Item 1. Business.
History and Operations
The Board of Directors of Bank of Charles Town (the "bank") caused Potomac Bancshares, Inc. ("Potomac" or the “company”) to be formed on March 2, 1994, as a single-bank holding company. To date, Potomac's only activities have involved the acquisition of the bank. Potomac acquired all of the shares of the bank’s common stock on July 29, 1994.
Bank of Charles Town is a West Virginia state-chartered bank that formed and opened for business in 1871. The Federal Deposit Insurance Corporation insures the bank’s deposits. The bank engages in general banking business primarily in Jefferson County and Berkeley County, West Virginia. The bank also provides services to Washington County and Frederick County, Maryland and Loudoun County, Frederick County and Clarke County, Virginia. In 2005 the bank opened a loan production office in Winchester, Virginia. The Winchester office was closed in August of 2008. The main office is in Charles Town, West Virginia at 111 East Washington Street, with branch offices in
Harpers Ferry, West Virginia,
Kearneysville, West Virginia,
Martinsburg, West Virginia and
Hedgesville, West Virginia.
The bank provides individuals, businesses and local governments with a broad range of banking services. These services include
Commercial credit lines, equipment loans, and construction financing,
Real estate loans, secondary market and adjustable rate mortgages,
Retail loan products including home equity lines of credit,
Checking and savings accounts for businesses and individuals and
Certificates of deposit and individual retirement accounts.
Automated teller machines located at each of the five offices and Touchline 24, an interactive voice response system available at 1-304-728-2424, provide certain services to customers on a twenty-four hour basis. The bank initiated the formation of an ATM network with two banks in the community to provide customers of all three banks 17 ATM locations in the eastern panhandle of West Virginia. Bill paying and certain other banking services are available through the Internet. The trust and financial services department provides financial management, investment and trust services. BCT Investments provides financial management, investment and brokerage services.
Lending Activities. The bank offers a variety of loans for consumer and commercial purposes. The majority of these loans are secured.
Underwriting standards for all lending include
Sound credit analysis,
Proper documentation according to the bank's loan policy standards,
Avoidance of loan concentrations to a single industry or with a single class of collateral,
Diligent maintenance of past due and nonaccrual loans and
A risk grading system that assists us in managing deteriorating credits on a proactive basis.
The lending policies of the bank address the importance of a diversified portfolio and of a balance between maximum yield and minimum risk. It is the bank’s policy to avoid concentrations of loans such as loans to one industry, loans to one borrower or guarantor or loans secured by similar collateral.
The bank's loan policy designates particular loan-to-value limits for real estate loans in accordance with recommendations in Section 304 of the Federal Deposit Insurance Corporation Improvement Act of 1991. As stated in the loan policy, there may be certain lending situations not subject to these loan-to-value limits and from time to time senior management of the bank may permit exceptions to the established limits. Any exceptions are sufficiently documented.
Loans secured by real estate are made to individuals and businesses for
The purchase of raw land and land development,
Commercial, multi-family and other non-residential construction,
Purchase of improved property,
Purchase of owner occupied one to four family residential property,
Lines of credit and
Home equity loans.
Approximately 91.0% of the bank's loans are secured by real estate. These loans had an average delinquency rate of 2.89% and a loss rate of 0.58% during 2008. The average delinquency rate and loss rate are based on comparisons to 2008 average total loans.
As of December 31, 2008, aggregate dollar amounts (in thousands) in loan categories secured by real estate are as follows:
Commercial loans not secured by real estate with an aggregate balance of $9.7 million at December 31, 2008 make up approximately 3.9% of the total loan portfolio. The bank’s loan policy for commercial loans including those commercial loans secured by real estate is to
Grant loans on a sound and collectible basis,
Invest the bank’s funds profitably for the benefit of shareholders and the protection of depositors and
Serve the legitimate credit needs of the community in which the bank is located.
Average delinquency and the loss rate for commercial loans not secured by real estate was less than 1% during 2008.
Retail loans to individuals for personal expenditures are approximately 4.9% of the bank's total loans at December 31, 2008. The aggregate balance of these loans was $12 million at December 31, 2008. The majority of these loans are installment loans with the remainder made as term loans.
There is some risk in every retail loan transaction. The bank accepts moderate levels of risk while minimizing retail loan losses through careful investigation into the character of each borrower, determining the source of repayment before closing each loan, collateralizing most loans, exercising care in documentation procedures, administering an aggressive retail loan collection program, and following the retail loan policies. Loans to individuals for personal expenditures had an average delinquency rate of 0.09% and a loss rate of 0.11% in 2008 (based on comparisons to 2008 average total loans).
All other loans total $457 thousand (0.2% of total loans) at December 31, 2008. These loans had no delinquency rate and no average loss rate in 2008 compared to 2008 average total loans.
Investment Activities. The bank's investment policy governs its investment activities.
The policy states that excess daily funds are to be invested in federal funds sold and securities purchased under agreements to resell. The daily funds are used to cover deposit draw downs by customers, to fund loan commitments and to help maintain the bank's asset/liability mix.
According to the policy, funds in excess of those invested in federal funds sold and securities purchased under agreements to resell are to be invested in (1) U.S. Treasury bills, notes or bonds, (2) obligations of U.S. Government agencies or (3) obligations of the State of West Virginia and political subdivisions thereof with a rating of not less than AAA or fully insured bonds.
The policy governs various other factors including maturities, the closeness of purchase price to par, amounts that may be purchased and percentages of the various types of investments that may be held.
Deposit Activities. The bank offers noninterest-bearing and interest-bearing checking accounts and statement savings accounts. The bank offers automatically renewable certificates of deposit in various terms from 91 days to five years. The bank is also a participant in the CDARS program. The bank offers CDARS program certificates of deposit in various terms from 4 weeks to five years. Individual retirement accounts in the form of certificates of deposit are also available.
To open a deposit account, the depositor must meet the following requirements for low risk individuals:
Present a valid identification,
Have a social security number,
Must be a U.S. citizen or possess evidence of legal alien status, and
Must be at least 18 years of age or share an account with a person at least 18 years of age.
When depositors are considered medium or high risk (i.e. out-of-state driver’s license and/or resident), additional verification requirements apply. Management believes that the bank fully complies with the USA Patriot Act.
Competition
As of March 19, 2009, there were 65 bank holding companies (including multi-bank and one bank holding companies) operating in the State of West Virginia. These holding companies are headquartered in various West Virginia cities and control banks throughout the State of West Virginia, including banks that compete with the bank in its market area.
The bank's market area is generally defined as Jefferson County and Berkeley County, West Virginia. As of June 30, 2008, there were six banks in Jefferson County with 16 banking offices. The total deposits of these commercial banks as of June 30, 2008 were $ 685 million, and the bank ranked number one in total deposits with $ 213 million or 31.05 % of the total deposits in the market at that time. The bank has two branch offices in Berkeley County at this time. Opening in July 2001 and June 2003, these branches have 4.21 % of the market share of deposits in Berkeley County where there are ten banks with 30 banking offices.
For most of the services that the bank performs, there is also competition from financial institutions other than commercial banks. For instance, credit unions, some insurance companies, and issuers of commercial paper and money market funds actively compete for funds and for various types of loans. In addition, personal and corporate trust and investment counseling services are offered by insurance companies, investment counseling firms and other business firms and individuals. Due to the geographic location of the bank's primary market area, the existence of larger financial institutions in Maryland, Virginia and Washington, D.C. influences the competition in the market area. Larger regional and national corporations continue to be increasingly visible in offering a broad range of financial services to all types of commercial and consumer customers. The principal competitive factors in the markets for deposits and loans are interest rates, either paid or charged. The chartering of numerous new banks in West Virginia and the opening of numerous federally chartered savings and loan associations has increased competition for the bank. The 1986 legislation passed by the West Virginia Legislature allowing statewide branch banking provided increased opportunities for the bank, but it also increased competition for the bank in its service area. With the beginning of reciprocal interstate banking in 1988, bank holding companies (such as Potomac Bancshares, Inc.) also face additional competition in efforts to acquire other subsidiaries throughout West Virginia.
In 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act. Under this Act, bank holding companies are permitted to acquire banks located in states other than the bank holding company’s home state without regard to whether the transaction is permitted under state law. Commencing on June 1, 1997, the Act allowed national banks and state banks with different home states to merge across state lines, unless the home state of a participating bank enacted legislation prior to May 31, 1997, that expressly prohibits interstate mergers. Additionally, the Act allows banks to branch across state lines, unless the state where the new branch will be located enacted legislation restricting or prohibiting de novo interstate branching on or before May 31, 1997. West Virginia adopted legislation, effective May 31, 1997, that allowed for interstate branch banking by merger across state lines and allowed for de novo branching and branching by purchase and assumption on a reciprocal basis with the home state of the bank in question. The effect of this legislation has been increased competition for West Virginia banks, including the bank.
Employees
Potomac currently has no employees.
As of March 10, 2009, the bank had 95 full-time employees and 15 part-time employees.
Supervision and Regulation
Introduction. Potomac is a bank holding company within the provisions of the Bank Holding Company Act of 1956, is registered as such, and is subject to supervision by the Board of Governors of the Federal Reserve System ("Board of Governors"). The Bank Holding Company Act requires Potomac to secure the prior approval of the Board of Governors before Potomac acquires ownership or control of more than five percent (5%) of the voting shares or substantially all of the assets of any institution, including another bank.
As a bank holding company, Potomac is required to file with the Board of Governors annual reports and such additional information as the Board of Governors may require pursuant to the Bank Holding Company Act. The Board of Governors may also make examinations of Potomac and its banking subsidiaries. Furthermore, under Section 106 of the 1970 Amendments to the Bank Holding Company Act and the regulations of the Board of Governors, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or any provision of credit, sale or lease of property or furnishing of services.
Potomac’s depository institution subsidiary is subject to affiliate transaction restrictions under federal law that limit the transfer of funds by the subsidiary bank to its respective parent and any nonbanking subsidiaries, whether in the form of loans, extensions of credit, investments or asset purchases. Such transfers by any subsidiary bank to its parent corporation or any nonbanking subsidiary are limited in an amount to 10% of the institution's capital and surplus and, with respect to such parent and all such nonbanking subsidiaries, to an aggregate of 20% of any such institution's capital and surplus.
Potomac is required to register annually with the Commissioner of Banking of West Virginia ("Commissioner") and to pay a registration fee to the Commissioner based on the total amount of bank deposits in banks with respect to which it is a bank holding company. Although legislation allows the Commissioner to prescribe the registration fee, it limits the fee to ten dollars per million dollars of deposits rounded off to the nearest million dollars. Potomac is also subject to regulation and supervision by the Commissioner.
Potomac is required to secure the approval of the West Virginia Board of Banking before acquiring ownership or control of more than five percent of the voting shares or substantially all of the assets of any institution, including another bank. West Virginia banking law prohibits any West Virginia or non-West Virginia bank or bank holding company from acquiring shares of a bank if the acquisition would cause the combined deposits of all banks in the State of West Virginia, with respect to which it is a bank holding company, to exceed 25% of the total deposits of all depository institutions in the State of West Virginia.
Depository Institution Subsidiary. The bank is subject to FDIC deposit insurance assessments. As part of regulations implementing The Federal Deposit Insurance Reform Act of 2005 (FDIRA), assessments for FDIC deposit insurance coverage are assessed and collected in the quarter following the period of insurance. Starting with the fourth quarter of 2007 assessment rate calculations have been based on a number of factors in order to assess more accurately the risk level of a bank. These factors include a bank’s CAMELS ratings, tier 1 leverage ratio, loans past due 30-89 days compared to gross assets, nonperforming assets compared to gross assets, net loan charge offs compared to gross assets and net income before taxes compared to risk-weighted assets. These factors are updated quarterly from data reported on the most recently filed call report of a bank. The FDIC assessed the bank for the period October 1 through December 31 of 2008 (which was charged to the bank on March 30, 2009) as a Risk Category I bank at the annual rate of 7.00 basis points or .0001750 times the total deposit assessment base. The FDIC set the Financing Corporation (FICO) Bank Insurance Fund (BIF) premium for the bank at the annual rate of 1.04 basis points or .0000260 times the total deposits of the bank for this same time period. This is a separate premium which is not tied to the bank's risk classification. It is possible that BIF insurance assessments will be changed, and it is also possible that there may be a special additional assessment. A large special assessment could have an adverse impact on Potomac’s results of operations. Currently there is the possibility of a 20 basis point special assessment based on June 30, 2009 deposits to be paid September 30, 2009. There is also the possibility of a 12 to 16 basis point increase in the regular assessment for Category 1 risk classification banks. This would be assessed on deposits as of March 31, 2009 and paid in the second quarter of 2009. These assessments have been heavily lobbied against by many banks and banking organizations since these assessments would have a major impact on earnings for these banks, including Bank of Charles Town.
Capital Requirements. The Federal Reserve Board has issued risk-based capital guidelines for bank holding companies, such as Potomac. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into explicit account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Under the guidelines and related policies, bank holding companies must maintain capital sufficient to meet both a risk-based asset ratio test and leverage ratio test on a consolidated basis. The risk-based ratio is determined by allocating assets and specified off-balance sheet commitments into four weighted categories, with higher levels of capital being required for categories perceived as representing greater risk. The leverage ratio is determined by relating core capital (as described below) to total assets adjusted as specified in the guidelines. The bank is subject to substantially similar capital requirements adopted by applicable regulatory agencies.
Generally, under the applicable guidelines, the financial institution's capital is divided into two tiers. "Tier 1", or core capital, includes common equity, noncumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts or consolidated subsidiaries, less goodwill. Bank holding companies, however, may include cumulative perpetual preferred stock in their Tier 1 capital, up to a limit of 25% of such Tier 1 capital. "Tier 2", or supplementary capital, includes, among other things, cumulative and limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan losses, subject to certain limitations, less required deductions. "Total capital" is the sum of Tier 1 and Tier 2 capital.
Financial institutions are required to maintain a risk-based ratio of 8%, of which 4% must be Tier 1 capital. The appropriate regulatory authority may set higher capital requirements when an institution's particular circumstances warrant.
Financial institutions that meet certain specified criteria, including excellent asset quality, high liquidity, low interest rate exposure and the highest regulatory rating, are required to maintain a minimum leverage ratio of 3%. Financial institutions not meeting these criteria are required to maintain a leverage ratio which exceeds 3% by a cushion of at least 100 to 200 basis points, and, therefore, the ratio of Tier 1 capital to total assets should not be less than 4%.
The guidelines also provide that financial institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the Federal Reserve Board's guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier 1 leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage is the ratio of an institution's Tier 1 capital, less all intangibles, to total assets, less all intangibles.
Failure to meet applicable capital guidelines could subject the financial institution to a variety of enforcement remedies available to the federal regulatory authorities, including limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital and the termination of deposit insurance by the FDIC, as well as to the measures described in the "Federal Deposit Insurance Corporation Improvement Act of 1991" as applicable to undercapitalized institutions.
The Federal Reserve Board, as well as the FDIC, has adopted changes to their risk-based and leverage ratio requirements that require that all intangible assets, with certain exceptions, be deducted from Tier 1 capital. Under the Federal Reserve Board's rules, the only types of intangible assets that may be included in (i.e., not deducted from) a bank holding company's capital are readily marketable purchased mortgage servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs"), provided that, in the aggregate, the total amount of PMSRs and PCCRs included in capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate limit of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that a bank holding company may include in its capital is limited to the lesser of (i) 90% of such assets' fair market value (as determined under the guidelines), or (ii) 100% of such assets' book value, each determined quarterly. Identifiable intangible assets (i.e., intangible assets other than goodwill) other than PMSRs and PCCRs, including core deposit intangibles, acquired on or before February 19, 1992 (the date the Federal Reserve Board issued its original proposal for public comment), generally will not be deducted from capital for supervisory purposes, although they will continue to be deducted for purposes of evaluating applications filed by bank holding companies.
As of December 31, 2008, Potomac had capital in excess of all applicable requirements as shown below:
Gramm-Leach-Bliley Act of 1999. On November 4, 1999, Congress adopted the Gramm-Leach-Bliley Act of 1999. This Act, also known as the Financial Modernization Law, repealed a number of federal limitations on the powers of banks and bank holding companies originally adopted in the 1930’s. Under the Act, banks, insurance companies, securities firms and other service providers may now affiliate. In addition to broadening the powers of banks, the Act created a new form of entity, called a financial holding company, which may engage in any activity that is financial in nature or incidental or complimentary to financial activities.
The Federal Reserve Board provides the principal regulatory supervision of financial services permitted under the Act. However, the Securities and Exchange Commission and state insurance and securities regulators also assume substantial supervisory powers and responsibilities.
The Act addresses a variety of other matters, including customer privacy issues. The obtaining of certain types of information by false or fraudulent pretenses is a crime. Banks and other financial institutions must notify their customers about their policies on sharing information with certain third parties. In some instances, customers may refuse to permit their information to be shared. The Act also requires disclosures of certain automatic teller machine fees and contains certain amendments to the federal Community Reinvestment Act.
Permitted Non-Banking Activities. Under the Gramm-Leach-Bliley Act, bank holding companies may become financial holding companies and engage in certain non-banking activities. Potomac has not yet filed to become a financial holding company and presently does not engage in, nor does it have any immediate plans to engage in, any such non-banking activities.
A notice of proposed non-banking activities must be furnished to the Federal Reserve and the Banking Board before Potomac engages in such activities, and an application must be made to the Federal Reserve and Banking Board concerning acquisitions by Potomac of corporations engaging in those activities. In addition, the Federal Reserve may, by order issued on a case-by-case basis, approve additional non-banking activities.
The Bank. The bank is a state-chartered bank that is not a member of the Federal Reserve System and is subject to regulation and supervision by the FDIC and the Commissioner.
Compliance with Environmental Laws. The costs and effects of compliance with federal, state and local environmental laws will not have a material effect or impact on Potomac or the bank.
International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (USA Patriot Act). The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (the “Patriot Act”) was adopted in response to the September 11, 2001 terrorist attacks. The Patriot Act provides law enforcement with greater powers to investigate terrorism and prevent future terrorist acts. Among the broad-reaching provisions contained in the Patriot Act are several designed to deter terrorists’ ability to launder money in the United States and provide law enforcement with additional powers to investigate how terrorists and terrorist organizations are financed. The Patriot Act creates additional requirements for banks, which were already subject to similar regulations. The Patriot Act authorizes the Secretary of the Treasury to require financial institutions to take certain “special measures” when the Secretary suspects that certain transactions or accounts are related to money laundering. These special measures may be ordered when the Secretary suspects that a jurisdiction outside of the United States, a financial institution operating outside of the United States, a class of transactions involving a jurisdiction outside of the United States or certain types of accounts are of “primary money laundering concern.” The special measures include the following: (a) require financial institutions to keep records and report on the transactions or accounts at issue; (b) require financial institutions to obtain and retain information related to the beneficial ownership of any account opened or maintained by foreign persons; (c) require financial institutions to identify each customer who is permitted to use a payable-through or correspondent account and obtain certain information from each customer permitted to use the account; and (d) prohibit or impose conditions on the opening or maintaining of correspondent or payable-through accounts.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Senate and the House of Representatives of the United States enacted the Sarbanes-Oxley Act of 2002, a law that addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information.
Effective August 29, 2002, as directed by Section 302(a) of Sarbanes-Oxley, Potomac’s chief executive officer and chief financial officer are each required to certify that Potomac’s Quarterly and Annual Reports do not contain any untrue statement of a material fact. The rules have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of Potomac’s internal controls; they have made certain disclosures to Potomac’s auditors and the audit committee of the Board of Directors about Potomac’s internal controls; and they have included information in Potomac’s Quarterly and Annual Reports about their evaluation and whether there have been significant changes in Potomac’s internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation. Effective in 2009, Section 404 of Sarbanes-Oxley will become applicable to Potomac.
Troubled Asset Relief Program - Capital Purchase Program. On October 3, 2008, the Federal government enacted the Emergency Economic Stabilization Act of 2008 (“EESA”). EESA was enacted to provide liquidity to the U.S. financial system and lessen the impact of looming economic problems. The EESA included broad authority. The centerpiece of the EESA is the Troubled Asset Relief Program (“TARP”). EESA’s broad authority was interpreted to allow the U.S. Treasury to purchase equity interests in both healthy and troubled financial institutions. The equity purchase program is commonly referred to as the Capital Purchase Program (“CPP”). Management and our Board of Directors have done a thorough evaluation of both the positive and negative aspects of the CPP. In the end, we came to the conclusion that based on our strong capital position, earnings capacity, and the fact that it would dilute the earnings of existing shareholders we have decided not to participate in the CPP.
America Recovery and Reinvestment Act of 2009. On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients that are in addition to those previously announced by the U.S. Treasury, until the institution has repaid the U.S. Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the recipient’s appropriate regulatory agency.
Future Legislation. Various other legislative and regulatory initiatives, including proposals to overhaul the banking regulatory system and to limit the investments that a depository institution may make with insured funds, are from time to time introduced in Congress and state legislatures, as well as regulatory agencies. Such legislation may change banking statutes and the operating environment of the company and the bank in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential 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. With the recent enactments of EESA and ARRA, the nature and extent of future legislative and regulatory changes affecting financial institutions is very unpredictable at this time. The company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations.
Available Information. The company files annual, quarterly and current reports, proxy statements and other information with the SEC. The company’s SEC filings are filed electronically and are available to the public through the Internet at the SEC’s website at http://www.sec.gov. In addition, any document filed by the company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, NE, Washington, DC 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free of charge by any shareholder by writing to Gayle Marshall Johnson, Sr. Vice President and Chief Financial Officer, Potomac Bancshares, Inc., PO Box 906, Charles Town, WV 25414.
Item 1A.
Item 1A. Risk Factors.
Due to Increased Competition, the Company May Not Be Able to Attract and Retain Banking Customers at Current Levels.
If, due to competition from competitors in the company’s market area of Jefferson and Berkeley Counties, West Virginia, the company is unable to attract new and retain current customers, loan and deposit growth could decrease causing the company’s results of operations and financial condition to be negatively impacted. The company faces competition from the following:
local, regional and national banks;
savings and loans;
internet banks;
credit unions;
insurance companies;
finance companies; and
brokerage firms serving the company’s market areas.
Because of the bank’s geographic location, the existence of larger financial institutions in Maryland, Virginia and Washington, DC influences the competition in the bank’s market area.
The Company’s Lending Limit May Prevent It from Making Large Loans.
In the future, the company may not be able to attract larger volume customers because the size of loans that the company can offer to potential customers is less than the size of the loans that many of the company’s larger competitors can offer. Accordingly, the company may lose customers seeking large loans to regional and national banks. We anticipate that our lending limit will continue to increase proportionately with the company’s growth in earnings; however, the company may not be able to successfully attract or maintain larger customers.
It should also be noted that the company may choose with its larger volume customers to “participate” or “syndicate” that portion of a loan that exceeds its legal lending limit. This may be done from time to time to retain that customer’s primary relationship within the bank.
Certain Loans That the Bank Makes Are Riskier than Loans for Real Estate Lending.
The bank makes loans that involve a greater degree of risk than loans involving residential real estate lending. Commercial business loans may involve greater risks than other types of lending although the bank’s commercial loans are generally real estate secured. Only a small portion of the bank’s commercial loans are secured by collateral other than real estate. Consumer loans may involve greater risk because adverse changes in borrowers’ incomes and employment after funding of the loans may impact their abilities to repay the loans.
The Company Is Subject to Interest Rate Risk.
Aside from credit risk, the most significant risk resulting from the company’s normal course of business, extending loans and accepting deposits, is interest rate risk. If market interest rate fluctuations cause the company’s cost of funds to increase faster than the yield of its interest-earning assets, then its net interest income will be reduced. The company’s results of operations depend to a large extent on the level of net interest income, which is the difference between income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond the company’s control, including general economic conditions and the policies of various governmental and regulatory authorities.
The Company May Not Be Able to Retain Key Members of Management.
The departure of one or more of the company’s officers or other key personnel could adversely affect the company’s operations and financial position. The company’s management makes most decisions that involve the company’s operations. The key personnel have all been with the company since 2001. They include Robert F. Baronner, Jr., David W. Irvin and Gayle Marshall Johnson.
An Economic Slowdown in the Company’s Market Area Could Hurt Our Business.
Because we focus our business in Jefferson and Berkeley Counties, West Virginia, an economic slowdown in these areas could hurt our business. An economic slowdown could have the following consequences:
Loan delinquencies may increase;
Problem assets and foreclosures may increase;
Demand for the products and services of the company may decline; and
Collateral (including real estate) for loans made by the company may decline in value, in turn reducing customers’ borrowing power and making existing loans less secure.
The housing market in Jefferson and Berkeley counties in West Virginia has shown a sharp decline. The results have included each of the situations described above. However, management has taken a proactive approach to marketing foreclosed and repossessed properties.
The Company and the Bank are Extensively Regulated.
The operations of the company are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on them. Policies adopted or required by these governmental authorities can affect the company’s business operations and the availability, growth and distribution of the company’s investments, borrowings and deposits. Proposals to change the laws governing financial institutions are frequently raised in Congress and before bank regulatory authorities. Changes in applicable laws or policies could materially affect the company’s business, and the likelihood of any major changes in the future and their effects are impossible to determine.
The Company’s Allowance for Loan Losses May Not Be Sufficient.
In the future, the company could experience negative credit quality trends that could lead to a deterioration of asset quality. Such deterioration could require the company to incur loan charge-offs in the future and incur additional loan loss provision, both of which would have the effect of decreasing earnings. The company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense that represents management’s best estimate of probable losses that may be incurred within the existing portfolio of loans. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the company’s financial condition and results of operation.
Management is constantly monitoring credit quality and any changes that may be tied to current economic conditions. As a result of deteriorating economic conditions bank management has increased the allowance for loan losses. The increase is based on the review of existing loans and management’s analysis of the credit quality of the existing loans. Management takes a conservative approach to the quality of loans in the portfolio and feels that the bank is adequately reserved for the current market and loan portfolio conditions.
A Shareholder May Have Difficulty Selling Shares.
Because a very limited public market exists for the holding company’s common stock, a shareholder may have difficulty selling his or her shares in the secondary market. We cannot predict when, if ever, we could meet the listing qualifications of the NASDAQ Stock Market’s National Market Tier or any exchange. We cannot assure you that there will be a more active public market for the shares in the near future.
Shares of the Company’s Common Stock Are Not FDIC Insured.
Neither the Federal Deposit Insurance Corporation nor any other governmental agency insures the shares of the company’s common stock. Therefore, the value of your shares in the company will be based on their market value and may decline.
Customers May Default on the Repayment of Loans.
The bank’s customers may default on the repayment of loans, which may negatively impact the company’s earnings due to loss of principal and interest income. Increased operating expenses may result from the allocation of management time and resources to the collection and work-out of these loans. Collection efforts may or may not be successful causing the company to write off these loans or repossess the collateral securing these loans which may or may not exceed the balance of these loans.
The Company’s Controls and Procedures May Fail or Be Circumvented.
Management regularly reviews and updates the company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, no matter how well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the company’s business, results of operations and financial conditions.
Financial Market and Economic Conditions May Adversely Affect Our Business.
The United States is considered to be in a recession, and many businesses are having difficulty due to reduced consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.
Because of declines in home prices and the values of subprime mortgages across the country, financial institutions and the securities markets have been adversely affected by significant declines in the values of most asset classes and by a serious lack of liquidity. These conditions have led to the failure or merger of a number of prominent financial institutions. In 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, but asset values have continued to decline and access to liquidity continues to be very limited.
The company’s financial performance and the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans depends on the business environment in the markets where the company operates.
An Increase in FDIC Assessments Could Impact Our Financial Performance.
The FDIC imposes an assessment against all depository institutions for deposit insurance. See “Supervision and Regulation - Depository Institution Subsidiary” on page 7. The FDIC is assessing the bank 7.00 basis points on an annual basis or .0001750 on a quarterly basis on the bank’s December 31, 2008 deposits to be paid in the first quarter of 2009. There is a proposed increase to the assessment of 12 to 16 basis points to begin the second quarter of 2009 plus a proposed special assessment of 20 basis points to be paid in the third quarter of 2009. In the current economic environment, it is likely that this assessment will increase in general for financial institutions across the country, including the bank, thereby increasing operating costs.
Item 2.
Item 2. Properties.
Potomac currently has no property.
The bank owns the land and buildings of the main office and the branch office facilities in Harpers Ferry, Kearneysville, Martinsburg and Hedgesville. The bank also owns a lot at the corner of Route 340 and Washington Street in Bolivar that may be used for future expansion or may be sold.
The main office property is located at 111 East Washington Street, Charles Town, West Virginia. This property consists of two separate two story buildings located side by side with adjoining corridors. During 2000, the construction of the newer of these two buildings was completed. The first floor of the new building houses the Trust and Financial Services Division. The second floor of the new building houses certain administrative and loan offices. Both of these floors open into the older bank premises, constructed in 1967. In July of 2006, the bank completed the purchase of a property adjacent to the main office for future expansion. In early 2008, construction began on an addition to the main office facilities. The new addition houses or will house a new drive through with 5 lanes (one ATM/night deposit lane and four transaction lanes), the call center, the Information Technology and Deposit Operations departments and certain administrative offices. Renovations to the existing two buildings are being completed along with the addition. The renovations are expected to be completed in June of 2009.
In October 2005 to provide additional office and storage areas, the bank leased space in Burr Industrial Park in Kearneysville, West Virginia. The leased space houses the Finance Department and provides record storage facilities for the bank.
The Harpers Ferry branch office is located at 1366 W. Washington Street, Bolivar, West Virginia. The office is a one story brick building constructed in 1975 and renovated in 2005. There is another building on this property that existed at the time of the bank's purchase. This separate building is rented to an outside party by the bank.
The branch facility at 5480 Charles Town Road, Kearneysville, West Virginia was erected in 1985. This one story brick building opened for business in April of 1985. During 1993, an addition was constructed, doubling the size of this facility. Renovation of these facilities was completed in 2006.
The branch facility at 119 Cowardly Lion Drive, Hedgesville, West Virginia was erected in 2003. This one story brick building opened for business in June of 2003.
The branch office at 9738 Tuscarora Pike in Martinsburg, West Virginia opened for business in July of 2001. Originally housed in a leased facility on the property, the one story brick building was completed in January 2005.
There are no encumbrances on any of these properties. In the opinion of management, these properties are adequately covered by insurance.
Item 3.
Item 3. Legal Proceedings.
Currently Potomac is involved in no legal proceedings.
The bank is involved in various legal proceedings arising in the normal course of business, and in the opinion of the bank, the ultimate resolution of these proceedings will not have a material effect on the financial position or operations of the bank.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
Not Applicable.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The following information reflects comparative per share data for the periods indicated for Potomac common stock for (a) trading values and (b) dividends. As of March 16, 2009, there were approximately 1,100 shareholders.
Trading of Potomac Bancshares, Inc. common stock is not extensive and cannot be described as a public trading market. Potomac Bancshares, Inc. is on the OTC Bulletin Board Market. To gather information about Potomac in this market use Potomac’s symbol PTBS.OB. Scott and Stringfellow, Inc., Koonce Securities Inc. and Ferris, Baker Watts, Inc. are market makers for Potomac’s stock. Market makers are firms that maintain a firm bid and ask price for a given number of shares at a given point in time in a given security by standing ready to buy or sell at publicly quoted prices. Information about sales of Potomac’s stock is available on the Internet through many of the stock information services using Potomac’s symbol. Shares of Potomac common stock are occasionally bought and sold by private individuals, firms or corporations, and, in most instances, Potomac does not have knowledge of the purchase price or the terms of the purchase. The trading values for 2007 and 2008 are based on information available through the Internet. No attempt was made by Potomac to verify or determine the accuracy of the representations made to Potomac or gathered on the Internet.
The primary source of funds for dividends paid by Potomac is the dividend income received from the bank. The bank's ability to pay dividends is subject to restrictions under federal and state law, and under certain cases, approval by the FDIC and the Commissioner could be required. Dividends will only be paid when and as declared by the board of directors.
Performance Graph
The following graph compares the yearly percentage change in Potomac’s cumulative total shareholder return on common stock for the five-year period ending December 31, 2008, with the cumulative total return of the Bank Holding Companies Index (SIC Code 6712) and the Hemscott Index. Shareholders may obtain a copy of the index by calling Hemscott, Inc. at telephone number (301) 760-2609. There is no assurance that Potomac’s stock performance will continue in the future with the same or similar trends as depicted in the graph.
The graph shall not be deemed incorporated by reference by any general statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Potomac specifically incorporates this graph by reference, and shall not otherwise be filed under such Acts.
COMPARE 5 YEAR CUMULATIVE TOTAL RETURN AMONG
POTOMAC BANCSHARES, INC., BANK HOLDING COMPANIES INDEX
AND HEMSCOTT INDEX
ASSUMES $100 WAS INVESTED ON JANUARY 1, 2004 AND ASSUMES DIVIDENDS WERE
REINVESTED THROUGH FISCAL YEAR ENDING DECEMBER 31, 2008
ISSUER PURCHASES OF EQUITY SECURITIES
On February 12, 2002, the company’s Board of Directors originally authorized the repurchase program. The program authorized the repurchase of up to 10% of the company’s stock over the next twelve months. The stock may be purchased in the open market and/or in privately negotiated transactions as management and the board of directors determine prudent. The program has been extended on annual basis.
Item 6.
Item 6. Selected Financial Data.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
AVERAGE BALANCES, INCOME/EXPENSE AND AVERAGE YIELD/RATE
This schedule is a comparison of interest earning assets and interest-bearing liabilities showing average yields or rates derived from average balances and actual income and expenses. Income and rates on tax exempt loans and securities are computed on a tax equivalent basis using a federal tax rate of 34%. Loans placed on nonaccrual status are reflected in the balances.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
GENERAL
The company’s financial statements are prepared in accordance with U. S. generally accepted accounting principles. The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, U. S. generally accepted accounting principles may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, “Accounting for Contingencies,” which requires that estimated losses be accrued when they are probable of occurring and (ii) SFAS 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
GENERAL
2008 was a challenging year for the banking industry and the company. The economy has contracted, credit has tightened for banks and consumers, and liquidity has become a concern. Management was able to reach its perpetual goal to increase the loan portfolio and, to a lesser degree, increase deposits. In addition, we were able to maintain an adequate level of liquidity.
A look at the consolidated selected financial data will show other areas of concern. Earnings decreased significantly during 2008. However, the company was able to increase shareholder dividends in each quarter of 2008. The decrease in capital, although small, presents some challenges. Capital provides the basis for continued expansion of the company including the ability to keep pace with the technology of our ever changing world. Maintaining the technology advantage is one of the most costly yet most necessary goals of doing business after costs of real estate and human resources.
The continuing increase of regulation in the banking industry and the associated costs continue to be a major concern of management. The cost of initial compliance with Sarbanes-Oxley Act of 2002 has been spread out over several years now, with the delay of the bank’s complete implementation date to December 31, 2009. Compliance costs add additional pressure for management to find ways to increase income.
Interest income from loans and investments is the largest source of revenue for the company. Decreasing interest rates and the stagnant housing market have affected this income stream. Therefore, management is continually looking for other sources of revenue. The bank continues to produce a significant amount of income from the overdraft protection plan. A new checking account, Smart Checking, that encourages use of the check card and requires customers to receive their statements via e-mail was introduced during 2008. The new account is expected to increase fee income from check card transactions and reduce the expense of mailing customer statements.
Reducing expenses is another avenue to increasing earnings. Lower interest rates reduce interest expense and are a benefit to the overall goal of reducing costs. The company seeks ways to reduce expenses in addition to ways to increase income while benefiting from processes introduced in the past five years for that purpose including (1) utilization of personnel to full potential by growing the company as much as possible without increasing personnel, (2) continuing the reclassification of deposits to allow a lower balance requirement at the Federal Reserve allowing funds to be used for other purposes such as making loans, (3) increasing service charges as appropriate and (4) the outsourcing of official checks which was a generous income producer with the bank earning interest on the outstanding balances of the official checks. With the decrease in interest rates in 2008, the company is currently earning no income on the outsourcing of official checks.
The company continues to benefit from tax exempt loan income, tax exempt income of bank owned life insurance policies and tax exempt municipal securities in the investment portfolio. These items reduce the income tax expense for the company as well as produce income. We received proceeds from one of our bank owned life insurance policies during 2008 upon the death of a covered former employee.
The bank has been monitoring its efficiency through the calculation of the efficiency ratio each month. This ratio is the comparison of the bank’s noninterest expenses (overhead) with net interest income plus noninterest income. A decrease in noninterest expenses or an increase in net interest income and/or noninterest income will cause the ratio to decrease, which is favorable. During 2008 the ratio fluctuated in both directions within a few percentage points ending the year at the high end of the fluctuation.
Management has recently been made aware of the possibility of changes in the deposit assessment required by the FDIC. Initial correspondence includes the possibility of a 12 to 16 point increase in the annual deposit assessment. An additional one time assessment of 20 basis points has been proposed as well. Either of these proposals could have a material adverse effect on earnings of the company.
The following table sets forth selected quarterly results (with dollars in thousands) of the company for 2008 and 2007.
NET INTEREST INCOME
The economy worsened, as expected, during 2008. In spite of the economy, the loan portfolio (net of reserves) increased 9% on the strength of increases mainly in the commercial loan area. The bulk of the increase was related to participations and other portfolio loans as a result of our relationship with BlueRidge Bank. Still, net interest income decreased 6% as the interest rates continued to drop throughout 2008. Interest on tax exempt securities and other interest and dividends showed increases. The tax exempt securities portfolio increased through new purchases at the end of 2007 and in 2008 and other interest benefited from interest on loans held to sell to BlueRidge Bank during the time they were waiting to receive their charter.
The loan portfolio (net of reserves) decreased 3% during 2007 as compared to 2006. Net interest income showed a 5% decrease when compared with the 2006 results. The decline in 2007 was a combination of the reduction in the loan portfolio and decreasing interest rates.
Interest expense decreased 21% in 2008 compared to 2007. This is a significant change from the 18% increase from 2006 to 2007. The reason for the decrease is the decreases in interest rates enacted by the Federal Reserve during 2008.
Calendar year 2008 ended with a lot of uncertainty. Most agree that the housing market has still not found a “bottom”, business and consumers each need a boost to their bottom lines and unemployment looms large for the economy in the coming months. However, the experts do not agree on when any of these situations will improve. Interest rates are expected to remain at current levels throughout 2009 and possibly beyond. Management is hopeful that interest rates will entice some back into the loan market during 2009. We also expect cost of funds to remain relatively inexpensive should the need arise.
VOLUME AND RATE ANALYSIS
This schedule analyzes the change in net interest income attributable to changes in volume of the various portfolios and changes in interest rates. The change due to both rate and volume variances has been allocated between rate and volume based on the percentage relationship of such variances to each other.
NONINTEREST INCOME AND EXPENSE
As in prior years, fees generated through the bank’s overdraft protection plan continue to be a major contributor to the bank’s noninterest income. These fees are included in the service charges on deposit accounts category which totaled $2.3 million in 2008, $2.1 million in 2007 and $1.7 million in 2006. Trust and financial services is the next largest contributor to the 2008 noninterest income figure. However, this income decreased 25.6% in 2008 compared to growth of 1.3% in 2007. Most of the trust and financial services decrease was offset by the receipt of proceeds from bank owned life insurance. VISA/MC fees have increased 13.9% in 2008. As consumers become increasingly comfortable with non cash transactions, this trend should continue. As mentioned earlier, the new Smart Checking account also contributed to the increase.
Fees on sales of loans in the secondary market are a source of noninterest income that varies with the market conditions. Our income from this source was $93 thousand in 2008, $197 thousand in 2007 and $117 thousand in 2006.
Salaries and employee benefits of $5.1 million are about 54% of the total noninterest expense for 2008. This percentage is similar to 2007 and 2006. Even though the bank has grown during the past few years, full utilization of personnel has allowed the bank to hold down salaries and benefit costs by holding down the increase in personnel. During 2008, salaries and employee benefits are expected to increase for the most part due to annual salary and wage increases, including merit increases, rather than any extensive increase in personnel and due to increased group health insurance expenses.
Expenses related to premises and furniture and equipment have remained relatively stable. We expect these expenses to increase in 2009 due to the depreciation of the recently completed addition to the main office and the furniture and equipment purchased to furnish the addition. Advertising and marketing expense increased 8.1% during 2008. This increase is a combination of increased fees being charged by vendors, some initial marketing expense for the new product, Smart Checking, and expense of printing new product brochures.
The other noninterest expense category is the total of approximately 60 separate expense accounts. None of the account balances in this category exceed 1% of gross income of the bank for any of the three years presented. Increases are due to the growth in the bank’s customer base and some inflationary increases.
INTEREST RATE SENSITIVITY
The table below shows the opportunities the company will have to reprice interest earning assets and interest-bearing liabilities as of December 31, 2008 (in thousands).
The matching of the maturities or repricing opportunities of interest earning assets and interest-bearing liabilities may be analyzed by examining the extent to which these assets and liabilities are interest rate sensitive and by monitoring an institution’s interest rate sensitivity gap. An asset or liability is interest rate sensitive within a specific time period if it will mature or reprice within that period. The interest rate sensitivity gap is the difference between the amount of interest earning assets that will mature or reprice within a specific time period and the amount of interest-bearing liabilities that will mature or reprice within the same time period.
A gap is considered negative when the amount of liabilities maturing or repricing in a specific period exceeds the amount of assets maturing or repricing in the same period. An even match between assets and liabilities in each time frame is the safest position especially in times of rapidly rising or declining rates. During other times, the even match is not as critical. The advantages or disadvantages of positive and negative gaps depend totally on the direction in which interest rates are moving. An asset sensitive institution’s net interest margin and net interest income generally will be impacted favorably by rising interest rates, while that of a liability sensitive institution generally will be impacted favorably by declining interest rates.
During the first twelve months shown in the schedule above, the company is liability sensitive, and after that time period the company is asset sensitive. During January, February and March of 2009, $11.5 million more liabilities may reprice or will mature than assets. During April through December of 2009, $29.9 million more liabilities may reprice or will mature than assets. The total effect for 2009 is that $41.4 million more liabilities may reprice or mature than assets. Since rates are not expected to change much during 2009, the company will hold deposit rates steady for the most part and insert floors in loans to help guard the bank’s income.
LOAN PORTFOLIO
Loans at December 31 (in thousands) for each of the five years in the period ended 2008.
Despite the poor housing market, both in our local market and through out the country, we were able to increase our loan portfolio in 2008. Most of the growth has come through commercial loans with much of the increase involving participation loans with BlueRidge Bank. The mortgage loans have dipped slightly but are very reasonable considering the current housing market.
In any year, it is the bank’s goal to increase the loan portfolio and 2009 will not be an exception. Most forecasts indicate 2009 will be another challenging year. The housing market and overall economy are expected to remain in decline through the second quarter of 2010. However, the loan staff continues to seek new opportunities for loan production while sticking to sound financial principles and judgment.
There were no categories of loans that exceeded 10% of outstanding loans at December 31, 2008 that were not disclosed in the table above.
REMAINING MATURITIES OF SELECTED LOANS (in thousands)
ALLOWANCE FOR LOAN LOSSES
The table shown below is an analysis of the company’s allowance for loan losses. Historically, net charge-offs (loans charged off as uncollectible less any amounts recovered on these loans) for the company have been very low when compared with the size of the total loan portfolio. Management continually monitors the loan portfolio with procedures that allow for problem loans and potentially problem loans to be highlighted and watched. Based on experience, the loan policies and the current monitoring program, management believes the allowance for loan losses is adequate. Due to the policies and procedures in place, management has increased the allowance to cover the increased risks in the portfolio resulting from the current housing market conditions and the economic slowdown.
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
The following table shows an allocation of the allowance among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors, and the ratio of the related outstanding loan balances to total loans.
RISK ELEMENTS IN THE LOAN PORTFOLIO
Loans are placed on nonaccrual status when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.
At December 31, 2008, other potential problem loans totaled $4.4 million. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis.
SECURITIES PORTFOLIO
In accordance with Financial Accounting Standards Board Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” the company records securities being held to maturity at amortized cost and securities available for sale at fair value. The effect of unrealized gains and losses on securities available for sale, net of tax effects, is recognized in stockholders’ equity.
The schedule below summarizes the carrying value of the portfolio by maturity classifications and shows the weighted average yield in each group.
DEPOSITS
Deposits increased less than 1% in 2008. Periodically we have continued to depend on alternative methods of funding. Even with only a slight increase in deposits, the bank has increased market share percentages in both Jefferson and Berkeley Counties of West Virginia as of June 30, 2008 compared to June 30, 2007. We have 31.05% of total deposits in Jefferson County and 4.21% of total deposits in Berkeley County.
Schedule of Average Deposits and Average Rates Paid
At December 31, 2008, time deposits of $100 thousand or more were 12.50 % of total deposits compared with 11.13% at December 31, 2007. Maturities of time deposits of $100 thousand or more (in thousands) at December 31, 2008 are as follows:
ANALYSIS OF CAPITAL
The adequacy of the company’s capital is reviewed by management on an ongoing basis in terms of the size, composition, and quality of the company’s asset and liability levels, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.
The Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The company had a ratio of total capital to risk-weighted assets of 13.63% and a ratio of Tier 1 capital to risk-weighted assets of 12.37% at December 31, 2008. These two ratios have decreased due to the small growth in capital compared to a larger increase in both average total assets and risk weighted assets. Both ratios exceed the capital requirements adopted by the federal regulatory agencies.
LIQUIDITY
Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. This could also be termed the management of the cash flows of an organization. Liquid assets include cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s liquidity during 2008 is detailed in the statement of cash flows included in the financial statements.
Operating Activities. The company’s net income usually provides cash from the bank’s operating activities. The net income figure is adjusted for certain noncash transactions such as depreciation expense that reduces net income but does not require a cash outlay. During 2008 net income as adjusted has provided cash of $12.8 million. Interest income earned on loans and investment securities is the company’s major income source.
Investing Activities. Customer deposits and company borrowings provide the funds used to invest in loans and investment securities. In addition, the principal portion of loan payments, loan payoffs and maturity of investment securities provide cash flow. Purchases of bank premises and equipment are an investing activity. As mentioned in the deposit discussion above, we have taken advantage of our borrowing capabilities for additional funding since deposit growth is not always sufficient to cover our needs. The net amount of cash used in investing activities in 2008 is $15 million.
Financing Activities. Customer deposits and company borrowings provide the financing for the investing activities as stated above. If the company has an excess of funds on any given day, the bank will sell these funds to make additional interest income to fund activities. Likewise, if the company has a shortage of funds on any given day it will purchase funds and pay interest for the use of these funds. Financing activities also include payment of dividends to shareholders, purchase of shares of the company’s common stock for the treasury and repayment of any borrowed or purchased funds. The net amount of cash used in financing activities in 2008 is $600 thousand.
At December 31, 2008, cash and due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell, federal funds sold and loans and securities maturing within one year were $51.1 million.
Borrowing capabilities provide additional liquidity. The subsidiary bank maintains a federal funds line of $7 million with one financial institution and a federal funds line of $8 million with a second financial institution. The subsidiary bank is also a member of the Federal Home Loan Bank of Pittsburgh and has short and/or long-term borrowing capabilities of approximately $120 million. In September 2008, the subsidiary bank borrowed $5.0 million amortized over five years from the Federal Home Loan Bank. The subsidiary bank has a Repo Plus account with the FHLB with a current credit line of $20 million that can be renewed on an annual basis.
Financial Instruments With Off-Balance-Sheet 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. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. 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 instruments for commitments to extend credit and standby letters of 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.
A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2008 and 2007 is as follows (in thousands):
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Unfunded commitments under commercial lines of credit are commitments for possible future extensions of credit to existing customers. The majority of these lines of credit is collateralized and usually contains a specified maturity date and may not be drawn upon to the extent to which the company is committed.
Standby letters of credit are conditional commitments issued by the company to guarantee the performance of a customer to a third party. 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 generally holds collateral supporting those commitments if deemed necessary.
At December 31, 2008, the company had $1.1 million in rate lock commitments to originate mortgage loans.
Short-Term Borrowings. At December 31, 2008 and 2007, short-term borrowings consist of securities sold under agreements to repurchase that are secured transactions with customers. The total of short-term borrowings was $8.4 million on December 31, 2008 and $12.5 million on December 31, 2007.
The table below presents selected information on these short-term borrowings (in thousands):
Contractual Obligations. The table below presents the contractual obligations of the company as of December 31, 2008:
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Potomac Bancshares, Inc.
Charles Town, West Virginia
We have audited the accompanying consolidated balance sheets of Potomac Bancshares, Inc. and Subsidiary as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Potomac Bancshares, Inc. and Subsidiary as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We were not engaged to examine management's assessment of the effectiveness of Potomac Bancshares, Inc. and Subsidiary’s internal control over financial reporting as of December 31, 2008, included in the accompanying Management’s Report on Internal Control Over Financial Reporting and, accordingly, we do not express an opinion thereon.
Winchester, Virginia
March 31,
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 2008 and 2007
(in thousands, except share data)
See Notes to Consolidated Financial Statements.
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2008, 2007 and 2006
(in thousands, except per share data)
See Notes to Consolidated Financial Statements.
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2008, 2007 and 2006
(in thousands, except per share data)
See Notes to Consolidated Financial Statements.
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)
Years Ended December 31, 2008, 2007 and 2006
(in thousands, except per share data)
See Notes to Consolidated Financial Statements.
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2008, 2007 and 2006
(in thousands)
See Notes to Consolidated Financial Statements.
POTOMAC BANCSHARES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Banking Activities and Significant Accounting Policies
Potomac Bancshares, Inc. and Subsidiary (the company) grant commercial, financial, agricultural, residential and consumer loans to customers, primarily in Berkeley County and Jefferson County, West Virginia. The company’s market area also includes Washington County and Frederick County, Maryland and Frederick County, Loudoun County and Clarke County, Virginia. The loan portfolio is well diversified and loans generally are collateralized by assets of the customers. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrowers.
The accounting and reporting policies of the company conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. The following is a summary of the more significant policies.
Principles of Consolidation
The consolidated financial statements of Potomac Bancshares, Inc. and its wholly-owned subsidiary, Bank of Charles Town (the bank), include the accounts of both companies. All material intercompany balances and transactions have been eliminated in consolidation.
Interest-bearing Deposits in Financial Institutions
Interest-bearing deposits in financial institutions mature within one year and are carried at cost.
Securities
Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (l) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Loans
The company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is comprised of loans secured by real estate. The ability of the company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions of the company’s market area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff, generally, are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Loans (Continued)
All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance is based on two basic principles of accounting: (1) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and are capable of estimation and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified and special mention loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects that margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the company does not separately identify individual consumer and residential loans for impairment disclosures.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Loans Held for Sale
Loans originated and intended for sale in the secondary market are carried at the lower of cost or market determined in the aggregate. The company does not retain mortgage servicing rights on loans held for sale.
In 2007, the bank entered into an agreement with BlueRidge Bank whereby Bank of Charles Town would fund loans for BlueRidge Bank until such time as BlueRidge Bank could obtain its charter. The balance of these loans was $7.8 million at December 31, 2007. Upon receiving its charter in 2008, BlueRidge Bank purchased the loans from Bank of Charles Town.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method. Estimated useful lives range from five to forty years for premises and improvements and three to twenty-five years for furniture and equipment.
Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation are eliminated from the accounts and gain or loss is included in operations.
Other Real Estate
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value net of estimated selling costs at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.
Employee Benefit Plans
The company sponsors the following employee benefit plans:
a noncontributory, defined benefit pension plan covering employees meeting certain age and service requirements,
a postretirement life insurance plan covering current and future retirees with 25 years of service over the age of 60,
a postretirement life insurance plan covering certain current retirees who met certain requirements that is not available for future retirees,
a health care plan for current retirees who met certain eligibility requirements that is not available for future retirees and
a 401(k) retirement savings plan available to all employees meeting certain age and service requirements. Under this plan, the employer may make a discretionary matching contribution each plan year and may also make other discretionary contributions to the plan.
Stock Dividends
On March 14, 2006, the Board of Directors declared a 2% stock dividend. Shares increased from 3,600,000 to 3,671,691.
Earnings Per Share
Basic earnings per share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings 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 method. All amounts have been retroactively restated for the stock dividends as described above.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Income Taxes
Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary difference between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the 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 are classified as additional income taxes in the consolidated statements of income.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits in financial institutions, securities purchased under agreements to resell and federal funds sold. Generally, securities purchased under agreements to resell and federal funds sold are purchased and sold for one-day periods.
Trust Division
Securities and other property held by the Trust Division in a fiduciary or agency capacity are not assets of the company and are not included in the accompanying consolidated financial statements.
Use of Estimates
In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet 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 and the valuation of foreclosed real estate, deferred tax assets and the pension benefit obligation.
Advertising
The company follows the policy of charging the costs of advertising to expense as incurred.
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 and changes in pension and postretirement benefit obligations , 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.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Stock-Based Compensation Plan
The 2003 Stock Incentive Plan was approved by stockholders on May 13, 2003. This is the first stock incentive plan adopted by the company. Under the plan, the option price cannot be less than the fair market value of the stock on the date granted. An option’s maximum term is ten years from the date of grant. Options granted under the plan may be subject to a graded vesting schedule.
The stockholders initially authorized up to 183,600 shares of common stock to be used in the granting of incentive options to employees and directors. These shares have been restated to reflect the 2% stock dividend declared March 14, 2006. On April 24, 2007, the shareholders authorized an additional 250,000 shares of common stock to be used in the granting of incentive options to employees and directors.
Stock option compensation expense is the estimated fair value of options granted, and is amortized on a straight-line basis over the requisite service period for each separately vesting portion of the award. There were no options granted in 2008. The weighted average estimated fair value of stock options granted in the twelve months ended December 31, 2007 and 2006 was $3.76 and $3.88, respectively. Fair value is estimated using the Black-Scholes option-pricing model with the following assumptions for grants during 2007 and 2006: option term until exercise of 10 years, expected volatility of 19.56% and 17.86%, risk-free interest rates of 4.66% and 4.43%, and expected dividend yields of 2.74% and 2.66%, respectively. Expected volatility is based on the historic volatility of the company’s stock price over the expected life of the options. We have determined that the expected term for options is their contractual life of 10 years. The risk-free interest rate is the U. S. Treasury zero-coupon issue with a remaining term equal to the expected term of the options granted. The dividend yield is estimated as the ratio of the company’s historical dividends paid per share of common stock to the stock price on the date of grant.
Reclassifications
Certain reclassifications have been made to prior period amounts to conform to the current year presentation.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (FASB) reached a consensus on Emerging Issues Task Force (EITF) Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements,” (EITF Issue 06-4). In March 2007, the FASB reached a consensus on EITF Issue 06-10, “Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements,” (EITF Issue 06-10). Both of these standards require a company to recognize an obligation over an employee’s service period based upon the substantive agreement with the employee such as the promise to maintain a life insurance policy or provide a death benefit postretirement. The company adopted the provisions of these standards effective January 1, 2008. The adoption of these standards was not material to the consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but rather, provides enhanced guidance to other pronouncements that require or permit assets or liabilities to be measured at fair value. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The FASB has approved a one-year deferral for the implementation of the statement for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. The company adopted SFAS 157 effective January 1, 2008. The adoption of SFAS 157 was not material to the consolidated financial statements.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Recent Accounting Pronouncements (Continued)
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The fair value option established by this statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument and is irrevocable. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, with early adoption available in certain circumstances. The company adopted SFAS 159 effective January 1, 2008. The company decided not to report any existing financial assets or liabilities at fair value that are not already reported, thus the adoption of this statement did not have a material impact on the consolidated financial statements.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), “Business Combinations” (SFAS 141(R)). The standard will significantly change the financial accounting and reporting of business combination transactions. SFAS 141(R) establishes principles for how an acquirer recognizes and measures the identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for acquisition dates on or after the beginning of an entity’s first year that begins after December 15, 2008. The company does not expect the implementation of SFAS 141(R) to have a material impact on its consolidated financial statements, at this time.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, “Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51” (SFAS 160). The standard will significantly change the financial accounting and reporting of noncontrolling (or minority) interests in consolidated financial statements. SFAS 160 is effective as of the beginning of an entity’s first fiscal year that begins after December 15, 2008, with early adoption prohibited. The company does not expect the implementation of SFAS 160 to have a material impact on its consolidated financial statements, at this time.
In November 2007, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings” (SAB 109). SAB 109 expresses the current view of the staff that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SEC registrants are expected to apply the views in Question 1 of SAB 109 on a prospective basis to derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. Implementation of SAB 109 did not have a material impact on the company’s consolidated financial statements.
In December 2007, the SEC issued Staff Accounting Bulletin No. 110, “Use of a Simplified Method in Developing Expected Term of Share Options” (SAB 110). SAB 110 expresses the current view of the staff that it will accept a company’s election to use the simplified method discussed in SAB 107 for estimating the expected term of “plain vanilla” share options regardless of whether the company has sufficient information to make more refined estimates. The staff noted that it understands that detailed information about employee exercise patterns may not be widely available by December 31, 2007. Accordingly, the staff will continue to accept, under certain circumstances, the use of the simplified method beyond December 31, 2007. Implementation of SAB 110 did not have a material impact on the company’s consolidated financial statements.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Recent Accounting Pronouncements (Continued)
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of SFAS No. 133,” (SFAS 161). SFAS 161 requires that an entity provide enhanced disclosures related to derivative and hedging activities. SFAS 161 is effective for the company on January 1, 2009 and is not expected to have a material impact on the company’s consolidated financial statements.
In April 2008, the FASB issued FASB Staff Position (FSP) No. 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3). FSP 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). The intent of FSP 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the assets under SFAS 141(R). FSP 142-3 is effective for the company on January 1, 2009, and applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. The adoption of FSP 142-3 is not expected to have a material impact on the company’s consolidated financial statements.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” (SFAS 162). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. SFAS 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” Management does not expect the adoption of the provision of SFAS 162 to have any impact on the consolidated financial statements.
In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161,” (FSP 133-1 and FIN 45-4). FSP 133-1 and FIN 45-4 require a seller of credit derivatives to disclose information about its credit derivatives and hybrid instruments that have embedded credit derivatives to enable users of financial statements to assess their potential effect on its financial position, financial performance and cash flows. The disclosures required by FSP 133-1 and FIN 45-4 will be effective for the company on December 31, 2008 and are not expected to have a material impact on the consolidated financial statements.
In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” (FSP 157-3). FSP 157-3 clarifies the application of SFAS 157 in determining the fair value of a financial asset during periods of inactive markets. FSP 157-3 was effective as of September 30, 2008 and did not have material impact on the company’s consolidated financial statements.
In December 2008, the FASB issued FSP No. FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities.” FSP No. FAS 140-4 and FIN 46(R)-8 requires enhanced disclosures about transfers of financial assets and interests in variable interest entities. The FSP is effective for interim and annual periods ending after December 15, 2008. Since the FSP requires only additional disclosures concerning transfers of financial assets and interest in variable interest entities, adoption of the FSP will not affect the company’s financial condition, results of operations or cash flows.
Note 1. Nature of Banking Activities and Significant Accounting Policies (Continued)
Recent Accounting Pronouncements (Continued)
In January 2009, the FASB reached a consensus on EITF Issue 99-20-1. This FSP amends the impairment guidance in EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,” to achieve more consistent determination of whether an other-than-temporary impairment has occurred. The FSP also retains and emphasizes the objective of an other-than-temporary impairment assessment and the related disclosure requirements in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and other related guidance. The FSP is effective for interim and annual reporting periods ending after December 15, 2008 and shall be applied prospectively. The FSP was effective as of December 31, 2008 and did not have a material impact on the consolidated financial statements.
Note 2. Securities
There were no securities held to maturity as of December 31, 2008 and 2007.
The amortized cost and fair value of securities available for sale as of December 31, 2008 and 2007 (in thousands) are as follows:
The amortized cost and fair value of the securities available for sale as of December 31, 2008 (in thousands), by contractual maturity, are shown below:
There were no sales of securities available for sale during 2008 or 2007.
Note 2. Securities (Continued)
The primary purpose of the investment portfolio is to generate income and meet liquidity needs of the company through readily saleable financial instruments. The portfolio is made up of fixed rate bonds, whose prices move inversely with rates. At the end of any accounting period, the investment portfolio has unrealized gains and losses. The company monitors the portfolio which is subject to liquidity needs, market rate changes and credit risk changes to see if adjustments are needed. The primary concern in a loss situation is the credit quality of the business behind the instrument. The primary cause of impairments is the decline in the prices of the bonds as rates have risen. There are approximately 9 accounts in the consolidated portfolio that have losses at December 31, 2008. These securities have not suffered credit deterioration and the company has the ability and intent to hold these issues to maturity or recovery of value; therefore, the gross unrealized losses are considered temporary as of December 31, 2008.
The following table summarizes the fair value and gross unrealized losses for securities aggregated by investment category and length of time that individual securities have been in a continuous gross unrealized loss position as of December 31, 2008 and 2007 (in thousands).
Securities with a carrying value of $18.4 million and $25.6 million at December 31, 2008 and 2007 were pledged to secure public funds and other balances as required by law.
Note 3. Loans and Related Party Transactions
The loan portfolio is composed of the following:
Note 3. Loans and Related Party Transactions (Continued)
At December 31, 2008 and 2007, overdraft demand deposits reclassified to loans totaled $457 thousand and $193 thousand, respectively.
Loans to directors and executive officers of the company or to their associates at December 31, 2008 and 2007 totaled $3.1 million and $2.8 million, respectively. Such loans were made on substantially the same terms as those prevailing for comparable transactions with similar risks. During 2008, total principal additions were $963 thousand and total principal payments were $725 thousand.
Note 4. Allowance for Loan Losses
The following is a summary of transactions in the allowance for loan losses for 2008, 2007 and 2006 (in thousands):
The following is a summary of information pertaining to impaired loans as of December 31 for each of the years presented (in thousands):
No additional funds are committed to be advanced in connection with impaired loans. Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at December 31, 2008 and 2007 totaled $607 thousand and $517 thousand, respectively. If interest had been accrued on these nonaccrual loans, such income would have approximated $36 thousand in 2008 and $3 thousand in 2007.
Note 5. Premises and Equipment, Net
Premises and equipment consists of the following:
Depreciation included in operating expense for 2008, 2007 and 2006 was $532 thousand, $568 thousand and $582 thousand, respectively.
Note 6. Deposits
The aggregate amount of time deposits with a balance of $100,000 or more was $31.8 million and $28.2 million at December 31, 2008 and 2007, respectively.
At December 31, 2008, the scheduled maturities of all time deposits (in thousands) are as follows:
Brokered deposits (all in the form of certificates of deposit) totaled $9.6 million and $3.4 million at December 31, 2008 and 2007, respectively.
Deposits of the company’s directors, executive officers and associates totaled $1.6 million and $1.4 million at December 31, 2008 and 2007, respectively.
Deposits of one public funds entity exceed 5% of the bank’s total deposits.
Note 7. Borrowings
Short-term borrowings consist of securities sold under agreements to repurchase.
Short-term borrowings totaled $8.4 million and $12.5 million as of December 31, 2008 and 2007, respectively, in securities sold under agreements to repurchase through secured transactions with customers.
During 2008, the bank incurred fixed rate long term debt consisting of a Federal Home Loan Bank, five year loan, with an original balance of $5 million and monthly payments of interest and principal with an interest rate of 4.61%. The seven year loan with Federal Home Loan Bank with an original balance of $2.5 million was paid off in June 2008.
Principal payments on the note are due as follows:
Note 7. Borrowings (Continued)
The company has unused lines of credit with the Federal Home Loan Bank and other financial institutions totaling approximately $135 million at December 31, 2008.
Note 8. Employee Benefit Plans
The company sponsors a 401(k) retirement savings plan available to all employees meeting certain age and service requirements. Employees become eligible to participate in the plan upon reaching age 21 and completing one year of service. Entry dates are January 1, April 1, July 1 and October 1. Employees can make a salary deferral election authorizing the employer to withhold up to the amount allowed by law each calendar year. The employer may make a discretionary matching contribution each plan year. The employer may also make other discretionary contributions to the plan. The company made 401(k) matching contributions of $100 thousand, $92 thousand and $56 thousand in 2008, 2007 and 2006, respectively.
The company sponsors a funded noncontributory, defined benefit pension plan covering full-time employees over 21 years of age upon completion of one year of service. Benefits are based on average compensation for the five consecutive full calendar years of service which produces the highest average.
The company sponsors an unfunded postretirement life insurance plan covering current and future retirees with 25 years of service over the age of 60 and an unfunded health care plan for current retirees that met certain eligibility requirements.
The company has entered into contracts with three retirees where the company agrees to pay the participants’ beneficiaries $50,000 upon the participants’ death. The present value of this postretirement benefit has been accrued as of December 31, 2008 in the amount of $127 thousand. While these liabilities are unfunded, life insurance has been obtained by the company to help offset these payments.
Note 8. Employee Benefit Plans (Continued)
Obligations and funded status:
The accumulated benefit obligation for the defined benefit pension plan was $7.4 million and $5.9 million at December 31, 2008 and 2007, respectively.
Note 8. Employee Benefit Plans (Continued)
Components of net periodic benefit cost and other amounts recognized in accumulated other comprehensive (loss):
The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year approximates $71 thousand. The estimated unrecognized transition liability for the other defined benefit postretirement plans that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year is $17 thousand.
Note 8. Employee Benefit Plans (Continued)
Assumptions
Long-Term Rate of Return
The plan sponsor selects the expected long-term rate-of-return-on-assets assumption in consultation with their investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience that may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions.
Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).
Asset Allocation
The pension plan’s weighted-average asset allocations at December 31, 2008 and October 31, 2007 (the plan’s valuation date), by asset category are as follows:
The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 60% equities and 40% fixed income/cash. The trust fund allocation is reviewed on a quarterly basis and rebalanced back to the original weighting if the actual weighting varies by at least 5% from the target allocation. The investment manager selects investment fund managers with demonstrated experience and expertise and funds with demonstrated historical performance for the implementation of the plan’s investment strategy. The investment manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.
It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust.
There is no company common stock included in the equity securities of the pension plan at December 31, 2008 and 2007.
Note 8. Employee Benefit Plans (Continued)
Cash Flow
The company expects to contribute $1 million to its pension plan in 2009 and $26 thousand to its postretirement plan in 2009.
The following benefit payments, which reflect future service, are expected to be paid:
For measurement purposes, a 7.10%, 7.35% and 7.60% annual rate of increase in per capita health care costs of covered benefits was assumed for 2008, 2007 and 2006, with such annual rate of increase gradually declining to 5% in 2013.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1% change in assumed health care cost trend rates would have the following effects:
Note 9. Weighted Average Number of Shares Outstanding and Earnings Per Share
The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock. Potential diluted common stock had no effect on earnings per share available to stockholders.
Shares outstanding have been restated to reflect the 2% stock dividend in 2006.
Stock options for 132,620, 120,534 and 83,811 shares of common stock were not considered in computing diluted earnings per common share for 2008, 2007 and 2006, respectively, because they were anti-dilutive.
Note 10. Stock-Based Compensation
During 2003, the company adopted an incentive stock plan which allows key employees and directors to increase their personal financial interest in the company. This plan permits the issuance of incentive stock options and non-qualified stock options. The plan authorizes the issuance of up to 183,600 shares of common stock (shares have been restated to reflect the 2% stock dividend declared March 14, 2006). In 2007, the shareholders authorized an additional 250,000 shares of common stock to be used in the granting of incentive options to employees and directors.
A summary of option activity under the plan as of December 31, 2008, and changes during the year then ended is presented below:
The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2008. The amount changes based on changes in the market value of the company’s stock.
The exercise price of stock options granted under this plan, both incentive and non-qualified, cannot be less than the fair market value of the common stock on the date that the option is granted. The maximum term for an option granted under this plan is ten years and options granted may be subject to a vesting schedule. The non-qualified options granted are exercisable immediately. The incentive options granted are subject to a five year vesting period whereby the grantees are entitled to exercise one fifth of the options on the anniversary of the grant date over the next five years. The following table summarizes options outstanding at December 31, 2008:
As of December 31, 2008, there was $97 thousand of total unrecognized compensation expense related to nonvested stock options, which will be recognized over the remaining requisite service period. The unrecognized compensation expense has a weighted average life of two years.
Note 11. Income Taxes
The company files income tax returns in the U. S. Federal jurisdiction and the state of West Virginia. With few exceptions, the company is no longer subject to U. S. Federal, state and local income tax examinations by tax authorities for years prior to 2005.
The company adopted the provisions of FIN 48, “Accounting for Uncertainty in Income Taxes”, on January 1, 2007 with no impact on the financial statements.
Net deferred tax assets consist of the following components as of December 31, 2008 and 2007:
The provision for income taxes charged to operations for the years ended December 31, 2008, 2007 and 2006 consists of the following:
The 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, 2008, 2007 and 2006 due to the following (in thousands):
Note 12. Commitments and Contingent Liabilities
In the normal course of business, there are outstanding various commitments and contingent liabilities which are not reflected in the accompanying financial statements. The company does not anticipate losses as a result of these transactions. See Note 14 with respect to financial instruments with off-balance-sheet risk.
The company has approximately $1 million in deposits in other financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at December 31, 2008.
The company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final bi-weekly reporting periods which included December 31, 2008 and 2007, the aggregate amounts of daily average required balances were approximately $300 thousand for each time period.
Note 13. Retained Earnings
Transfers of funds from the banking subsidiary to the parent company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2008, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent company without prior regulatory approval, totaled $3.5 million or 12.5% of the consolidated net assets.
Note 14. Financial Instruments With Off-Balance-Sheet 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. Those financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. 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 instruments for commitments to extend credit and standby letters of 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.
A summary of the contract or notional amount of the company’s exposure to off-balance-sheet risk as of December 31, 2008 and 2007 (in thousands) is as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the company upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Unfunded commitments under commercial lines of credit are commitments for possible future extensions of credit to existing customers. The majority of these lines of credit are collateralized and usually contain a specified maturity date and may not be drawn upon to the extent to which the company is committed.
Standby letters of credit are conditional commitments issued by the company to guarantee the performance of a customer to a third party. 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 generally holds collateral supporting those commitments if deemed necessary.
Note 14. Financial Instruments With Off-Balance-Sheet Risk (Continued)
At December 31, 2008, the company had rate lock commitments to originate mortgage loans amounting to $1.1 million and mortgage loans held for sale in the amount of $329 thousand. The company enters into corresponding mandatory commitments, on a best-efforts basis, to sell the loans. These commitments to sell loans are designed to eliminate the company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.
Note 15. Fair Value Measurements
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Short-Term Investments
For those short-term instruments, the carrying amount is a reasonable estimate of fair value.
Securities
For securities held for investment purposes, fair values are based on quoted market prices or dealer quotes.
Loans
For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans were estimated using discounted cash flow analyses, using interest rates currently being offered.
Loans Held for Sale
The carrying amount of loans held for sale approximates fair value.
Deposit Liabilities
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.
Short-Term Borrowings
The carrying amounts of borrowings under repurchase agreements and federal funds sold approximate fair value.
FHLB Advances
The fair values of the company’s FHLB advances are estimated using discounted cash flow analysis based on the company’s incremental borrowing rates for similar types of borrowing arrangements.
Accrued Interest
The carrying amounts of accrued interest approximate fair value.
Off-Balance Sheet Financial Instruments
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.
At December 31, 2008 and 2007, the fair value of loan commitments and standby-letters of credit was immaterial. Therefore, they have not been included in the following table.
Note 15. Fair Value Measurements (Continued)
The carrying amounts and estimated fair values of the company’s financial instruments are as follows:
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.
The company adopted SFAS No. 157, “Fair Value Measurements” (SFAS 157), on January 1, 2008 to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. SFAS 157 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
In February of 2008, the FASB issued Staff Position No. 157-2 (FSP 157-2) which delayed the effective date of SFAS 157 for certain nonfinancial assets and nonfinancial liabilities except for those items that are recognized or disclosed at fair value in the financial statements on a recurring basis. FSP 157-2 defers the effective date of SFAS 157 for such nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. Thus, the company has only partially applied SFAS 157. The items affected by FSP 157-2 include other real estate owned.
In October of 2008, the FASB issued Staff Position No. 157-3 (FSP 157-3) to clarify the application of SFAS 157 in a market that is not active and to provide key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP 157-3 was effective upon issuance, including prior periods for which financials statements were not issued.
SFAS 157 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the company’s market assumptions. The three levels of the fair value hierarchy under SFAS 157 based on these two types of inputs are as follows:
Note 15. Fair Value Measurements (Continued)
Level Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 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 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 table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2008:
Certain financial assets are measured at fair value on a nonrecurring basis in accordance with generally accepted accounting principles. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs 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 financial statements:
Loans held for sale: Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the year ended December 31, 2008. Gains and losses on the sale of loans are recorded within other operating income on the consolidated statements of income.
Note 15. Fair Value Measurements (Continued)
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. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. 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 is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.
The following table summarizes the company’s financial assets that were measured at fair value on a nonrecurring basis during the period.
Note 16. Regulatory Matters
The company (on a consolidated basis) and the bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the company’s and the bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the company and bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the company and the bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2008 and 2007, that the company and the bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2008, the most recent notification from the Federal Deposit Insurance Corporation categorized the bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category.
Note 16. Regulatory Matters (Continued)
The company’s and the bank’s actual capital amounts and ratios are also presented in the table.
Note 17. Parent Company Only Financial Statements
POTOMAC BANCSHARES, INC.
(Parent Company Only)
Balance Sheets
December 31, 2008 and 2007
(in thousands)
POTOMAC BANCSHARES, INC.
(Parent Company Only)
Statements of Income
Years Ended December 31, 2008, 2007 and
(in thousands)
Note 17. Parent Company Only Financial Statements (Continued)
POTOMAC BANCSHARES, INC.
(Parent Company Only)
Statements of Cash Flows
Years Ended December 31, 2008, 2007 and 2006
(in thousands)
Item 9.
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
Not Applicable.
Item 9A(T).
Item 9A(T). Controls and Procedures.
The company’s chief executive officer and chief financial officer, based on their evaluation as of the date of this report of the company’s disclosure controls and procedures (as defined in Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have concluded that the company’s disclosure controls and procedures are adequate and effective for purposes of Rule 13(a)-14(c) and timely, alerting them to material information relating to the company required to be included in the company’s filings with the Securities and Exchange Commission under the Securities Exchange Act of 1934.
This annual report does not include an attestation report of the company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the company to provide only management’s report in this annual report.
There were no significant changes in the company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation.
Management’s Report on Internal Control Over Financial Reporting
To the Stockholders:
Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.
Management is also responsible for establishing and maintaining adequate internal control over financial reporting. The company’s internal control over financial reporting includes those policies and procedures that pertain to the company’s ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.
In order to ensure that the company’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2008. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management has concluded that the internal control over financial reporting was effective as of December 31, 2008.
The Board of Directors, acting through its Audit Committee, is responsible for the oversight of the company’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent registered public accounting firm and approves decisions regarding the appointment or removal of the company’s internal auditor. It meets periodically with management, the independent registered public accounting firm and the internal auditor to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the company in addition to reviewing the company’s financial reports. The independent registered public accounting firm and the internal auditor have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information contained on pages 7-8 of the Proxy Statement dated April 8, 2009, for the May 19, 2009 Annual Meeting under the captions “Management Nominees to the Board of Potomac” and “Directors Continuing to Serve Unexpired Terms,” and page 15 under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.
The Executive Officers are as follows:
The bank has adopted a Code of Ethics that applies to all employees, including Potomac’s and the bank’s chief executive officer and chief financial officer and other senior officers. Additionally, there is a Code of Ethics for Senior Financial Officers which applies to Potomac’s and the bank’s chief executive officer and chief financial officer. These Codes of Ethics are attached to this document as Exhibits 14.1 and 14.2. If we make any substantive amendments to this code or grant any waiver from a provision of the code to our chief executive officer or chief financial officer, we will disclose the amendment or waiver in a report on Form 8-K.
Item 11.
Item 11. Executive Compensation.
The information contained on pages 10-14 of the Proxy Statement dated April 8, 2009, for the May 19, 2009 Annual Meeting under the captions “Executive Compensation,” “Employee Benefit Plans,” “Employment Agreement,” and “Compensation of Directors” is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information contained on pages 9-10 of the Proxy Statement dated March 31, 2009, for the May 19, 2009 Annual Meeting under the caption “Ownership of Securities by Nominees, Directors and Officers” is incorporated herein by reference.
Securities authorized for issuance under Potomac’s 2003 Stock Incentive Plan are listed below:
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information contained on page 14 of the Proxy Statement dated April 8, 2009, for the May 19, 2009 Annual Meeting under the caption “Certain Transactions with Directors, Officers and Their Associates” is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information contained on pages 6-7 of the Proxy Statement dated April 8, 2009, for the May 19, 2009 Annual Meeting under the caption “Audit Committee Report” is incorporated herein by reference.
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a)
(1)
Financial Statements. Reference is made to Part II, Item 8 of this Annual Report on Form 10-K.
(2)
Financial Statement Schedules. These schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
(3)
Exhibits. See below.
2.1 Agreement and Plan of Merger dated March 8, 1994, by and between Potomac Bancshares, Inc., and Bank of Charles Town filed with and incorporated by reference from the Registration on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.
3.1 Articles of Incorporation of Potomac Bancshares, Inc. filed with and incorporated by reference from the Registration Statement on Form S-4 filed with the Securities and Exchange Commission on June 10, 1994, Registration No. 33-80092.
3.2 Amendments to Articles of Incorporation of Potomac Bancshares, Inc. adopted by shareholders on April 25, 1995 and filed with the West Virginia Secretary of State on May 23, 1995, and incorporated by reference from Potomac’s Form 10-KSB for the year ended December 31, 1995 and filed with the Securities and Exchange Commission, File No. 0-24958.
3.3 Amended and Restated Bylaws of Potomac Bancshares, Inc. and subsequent amendments thereto.*
10.1 2003 Stock Incentive Plan adopted by the Potomac Board February 20, 2003 and approved by the company’s shareholders on May 13, 2003, amended by the company’s shareholders on April 24, 2007 and incorporated by reference from Potomac’s Form 10-K for the year ended December 31, 2006 and filed with the Securities and Exchange Commission, File No. 0-24958.
10.2 Employment Agreement of Mr. Robert F. Baronner, Jr., filed with and incorporated by reference from Form 10-KSB for the year ended December 31, 2001, and filed with the Securities and Exchange Commission, File No. 0-24958.
14.1 Code of Ethics (for all employees)*
14.2 Code of Ethics for Senior Financial Officers*
Subsidiaries of the Registrant*
23.1 Consent of Independent Registered Public Accounting Firm *
31.1 Rule 13a-15(e)/15d-15(e) Certification of Chief Executive Officer*
31.2 Rule 13a-15(e)/15d-15(e) Certification of Chief Financial Officer*
32.1 Section 1350 Certification of Chief Executive Officer*
32.2 Section 1350 Certification of Chief Financial Officer*
99.1 Proxy Statement for the 2009 Annual Meeting for Potomac, portions are incorporated by reference in Form 10-K Annual Report*
* Filed herewith.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
POTOMAC BANCSHARES, INC.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.