000 gain was realized from a call of a security during 2020. For the year ended December 31, 2019, proceeds from the sales of securities amounted to $21.1 million, and gross realized gains on these securities were $71,000. An additional $3,000 gain was realized from a call of a security during 2019. Management proactively manages the mix of earning assets and cost of funds to maximize the earning capacity of the Company.
In accordance with ASC 320, “Investments - Debt and Equity Securities,” the Company has categorized its unrestricted securities portfolio as Available for Sale (“AFS”). Securities classified as AFS may be sold in the future, prior to maturity. Any decision to sell a security classified as AFS would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. AFS securities are carried at fair value. Net aggregate unrealized gains or losses on these securities are included, net of taxes, as a component of shareholders’ equity. All of the Company’s unrestricted securities were investment grade or better as of December 31, 2020. Given the generally high credit quality of the Company’s AFS investment portfolio, management expects to realize all of its investment upon market recovery or the maturity of such instruments and thus believes that any impairment in value is interest-rate-related and therefore temporary. AFS securities included gross unrealized gains of $2.4 million and gross unrealized losses of $501,000 as of December 31, 2020.
All mortgage-backed securities included in the above tables were issued by U.S. government agencies and corporations. At December 31, 2020, the securities issued by political subdivisions or agencies were highly rated with 100% of the municipal bonds having AA or higher ratings. Approximately 59% of the municipal bonds are general obligation bonds, and issuers are geographically diverse. The Company held one short-term corporate bond in the amount of $7.5 million as of December 31, 2019 which matured in March 2020. The Company does not hold any derivative instruments. The Company held no issues that exceeded 10% of the Company’s shareholders' equity at December 31, 2020.
The Company’s holdings of restricted securities totaled $3.0 million and $1.7 million at December 31, 2020 and December 31, 2019, respectively, and consisted of stock in the Federal Reserve Bank, stock in the FHLB, and stock in CBB Financial Corporation, the holding company for Community Bankers’ Bank. The Bank is required to hold stock in the Federal Reserve Bank and the FHLB as a condition of membership with each of these correspondent banks. The amount of stock required to be held by the Bank is periodically assessed by each bank, and the Bank may be subject to purchase or surrender stock held in these banks, as determined by their respective calculations. The amount of FHLB stock held increased $1.3 million from December 31, 2019 to December 31, 2020, as increased purchases of the stock were required due to additional advances held from period to period. Stock ownership in the bank holding company for Community Bankers’ Bank provides the Bank with several benefits that are not available to non-shareholder correspondent banks. None of these stock issues are traded on the open market and can only be redeemed by the respective issuer. Restricted stock holdings are recorded at cost.
The table shown below details the amortized cost and fair value of available for sale debt securities at December 31, 2020 based upon contractual maturities, by major investment categories. Expected maturities may differ from contractual maturities because issuers have the right to call or prepay obligations. The tax-equivalent yield is based upon a federal tax rate of 21%. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP Presentations section earlier in Item 7.
Maturity Distribution and Average Yields
(dollars in thousands)
As stated, the preceding table reflects the distribution of the contractual maturities of the investment portfolio at December 31, 2020. Management’s investment portfolio strategy is to structure the portfolio so that it is a constant source of liquidity for the balance sheet. In order to achieve greater liquidity in the portfolio, securities that have a monthly flow of principal repayments become a key component. To illustrate the difference between contractual maturity and average life, consider the difference for the fixed rate mortgage-backed securities (“MBS”) component of this portfolio. At December 31, 2020, the weighted average maturity of the fixed rate MBS sector was 19.0 years, and the projected average life for this group of securities is 3.4 years.
Another indication of the investment portfolio’s liquidity potential is shown by the projected annual principal cash flow from maturities, callable bonds, and monthly principal repayments. For the next three years, the principal cash flows are estimated to be $41.4 million for 2021, $20.8 million for 2022, and $9.5 million for 2023, based upon rates remaining at current levels. This represents approximately 42% of the investment portfolio’s available for sale balance at December 31, 2020 that will be available to support the future
liquidity needs of the Company. Cash flow projections are subject to change based upon changes to market interest rates.
Loan Portfolio
The Company’s loan portfolio totaled $609.4 million as of December 31, 2020 or 71.8% of total assets. Loan balances increased $69.9 million, or 13.0%, from the balance of $539.5 million as of December 31, 2019. The table below shows the composition of the loan portfolio:
Loan Portfolio
(dollars in thousands)
During 2020, the Company assisted nonprofit organizations and local businesses by funding $86.9 million of PPP loans, which were designed to provide economic relief to small businesses adversely impacted by the COVID-19 pandemic. These loans carry a 1% annual interest rate; however, in addition, the Company recognized $2.1 million in PPP loan origination fees in 2020. As of December 31, 2020, 37% of the total dollars of PPP loans had been forgiven by the SBA, with $54.2 million outstanding, net of deferred fees.
The origination of PPP loans contributed significantly to the $69.9 million increase in loan balances during 2020. In addition, there was meaningful net growth of $42.4 million in organic, non-PPP loans. Strategic decisions made in 2019 to expand the lending teams and add new products put the Company in a better position to increase organic growth without having to supplement the portfolio with purchased loans.
Balances outstanding in purchased loans totaled $119.9 million as of December 31, 2019 and declined $26.7 million during 2020. The balances outstanding in purchased loans of $93.2 million as of December 31, 2020 were comprised of:
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Student loans totaling $37.4 million. The Company purchased two student loan packages in 2015, a third in the fourth quarter of 2016 and a fourth in the fourth quarter of 2017. Along with the purchase of these four packages of student loans, the Company purchased surety bonds to fully insure this portion of the Company’s consumer portfolio. However, during June 2018, ReliaMax Surety, the insurance company which issued the surety bonds, was placed into liquidation due to insolvency. Loss claims were filed for loans in default as of July 27, 2018, when the surety bonds were terminated, and in 2019 the Company received payment on the balance of the claims approved by the liquidator. Also, in 2020 the Company realized a partial recovery of unearned insurance premiums related to the loss of insurance on the student loan portfolio in the amount of $401,000. The Company expects to receive the balance of unearned premiums of approximately $400,000 in the future.
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Loans guaranteed by a U.S. government agency (“government guaranteed”) totaling $30.9 million, inclusive of premium. During the fourth quarter of 2016, the Company began augmenting the commercial and industrial portfolio with government guaranteed loans which represent the portion of loans that are 100% guaranteed by either the USDA or the SBA; the originating institution holds the unguaranteed portion of each loan and services it. These government guaranteed portion
of loans are typically purchased at a premium. In the event of early prepayment, the Bank may need to write off any unamortized premium.
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Mortgage loans totaling $18.5 million, inclusive of premium. In each of the fourth quarters of 2019 and 2018, the Company purchased a package of 1-4 family residential mortgages. Each of the adjustable rate loans purchased were individually underwritten by the Company prior to the closing of the purchases. The collateral on these loans is located primarily on the East Coast of the United States.
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Syndicated loans totaling $6.4 million. Syndicated loans represent shared national credits in leveraged lending transactions and are included in the commercial and industrial portfolio. The Company has developed policies to limit overall credit exposure to the syndicated market, as well as limits by industry and amount per borrower.
From the $482.1 million outstanding at December 31, 2016, gross loans have increased $127.3 million, or 26.4%. The purchase of loans has augmented organic loan growth over the five-year period but is considered a secondary strategy. Management will continue to evaluate loan purchase transactions as needed to supplement organic loan growth, as part of the Company’s strategy to strengthen earnings and to optimize the mix of earning assets. No loans were purchased during 2020, as the origination of organic and PPP loans were the primary focus.
At December 31, 2020, the loan-to-deposit ratio stood at 83.4%, compared to 86.9% at December 31, 2019 and 93.8% at December 31, 2018.
The Company’s objective is to maintain the historically strong credit quality of the loan portfolio by maintaining rigorous underwriting standards. These standards coupled with regular evaluation of the creditworthiness of, and the designation of lending limits for, each borrower has helped the Company achieve this objective. The primary portfolio strategy includes seeking industry and loan size diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar. The predominant market area for loans includes Charlottesville, Albemarle County, Winchester, Frederick County, Richmond and areas in the Commonwealth of Virginia that are within a 75 mile radius of any Virginia National Bank location.
Based on underwriting standards, loans may be secured in whole or in part by collateral such as liquid assets, accounts receivable, equipment, inventory and real property. The collateral securing any loan may depend on the type of loan and may vary in value based on market conditions.
The Company’s real estate loan portfolio increased by $38.8 million to a balance of $410.1 million at December 31, 2020 from $371.2 million at December 31, 2019. This category comprised 67.3% of all loans, and these loans are secured by mortgages on real property located principally in Virginia. Of this amount, approximately $127.3 million represented loans on residential properties. Commercial real estate loans totaled $282.8 million as of December 31, 2020. Sources of repayment are from the borrower’s operating profits, cash flows and liquidation of pledged collateral.
As of December 31, 2020, the Company’s commercial and industrial loan portfolio totaled $118.7 million, a $38.1 million increase from the $80.6 million balance at year-end 2019. This category, representing approximately 19.5% of all loans, includes loans made to individuals and small to medium-sized businesses, as well as loans purchased on the syndicated and government guaranteed markets. As discussed previously, the Company participated in the PPP loan initiative during 2020 and the balance at year-end of $54.2 million drove the increase in commercial and industrial loans. Purchased government guaranteed loans of $30.9 million, inclusive of premium, together with purchased syndicated loans of $6.4 million represented 31.4% of the commercial and industrial loan total at the end of 2020.
Consumer loans, comprised of student loans purchased, revolving credit, and other fixed payment loans, totaled $58.1 million as of December 31, 2020 or 9.5% of all loans. Consumer loans ended 2020 with balances $12.4 million lower than the prior year-end, primarily due to normal amortization and increased charge-offs within the student loan portfolio.
Loans for construction and land development totaled $22.5 million and made up the remaining 3.7% of loans as of December 31, 2020. These loan balances increased by $5.4 million compared to December 31, 2019.
The following table presents the maturity/repricing distribution of the Company’s loans at December 31, 2020. The table also presents the portion of loans that have fixed interest rates or variable/floating interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the Wall Street Journal prime rate, LIBOR rates, or U.S. Treasury bond indices.
Maturities and Sensitivities of Loans to Changes in Interest Rates
Loan Asset Quality
Intrinsic to the lending process is the possibility of loss. While management endeavors to minimize this risk, it recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio, which in turn depend on current and future economic conditions, the financial condition of borrowers, the realization of collateral, and the credit management process.
Generally, loans are placed on non-accrual status when management believes, after considering economic and business conditions and collections efforts, that it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement, or when the loan is past due for 90 days or more, unless the debt is both well-secured and in the process of collection.
At December 31, 2020, 2019, and 2018, the Company had loans classified as non-accrual with balances of $8,000, $299,000, and $615,000, respectively. The 2018 non-accrual balances included $445,000 of student loan balances. The Company received payment in the amount of $311,000 in the fourth quarter of 2019 from the liquidation process. This amount represented the balance of the claims approved by the liquidator.
Student loans purchased with balances of $137,000 accounted for the loans over 90 days past due that were still accruing interest as of December 31, 2020.
TDRs occur when the Company agrees to modify the original terms of a loan by granting a concession that it would not otherwise consider due to the deterioration in the financial condition of the borrower. These concessions are done in an attempt to improve the paying capacity of the borrower, and in some cases to avoid foreclosure, and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs that are considered to be performing continue to accrue interest under the terms of the restructuring agreement. TDRs that have been placed in non-accrual status are considered to be nonperforming.
Total performing TDR balances declined to $1.3 million as of December 31, 2020 compared to $2.2 million at both December 31, 2019 and 2018. Based on regulatory guidance issued in 2016 on Student Lending, the Company classified 75 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2020 and 67 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2019. Total performing TDR balances declined to $1.3 million as of December 31, 2020 compared to $2.2 million at both December 31, 2019 and 2018. There were no student loan TDRs that were not performing as of December 31, 2020 or December 31, 2019.
Below is a summary of loans identified with these risk elements:
In accordance with 2020 regulatory guidance and the CARES Act, the Bank has approved for certain customers who have been adversely affected by the COVID-19 pandemic to defer principal-only, or principal and interest, payments for a 90- to 180-day period. Such short-term modifications, which were made on a good faith basis in response to the COVID-19 pandemic to borrowers who were current prior to any relief, are not to be considered TDRs. While interest will continue to accrue to income, in accordance with GAAP, if the Bank ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively impacted. A total of $59.0 million in loan deferments have been approved since the beginning of the pandemic. As of December 31, 2020, $55.7 million, or 94.3%, of the total loan deferments approved have returned to normal payment schedules and are now current.
See Note 3 - Loans and Note 4 - Allowance for Loan Losses in the accompanying Notes to Consolidated Financial Statements included in Item 8. Financial Statements and Supplementary Data for further details regarding the Company’s loan asset quality measurements.
Allowance for Loan Losses
In general, the Company determines the adequacy of its allowance for loan losses by considering the risk classification and delinquency status of loans and other factors. Management may also establish specific allowances for loans which management believes require allowances greater than those allocated according to their risk classification. The purpose of the allowance is to provide for losses inherent in the loan portfolio. Since risks to the loan portfolio include general economic trends as well as conditions affecting individual borrowers, the allowance is an estimate. The Company is committed to determining, on an ongoing basis, the adequacy of its allowance for loan losses.
The Company applies historical loss rates to various pools of loans based on risk rating classifications. In addition, the adequacy of the allowance is further evaluated by applying estimates of loss that could be attributable to any one of the following eight qualitative factors:
1)
Changes in national and local economic conditions, including the condition of various market segments;
2)
Changes in the value of underlying collateral;
3)
Changes in volume of classified assets, measured as a percentage of capital;
4)
Changes in volume of delinquent loans;
5)
The existence and effect of any concentrations of credit and changes in the level of such concentrations;
6)
Changes in lending policies and procedures, including underwriting standards;
7)
Changes in the experience, ability and depth of lending management and staff; and
8)
Changes in the level of policy exceptions.
Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations by further segmenting the loan classes. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.
See Note 3 - Loans and Note 4 - Allowance for Loan Losses in the Notes to Consolidated Financial Statements, included in Item 8. Financial Statements and Supplementary Data, for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
Activity for the allowance for loan losses is provided in the following table.
As of December 31, 2020, the allowance for loan losses was $5.5 million, a net increase of $1.3 million from $4.2 million at December 31, 2019. Management’s estimates for the allowance for loan losses resulted in the Company’s allowance to total loans outstanding ratio of 0.90% at December 31, 2020, compared to 0.78% at December 31, 2019 and 0.91% at December 31, 2018. The primary reason that the allowance for loan losses increased from December 31, 2019 to December 31, 2020 was that the economic qualitative factors associated with the COVID-19 pandemic worsened. Note that without the effects of the PPP loans, which do not require a reserve as they are guaranteed by the SBA, the allowance to total loans outstanding would have been 0.98% as of December 31, 2020 (for reconcilement of this non-GAAP measure, see the “Non-GAAP Presentation” section earlier in Item 7).
During 2020, there were $805,000 in loan balances charged off, with a total of $429,000 in recoveries of previously charged-off balances, resulting in net charge-offs of $376,000. During 2019, there were $2.3 million in loan balances charged off, with a total of $202,000 in recoveries of previously charged-off balances, resulting in net charge-offs of $2.1 million. The ratio of net charge-offs to average loans was 0.06%, 0.39%, and 0.19% for 2020, 2019, and 2018, respectively.
The table below provides an allocation of year-end allowance for loan losses by loan type; however, allocation of a portion of the allowance to one loan category does not preclude its availability to absorb losses in other categories.
Allocation of the Allowance for Loan Losses
(dollars in thousands)
Deposits
Depository accounts represent the Company’s primary source of funding and are comprised of demand deposits, interest-bearing checking accounts, money market deposit accounts and time deposits. These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville/Albemarle, Richmond and Winchester areas.
Depository accounts held by the Company as of December 31, 2020, totaled $730.8 million, an increase of $109.6 million or 17.6% compared to the December 31, 2019 total of $621.2 million.
At December 31, 2020, the balances of non-interest bearing demand deposits were $209.8 million or 28.7% of total deposits, a 25.6% increase from $167.0 million at December 31, 2019. Interest-bearing transaction and money market accounts totaled $421.9 million at December 31, 2020, an increase of $76.9 million compared to $345.0 million at December 31, 2019. During 2018, the Company implemented ICS®, which allows customers access to multi-million-dollar FDIC insurance on funds placed into demand deposit and/or money market deposit accounts. As of December 31, 2020, the reciprocal ICS® balances included in demand deposit and money market accounts were $28.0 million and $81.1 million, respectively. Along with the roll-out of ICS® to customers, the Company eliminated the repurchase agreement product effective December 31, 2018. The Company’s low-cost deposit accounts, which include both non-interest and interest bearing checking accounts as well as money market accounts, represented 86.4% of total deposit account balances at December 31, 2020 and compared favorably to the 82.4% of total deposit account balances at December 31, 2019.
Certificates of deposit and other time deposit balances decreased $10.2 million to $99.1 million at December 31, 2020 from the balance of $109.3 million at December 31, 2019. Included in this deposit total were reciprocal relationships under CDARS™, whereby depositors can obtain FDIC insurance on deposits up to $50 million. These reciprocal CDARS™ deposits totaled $8.5 million and $13.7 million at December 31, 2020 and 2019, respectively.
The aggregate amount of total certificates of deposit with a minimum balance of $100,000 was $72.5 million at December 31, 2020. Included in this total are deposits of $34.5 million with balances of $250,000 or more.
Deposits
(dollars in thousands)
Borrowings
Borrowings, consisting primarily of FHLB advances and federal funds purchased, are additional sources of funds for the Company. The level of these borrowings is determined by various factors, including customer demand and the Company's ability to earn a favorable spread on the funds obtained.
The Company has a collateral dependent line of credit with the FHLB. As of December 31, 2020, the Company had outstanding balances of $30.0 million from three FHLB advances with $10 million maturing in each of the years 2021, 2023, and 2025. Due to historically low rates, the Company entered into a leverage strategy, locking into low fixed term rates for one, three and five-year periods and investing the proceeds into securities. The Company had no outstanding borrowings from the FHLB as of December 31, 2019 or 2018.
Additional borrowing arrangements maintained by the Bank include formal federal funds lines with four major regional correspondent banks. The Company had no outstanding balances in federal funds purchased as of December 31, 2020, 2019, or 2018.
Total borrowings consist of the following as of December 31, 2020, 2019, and 2018:
Details on available borrowing lines can be found later under Liquidity in the Asset/Liability Management section that follows.
ASSET/LIABILITY MANAGEMENT
The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and resources to assist in the management of interest rate risk and asset quality. The Company’s net interest income is affected by changes in market interest rates and by the level and composition of interest-earning assets and interest-bearing liabilities. The Company’s objectives in its asset/liability management are to utilize its capital effectively, to provide adequate liquidity and to enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its liquidity, capital and interest rate risk. This risk management process is governed by policies and limits established by the Bank’s Asset/Liability Committee, which are reviewed and approved by the Bank’s Board of Directors. This committee, which is comprised of directors and members of management, meets to review, among other things, economic conditions, interest rates, yield curves, cash flow projections, expected customer actions, liquidity levels, capital ratios and repricing characteristics of assets, liabilities and financial instruments.
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market indices such as interest rates. The Company’s principal market risk exposure is interest rate risk. Interest rate risk is the exposure to changes in market interest rates. Interest rate sensitivity is the relationship between market interest rates and net interest income due to the repricing characteristics of assets and liabilities. The Company monitors the interest rate sensitivity of its balance sheet positions by examining its near-term sensitivity and its longer-term gap position. In its management of interest rate risk, the Company utilizes several financial and statistical tools including traditional gap analysis and sophisticated income simulation models.
A traditional gap analysis is prepared based on the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on the net interest margin. The Company’s balance sheet structure is primarily short-term in nature with a substantial portion of rate-sensitive assets and rate-sensitive liabilities repricing or maturing within one year, as shown in the Gap Interest Sensitivity Analysis table below.
Gap Interest Sensitivity Analysis
As of December 31, 2020
(dollars in thousands)
The Company utilizes the gap analysis to complement its income simulations modeling. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income.
The Asset/Liability Committee routinely monitors simulated net interest income sensitivity over a rolling two-year horizon. It also utilizes additional tools to monitor potential longer-term interest rate risk. The income simulation models measure the Company’s net interest income volatility or sensitivity to interest rate changes utilizing statistical techniques that allow the Company to consider various factors which impact net interest income. These factors include actual maturities, estimated cash flows, repricing characteristics, deposit growth/retention and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets. The core deposit costs are internally managed and tend to exhibit less sensitivity to changes in interest rates than the Company’s adjustable rate assets whose yields are based on external indices and generally change in concert with market interest rates. The Company’s interest rate sensitivity is determined by identifying the probable impact of changes in market interest rates on the yields on the Company’s assets and the rates that would be paid on its liabilities. This modeling technique involves a degree of estimation based on certain assumptions that management believes to be reasonable. Utilizing this process, management projects the impact of changes in interest rates on net interest margin. The Company has established certain policy limits for the potential volatility of its net interest margin assuming certain levels of changes in market interest rates with the objective of maintaining a stable net interest margin under various probable rate scenarios. Management generally has maintained a risk position well within the policy limits.
As market conditions vary from those assumed in the income simulation models, actual results will also differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other variables. Furthermore, this sensitivity analysis does not reflect actions that the Asset/Liability Committee might take in responding to or anticipating changes in interest rates.
In simulating the effects of upward and downward changes in market rates to net interest income over a rolling two-year horizon, the model utilizes a “static” balance sheet approach where balance sheet composition or mix as of the measurement date is maintained over the two-year horizon. Similarly, the base case simulation performed assumes interest rates on the measurement date are unchanged for the next 24 months. Then the simulation assumes all rate indices are instantaneously shocked upward and downward by 100 basis points to 400 basis points, in 100 basis point increments. Due to the low level of interest rates, the shock down analysis where the rates fall 300 basis points or more are not considered meaningful and are therefore not shown in the results below as of December 31, 2020.
In addition to monitoring the effects to interest income, the model computes the effects to the economic value of equity using the same “static” balance sheet with immediate and parallel rate changes for the same rate change horizons. The Asset/Liability Committee monitors the results compared to policy limits that have been established.
As individual rate indices have not historically moved to the same degree, non-parallel rate shocks are also performed to add a degree of sophistication over the parallel rate shocks. In these analyses, the effects to net interest income and market value of equity are computed using eight different scenarios. Changing slopes and twists of the yield curve are achieved by incorporating both likely and unlikely change across different tenors. Since Federal funds rates may not change to the same degree or direction that longer term Treasury bonds may move, the different scenarios are analyzed so that management and the Asset/Liability Committee can monitor risks as they more severely stress the Company’s balance sheet.
The shape of the yield curve can cause downward pressure on net interest income. In general, if and to the extent that the yield curve is flatter (i.e., the differences between interest rates for different maturities are relatively smaller) than previously anticipated, then the yield on the Company’s interest earning assets and its cash flows will tend to be lower. Management believes that a relatively flat yield curve could continue to affect adversely the Company’s net interest income in 2021.
Liquidity
Liquidity represents the Company’s ability to provide funds to meet customer demand for loan and deposit withdrawals without impairing profitability. Effective management of balance sheet liquidity is necessary to fund growth in earning assets and to pay liability maturities and depository customers’ withdrawal requirements. The Company maintains a Liquidity Management Policy that is approved by the Board of Directors. The policy sets limits in a number of areas, including limits on the amount of non-core liabilities, and funding long-term assets with non-core liabilities.
The Bank’s customer base has provided a stable source of funds and liquidity. Limits contained within the Bank’s Investment Policy also provides for appropriate levels of liquidity through maturities and cash flows within the securities portfolio. Other sources of balance sheet liquidity are obtained from the repayment of loan proceeds and overnight investments. The Bank has numerous secondary sources of liquidity including access to borrowing arrangements from a number of correspondent banks. Available borrowing arrangements maintained by the Bank include formal federal funds lines with four major regional correspondent banks, access to advances from the Federal Home Loan Bank and access to the discount window at the Federal Reserve Bank.
Borrowing Lines
As of December 31, 2020
(dollars in thousands)
As of December 31, 2020, $30 million in advances were outstanding with the FHLB.
Any excess funds are sold on a daily basis in the federal funds market. The Company maintained an average of $34.1 million outstanding in federal funds sold and an average of $211,000 in federal funds purchased during 2020. On December 31, 2020 the Company had no balance outstanding in federal funds purchased. The Company intends to maintain sufficient liquidity at all times to meet its funding commitments.
Capital
The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a 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 Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Company were 14.37%, 14.37%, 15.35% and 9.54%, respectively, as of December 31, 2020, thus exceeding the minimum requirements. The Tier 1, common equity Tier 1, total capital to risk-weighted assets, and leverage ratios of the Bank were 14.24%, 14.24%, 15.22% and 9.46%, respectively, as of December 31, 2020, also exceeding the minimum requirements.
With respect to the Bank, to be “well capitalized” under the “prompt corrective action” regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. The Bank exceeds the thresholds to be considered well capitalized as of December 31, 2020.
On September 17, 2019 the FDIC finalized a rule that introduced an optional simplified measure of capital adequacy for qualifying community banking organizations, referred to as, the community bank leverage ratio framework, as required by the EGRRCPA. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital.
The CBLR framework was made available for community banking organizations to use in their March 31, 2020 Call Report. The Company has not opted into the CBLR framework.
The Basel III capital regulations and CBLR framework are discussed in greater detail under the caption “Supervision and Regulation,” found earlier in this report under “Item 1. Business.” In addition, information regarding the Company’s risk-based capital at December 31, 2020 and December 31, 2019 is presented in Note 14 - Capital Requirements of the Notes to Consolidated Financial Statements, contained in Item 8. Financial Statements and Supplementary Data. Using the most recent capital requirements, the Bank’s capital ratios remain above the levels designated by bank regulators as "well capitalized" at December 31, 2020.
Impact of Inflation and Changing Prices
The Company’s financial statements included herein have been prepared in accordance with GAAP, which requires the financial position and operating results to be measured principally in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. Inflation affects the Company’s results of operations mainly through increased operating costs, but since nearly all of the Company’s assets and liabilities are monetary in nature, changes in interest rates affect the financial condition of the Company to a greater degree than changes in the rate of inflation. Although 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. The Company’s management reviews pricing of its products and services, in light of current and expected costs due to inflation, to mitigate the inflationary impact on financial performance.
Off-Balance Sheet Arrangements
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Additional information concerning the Company’s off-balance sheet arrangements is contained in Note 12 of the Notes to Consolidated Financial Statements, found in Item 8. Financial Statements and Supplementary Data.
Related Party Transactions
The Company and its subsidiaries have business dealings with companies owned by directors and beneficial shareholders of the Company. In 2020 and 2019, leasing/rental expenditures of $511,000 and $500,000 respectively, (including reimbursements for taxes, insurance, and other expenses) were paid to an entity indirectly owned by a director of the Company.
Contractual Commitments
In the normal course of business, the Company and its subsidiaries enter into contractual obligations, including obligations on lease arrangements, contractual commitments for capital expenditures, and service contracts. The significant contractual obligations include the leasing of certain of its banking and operations offices under operating lease agreements on terms ranging from 1 to 10 years, most with renewal options.
Following is a schedule of future minimum rental payments under non-cancelable operating leases that have initial or remaining terms in excess of one year as of December 31, 2020:
Item 7A.
Item 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not required for smaller reporting company.
Item 8.
Item 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors
Virginia National Bankshares Corporation
Charlottesville, Virginia
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Virginia National Bankshares Corporation and Subsidiaries (the Corporation) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Corporation as of December 31, 2020 and 2019, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on the Corporation’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing separate opinions on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Loan Losses - Qualitative Factors
As described in Note 1 - Summary of Significant Accounting Policies and Note 4 - Allowance for Loan Losses to the consolidated financial statements, the Corporation maintains an allowance for loan losses that represents management’s best estimate of probable losses inherent in the loan portfolio. For loans that are not specifically identified for impairment, management determines the allowance for loan losses based on historical loss experience adjusted for qualitative factors. Qualitative adjustments to the historical loss experience are established by applying a loss percentage to the loan segments established by management based on their assessment of shared risk characteristics within groups of similar loans.
Qualitative factors are determined based on management’s continuing evaluation of inputs and assumptions underlying the quality of the loan portfolio. Management evaluates qualitative factors by loan segment, primarily considering changes in current economic conditions, collateral values, classified asset and delinquency trends, the existence and effect of concentrations, lending policies and procedures, the experience and depth of the lending team, and policy exception levels. Qualitative factors contribute significantly to the allowance for loan losses. Management exercised significant judgment when assessing the qualitative factors in estimating the allowance for loan losses. We identified the assessment of the qualitative factors as a critical audit matter as auditing the qualitative factors involved especially complex and subjective auditor judgment in evaluating management’s assessment of the inherently subjective estimates.
The primary audit procedures we performed to address this critical audit matter included:
•Substantively testing management’s process, including evaluating their judgments and assumptions for developing the qualitative factors, which included:
o
Evaluating the completeness and accuracy of data inputs used as a basis for the qualitative factors.
o
Evaluating the reasonableness of management’s judgments related to the determination of qualitative factors.
o
Evaluating the qualitative factors for directional consistency and for reasonableness.
o
Testing the mathematical accuracy of the allowance calculation, including the application of the qualitative factors.
/s/ Yount, Hyde & Barbour, P.C.
We have served as the Company's auditor since 1998.
Richmond, Virginia
March 19, 2021
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
See Notes to Consolidated Financial Statements
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands, except per share data)
*
Per share data has been adjusted to reflect the 5% stock dividend effective July 5, 2019.
See Notes to the Consolidated Financial Statements
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in thousands)
See Notes to Consolidated Financial Statements
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(dollars in thousands, except per share data)
See Notes to Consolidated Financial Statements
VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
See Notes to Consolidated Financial Statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - Summary of Significant Accounting Policies
Organization
Virginia National Bankshares Corporation (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia. The Company is authorized to issue (a) 10,000,000 shares of common stock with a par value of $2.50 per share and (b) 2,000,000 shares of preferred stock at a par value $2.50 per share. There is currently no preferred stock outstanding. The Company is regulated under the Bank Holding Company Act of 1956, as amended and is subject to inspection, examination, and supervision by the Federal Reserve Board.
Virginia National Bank (the “Bank”) is a wholly-owned subsidiary of the Company and was organized in 1998 under federal law as a national banking association to engage in a general commercial and retail banking business. The Bank is headquartered in Charlottesville, Virginia and primarily serves the Virginia communities in and around the cities of Charlottesville, Winchester and Richmond, and the counties of Albemarle and Frederick. As a national bank, the Bank is subject to the supervision, examination and regulation of the Office of the Comptroller of the Currency (“OCC”).
Beginning in 2019, the services offered under the umbrella of VNB Wealth are provided by Masonry Capital Management, LLC (“Masonry Capital”) or by the Bank under VNB Trust & Estate Services or Sturman Wealth Advisors, formerly known as VNB Investment Services.
On October 1, 2020, the Company announced the signing of a definitive merger agreement with Fauquier Bankshares, Inc., pursuant to which the companies are expected to combine in an all-stock merger with the Company as the surviving company. At or immediately following consummation of the merger, The Fauquier Bank, the wholly owned banking subsidiary of Fauquier, will be merged with and into the Bank, with the Bank as the surviving bank. Under the terms of the merger agreement, Fauquier shareholders will receive 0.675 shares of Company stock for each share of Fauquier common stock they own. Shareholders of the Company will own approximately 51.4% and Fauquier shareholders will own approximately 48.6% of the combined company. The combined company will operate under the Virginia National Bankshares Corporation name and the combined bank will operate under the Virginia National Bank name.
Basis of Presentation
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to the reporting guidelines prescribed by regulatory authorities. The following is a description of the more significant of those policies and practices.
Principles of consolidation - The consolidated financial statements include the accounts of Virginia National Bankshares Corporation (the “Company”), and its subsidiaries, Virginia National Bank (the “Bank”) and Masonry Capital. All significant intercompany balances and transactions have been eliminated in consolidation.
Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 (including impaired loans), other-than-temporary impairment of securities, intangible assets, income taxes, and fair value measurements.
Cash flow reporting - For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash and cash equivalents consist of cash on hand, funds due from banks, and federal funds sold.
Securities - Unrestricted investments are classified in two categories as described below.
•
Securities held to maturity - Securities classified as held to maturity are those debt securities the Company has both the positive intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or changes in general economic conditions. Currently the Company has no securities classified as held to maturity because of Management’s desire to have more flexibility in managing the investment portfolio.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
•
Securities available for sale - Securities classified as available for sale are those debt securities that the Company intends to hold for an indefinite period of time but not necessarily to maturity. Any decision to sell a security classified as available for sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company’s assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. Securities available for sale are carried at fair value. Unrealized gains or losses are reported as a separate component of other comprehensive income. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities or to “call” dates, whichever occurs first. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
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 (1) the Company intends to sell the security or (2) 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-than-likely 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 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.
Restricted securities - As members of the Federal Reserve Bank of Richmond (“FRB”) and the Federal Home Loan Bank of Atlanta (“FHLB”), the Company is required to maintain certain minimum investments in the common stock of the FRB and FHLB. Required levels of investments are based upon the Bank’s capital and a percentage of qualifying assets. Additionally, the Company has purchased common stock in CBB Financial Corp. (“CBBFC”), the holding company for Community Bankers’ Bank. Shares of common stock from the FRB, FHLB and CBBFC are classified as restricted securities which are carried at cost.
Loans - Loans are reported at the principal balance outstanding net of unearned discounts and of the allowance for loan losses. Interest income on loans is reported on the level-yield method and includes amortization of deferred loan fees and costs over the loan term. Purchased performing loans are accounted for in the same manner as the rest of the loan portfolio. Further information regarding the Company’s accounting policies related to past due loans, non-accrual loans, impaired loans and troubled-debt restructurings is presented in Note 3 - Loans.
Allowance for loan losses - The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses inherent in the loan portfolio. The allowance for loan losses includes allowance allocations calculated in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Further information regarding the Company’s policies and methodology used to estimate the allowance for loan losses is presented in Note 4 - Allowance for Loan Losses.
Transfers of financial assets - Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company or its subsidiaries - put presumptively beyond reach of the transferor 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 or its subsidiaries 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.
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Premises and equipment - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method based on the estimated useful lives of assets, which range from 3 to 20 years. Expenditures for repairs and maintenance are charged to expense as incurred. The costs of major renewals and betterments are capitalized and depreciated over their estimated useful lives. Upon disposition, the asset and related accumulated depreciation are removed from the books and any resulting gain or loss is charged to income. More information regarding premises and equipment is presented in Note 5 - Premises and Equipment.
Leases - The Company recognizes a lease liability and a right-of-use asset in connection with leases in which it is a lessee, except for leases with a term of twelve months or less. A lease liability represents the Corporation’s obligation to make future payments under lease contracts, and a right-of-use asset represents the Corporation’s right to control the use of the underlying property during the lease term. Lease liabilities and right-of-use assets are recognized upon commencement of a lease and measured as the present value of lease payments over the lease term, discounted at the incremental borrowing rate of the lessee. Further information regarding leases is presented in Note 6 - Leases.
Intangible assets - Goodwill is determined as the excess of the fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and other intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually, or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. Intangible assets with definite useful lives are amortized over their estimated useful lives, which range from 3 to 10 years, to their estimated residual values. Goodwill is the only intangible asset with an indefinite life included on the Company’s Consolidated Balance Sheets. Management has concluded that no impairment of these assets existed as of the balance sheet date. More information regarding intangible assets is presented in Note 7 - Intangible Assets.
Bank owned life insurance - The Company has purchased life insurance on certain key employees. These policies are recorded at their cash surrender value on the Consolidated Balance Sheets. Income generated from polices is recorded as noninterest income.
Fair value measurements - ASC Topic 820, “Fair Value Measurements and Disclosures,” defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and requires certain disclosures about fair value measurements. In general, fair values of financial instruments are based upon internally developed models that primarily use, as inputs, observable market-based parameters. Any such valuation adjustments are applied consistently over time. Additional information on fair value measurements is presented in Note 16 - Fair Value Measurements.
Stock-based compensation - The Company accounts for all plans under recognition and measurement accounting principles which require that the compensation cost relating to stock-based payment transactions be recognized in the financial statements. Stock-based compensation arrangements include stock options and unrestricted or restricted stock grants. For stock options, compensation is estimated at the date of grant, using the Black-Scholes option valuation model for determining fair value. The model employs the following assumptions:
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Dividend yield - calculated as the ratio of historical cash dividends paid per share of common stock to the stock price on the date of grant;
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Expected life (term of the option) - based on the average of the contractual life and vesting schedule for the respective option;
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Expected volatility - based on the monthly historical volatility of the Company’s stock price over the expected life of the options;
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Risk-free interest rate - based upon the U.S. Treasury bill yield curve, for periods within the contractual life of the option, in effect at the time of grant.
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The Company has elected to estimate forfeitures when recognizing compensation expense, and this estimate of forfeitures is adjusted over the requisite service period or vesting schedule based on the extent to which actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative catch-up adjustment, which is recognized in the period of change, and also will impact the amount of estimated unamortized compensation expense to be recognized in future periods. Further information on stock-based compensation is presented in Note 19 - Stock Incentive Plans.
Net income per common share - Basic net income per share, commonly referred to as earnings per share, represent income available to common shareholders divided by the weighted-average number of common shares outstanding during the period, including restricted shares that have not yet vested. Diluted net income per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method. All net income per common share information has been adjusted to reflect the 5% stock dividend effective July 5, 2019. Additional information on net income per share is presented in Note 20 - Net Income per Share.
Comprehensive income - Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Further information on the Company’s other comprehensive income is presented in Note 21 - Other Comprehensive Income.
Advertising costs - The Company follows the policy of charging the costs of advertising to expense as they are incurred.
Income taxes - Deferred taxes are provided on the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry forwards, and tax credit carry forwards. Deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets 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. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
When tax returns are filed, it is highly probable 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 accompanying 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, if any, are classified as additional income taxes in the statements of income. For the years ended December 31, 2020 and 2019, there were no such interest or penalties recognized. Further information on the Company’s accounting policies for income taxes is presented in Note 10 - Income Taxes.
Securities and other property held in a fiduciary capacity - Securities and other property held by VNB Trust and Estate Services, Sturman Wealth Advisors or Masonry Capital in a fiduciary or agency capacity are not assets of the Company and are not included in the accompanying consolidated financial statements.
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Revenue Recognition ASU 2014-09, “Revenue from Contracts with Customers”, and all subsequent amendments to the ASU (collectively “ASC 606”), (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as OREO. The majority of the Company’s revenue is from interest income, including loans and securities, which are outside the scope of the standard. The services that fall within the scope of the standard are presented within noninterest income on the consolidated statement of income and are recognized as revenue as the Company satisfies its obligations to the customer. The revenue that falls within the scope of ASC 606 is primarily related to service charges on deposit accounts, debit/credit card and ATM fees, asset management fees and sales of other real estate owned, when applicable.
Reclassifications - Certain reclassifications have been made to the prior year financial statements to conform to current year presentation. The results of the reclassifications are not considered material.
Recent Accounting Pronouncements
Financial Instruments - Credit Losses - In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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 now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will 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 FASB has issued multiple updates to ASU 2016-13 as codified in Topic 326, including ASU’s 2019-04, 2019-05, 2019-10, 2019-11, 2020-02, and 2020-03. These ASU’s have provided for various minor technical corrections and improvements to the codification as well as other transition matters. Smaller reporting companies who file with the U.S. Securities and Exchange Commission (SEC) and all other entities who do not file with the SEC are required to apply the guidance for fiscal years, and interim periods within those years, beginning after December 15, 2022. The Company is currently assessing the impact that Topic 326 will have on its consolidated financial statements. Early in 2017, the Company formed a cross-functional steering committee, including some members of senior management, to provide governance and guidance over the project plan. The steering committee meets regularly to address the compliance requirements, data requirements and sources, and analysis efforts that are required to adopt these new requirements. The Company has engaged a vendor to assist in modeling expected lifetime losses under Topic 326 and expects to continue developing and refining an approach to estimating the allowance for credit losses during 2021. The extent of the change is indeterminable at this time as it will be dependent upon portfolio composition and credit quality at the adoption date, as well as economic conditions and forecasts at that time. Upon adoption, the impact to the allowance for credit losses (currently allowance for loan losses) will have an offsetting one-time cumulative-effect adjustment to retained earnings.
Effective November 25, 2019, the SEC adopted Staff Accounting Bulletin (SAB) 119. SAB 119 updated portions of SEC interpretative guidance to align with FASB ASC 326, “Financial Instruments - Credit Losses.” It covers topics including (1) measuring current expected credit losses; (2) development, governance, and documentation of a systematic methodology; (3) documenting the results of a systematic methodology; and (4) validating a systematic methodology.
Simplifying the Accounting for Income Taxes - In December 2019, the FASB issued ASU 2019-12, “Income Taxes (Topic 740) - Simplifying the Accounting for Income Taxes.” The ASU is expected to reduce cost and complexity related to the accounting for income taxes by removing specific exceptions to general principles in Topic 740 (eliminating the need for an organization to analyze whether certain exceptions apply in a given period) and improving financial statement preparers’ application of certain income tax-related guidance. This ASU is part of the FASB’s simplification initiative to make narrow-scope simplifications and improvements to accounting standards through a series of short-term projects. For public business entities, the amendments are effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently assessing the impact that ASU 2019-12 will have on its consolidated financial statements.
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Investments - Equity Securities - In January 2020, the FASB issued ASU 2020-01, “Investments - Equity Securities (Topic 321), Investments - Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815) - Clarifying the Interactions between Topic 321, Topic 323, and Topic 815.” The ASU is based on a consensus of the Emerging Issues Task Force and is expected to increase comparability in accounting for these transactions. ASU 2016-01 made targeted improvements to accounting for financial instruments, including providing an entity the ability to measure certain equity securities without a readily determinable fair value at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Among other topics, the amendments clarify that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting. For public business entities, the amendments in the ASU are effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2020-01 to have a material impact on its consolidated financial statements.
LIBOR and Other Reference Rates - In March 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2020-04 “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022.
Subsequently, in January 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2021-01 “Reference Rate Reform (Topic 848): Scope.” This ASU clarifies that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in Topic 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply ASU No. 2021-01 on contract modifications that change the interest rate used for margining, discounting, or contract price alignment retrospectively as of any date from the beginning of the interim period that includes March 12, 2020, or prospectively to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued. An entity may elect to apply ASU No. 2021-01 to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020.
To facilitate an orderly transition from LIBOR, Inter-bank Offered Rate (“IBOR”) and other benchmark rates to alternative reference rates (“ARRs”), the Company has established a focus committee, which includes members of senior management, including the Chief Credit Officer and Chief Financial Officer, among others. The task of this committee is to identify, assess and monitor risk associated with the expected discontinuation or unavailability of benchmarks, including LIBOR, achieve operations readiness and engage impacted clients in connection with the transition to ARRs. The Company is assessing ASU 2020-04 and ASU 2021-01 and their impact on the Company’s transition away from LIBOR for its loan and other financial instruments.
SEC Filing Requirements - On March 12, 2020, the SEC finalized amendments to its “accelerated filer” and “large accelerated filer” definitions. The amendments increase the threshold criteria for meeting these filer classifications and were effective on April 27, 2020. Any changes in filer status are to be applied beginning with the filer’s first annual report filed with the SEC subsequent to the effective date. Prior to these changes, the Company was required to comply with section 404(b) of the Sarbanes Oxley Act concerning auditor attestation over internal control over financial reporting as an “accelerated filer” as it had more than $75 million in public float but less than $700 million at the end of the Company’s most recent second quarter. The rule change revises the definition of “accelerated filers” to exclude entities with public float of less than $700 million and less than $100 million in annual revenues. The Company expects to meet this expanded category of small reporting company and will no longer be considered an accelerated
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filer. If the Company’s annual revenues exceed $100 million, its category will change back to “accelerated filer”. The classifications of “accelerated filer” and “large accelerated filer” require a public company to obtain an auditor attestation concerning the effectiveness of internal control over financial reporting (ICFR) and include the opinion on ICFR in its annual report on Form 10-K. Non-accelerated filers also have additional time to file quarterly and annual financial statements. All public companies are required to obtain and file annual financial statement audits, as well as provide management’s assertion on effectiveness of internal control over financial reporting, but the external auditor attestation of internal control over financial reporting is not required for non-accelerated filers. As the Bank’s total assets exceed $500 million, it remains subject to FDICIA’s internal reporting requirements, but does not require an auditor attestation concerning internal controls over financial reporting. As such, professional and consulting expenditures should decline by an immaterial amount.
Nonrefundable Fees and Other Costs - In October 2020, the FASB issued ASU 2020-08, “Codification Improvements to Subtopic 310-20, Receivables - Nonrefundable fees and Other Costs.” This ASU clarifies that an entity should reevaluate whether a callable debt security is within the scope of ASC paragraph 310-20-35-33 for each reporting period. For public business entities, the ASU is effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. Early adoption is not permitted. All entities should apply ASU No. 2020-08 on a prospective basis as of the beginning of the period of adoption for existing or newly purchased callable debt securities. The Company does not expect the adoption of ASU 2020-08 to have a material impact on its consolidated financial statements.
Recently Adopted Accounting Developments
Goodwill Impairment Testing - In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). ASU 2017-04 simplifies the accounting for goodwill impairment for all entities by requiring impairment charges to be based on the first step in the previous two-step impairment test. Under the new guidance, if a reporting unit’s carrying amount exceeds its fair value, an entity will record an impairment charge based on that difference. The impairment charge will be limited to the amount of goodwill allocated to that reporting unit. The standard eliminates the prior requirement to calculate a goodwill impairment charge using Step 2, which requires an entity to calculate any impairment charge by comparing the implied fair value of goodwill with its carrying amount. ASU 2017-04 was effective for the Company on January 1, 2020. The adoption of ASU 2017-04 had no material impact on the Company’s consolidated financial statements.
Disclosure Requirements for Fair Value Measurement - In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820) - Changes to the Disclosure Requirements for Fair Value Measurement” (“ASU 2018-13”). ASU 2018-13 modifies the disclosure requirements on fair value measurements by requiring that Level 3 fair value disclosures include the range and weighted average of significant unobservable inputs used to develop those fair value measurements. For certain unobservable inputs, an entity may disclose other quantitative information in lieu of the weighted average if the entity determines that other quantitative information would be a more reasonable and rational method to reflect the distribution of unobservable inputs used to develop Level 3 fair value measurements. Certain disclosure requirements in Topic 820 were also removed or modified. ASU 2018-13 was effective for the Company on January 1, 2020. The adoption of ASU 2018-13 had no material impact on the Company’s consolidated financial statements.
Interagency COVID-19 Guidance - In March 2020 (Revised in April 2020), various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, (“the agencies”) issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the Coronavirus. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, “Receivables - Troubled Debt Restructurings by Creditors,” (“ASC 310-40”), a restructuring of debt constitutes a troubled debt restructuring (“TDR”) if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time
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a modification program is implemented. In August 2020, a joint statement on additional loan modifications was issued. Among other things, the Interagency Statement addresses accounting and regulatory reporting considerations for loan modifications, including those accounted for under Section 4013 of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act. The CARES Act was signed into law on March 27, 2020 to help support individuals and businesses through loans, grants, tax changes and other types of relief. The most significant impacts of the Act related to accounting for loan modifications and establishment of the Paycheck Protection Program (“PPP”). On December 21, 2020, the Consolidated Appropriates Act of 2021 (“CAA”) was passed. The CAA extends or modifies many of the relief programs first created by the CARES Act, including the PPP and treatment of certain loan modifications related to the COVID-19 pandemic. Refer to Note 3 - Loans for a discussion regarding details of loan modifications as of December 31, 2020.
Note 2 - Securities
The amortized cost and fair values of securities available for sale as of December 31, 2020 and December 31, 2019 are as follows:
All mortgage-backed securities included in the above tables were issued by U.S. government agencies and corporations. At December 31, 2020, the securities issued by political subdivisions or agencies were highly rated with 100% of the municipal bonds having AA or higher ratings. Approximately 59% of the municipal bonds are general obligation bonds with issuers that are geographically diverse. The Company does not hold any derivative instruments.
Marketable equity securities consist of nominal investments made by the Company in equity positions of various community banks and bank holding companies and are reported in other assets on the consolidated balance sheet.
There were no securities classified as held to maturity as of December 31, 2020 or December 31, 2019.
Restricted securities are securities with limited marketability and consist of stock in the FRB, FHLB and CBBFC totaling $3.0 million and $1.7 million as of December 31, 2020 and December 31, 2019, respectively. These restricted securities are carried at cost as they are not permitted to be traded.
For the year ended December 31, 2020, proceeds from the sales of securities amounted to $69.5 million, and gross realized gain on these securities were $742,000. (An additional $1,000 gain was realized from a call of a security during 2020.) For the year ended December 31, 2019, proceeds from the sales of securities amounted to $21.1 million, and gross realized gain on these securities were $71,000. (An additional $3,000 gain was realized from a call of a security during 2019.)
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Securities pledged to secure deposits, and for other purposes required by law, had carrying values of $6.0 million at December 31, 2020 and $5.0 million at December 31, 2019.
Year-end securities with unrealized losses, segregated by length of time in a continuous unrealized loss position, were as follows:
As of December 31, 2020, there were $65.3 million, or thirty-seven issues, of individual securities in a loss position. These securities had an unrealized loss of $501,000 and consisted of twelve mortgage-backed/CMOs, fourteen municipal bonds, and eleven Agency notes with none in an unrealized loss position for greater than 12 months.
The Company’s securities portfolio is primarily made up of fixed rate bonds, whose prices move inversely with interest rates. Any unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. At the end of any accounting period, the portfolio may have both unrealized gains and losses. Management does not believe any of the securities in an unrealized loss position are impaired due to credit quality and does not intend to sell or believe it will be required to sell any of the securities before recovery of the amortized cost basis. Accordingly, as of December 31, 2020, management believes the impairments detailed in the table above are temporary, and no impairment loss has been realized in the Company’s consolidated income statements.
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The amortized cost and fair value of available for sale debt securities at December 31, 2020 are presented below based upon contractual maturities, by major investment categories. Expected maturities may differ from contractual maturities because issuers have the right to call or prepay obligations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3 - Loans
The composition of the loan portfolio by loan classification appears below.
During the twelve months ended December 31, 2020, the Bank originated $86.9 million of Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans, which were designated to provide economic relief to small businesses adversely impacted by COVID-19.
The balances in the table above include unamortized premiums and net deferred loan costs and fees. Unamortized premiums on loans purchased were $1.8 million and $2.5 million as of December 31, 2020 and December 31, 2019. Net deferred loan (fees) costs totaled $(931,000) and $100,000 as of December 31, 2020 and December 31, 2019, respectively. The deferred fees increased $1.0 million due to the remaining fees collected from the SBA for the PPP loans that are being amortized over the contractual life of the remaining loans, most of which are over a 24-month period.
Loan origination/risk management. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and the Board of Directors approves lending policies on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, and nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.
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Commercial and industrial loans are reported in four classes. Organic loans are originated by the Bank’s commercial lenders. PPP loans are reported separately from other organic loans due to the special purpose and provisions of these loans through the SBA. Government guaranteed loan balances represent the guaranteed portion of loans which the Company purchased that are 100% guaranteed by either the United States Department of Agriculture (“USDA”) or the Small Business Administration (“SBA”); the originating institution holds the unguaranteed portion of each loan and services it. Syndicated loans, also referred to as shared national credits, are purchased from national lending correspondents. The government guaranteed loans and the shared national credits are typically purchased at a premium. In the event of early prepayment, the Bank may need to write off any unamortized premium.
Both organic and syndicated loans are underwritten according to the Bank’s loan policies. The Company has developed policies to limit overall credit exposure to the syndicated market as a whole and to each borrower. The Bank’s loan policies for underwriting syndicated loans are based on the “Interagency Guidance on Leveraged Lending” applicable to national banks supervised by the OCC.
Organic commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Management examines current and projected cash flows to determine the ability of borrowers to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected, and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or marketable securities and may incorporate personal guarantees; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.
Real estate construction and land loans consist primarily of loans for the purchase or refinance of unimproved lots or raw land. Additionally, the Company finances the construction of real estate projects typically where the permanent mortgage will remain with the Company. Specific underwriting guidelines are delineated in the Bank’s loan policies.
Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those specific to real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts, and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. Management monitors and evaluates commercial real estate loans based on cash flows, collateral, geography and risk grade criteria. As a general rule, the Company avoids financing projects where the source of repayment is dependent upon the sale or operation of the collateral, unless other underwriting factors are present to help mitigate risk.
Residential mortgages include consumer purpose 1-4 family residential properties and home equity loans, as well as investor-owned residential real estate. The Company has purchased two packages of 1-4 family residential mortgages, one in December of 2018 and a second package in November of 2019. Each of the adjustable rate loans purchased were individually underwritten by the Company prior to the closing of the sale. As of December 31, 2020, the balance in both packages totaled approximately $18.5 million. Consumer purpose loans have underwriting standards that are heavily influenced by statutory requirements, which include, but are not limited to, documentation requirements, limits on maximum loan-to-value percentages, and collection remedies. Loans to finance 1-4 family investment properties are primarily dependent upon rental income generated from the property and secondarily supported by the borrower’s personal income. The Company typically originates residential mortgages with the intention of retaining in its portfolio adjustable-rate mortgages and shorter-term, fixed-rate loans. The Company also originates longer-term, fixed rate loans, which are sold to secondary mortgage market correspondents.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Consumer loans are generally small loans spread across many borrowers and are underwritten after determining the ability of the consumer borrower to repay their obligations as agreed. The underwriting standards are heavily influenced by statutory requirements, which include, but are not limited to, documentation requirements and collection remedies. Consumer loans may be secured or unsecured and are comprised of revolving lines, installment loans and other consumer loans. Included in consumer loans are student loan packages that were purchased beginning in 2015. Along with the purchase of these student loans, the Company purchased surety bonds to fully insure this portion of the Company’s consumer portfolio. ReliaMax Surety Company (“ReliaMax Surety”), the South Dakota insurance company which issued surety bonds for the student loan pool, was placed into liquidation due to insolvency on June 27, 2018, and the surety bonds terminated on July 27, 2018. Deposit account overdrafts are included in the consumer loan balances and totaled $169,000 and $197,000 at December 31, 2020 and December 31, 2019, respectively.
Independent loan review on a portion of the loan portfolio is performed by an independent loan review firm that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management and the Audit and Compliance Committee of the Board. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company’s policies and procedures.
Concentrations of credit. Most of the Company’s lending activity occurs within the Commonwealth of Virginia, predominantly in the Company’s primary markets and surrounding areas. The majority of the Company’s loan portfolio consists of commercial real estate loans. The Company manages this risk by using specific underwriting policies and procedures for these types of loans and by avoiding excessive concentrations to any one business or industry.
Related party loans. In the ordinary course of business, the Company has granted loans to certain directors, principal officers and their affiliates (collectively referred to as “related party loans”). Activity in related party loans during 2020 and 2019 is presented in the following table.
Past due, non-accrual and charged-off loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.
Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due. In determining whether or not a borrower may be unable to meet payment obligations for each class of loans, the Company considers the borrower’s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Company’s collateral position. Regulatory provisions generally require a loan to be placed on non-accrual status if (i) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection or (ii) full payment of principal and interest is not expected. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income on non-accrual loans is recognized only to the extent that cash payments are received in excess of principal due. A loan may be returned to accrual status when all the principal and interest amounts contractually due are brought current and future principal and interest amounts contractually due are reasonably assured, which is typically evidenced by a sustained period (at least six months) of repayment performance by the borrower.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Loans are charged off when 120 days past due. Smaller, unsecured consumer loans, including the student loan portfolio, are typically charged-off when management judges such loans to be uncollectible or the borrowers file for bankruptcy; these loans are generally not placed in non-accrual status prior to charge-off. The Company has contracted with a third party to proactively manage the collections of past due student loans; this third party has extensive experience and specializes in this type of asset management.
Student loans purchased which were 120 or more days past due as of July 27, 2018, were placed in non-accrual based on the loss of insurance on these loans. The Company filed claims for these non-accrual loans with the liquidator of ReliaMax Surety, which issued surety bonds on the student loan portfolio. In the fourth quarter of 2019, the Company collected $311,000 in principal and $9,000 toward interest outstanding on those claims approved by the liquidator. In 2020, the Company received a refund of premiums from the liquidator in the amount of $401,000.
Non-accrual loans are shown below by class:
The following tables show the aging of past due loans as of December 31, 2020 and December 31, 2019.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Impaired loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts when due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated on an individual loan basis. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net of the impairment, using either the present value of estimated future cash flows at the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
Regulatory guidelines require the Company to re-evaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following tables provide a breakdown by class of the loans classified as impaired loans as of December 31, 2020 and December 31, 2019. These loans are reported at their recorded investment, which is the carrying amount of the loan as reflected on the Company’s balance sheet, net of charge-offs and other amounts applied to reduce the net book balance. Average recorded investment in impaired loans is computed using an average of month-end balances for these loans for the twelve months ended December 31, 2020 and December 31, 2019. Interest income recognized is for the years ended December 31, 2020 and December 31, 2019.
Troubled debt restructurings (“TDRs”) are also considered impaired loans. TDRs occur when the Bank agrees to modify the original terms of a loan by granting a concession that it would not otherwise consider due to the deterioration in the financial condition of the borrower. These concessions are done in an attempt to improve the paying capacity of the borrower, and in some cases to avoid foreclosure, and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions.
In accordance with regulatory guidance and the CARES Act, the Bank has approved for certain customers who have been adversely affected by the COVID-19 pandemic to defer principal-only, or principal and interest, payments for a 90- to 180-day period. Such short-term modifications, which were made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. While interest will continue to accrue to income, in accordance with GAAP, if the Bank ultimately incurs a credit loss on these deferred payments, interest income would need to be reversed and therefore, interest income in future periods could be negatively impacted. A total of $59.0 million in loan deferments have been approved since the beginning of the pandemic. As of December 31, 2020, $55.7 million, or 94.3%, of the total loan deferments approved have returned to normal payment schedules and are now current.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Based on regulatory guidance on Student Lending, the Company classified 75 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2020. The Company classified 67 of its student loans purchased as TDRs for a total of $1.2 million as of December 31, 2019. These borrowers, who should have been in repayment, requested and were granted payment extensions exceeding the maximum lifetime allowable payment forbearance of twelve months (36 months lifetime allowance for military service), as permitted under the regulatory guidance, and are therefore considered restructurings. Student loan borrowers are allowed in-school deferments, plus an automatic six month grace period post in-school status, before repayment is scheduled to begin, and these deferments do not count toward the maximum allowable forbearance. Initially, all student loans were fully insured by a surety bond, and the Company did not expect to experience a loss on these loans. Based on the termination of the surety bond on July 27, 2018 due to the insolvency of the insurer, management has evaluated these loans individually for impairment and included any potential loss in the allowance for loan losses; interest continues to accrue on these TDRs during any deferment and forbearance periods.
The following provides a summary, by class, of modified loans that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and modified loans that have been placed in non-accrual status, which are considered to be nonperforming.
A summary of loans shown above that were modified as TDRs during the years ended December 31, 2020 and December 31, 2019 is shown below by class. Loans modified as TDRs that were fully paid down, charged-off, or foreclosed upon by period end are not reported. The Post-Modification Recorded Balance reflects any interest or fees from the original loan which may have been added to the principal balance on the new note as a condition of the TDR. Additionally, the Post-Modification Recorded Balance is reported below at the period end balances, inclusive of all partial principal pay downs and principal charge-offs since the modification date.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During the year ended December 31, 2020, there were five loans modified as TDRs that subsequently defaulted which had been modified as TDRs during the twelve months prior to default. These student loans had balances totaling $48,000 prior to being charged off. There were three loans modified as a TDR that subsequently defaulted during the year ended December 31, 2019 and were modified as a TDR during the twelve months prior to default. These student loans had balances of $23,000 prior to being charged off.
There were no loans secured by 1-4 family residential property that were in the process of foreclosure at either December 31, 2020 or December 31, 2019.
Note 4 - Allowance for Loan Losses
A summary of the transactions in the allowance for loan losses for the years ended December 31, 2020 and 2019 appears below:
Management has an established methodology to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Company has segmented certain loans in the portfolio by product type. Within these segments, the Company has sub-segmented its portfolio by classes, based on the associated risks within these classes.
Loan Classes by Segments
Commercial loan segment:
Commercial and industrial - organic
Commercial and industrial - Paycheck Protection Program
Commercial and industrial - government guaranteed1
Commercial and industrial - syndicated
Real estate construction and land loan segment:
Residential construction
Commercial construction
Land and land development
Real estate mortgage loan segment:
1-4 family residential, first lien, investment
1-4 family residential, first lien, owner occupied
1-4 family residential, junior lien
1-4 family residential, first lien - purchased
Home equity lines of credit, first lien
Home equity lines of credit, junior lien
Farm
Multifamily
Commercial owner occupied
Commercial non-owner occupied
Consumer loan segment:
Consumer revolving credit
Consumer all other credit
Student loans purchased
1 Commercial and industrial - government guaranteed class excludes PPP loans.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.
The migration analysis loss method is used for all loan classes except for the following:
•
Commercial and industrial PPP loans - These loans require no reserve as these are 100% guaranteed by the SBA.
•
Student loans purchased - On June 27, 2018, the Company was notified that ReliaMax Surety Company (“ReliaMax Surety”), the South Dakota insurance company which issued surety bonds for the student loan pools, was placed into liquidation due to insolvency. As such, the historical charge-off rate on this portfolio is determined by using the Company’s own losses/charge-offs since July 1, 2018, together with prior insurance claim history. For reporting periods prior to June 30, 2018, the Company did not charge off student loans as the insurance covered the past due loans, but the Company did apply qualitative factors to calculate a reserve on these loans, net of the deposit reserve accounts held by the Company for this group of loans. The deposit reserve accounts have been depleted to cover the charge-offs experienced on these loans and recorded as a recovery to student loans.
•
Commercial and industrial government guaranteed loans - These loans require no reserve as these are 100% guaranteed by either the SBA or the USDA.
•
Commercial and industrial syndicated loans - Beginning with the quarter ended September 30, 2016, migration analysis was utilized on the Pass pool. For all other pools, there was not an established loss history; therefore, the S&P credit and recovery ratings on the credit facilities were utilized to calculate a three-year weighted average historical default rate. As of December 31, 2019, only migration analysis was utilized since all outstanding syndicated loans at that time were in the Pass pool.
Under the migration analysis method, average loss rates are calculated at the risk grade and class levels by dividing the twelve-quarter average net charge-off amount by the twelve-quarter average loan balances. Qualitative factors are combined with these quantitative factors to arrive at the overall general allowances.
The Company’s internal creditworthiness grading system is based on experiences with similarly graded loans. The Company performs regular credit reviews of the loan portfolio to review the credit quality and adherence to its underwriting standards. Additionally, an independent loan review of a portion of the Company’s loan portfolio is performed periodically.
Loans that trend upward toward more positive risk ratings generally have a lower risk factor associated. Conversely, loans that migrate toward more negative ratings generally will result in a higher risk factor being applied to those related loan balances.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Risk Ratings and Historical Loss Factor Assigned
Excellent
A 0% historical loss factor is applied, as these loans are secured by cash or fully guaranteed by a U.S. government agency and represent a minimal risk. The Company has never experienced a loss within this category.
Good
A 0% historical loss factor is applied, as these loans represent a low risk and are secured by marketable collateral within margin. In an abundance of caution, a nominal loss reserve is applied to these loans. The Company has never experienced a loss within this category.
Pass
A historical loss factor for loans rated “Pass” is applied to current balances of like-rated loans, pooled by class. Loans with the following risk ratings are pooled by class and considered together as “Pass”:
Satisfactory - modest risk loans where the borrower has strong and liquid financial statements and more than adequate cash flow
Average - average risk loans where the borrower has reasonable debt service capacity
Marginal - acceptable risk loans where the borrower has acceptable financial statements but is leveraged
Watch
These loans have an acceptable risk but require more attention than normal servicing. A historical loss factor for loans rated “Watch” is applied to current balances of like-rated loans pooled by class.
Special Mention
These potential problem loans are currently protected but are potentially weak. A historical loss factor for loans rated “Special Mention” is applied to current balances of like-rated loans pooled by class.
Substandard
These problem loans are inadequately protected by the sound worth and paying capacity of the borrower and/or the value of any collateral pledged. These loans may be considered impaired and evaluated on an individual basis. Otherwise, a historical loss factor for loans rated “Substandard” is applied to current balances of all other “Substandard” loans pooled by class.
Doubtful
Loans with this rating have significant deterioration in the sound worth and paying capacity of the borrower and/or the value of any collateral pledged, making collection or liquidation of the loan in full highly questionable. These loans would be considered impaired and are evaluated on an individual basis.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following represents the loan portfolio designated by the internal risk ratings assigned to each credit at December 31, 2020 and 2019. There were no loans rated “Doubtful” as of either period.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In addition to the historical factors, the adequacy of the Company’s allowance for loan losses is evaluated through reference to eight qualitative factors, listed below and ranked in order of importance:
1)
Changes in national and local economic conditions, including the condition of various market segments;
2)
Changes in the value of underlying collateral;
3)
Changes in volume of classified assets, measured as a percentage of capital;
4)
Changes in volume of delinquent loans;
5)
The existence and effect of any concentrations of credit and changes in the level of such concentrations;
6)
Changes in lending policies and procedures, including underwriting standards;
7)
Changes in the experience, ability and depth of lending management and staff; and
8)
Changes in the level of policy exceptions.
It has been the Company’s experience that the first five factors drive losses to a much greater extent than the last three factors; therefore, the first five factors are weighted more heavily. Qualitative factors are not assessed against loans rated “Excellent” or “Good,” as the Company has never experienced a loss within these categories.
As of March 31, 2020 and June 30, 2020, the Company downgraded the economic qualitative factors within its ALLL model in light of the effects of the COVID-19 pandemic on the economy. No additional downgrades of such factors were taken during the quarters ended September 30, 2020 or December 31, 2020. If economic conditions improve or worsen, the Company could experience changes in the required ALLL. It is possible that asset quality metrics could decline in the future if the effects of COVID-19 are sustained.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For each segment and class of loans, management must exercise significant judgment to determine the estimation method that fits the credit risk characteristics of the various segments. Although this evaluation is inherently subjective, qualified management utilizes its significant knowledge and experience related to both the market and history of the Company’s loan losses.
During these evaluations, particular characteristics associated with a segment of the loan portfolio are also considered. These characteristics are detailed below:
•
Commercial loans not secured by real estate carry risks associated with the successful operation of a business, and the repayments of these loans depend on the profitability and cash flows of the business. Additional risk relates to the value of collateral where depreciation occurs and the valuation is less precise.
•
Commercial loans purchased from the syndicated loan market generally represent shared national credits, which are participations in loans or loan commitments that are shared by three or more banks. Included in the Company’s shared national credit portfolio are purchased participations and assignments in leveraged lending transactions. Leveraged lending transactions are generally used to support a merger- or acquisition-related transaction, to back a recapitalization of a company's balance sheet or to refinance debt. When considering a participation in the leveraged lending market, the Company participates only in first lien senior secured term loans. To further minimize risk, the Company has developed policies to limit overall credit exposure to the syndicated market as a whole, as well as limits by industry and borrower.
•
Loans secured by commercial real estate also carry risks associated with the success of the business and the ability to generate a positive cash flow sufficient to service debts. Real estate security diminishes risks only to the extent that a market exists for the subject collateral.
•
Consumer loans carry risks associated with the continued creditworthiness of the borrower and the value of the collateral, such as automobiles which may depreciate more rapidly than other assets. In addition, these loans may be unsecured. Consumer loans are more likely than real estate loans to be immediately affected in an adverse manner by job loss, divorce, illness or personal bankruptcy. Consumer loans are further segmented into consumer revolving lines, all other consumer loans and student loans purchased.
•
Real estate secured construction loans carry risks that a project will not be completed as scheduled and budgeted and that the value of the collateral may, at any point, be less than the principal amount of the loan. Additional risks may occur if the general contractor, who may not be a loan customer, is unable to finish the project as planned due to financial pressures unrelated to the project.
•
Residential real estate loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral. In addition, for investor-owned residential real estate, the repayment may be volatile as leases are generally shorter term in nature.
Impaired loans are individually evaluated and, if deemed appropriate, a specific allocation is made for these loans. In reviewing the loans classified as impaired totaling $1.3 million at December 31, 2020, there was $4,000 in valuation allowance on these loans after consideration was given for each borrowing as to the fair value of the collateral on the loan or the present value of expected future cash flows from the customer.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Allowance for Loan Losses Rollforward by Portfolio Segment
As of and for the year ended December 31, 2020
As of and for the year ended December 31, 2019
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 5 - Premises and Equipment
Premises and equipment are summarized as follows:
Depreciation and amortization on these premises and equipment totaled $1.9 million and $1.1 million for the years ended December 31, 2020 and December 31, 2019, respectively.
Note 6 - Leases
On January 1, 2019, the Company adopted ASU No. 2016-02 “Leases (Topic 842)” and all subsequent ASUs that modified Topic 842. The Company elected the prospective application approach provided by ASU 2018-11 and did not adjust prior periods for ASC 842. The Company also elected certain practical expedients within the standard and consistent with such elections did not reassess whether any expired or existing contracts are or contain leases, did not reassess the lease classification for any expired or existing leases, and did not reassess any initial direct costs for existing leases. Lease payments for short-term leases are recognized as lease expense on a straight-line basis over the lease term. Payments for leases with terms longer than twelve months are included in the determination of the lease liability.
The implementation of the new standard resulted in the recognition of a right-of-use asset and lease liability of $4.3 million at the date of adoption, which is related to the Company’s lease of premises used in operations. The right-of-use asset and lease liability are included in other assets and other liabilities, respectively, in the Consolidated Balance Sheets.
Lease liabilities represent the Company’s obligation to make lease payments and are presented at each reporting date as the net present value of the remaining contractual cash flows. Cash flows are discounted at the Company’s incremental borrowing rate in effect at the commencement date of the lease for a term similar to the length of the lease, including any probable renewal options available. Right-of-use assets represent the Company’s right to use the underlying asset for the lease term and are calculated as the sum of the lease liability and if applicable, prepaid rent, initial direct costs and any incentives received from the lessor.
At December 31, 2020, the Company had leased certain of its banking and operations offices, or the land on which such offices were built, under operating lease agreements on terms ranging from 1 to 10 years, most with renewal options. Each of the Company’s long-term lease agreements are classified as operating leases. Certain of these leases offer the option to extend the lease term and the Company has included such extensions in its calculation of the lease liabilities to the extent the options are reasonably assured of being exercised. The lease agreements do not provide for residual value guarantees and have no restrictions or covenants that would impact dividends or require incurring additional financial obligations. Refer to Note 13 - Related Party Transactions for information regarding leasing transactions with related parties.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following tables present information about the Company’s leases (dollars in thousands):
A maturity analysis of operating lease liabilities and reconciliation of the undiscounted cash flows to the total of operating lease liabilities is as follows (dollars in thousands):
Note 7 - Intangible Assets
On February 1, 2016 (the “Effective Date”), VNB Wealth purchased the book of business, including interest in the client relationships, (“Purchased Relationships”), from an officer (the “Seller”) of VNB Wealth pursuant to an employment and asset purchase agreement (the “Purchase Agreement”). Prior to becoming an employee of the Company and until the Effective Date of the sale, the Seller provided services to these Purchased Relationships as a sole proprietor. As of January 15, 2016, the fair value of the assets under management associated with the Purchased Relationships totaled $31.5 million. Under the terms of the Purchase Agreement, the Company will receive all future revenue for investment management, advisory, brokerage, insurance, consulting, trust and related services performed for the Purchased Relationships.
The purchase price of $1.2 million was payable over a five year period with the last payment being made in January 2020. During the first quarter of 2016, the Company recognized goodwill and other intangible assets arising from this purchase. As required under ASC Topic 805, “Business Combinations,” using the acquisition method of accounting, below is a summary of the net asset values, as determined by an independent third party, based on the fair value measurements and the purchase price.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The intangible assets identified below will be amortized using a straight line method over the estimated useful life, and the amortized cost will be shown as noninterest expense. In accordance with ASC 350, “Intangibles-Goodwill and Other,” the Company will review the carrying value of indefinite lived goodwill at least annually or more frequently if certain impairment indicators exist.
Through the twelve months ended December 31, 2020, the Company recognized $90,000 in amortization expense from these identified intangible assets with a finite life. The net carrying value of $341,000 will be recognized as amortization expense in future reporting periods through 2026. The following shows the gross and net balance of these intangible assets as of December 31, 2020.
As of December 31, 2020, the Company carried no contingent liability, as all five payments due to the Seller, as delineated in the Purchase Agreement, were paid, with the last annual payment paid from this liability in January 2020.
Note 8 - Deposits
At December 31, 2020, the scheduled maturities of time deposits are as follows:
The aggregate amount of time deposits with a minimum balance of $250,000 was $34.7 million at December 31, 2020 and $38.4 million at December 31, 2019.
Included in the time deposits reported above are Certificate of Deposit Account Registry Service CDs, known as CDARSTM, whereby depositors can obtain FDIC deposit insurance on account balances of up to $50 million. CDARSTM deposits totaled $8.5 million as of December 31, 2020 and $13.7 million as of December 31, 2019, all of which were reciprocal balances for the Bank’s customers. In May 2018, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” was enacted, which excluded reciprocal CDARS™ deposits for certain banks from brokered deposit treatment up to the lesser of $5 billion or 20% of a bank’s total liabilities. Therefore, the Company’s CDARS™ reciprocal deposits as of December 31, 2020 and December 31, 2019 were not treated as brokered deposits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company implemented an Insured Cash Sweep® (ICS®) product during 2018. At December 31, 2020, ICS® balances, included in demand deposit and money market account balances, were $28.0 million and $81.1 million, respectively. At December 31, 2019, ICS® balances, included in demand deposit and money market account balances, were $19.3 million and $53.6 million, respectively. Such balances were not treated as brokered deposits.
The company had no deposits to report as brokered deposits as of December 31, 2020 or December 31, 2019.
Deposit account overdrafts reported as loans totaled $169,000 and $197,000 at December 31, 2020 and December 31, 2019, respectively.
The Company has entered into deposit transactions with certain directors, principal officers and their affiliates (collectively referred to as “related party deposits”), all of which are under the same terms as other customers. The aggregate amount of these related party deposits was $8.1 million and $15.4 million as of December 31, 2020 and December 31, 2019, respectively.
Note 9 - Borrowings
The Company uses both short-term and long-term borrowings to supplement deposits when they are available at a lower overall cost to the Company or they can be invested at a positive rate of return.
Each FHLB credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB may prescribe the acceptable uses to which the advances may be put, as well as on the size of the advances and repayment provisions. FHLB borrowings are secured by the pledge of commercial real estate loans. The Company had FHLB advances of $30,000,000 at December 31, 2020 maturing through 2025 that consisted of the following:
In addition to access to short-term borrowings from FHLB, the Company uses federal funds purchased for short-term borrowing needs. Available borrowing arrangements maintained by the Bank include formal federal funds lines with four major correspondent banks. There were no borrowings against the lines at December 31, 2020 or December 31, 2019.
The Company’s unused lines of credit for future borrowings total approximately $48.9 million at December 31, 2020, which consists of $7.9 million available from the FHLB and $41.0 million from third party financial institutions. Additional loans and securities are available that can be pledged as collateral for future borrowings from the Federal Reserve Bank of Richmond or the FHLB above the current lendable collateral value.
Information related to borrowings as of December 31, 2020 and 2019 is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10 - Income Taxes
The Company files tax returns in the U.S. federal jurisdiction. With few exceptions, the Company is no longer subject to U.S. federal tax examinations by tax authorities for years prior to 2017.
The Commonwealth of Virginia assesses a Bank Franchise Tax on banks instead of a state income tax. The Bank Franchise Tax expense is reported in noninterest expense, and the calculation of that tax is unrelated to taxable income.
Net deferred tax assets consist of the following components as of year-end:
The provision for income taxes charged to operations for years ended December 31, 2020 and December 31, 2019 consists of the following:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company’s income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2020 and December 31, 2019 due to the following:
Note 11 - 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 consolidated financial statements. The Company does not anticipate any material loss as a result of these transactions.
As a member of the Federal Reserve System, the Company is required to maintain certain average clearing balances. Those balances include amounts on deposit with the Federal Reserve. For the final weekly reporting period in the years ended December 31, 2020 and December 31, 2019, no daily average required balances were required for either year.
Note 12 - Financial Instruments with Off-Balance Sheet Risk and Credit Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit, such as unfunded lines of credit and standby letters of credit. The Company also treats authorization limits for originating Automated Clearing House (“ACH”) transactions as commitments. In addition to the amounts shown below, the Company has extended commitment letters at December 31, 2020 in the amount of $4.0 million to various borrowers. At December 31, 2019, commitment letters totaled $14.4 million. Commitment letters are done in the normal course of business and typically expire after 120 days. All of these off-balance-sheet instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet, although material losses are not anticipated. The contract or notional amounts of those instruments reflect the extent of involvement the Company has 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 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.
The totals for financial instruments whose contract amount represents credit risk are shown below:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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 creditworthiness on a case-by-case basis. The amount of collateral, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral normally consists of real property.
Standby letters of credit are conditional commitments by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate and bank deposits as collateral supporting those commitments for which collateral is deemed necessary.
The Company has approximately $258,000 in deposits in other financial institutions in excess of amounts insured by the FDIC at December 31, 2020.
Note 13 - Related Party Transactions
From time to time, the Company and its subsidiaries have business dealings with companies owned by directors and beneficial shareholders of the Company. Payments made to these companies that exceeded the disclosure threshold of $120,000 in 2020 are reported below.
In 2020 and 2019, leasing/rental expenditures of $511,000 and $500,000 respectively, (including reimbursements for taxes, insurance, and other expenses) were paid to an entity indirectly owned by a director of the Company.
Note 14 - Capital Requirements
The Bank is 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 Bank’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Federal banking regulations also impose regulatory capital requirements on bank holding companies. However, in August 2018, the Federal Reserve Board issued an interim final rule, which was effective August 30, 2018, that expanded its small bank holding company policy statement (the “SBHC Policy Statement”) to bank holding companies with total consolidated assets of less than $3 billion (up from the prior $1 billion threshold). Under the SBHC Policy Statement, qualifying bank holding companies have additional flexibility in the amount of debt they can issue and are also exempt from the Basel III Capital Rules (subsidiary depository institutions of qualifying bank holding companies are still subject to capital requirements). The Company currently has less than $3 billion in total consolidated assets and would likely qualify under the revised SBHC Policy Statement. However, the Company does not currently intend to issue a material amount of debt or take any other action that would cause its capital ratios to fall below the minimum ratios required by the Basel III Capital Rules.
The Basel III Capital Rules require banks and bank holding companies to comply with the following minimum capital ratios: (i) a ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7%); (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum Tier 1 capital ratio of 8.5%); (iii) a ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (effectively resulting in a minimum total capital ratio of 10.5%); and (iv) a 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).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
With respect to the Bank, the “prompt corrective action” regulations, to be “well capitalized” under the revised regulations, a bank must have the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of at least 6.5%; (ii) a Tier 1 capital to risk-weighted assets ratio of at least 8.0%; (iii) a total capital to risk-weighted assets ratio of at least 10.0%; and (iv) a leverage ratio of at least 5.0%. The Bank exceeds the thresholds to be considered well capitalized as of December 31, 2020.
The Bank’s capital ratios remained well above the levels designated by bank regulators as “well capitalized” at December 31, 2020. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table below. There are no conditions or events since that management believes have changed the institution’s category.
On September 17, 2019 the Federal Deposit Insurance Corporation finalized a rule that introduced an optional simplified measure of capital adequacy for qualifying community banking organizations, referred to as, the community bank leverage ratio (CBLR) framework, as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.
In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital.
The CBLR framework was available for banks to use in their March 31, 2020 Call Report and going forward. The Bank decided not to opt into the CBLR framework.
The Bank calculates its regulatory capital under the Basel III regulatory capital framework. The table below summarizes the Bank’s regulatory capital and related ratios for the periods presented:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 15 - Dividend Restrictions
The primary source of funds for the dividends paid by the Company to shareholders is dividends received from the Bank. Federal regulations limit the amount of dividends which the Bank can pay to the Company without obtaining prior approval. The amount of cash dividends that the Bank may pay is limited to current year earnings plus retained net profits for the two preceding years. In addition, dividends paid by the Bank would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.
In addition to the regulatory limits, the Company’s Board of Directors, under current policies, will generally only consider a cash dividend payment to shareholders that, when combined with any previous cash dividends paid within the last 12 months, does not exceed 50% of the Bank’s after-tax earnings for the preceding 12-months, or 60% if the previous three quarterly dividends are not within the preceding 12 months.
At December 31, 2020, the maximum amount of retained earnings available to the Bank for cash dividends to the Company was $15,609,000.
Note 16 - Fair Value Measurements
Determination of Fair Value
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurements and Disclosures” topic of FASB ASC 825, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value guidance provides a consistent definition of fair value, which focuses on exit price in the principal or most advantageous market for the asset or liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
Fair Value Hierarchy
In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
Level 1 -
Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 -
Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 -
Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.
The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:
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).
The following tables present the balances measured at fair value on a recurring basis:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or writedowns of individual assets.
The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the consolidated financial statements:
Other real estate owned
Other real estate owned is measured at fair value less cost to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company (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 nonrecurring 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 Company had no OREO at December 31, 2020 or December 31, 2019.
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 (a) the observable market price of the loan or the fair value of the collateral, or (b) using the present value of expected future cash flows discounted at the loan’s effective interest rate, which is not a fair value measurement. 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.
Impaired loans that are measured based on expected future cash flows discounted at the loan’s effective interest rate rather than the market rate of interest are not recorded at fair value, and are therefore excluded from fair value disclosure requirements.
The value of business equipment is based upon an outside appraisal if deemed significant (Level 2) or the net book value on the applicable business’ financial statements if not considered significant (Level 3). Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses in the Consolidated Statements of Income. The Company had $1.3 million and $2.5 million in impaired loans as of December 31, 2020 and December 31, 2019, respectively. All impaired loans were measured based on expected cash flows discounted at the loan’s effective interest rate, or fair value of collateral, as noted above.
ASC 825, “Financial Instruments,” requires disclosures about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
The Company uses the exit price notion in calculating the fair values of financial instruments not measured at fair value on a recurring basis.
The carrying values and estimated fair values of the Company’s financial instruments are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its 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. Management 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 and more likely to prepay in a falling 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. Management 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 17 - Other Noninterest Expenses
The Company had the following other noninterest expenses as of the dates indicated:
Note 18 - Employee Benefit Plans
The Company has a 401(k) plan available to all employees who are at least 18 years of age. Employees are able to elect the amount to contribute, not to exceed a maximum amount as determined by Internal Revenue Service regulation. The Company matches 100% of the first 6% of employee contributions.
“Vesting” refers to the rights of ownership to the assets in the 401(k) accounts. Matching contributions as well as employee contributions are fully vested immediately.
The Company contributed $398,000 and $342,000 to the 401(k) plan in 2020 and 2019, respectively. These expenses represent the matching contribution by the Company.
Note 19 - Stock Incentive Plans
At the Annual Shareholders Meeting on May 21, 2014, shareholders approved the Virginia National Bankshares Corporation 2014 Stock Incentive Plan (“2014 Plan”). The 2014 Plan makes available up to 275,625 shares of the Company’s common stock, as adjusted by the 5% stock dividend effective July 5, 2019 (the “Stock Dividend”) and the 5% stock dividend effective April 13, 2018 (the “2018 Stock Dividend”), to be issued to plan participants. The 2014 Plan provides for granting of both incentive and nonqualified stock options, as well as restricted stock, unrestricted stock and other stock based awards. No new grants will be issued under the 2005 Plan as this plan has expired.
For all of the Company’s stock incentive plans (the “Plans”), the option price of incentive options will not be less than the fair value of the stock at the time an option is granted. Nonqualified options may be granted at prices established by the Board of Directors, including prices less than the fair value on the date of grant. Outstanding options generally expire in ten years from the grant date. Stock options generally vest by the fourth or fifth anniversary of the date of the grant.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the shares issued and available under each of the Company’s stock incentive plans (the “Plans”) is shown below as of December 31, 2020. Share data and exercise price range per share have been adjusted to reflect the 2019 Stock Dividend and the 2018 Stock Dividend (collectively, “5% Stock Dividends”) and, with respect to the 2005 Plan, the 15% stock dividend effective June 30, 2011 (together with the 5% Stock Dividends, the “Stock Dividends”). Although the 2005 Plan has expired and no new grants will be issued under this plan, there were shares issued before the plan expired which are still outstanding as shown below.
The Company accounts for all of its stock incentive plans under recognition and measurement accounting principles which require that the compensation cost relating to stock-based payment transactions be recognized in the financial statements. Stock-based compensation arrangements for 2020 and prior years include stock options, unrestricted stock and restricted stock. All stock-based payments to employees are required to be valued using a fair value method on the date of grant and expensed based on that fair value over the applicable vesting period.
Stock Options
Changes in the stock options outstanding related to all of the Plans are summarized below.
As no options were exercised during the year ended December 31, 2020, there was no intrinsic value for options exercised.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended December 31, 2020 and 2019, the Company recognized $124,000 and $97,000, respectively, in compensation expense for stock options. As of December 31, 2020, there was $396,000 in unrecognized compensation expense for stock options remaining to be recognized in future reporting periods through 2025. The fair value of any option grant is estimated at the grant date using the Black-Scholes pricing model. There were stock option grants of 66,000 and 12,420 shares, as adjusted to reflect the 5% Stock Dividends, issued during the years ended December 31, 2020 and 2019, respectively and the fair value on each option granted was estimated based on the assumptions noted in the following table:
1 Based on the monthly historical volatility of the Company’s stock price over the expected life of the options.
2 Calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.
3 Based on the average of the contractual life and vesting period for the respective option.
4 Based upon an interpolated US Treasury yield curve interest rate that corresponds to the contractual life of the option, in effect at the time of the grant.
Summary information pertaining to options outstanding at December 31, 2020, as adjusted for Stock Dividends, is as follows:
Stock Grants
Unrestricted stock grants - There were no unrestricted stocks grants awarded in 2020 and no expense associated with unrestricted stock grants in 2020. On February 20, 2019, a total of 11,535 shares of unrestricted stock, as adjusted for the 2019 Stock Dividend, were granted to non-employee directors and certain members of executive management for services to be provided during the year ended December 31, 2019. The total expense for these shares of $425,000 was recognized in 2019.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Restricted stock grants - In September 2019, 4,000 shares of restricted stock were granted to certain members of executive management, vesting over a four-year period, with an associated expense of $12,000 taken in 2019. In March 2020, 10,368 restricted shares were granted to non-employee directors, vesting over a four-year period. In April 2020, 1,900 shares were issued to lenders in accordance with an internal lender incentive plan, vesting over a five-year period, and in May 2020, 10,000 restricted shares were granted to certain members of executive management, vesting over a four-year period. In 2020 restricted stock grants resulted in an associated expense of $140,000. As of December 31, 2020, there was $556,000 in unrecognized compensation expense for restricted stock grants remaining to be recognized in future reporting periods through 2025.
The weighted average period over which nonvested restricted stock grants are expected to be recognized is 1.8 years.
Note 20 - Net Income per Share
On June 13, 2019, the Board of Directors approved a stock dividend of five percent (5%) on the outstanding shares of common stock of the Company (or .05 share for each share outstanding) which was issued on July 5, 2019 to all shareholders of record as of the close of business on June 26, 2019. Shareholders received cash in lieu of any fractional shares that they otherwise would have been entitled to receive in connection with the stock dividend. The price paid for fractional shares was based on the volume-weighted average price of a share of common stock for the most recent three (3) days prior to the record date during which a trade of the Company’s stock occurred.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the following table, share and per share data have been adjusted to reflect the 2019 Stock Dividend. The table shows the weighted average number of shares used in computing net income per common share and the effect on the weighted average number of shares of diluted potential common stock for the years ended December 31, 2020 and 2019. Potential dilutive common stock equivalents have no effect on net income available to the Company’s shareholders. The weighted average shares below as of December 31, 2020 and December 31, 2019 include 19,603 and 4,000 shares, respectively, of restricted stock that have not yet vested. The recipients of nonvested restricted shares have full voting and dividend rights.
In 2020 and 2019, stock options representing 145,404 and 78,301 average shares, respectively, were not included in the calculation of net income per share, as their effect would have been antidilutive.
Note 21 - Other Comprehensive Income
A component of the Company’s comprehensive income, in addition to net income from operations, is the recognition of the realized gains and losses on AFS securities, net of income taxes. Reclassifications of unrealized gains and losses on AFS securities are reported in the income statement as “Gains (losses) on sales and calls” of securities with the corresponding income tax effect reflected as a component of income tax expense. Amounts reclassified out of accumulated other comprehensive income (loss) are presented below:
Note 22 - Segment Reporting
Virginia National Bankshares Corporation has four reportable segments. Each reportable segment is a strategic business unit that offers different products and services. They are managed separately, because each segment appeals to different markets and, accordingly, require different technology and marketing strategies. The accounting policies of the segments are the same as those described in the summary of significant accounting policies provided earlier in this report.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The four reportable segments are:
•
Bank - The commercial banking segment involves making loans and generating deposits from individuals, businesses and charitable organizations. Loan fee income, service charges from deposit accounts, and other non-interest-related fees, such as fees for debit cards and ATM usage and fees for treasury management services, generate additional income for the Bank segment.
•
Sturman Wealth Advisors - Sturman Wealth Advisors, formerly known as VNB Investment Services, offers wealth management and investment advisory services. Revenue for this segment is generated primarily from investment advisory and financial planning fees, with a small and decreasing portion attributable to brokerage commissions.
•
VNB Trust and Estate Services - VNB Trust and Estate Services offers corporate trustee services, trust and estate administration, IRA administration and custody services. Revenue for this segment is generated from administration, service and custody fees, as well as management fees which are derived from Assets Under Management. Investment management services currently are offered through in-house and third-party managers. In addition, royalty income, in the form of fixed and incentive fees, from the sale of Swift Run Capital Management, LLC in 2013 is reported as income of VNB Trust and Estate Services. More information on royalty income and the related sale can be found under Note 1 - Summary of Significant Accounting Policies.
•
Masonry Capital - Masonry Capital offers investment management services for separately managed accounts and a private investment fund employing a value-based, catalyst-driven investment strategy. Revenue for this segment is generated from management fees which are derived from Assets Under Management and incentive income which is based on the investment returns generated on performance-based Assets Under Management.
A management fee for administrative and technology support services provided by the Bank is allocated to the non-bank segments. For both the years ended December 31, 2020 and 2019, management fees of $100,000 were charged to the non-bank segments and eliminated in consolidated totals.
Segment information for the years ended December 31, 2020 and 2019 is shown in the following tables. Note that asset information is not reported below, as the assets of Sturman Wealth Advisors and VNB Trust
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
& Estate Services are reported at the Bank level; also, assets specifically allocated to the lines of business other than the Bank are insignificant and are no longer provided to the chief operating decision maker.
Note 23- Condensed Parent Company Financial Statements
Condensed financial statements pertaining only to the Parent Company are presented below. The investment in subsidiary is accounted for using the equity method of accounting.
Cash dividend payments authorized by the Bank’s Board of Directors were paid to the Parent Company in 2020 and 2019, totaling $4.4 million and $3.4 million, respectively.
The payment of dividends by the Bank is restricted by various regulatory limitations. Banking regulations also prohibit extensions of credit to the parent company unless appropriately secured by assets. For more detail on dividends, see Note 15 - Dividend Restrictions.
Condensed Parent Company Only
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Condensed Parent Company Only (Continued)
Item 9.
Item 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None
Item 9A.
Item 9A.
CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. The Company maintains “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective at the reasonable assurance level.
Management’s Report on Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Exchange Act. 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.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020. This assessment was based on criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) on May 14, 2013. Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the internal control over financial reporting was effective based on those criteria.
Changes in Internal Control over Financial Reporting. There was no change in the internal control over financial reporting that occurred during the year ended December 31, 2020 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.
Item 9B.
Item 9B.
OTHER INFORMATION.
None
Part III
Item 10.
Item 10.
DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE.
Information is incorporated by reference to the information that appears under the headings “Proposal 1 - Election of Directors,” “Related Person Transactions and Other Information,” “Executive Compensation - Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Code of Ethics,” and “Information about the Board of Directors and Board Committees” contained in the Company’s Definitive Proxy Statement to be used in connection with the Company’s 2021 Annual Meeting of Shareholders (“Definitive Proxy Statement”).
Item 11.
Item 11.
EXECUTIVE COMPENSATION.
Information is incorporated by reference to the information that appears under the headings “Executive Compensation - Executive Officers” and “Information about the Board of Directors and Board Committees - Compensation of Directors” contained in of the Company’s Definitive Proxy Statement.
Item 12.
Item 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
Other than as set forth below, this information is incorporated by reference from Note 19, “Stock Incentive Plans,” in the Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data of this Form 10-K and from the “Beneficial Ownership of Company Common Stock” section of the Company’s Definitive Proxy Statement.
The following table summarizes information, as of December 31, 2020, relating to the Company’s Stock Incentive Plans:
Item 13.
Item 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.
This information is incorporated by reference from the “Information about the Board of Directors and Board Committees” and “Related Person Transactions and Other Information” sections of the Company’s Definitive Proxy Statement. For further information, see Note 13 of the Notes to Consolidated Financial Statements contained in Item 8. Financial Statements and Supplementary Data in this Form 10-K.
Item 14.
Item 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES.
This information is incorporated by reference from the “Independent Auditors” section of the Company’s Definitive Proxy Statement.
Part IV
Item 15.
Item 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
The following documents are files as part of this report:
(a)(1)Financial Statements
The following consolidated financial statements and reports of independent registered public accountants of the Company are in Part II, Item 8. Financial Statements and Supplementary Data:
(i)
Consolidated Balance Sheets - December 31, 2020 and December 31, 2019
(ii)
Consolidated Statements of Income - Years ended December 31, 2020 and December 31, 2019
(iii)
Consolidated Statements of Comprehensive Income - Years ended December 31, 2020 and December 31, 2019
(iv)
Consolidated Statements of Changes in Shareholders’ Equity - Years ended December 31, 2020 and December 31, 2019
(v)
Consolidated Statements of Cash Flows - Years ended December 31, 2020 and December 31, 2019
(vi)
Notes to Consolidated Financial Statements
(a)(2)Financial Statement Schedules
All schedules are omitted since they are not required, are not applicable, or the required information is shown in the consolidated statements or notes thereto.
(a)(3)Exhibit Index:
Exhibit
Number
Description of Exhibit
2.1
Agreement and Plan of Reorganization, dated as of September 30, 2020, between Virginia National Bankshares Corporation and Fauquier Bankshares, Inc. (incorporated by reference to Exhibit 2.1 to Virginia National Bankshares Corporation’s Form 8-K filed with the SEC on October 2, 2020).
3.1
Articles of Incorporation of Virginia National Bankshares Corporation, as amended and restated (incorporated by reference to Exhibit 3.1 to Virginia National Bankshares Corporation’s Pre-effective Amendment No. 1 to Form S-4 Registration Statement filed with the Securities and Exchange Commission on April 12, 2013).
3.2
Bylaws of Virginia National Bankshares Corporation, as amended and restated (incorporated by reference to Exhibit 3.2 of Virginia National Bankshares Corporation’s Current Report on Form- 8-K filed with the Securities and Exchange Commission on March 30, 2020).
10.1
Virginia National Bank 2003 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to Virginia National Bankshares Corporation’s Quarterly Report on Form 10-Q filed with the Securities and Exchange Commission on November 9, 2017. Virginia National Bankshares Corporation assumed this plan from Virginia National Bank on December 16, 2013 upon consummation of the reorganization under the agreement referenced as Exhibit 2.0).
10.2
Virginia National Bank Amended and Restated 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 to Virginia National Bankshares Corporation’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on July 25, 2017. Virginia National Bankshares Corporation assumed this plan from Virginia National Bank on December 16, 2013 upon consummation of the reorganization under the agreement referenced as Exhibit 2.0).
10.3
Virginia National Bankshares Corporation 2014 Stock Incentive Plan (incorporated by reference to Exhibit 99.2 to Virginia National Bankshares Corporation’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on July 25, 2017).
10.4
Form of Amended and Restated Management Continuity Agreement executed September 28, 2020 between Virginia National Bankshares Corporation and each of Glenn W. Rust, Virginia R. Bayes, Tara Y. Harrison and Donna G. Shewmake (incorporated by reference to Exhibit 10.1 to Virginia National Bankshares Corporation’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 28, 2020).
21.0
Subsidiaries of the Registrant (refer to Item 1. Business, beginning on page 5 of this Form 10-K Report for a discussion of Virginia National Bankshares Corporation’s direct and indirect subsidiaries).
31.1
302 Certification of Principal Executive Officer
31.2
302 Certification of Principal Financial Officer
32.1
906 Certification
101.0
Interactive data files pursuant to Rule 405 of Regulation S-T, formatted in Inline eXtensible Business Reporting Language (Inline XBRL), (i) the Consolidated Balance Sheets as of December 31, 2020 and December 31, 2019, (ii) the Consolidated Statements of Income for the years ended December 31, 2020 and December 31, 2019, (iii) the Consolidated Statements of Comprehensive Income for the years ended December 31, 2020 and December 31, 2019, (iv) the Consolidated Statements of Changes in Shareholders’ Equity for years ended December 31, 2020 and December 31, 2019, (v) the Consolidated Statements of Cash Flows for the years ended December 31, 2020 and December 31, 2019, and (vi) the Notes to Consolidated Financial Statements (furnished herewith), tagged as blocks of text and including detailed tags.
Cover page interactive data file (embedded with the Inline XBRL document)
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.
VIRGINIA NATIONAL BANKSHARES CORPORATION
/s/ Tara Y. Harrison
Tara Y. Harrison
Executive Vice President & Chief Financial Officer
Date: March 19, 2021
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 on March 19, 2021.
Signatures
Title
/s/ H. K. Benham, III
Director
H. K. Benham, III
s/ Steven W. Blaine
Director
Steven W. Blaine
/s/ Hunter E. Craig
Director
Hunter E. Craig
/s/ William D. Dittmar, Jr.
Chairman of the Board
William D. Dittmar, Jr.
/s/ Tara Y. Harrison
Executive Vice President & Chief Financial Officer
Tara Y. Harrison
(principal financial and accounting officer)
/s/ James T. Holland
Director
James T. Holland
/s/ Linda M. Houston
Director
Linda M. Houston
/s/ Susan King Payne
Director
Susan King Payne
/s/ Glenn W. Rust
President & Chief Executive Officer and Director
Glenn W. Rust
(principal executive officer)
/s/ Gregory L. Wells
Director
Gregory L. Wells
/s/ Bryan D. Wright
Director
Bryan D. Wright