Item 1. Description of Business
Valley Financial Corporation (the “Company”) was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of Valley Bank (the “Bank”). The Company posts all reports required to be filed under the Securities Exchange Act of 1934 on its web site at www.myvalleybank.com.
The Bank opened for business on May 15, 1995 at its main office in the City of Roanoke, opened its second office on September 11, 1995 in the County of Roanoke, its third office on January 15, 1997 in the City of Roanoke, its fourth office in the City of Salem on April 5, 1999, its fifth office in the City of Roanoke on May 7, 2001, its sixth office in County of Roanoke on May 20, 2002, its seventh office in the City of Roanoke on December 8, 2003, and its eighth office in the City of Roanoke on May 9, 2005. Additionally, the Bank opened its wealth management subsidiary, Valley Wealth Management Services, Inc., in the City of Roanoke on June 23, 2005.
The Bank operates under a state charter issued by the Commonwealth of Virginia, and engages in the business of commercial banking. Its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) and it is a member of the Federal Reserve System. Our primary purpose is to own and manage the Bank.
Effective June 26, 2003, Valley Financial (VA) Statutory Trust I was established as a wholly-owned subsidiary of the Company for the purpose of issuing trust preferred securities. Effective October 16, 2002, the Bank established VB Investments, LLC as a wholly-owned subsidiary of the Bank to be a limited partner in Grandin Theatre, LP. The establishment of the subsidiary gives the Bank the right to utilize certain federal and state tax credits. Effective September 26, 2005, Valley Financial (VA) Statutory Trust II was established as a wholly-owned subsidiary of the Company for the purpose of issuing additional trust preferred securities. These entities are for capital raising (in the case of the statutory trusts) or investment (in the case of the LLC) purposes.
Banking Services
We conduct a general commercial banking business while emphasizing the needs of small-to-medium sized businesses, professional concerns and individuals.
Deposit Services
We offer a full range of deposit services that are typically available in most banks and savings and loan associations, including checking accounts, NOW accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit. The transaction accounts and time certificates are tailored to the Bank’s principal market area at rates competitive to those offered in the area. In addition, we offer certain retirement account services, such as Individual Retirement Accounts. All deposit accounts are insured by the FDIC up to the maximum amount allowed by law (generally, $100,000 per depositor, subject to aggregation rules). We solicit accounts from individuals, businesses, associations and organizations and governmental authorities.
Lending Activities
Our lending activities are subject to a variety of lending limits imposed by state and federal laws and regulations. In general, the Bank is subject to a loan-to-one borrower limit of an amount equal to 15% of the total of the Bank’s unimpaired capital, surplus, and allowance for loan loss. We may not make any extensions of credit to any director, executive officer, or principal shareholder of the Bank or the Company, or to any related interest of such person, unless the extension of credit is approved by the Board of Directors of the Bank and the credit is made on terms not more favorable to such person than would be available to an unaffiliated party.
Commercial loans include both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements) and purchase of equipment and machinery. Loan requests are granted based upon several factors including credit history, past and present relationships with the bank, marketability of collateral and the cash flow of the borrowers. Unsecured commercial loans must be supported by a satisfactory balance sheet, income statement and cash flow statement. Collateralized business loans may be secured by a security interest in marketable equipment, accounts receivable, business equipment and/or general intangibles of the business. In addition, or as an alternative, the loan may be secured by a deed of trust lien on business real estate. The risks associated with commercial loans are related to the strength of the individual business, the value of loan collateral, and the general health of the economy.
Residential real estate loans are secured by deeds of trust on 1-4 family residential properties. The Bank also serves as a broker for residential real estate loans placed in the secondary market. There are occasions when a borrower or the real estate do not qualify under secondary market criteria, but the loan request represents a reasonable credit risk. Also, an otherwise qualified borrower may choose not to have their mortgage loan sold. On these occasions, if the loan meets the Bank’s internal underwriting criteria, the loan will be closed and placed in the Bank’s portfolio. Residential real estate loans carry risk associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.
The Bank makes loans for the purpose of financing the construction of business and residential structures to financially responsible business entities and individuals. Additionally, the Bank makes loans for the purpose of financing the acquisition and development of commercial and residential projects. These loans are subject to additional underwriting standards as compared to our commercial and residential real estate loans, due to the following inherent risks associated with construction and development loans. Construction loans and acquisition and development loans bear the risks that the project will not be finished according to schedule, the project will not be finished according to budget and the value of the collateral may at any point in time be less than the principal amount of the loan. Construction loans and acquisition and development loans also bear the risk that the general contractor, who may or may not be the Bank’s loan customer, is unable to finish the construction project as planned because of financial pressures unrelated to the project. Loans to customers that are made as permanent financing of construction loans may likewise under certain circumstances be affected by external financial pressures.
The Bank routinely makes consumer loans, both secured and unsecured for financing automobiles, home improvements, education, and personal investments. The credit history, cash flow and character of individual borrowers is evaluated as a part of the credit decision. Loans used to purchase vehicles or other specific personal property and loans associated with real estate are usually secured with a lien on the subject vehicle or property. Negative changes in a customer’s financial circumstances due to a large number of factors, such as illness or loss of employment, can place the repayment of a consumer loan at risk. In addition, deterioration in collateral value can add risk to consumer loans.
We will occasionally buy or sell all or a portion of a loan. We will consider selling a loan or a participation in a loan, if: (i) the full amount of the loan will exceed our legal lending limit to a single borrower; (ii) the full amount of the loan, when combined with a borrower’s previously outstanding loans, will exceed our legal lending limit to a single borrower; (iii) the Board of Directors or an internal Loan Committee believes that a particular borrower has a sufficient level of debt with us; (iv) the borrower requests the sale; (v) the loan to deposit ratio is at or above the optimal level as determined by bank management; and/or (vi) the loan may create too great a concentration of loans in one particular location or in one particular type of loan. We will consider purchasing a loan, or a participation in a loan, from another financial institution (including from another subsidiary of the Company) if the loan meets all applicable credit quality standards and (i) the Bank’s loan to deposit ratio is at a level where additional loans would be desirable; and/or (ii) a common customer requests the purchase.
We offer leasing services for our small business, private banking and business banking customers and prospects to access equipment, technology or other capital assets that they need to improve productivity and to facilitate growth without taking on debt or investing significant working capital. Leasing facilities do generally incorporate above-average risk as they generally require minimal initial equity investments on the part of the lessee and may include residual value risks at the time of lease maturity.
We offer several forms of specialized asset-based lending to our commercial business customers, which include:
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Accounts Receivable Financing - enables small businesses to unlock the cash typically frozen in accounts receivable which provides cash flow to support operations. The Bank utilizes an automated software program to manage and monitor collateral values on a consistent and routine basis.
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Automobile Floor Plan Financing - enables auto-related businesses to carry sufficient levels of inventories to support sales demand.
Asset-based loans require substantial risk management and monitoring processes which should help mitigate collateral exposures; however, these types of financing are inherently high risk due to the every changing status of the underlying collateral.
Other Services
Other Bank services include safe deposit boxes, certain cash management services including overnight repurchase agreements, merchant purchase and management programs, traveler’s checks, direct deposit of payroll and social security checks and automatic drafts for various accounts. We operate seven proprietary ATM’s and are associated with the Honor, Cirrus and The Exchange shared networks of automated teller machines that may be used by Bank customers throughout Virginia and other regions. We also offer VISA and MasterCard credit card services as well as a debit-check card. Our lockbox service provides a simple and efficient way to collect accounts receivable payments locally for businesses and non-profit organizations.
Financial Services
On June 23, 2005, Valley Wealth Management Services, Inc., (VWM) a wholly-owned subsidiary of the Bank, began offering non-deposit investment products and insurance products for sale to the public. VWM is working with Bankers Insurance, LLC, a joint effort of Virginia banks originally sponsored by the Virginia Bankers Association.
We have no immediate plans to obtain or exercise trust powers. We may in the future offer a full-service trust department, but cannot do so without the prior approval of its primary regulators, the Federal Reserve Bank of Richmond and the Virginia State Corporation Commission, before exercise of trust powers.
Operating Revenue
The following table sets forth, for the three fiscal years ended December 31, 2005, 2004, and 2003, the percentage of total operating revenue contributed by each class of similar services which contributed 15 percent or more of total operating revenues of the Company during such periods.
Location and Service Area
Our primary service area is The Roanoke Metropolitan Statistical Area (the “Roanoke MSA”), which is the regional center for southwest Virginia, and is located approximately 165 miles west of Richmond, Virginia, 178 miles northwest of Charlotte, North Carolina, 178 miles east of Charleston, West Virginia and 222 miles southwest of Washington, D.C. There are 20 colleges and universities within a 60-mile radius of Roanoke. Hollins University and Roanoke College, with student enrollments of approximately 1,000 and 1,850, respectively, are located in the Roanoke MSA. Virginia Polytechnic Institute & State University (VPI) and Radford University (RU), with student bodies of some 25,600 and 9,300, respectively, are approximately a 45-minute drive away. VPI is the Commonwealth’s land grant college and also its largest university. Employment at VPI has remained relatively stable over the past three years, and it is not expected to change materially in the next few years. RU has also provided stable employment opportunities in the region.
The population in the Roanoke MSA was estimated at 290,100 in 2003 per the Weldon Cooper Center for Public Services, University of Virginia. The Roanoke MSA’s growth typically is slower than that in the Commonwealth overall and in other key Virginia markets in particular. The Virginia Employment Commission reported that the Roanoke MSA had an unemployment rate of 2.8% in December 2005, compared with 4.6% nationally and 3.0% for Virginia.
The business community in the Roanoke MSA is well diversified by industry group. The principal components of the economy are retail trade, services, transportation, manufacturing and finance, insurance and real estate. The Roanoke MSA’s position as a regional center creates a strong medical, legal and business professional community. Carillion Health System, Advance Auto Parts, Lewis-Gale Hospital, and the Veterans Administration Hospital are among Roanoke’s largest employers. Other large employers include Norfolk Southern Corporation, General Electric Co., Wachovia Corporation, The Kroger Company - Mid Atlantic, and ITT Industries Night Vision.
Competition
The banking and financial service business in Virginia, and in our primary market area specifically, is highly competitive. The increasingly competitive environment is a result of changes in regulation, changes in technology and product delivery systems and new competition from non-traditional financial services. We compete for loans and deposits with other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other nonbank financial service providers. In order to compete, we rely upon a service-based business philosophy, personal relationships with customers, specialized services tailored to meet customers’ needs and the convenience of office locations. In addition, we are generally competitive with other financial institutions in our market area with respect to interest rates paid on deposit accounts, interest rates charged on loans and other service charges on loans and deposit accounts.
Our market area is a highly concentrated, highly branched banking market. Currently, the Bank, Bank of Botetourt, Bank of Fincastle, and the newly formed Hometown Bank are the only locally owned and operated commercial banks. Most competitors are subsidiaries of holding companies headquartered in North Carolina, Georgia, Tennessee, and Northern Virginia. Numerous credit unions in the aggregate operate additional offices in the Roanoke MSA. Further, various other financial companies, ranging from local to national firms, provide financial services to residents of the Bank’s market area.
We believe that the Bank will be able to compete effectively in this market, and that the community reacts favorably to our community bank focus and emphasis on service to small businesses, individuals and professional concerns.
Employees
At December 31, 2005 the Bank had 103 full-time employees and 8 part-time employees.
Supervision and Regulation
The Company and the Bank are subject to state and federal banking laws and regulations which impose specific requirements or restrictions on and provide for general regulatory oversight with respect to virtually all aspects of operations. As a result of the substantial regulatory burdens on banking, financial institutions, including the Company, are disadvantaged relative to other competitors who are not as highly regulated, and our costs of doing business are much higher. The following is a brief summary of the material provisions of certain statutes, rules and regulations affecting the Company and the Bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below, and is not intended to be an exhaustive description of the statutes or regulations which are applicable to the business of the Company and/or the Bank. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company and/or the Bank.
The Company
The Company is a bank holding company within the meaning of the Federal Bank Holding Company Act of 1956, as amended (the “BHCA”), and Chapter 13 of the Virginia Banking Act, as amended (the “Virginia Act”).
The BHCA. The BHCA is administered by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), and the Company is required to file periodic reports and such additional information as the Federal Reserve may require. The Federal Reserve Board also is authorized to examine the Company and its subsidiaries. The BHCA, with limited exceptions, requires every bank holding company to obtain the prior approval of the Federal Reserve before, (i) it or any of its subsidiaries (other than a bank) acquires substantially all the assets of any bank, (ii) it acquires ownership or control of any voting shares of any bank if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank, or (iii) it merges or consolidates with any other bank holding company.
The BHCA and the Change in Bank Control Act, together with regulations promulgated by the Federal Reserve, require that, depending on the particular circumstances, either Federal Reserve Board approval must be obtained or notice must be furnished to the Federal Reserve and not disapproved prior to any person or company acquiring “control” of a bank holding company, such as the Company, subject to certain exemptions for certain transactions. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more but less than 25% of any class of voting securities of the Company. The regulations provide a procedure for challenging the rebuttable control presumption.
Under the BHCA, the Company is generally prohibited from engaging in, or acquiring direct or indirect control of more that 5% of the voting shares of any company engaged in nonbanking activities unless the Federal Reserve, by order or regulation, has found those activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
The Federal Reserve imposes certain capital requirements on the Company under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. Subject to its capital requirements and certain other restrictions, the Company is able to borrow money to make a capital contribution to the Bank, and such loans may be repaid from dividends paid from the Bank to the Company, although the ability of the Bank to pay dividends is subject to regulatory restrictions. The Company is also able to raise capital for contribution to the Bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.
The Virginia Banking Act. All Virginia bank holding companies must register with the Bureau of Financial Institutions of the State Corporation Commission of Virginia (the “Virginia Commission”) under the Virginia Banking Act. A registered bank holding company must provide the Virginia Commission with information with respect to the financial condition, operations, management and intercompany relationships of the holding company and its subsidiaries. The Virginia Commission also may require such other information as is necessary to keep itself informed about whether the provisions of Virginia law and the regulations and orders issued thereunder by the Virginia Commission have been complied with, and may make examinations of any Virginia holding company and its subsidiaries. Under the Virginia Act, it is generally unlawful, without the prior approval of the Virginia Commission, for any Virginia bank holding company to acquire direct or indirect ownership or control of more than 5% of the voting shares of any Virginia bank or any other bank holding company. The Virginia Banking Act allows bank holding companies located in any state to acquire a Virginia bank or bank holding company if the Virginia bank or bank holding company could acquire a bank holding company in their state and the Virginia bank or bank holding company to be acquired has been in existence and continuously operated for more than two years. The Virginia Banking Act permits bank holding companies from throughout the United States to enter the Virginia market, subject to federal and state approval.
Financial Modernization Legislation/Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act (the “GLBA”), enacted on November 12, 1999, broadly rewrote financial services legislation. The GLBA permits significant combinations among different sectors of the financial services industry; allows for significant expansion of financial service activities by Bank holding companies and provides for a regulatory framework by various governmental authorities responsible for different financial activities; and offers certain financial privacy protections to consumers. The GLBA repealed affiliation and management interlock prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank Holding Company Act, the GLBA added new substantive provisions to the non-banking activities permitted under the BHCA with the creation of the financial holding company. The GLBA preempts most state laws that prohibit financial holding companies from engaging in insurance activities. The GLBA permits affiliations between banks and securities firms within the same holding company structure, and the Act permits financial holding companies to directly engage in a broad range of activities as described below.
In order for a bank holding company to qualify as a financial holding company, all of its depository subsidiaries (i.e., banks and thrifts) must be well capitalized and well managed, and must have a satisfactory Community Reinvestment Act (“CRA”) rating. The bank holding company also must declare its intention to become a financial holding company to the Federal Reserve and certify that it meets the requirements. Banks and thrifts acquired by a financial holding company within 12 months prior to the date on which the election is filed may be excluded from this test if they have less than a satisfactory CRA rating, but they must submit a plan to the applicable federal banking agency describing how the CRA rating will be brought into conformance.
Financial holding company powers that are either specified in the statue or have been determined by the Federal Reserve to be financial in nature include the following:
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Underwriting insurance or annuities;
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Providing financial or investment advice;
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Underwriting, dealing in, or making markets in securities;
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Merchant banking, subject to limitations on size and capital restrictions;
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Insurance portfolio investing, subject to limitations; and
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Any other activities previously found to be closely related to banking by the Federal Reserve.
The GLBA also establishes a system of functional regulation for financial holding companies and banks providing regulation of securities by the Securities and Exchange Commission and state securities regulators, regulation of futures by the Commodity Futures Trading Commission, and regulation of insurance activities by the state insurance regulators. Banks may sell title insurance only when specifically permitted under the applicable state law.
The Company meets all of the requirements to become a financial holding company, but currently has not made an election with the Federal Reserve to become a financial holding company.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 was signed into law on July 30, 2002. It comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Securities Exchange Act of 1934. It enacted sweeping reforms of the federal securities laws intended to protect investors by improving the accuracy and reliability of corporate disclosures. Compliance with this complex legislation and with subsequent Securities and Exchange Commission rules has since been a major focus of all public corporations in the United States, including the Company. Among the many significant provisions of the Sarbanes-Oxley Act, Section 404 and related Securities and Exchange Commission rules created increased scrutiny by internal and external auditors of our systems of internal controls over financial reporting. These ongoing and extensive efforts are designed to insure that our internal controls are effective in terms of both design and operation, but compliance is costly, especially for community banking companies like ours.
The Bank
General. The Bank is a state-chartered commercial bank organized under the laws of the Commonwealth of Virginia, and is subject to examination by the Federal Reserve and the Virginia State Corporation Commission. The regulators monitor all areas of the Bank’s operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, issuances of securities, payment of dividends, interest rates payable on deposits, interest rates or fees chargeable on loans, establishment of branches, corporate reorganizations and maintenance of books and records. The Bank must maintain certain minimum capital ratios and is subject to certain limits on aggregate investments in real estate, bank premises and furniture and fixtures. The Bank is required to prepare quarterly reports on the Bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with prescribed minimum standards and procedures. The Bank also is required to adopt internal control structures and procedures in order to safeguard assets and monitor and reduce risk exposure. While considered appropriate for the safety and soundness of banks, these requirements adversely impact overhead costs.
The FDIC establishes rates for the payment of premiums by federally insured banks for deposit insurance. A Bank Insurance Fund (the “BIF”) is maintained for commercial banks with insurance premiums from the industry used to offset losses from insurance payouts when banks fail. Also, the Bank is charged a deposit-based assessment by the FDIC in connection with the so-called Financing Corporation (“FICO”) bonds issued by the federal government to finance the savings and loan industry bailout. The total BIF and FICO assessment combined was approximately $40,000 in 2005. Future deposit insurance premiums will vary with the strength of the banking industry, the level of the BIF insurance fund and the Bank’s individual risk rating as determined by the FDIC, and there can be no assurance that premiums will remain at their current level.
Transactions with Affiliates. The Federal Reserve Act restricts the amount and prescribes conditions with respect to loans, investments, asset purchases and other transactions (collectively, “Covered Transactions”) between banks and their affiliates. In addition to limitations as to amount, each Covered Transaction must meet specified collateral requirements. Compliance also is required with certain provisions designed to avoid the taking of low quality assets. Additionally, transactions, including Covered Transactions and service contracts entered into between banks and certain affiliates must be on terms and under circumstances that are substantially the same as those prevailing at the time for comparable transactions involving nonaffiliated companies. The foregoing restrictions and conditions apply to certain transactions between the Company and the Bank.
The Bank is subject to restrictions on extensions of credit to executive officers, directors, principal shareholders, and their related interests. Such extensions of credit are limited in their aggregate amount and (i) must be made on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated parties and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.
Branching. The Bank may branch without geographic restriction in Virginia since the Virginia Act permits statewide branching for state banks in Virginia. The federal Interstate Banking and Branching Efficiency Act of 1994 allows bank holding companies to acquire banks in any state, without regard to state law, except for state laws relating to the minimum amount of time a bank must be in existence to be acquired. Under the Virginia Act, a Virginia bank or all the subsidiaries of a Virginia bank holding company sought to be acquired must have been in continuous operation for more than two years before the date of such proposed acquisition.
Community Reinvestment Act. The federal Community Reinvestment Act (“CRA”) requires that, in connection with examinations of financial institutions within their jurisdiction, the federal banking regulators evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions. The focus of the regulations is on the volume and distribution of a bank’s loans, with particular emphasis on lending activity in low and moderate-income areas and to low and moderate-income persons. The regulations place substantial importance on a bank’s product delivery system, particularly branch locations. The regulations require banks to comply with significant data collection requirements. The regulatory agency’s assessment of the bank’s record is made available to the public. Further, this assessment is required for any bank which has applied to, among other things, establish a new branch office that will accept deposits, relocate an existing office, or merge, consolidate with or acquire the assets or assume the liabilities of a federally regulated financial institution. It is likely that banks’ compliance with the CRA, as well as other fair lending laws, will face ongoing government scrutiny and that costs associated with compliance will continue to increase. The Bank received a “Satisfactory” rating pursuant to its latest CRA examination.
Other Regulations. Interest and certain other charges collected or contracted for by the Bank are subject to state usury laws and certain federal laws concerning interest rates. These laws restrict the interest and charges which the Bank may impose for certain loans and thereby affect the Bank’s interest income. The Bank’s loan operations also are subject to certain federal laws applicable to credit transactions, such as the Truth in Lending Act governing disclosures of credit terms to consumer borrowers, the Home Mortgage Disclosure Act requiring financial institutions to provide information concerning their obligation to help meet the housing needs of the local community, the Equal Credit Opportunity Act prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit, the Fair Credit Reporting Act governing the use and provision of information to credit reporting agencies, and the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws. The deposit operations of the Bank also are subject to the Truth in Savings Act, which governs disclosure and advertisement of yields and costs of deposits and deposit accounts, the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records, the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that Act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services, the Expedited Funds Availability Act and Regulation CC issued by the Federal Reserve to implement that Act, which govern the availability of funds, return of checks, the settlement of checks, check endorsement and presentment and notification of nonpayment, and the Bank Secrecy Act, which requires reporting to the federal government of certain cash transactions. These and other similar laws result in significant costs to financial institutions and create the potential for liability to consumers and regulatory authorities. Recently regulatory authorities have imposed significant penalties for inadequate compliance.
Dividends. A Virginia bank may not pay dividends from its capital; all dividends must be paid out of net undivided profits then on hand, after providing for all expenses, losses, interest and taxes accrued, or due by the Bank. Before any dividend is declared, any deficit in capital funds originally paid in must have been restored by earnings to their initial level, and no dividend shall be declared or paid by any bank which would impair the paid-in capital of the bank. To ascertain the net undivided profits before any dividend shall be declared, all debts due to the bank on which interest is past due and unpaid for a period of twelve months, unless they are well secured and in process of collection, are deducted from the undivided profits in addition to all expenses, losses, interest and taxes accrued, and the balance is deemed to be the net undivided profits. The Virginia State Corporation Commission may limit or approve the payment of dividends by the board of directors of any bank when the Commission determines that the limitation or approval is warranted by the financial condition of the bank. The Bank began paying dividends to the Company in 2003 to cover the interest expense due on the guaranteed preferred beneficial interests in the Company’s junior subordinated debentures. The amount of dividends that may
be paid by the Bank to the Company will depend on the Bank’s earnings and capital position and is limited by state law, regulations and policies. See “Capital Regulations” below, “Item 5. Market for Common Equity and Related Stockholder Matters” and Note 15 to the Consolidated Financial Statements.
Capital Regulations. The federal bank regulatory authorities impose certain capital requirements on the Company and the Bank. The requirements apply to a bank holding company with more than $150 million in consolidated assets on a bank-only basis with limited exceptions. In addition to minimum capital levels prescribed by regulation, the Virginia State Corporation Commission and the Federal Reserve have authority to require higher capital levels on a case-by-case basis as part of their supervisory and enforcement powers, including approval of expansion programs.
In an effort to achieve a measure of capital adequacy that is more sensitive to the individual risk profiles of financial institutions, the federal bank regulatory authorities have adopted risk-based capital adequacy guidelines that redefine traditional capital ratios to take into account assessments of risks related to each balance sheet category, as well as off-balance sheet financing activities. Under the guidelines, banks’ and bank holding companies’ assets are given risk weightings based on assumptions as to the relative risk inherent in each asset category. The total risk-weighted assets are equal to the sum of the aggregate dollar value of assets and certain off-balance sheet items (such as currency or interest rate swaps) in each category, multiplied by the weight assigned to that category. The qualifying total capital base is divided by the total risk-weighted assets to derive a ratio.
An institution’s qualifying total capital consists of three components-Core or Tier 1 capital, Supplementary or Tier 2 capital, and Market Risk Allocated or Tier 3 capital. Tier 1 capital is essentially equal to common stockholders’ equity, qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less disallowed intangibles. Tier 2 capital, generally includes certain types of preferred stock and debt securities, hybrid capital instruments and a limited amount, not to exceed 1.25% of gross risk-weighted assets, of the allowance for loan and lease losses. Tier 3 capital is only applicable to banks which are subject to the market risk capital guidelines. The amount reported in this item may only be used to satisfy the bank’s market risk capital requirement and may not be used to support credit risk.
To supplement the risk-based capital guidelines, the federal bank regulatory agencies also have imposed a leverage ratio, which is Tier 1 capital as a percentage of certain average quarterly assets. The principal objective of the leverage ratio is to place a constraint on the maximum degree to which a bank or bank holding company may leverage its equity capital base. Institutions receiving less than the highest composite examination ratings are required to maintain a leverage ratio of at least 100 basis points above the regulatory minimum.
At December 31, 2005, the Company and the Bank had the following risk-based capital and leverage ratios relative to regulatory minimums:
Capital Ratios
The regulations define five categories of compliance with regulatory capital requirements, ranging from “well capitalized” to “critically undercapitalized.” To qualify as a “well capitalized” institution, a bank must have a leverage ratio of no less than 5%, a Tier 1 risk-based ratio of no less than 6%, and a total risk-based ratio of no less than 10%, and the bank must not be under any order or directive from the appropriate regulatory agency to meet and maintain a specific capital level. As of December 31, 2005 the Company and the Bank qualified as “well-capitalized” institutions (see Note 16 to the Consolidated Financial Statements).
The applicable federal bank regulatory agency can treat an institution as if it were in the next lower category if the agency determines (after notice and an opportunity for hearing) that the institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice. The degree of regulatory scrutiny of a financial institution will increase, and the permissible activities of the institution will decrease, as it moves downward through the capital categories. Institutions that fall into one of the three undercapitalized categories may be required to submit a capital restoration plan, raise additional capital, restrict their growth, deposit interest rates and other activities, improve their management, eliminate management fees to parent holding companies, and even divest themselves of all or a part of their operations. Bank holding companies can be called upon to boost their subsidiary banks’ capital and to partially guarantee the institutions’ performance under their capital restoration plans. If this occurs, capital which otherwise would be available for holding company purposes, including possible distribution to shareholders, would be required to be down streamed to one or more subsidiary banks.
The Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance System, and the Office of the Thrift Supervision issued their joint final rule regarding the obligation of financial institutions to protect the financial privacy of their consumers under the GLBA. Compliance with the Joint Rule was mandatory July 2001. The Final Rule applies to nonpublic personal information about individuals who obtain financial products or services from a bank or thrift institution and their subsidiaries. The Bank should provide consumers with a “clear and conspicuous” notice regarding the bank’s privacy policies and practices and describe the conditions under which the Bank may disclose nonpublic personal information about its consumers to affiliates and nonaffiliated third parties. The Bank should provide a method for its consumers to opt out of the disclosure of nonpublic personal information to third parties. The Bank must adopt policies and procedures reasonably designed to protect customer records and information from any anticipated threats, hazards, or unauthorized access or use that could result in “substantial harm or inconvenience” to any customer. The Bank must disclose their specific privacy policies to their customers annually. Upon making such disclosure, there is no specific restriction on the Bank disclosing customer information to affiliated parties. The Bank must comply with state law, however, if it protects customer privacy more fully than federal law.
The GLBA also revises the present Federal Home Loan Bank system, imposing new capital requirements on Federal Home Loan Banks and authorizing them to issue two classes of stock with differing dividend rates and redemption requirements. Permissible uses of Federal Home Loan Bank advances by community financial institutions (under $500 million in assets) have been expanded to include funding loans to small businesses, and small farms and agribusiness. The Bank uses Federal Home Loan Bank loans extensively to fund lending opportunities.
The GLBA contains a variety of other provisions. Automated teller machine surcharges are prohibited unless the customer first has been provided notice of the imposition and amount of the fee. Community Reinvestment Act examinations for smaller institutions (including the Bank) will be less frequent. Certain reporting requirements are now imposed on depository institutions that make payments to non-governmental entities in connection with the Community Reinvestment Act.
International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (USA Patriot Act). The USA Patriot Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires such financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including the adoption of effective customer identification programs. Federal bank regulatory agencies to consider the effectiveness of anti-money laundering activities by a financial institution when reviewing bank mergers and bank holding company acquisitions. Compliance with the Patriot Act by the Company has not had a material impact on its results of operations or financial condition.
Effect of Governmental Monetary Policies
The earnings of the Bank are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve’s monetary policies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments, deposits, interest income and interest expense through its open market operations in United States government securities and through its regulation of interest rates and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.
Company Website
The Company and the Bank maintain a website at www.myvalleybank.com. The Company makes available through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the material is electronically filed with the Securities and Exchange Commission.
Item 1A.
Item 1A. Risk Factors.
If there is a significant downturn in our region, our credit risk could be adversely affected and result in loss.
We conduct business in a small geographic area, and a large percentage of our loans are made in our market area. If the region suffers a significant or prolonged period of economic downturn, there is a greater likelihood that more of our customers could become delinquent on their loans or other obligations to us. This could result in higher levels of credit-related losses, which could adversely affect our performance.
If market interest rates decrease, our net interest income can be negatively affected in the short term.
The direction and speed of interest rate changes affect our net interest margin and net interest income. In a period of declining interest rates, our net interest income can be negatively affected in the short term because our interest-earning assets (loans) reprice sooner than our interest-bearing liabilities (deposits).
If we do not maintain our capital requirements and our status as a “well-capitalized” bank, there could be an adverse effect on the way in which we do business and in the confidence of our customers.
The Bank is subject to regulatory capital adequacy guidelines. If the Bank fails to meet the capital adequacy guidelines for a “well-capitalized” bank, it could increase the regulatory scrutiny for the Bank and the Company, increase our FDIC insurance premiums, and could lead to a decline in the confidence that our customers have in us and a reduction in the demand for our products and services.
If the large bank competition increases or focuses more heavily on our market, our business could suffer.
Financial services in our market area is highly competitive, with a number of commercial banks, credit unions, insurance companies and stockbrokers seeking to do business with our customers. Additionally, our primary competition is with large banks, who can achieve greater economies of scale due to their financial strength and marketing clout. If these large banks focus more attention on our market, we could lose customers and our business could suffer.
If we are not in compliance with governmental regulation, we can be subject to fines, penalties, or restrictions of our business.
Our business is subject to stringent regulation by federal and state governmental and regulatory agencies and self-regulatory organizations. We have established policies, procedures and systems that are designed to comply with these regulatory and operational risk requirements. However, as a financial services institution, we face complexity and costs related to our compliance efforts. We also face the potential for loss resulting from failed or inadequate internal processes and from external events, which could have a material impact on our results of operations. Adverse publicity and damage to our reputation from the failure or perceived failure to comply with legal, regulatory or capital requirements could affect our ability to attract or maintain customers or maintain access to capital markets, or could result in enforcement actions, fines, penalties and lawsuits.
If the disaster recovery plans that we have in place are not adequate to continue our operations in the event of a disaster, the business disruption can adversely impact our operations.
Natural or man-made disasters, such as fires, storms, terrorist or military actions could cause damage to our physical facilities, or could cause delays or disruptions to operational functions, including information processing or check settlements. In addition, our vendors could suffer from such events. Should these events affect us or the vendors with whom we do business, our results of operations could be negatively impacted.
We depend on the services of our key personnel, and a loss of any of those personnel would disrupt our operations and result in reduced revenues.
Competition for qualified employees is intense and our success depends upon the continued service of our senior management team as well as our ability to attract and retain qualified financial services personnel. In our experience, it can take a significant period of time to identify and hire personnel with the combination of experience, skills and attributes required in executing our business model. If we lose the services of our key personnel, or are unable to attract additional qualified personnel, our business, financial condition, results of operations and cash flows could be materially adversely affected.
We may identify a material weakness or a significant deficiency in our internal control over financial reporting that may adversely affect our ability to properly account for non-routine transactions.
As we have grown and expanded, we have acquired and added, and expect to continue to acquire and add, businesses and other activities that complement our core commercial and retail banking functions. Such expansions or possible acquisitions may involve complex operational and financial reporting issues that can impact management’s internal control system. While we make every effort to thoroughly understand any new activity or acquired entity’s business processes, we can give no assurance that we will not encounter operational and financial reporting difficulties impacting our internal controls over the Company as we integrate the new activity and/or process into our Company.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth and our growth may be constrained if we are unable to raise additional capital as needed. We anticipate that we will be able to support this growth through the generation of net income, additional deposits, and investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain our capital levels. Our ability to raise capital through the sale of additional securities in the public market will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Our main office is located in a seven-story office building at 36 Church Avenue, S.W., in downtown Roanoke, Virginia 24011. At December 31, 2005 we leased approximately 8,148 square feet of office space on the first floor of this facility, approximately 2,400 square feet of space on the mezzanine level, approximately 2,750 square feet of space on the mezzanine floor of “Annex A”, and 3,212 square feet of the second floor. The lease on all floors terminates on December 31, 2009 with options to renew for three additional five-year terms at the end of the December 31, 2009 extension period.
In December 2005, we started a renovation of the 6th and 7th floors of the building, with planned occupancy by the end of the first quarter of 2006. This expansion will add approximately 3,800 square feet of office space on the 6th floor and an additional 1,000 square feet of meeting room space on the 7th floor.
Our Starkey Road office is a 2,700 square foot building constructed in 1995 on a one-acre site at 4467 Starkey Road in southwest Roanoke County (Tanglewood Mall area).
Our South Roanoke office is a 914 square foot facility that the Bank leased beginning January 1, 1997 and has an initial term of twelve years with one five-year renewal option.
Our Salem office is a Colonial Williamsburg style building with two floors containing 6,000 square feet, of which the Bank occupies the first story and leases the second story. The structure is located on an approximately one-half acre site at 8 East Main Street in the City of Salem. We did not lease the second story during 2005; however we anticipate the execution of a lease agreement by the end of the first quarter of 2006.
Our Hershberger Road office is a 2,400 square foot building on a one-acre site at 1518 Hershberger Road in the City of Roanoke (Crossroads Mall area). The land with the existing branch was purchased from First Union National Bank in September 2000. The branch was renovated and opened on May 7, 2001.
Our Vinton office is a 2,950 square foot building on an .8-acre site at 1003 Hardy Road (Vinton) in the County of Roanoke. The land was purchased on August 1, 2001. The branch was constructed and opened on May 20, 2002.
Our Lewis-Gale office is a 3,000 square foot building on an approximate one-acre site at 3850 Keagy Road in the City of Roanoke. The land was purchased on December 28, 2001. The branch was constructed and opened on December 8, 2003.
In 2005, we leased approximately 2,000 square feet in a building shared with other tenants for our Grandin Village office. The lease commenced on January 1, 2005 and the initial term is for a period of five years, with an option to renew for four additional five year periods.
In the opinion of management of the Company, its properties are adequate for its current operations and adequately covered by insurance.
Item 3.
Item 3. Legal Proceedings.
Neither the Company nor the Bank is a party to, nor is any of their property the subject of, any material pending legal proceedings other than routine litigation incidental to the Bank’s business.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II.
Item 5.
Item 5. Market for Common Equity and Related Stockholder Matters.
Market information. The Company is authorized to issue up to 10,000,000 shares of Common Stock, no par value, of which 4,076,993 shares were issued and outstanding and held of record by approximately 469 shareholders at February 24, 2006.
The Common Stock is quoted under the symbol VYFC on the OTC Bulletin Board, an electronic quotation and trade reporting service of the National Association of Securities Dealers. According to information obtained by Company management and believed to be reliable, the quarterly range of closing prices per share (adjusted for the 2-for-1 stock split declared April 28, 2004) for the Common Stock during the last two fiscal years was as follows:
Dividends. On April 27, 2005 the Company declared a $.06 per share cash dividend, payable July 1, 2005 to shareholders of record June 1, 2005. On November 17, 2005 the Company declared a $.07 per share cash dividend, payable January 3, 2006 to shareholders of record December 15, 2005. The Company declared two semi-annual dividends of $0.06 per share each during the year ended December 31, 2004. See “Supervision and Regulation” and Note 15 to the Consolidated Financial Statements for restrictions on the payment of dividends.
Securities authorized for issuance under equity compensation plans.
Equity Compensation Plan Information
As of December 31, 2005 there were no compensation plans, including individual compensation arrangements, under which equity securities of the Company are authorized for issuance that have not been approved by a vote of security holders.
Item 6.
Item 6. Selected Financial Data
Selected Financial Data
(000’s omitted)
Supplementary Financial Information
Selected Quarterly Financial Data
(000’s omitted)
Selected Quarterly Financial Data
(000’s omitted)
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is management’s discussion and analysis of the financial condition and results of operations of the Company as of and for the years ended December 31, 2005, 2004 and 2003. The discussion should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto.
Critical Accounting Policies
The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies that require our most difficult, subjective or complex judgments and uncertainties include (1) the allowance for loan losses and (2) impaired loans. Further information about these critical policies is described below.
Allowance for Loan Losses: Certain credit risks are inherent in making loans. We seek to prudently assess these risks and manage them effectively. We have internal credit policies and procedures in place to reduce repayment risks. These policies and procedures include:
•
Officer and customer limits
•
Periodic loan documentation review, and
•
Follow-up on exceptions to credit policies.
We establish the allowance for loan losses through charges to earnings through a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be appropriate to absorb probable losses on existing loans that may become uncollectible. Some of the factors we consider in determining the appropriate level of the allowance for loan losses are as follows:
•
An evaluation of the current loan portfolio
•
Identified loan problems
•
Loan volume outstanding
•
Past loss experience
•
Present and expected industry and economic conditions and, in particular, how such conditions relate to our market area.
Bank regulators also periodically review the loan portfolio and other assets to assess their quality, and we employ independent, third party loan reviewers (semi-annually) as well. This evaluation is inherently subjective because it requires estimates that may be significantly revised as more information becomes available. We believe the allowance for loan losses is appropriate to provide for expected losses in the loan portfolio, but there are no assurances that it will be.
Impairment of Loans: We consider a loan impaired when it is probable that we will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due. 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 of the reserve 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 our estimate of probable losses. It also reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. The allowance for loan losses is evaluated on a regular basis by management. On a quarterly basis, we perform a detailed analysis of the allowance for loan losses to verify the adequacy and appropriateness of the allowance in meeting possible losses in the loan portfolio.
Overview
The Company was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of the Bank. The Bank opened for business on May 15, 1995. There are currently eight full-service branch locations, operating in various locations throughout the Cities of Roanoke and Salem, Town of Vinton, and the County of Roanoke.
During the second quarter of 2005, we opened our eighth full-service branch location in the Grandin Village area and started a wealth management subsidiary, Valley Wealth Management Services, Inc. which markets investment and insurance products. Net income derived from the new subsidiary is not significant at this time. The Company’s investment in the Bank was $39.0 million as of December 31, 2005.
Performance Summary
The following table shows our key performance ratios for the years ended December 31, 2005, 2004, and 2003:
Key Performance Ratios
All percentage calculations are on an annualized basis.
1. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities available-for-sale.
2. Calculated on a fully taxable equivalent basis (“FTE”)
Like the vast majority of banks, we have continued to see the net interest margin remain under considerable pressure. While the Federal Reserve has continued to increase its target rates throughout 2005, long term interest rates have actually come down resulting in a flattening of the yield curve. The steps we took during 2003 and 2004 to restructure both the investment and loan portfolios in anticipation of rising rates have not yet fully yielded the intended results as deposit costs have increased faster than asset yields.
Growth
The following table shows our key growth indicators:
Key Growth Indicators
(000’s omitted)
Total assets at December 31, 2005 were $499.0 million, up $125 million or 33.4% from $374.0 million at December 31, 2004. The principal components of the Company’s assets at the end of the period were $37.6 million in securities available-for-sale, including restricted equity securities, $20.8 million in securities held-to-maturity, and $414.4 million in gross loans. The asset growth is due to the 46.6% growth in our loan portfolio, offset by the 18.8% decrease in our investment portfolio. Due to the expansion of our business banking department during the last quarter of 2004, our loan growth in the first half of 2005 temporarily outstripped our immediate ability to grow deposits. Therefore, we liquidated a portion of our investment portfolio during the first half of the year to help fund this growth. Total assets at December 31, 2004 were up $64.9 million or 21.0% from $309.1 million at December 31, 2003. The principal components of the Company’s assets at December 31, 2004 were $49.3 million in securities available-for-sale, including restricted equity securities, $22.2 million in securities held to maturity, and $282.8 million in gross loans. The principal components of the Company’s assets at December 31, 2003 were $43.2 million in securities available-for-sale, including restricted equity securities, $23.0 million in securities held to maturity and $222.6 million in gross loans.
Total liabilities at December 31, 2005 were $468.2 million, up from $345.7 million at December 31, 2004, an increase of $122.6 million or 35.5%, with the increase primarily represented by an $86.0 million growth in deposits, a $7.2 million increase in guaranteed preferred beneficial interests in the Company’s junior subordinated debentures, an $8.0 million increase in short-term borrowings, a $14.9 million increase in federal funds purchased and a $5.0 million increase in securities sold under agreements to repurchase. During 2005, we raised deposits through local CD campaigns and also marketed CDs nationally to institutional depositors, primarily banks, thrift institutions and credit unions through an internet-based rate posting service to raise funds to support the rapid loan growth. Total liabilities at December 31, 2004 were $345.7 million, up from $287.6 million at December 31, 2003, an increase of $58.1 million or 20.2%. Deposits increased $56.3 million or 25.2% to $279.3 million from the $223.0 million level at December 31, 2003.
Our primary market area, the Roanoke Valley, has shown signs of slow growth over the past two years when compared with other metropolitan areas in Virginia. The banking industry in our primary market has experienced consolidation in the last two years, including the acquisition of First Virginia Bank by BB&T and National Bank of Commerce by SunTrust Bank. Additionally, Hometown Bank, the newly formed community bank in Roanoke, opened its doors in November 2005. We intend to continue to execute our business model by focusing on our core business and stressing personal service to satisfy customers, although we constantly evaluate the effectiveness of the model. We believe our 2005 growth rates of 46.6% for loans and 30.8% for deposits demonstrate the preference of local businesses and individuals to seek the high degree of personalized service and local decision-making offered by Valley Bank.
Shareholders’ Equity
Total shareholders’ equity at December 31, 2005 was $30.7 million, an increase of $2.4 million or 8.5% over the $28.3 million level at December 31, 2004. The increase is attributable to net income of $3.4 million, reduced by the decrease in accumulated other comprehensive income of $0.5 million and dividends declared of $0.5 million. Total shareholders’ equity at December 31, 2004 was $28.3 million, an increase of $6.8 million or 31.3% in 2004 from the December 31, 2003 level of $21.6 million, which included $197,000 of unrealized gains on securities available-for-sale, net of related deferred tax expense. The biggest factors in the increase from December 31, 2003 to December 31, 2004 were the private placement net proceeds of $3.8 million and an increase of $2.4 million or 26.2% in retained earnings.
Net Income
We earned net income of $3,392,000 for the year ended December 31, 2005, an increase of 20.1% over the $2,824,000 reported for the same period in 2004. Net income for the three months ended December 31, 2005 was $1,122,000, an increase of 31.4% over the $854,000 reported for the fourth quarter of 2004. The biggest factor contributing to the increase in net income for both periods is the increase in our interest and fees on loans, which is the result of the overall growth in our loan portfolio, as well as the result of measures we took in 2004 to position our portfolio to take advantage of the rising rate environment. Additionally, we earned gains of $131,000 on the sale of real estate acquired by foreclosure during 2005.
We earned net income of $2.8 million for the year ended December 31, 2004 compared with $2.6 million for the year ended December 31, 2003, an increase of $224,000 or 8.6%. The increase is the result of a $1.5 million or 15.5% improvement in net interest income, a $333,000 or 34.5% decline in the provision for loan losses and a modest $32,000 or 2.4% increase in noninterest income, partially offset by increases of $1.4 million or 21.0% in noninterest expense and $252,000 or 32.7% in income taxes.
Net Interest Income
Net interest income is our principal source of earnings and is calculated as the amount which loan and investment (earning assets) income exceeds the interest expense on deposits and borrowings (interest-bearing liabilities). Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Changes in the interest rate environment and the Company’s cost of funds also affect net interest income.
Net interest income for the year ended December 31, 2005 was $13.6 million, a 24.4% increase when compared to prior year. Net interest income for the quarter ended December 31, 2005 was $3.9 million, a 26.3% increase over the same period last year. Net interest income for the year ended December 31, 2004 was $10.9 million, a 15.5% increase over the $9.5 million level at December 31, 2003. The yield on average loans increased in 2005 by 0.47% to 6.42% from its level of 5.95% in 2004. The overall tax equivalent yield on earning assets was 6.13% for the year ended 2005, as compared to 5.57% for the prior year. The yield on average loans decreased in 2004 by 0.41% to 5.95% from its level of 6.36% in 2003. The overall tax equivalent yield on earning assets was 5.57% for the year ended 2004, as compared to 5.94% for the prior year.
The following table presents the major categories of interest-earning assets, interest-bearing liabilities and shareholders’ equity with corresponding average balances, related interest income or expense, and resulting yields and rates for the periods indicated. Where appropriate, income categories and yields have been adjusted in the table to their fully taxable equivalent basis.
NET INTEREST INCOME AND AVERAGE BALANCES (1)
(000’s omitted)
Legends for the table are as follows:
(1) Averages are daily averages.
(2) Loan interest income includes loan fees of $1.1 million, $1.7 million and $1.6 million for the years ended 2005, 2004, and 2003, respectively.
(3) Nontaxable interest income is adjusted to its fully taxable equivalent basis using a federal tax rate of 34 percent.
(4) The net interest margin is calculated by dividing net interest income (tax equivalent basis) by average total earning assets.
(5) Non-accrual loans are included in the above yield calculation.
As discussed above, the Company’s net interest income is affected by the change in the amount and mix of interest-earning assets and interest-bearing liabilities (referred to as “volume change”) as well as by changes in yields earned on interest-earning assets and rates paid on deposits and borrowed funds (referred to as “rate change”). The following table presents, for the periods indicated, a summary of changes in interest income and interest expense for the major categories of interest-earning assets and interest-bearing liabilities and the amounts of change attributable to variations in volumes and rates. Changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
RATE/VOLUME ANALYSIS
(000’s omitted)
RATE/VOLUME ANALYSIS
(000’s omitted)
Interest Rate Risk
Interest rate risk is the risk to earnings or capital generated by the effects of changes in interest rates on our on- and off-balance sheet positions, and can take one or more of several forms:
•
Repricing risk comes from timing mismatches in the ability to alter contractual rates earned on financial assets held or paid on interest-bearing liabilities
•
Basis risk refers to changes in the underlying relationships between market rates or indices, which result in a narrowing of the spread earned on a loan or investment relative to its cost of funds.
•
Option risk arises from “embedded options” in many financial instruments such as:
•
interest rate options,
•
loan prepayment options,
•
deposit early withdrawal options,
•
callable Federal Home Loan Bank advances, and
•
pre-payment of the underlying collateral of asset-backed securities.
Embedded options are complex risk positions that are difficult to predict and offset, and are a large component of our overall interest rate risk.
We have established risk measures, limits, policy guidelines and internal control mechanisms for managing our overall asset/liability management (“ALM”) position. The responsibility for interest rate risk control resides with management, with oversight by the board of directors and the ALCO Oversight Committee. We seek to balance the return potential of the ALM position against the desire to limit volatility in earnings.
At least quarterly, we measure the ALM position using earnings simulation modeling to estimate what assets and liabilities would re-price, and to what extent, within a one-year period in response to an immediate 200 and 100 basis point change in the Prime Rate, as well as in response to more gradual interest rate changes. Our objective is to keep the change in net interest income over twelve months at or below 5%, and the change in net income at or below 10%, under an immediate 200 basis point interest rate shock scenario.
The model also incorporates management’s forecasts for balance sheet growth, noninterest income and noninterest expense. The interest rate scenarios are used for analytical purposes and do not necessarily represent management’s view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may apply to our earnings. Modeling the sensitivity of earnings to interest rate risk is highly dependent on numerous assumptions embedded in the simulation model. While the earnings sensitivity analysis incorporates management’s best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact likely will differ from that projected.
We also estimate interest sensitivity by calculating the net present value of the balance sheet’s cash flows or the residual value of future cash flows ultimately due to shareholders. This calculation is known as Economic Value of Equity or “EVE” and is generally considered a better measure of long-term interest sensitivity than is IRS. Our objective is for the result to change 25% or less in an immediate 200 basis point interest rate shock scenario.
The following table shows the sensitivity of the Company’s balance sheet at the date indicated, but is not necessarily indicative of the position on other dates.
INTEREST RATE SENSITIVITY
Maturities/Repricing
(000’s omitted)
Noninterest Income
Noninterest income is made up of several categories as shown in the following table:
Noninterest Income
(000’s omitted)
Service charges on deposit accounts consist of a variety of charges imposed on demand deposits, interest-bearing deposits and savings deposit accounts. These include, but are not limited to, the following:
•
Demand deposit monthly activity fees
•
Service charges for checks for which there are non-sufficient funds or overdraft charges
•
ATM transaction fees
•
Debit card transaction fees
The principal factors that may affect current or future income for service charges on deposit accounts are:
•
Internally generated growth
•
Acquisitions of other banks/branches or de novo branches
•
Adjustments to service charge structures
Other income consists of several categories, primarily the following:
•
Income earned on insurance policies owned by the bank on key executives
•
Fees for the issuance of official checks
•
Fees for wire transfers
•
Safe deposit box rent
•
Income from the sale of customer checks
•
Income on real estate loans
•
Extension fees, insurance premiums, and letter of credit fees
Levels of income derived from these categories vary. For example, general market conditions and new insurance premiums purchased affect the income earned on bank owned life insurance. Fees for the issuance of official checks and customer check sales tend to grow as new branches are added. Fee schedules, while subject to change, generally do not alone yield a significant or discernable increase in income when they change. Additionally, with rising interest rates, mortgage originations and re-financings have slowed down, which decreases the fee income earned on real estate loans.
Realized gains on securities sold were $53 for the year ending December 31, 2005. We sold securities during the second quarter of 2005 to provide additional liquidity for the rapid growth in the loan portfolio.
Noninterest Expense
Noninterest Expense
(000’s omitted)
As seen in the tables above, for the year ended December 31, 2005, advertising and marketing is the largest percentage increase in noninterest expense due primarily to the costs associated with promoting the new branch opening, deposit generating promotions, and our new wealth management subsidiary, Valley Wealth Management Services, Inc. Additionally, audit fees has increased due to the fees associated with the Sarbanes Oxley Act of 2002. Occupancy expense has increased due to the expansion of our commercial and business banking departments and loan expense has increased due to the rapid growth in our loan portfolio. Compensation expense has increased over the prior year due to the addition of new employees and due to merit increases throughout the year. Deposit and loan expenses both have increased as a result of the rapid growth trends we experienced during 2005.
Noninterest expense for 2004 was $7.8 million, an increase of $1.4 million or 21% over their level in 2003. Noninterest expense in 2004 included a full year of costs associated with the opening of the Bank’s Lewis-Gale office on December 8, 2003. All major categories experienced increases due to continued rapid growth and expansion, with the exception of purchased tax credit expense which declined $257,000 from 2003. Bank franchise tax expense was $171,000 in 2004, compared to $0 in 2003, when it was offset by the purchase of historical tax credits.
Noninterest expenses are expected to continue to increase as a direct result of business growth and expansion as well as the impact of additional regulatory burdens.
Income Taxes
During 2005, 2004, and 2003 the Company recorded federal income tax provision in the amounts of $1.3 million, $1.0 million, and $0.8 million, respectively. The anticipated federal income tax liability equates to an effective tax rate of 27.9%, 26.6%, and 22.9%, respectively. During the first quarter of 2003, the bank purchased federal and state historical tax credits in the amounts of $174,000 and $217,000, respectively. The tax credits were purchased at a total cost of $156,000 and $151,000, respectively. The tax credits were expensed in the amount of $282,000 during 2003, comprised of $156,000 federal and $126,000 state, as purchased tax credit expense (a noninterest expense). The federal tax credits offset income tax expense in 2003 while the state tax credits offset franchise tax expense in 2003, 2004, and 2005. Other factors contributing to the difference between the effective tax rate and the statutory rate of 34 percent include tax-exempt interest income on municipal securities, net of disallowance, and tax-exempt income earned on bank owned life insurance.
Earning Assets
Average earning assets were $405.8 million at December 31, 2005, an increase of $79.2 million or 24.3% over 2004. Total average earning assets were 94.8% of total average assets at December 31, 2005. Average loans represented the largest component of average earning assets and increased $89.6 million or 35.9% to $339.7 million at December 31, 2005. Average loans were 83.6% of average earning assets and 79.3% of average total assets as of December 31, 2005. Average investment securities, both taxable and nontaxable, decreased $8.3 million or 11.6% from their level as of December 31, 2004. Average investment securities were 15.7% of average earning assets and 14.9% of average total assets as of December 31, 2005.
Average earning assets were $326.6 million at December 31, 2004, an increase of $64.8 million or 24.8% over 2003. Total average earning assets were 94.6% of total average assets at December 31, 2004. Average loans represented the largest component of average earning assets and increased $46.2 million or 22.6% to $250.0 million at December 31, 2004. Average loans were 76.6% and 72.4% of average earning assets and average total assets as of December 31, 2004. Average investment securities, both taxable and nontaxable, increased $18.2 million or 34.0% from their level as of December 31, 2003. Average investment securities were 22.0% and 20.8% of average earning assets and average total assets as of December 31, 2004.
Investment Securities
Our investment portfolio is used both for investment income and liquidity purposes. At this time, we do not invest in derivatives or other types of high-risk securities. Unrealized gains and losses on securities available-for-sale are recognized as direct increases or decreases in net shareholders’ equity. Funds not used for capital expenditures or lending activities are invested in the following:
•
Securities of the U.S. Government and its agencies
•
Treasury notes
•
Callable agency bonds
•
Noncallable agency bonds
•
Mortgage-backed securities and collateralized mortgage obligations
•
Pools issued by government agencies
•
AAA rated corporate mortgage pools
•
Municipal bonds
•
Taxable general obligation and revenue issues
•
Tax-exempt general obligation and revenue issues
•
Investment grade corporate bonds
•
Restricted equity securities
•
Federal Reserve Bank of Richmond shares
•
Federal Home Loan Bank of Atlanta shares
•
Community Bankers Bank shares
Investment securities (available for sale and held to maturity), including restricted equity securities, at December 31, 2005 were $58.0 million, a decrease of $13.5 million or 18.9% from their level of $71.5 million on December 31, 2004. The decrease is attributable to the principal prepayments on mortgage-backed securities and the sale of a portion of our investment portfolio to help fund our rapid loan growth. See Note 3 to the Consolidated Financial Statements.
Investment securities (available-for-sale and held-to-maturity), including restricted equity securities, at December 31, 2004 were $71.5 million, an increase of $5.3 million or 8.0% from their level on December 31, 2003. The increase is primarily due to purchases in the amount of $22.6 million, offset by principal repayments, called proceeds, and sales in the amount of $17.2 million and a decrease in net unrealized gains on securities on the available-for-sale portfolio, which is carried at approximate fair market value, in the amount of $266,000.
The following table presents the composition of securities available-for-sale, which is carried at approximate market value at December 31, 2005, 2004 and 2003.
AVAILABLE FOR SALE INVESTMENT PORTFOLIO
CATEGORY DISTRIBUTION
(000’s omitted)
The following table sets forth the composition of securities held-to-maturity, which is carried at amortized cost at December 31, 2005, 2004 and 2003.
HELD TO MATURITY INVESTMENT PORTFOLIO
CATEGORY DISTRIBUTION
(000’s omitted)
The following table presents the maturity ranges of securities available-for-sale as of December 31, 2005 and the weighted average yields of such securities. Maturities may differ from scheduled maturities on mortgage-backed securities and collateralized mortgage obligations because the mortgages underlying the securities may be repaid prior to the scheduled maturity date. Maturities on all other securities are based on the contractual maturity. The weighted average yields are calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. Weighted average yields on tax-exempt obligations have been computed on a taxable equivalent basis using a tax rate of 34%.
INVESTMENT PORTFOLIO - MATURITY DISTRIBUTION
(000’s omitted)
* Maturities on mortgage-backed securities and collateralized mortgage obligations are not presented this table because maturities may differ substantially from contractual terms due to early repayments of principal.
The following table presents the maturity ranges of securities held-to-maturity as of December 31, 2005 and the weighted average yields of such securities. Maturities may differ from scheduled maturities on mortgage-backed securities and collateralized mortgage obligations because the mortgages underlying the securities may be repaid prior to the scheduled maturity date. Maturities on all other securities are based on the contractual maturity. The weighted average yields are calculated on the basis of the cost and effective yields weighted for the scheduled maturity of each security. Weighted average yields on tax-exempt obligations have been computed on a taxable equivalent basis using a tax rate of 34%.
INVESTMENT PORTFOLIO - MATURITY DISTRIBUTION
(000’s omitted)
Loan Portfolio
Our total gross loans were $414.4 million at December 31, 2005, an increase of $131.6 million or 46.5% from the $282.8 million reported one year earlier. Our ratio of total loans to total funding sources (customer deposits, securities sold under agreements to repurchase, federal funds purchased, Federal Home Loan Bank advances, and trust preferred securities) stood at 91.4% at December 31, 2005, 82.4% at December 31, 2004, and 77.8% at December 31, 2003. Management seeks to maintain the ratio of loans to funding sources at a maximum of 85%. The Board of Directors have approved the temporary overage at December 31, 2005. Management will work diligently to bring the ratio back below the 85% level during 2006.
The loan portfolio primarily consists of commercial, real estate (including real estate term loans, construction loans and other loans secured by real estate) and loans to individuals for household, family and other consumer purposes. We adjust the mix of lending and the terms of our loan programs according to economic and market conditions, asset/liability management considerations and other factors. Loans typically (in excess of 90%) are made to businesses and individuals located within our primary market area, most of whom maintain deposit accounts with the Bank. There is no concentration of loans exceeding 10% of total loans, which is not disclosed in the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements or discussed below.
The following table summarizes the loan portfolio by category for the five years ended December 31, 2005.
LOAN PORTFOLIO SUMMARY
(000’s omitted)
The following table presents maturity information (based upon interest rate repricing dates) on the loan portfolio based upon scheduled repayments at December 31, 2005.
LOAN MATURITY
(000’s omitted)
The following table presents maturity information based upon contractual terms and scheduled repayments at December 31, 2005.
FIXED AND VARIABLE RATE LOANS
(000’s omitted)
Loan Category Analysis
Commercial Loans. Commercial loans generally are made to provide operating lines of credit, to finance the purchase of inventory or equipment, and for other business purposes. The credit worthiness of the borrower is analyzed and re-evaluated on a periodic basis. Most commercial loans are collateralized with business assets such as accounts receivable, inventory and equipment. Even with substantial collateral, such as all the assets of the business and personal guarantees, commercial lending involves considerable risk of loss in the event of a business downturn or failure of the business.
Commercial Real Estate Loans. Commercial real estate construction and commercial real estate mortgages represent interim and permanent financing of commercial properties that are secured by real estate. The Company prefers to make commercial real estate loans secured by owner-occupied properties. These borrowers are engaged in business activities other than real estate, and the primary source of repayment is not solely dependent on conditions in the real estate market.
Real Estate Construction Loans. Real estate construction loans represent interim financing on residential and commercial properties under construction, and are secured by real estate. This category also includes acquisition and development financing for residential and commercial projects. Once construction is completed and the loan becomes permanent, the loans are reclassified as either commercial real estate loans, which are secured by commercial property, or residential real estate loans, which are secured by first deeds of trust.
Residential Real Estate Loans. Residential real estate loans are secured by deeds of trust on 1-4 family residential properties. To mitigate interest rate risk, the Company usually limits the final maturity of residential real estate loans held for its own portfolio to 15-20 years, although exceptions are made for competitive reasons and under special programs. Residential real estate lending involves risk elements when there is lack of timely payment and/or a decline in the value of the collateral.
Loans to Individuals. We offer various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans, letters of credit, and home equity loans.
Asset Quality
Summary of Allowance for Loan Losses
The allowance for loan losses represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible, although there can be no assurance that this will be so. The provision for loan losses increases the allowance, and loans charged off (net of recoveries) reduce the allowance.
A provision for loan losses of $1,297,000 was made during 2005, an increase of $664,000 or 104.9% from the $633,000 provided during 2004, in recognition of our estimate of inherent risks associated with lending activities. A provision for loan losses of $633,000 was made during 2004, a decrease of $333,000 or 34.5% from the $966,000 provided during 2003.
The allowance for loan losses was $4.1 million, $3.0 million, and $2.6 million as of December 31, 2005, 2004 and 2003, respectively. The ratio of the allowance for loan losses to total loans outstanding was approximately 1.0% at December 31, 2005, which compares to approximately 1.1% of total loans at December 31, 2004, and 1.2% of total loans at December 31, 2003 (see Note 4 to the Consolidated Financial Statements). These estimates are primarily based on our historical loss experience, portfolio concentrations, evaluation of individual loans and economic conditions. A total of $344,000 in special reserves was included in the balance of the allowance for loan losses as of December 31, 2005 for impaired loans, which compares to a total of $31,000 as of December 31, 2004 and $127,000 as of December 31, 2003. The $344,000 in special reserves were primarily concentrated in three large relationships within our overall loan portfolio.
We regularly review asset quality and re-evaluate the allowance for loan losses. However, no assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in the future. Additionally, regulatory examiners may require us to recognize additions or reductions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations. (See “Allowance for Loan Losses” under “Critical Accounting Policies”.) For the year ended December 31, 2005, our non-performing assets to total assets ratio increased from 0.10% at December 31, 2004 to 0.72%. Additionally, our loans past due more than 90 days to total loans increased from 0.08% at December 31, 2004 to 0.10% at December 31, 2005. Net charge-offs for the year ended December 31, 2005 amounted to $162,000. While these ratios have increased slightly, they still compare favorably to our peer institutions.
The following table summarizes the loan loss experience for the five years ended December 31, 2005.
ALLOWANCE FOR LOAN LOSSES
(000’s omitted)
The following table summarizes the allocation of the allowance for loan losses for the five years ended December 31, 2005. The percentage in the table below refers to the percent of loans in each category to total loans.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
(000’s omitted)
Nonperforming Assets. Nonperforming assets include nonaccrual loans, loans past due 90 days or more, restructured loans and foreclosed/repossessed property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will automatically be placed on nonaccrual status when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.
A restructured loan is a loan in which the original contract terms have been modified due to a borrower’s financial condition or there has been a transfer of assets in full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not normally consider.
An impaired loan as defined in SFAS 114 is a loan when, based on current information and events, it is likely that a lending institution will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the loan agreement.
Nonperforming assets for the five years ended December 31, 2005 are detailed as follows:
NONPERFORMING ASSETS
(000’s omitted)
(1) Other nonperforming loans include impaired loans which are not on nonaccrual status nor past due 90 days or more.
Each quarter, the Directors’ Loan Committee, composed of eight directors, will review all loans on our watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review. We believe that the above allocated reserves are appropriate for the impaired loans in our portfolio based upon a detailed review of the quality and pledged collateral of each individual loans considered impaired at each of the above-referenced periods. (See “Impairment of Loans” under “Critical Accounting Policies”.)
If the nonaccrual loans disclosed above had performed in accordance with their original terms, additional interest income in the amount of $1,230, $6,000, and $18,000 would have been recorded for the years ended December 31, 2005, 2004 and 2003, respectively.
Additionally, the Bank’s credit risk process provides ongoing assessment of the loan portfolio’s risk profile in accordance with standard industry practices. Loan assets which do not support satisfactory risk ratings under this basis are subjected to a well-defined, ongoing management and reporting process. These “Watch List” loan assets were as follows for the five years ended December 31, 2005:
As of December 31, 2005, the Watch List assets include a $5 million concentration in one large commercial borrower, which management continues to monitor closely.
Other Assets
We have purchased life insurance contracts on key employees, the tax-exempt income from which is the funding vehicle for the Company’s Supplemental Executive Retirement Plan (“SERP”) and other employee benefit costs including health insurance, dental insurance, life insurance, and 401(k) employer match. Bank owned life insurance was $8.9 million at December 31, 2005, an increase of $2.8 million over the $6.1 million reported as of December 31, 2004. The increase is due to the $2.5 million purchase of additional life insurance contracts on key employees and a $0.3 million increase in the cash surrender value of the life insurance contracts.
Deposits
The levels and mix of deposits are influenced by such factors as customer service, interest rates paid, service charges and the convenience of banking locations. Competition for deposits is intense from other depository institutions and money market funds, some of which offer interest rates higher than we pay. We attempt to identify and implement pricing and marketing strategies designed to control the overall cost of deposits and to maintain a stable deposit mix.
The following table summarizes our total deposits for the years ended December 31, 2005, 2004 and 2003:
Deposit Summary
(000’s omitted)
In September 2005, we implemented a deposit reclassification program that restructures interest and non-interest checking accounts so that a certain portion of the balance in each account is actually maintained in a linked Savings sub-account. The Savings portion of the combined account balance is not subject to the 10% reserve that is required for checking balances, therefore the overall daily cash reserve requirement for the Federal Reserve has been reduced. We received approval from our Federal Reserve district for this program. As such, for financial reporting purposes, our interest and non-interest bearing demand deposits have been reduced and our savings deposits have been increased. Had we not implemented the deposit reclassification program, our total interest bearing and money market accounts would have been $66.4 million, savings $4.9 million, and noninterest demand and official checks $59.2 million.
We would prefer to have transaction accounts comprise a larger percentage of total deposits, but in order to fund our substantial loan growth, we often have to rely on higher-cost certificates of deposit. Within the certificate of deposit category, we have marketed CDs nationally to institutional depositors, primarily banks, thrift institutions and credit unions through an Internet-based rate posting service. National market CDs at December 31, 2005 were $16.5 million, a decrease of $1.4 million from the $17.9 million reported at December 31, 2004 and represent 7.0% of total CDs and 4.5% of total deposits at December 31, 2005.
The following table summarizes average deposits for the years ended December 31, 2005, 2004 and 2003, not including the deposit reclassification noted above.
AVERAGE DEPOSIT MIX
(000’s omitted)
The following table presents the maturity schedule of certificates of deposit of $100,000 or more as of December 31, 2005, 2004 and 2003.
MATURITY SCHEDULE OF CERTIFICATES
OF DEPOSIT OF $100,000 OR MORE
(000’s omitted)
Short-Term Borrowings
Total short-term borrowings (including federal funds purchased and securities sold under agreements to repurchase) increased by $27.8 million from their level of $23.0 million at December 31, 2004 to a total of $50.8 million as of December 31, 2005. Short-term borrowings at December 31, 2005 include federal funds purchased of $17.0 million, Federal Home Loan Bank of Atlanta (“FHLB”) borrowings in the amount of $23.0 million, and a commercial sweep account program in the amount of $10.8 million. Total short-term borrowings (including federal funds purchased and securities sold under agreements to repurchase) at December 31, 2003 were $22.3 million.
The FHLB borrowings include a $10 million adjustable rate credit which matures on December 18, 2006 and reprices quarterly on the date of each quarterly interest payment (rate of 4.39% on December 31, 2005). The second FHLB credit of $5 million matures on January 30, 2006 and reprices monthly at 1-month LIBOR flat (rate of 4.58% on December 31, 2005). The third FHLB borrowing is an $8 million daily rate credit which matures on September 27, 2006 (rate of 4.44% on December 31, 2005). See the liquidity section for further information on the preceding borrowings.
The commercial sweep program involves balances subject to repurchase agreements which are reported as short term borrowings rather than deposits since they are not FDIC insured. The balance in the program increased by $5 million from the $5.8 million reported at December 31, 2004 and increased by $6.1 million from the $4.7 million reported at December 31, 2003. The program consists of a demand deposit account from which we invest available balances daily in securities on an overnight basis subject to repurchase. On the following business day, we repurchase from the customer the securities for an amount equal to the amount of available balances invested in the securities. Interest is calculated daily at the rate applicable for each overnight period; however, it is posted to the customer accounts only once per month.
The following table presents information on each category of the Company’s short-term debt, which generally mature within one to seven days from the transaction date.
SHORT-TERM BORROWINGS
(000’s omitted)
Long-Term Borrowings
Federal Home Loan Bank advances are relatively cost-effective funding sources and provide the Company with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity. The increase in advances during the year reflects the funding to support investment growth.
The Company had outstanding long-term debt with the Federal Home Bank of Atlanta in the amount of $37.0 million as of December 31, 2005, unchanged from December 31, 2004 and December 31, 2003. There are four convertible advances in the amount of $5.0 million each, one convertible advance in the amount of $7.0 million, and one convertible advance in the amount of $10.0 million currently drawn. The Federal Home Bank of Atlanta has the option to convert the $37.0 million in convertible advances on the conversion dates below and any interest payment date thereafter with at least two business days notice. If called, the four $5.0 million convertible advances and the one $7.0 million convertible advance will be converted into a 3-month LIBOR-based adjustable rate credit (ARC) at 3-month LIBOR flat. The $10.0 million convertible advance may be converted into a 3-month LIBOR-based floating rate advance (ARC) at 3-month LIBOR flat only if 3-month LIBOR is greater than or equal to 7.0%. (See Footnote 9 of the Company’s Consolidated Financial Statements for more information on the long-term advances.)
Guaranteed Preferred Beneficial Interests in the Company’s Junior Subordinated Debentures
Valley Financial (VA) Statutory Trust I, a statutory business trust (“Trust I”), was created on June 26, 2003, at which time the Trust issued $4.0 million in aggregate liquidation amount of $1 par value preferred capital trust securities which mature June 26, 2033. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate (“LIBOR”) plus 3.10%, capped at 11.75%, and the securities may be prepaid at par by Trust I at any time after June 26, 2008. The principal assets of Trust I are $4.1 million of the Company’s junior subordinated debentures which mature on June 26, 2033, and bear interest at a floating rate equal to the 3-month LIBOR plus 3.10%, capped at 11.75%, and which are callable by the Company after June 26, 2008. All $124,000 in aggregation liquidation amount of Trust I’s common securities are held by the Company.
Valley Financial (VA) Statutory Trust II, a statutory business trust (“Trust II”), was created on September 26, 2005, at which time Trust II issued $7.0 million in aggregate liquidation amount of $1 par value preferred capital trust securities which mature December 15, 2035. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate (“LIBOR”) plus 1.49%, and the securities may be prepaid at par by Trust II at any time after December 15, 2010. The principal assets of Trust II are $7.2 million of the Company’s junior subordinated debentures which mature on December 15, 2035, and bear interest at a floating rate equal to the 3-month LIBOR plus 1.49%, and which are callable by the Company after December 15, 2010. All $217,000 in aggregation liquidation amount of Trust II’s common securities are held by the Company.
The debenture proceeds from Trust I and Trust II are included in our Tier 1 capital for regulatory capital adequacy purposes to the extent that they do not exceed 25% of our total Tier I capital including the securities. This amount totaled $10.4 million (of the $11 million outstanding) at December 31, 2005. The remaining $600,000 is included in the calculation of our total risk-based capital ratio as Tier 2 capital. Our obligations with respect to the issuance of Trust I and Trust II’s preferred securities and common securities constitute a full and unconditional guarantee of Trust I and Trust II’s obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, we may elect from time to time to defer interest payments on its junior subordinated debentures, which would result in a deferral of distribution payments on Trust I and Trust II’s preferred trust securities and common securities. As a result of the Company’s adoption of FIN 46, both Trusts’ common securities have been presented as a component of other assets.
Contractual Obligations, Commitments, Contingent Liabilities, Off-Balance Sheet Arrangements, and Related Party Transactions
A summary of the Company’s significant contractual obligations and commitments is presented in the following table, with a reference to the footnote disclosure in Item 8
Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Valley Financial Corporation
Roanoke, Virginia
We have audited the consolidated balance sheets of Valley Financial Corporation and its subsidiary (Valley Bank) as of December 31, 2005 and 2004 and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards established by 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 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 Valley Financial Corporation and subsidiary as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
/s/ Larrowe & Company, plc
Galax, Virginia
February 3, 2006
Valley Financial Corporation
Consolidated Balance Sheets
December 31, 2005 and 2004
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Valley Financial Corporation
Consolidated Statements of Income
For the Years Ended December 31, 2005, 2004, and 2003
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Valley Financial Corporation
Consolidated Statements of Shareholders’ Equity
For the Years Ended December 31, 2005, 2004, and 2003
(In thousands, except share data)
See accompanying notes to consolidated financial statements
Valley Financial Corporation
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2005, 2004, and 2003
(In thousands, except share data)
See accompanying notes to the consolidated financial statements.
Valley Financial Corporation
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2005, 2004, and 2003
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies
General
The Bank provides traditional commercial banking services concentrated primarily in the Roanoke Valley. The Bank does not currently offer trust services. As a state chartered, Federal Reserve member bank, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve.
Critical Accounting Policies
The accounting and reporting policies of Valley Financial Corporation (“the Company”) and Valley Bank (“the Bank”) conform to generally accepted accounting principles (GAAP) and to general banking industry practices. Our policies with respect to the methodology for determination of the allowance for loan losses involve a high degree of complexity. Management must make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions, or estimates would cause reported results to differ materially. These critical policies and their application are reviewed periodically with our Audit Committee and Board of Directors. The following is a summary of the more significant accounting policies:
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and the Bank, thereafter referred to collectively as the Company. All significant intercompany transactions and balances have been eliminated in consolidation.
Business Segments
The Company reports its activities in one business segment. In determining the appropriateness of segment definition, the Company considers the materiality of potential business segments and components of the business about which financial information is available and regularly evaluated relative to resource allocation and performance assessment.
Advertising Costs
The Company expenses all advertising and business promotion costs as incurred. The costs are not material to the Company’s results of operations.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and foreclosed real estate losses, management obtains independent appraisals for significant properties.
Substantially all of the Bank’s loan portfolio consists of loans in the Roanoke Valley. Accordingly, the ultimate collectibility of a substantial portion of the Bank’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions. The regional economy is reasonably diverse.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Use of Estimates, continued
While management uses available information to recognize loan and foreclosed real estate losses, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as a part of their routine examination process, periodically review the Bank’s allowances for loan and foreclosed real estate losses. Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the allowances for loan and foreclosed real estate losses may change materially in the near term.
Cash and Cash Equivalents
For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption “cash and due from banks.”
Interest-Bearing Deposits in Banks
Interest bearing deposits in banks mature within one year and are carried at cost.
Trading Securities
The Company does not hold securities for short-term resale and therefore does not maintain a trading securities portfolio.
Securities Held-to-Maturity
Bonds, notes, and debentures for which the Bank has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates.
Securities Available-for-Sale
Available-for-sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held-to-maturity securities.
Unrealized holding gains and losses, net of tax, on available-for-sale securities are reported as a net amount in a separate component of shareholders’ equity. Realized gains and losses on the sale of available-for-sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.
Declines in the fair value of individual held-to-maturity and available-for-sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Loans Receivable
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal amount adjusted for the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.
Loan origination fees and costs are not capitalized and recognized as an adjustment to the yield on the related loan as such deferrals are not material to the Company’s financial position or results of operations. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method.
Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. When facts and circumstances indicate the borrower has regained the ability to meet required payments, the loan is returned to accrual status. Past due status of loans is determined based on contractual terms.
Allowance for Loan Losses
The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on three basic principles of accounting: (i) Statement of Financial Accounting Standards (“SFAS”) 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable, (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, and (iii) SFAS 118, Accounting by Creditors for Impairment of a Loan, Income Recognition and Disclosures - an amendment of SFAS 114, which allows a creditor to use existing methods for recognizing interest income on an impaired loan.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. 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 the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
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 for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility 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.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Allowance for Loan Losses, continued
A loan is considered impaired when, based on current information and events, it is probable that the Bank 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 Bank does not separately identify individual consumer and residential loans for impairment disclosures.
Property and Equipment
Land is carried at cost. Bank premises, furniture and equipment, and leasehold improvements are carried at cost, less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:
Years
Buildings and improvements
Furniture and equipment
3-10
Land and leasehold improvements
3-15
Foreclosed Properties
Assets acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value less anticipated cost to sell at the date of foreclosure establishing a new cost basis. After foreclosure, valuations are periodically performed by management and the asset is 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 foreclosed asset expense.
Stock-based Compensation
The Company accounts for its stock-based compensation plans using the accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The Company is not required to adopt the fair value based recognition provisions prescribed under SFAS No. 123, Accounting for Stock-Based Compensation (issued in October 1995), but complies with the disclosure requirements set forth in the Statement, which include disclosing pro forma net income as if the fair value based method of accounting had been applied. The Company will be required to adopt the expense recognition provisions prescribed under SFAS No. 123(R) Share-Based Payments (issued in December 2004) beginning January 1, 2006.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Income Taxes
Provision for income taxes is based on amounts reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities and income earned on bank-owned life insurance) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Deferred income tax liability relating to unrealized appreciation (or the deferred tax asset in the case of unrealized depreciation) on investment securities available for sale is recorded in other liabilities (assets). Such unrealized appreciation or depreciation is recorded as an adjustment to equity in the financial statements and not included in income determination until realized. Accordingly, the resulting deferred income tax liability or asset is also recorded as an adjustment to equity.
Basic Earnings per Share
Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period, after giving retroactive effect to stock splits and dividends.
Diluted Earnings per Share
The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares.
Comprehensive Income
Annual comprehensive income reflects the change in the Company’s equity during the year arising from transactions and events other than investments by and distributions to shareholders. It consists of net income plus certain other changes in assets and liabilities that are reported as separate components of shareholders’ equity rather than as income or expense.
Financial Instruments
Derivatives that are used as part of the asset/liability management process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. In addition, forwards and option contracts must reduce an exposure’s risk, and for hedges of anticipatory transactions, the significant terms and characteristics of the transaction must be identified and the transactions must be probable of occurring. All derivative financial instruments held or issued by the Company are held or issued for purposes other than trading.
In the ordinary course of business the Bank has entered into off-balance-sheet financial instruments consisting of commitments to extend credit and commercial and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Fair Value of Financial Instruments
Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance sheet for cash and cash equivalents approximate their fair values.
Interest-bearing deposits with banks: Fair values for time deposits are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.
Available-for-sale and held-to-maturity securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of restricted equity securities approximate fair values.
Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable. The carrying amount of accrued interest receivable approximates its fair value.
Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits. The carrying amount of accrued interest payable approximates fair value.
Short-term debt: The carrying amounts of short-term debt approximate their fair values.
Other debt: The fair values of other debt is estimated using a discounted cash flow calculation that applies contracted interest rates being paid on the debt to the current market interest rate of similar debt.
Other liabilities: For fixed-rate loan commitments, fair value considers the difference between current levels of interest rates and the committed rates. The carrying amounts of other liabilities approximates fair value as the estimated value of loan commitments approximates the fees charged.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 1. Summary of Significant Accounting Policies, continued
Reclassification
Certain reclassifications have been made to the financial statements of the prior year to place them on a comparable basis with the current year. Net income and shareholders’ equity previously reported were not affected by these reclassifications.
Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123(R)”), Share-Based Payments. SFAS 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. The Company will apply SFAS 123(R) on a modified prospective method. Under this method, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted stock option awards that remain outstanding at the date of adoption. In addition, the Company may elect to adopt SFAS 123(R) by restating previously issued financial statements, basing the amounts on the expense previously calculated and reported in the pro forma disclosures that had been required by SFAS 123, Accounting for Stock-Based Compensation. SFAS 123(R) is effective for the Company beginning January 1, 2006.
Note 2. Restrictions on Cash
To comply with Federal Reserve regulations, the Bank is required to maintain certain average reserve balances. The daily cash reserve requirement for the week including December 31, 2005 was $211, less cash on hand in the amount of $1,067, or a net of $0. The daily cash reserve requirement for the week including December 31, 2004 was $2,132, less cash on hand in the amount of $891, or a net of $1,241. The Company implemented a deposit reclassification program in September 2005 that restructures interest and non-interest checking accounts so that a portion of the balance in each account is actually maintained in a linked Savings sub-account. The Savings portion of the combined account balance is not subject to the 10% reserve that is required for checking balances; therefore the overall daily cash reserve requirement for the Federal Reserve has been reduced.
As a condition of our correspondent bank agreement, the Bank is also required to maintain a target balance. The target balance as of December 31, 2005 was $250.
Note 3. Securities
The amortized costs, gross unrealized gains and losses, and approximate fair values of securities available-for-sale as of December 31, 2005 and 2004 were as follows:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
The amortized costs, gross unrealized gains and losses, and approximate fair values of securities held-to-maturity as of December 31, 2005 and 2004 were as follows:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 3. Securities, continued
The following tables detail unrealized losses and related fair values in the Bank’s available-for-sale and held-to-maturity investment securities portfolios. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2005.
Temporarily Impaired Securities in AFS Portfolio
Temporarily Impaired Securities in HTM Portfolio
This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2004.
Temporarily Impaired Securities in AFS Portfolio
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 3. Securities, continued
Temporarily Impaired Securities in HTM Portfolio
Management considers the nature of the investment, the underlying causes of the decline in the market value and the severity and duration of the decline in market value in determining if impairment is other than temporary. Management believes all unrealized losses presented in the tables above are not related to an issuer’s financial condition but are due to changes in the level of interest rates and no declines are deemed to be other than temporary in nature.
The amortized costs and approximate fair values of available-for-sale securities as of December 31, 2005, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The amortized costs and approximate fair values of held-to-maturity securities as of December 31, 2005, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 3. Securities, continued
Securities (excluding restricted equity securities) with amortized costs of $40,604 and $32,580 as of December 31, 2005 and 2004, respectively, were pledged as collateral for public deposits and for other purposes as required or permitted by law.
Restricted equity securities consist of Federal Home Loan Bank stock in the amount of $3,443 and $2,958, Federal Reserve Bank stock in the amount of $483 and $483, and Community Bankers Bank stock in the amount of $60 as of December 31, 2005 and 2004, respectively. Restricted equity securities are carried at cost. The Federal Home Loan Bank requires the Bank to maintain stock in an amount equal to 5% of outstanding borrowings. The Federal Reserve Bank of Richmond requires the Bank to maintain stock with a par value equal to 3% of its outstanding capital. Community Bankers Bank stock is restricted in the fact that the stock may only be repurchased by that Company.
Note 4. Loans Receivable
The major components of loans in the consolidated balance sheets at December 31, 2005 and 2004 are as follows:
Substantially all one-four family residential and commercial real estate loans collateralize the line of credit available from the Federal Home Loan Bank.
Note 5. Allowance for Loan Losses
Changes in the allowance for loan losses are as follows:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 5. Allowance for Loan Losses, continued
An allowance determined in accordance with SFAS No. 114 and No. 118 is provided for all impaired loans. The total recorded investment in impaired loans and the related allowance for loan losses at December 31, 2005, 2004, and 2003 is as follows:
The average annual recorded investment in impaired loans and interest income recognized on impaired loans for the years ended December 31, 2005, 2004, and 2003 (all approximate) is summarized below:
No additional funds are committed to be advanced in connection with impaired loans.
Nonaccrual loans totaled $104 and $150 as of December 31, 2005 and 2004, respectively. Loans past due more than ninety days and still accruing totaled $423 and $240 as of December 31, 2005 and 2004, respectively. Restructured loans totaled $0 and $0 as of December 31, 2005 and 2004, respectively.
Note 6. Foreclosed Assets
Expenses applicable to foreclosed assets include the following:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 7. Premises and Equipment
Components of premises and equipment and total accumulated depreciation and amortization as of December 31, 2005 and 2004 are as follows:
Depreciation expense for the years ended December 31, 2005, 2004, and 2003 amounted to $698, $625, and $499, respectively.
The Company currently leases its main office location under a non-cancelable operating lease. The lease for the main office has a term of six years with the option of three additional renewal terms of five years each. In addition, the Company currently leases two of its branch locations. The first branch has an initial lease term of twelve years with the option of one additional renewal term of five years. The second branch has an initial lease term of five years with the option to renew for four additional five year periods. Rental expenses under operating leases were approximately $231, $155 and $163 for 2005, 2004, and 2003, respectively. Future minimum lease payments under non-cancelable operating leases at December 31, 2005 were as follows:
Note 8. Time Deposits
At December 31, 2005 the approximate scheduled maturities of time deposits are as follows:
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2005 and 2004 was $52,518 and $39,786, respectively.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 9. Borrowed Funds
Short-term debt
Short-term debt includes Federal Home Loan Bank Advances that mature in 12 months or less, securities sold under agreements to repurchase and federal funds purchased generally maturing within one to seven days from the transaction date. Federal Home Loan Bank of Atlanta advances totaled $23,000 and $15,000 at December 31, 2005 and 2004, respectively. The $23,000 balance as of December 31, 2005 is comprised of an $8,000 daily rate credit, an adjustable rate credit in the amount of $10,000 and a second adjustable rate credit in the amount of $5,000. The $8,000 daily rate credit was borrowed in September of 2005. The daily rate credit matures daily and is rolled over on a daily basis at the stated Federal Home Loan Bank of Atlanta daily rate. There is no stated maturity date and interest is paid monthly. The current rate is 4.44%. The $10,000 adjustable rate credit was renewed for another year in December 2005. The new maturity date is December 18, 2006. The advance reprices quarterly on the date of each quarterly interest payment. The current rate is 4.39%. The $5,000 adjustable rate credit was borrowed in September of 2005 and matures January 31, 2006. The advance reprices monthly. The current rate is 4.58%. At December 31, 2005, the Company had $10,973 available under short-term unsecured lines of credit and $51,012 available under short-term secured lines of credit.
Additional information is summarized below:
Securities with a fair market value of $19,871 and $13,133 collateralized securities sold under agreements to repurchase at December 31, 2005 and 2004, respectively.
Long-term debt
At December 31, 2005 and 2004, long-term debt was $37,000 and consisted of advances from the Federal Home Loan Bank. These advances are convertible to a floating rate of three month LIBOR by the FHLB on the dates indicated. The weighted average rate at December 31, 2005 was 4.26%.
Details related to long-term debt at December 31, 2005 and 2004 is as follows:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 9. Borrowed Funds, continued
Guaranteed Preferred Beneficial Interests in the Company’s Junior Subordinated Debentures
Valley Financial (VA) Statutory Trust I, a statutory business trust (the “Trust”), was created by the Company on June 26, 2003, at which time the Trust issued $4,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature June 26, 2033. Distributions are payable on the securities at a floating rate equal to the 3-month London Interbank Offered Rate (“LIBOR”) plus 3.10%, capped at 11.75%, and the securities may be prepaid at par by the Trust at any time after June 26, 2008. The principal assets of the Trust are $4,124 of the Company’s junior subordinated debentures which mature on June 26, 2033, and bear interest at a floating rate equal to the 3-month LIBOR plus 3.10%, capped at 11.75%, and which are callable by the Company after June 26, 2008. All $124 in aggregation liquidation amount of the Trust’s common securities are held by the Company.
Valley Financial (VA) Statutory Trust II, a statutory business trust (“Trust II”), was created by the Company on September 26, 2005, at which time Trust II issued $7,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature December 15, 2035. Distributions are payable on the securities at a floating rate equal to the 3-month LIBOR plus 1.49%, and the securities may be prepaid at par by Trust II at any time after December 15, 2010. The principal assets of Trust II are $7,217 of the Company’s junior subordinated debentures which mature on December 15, 2035, and bear interest at a floating rate equal to the 3-month LIBOR plus 1.49%, and which are callable by the Company after December 15, 2010. All $217 in aggregation liquidation amount of Trust II’s common securities are held by the Company.
The preferred securities and common securities of both trusts may be included in the Company’s Tier 1 capital for regulatory capital adequacy purposes to the extent that they do not exceed 25% of the Company’s total Tier I capital excluding the securities. Amounts in excess of this ratio will not be considered Tier 1 capital but may be included in the calculation of the Company’s total risk-based capital ratio. The Company’s obligations with respect to the issuance of the preferred securities and common securities of both trusts constitute a full and unconditional guarantee by the Company of the trusts obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on its junior subordinated debentures, which would result in a deferral of distribution payments on the trusts’ preferred trust securities and common securities. As a result of the Company’s adoption of FIN 46, both Trusts’ common securities have been presented as a component of other assets.
Note 10. Fair Value of Financial Instruments
The carrying amounts and approximate fair values of the Corporation’s financial instruments are as follows at December 31, 2005 and 2004:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 10. Fair Value of Financial Instruments, continued
Note 11. Earnings per Share
Basic earnings per share is based upon the weighted average number of common shares outstanding during the period. The weighted average shares outstanding for the diluted earnings per share computations were adjusted to reflect the assumed conversion of shares available under stock options. The following table details the computation of basic and diluted earnings per share for each year ended December 31.
Note 12. Employee Benefit Plan
The Company has a defined contribution plan (the Plan) qualifying under IRS Code Section 401(k). Eligible participants in the Plan can contribute up to the maximum percentage allowable not to exceed the dollar limit under IRC Section 401(k). Employee contributions are matched by the Company based on 100 percent of the first three percent of an employee’s contribution and 50 percent of employee contributions which exceed three percent but do not exceed six percent. For the years ended December 31, 2005, 2004, and 2003, the Company contributed $126, $94, and $79 to the Plan, respectively.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 12. Employee Benefit Plan, continued
During 2002, the Company adopted a deferred compensation plan to provide future compensation to certain members of management. Under plan provisions, payments projected to range from $26 to $161 are payable for 15 years certain, generally beginning at age 65. The liability accrued for compensation deferred under the plan was $663 at December 31, 2005 and $483 at December 31, 2004. Deferred compensation expense, an actuarially determined amount, was $180 during 2005, $208 during 2004, and $275 during 2003. Assumed discount rate, rate of compensation increase, and expected after-tax long-term rate of return on plan assets were 7.25%, 5%, and 4.8%, respectively at December 31, 2005. Assumed discount rate, rate of compensation increase, and expected long-term rate of return on plan assets were 7.25%, 5%, and 5%, respectively at December 31, 2004. Assumed discount rate, rate of compensation increase, and expected long-term rate of return on plan assets were 7.25%, 5%, and 6%, respectively at December 31, 2003.
The Company has purchased and is the beneficiary of life insurance policies designed to fund the deferred compensation liability. The cash value totaled approximately $8,950 and $6,125 at December 31, 2005 and 2004, respectively.
Note 13. Stock Based Compensation
The Company accounts for its stock-based compensation plan using the accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The Company is not required to adopt the fair value based recognition provisions prescribed under SFAS No. 123, Accounting for Stock Based Compensation, but complies with the disclosure requirements set forth in the Statement (as amended by SFAS No. 148), which include disclosing pro forma net income as if the fair value based method of accounting had been applied.
Stock Option Plans
The Company has a 2005 Key Employee Equity Award Plan (the 2005 Plan). The 2005 Plan gives the Company flexibility in tailoring equity based compensation awards for employees from time to time to the continuing objective of aligning employee incentives with the interests of shareholders as the Company grows and develops. In addition to incentive and non qualified stock options, the 2005 Plan permits the grant of restricted stock, stock appreciation rights and stock units to persons designated as “Key Employees”. The 2005 Plan will remain in effect for ten years, subject to the right of the Board of Directors to terminate the 2005 Plan earlier, except with respect to awards made prior to and outstanding on that date which remain valid in accordance with their terms. The maximum aggregate number of shares of the Company’s common stock (no par value) that may be issued pursuant to awards made under the Plan may not exceed 250,000. Accordingly, 250,000 shares of authorized but unissued common stock are reserved for use in the 2005 Plan. Within the maximum limits, the Plan specifies that stock appreciation rights may not be granted with respect to more than 500 shares per recipient (2,000 shares for a new employee recipient) per year; and restricted shares and stock units, respectively, may not be granted for more than 5,000 shares per year per recipient.
Additionally, the Company has a 1995 Incentive Stock Plan (the 1995 Plan) pursuant to which the Human Resources Committee of the Company’s Board of Directors may grant stock options to officers and key employees. The 1995 Plan authorizes grants of options to purchase up to 311,850 shares (adjusted for stock splits) of the Company’s authorized but unissued common stock. Accordingly, 304,493 options for shares of authorized common stock have been issued under the Plan and 7,357 options for shares of authorized common stock are available for issue under the Plan.
Under the 2005 Plan, there are options for 44,400 shares granted to officers and key employees currently outstanding as of December 31, 2005. Under the 1995 Plan, there are options for 238,882 shares granted to officers and key employees currently outstanding as of December 31, 2005. All stock options (for both plans) have been granted with an exercise price equal to the stock’s fair market value at the date of the
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 13. Stock Based Compensation, continued
grant. Stock options under the Plan generally have 10-year terms, vest at the rate of 20 percent per year, and become fully exercisable five years from the date of the grant. In addition, certain other options for 182,196 shares (adjusted for stock splits), of which 82,098 are outstanding as of December 31, 2005, based on meeting certain past performance criteria have been granted.
Additionally under the 2005 Plan, there are 14,875 restricted stock grants (“RSG’s”) that have been granted to officers and key employees currently outstanding as of December 31, 2005. These RSG’s will vest 100% on January 31, 2008 (“Vesting Date”) based upon successfully meeting certain performance criteria.
The per share weighted average fair value of stock options granted during 2005, 2004, and 2003 was $5.16, $4.59, and $2.17 respectively, on the date of grant utilizing the Black-Scholes option-pricing model using the assumptions noted below.
As previously mentioned, the Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value of its stock options at the grant date under SFAS No. 123, the Company’s net income and net income per share would have decreased to the pro forma amounts indicated below:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 13. Stock Based Compensation, continued
Stock option activity during the years ended December 31, 2005, 2004, and 2003 (adjusted for stock splits) is as follows:
At December 31, 2005, the range of exercise prices was $2.78 - $14.23 (adjusted for stock split) and the weighted average remaining contractual life of outstanding options was 4.6 years. The grant date fair value of options issued in 2005 is $256.
At December 31, 2004, the range of exercise prices was $2.78 - $14.23 (adjusted for stock split) and the weighted average remaining contractual life of outstanding options was 5.3 years. The grant date fair value of options issued in 2004 is $120.
At December 31, 2003, the range of exercise prices was $2.78 - $11.43 (adjusted for stock split) and the weighted average remaining contractual life of outstanding options was 5.3 years. The grant date fair value of options issued in 20034 is $49.
At December 31, 2005, 2004, and 2003 the number of options exercisable was 268,500, 244,443, and 337,366 respectively, and the weighted average exercise price of those options was $4.69, $5.40, and $3.78 respectively (adjusted for stock split). There was no compensation cost recognized in income related to stock-based compensation in 2005, 2004 or 2003.
Note 14. Income Taxes
Current and Deferred Income Tax Components
Total income tax expense (benefit) for the years ended December 31, 2005, 2004, and 2003 consists of the following:
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 14. Income Taxes, continued
Rate Reconciliation
Total income tax expense (benefit) differed from the “expected” amount computed by applying the U.S. Federal income tax rate of 34 percent to income before income taxes as a result of the following:
Deferred Income Tax Analysis
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 are as follows:
Note 15. Commitments and Contingencies
Concentrations of Credit Risk
The Bank grants commercial, residential and consumer loans to customers primarily in the Roanoke Valley area. The Bank has a diversified loan portfolio which is not dependent upon any particular economic or industry sector. As a whole, the portfolio could be affected by general economic conditions in the Roanoke Valley region.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 15. Commitments and Contingencies, continued
A detailed composition of the Bank’s loan portfolio is provided in the consolidated financial statements. The Bank’s commercial loan portfolio is diversified, with no significant concentrations of credit. Commercial real estate loans are generally collateralized by the related property. The residential real estate loan portfolio consists principally of loans collateralized by 1-4 family residential property. The loans to individuals portfolio consists of consumer loans primarily for home improvements, automobiles, personal property and other consumer purposes. These loans are generally collateralized by the related property. Overall, the Bank’s loan portfolio is not concentrated within a single industry or group of industries, the loss of any one or more of which would generate a materially adverse impact on the business of the Bank.
The Bank has established operating policies relating to the credit process and collateral in loan originations. Loans to purchase real and personal property are generally collateralized by the related property. Credit approval is principally a function of collateral and the evaluation of the creditworthiness of the borrower based on available financial information.
Litigation
In the normal course of business the Bank may be involved in various legal proceedings. After consultation with legal counsel, management believes that any liability resulting from such proceedings will not be material to the financial statements.
Financial Instruments with Off-Balance-Sheet Risk
The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheets. The contract amounts of these instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.
Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract. The Bank’s maximum exposure to credit loss under commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
The Bank requires collateral to support financial instruments when it is deemed necessary. The Bank evaluates customers’ creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit is based on management’s credit evaluation of the customer. Collateral may include deposits held in financial institutions, U.S. Treasury securities, other marketable securities, real estate, accounts receivable, inventory, and property, plant and equipment. Financial instruments whose contract amounts represent credit risk as of December 31 are 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. Commitments may be at fixed or variable rates and generally expire within one year. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 15. Commitments and Contingencies, continued
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions. Unless renewed, substantially all of the Bank’s credit commitments at December 31, 2005 will expire within one year. Management does not anticipate any material losses as a result of these transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
Employment Agreements
The Company has entered into employment agreements with certain executive officers. The employment agreements provide for a certain minimum salary level that may be increased, but not decreased, by the Board pursuant to an annual evaluation and also contain change-in-control provisions entitling the executive officer to certain benefits in the event employment is terminated within three years of a change in control of the Company for reasons other than death, retirement, disability, cause, voluntary resignation other than for good reason, or pursuant to notice of termination given prior to the change in control.
Note 16. Regulatory Restrictions
Dividends
The Company’s principal source of funds for dividend payments is dividends received from the Bank. The amount of dividends that may be paid by the Bank to the Company will depend on the Bank’s earnings and capital position and is limited by state law, regulations and policies. A state bank may not pay dividends from its capital; all dividends must be paid out of net undivided profits then on hand. Before any dividend is declared, any deficit in capital funds originally paid in shall have been restored by earnings to their initial level, and no dividend shall be declared or paid by any bank which would impair the paid-in-capital of the bank. As of December 31, 2005 and 2004, the amount available for payment of dividends was $15,133 and $11,837, respectively.
Capital Requirements
The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
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 I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2005 and 2004, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2005 and 2004, the Company and the Bank were categorized as “well capitalized” as defined by applicable regulations. To be categorized as “well capitalized”, the Company and Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table below. There are no conditions or events since that date that management believes have changed the Company’s or the Bank’s category.
The Company’s and the Bank’s actual capital amounts and ratios are also presented in the table below.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 16. Regulatory Restrictions, continued
Inter-company transactions
Legal lending limits on loans by the Bank to the Company are governed by Federal Reserve Act 23A, and differ from legal lending limits on loans to external customers. Generally, a bank may lend up to 10% of its capital and surplus to its parent, if the loan is secured. If collateral is in the form of stocks, bonds, debentures or similar obligations, it must have a market value when the loan is made of at least 20% more than the amount of the loan, and if obligations of a state or political subdivision or agency thereof, it must have a market value of at least 10% more than the amount of the loan. If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers’ acceptances eligible for rediscount or purchase by a Federal Reserve Bank, requirements for collateral in excess of loan amount do not apply. Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $3.8 million at December 31, 2005. There were no loans from the Bank to the Company at December 31, 2005.
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 17. Related Party Transactions
The Company has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.
Aggregate 2005 and 2004 loan transactions with directors and executive officers were as follows:
Note 18. Parent Company Financial Information
Condensed financial information of Valley Financial Corporation is presented below:
Condensed Balance Sheets
December 31, 2005 and 2004
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 18. Parent Company Financial Information, continued
Condensed Statements of Income
Years Ended December 31, 2005, 2004, and 2003
Condensed Statements of Cash Flows
Years Ended December 31, 2005, 2004, and 2003
Valley Financial Corporation
Notes to Consolidated Financial Statements
(In thousands, except share data)
Note 18. Parent Company Financial Information, continued
Item 9.
Item 9. Changes in and Disagreements on Accounting and Financial Disclosures
None.
Item 9A.
Item 9A. Disclosure Controls and Procedures
As of the end of the period covered by this annual report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There were no significant changes in our internal controls or in the other factors that could significantly affect these controls subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.
The design of any system of controls is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goal under every potential condition, regardless of how remote. In addition, the operation of any system of controls and procedures is dependent upon the employees responsible for executing it. While we have evaluated the operation of our disclosure controls and procedures and found them effective, there can be no assurance that they will succeed in every instance to achieve their objective.
Item 9B.
Item 9B. Other Information
None.
PART III.
Item 10.
Item 10. Directors and Executive Officers.
The information required by Items 401, 405, and 406 of Regulation S-K is set forth under the captions “Information Concerning Directors and Nominees”, “Certain Relationships and Related Transactions”, “Audit Committee Information”, “Nominating Committee”, “Audit Committee Financial Expert”, “Section 16(a) Beneficial Ownership Reporting Compliance”, and “Code of Ethics’ of the Company’s Proxy Statement dated March 15, 2006 and is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation.
The information required by Item 402 of Regulation S-K is set forth under the caption “Executive Compensation” of the Company’s Proxy Statement dated March 15, 2006 and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by Items 201(d) and 403 of Regulation S-K is set forth under the caption “Security Ownership of Certain Beneficial Owners” of the Company’s Proxy Statement dated March 15, 2006 and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required by Item 404 of Regulation S-K is set forth under the caption “Certain Relationships and Related Transactions” of the Company’s Proxy Statement dated March 15, 2006 and is incorporated herein by reference.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information required by item 9(e) of Schedule 14A is set forth under the caption “Audit Committee Information” of the Company’s Proxy Statement dated March 15, 2006 and is incorporated herein by reference.
PART IV.
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this Report and can be found on our Company website at www.myvalleybank.com:
1. Financial Statements:
Independent Auditors’ Report.
Consolidated Balance Sheets as of December 31, 2005 and 2004.
Consolidated Statements of Income for the Years Ended December 31, 2005 and 2004.
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2005 and 2004.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005 and 2004.
Notes to Consolidated Financial Statements.
2. Financial Statement Schedules:
All schedules are omitted as the required information is inapplicable or the information is presented in the Financial Statements or related notes.
3. Exhibits and Reports on Form 8-K:
* Management contract or compensatory plan or agreement required to be filed as an Exhibit to this Form 10-K pursuant to Item 13(a).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on March 31, 2006.
Valley Financial Corporation
By:
/s/ Ellis L. Gutshall
Ellis L. Gutshall
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the following persons in the capacities indicated as of March 31, 2006.
Signature
Title
/s/ Ellis L. Gutshall
(Ellis L. Gutshall)
President, Chief Executive Officer and Director
(Chief Executive Officer)
/s/ Kimberly B. Snyder
(Kimberly B. Snyder)
Senior Vice President, Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ J. Randy Woodson
(J. Randy Woodson)
Executive Vice President, Chief Operating Officer
/s/ Abney S. Boxley, III *
(Abney S. Boxley, III)
Director
/s/ William D. Elliot *
(William D. Elliot)
Director
/s/ James S. Frantz, Jr.
(James S. Frantz, Jr.)
Director
/s/ Mason Haynesworth *
(Mason Haynesworth)
Director
/s/ Eddie F. Hearp *
(Eddie F. Hearp)
Director
/s/ Anna L. Lawson *
(Anna L. Lawson)
Director
/s/ Barbara B. Lemon *
(Barbara B. Lemon)
Director
/s/ A. Wayne Lewis *
(A. Wayne Lewis)
Director
/s/ Samuel L. Lionberger, Jr. *
(Samuel L. Lionberger, Jr.)
Director
/s/ George W. Logan *
(George W. Logan)
Chairman, Director
/s/ Geoffrey M. Ottaway *
(Geoffrey M. Ottaway)
Director
/s/ John W. Starr *
(John W. Starr)
Director
/s/ Ward W. Stevens *
(Ward W. Stevens)
Director
/s/ Michael E. Warner *
(Michael E. Warner)
Director
INDEX TO EXHIBITS