ITEM 1.
BUSINESS
General
Middleburg Financial Corporation (the “Company”) is a bank holding company that was incorporated under Virginia law in 1993. The Company conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc., both of which are chartered under Virginia law. The Company has one other wholly owned subsidiary, MFC Capital Trust II, which is a Delaware Business Trust that the Company formed in connection with the issuance of trust preferred debt in December 2003. This trust is an unconsolidated subsidiary of the Company and its principal assets are $5.2 million of the Company's subordinated debt securities (referred to herein as "subordinated debt") that are reported as liabilities of the Company. The Bank has the following subsidiaries, all incorporated under the laws of the Commonwealth of Virginia:
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Middleburg Bank has one wholly owned subsidiary, Middleburg Bank Service Corporation, who is a partner in two limited liability companies, Bankers Title Shenandoah, LLC, which sells title insurance through its members, and Bankers Insurance, LLC, which acts as a broker for insurance sales for its member banks.
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Middleburg Bank owns 62.4% of the issued and outstanding membership interest units of Southern Trust Mortgage, LLC. The remaining 37.6% of issued and outstanding membership interest units are owned by other partners. The ownership of these partners is represented in the financial statements as “Non-controlling Interest in Consolidated Subsidiary.” Southern Trust Mortgage is a regional mortgage lender headquartered in Virginia Beach, Virginia and has offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.
The Company operates in a decentralized manner in three principal business activities: (1) commercial and retail banking services through Middleburg Bank, (2) wealth management services through Middleburg Investment Group, Inc. and (3) mortgage banking services through Southern Trust Mortgage. The following general business discussion focuses on the activities within each of these segments. Refer to Note 22 "Segment Reporting", included in the Company's consolidated financial statements for additional discussion.
Middleburg Bank and the Company have assets in custody with Middleburg Trust Company and accordingly pays Middleburg Trust Company a monthly fee. Middleburg Bank also pays interest to Middleburg Trust Company and Southern Trust Mortgage on deposit accounts they have with Middleburg Bank. Southern Trust Mortgage has an outstanding line of credit for which it pays interest to Middleburg Bank. Middleburg Bank provides office space and data processing services to Southern Trust Mortgage for which it receives rental and fee income. Middleburg Trust Company pays the Company a management fee each month for accounting and other services provided. Transactions related to these relationships are eliminated to reach consolidated totals.
Commercial and Retail Banking Services
Middleburg Bank opened for business on July 1, 1924 and has continuously offered banking products and services to surrounding communities since that date. Middleburg Bank has twelve full service facilities and one limited service facility. The main office is located at 111 West Washington Street, Middleburg, Virginia 20117. Middleburg Bank has two full service facilities and one limited service facility in Leesburg, Virginia. Other full service facilities are located in Ashburn, Gainesville, Marshall, Purcellville, Reston, Richmond, Warrenton, and Williamsburg, Virginia.
Middleburg Bank serves the Virginia counties of Loudoun, Fairfax, Fauquier and western Prince William as well as the Town of Williamsburg and the City of Richmond.
Loudoun, Fairfax, Fauquier and western Prince William counties are located in northwestern Virginia and included in the Washington-Baltimore metropolitan statistical area. The local economy of these counties is driven by service industries, including but not limited to, professional and technical services requiring a high skill level; federal, state and local government; construction; agriculture and retail trade. According to the latest available U.S. Census Bureau data, the estimated population in these counties was:
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Loudoun County - 312,311
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Fairfax County - 1,081,726
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Fauquier County - 65,203
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Prince William County - 402,002
The Town of Williamsburg is located in the Tidewater region of Virginia and has an estimated population of 14,068 according to U.S. Census Bureau, while the surrounding area (James City County) has an estimated population of 67,009.
The City of Richmond has an estimated population of 204,214 according to the U.S. Census Bureau while the Richmond metropolitan statistical area has a population of 1,258,251.
Revenue from commercial and retail banking activities consists primarily of interest earned on loans and investment securities and service charges on deposit accounts. At December 31, 2013, assets of the commercial and retail banking segment totaled $1.2 billion. For the year ended December 31, 2013, the net income for this segment totaled $5.7 million.
Wealth Management Services
Middleburg Investment Group is a non-bank holding company that was formed in 2005. It has one wholly-owned subsidiary, Middleburg Trust Company.
Middleburg Trust Company is chartered under Virginia law and opened for business in January 1994. Its main office is located at 821 East Main Street, Richmond, Virginia, 23219. Middleburg Trust Company serves primarily the greater Richmond area including the counties of Henrico, Chesterfield, Hanover, Goochland and Powhatan. Richmond is the capital of the Commonwealth of Virginia. In 2008, Middleburg Trust Company opened an office in Williamsburg, Virginia. Middleburg Trust Company also serves the counties of Fairfax, Fauquier and Loudoun with staff available in several of Middleburg Bank's financial service centers.
Revenue from the wealth management activities is comprised mostly of fees based upon the market value of the accounts under administration as well as commissions on investment transactions. The wealth management services are conducted by Middleburg Trust Company. At December 31, 2013, assets of the wealth management services segment totaled $5.9 million. For the year ended December 31, 2013, the net income for this segment totaled $448,000.
Mortgage Banking Services
Mortgage banking activities are conducted through Southern Trust Mortgage. The Bank also purchases loans from Southern Trust Mortgage. Southern Trust Mortgage originates conventional mortgage loans, mortgage loans insured by the Federal Housing Administration (the FHA), mortgage loans guaranteed by the United States Department of Agriculture (the USDA) and the Veterans Administration (the VA), and home equity loans. A majority of the conventional loans are conforming loans that qualify for purchase by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac). The remainder of the conventional loans is non-conforming in that they do not meet Fannie Mae or Freddie Mac guidelines, but are eligible for sale to various other investors. Revenues from mortgage banking operations consist principally of gains on sales of loans to investors in the secondary mortgage market, loan origination fee income and interest earned on mortgage loans held for sale. At December 31, 2013, assets of the mortgage banking segment totaled $41.7 million. For the year ended December 31, 2013, net income for this segment totaled $14,000.
Products and Services
The Company, through its subsidiaries, offers a wide range of banking, fiduciary and investment management services to both individuals and small businesses. Middleburg Bank’s services include various types of checking and savings deposit accounts, and the origination of business, real estate, development, mortgage, home equity, automobile and other installment, demand and term loans. Also, Middleburg Bank offers ATMs at 12 facilities and at two off-site locations. Additional banking services available to the Company’s clients include, but are not limited to, Internet banking, travelers’ checks, safe deposit rentals, notary public and wire services. Southern Trust Mortgage offers mortgage banking services to residential borrowers in five states within the southeastern United States. Southern Trust Mortgage operates as Middleburg Mortgage within all of the Company’s financial service centers to provide mortgage banking services for the Company’s clients.
Middleburg Investment Group offers wealth management services through Middleburg Trust Company and through the investment services department of Middleburg Bank. Middleburg Trust Company provides a variety of investment management and fiduciary services including trust and estate settlement. Middleburg Trust Company can also serve as escrow agent, attorney-in-fact, and guardian of property or trustee of Individual Retirement Accounts (IRA). Middleburg Investment Services provides investment brokerage services for the Company’s clients.
Employees
As of December 31, 2013, the Company and its subsidiaries had a total of 352 full time equivalent employees, including 167 employees at Southern Trust Mortgage. The Company considers relations with its employees to be excellent. The Company’s employees are not represented by a collective bargaining unit.
U.S. Securities and Exchange Commission Filings
The Company maintains an Internet website at www.middleburgbank.com. Shareholders of the Company and the public may access the Company’s periodic and current reports (including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to those reports) filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, through the “Shareholder Relations” section of the Company’s website. The reports are made available on this website as soon as practicable following the filing of the reports with the SEC. The information is free of charge and may be reviewed, downloaded and printed from the website at any time.
Competition
The Company’s commercial and retail banking segment faces significant competition for both loans and deposits. Competition for loans comes from commercial banks, savings and loan associations and savings banks, mortgage banking subsidiaries of regional commercial banks, subsidiaries of national mortgage bankers, insurance companies, and other institutional lenders. Its most direct competition for deposits has historically come from commercial banks, credit unions, savings banks, savings and loan associations and other financial institutions. Based upon total deposits at June 30, 2013, as reported to the Federal Deposit Insurance Corporation (the “FDIC”), the Company had:
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15.81% of the nearly $4.9 billion in deposits in Loudoun County.
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1.58% of the $3.5 billion in deposits in the Reston market.
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5.64% of the $1.3 billion in deposits in Fauquier County.
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3.32% of the $949 million in deposits in James City County.
The Company also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds.
The Company’s wealth management segment faces competition on several fronts. Middleburg Trust Company competes for clients and accounts with banks, other financial institutions and money managers. Even though many of these institutions have been engaged in the trust or investment management business for a considerably longer period of time than Middleburg Trust Company and have significantly greater resources, Middleburg Trust Company has grown through its commitment to quality trust and investment management services and a local community approach to business.
Competition for the Company’s mortgage banking segment, Southern Trust Mortgage is largely from other mortgage banking entities. Traditional financial institutions, investment banking companies and Internet sources for mortgages also add to the competitive market for mortgages.
Lending Activities
Credit Policies
The principal risk associated with each of the categories of loans in Middleburg Bank’s portfolio is the creditworthiness of its borrowers, which can vary depending on prevailing economic conditions, market employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness.
In an effort to manage risk, Middleburg Bank has written policies and procedures, which include approval limits assigned to individual loan officers based on their position and level of experience. Middleburg Bank also utilizes an outside third party loan review process that includes regular portfolio reviews to establish loss exposure and to ascertain compliance with Middleburg Bank’s loan policy.
Middleburg Bank has three levels of lending authority. Individual loan officers are the first level and are limited to their lending authority. The second level is the Officers Loan Committee, which is composed of four officers of Middleburg Bank, including the Company’s Chairman, the President and Chief Executive Officer, and the Senior Lending Officer. The Officers Loan Committee approves loans that exceed the individual loan officers’ lending authority and reviews loans to be presented to the Directors Loan Committee. The Directors Loan Committee is composed of seven Directors, of which five are independent Directors. The
Directors Loan Committee approves new, modified and renewed credits that exceed Officer Loan Committee authorities. The Chairman of the Directors Loan Committee is the Chairman of the Company. A quorum is reached when four committee members are present, of which at least three must be independent Directors. An application requires four votes to receive approval by this committee. In addition, the Directors Loan Committee reports all new loans reviewed and approved to Middleburg Bank’s Board of Directors monthly. Monthly reports shared with the Directors Loan Committee include names and monetary amounts of all new credits in excess of $12,500 or which had been extended; a watch list including names, monetary amounts, risk rating and payment status; non accruals and charge offs as recommended and a list of overdrafts in excess of $1,500 and which have been overdrawn more than four days. The Directors Loan Committee also reviews lending policies proposed by management.
Construction Lending
The Company originates local construction loans, primarily residential, and land acquisition and development loans. The construction loans are primarily secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of a construction loan is approximately 12 months and will reprice monthly to meet the market, typically the prime interest rate plus one percent. Because the interest rate charged on these loans floats with the market, this helps the Company in managing its interest rate risk. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction lending is attributable to loan funds being advanced upon the security of the land or home under construction, which value is estimated prior to the completion of construction. Thus, it is more difficult to evaluate accurately funds required to complete a project and related loan-to-value ratios. To mitigate the risks associated with construction lending, the Company generally limits loan amounts to 75% to 85% of appraised value, in addition to analyzing the creditworthiness of its borrowers. The Company also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrowing entity’s principal owners.
Commercial Business Loans
Commercial business loans generally have a higher degree of risk than residential mortgage loans, but have higher yields. To manage these risks, the Company generally obtains appropriate collateral and personal guarantees from the borrowing entity’s principal owners and monitors the financial condition of its business borrowers. Commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.
Commercial Real Estate Lending
Commercial real estate loans are secured by various types of commercial real estate in the Company's market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches.
In its underwriting of commercial real estate, the Company may lend, in accordance with internal policy, up to 80% of the secured property’s appraised value. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy. The Company's commercial real estate loan underwriting criteria require an examination of debt service coverage ratios and the borrower’s creditworthiness, prior credit history and reputation. The Company also evaluates the location of the security property and typically requires personal guarantees or endorsements of the borrowing entity’s principal owners.
1 - 4 Family Residential Real Estate Lending
Residential lending activity may be generated by loan originator solicitation, referrals by real estate professionals, existing or new clients and purchases of whole loans from Southern Trust Mortgage. As part of the loan application process, information is gathered concerning income, employment and credit history of the applicant. Loan originations are underwritten using Middleburg Bank’s underwriting guidelines. Security for the majority of residential lending is in the form of owner occupied 1-4 family dwellings. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Company's Board of Directors. In connection with residential real estate loans, the Company requires title insurance, hazard insurance and if required, flood insurance. Flood determination letters with life of loan tracking are obtained on all federally related transactions with improvements serving as security for the transaction.
Consumer Lending
The Company offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans. The Company currently originates all of its consumer loans in its geographic market area. Most of the consumer loans are tied to the prime lending rate and reprice monthly.
Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. Consumer loan delinquencies often increase over time as the loans age.
The underwriting standards for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of the applicant's ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.
Supervision and Regulation
General
As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Middleburg Bank is subject to regulation, supervision and examination by the Virginia State Corporation Commission’s Bureau of Financial Institutions. It is also subject to regulation, supervision and examination by the Federal Reserve Board. Other federal and state laws, including various consumer and compliance laws, govern the activities of Middleburg Bank, the investments that it makes and the aggregate amount of loans that it may grant to one borrower.
The following description summarizes the significant federal and state laws applicable to the Company and its subsidiaries. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.
The Bank Holding Company Act
Under the Bank Holding Company Act, the Company is subject to periodic examination by the Federal Reserve and is required to file periodic reports regarding its operations and any additional information that the Federal Reserve may require. Activities at the bank holding company level are limited to:
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banking, managing or controlling banks;
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furnishing services to or performing services for its subsidiaries; and
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engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.
Some of the activities that the Federal Reserve Board has determined by regulation to be proper incidents to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary, investment, or financial adviser.
With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:
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acquiring substantially all the assets of any bank;
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acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or
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merging or consolidating with another bank holding company.
In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring 25% or more of any class of voting securities of a bank or bank holding company. Prior notice to the Federal Reserve is required if a person acquires 10% or more, but less than 25%, of any class of voting securities of a bank or bank holding company and either the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or no other person owns a greater percentage of that class of voting securities immediately after the transaction.
Payment of Dividends
The Company is a legal entity separate and distinct from its banking and non-banking subsidiaries. The majority of the Company’s revenues are from dividends paid to the Company by its subsidiaries. Middleburg Bank is subject to laws and regulations that limit the amount of dividends it can pay. In addition, both the Company and Middleburg Bank are subject to various regulatory restrictions relating to the payment of dividends, including requirements to maintain capital at or above regulatory minimums. Banking regulators have indicated that banking organizations should generally pay dividends only if the organization’s net income available to common shareholders is sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. The Company does not expect that any of these laws, regulations or policies will materially affect the ability of Middleburg Bank to pay dividends. During the year ended December 31, 2013, Middleburg Bank and Middleburg Investment Group paid $1.9 million and $750,000 respectively in dividends to the Company.
The FDIC has the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. The FDIC has indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.
Insurance of Accounts, Assessments and Regulation by the FDIC
The deposits of Middleburg Bank are insured by the FDIC up to the limits set forth under applicable law. The deposits of Middleburg Bank are subject to the deposit insurance assessments of the Deposit Insurance Fund (“DIF”) of the FDIC.
The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations. In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks. Beginning April 1, 2011, an institution’s assessment base became consolidated total assets less its average tangible equity as defined by the FDIC. The FDIC has authority to impose special assessments from time to time.
The FDIC is authorized to prohibit any DIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund. Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. The Company is not aware of any existing circumstances that could result in termination of any of Middleburg Bank’s deposit insurance.
Capital Requirements
The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises. Under the risk-based capital requirements, the Company and Middleburg Bank are each generally required to maintain a minimum ratio of total risk-based capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total risk-based capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles and ineligible deferred tax assets. The remainder may consist of “Tier 2 Capital,” which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the allowance for loan losses. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets
equal to 4%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness. Capital measures used by the federal banking regulators are:
•the Total Capital ratio, which includes Tier 1 Capital and Tier 2 Capital;
•the Tier 1 Capital ratio; and
•the leverage ratio.
Under these regulations, a bank will be:
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“well capitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1 Capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal banking regulatory agency to meet and maintain a specific capital level for any capital measure;
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“adequately capitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1 Capital ratio of 4% or greater, and a leverage ratio of 4% or greater or 3% in certain circumstances and is not well capitalized;
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“undercapitalized” if it has a Total Capital ratio of less than 8%, a Tier 1 Capital ratio of less than 4% or 3% in certain circumstances;
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“significantly undercapitalized” if it has a Total Capital ratio of less than 6%, a Tier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%; or
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“critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets.
The risk-based capital standards of the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.
The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers. The Company and Middleburg Bank presently maintain sufficient capital to remain in compliance with these capital requirements.
Basel III Capital Rules
The final Basel III capital rules ("Basel III") require banks to maintain a minimum ratio of Tier 1 capital to risk weighted assets of at least 6.0%, plus a capital conservation buffer of 2.5% effectively resulting in Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Institutions that do not maintain the required capital buffer would be subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. Basel III also introduces a non-risk adjusted Tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity standards.
The capital rules also introduce new methodologies for determining risk-weighted assets, including higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. The implementation date of the final rule is January 1, 2015, and the changes set forth in the final rules will be phased in from January 1, 2015 through January 1, 2019.
Other Safety and Soundness Regulations
There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent. For example, under the requirements of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the insolvency of commonly controlled insured depository institutions or for any assistance provided by the FDIC to commonly controlled insured depository institutions in danger of failure. The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in the best interests of the deposit insurance
funds. The FDIC’s claim for reimbursement under the cross guarantee provisions is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and nonaffiliated holders of subordinated debt of the commonly controlled insured depository institutions.
Monetary Policy
The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against deposits held by all federally insured banks. The Federal Reserve Board’s monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary fiscal authorities, including the Federal Reserve Board, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand of Middleburg Bank or the business and earnings of the Company.
Federal Reserve System
In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits. NOW accounts, money market deposit accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements, as are any non-personal time deposits at an institution. For net transaction accounts in 2014, the first $13.3 million will be exempt from reserve requirements. A 3% reserve ratio will be assessed on net transaction accounts over $13.3 million up to and including $89.0 million, compared to over $12.2 million up to and including $67.1million in 2013. A 10% reserve ratio will be applied above $89.0 million in 2014, compared to above $67.1 million in 2013. These percentages are subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets.
Transactions with Affiliates
Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank. Generally, Sections 23A and 23B:
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limit the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus; and
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require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a non-affiliate.
The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.
Transactions with Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100 million, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.
Community Reinvestment Act
Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practices. The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institution’s Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiaries.
The Gramm-Leach-Bliley Act and federal bank regulators have made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulator. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a “satisfactory” rating in its latest Community Reinvestment Act examination.
Fair Lending; Consumer Laws
In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.
Gramm-Leach-Bliley Act of 1999
The GLBA covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA permits unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, a bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law. Under the new law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the SEC for securities affiliates, and state insurance regulators for insurance affiliates. It repeals the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Exchange Act, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a “dealer.” Additionally, the new law makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the Act.
Bank Secrecy Act
Under the Bank Secrecy Act, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, the transactions involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution’s compliance with the BSA when reviewing applications from a financial institution. As part of its BSA program, the USA PATRIOT Act also requires a financial institution to follow customer identification procedures when opening accounts for new customers and to review lists of individuals who and entities which are prohibited from opening accounts at financial institutions.
Dodd-Frank Act
In July 2010, the Dodd-Frank Act was signed into law, incorporating numerous financial institution regulatory reforms. The Dodd-Frank Act implements far-reaching reforms of major elements of the financial landscape, particularly for larger financial institutions. Many of its provisions do not directly impact community-based institutions like the Bank. Provisions that could impact the Bank include the following:
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FDIC Assessments. The Act changes the assessment base for federal deposit insurance from the amount of insured deposits to average consolidated total assets less its average tangible equity. In addition, it increases the minimum size of the Deposit Insurance Fund (“DIF”) and eliminates its ceiling, with the burden of the increase in the minimum size on institutions with more than $10 billion in assets.
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Deposit Insurance. The Act makes permanent the $250,000 limit for federal deposit insurance and provided unlimited federal deposit insurance until December 31, 2012 for non-interest-bearing demand transaction accounts.
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Interest on Demand Deposits. The Act also provides that, effective one year after the date of enactment, depository institutions may pay interest on demand deposits, including business transaction and other accounts.
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Interchange Fees. The Act requires the Federal Reserve to set a cap on debit card interchange fees charged to retailers. The Federal Reserve implemented these regulations in 2011. While banks with less than $10 billion in assets, such as the Bank, are exempted from this measure, it is likely that all banks could be forced by market pressures to lower their interchange fees or face potential rejection of their cards by retailers.
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Capital Adequacy The Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which may result in more stringent capital requirements. Under the Collins Amendment to the Dodd-Frank Act, federal regulators have been directed to establish minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis. These minimum requirements cannot be less than the generally applicable leverage and risk-based capital requirements established for insured depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of July 21, 2010. These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions. The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets. Trust preferred securities
issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013. Accordingly, the Company's trust preferred securities will continue to qualify as Tier 1 Capital.
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De Novo Interstate Branching. National and state banks are permitted to establish de novo interstate branches outside of their home state. Bank holding companies and banks must be well-capitalized and well managed in order to acquire banks located outside their home state.
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Transactions with Affiliates. The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.
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Transactions with Insiders. Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors. The Act also provides that banks may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (i) the transaction is conducted on market terms between the parties, and (ii) if the proposed transaction represents more than 10% of the capital stock and surplus of the bank, it has been approved in advance by a majority of the bank’s non-interested directors.
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Corporate Governance. The Act includes corporate governance revisions that apply to all public companies, not just financial institutions, including with regard to executive compensation and proxy access to shareholders.
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Consumer Financial Protection Bureau. The Act created a new, independent federal agency, the Consumer Financial Protection Bureau (“CFPB”) having broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions, including the Bank, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes.
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Derivative transactions. The Act and regulations may limit or place significant burdens and compliance and other costs on arranging and participating in certain types of swap and derivate transactions, including requirements for central clearing, exchange trading and transaction reporting for swaps and derivate transactions and new margin requirements for uncleared swaps. Provisions that regulate derivative transactions and limit derivatives trading activity of federally-insured institutions, enhance supervision of “systemically significant” institutions, impose new regulatory authority over hedge funds, limit proprietary trading by banks, and phase-out the eligibility of trust preferred securities for Tier 1 capital are among the provisions that do not directly impact the Bank either because of exemptions for institutions below a certain asset size or because of the nature of the Bank’s operations.
Many aspects of the Dodd-Frank Act are subject to continued rulemaking by various federal banking and securities regulatory agencies and will take effect over several years, and their impact on the Company or the financial industry is difficult to predict before such regulations are adopted.
Mortgage Lending
In 2013, the CFPB adopted a rule, effective in January 2014, to implement certain sections of the Dodd-Frank Act requiring creditors to make a reasonable, good faith determination of a consumer’s ability to repay any closed-end consumer credit transaction secured by a 1-4 family dwelling. The rule also establishes certain protections from liability under this requirement to ensure a borrower’s ability to repay for loans that meet the definition of “qualified mortgage.” Loans that satisfy this “qualified mortgage” safe harbor will be presumed to have complied with the new ability-to-repay standard.
Volcker Rule
On December 10, 2013, five financial regulatory agencies, including the Board of Governors of the Federal Reserve System, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and the Securities and Exchange Commission, adopted final rules implementing a provision of the Dodd-Frank Act, commonly referred to as the Volcker Rule. The final rules generally would prohibit banking entities from:
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engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account;
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owning, sponsoring, or having certain relationships with hedge funds or private equity funds, referred to as “covered funds”.
On January 14, 2014, the five financial regulatory agencies, approved an adjustment to the final rule by allowing banks to keep certain collateralized debt obligations (“CDOs”) acquired by the bank before the Volcker Rule was finalized, if the CDO was established before May 2010 and is backed primarily by trust preferred securities issued by banks with less than $15 billion in assets. The final rules are effective April 1, 2014; however, the Federal Reserve Board has extended the conformance period until July 21, 2015. It is uncertain at this time of the full impact of the Volcker Rule on the Company; however, should it be determined that any of its portfolio would be considered covered funds, we will take the appropriate corrective actions in order to be in full compliance with the final rule.
Future Regulatory Uncertainty
Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, the Company cannot forecast how federal regulation of financial institutions may change in the future and impact its operations. Although Congress, in recent years, has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, the Company fully expects that the financial institution industry will remain heavily regulated in the near future and additional laws or regulations may be adopted further regulating specific banking practices.
Middleburg Trust Company
Middleburg Trust Company is subject to supervision and regulation by the Virginia State Corporation Commission’s Bureau of Financial Institutions and the Federal Reserve Board.
State and federal regulators have substantial discretion and latitude in the exercise of their supervisory and regulatory authority over Middleburg Trust Company, including the statutory authority to promulgate regulations affecting the conduct of its business and operations of Middleburg Trust Company. They also have the ability to exercise substantial remedial powers with respect to Middleburg Trust Company in the event that it determines that Middleburg Trust Company is not in compliance with applicable laws, orders or regulations governing its operations, is operating in an unsafe or unsound manner, or is engaging in any irregular practices.
ITEM 1A.
ITEM 1A.
RISK FACTORS
The Company is subject to various risks, including the risks described below. The Company’s (“We” or “Our”) operations, financial condition, performance and, the market value of our securities could be materially adversely affected by any of these risks or additional risks not presently known or risks that we currently deem immaterial.
We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.
A key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:
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open new financial service centers;
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attract deposits to those locations; and
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identify attractive loan and investment opportunities.
We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future. Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth, maintain cost controls and asset quality and successfully integrate any new financial service centers into our organization.
As we continue to implement our growth strategy by opening new financial service centers, we expect to incur construction costs and increased personnel, occupancy and other operating expenses. We generally must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, our plans to grow could depress our earnings in the short run, even if we efficiently execute this growth.
Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.
Our banking subsidiary faces vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market
area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. Our non-banking subsidiary faces competition from money managers and investment brokerage firms.
To a limited extent, our banking subsidiary also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.
Revenue from our mortgage lending segment is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates, the competitive and regulatory environment or new legislation and may adversely impact our profits.
Changes in our revenue stream from Southern Trust Mortgage is dependent upon our ability to originate loans and sell them to investors. Loan production levels are sensitive to changes in economic conditions and can suffer from decreased economic activity, a slowdown in the housing market, higher interest rates and decreased refinancing activity. Generally, any sustained period of decreased economic activity or higher interest rates could adversely affect Southern Trust Mortgage’s mortgage originations and, consequently, reduce its income from mortgage lending activities. In addition, changes to the competitive or regulatory environment or new legislation, including legislation that would require Southern Trust Mortgage to retain 5% of the credit risk of securitized exposures, could adversely affect its operations.
In light of declining profitability in the mortgage business and increasing regulatory burdens, we have reduced the carrying value of our equity investment in Southern Trust Mortgage by recording a goodwill impairment of $500,000. This reduced our after tax net income in the fourth quarter of 2013 by $330,000. We may record additional impairment in the future should market conditions continue to deteriorate.
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain cases where Southern Trust Mortgage has originated loans and sold them to investors, it may be required to repurchase loans or provide a financial settlement to investors if it is proved that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would also adversely affect our net income.
Proposed and final regulations could restrict our ability to originate loans.
Pursuant to the Dodd-Frank Act, the CFPB issued a final rule effective January 10, 2014, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms, or to originate “qualified mortgages” that meet specific requirements with respect to terms, pricing and fees. The new rule also contains new disclosure requirements at mortgage loan origination and in monthly statements. These requirements will likely require significant personnel resources and could have a material adverse effect on our operations.
We may incur losses if we are unable to successfully manage interest rate risk.
Our profitability will depend upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, the volume of loan originations in our mortgage banking business and the value we can recognize on the sale of mortgage and home equity loans in the secondary market. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Based on our asset/liability position at December 31, 2013, a rise in interest rates would increase our net interest income slightly in the short term. Our net interest spread will depend on many factors that are partly or entirely outside of our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.
For mortgage banking activities, we manage the majority of our interest rate risk by locking in the interest rate for each mortgage loan with our correspondents (investors) and borrowers at the same time, which is a “best efforts” delivery process. In 2012, we changed the delivery process on a portion of our mortgage loans to incorporate a “mandatory delivery” process. Under mandatory delivery the interest rate risk associated with a rate lock on a mortgage loan shifts from the investor back to the Company. We will hedge the portion of the mortgage loans that are committed to mandatory delivery. However, to the extent we adopt the mandatory
delivery process and interest rates are volatile, the Company's interest income could be adversely impacted if the interest rate hedges do not function as expected. In 2014, we will continue to hedge mortgage loans that are committed to mandatory delivery.
New regulations could adversely impact our earnings due to, among other things, increased compliance costs or costs due to noncompliance.
The Consumer Financial Protection Bureau has issued a rule, effective as of January 14, 2014, designed to clarify for lenders how they can avoid monetary damages under the Dodd-Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that satisfy this “qualified mortgage” safe-harbor will be presumed to have complied with the new ability-to-repay standard. Under the Consumer Financial Protection Bureau’s rule, a “qualified mortgage” loan must not contain certain specified features, including but not limited to:
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excessive upfront points and fees (those exceeding 3% of the total loan amount, less “bona fide discount points” for prime loans);
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interest-only payments;
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negative-amortization; and
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terms longer than 30 years.
Also, to qualify as a “qualified mortgage,” a borrower’s total monthly debt-to-income ratio may not exceed 43%. Lenders must also verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the loan based on a fully amortizing payment schedule and maximum interest rate during the first five years, taking into account all applicable taxes, insurance and assessments. The Consumer Financial Protection Bureau’s rule on qualified mortgages could limit our ability or desire to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could adversely impact our growth or profitability.
Additionally, on December 10, 2013, five financial regulatory agencies, including our primary federal regulator, the Federal Reserve, adopted final rules (the “Final Rules”) implementing the so-called Volcker Rule embodied in Section 13 of the Bank Holding Company Act, which was added by Section 619 of the Dodd-Frank Act. The Final Rules prohibit banking entities from, among other things, (1) engaging in short-term proprietary trading for their own accounts, and (2) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). The Final Rules are intended to provide greater clarity with respect to both the extent of those primary prohibitions and of the related exemptions and exclusions. The Final Rules also require each regulated entity to establish an internal compliance program that is consistent with the extent to which it engages in activities covered by the Volcker Rule, which must include (for the largest entities) making regular reports about those activities to regulators. Community banks, such as Middleburg Bank, have been afforded some relief under the final rules. If such banks are engaged only in exempted proprietary trading, such as trading in U.S. government, agency, state and municipal obligations, they are exempt entirely from compliance program requirements. Moreover, even if a community bank engages in proprietary trading or covered fund activities under the rule, they need only incorporate references to the Volcker Rule into their existing policies and procedures. The Final Rules are effective April 1, 2014, but the conformance period has been extended from its statutory end date of July 21, 2014 until July 21, 2015. We are currently evaluating the Final Rules; if we are required to divest any securities in our portfolio as a result of the Volcker Rule, it could result in impairments that could adversely impact our financial condition and results of operations.
Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. A major change in the real estate market, such as deterioration in the value of collateral, or in the local or national economy, could adversely affect our clients’ ability to repay these loans, which in turn could negatively impact us. While we are in one of the fastest growing real estate markets in the United States, risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
We may be adversely affected by further deterioration of economic conditions in our market area.
Our banking operations are located primarily in the Virginia counties of Loudoun, Fairfax, Fauquier and Prince William and also in the Town of Williamsburg and the City of Richmond. Because our lending is concentrated in this market, we will be affected by the general economic conditions in these areas. Changes in the economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing. A further decline in general economic conditions caused
by inflation, recession, unemployment or other factors beyond our control would impact the demand for banking products and services generally, which could negatively affect our financial condition and performance.
A loss of our senior officers could impair our relationship with our customers and adversely affect our business.
Many community banks attract customers based on the personal relationships that the banks’ officers and customers establish with each other and the confidence that the customers have in the officers. We depend on the performance of our senior officers. These officers have many years of experience in the banking industry and have numerous contacts in our market area. The loss of the services of any of our senior officers, or the failure of any of them to perform management functions in the manner anticipated by our board of directors, could have a material adverse effect on our business. Our success will be dependent upon the board’s ability to attract and retain quality personnel, including these individuals. We do not carry key man life insurance on our senior officers.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth. We anticipate that we will be able to support this growth through the generation of additional deposits at new branch locations as well as investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain our capital levels. Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.
Our profitability and the value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.
We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Some of these regulations may increase our costs and thus place other financial institutions that are not subject to similar regulation in stronger, more favorable competitive positions.
Banking regulators have broad enforcement power, but regulations are meant to protect depositors, and not investors.
Bank regulations, and the interpretation and application of them by regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence earnings and growth. In addition, these regulations may limit the Company’s growth and the return to investors by restricting activities such as the payment of dividends, mergers with, or acquisitions by, other institutions, investments, loans and interest rates, interest rates paid on depositors and the creation of financial service centers. Information on the regulations that impact the Company are included in Item 1., “Business - Supervision and Regulation”. Although these regulations impose costs on the Company, they are intended to protect depositors, and should not be assumed to protect the interest of shareholders. The regulations to which we are subject may not always be in the best interest of investors.
Trading in our common stock has been sporadic and volume has been light. As a result, shareholders may not be able to quickly and easily sell their common stock.
Although our common stock trades on the Nasdaq Capital Market and a number of brokers offer to make a market in common stock on a regular basis, trading volume to date has been limited and there can be no assurance that an active and liquid market for the common stock will develop.
Our directors and officers have significant voting power.
Our directors and executive officers beneficially own 5.37% of our common stock and may purchase additional shares of our common stock by exercising vested stock options. By voting against a proposal submitted to shareholders, the directors and officers may be able to make approval more difficult for proposals requiring the vote of shareholders such as mergers, share exchanges, asset sales and amendment to the Company’s articles of incorporation.
An inadequate allowance for loan losses would reduce our earnings.
Our earnings are significantly affected by our ability to properly originate, underwrite and service loans. We maintain an allowance for loan losses based upon many factors, including the following:
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actual loan loss history;
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volume, growth, and composition of the loan portfolio;
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the amount of non-performing loans and the value of their related collateral;
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the effect of changes in the local real estate market on collateral values;
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the effect of current economic conditions on a borrower’s ability to pay; and
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other factors deemed relevant by management.
These determinations are based upon estimates that are inherently subjective, and their accuracy depends on the outcome of future events; therefore, realized losses may differ from current estimates. Changes in economic, operating, and other conditions, including changes in interest rates, which are generally beyond our control, could increase actual loan losses significantly. As a result, actual losses could exceed our current allowance estimate. We cannot provide assurance that our allowance for loan losses is sufficient to cover actual loan losses should such losses differ significantly from the current estimates.
In addition, there can be no assurance that our methodology for assessing our asset quality will succeed in properly identifying impaired loans or calculating an appropriate loan loss allowance. We could sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to deterioration in asset quality in a timely manner. If our assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if bank regulatory authorities require us to increase the allowance for loan losses as a part of their examination process, our earnings and capital could be significantly and adversely affected.
Difficult market conditions have adversely affected our industry.
Dramatic declines in the housing market, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values by financial institutions. These write-downs have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Government measures to regulate the financial industry, including the Dodd-Frank Act, subject us to increased regulation and could aversely affect us.
As a financial institution, we are heavily regulated at the state and federal levels. As a result of the financial crisis and related global economic downturn that began in 2007, we have faced, and expect to continue to face, increased public and legislative scrutiny as well as stricter and more comprehensive regulation of our financial services practices. The Dodd-Frank Act includes significant changes in the financial regulatory landscape and will impact all financial institutions, including the Company and the Bank. Many of the provisions of the Dodd-Frank Act have begun to be or will be implemented over the next several years and
will be subject both to further rulemaking and the discretion of applicable regulatory bodies. Because the ultimate impact of the Dodd-Frank Act will depend on future regulatory rulemaking and interpretation, we cannot predict the full effect of this legislation on our businesses, financial condition or results of operations. Among other things, the Dodd-Frank Act and the regulations implemented thereunder could limit debit card interchange fees, restrict ownership of covered funds, increase FDIC assessments, impose new requirements on mortgage lending, and establish more stringent capital requirements on bank holding companies. As a result of these and other provisions in the Dodd-Frank Act, we could experience additional costs, restrictions on allowable investments, as well as limitations on the products and services we offer and on our ability to efficiently pursue business opportunities, which may adversely affect our businesses, financial condition or results of operations.
The Basel III capital framework will require higher levels of capital and liquid assets, which could adversely affect the Company's net income and return on equity.
The Basel III capital framework represents the most comprehensive overhaul of the U.S. banking capital framework in over two decades. This new capital framework and related changes to the standardized calculations of risk-weighted assets are complex and create additional compliance burdens, especially for community banks. The Basel III Capital Rules require bank holding companies and their subsidiaries, to maintain significantly more capital as a result of higher required capital levels and more demanding regulatory capital risk weightings and calculations. As a result of the Basel III Capital Rules, many community banks could be forced to limit banking operations and activities, and growth of loan portfolios, in order to focus on retention of earnings to improve capital levels. The Company believes that it maintains sufficient levels of Tier 1 and Common Equity Tier 1 capital to comply with the Basel III Final Rules, as currently scheduled to be effective and implemented. However, the Company can offer no assurances with regard to the ultimate effect of the Basel III Capital Rules, and satisfying increased capital requirements imposed by the Basel III Capital Rules may require the Company to limit its banking operations, retain net income or reduce dividends to improve regulatory capital levels, which could negatively affect our business, financial condition and results of operations.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient capital in the Company and in our subsidiaries. The ability of our bank subsidiary to pay dividends to us is limited by the bank’s obligations to maintain sufficient capital, earnings and liquidity and by other general restrictions on their dividends under federal and state bank regulatory requirements. In September 2013, we increased the dividend to $0.07 per share from $0.05 per share. We cannot be certain as to when, if ever, the dividend may be increased further, nor can we be certain that future reductions of the dividend will not be made.
In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Board of Governors of the Federal Reserve System, or the Federal Reserve, regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) on our financial condition. These guidelines also require that we review our net income for the current and past four quarters, and the level of dividends on common stock and other Tier 1 Capital instruments for those periods, as well as our projected rate of earnings retention.
Under the Federal Reserve’s policy, the board of directors of a bank holding company should also consider different factors to ensure that its dividend level is prudent relative to the organization’s financial position and is not based on overly optimistic earnings scenarios such as any potential events that may occur before the payment date that could affect its ability to pay while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce the bank holding company’s dividends if: (i) its net income available to shareholders for the current period is not sufficient to fully fund the dividends; (ii) its prospective rate of earnings retention is not consistent with the its capital needs and overall current and prospective financial condition; or (iii) it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. If we do not satisfy these regulatory requirements or the Federal Reserve’s policies, we will be unable to pay dividends on our common stock.
In July 2013 the Federal Reserve issued the final Basel III capital rules, which apply to all banks. The rules require us to maintain a capital conservation buffer above well capitalized capital levels. If we fail to maintain the capital conservation buffer, we may be subject to restrictions on payment of dividends.
Further, we cannot pay any dividends on the common stock, or acquire any shares of common stock, if any distributions on our trust preferred securities are in arrears.
Increases in FDIC insurance premiums may cause our earnings to decrease.
The limit on FDIC coverage has been increased to $250,000 for all accounts. In addition, the costs associated with bank resolutions or failures have substantially depleted the DIF. As a result, the FDIC has implemented a new methodology by which it will assess premium amounts. The FDIC adopted a final rule in 2011, to change the FDIC’s assessment rates as well as providing that the assessment base will be the institution’s average consolidated total assets less its average tangible equity. Although the burden of replenishing the DIF will be placed primarily on institutions with assets greater than $10 billion, we expect higher annual deposit insurance assessments than we historically incurred before the financial crisis began several years ago. Any future increases in required deposit insurance premiums or special assessments could have a significant adverse impact on our financial condition and results of operations.
The Company’s operations may be adversely affected by cyber security risks.
In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information of its customers and employees in systems and on networks. The secure processing, maintenance and use of this information is critical to operations and the Company’s business strategy. The Company has invested in accepted technologies, and continually reviews processes and practices that are designed to protect its networks, computers and data from damage or unauthorized access. Despite these security measures, the Company’s computer systems and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. A breach of any kind could compromise systems and the information stored there could be accessed, damaged or disclosed. A breach in security could result in legal claims, regulatory penalties, disruption in operations, and damage to the Company’s reputation, which could adversely affect our business.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
The Company’s corporate headquarters, and that of Middleburg Bank, is located at 111 West Washington Street, Middleburg, Virginia, 20117. The Company’s subsidiaries own or lease various other offices in the counties and municipalities in which they operate. At December 31, 2013, Middleburg Bank operated 12 branches in the Virginia communities of Ashburn, Gainesville, Leesburg, Marshall, Middleburg, Purcellville, Reston, Richmond, Warrenton and Williamsburg. All of the offices of Middleburg Trust Company and Southern Trust Mortgage are leased. Additionally, Middleburg Bank owns an operations center building located at 106 Catoctin Circle, SE, Leesburg, Virginia 20175. See Note 1 “Nature of Banking Activities and Significant Accounting Policies” and Note 5 “Premises and Equipment, Net” in the “Notes to the Consolidated Financial Statements” of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.
All of the Company’s properties are well maintained, are in good operating condition and are adequate for the Company’s present and anticipated future needs.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Shares of the Company’s Common Stock trade on the Nasdaq Capital Market under the symbol “MBRG.” The high and low sale prices per share for the Company’s Common Stock for each quarter of 2013 and 2012, and the amount of cash dividends per share in each quarter, are set forth in the table below.
Market Price and Dividends
As of March 5, 2014, the Company had approximately 436 shareholders of record and approximately 2,333 additional beneficial owners of shares of Common Stock.
The Company historically has paid cash dividends on a quarterly basis. The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiaries, principally Middleburg Bank, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies as discussed above in Item 1. “Business - Supervision and Regulation - Payment of Dividends”.
The Company did not repurchase any shares of Common Stock during the fourth quarter of 2013. On June 16, 1999, the Company adopted a repurchase plan, which authorized management to purchase up to $5 million of the Company’s common stock from time to time. Subsequently, the plan was amended to authorize management to purchase up to 100,000 shares and to eliminate the $5 million limit. As of March 5, 2014, the Company has 24,084 shares eligible for repurchase under the plan.
The following graph compares the cumulative total return to the shareholders of the Company for the last five fiscal years with the total return on the NASDAQ Composite Index and the SNL $1B-$5B Bank Index as reported by SNL Financial LC, assuming an investment of $100 in shares of Common Stock on December 31, 2008 and the reinvestment of dividends.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following consolidated summary sets forth the Company’s selected financial data that has been derived from the Company's audited financial statements for each of the periods and at the dates indicated.
(1)
The ratio is calculated by dividing non-interest expense (adjusted for amortization of intangibles, other real estate expenses, and non-recurring one-time charges) by the sum of tax equivalent net interest income and non-interest income excluding gains and losses on the investment portfolio.
(2)
Tangible book value is computed by subtracting identified intangible assets and goodwill from total Middleburg Financial Corporation shareholders’ equity and then dividing the result by the number of shares of common stock issued and outstanding at the end of the accounting period.
ITEM 7.
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITON AND RESULTS OF OPERATIONS
The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of the Company. This discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and Notes to Consolidated Financial Statements. It should also be read in conjunction with the “Caution About Forward Looking Statements” section at the end of this discussion.
Overview
The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc. and a majority owned subsidiary, Southern Trust Mortgage, LLC. Middleburg Bank is a community bank serving the Virginia counties of Prince William, Loudoun, Fairfax, Fauquier, the Town of Williamsburg and the City of Richmond with twelve financial service centers and one limited service facility. Middleburg Investment Group is a non-bank holding company with one wholly owned subsidiary, Middleburg Trust Company. Middleburg Trust Company is a trust company headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank’s facilities. Southern Trust Mortgage is a regional mortgage company headquartered in Virginia Beach, Virginia and maintains offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.
The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. Middleburg Bank’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses or potential other-than-temporary impairment of securities. Middleburg Investment Group’s subsidiary, Middleburg Trust Company, generates fee income by providing investment management and trust services to its clients. Investment management and trust fees are generally based upon the value of assets under management, and, therefore can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets. Southern Trust Mortgage generates fees from the origination and sale of mortgages loans. Southern Trust Mortgage also maintains a real estate construction portfolio and receives interest and fee income from these loans, which, net of interest expense, is included in net interest income.
At December 31, 2013, total assets were $1.2 billion, a decrease of 0.73% or $9.0 million compared to December 31, 2012. Total gross loans increased $19.0 million from $709.5 million at December 31, 2012 to $728.5 million at December 31, 2013. Total deposits increased $496,000 or 0.05% to $982.4 million at December 31, 2013 from $981.9 million at December 31, 2012. Lower cost deposits, including demand checking, interest checking and savings increased $24.6 million or 3.6% from December 31, 2012 to $714.5 million at December 31, 2013. Higher cost time deposits decreased 8.2% or $24.1 million from December 31, 2012 to $267.9 million at December 31, 2013. The net interest margin, a non-GAAP measure more fully described in the “Results of Operations” section below, decreased from 3.47% for the year ended December 31, 2012 to 3.40% for the year ended December 31, 2013. The decrease is primarily attributed to the 28 basis point decrease, on a tax equivalent basis, in the yield on total earning assets, offset by the 23 basis point decrease in the cost of total interest bearing liabilities. The provision for loan losses decreased by $3.3 million for the year ended December 31, 2013 to $109,000 compared to $3.4 million for the same period in 2012. Total non-interest income decreased by $4.9 million for the year ended December 31, 2013, compared to 2012. The decrease is largely due to the decline in gains on the sale of loans by the Company’s mortgage banking subsidiary, Southern Trust Mortgage. Non-interest expense in 2013 decreased $218,000 from 2012. The Company remains well capitalized as evidenced by all regulatory capital ratios exceeding the regulatory minimums.
The Company is not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on the registrant’s liquidity, capital resources or results of operations.
Critical Accounting Policies
General
The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to some degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.
Presented below is discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of Middleburg Financial Corporation’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.
Allowance for Loan Losses
Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.
Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting standards. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, troubled debt restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics.
For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.
The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans losses. This estimate of losses is compared to the allowance for loan losses of Middleburg Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the consolidated financial statements.
Goodwill and Intangibles
With the adoption of Accounting Standards Update 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment", the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, we determine that it is more likely than not that the fair value of each applicable reporting unit is less than its carrying amount. If the likelihood of impairment is more than 50%, the Company must perform a test for impairment and may be required to record impairment charges. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit is greater than zero and its fair value exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; thus, the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is recognized.
Management estimates fair value utilizing multiple methodologies which include discounted cash flows, comparable companies, third-party sale and assets under management analysis. Determining the fair value of the Company’s reporting units requires management to make judgments and assumptions related to various items, including estimates of future operating results, allocations of indirect expenses, and discount rates. Management believes its estimates and assumptions are reasonable; however, the fair value of each reporting unit could be different in the future if actual results or market conditions differ from the estimates and assumptions used.
The Company’s forecasted cash flows for its reporting units assume a stable economic environment and consistent long-term growth in loan originations and assets under management over the projected periods. Additionally, expenses are assumed to be consistently correlated with projected asset and revenue growth over the time periods projected. Although we believe the key assumptions underlying the financial forecasts to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond the control of the Company. Accordingly, there can be no assurance that the forecasted results will be realized and variations from the forecast may be material. If weak economic conditions continue or worsen for a prolonged period of time, or if the reporting unit loses key personnel, the fair value of the reporting unit may be adversely affected which may result in impairment of goodwill or other intangible assets in the future. Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company’s financial condition and results of operations.
Middleburg Investment Group has intangible assets in the form of certain customer relationships that were acquired in 2002. We amortize those intangible assets on a straight line basis over their estimated useful life.
Other-Than-Temporary Impairment (OTTI) for Securities
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.
Results of Operations
The Company had net income for 2013 of $6.2 million, a decrease of $332,000 or 5.1% from 2012. For 2013, the earnings per diluted share was $0.87 compared to earnings per diluted share of $0.92 for 2012.
Return on average assets (“ROA”) measures how effectively the Company employs its assets to produce net income. The ROA for the Company was 0.51%, 0.54% and 0.44% for the years ended December 31, 2013, 2012 and 2011, respectively. Return on average equity (“ROE”), another measure of earnings performance, indicates the amount of net income earned in relation to the total average equity capital invested. ROE was 5.4%, 5.9% and 4.9% for the years ended December 31, 2013, 2012 and 2011, respectively.
The following table reflects an analysis of the Company’s net interest income using the daily average balances of the Company’s assets and liabilities as of December 31.
(1)
Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%.
(2)
All yields and rates have been annualized on a 365 day year for 2013 and 2011 and a 366 day year for 2012.
(3)
Total average loans include loans on non-accrual status.
Net Interest Income
Net interest income represents the principal source of earnings of the Company. Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets. Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.
Net interest income was $37.7 million for the year ended December 31, 2013. This is a decrease of 1.3% and 0.63% over net interest income of $38.2 million and $37.9 million reported for 2012 and 2011, respectively. The net interest margin of 3.40% for 2013 decreased 7 basis points compared to 3.47% for 2012 and decreased 32 basis points compared to 3.72% for 2011. The net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. The tax rate utilized in calculating the tax benefit for each of the reported periods is 34%. The reconciliation of tax equivalent net interest income, which is not a measurement under accounting principles generally accepted in the United States, to net interest income is reflected in the table below.
The decrease in net interest income for 2013 compared to 2012 and 2011 primarily resulted from lower interest income as a result of declining yields on loans and securities. This decrease was partially offset by a reduction in funding costs. Interest income and fees from loans and investments decreased 5.9% and 9.0% compared to 2012 and 2011, respectively. The cost of interest bearing liabilities in 2013 decreased to 0.72%, a decline of 23 basis points and 49 basis points relative to 2012 and 2011, respectively.
The yield on the loan portfolio decreased 35 basis points for 2013 to 4.66% compared to 5.01% for 2012 and decreased 81 basis points compared to 5.47% for 2011 as a result of lower yields on newly originated loans as well as a reduction in rates for existing loans that the Company refinanced. On average, the loan portfolio increased $667,000 or 0.09% from the year ended December 31, 2012 and increased $36.0 million or 5.0% compared to 2011. Interest income from loans, on a tax-equivalent basis, decreased $2.6 million or 7.0% from the year ended December 31, 2012 and decreased $4.1 million or 10.5% compared to 2011. The average balance in the securities portfolio increased $10.0 million and $47.0 million compared to 2012 and 2011, respectively. The tax-equivalent yield on the securities was 3.04% at December 31, 2013, a decrease of 11 basis points and 55 basis points compared to 2012 and 2011, respectively.
The average balance of interest bearing deposit accounts (interest bearing checking, savings and money market accounts) increased to $510.3 million at December 31, 2013, from $493.0 million at December 31, 2012 and $450.7 million at December 31, 2011. These increases were the result of strong growth in both business and retail deposit accounts. The average balances in total time deposits decreased $30.1 million compared to 2012 and decreased $30.1 million compared to 2011. The cost of total interest bearing deposits decreased 24 basis points compared to 2012 and decreased 55 basis points compared to 2011. The decline in the cost of total interest bearing deposits is the result of reductions in rates for retail deposits during 2013.
During 2013, the Company decreased its average short-term borrowings by $5.2 million from the year ended December 31, 2012 and $6.0 million from the year ended 2011. The Company increased its average FHLB borrowings by $3.1 million compared to the year ended December 31, 2012 and increased $5.5 million compared to 2011. Total interest expense for 2013 was $6.6 million, a decrease of $2.3 million and $4.1 million compared to 2012 and 2011, respectively. The cost of interest-bearing liabilities decreased 23 basis points from the year ended December 31, 2012, and decreased 49 basis points from 2011 primarily due to
reductions in rates for retail deposits as well as a reduction in wholesale borrowings, including brokered certificates of deposit that matured or were called by the Company in 2013.
Management believes that the net interest margin could be relatively unchanged during 2014. Based on conservative internal interest rate risk models and the assumption of a sustained low rate environment, the Company expects net interest income to trend downward slightly throughout the next 12 months as loan related assets reprice and the decline in funding costs slows. It is anticipated that targeted growth in earning assets and liability repricing opportunities will help mitigate the impact to the Company’s net interest margin. The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.
The following table analyzes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates, on a tax equivalent basis. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Nonaccrual loans are included in the average outstanding loans.
(1) Income and yields are reported on tax equivalent basis assuming a federal tax rate of 34%.
Provision for Loan Losses
The Company’s loan loss provision during 2013, 2012 and 2011 was $109,000, $3.4 million, and $2.9 million, respectively. Improved credit quality and a reduction in nonperforming loans contributed to the decline in the provision for loan losses in 2013 compared to 2012. The Company is committed to making loan loss provisions that maintain an allowance that adequately reflects the risk inherent in the loan portfolio. This commitment is more fully discussed in the “Allowance for loan losses” section below.
Non-interest Income
Non-interest income has been and will continue to be an important factor for increasing profitability. Management recognizes this and continues to review and consider areas where non-interest income can be increased. Non-interest income includes fees generated by the commercial and retail banking segment, the wealth management segment and the mortgage banking segment of
the Company. Non-interest income was $24.5 million for the year ended December 31, 2013 compared to $29.5 million for 2012 and $20.0 million for 2011. The decrease in non-interest income for 2013 was largely the result of decreases in gains on loans held for sale as loan originations from our mortgage subsidiary have declined. The following table depicts the changes in non-interest income:
The revenues, expenses, assets and liabilities of Southern Trust Mortgage for the year ended December 31, 2013 are reflected in the Company’s consolidated financial statements, with the proportionate share of Southern Trust Mortgage’s income not owned by the Company reported as “Net income (loss) attributable to non-controlling interest”. Accordingly, gains on loans held for sale of $15.7 million and fees on mortgages held for sale of $103,000 generated by Southern Trust Mortgage for the year ended December 31, 2013, are being reported as part of the consolidated non-interest income. For the year ended December 31, 2013, Southern Trust Mortgage originated $729 million in loans, compared to $946 million in loans for the year ended 2012. In light of declining profitability in the mortgage business and increasing regulatory burdens, the Company is evaluating a range of options for its interest in Southern Trust Mortgage. Due in part to these factors and to reflect the diminished fair value of Southern Trust Mortgage, the Company recorded an impairment charge of $500,000, which is included in non-interest expenses in the consolidated statements of income.
Income from the wealth management segment is produced by Middleburg Trust Company and Middleburg Investment Services. Middleburg Trust Company produced fees that increased 5.8% to $4.0 million for the year ended December 31, 2013 compared to $3.8 million for the same period in 2012 and increased 9.2% compared to 2011. Assets under management were $1.55 billion at December 31, 2013, compared to $1.49 billion at December 31, 2012 and $1.39 billion at December 31, 2011. Commissions on investment sales decreased to $470,000 for the year ended December 31, 2013, compared to $518,000 for the year ended December 31, 2012 and increased $77,000 compared to 2011. Middleburg Investment Group continues to expand the integration of Middleburg Trust Company and Middleburg Investment Services into a focused wealth management program for all of the Company’s clients. Wealth management services are available at each of the Company's financial service centers.
Other operating income increased by $279,000 to $1.2 million for the year ended December 31, 2013, compared to the same period in 2012 and increased $485,000 compared to 2011. These increases are primarily the result of income recognized from several of the Company's equity investments.
Non-interest Expense
Non-interest expense decreased to $54.0 million for the year ended December 31, 2013, compared to $54.3 million for 2012 and $49.0 million for 2011. Non-interest expense as a percentage of total average assets was 4.4%, 4.5% and 4.4% for the years ended December 31, 2013, 2012 and 2011, respectively. The following table depicts the changes in non-interest expense:
Salaries and employee benefits increased $210,000 to $30.6 million when comparing the year ended December 31, 2013 to 2012, and increased 11.9% when compared to 2011. These increases have been the result of the addition in the number of employees at our mortgage subsidiary over the last several years. However, in light of the current declining production levels in the mortgage industry, management has taken and will continue to take measures to reduce overhead in order to align expenses with the decline in loan originations and revenue from mortgage sales. These measures will include further reductions in salary expenses throughout the mortgage subsidiary.
Occupancy and equipment expenses increased 3.1% to $7.3 million for the year ended December 31, 2013, compared to $7.1 million for the same period in 2012 and increased 7.7% compared to 2011. These continued increases were largely due to the opening of one new financial service center in 2012. Management does not anticipate significant changes in occupancy related expenses in the upcoming year.
Advertising expense decreased 28.4% in 2013 to $1.5 million compared to $2.0 million in 2012 and increased 4.1% compared to 2011. The decrease in advertising expenses in 2013 was largely due to fewer promotions undertaken by the Company. Fluctuations in advertising expenses are due to the changes in the number of households serviced, advertising campaigns focused on new products and services for all segments, and changes in advertising methodologies.
Computer operations expense increased 18.3% and 23.9% for the year ended December 31, 2013 compared to the year ended December 31, 2012 and 2011, respectively. The primary reasons for the increase in expenses were due to the higher costs related to computer maintenance, additional expenses related to a new anti-money laundering monitoring and tracking software added in 2013, and continued increases in expenses related to our on-line banking products.
Expenses relating to other real estate owned (OREO) decreased by 46.5% to $1.5 million for the year ended December 31, 2013 compared to $2.7 million for the year ended December 31, 2012 and decreased 43.2% compared to 2011. These decreases are primarily the result of declines in the level of loans transferred to OREO to $2.4 million in 2013 from $8.5 million in 2012 and $5.9 million in 2011 and declines in the level of valuation allowances required based on the fair market value of properties held to $235,000 in 2013 from $1.7 million in 2012 and $1.5 million in 2011.
Other operating expenses increased 8.1% compared to 2012 and increased 26.5% compared to 2011. The increase in other operating expenses in 2013 compared to 2012 and 2011 was primarily related to recruiting expenses for senior level positions during 2013.
Income Taxes
Reported income tax expense was $1.9 million for the year ended December 31, 2013, compared to income tax expense of $2.0 million for the year ended December 31, 2012 and $1.4 million for the year ended December 31, 2011. The effective tax rate was 23.9%, 19.7% and 22.5% for 2013, 2012 and 2011, respectively. Note 10 of the Company’s consolidated financial statements provides a reconciliation between the amount of income tax expense computed using the federal statutory rate and the Company’s actual income tax expense.
Summary of Financial Results by Quarter
The following table summarizes the major components of the Company’s results of operations for each quarter of the last three fiscal years.
Financial Condition
The Company’s total assets were $1.2 billion at December 31, 2013, relatively unchanged compared to December 31, 2012. Securities increased $9.0 million or 2.8% from 2012 to 2013. Net loans increased by $20.0 million or 2.9% from 2012 to 2013. Total liabilities were $1.1 billion as of December 31, 2013, relatively unchanged compared to December 31, 2012. Total shareholders’ equity, excluding the non-controlling interest in consolidated subsidiary, at year end 2013 and 2012 was $112.6 million and $113.9 million, respectively.
Loans
The Company’s loan portfolio totaled 63.4% of average earning assets with a tax equivalent yield of 4.66% at December 31, 2013. Nonaccrual loans and loans past due more than 90 days and still accruing was 2.7% of average loans at December 31, 2013. The Company is focused on originating and maintaining high credit quality loans and diversification as a means of increasing earnings.
Changes in the loan portfolio at December 31, 2013 compared to December 31, 2012 were:
•
Total loans were $728.5 million, an increase of 2.7% from $709.5 million.
•
Real estate construction loans consist primarily of pre-sold 1-4 family residential loans along with a marginal amount of commercial construction loans. These loans represented 5.0% of total loans, a decrease of approximately $14.2 million from $50.2 million to $36.0 million.
•
Loans secured by farmland increased $4.7 million from $11.9 million to $16.6 million.
•
Loans secured by 1-4 family residential real estate represented 37.5% of total loans, an increase of $12.8 million.
•
Other real estate loans are typically non-farm, non-residential real estate loans which are, in most cases, owner-occupied commercial buildings. Other real estate loans represented 35.7% of total loans, relatively unchanged for the year.
•
Commercial loans, which consist of secured and unsecured loans to small businesses, increased 9.3%.
•
Consumer loans remained relatively unchanged for the year.
Consistent with its focus on providing community-based financial services, the Company generally does not extend loans outside its principal market area. The Company’s market area for its lending services encompasses Fairfax, Fauquier and Loudoun and Prince William counties, as well as, the Town of Williamsburg and the City of Richmond where it operates full service financial centers.
At December 31, 2013, the Company had no concentration of loans in any one industry in excess of 25% of its total loan portfolio. However, because of the nature of the Company’s market, loan collateral is predominantly real estate.
The Company holds in its portfolio loans that adjust or float according to changes in “prime” lending rate. These holdings are not considered speculative but instead necessary for good asset/liability management. The following table reflects the remaining maturity distribution of selected loan categories at December 31, 2013:
Asset Quality
The Company has policies and procedures designed to control credit risk and to maintain the quality of its loan portfolio. These include underwriting standards for new originations and ongoing monitoring and reporting of asset quality and the adequacy of the allowance for loan losses. There were $28.7 million in total nonperforming assets, which consist of loans more than 90 days past due and still accruing, nonaccrual loans, restructured loans and foreclosed property at December 31, 2013. This is a decrease of $9.1 million when compared to the December 31, 2012 balance of $37.8 million. Other real estate owned decreased 65.5% to $3.4 million at December 31, 2013, compared to $9.9 million at December 31, 2012. Loans more than 90 days past due and still accruing were $808,000 at December 31, 2013 compared to $1.0 million at December 31, 2012.
Nonperforming Assets
Loans are placed on nonaccrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on nonaccrual.
•
All interest accrued but unpaid at the date the loan is placed on nonaccrual is either deducted from interest income or written-off as a loss.
•
Accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid.
•
There may be actual losses that require additional provisions for loan losses to be charged against earnings.
For real estate loans, upon foreclosure, the balance of the loan is transferred to “Other Real Estate Owned” (“OREO”) and carried at fair market value based on current appraisals and other current market trends, less estimated selling costs. If a write-down is necessary at the time of foreclosure, the amount is charged-off against the allowance for loan losses. A review of the recorded property value for OREO is performed in accordance with policy standards, and if market conditions indicate that the recorded value exceeds the fair market value, additional write-downs of the property value are charged directly to operations.
The table below summarizes nonperforming assets at December 31 of each of the past five years.
(1) Amount reflects restructured loans that are not included in nonaccrual loans.
Nonperforming loans decreased $2.6 million, or 9.4%, from December 31, 2012 to December 31, 2013 while the allowance for loan losses balance decreased $991,000, or 6.9%, during the same period.
Also included in nonperforming loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at December 31, 2013 was $15.6 million of which $10.9 million were included in the Company’s nonaccrual loan totals at that date and $4.7 million represented loans performing as agreed to the restructured terms. This compares with $12.0 million in total TDRs at December 31, 2012, an increase of $3.6 million or 30.0%. The amount of the valuation allowance related to TDRs was $2.8 million and $2.0 million as of December 31, 2013 and 2012, respectively. The increase in TDRs during 2013 was attributable to the Company's continued approach to managing asset quality and working with borrowers who are experiencing financial difficulty, which may result in additional TDRs in the future.
During the year ended December 31, 2013, the Company modified 23 loans considered TDRs, which totaled $5.2 million, compared to the modification of 15 loans considered TDRs, which totaled $5.3 million during 2012.
The Company requires six timely consecutive monthly payments be made and that future payments are reasonably assured, before a restructured loan that has been placed on nonaccrual can be returned to accrual status. One restructured loan was charged-off
during the year ended December 31, 2013. The Company does not utilize formal modification programs or packages when loans are considered for restructuring. Any loan restructuring is based on the borrower’s circumstances and may include modifications to more than one of the terms and conditions of the loan.
The Company has not performed any commercial real estate or other type of loan workout whereby the existing loan would have been structured into multiple new loans.
The allowance for loan losses was 52.8% of nonperforming loans at December 31, 2013. At December 31, 2012 and 2011 the allowance for loan losses was 51.4% and 48.1% of nonperforming loans, respectively. Management evaluates nonperforming loans relative to their collateral value and makes appropriate reductions in the carrying value of those loans based on that review.
Allowance For Loan Losses
For a discussion of the Company’s accounting policies with respect to the allowance for loan losses, see “Critical Accounting Policies - Allowance for Loan Losses”.
The following table depicts the transactions, in summary form, related to the allowance for loan losses in each year presented:
The allocation of the allowance (dollars in thousands) at December 31 for the years indicated and the ratio of related outstanding loan balances to total loans were:
The Company has allocated the allowance according to the amount deemed reasonably necessary to provide for the possibility of losses being incurred within each loan category. The allocation of the allowance should not be interpreted as an indication that loan losses in future years will occur in the same proportions that they may have in prior years or that the allocation indicates future loan loss trends. Additionally, the proportion allocated to each loan category is not the total amount that may be available for future losses that could occur within such categories since the total allowance is a general allowance applicable to the total portfolio.
Securities
The Company manages its investment securities portfolio consistent with established policies that include guidelines for earnings, rate sensitivity, liquidity and pledging needs. The Company holds bonds issued by the Commonwealth of Virginia and its political subdivisions with an aggregate market value of $14.7 million at December 31, 2013. The aggregate holdings of these bonds approximate 12.8% of the Company’s shareholders’ equity.
The Company accounts for securities under applicable accounting standards. These standards require classification of investments into three categories, “held to maturity” (“HTM”), “available for sale” (“AFS”), or “trading,” as further defined in Note 1 to the Company’s consolidated financial statements. The Company does not maintain a trading account and has classified no securities in this category. HTM securities are required to be carried at amortized cost. The HTM classification places restrictions on the Company’s ability to sell securities or to transfer securities into the AFS classification. The Company does not classify any securities as HTM for the periods presented. AFS securities are carried at fair value. The unrealized gains or losses, net of deferred income taxes, are reflected in shareholders’ equity.
The carrying value of the securities portfolio was $328.4 million at December 31, 2013, an increase of $9.0 million or 2.8% from the carrying value of $319.5 million at December 31, 2012. The unrealized gains and losses on the AFS securities were $5.8 million and $5.4 million at December 31, 2013, respectively.
The securities portfolio represented approximately 28.6%, 28.1% and 29.3% of the average earning assets of the Company at December 31, 2013, 2012 and 2011, respectively. The carrying values of securities available for sale at the dates indicated were:
In 2013 and 2012, there were no losses related to other-than-temporary impairment (OTTI). Losses of $25,000 related to other-than-temporary impairment on trust-preferred securities was recognized in 2011. At December 31, 2013, there were no trust-preferred securities in the Company's investment securities portfolio.
Securities with maturities greater than five years totaled $289.2 million, of which $188.2 million or 65.1% were mortgage-backed securities with a weighted average yield of 3.25%. For that reason, the portfolio is managed primarily to provide superior returns without sacrificing interest rate, market and credit risk. Through the asset/liability process, the Company considers the securities portfolio as a liquidity source in the event that funding is needed quickly within a 30-day period of time. The Company holds in its securities portfolio investments that adjust or float according to changes in benchmark rates such as the London InterBank Offered Rate ("LIBOR"). These holdings are not considered speculative but instead necessary for good asset/liability management. The following table describes the maturity distribution and yields of the Company's securities available for sale portfolio, on a tax equivalent basis, at December 31, 2013.
(1)
Yields on tax-exempt securities, which includes tax-exempt obligations of states and political subdivisions have been computed on a tax-equivalent basis assuming a federal tax rate of 34%.
(2)
Includes corporate bonds, equity securities, asset-backed securities and taxable obligations of states and political subdivisions.
(3)
Amounts exclude Federal Reserve Stock of $1.7 million and Federal Home Loan Bank Stock of $5.1 million.
Goodwill
As of December 31, 2013, the Company recognized two consolidated subsidiaries as reporting units for the purpose of goodwill evaluation and reporting: Southern Trust Mortgage (“STM”) and Middleburg Investment Group (“MIG”). MIG is the parent company of Middleburg Trust Company. The following table shows the allocation of goodwill between the two reporting units and the percentage by which the fair value of each reporting unit as of December 31, 2013 (the most recent fair value evaluation date) exceeded the carrying value as of that date:
(1) Reported amounts reflect only Middleburg Financial Corporation shareholder's ownership interests.
(2) Includes $557,000 of amortizing intangible assets.
Based on the results of the Company's impairment evaluation of goodwill, the estimated fair value of MIG exceed the carrying value as of December 31, 2013, therefore no goodwill impairment charges was recorded. The Company's impairment evaluation of goodwill for STM, as summarized above, indicated the carrying value exceeded its fair value by approximately $500,000. Therefore, a goodwill impairment charge related to STM was recorded for $500,000 as of December 31, 2013.
In light of declining profitability in the mortgage business and increasing regulatory burdens, the Company is evaluating a range of options for its interest in Southern Trust Mortgage.
Deposits
Deposits continue to be an important funding source and primary supply of the Company’s growth. The Company’s strategy has been to increase its core deposits at the same time that it is controlling its cost of funds. The maturity of the branch network, as well as increased advertising campaigns, have contributed to the growth in deposits over the last several years. By monitoring interest rates within the local market and that of alternative funding sources, the Company is able to price the deposits effectively to develop a core base of deposits in each market.
The following table is a summary of average deposits and average rates paid on those deposits:
Average total deposits increased 0.73% during 2013, 7.6% during 2012 and 3.9% during 2011. At December 31, 2013, the average balance of non-interest bearing deposits increased 12.7% and 34.8% compared to December 31, 2012 and 2011, respectively.
The Company will continue to focus on core deposit growth as the primary source of liquidity and stability. The Company offers individuals and small to medium-sized businesses a variety of deposit accounts, including demand and interest checking, money market, savings and time deposit accounts. The Company also had $61.0 million in brokered deposits as of December 31, 2013 compared to $65.1 million in brokered deposits as of December 31, 2012. This is reflected in the balance of total time deposits.
The following table is a summary of the maturity distribution of certificates of deposit equal to or greater than $100,000 as of December 31, 2013:
Financial Instruments with Off-Balance Sheet Risk and Credit Risk and Contractual Obligations
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit and interest rate swaps. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
A summary of the the Company’s exposure to off-balance sheet risk as of December 31, 2013 and 2012 is as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which the Company is committed.
Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary.
The Company utilizes derivative financial instruments as a part of its asset-liability management program to control exposure to interest rate changes and resulting fluctuations in market values and cash flows associated with certain financial instruments. The Company accounts for derivatives in accordance with ASC 815, "Derivatives and Hedging". Under current guidance, derivative transactions are classified as either cash flow hedges or fair value hedges or they are not designated as hedging instruments. The Company designates each transaction at its inception.
The Company documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value hedges or cash flow hedges to specific assets or liabilities on the balance sheet. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are effective in offsetting changes in fair values or cash flows of hedged items.
As of December 31, 2013, the Company had both fair value hedges and cash flow hedges on its balance sheet as well as derivative financial instruments that have not been designated as hedging instruments. The derivatives are reported at their fair values as of each balance sheet date. For designated cash flow hedges, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income (loss) and are recognized on the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings as are changes in market value of derivatives not designated as hedging instruments.
Information concerning each of the Company's categories of derivatives as of December 31, 2013 and 2012 is presented in Note 24 to the consolidated financial statements.
A summary of the Company’s contractual obligations at December 31, 2013 is as follows:
The Company does not have any capital lease obligations, as classified under applicable FASB statements, or other purchase or long-term obligations.
Capital Resources and Dividends
The Company has an ongoing strategic objective of maintaining a capital base that supports the pursuit of profitable business opportunities, provides resources to absorb risks inherent in its activities and meets or exceeds all regulatory requirements.
The Federal Reserve Board has established minimum regulatory capital standards for bank holding companies and state member banks. The regulatory capital standards categorize assets and off-balance sheet items into four categories that weigh balance sheet assets according to risk, requiring more capital for holding higher risk assets. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity and retained earnings. The Company had a ratio of total capital to risk-weighted assets of 15.9% and 15.3% at December 31, 2013 and 2012, respectively. The ratio of Tier 1 capital to risk-weighted assets was 14.6% and 14.0% at December 31, 2013 and 2012, respectively. The Company’s leverage ratio was 9.4% at December 31, 2013 compared to 9.1% at December 31, 2012. These ratios include the trust-preferred
securities in Tier 1 capital for regulatory capital adequacy determination purposes. These ratios exceed the minimum capital requirements adopted by the federal banking regulatory agencies.
Regulatory capital levels for the Company meet those established for well-capitalized institutions. While we are currently considered well-capitalized, we may from time-to-time find it necessary to access the capital markets to meet our growth objectives or capitalize on specific business opportunities.
Shareholders' equity was $112.6 million at year-end 2013 compared with $113.9 million at year-end 2012. During 2013, the Company declared common stock dividends of $0.24 per share, compared to $0.20 per share in 2012 and 2011. The dividend payout ratio, based on net income available to common shareholders, was 27.6% in 2013, 21.7% in 2012 and 28.2% in 2011.
The primary source of funds for dividends paid by the Company to its shareholders is the dividends received from its subsidiaries. Federal regulatory agencies impose certain restrictions on the payment of dividends and the transfer of assets from the banking subsidiaries to the holding company. Historically, these restrictions have not had an adverse impact on the Company’s dividend policy.
Short-term Borrowings
The Company has various unused lines of credit available from certain correspondent banks in the aggregate amount of $24.0 million and a borrowing capacity of $43.1 million with the Federal Reserve Bank of Richmond. These lines of credit, which bear interest at prevailing market rates, permit the Company to borrow funds in the overnight market, and are renewable annually subject to certain conditions. Securities sold under agreements to repurchase include an interest bearing product that the Company has developed which integrates the use of the cash within client accounts at Middleburg Trust Company for overnight funding at Middleburg Bank. This account is referred to as Tredegar Institutional Select. The overall balance of this product was $42.1 million at December 31, 2013. All repurchase agreements entered into by the Company are accounted for as collateralized financings. No repurchase agreements are accounted for as sales.
The following table shows the distribution of the Company’s short-term borrowings at the end of each of the last three years.
Liquidity
Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, short-term investments, securities classified as available for sale and loans and securities maturing within one year. As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.
The Company also maintains additional sources of liquidity through a variety of borrowing arrangements. Middleburg Bank maintains federal funds lines with large regional and money-center banking institutions. These available lines total approximately $24.0 million, none of which were outstanding at December 31, 2013. Middleburg Bank is also able to borrow from the discount window of the Federal Reserve Bank of Richmond. Available borrowing capacity from this source at December 31, 2013 was $43.1 million. At December 31, 2013 and 2012, Middleburg Bank had $22.1 million and $21.3 million, respectively, of outstanding borrowings pursuant to securities sold under agreement to repurchase transactions (“Repo Accounts”), with maturities of one day. The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000. At December 31, 2013 and 2012, the Company had $12.4 million and $15.0 million, respectively, of outstanding borrowings pursuant to securities sold under agreement to repurchase transactions with remaining maturities of greater than one year.
As of December 31, 2013, Middleburg Bank had remaining credit availability in the amount of $282.8 million at the Federal Home Loan Bank of Atlanta. This line may be utilized for short and/or long-term borrowing. Through December 13, 2013, Southern Trust Mortgage had $24.0 million in a revolving line of credit with a regional bank, which was primarily used to fund its mortgages held for sale. This line of credit expired on December 13, 2013 and was not renewed.
At December 31, 2013, cash, interest-bearing deposits with financial institutions, federal funds sold, short-term investments and unencumbered securities available for sale were 25.7% of total deposits and liabilities.
Caution About Forward Looking Statements
Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import.
Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:
•
further adverse changes in general economic and business conditions in the Company’s market area;
•
changes in banking and other laws and regulations applicable to the Company;
•
maintaining asset qualities;
•
the ability to properly identify risks in our loan portfolio and calculate an adequate loan loss allowance;
•
risks inherent in making loans such as repayment risks and fluctuating collateral values;
•
concentration in loans secured by real estate;
•
changing trends in customer profiles and behavior;
•
changes in interest rates and interest rate policies;
•
maintaining cost controls as the Company opens or acquires new facilities;
•
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
•
the ability to continue to attract low cost core deposits to fund asset growth;
•
the ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;
•
reliance on the Company’s management team, including its ability to attract and retain key personnel;
•
demand, development and acceptance of new products and services;
•
problems with technology utilized by the Company;
•
maintaining capital levels adequate to support the Company’s growth; and
•
other factors described in Item 1A, “Risk Factors,” above.
Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company’s primary market risk exposure is interest rate risk, though it should be noted that the assets under management by Middleburg Trust Company are affected by equity price risk. The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability management process, which is governed by policies established by its Board of Directors that are reviewed and approved every three years baring any significant changes. The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee (“ALCO”) of Middleburg Bank. In this capacity, ALCO develops guidelines and strategies that govern the Company’s asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.
Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with the Company’s financial instruments also change, affecting net interest income, the primary component of the Company’s earnings. ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also employs additional tools to monitor potential longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company’s balance sheet. The simulation model is prepared and updated four times during each year. This sensitivity analysis is compared to ALCO policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given a 200 basis point (bp) upward shift and a 200 basis point downward shift in interest rates. The following reflects the range of the Company’s net interest income sensitivity analysis during the fiscal years of 2013 and 2012 as compared to the 20% Board-approved policy limit.
At the end of 2013, the Company’s interest rate risk model indicated that in a rate environment of an immediate 200 basis points increase, net interest income will increase by 2.7% over a 12-month period. For the same time period, the interest rate risk model indicated that, in a rate environment of an immediate 200 basis points decrease, net interest income could decrease by 11.6% over a 12-month period. Down rate scenarios were not meaningful in the interest rate environment that prevailed as of December 31, 2013. While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is very balanced and is working to minimize risks to rising rates in the future.
The Company’s specific goal is to lower, where possible, the cost of its borrowed funds.
The preceding sensitivity analysis does not represent the Company's forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in response to or anticipation of changes in interest rates.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are filed as a part of this report following Item 15 below:
•
Reports of Independent Registered Public Accounting Firm;
•
Consolidated Balance Sheets as of December 31, 2013 and 2012;
•
Consolidated Statements of Income for the Years Ended December 31, 2013, 2012 and 2011;
•
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2013, 2012 and 2011
•
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2013, 2012 and 2011;
•
Consolidated Statements of Cash Flows for the Years Ended December 31, 2013, 2012 and 2011; and
•
Notes to Consolidated Financial Statements.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants on accounting and financial disclosure during the last two fiscal years.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company maintains “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, that are designed to ensure that information required to be disclosed in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, the Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective and there has been no change in the Company’s internal controls over financial reporting that occurred during the fourth quarter of 2013 that has materially affected, or is reasonably likely to effect the Company’s internal controls over financial reporting.
Management’s Report on Internal Control over Financial Reporting
The management of the Company is responsible for the preparation, integrity and fair presentation of the Company’s financial statements for the year ended December 31, 2013. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning the effects of events and transactions that are accounted for or disclosed.
Management is also responsible for establishing and maintaining an effective internal control structure over financial reporting. The Company’s internal control over financial reporting includes those policies and procedures that pertain to the Company’s ability to record, process, summarize and report reliable financial data. The internal control system contains monitoring mechanisms, and appropriate actions are taken to correct identified deficiencies. Management believes that internal controls over financial reporting, which are subject to scrutiny by management and the Company’s internal auditors, support the integrity and reliability of the financial statements. Management recognizes that there are inherent limitations in the effectiveness of any internal control system, including the possibility of human error and the circumvention or overriding of internal controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. In addition, because of changes in conditions and circumstances, the effectiveness of internal control over financial reporting may vary over time.
In order to ensure that the Company’s internal control structure over financial reporting is effective, management assessed these controls as they conformed to accounting principles generally accepted in the United States of America and related call report instructions as of December 31, 2013. This assessment was based on criteria for effective internal control over financial reporting as described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992. Based on this assessment, management believes that the Company maintained effective internal controls over financial reporting as of December 31, 2013. Management’s assessment did not determine any material weakness within the Company’s internal control structure.
The financial statements for the year ended December 31, 2013 have been audited by the independent registered public accounting firm of Yount, Hyde & Barbour, P.C. Personnel from that firm were given unrestricted access to all financial records and related data, including minutes of all meetings of the Board of Directors and Committees thereof.
Management believes that all representations made to the independent registered public accounting firm were valid and appropriate. The resulting report from Yount, Hyde & Barbour, P.C accompanies the financial statements.
Yount, Hyde & Barbour, P.C. has also issued an attestation report on the effectiveness of the Company’s internal controls over financial reporting. That report has also been made a part of the consolidated financial statements of the Company. See Item 8, “Financial Statements and Supplementary Data,” above for more information.
Changes in Internal Control over Financial Reporting
There were no changes in the internal control over financial reporting that occurred during the quarter ended December 31, 2013 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Election of Directors - Nominees for Election for Terms Expiring in 2014” and “ - Executive Officers Who Are Not Directors,” “Security Ownership - Section 16(a) Beneficial Ownership Reporting Compliance,” and “Corporate Governance and the Board of Directors - Committees of the Board - Audit Committee” and “- Code of Ethics” in the Company’s Proxy Statement for the 2014 Annual Meeting of Shareholders is incorporated herein by reference.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Corporate Governance and the Board of Directors - Director Compensation” and “Executive Compensation” in the Company’s Proxy Statement for the 2014 Annual Meeting of Shareholders is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Security Ownership - Security Ownership of Management” and “- Security Ownership of Certain Beneficial Owners” and “Executive Compensation - Equity Compensation Plans” in the Company’s Proxy Statement for the 2014 Annual Meeting of Shareholders is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Pursuant to General Instruction G (3) of Form 10-K, the information contained under the heading “Executive Compensation - Transactions with Management” in the Company’s Proxy Statement for the 2014 Annual Meeting of Shareholders is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Audit Information - Fees of Independent Public Accountants” and “Pre-Approval Policies” in the Company’s Proxy Statement for the 2014 Annual Meeting of Shareholders is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)
(1) and (2). The response to this portion of Item 15 is submitted as a separate section of this report.
(3).
Exhibits:
* Management contracts and compensatory plans and arrangements.
(All exhibits not incorporated herein by reference are attached as exhibits to the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission.)
(b)
Exhibits
The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted as a separate section of this report.
(c)
Financial Statement Schedules
The response to this portion of Item 15 is submitted as a separate section of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
* Tammy P. Frazier, by signing her name hereto, signs this document on behalf of each of the persons indicated by an asterisk above pursuant to the powers of attorney duly executed by such persons and filed with the SEC as Exhibit 24.1 to this Annual Report on Form 10-K.
/s/ Tammy P. Frazier
Tammy P. Frazier March 14, 2014
Exhibit Index
* Management contracts and compensatory plans and arrangements.
MIDDLEBURG FINANCIAL CORPORATION
Middleburg, Virginia
FINANCIAL REPORT
DECEMBER 31, 2013
C O N T E N T S
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Middleburg Financial Corporation
Middleburg, Virginia
We have audited the accompanying consolidated balance sheets of Middleburg Financial Corporation and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income (loss), changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2013. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Middleburg Financial Corporation and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Middleburg Financial Corporation and subsidiaries' internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992, and our report dated March 14, 2014 expressed an unqualified opinion on the effectiveness of Middleburg Financial Corporation and subsidiaries' internal control over financial reporting.
Winchester, Virginia
March 14, 2014
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Middleburg Financial Corporation
Middleburg, Virginia
We have audited Middleburg Financial Corporation and subsidiaries' internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992. Middleburg Financial Corporation and subsidiaries' management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Middleburg Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income (loss), changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2013 of Middleburg Financial Corporation and subsidiaries and our report dated March 14, 2014 expressed an unqualified opinion.
Winchester, Virginia
March 14, 2014
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
MIDDLEBURG FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to the consolidated financial statements.
MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
Note 1.
Nature of Banking Activities and Significant Accounting Policies
Middleburg Financial Corporation (the “Company”) is a bank holding company and through its banking subsidiary, Middleburg Bank, grants commercial, financial, agricultural, residential and consumer loans to customers principally in Loudoun County, Fauquier County and Fairfax County, Virginia as well as the Town of Williamsburg and the City of Richmond. The loan portfolio is well diversified and generally is collateralized by assets of the borrowers. The loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. Middleburg Trust Company is a non-banking subsidiary of Middleburg Financial Corporation which offers a comprehensive range of fiduciary and investment management services to individuals and businesses. Middleburg Financial Corporation, through its banking subsidiary, Middleburg Bank, has a controlling interest in Southern Trust Mortgage LLC, which originates and sells mortgages secured by personal residences primarily in the southeastern United States.
The accounting and reporting policies of the Company conform to U. S. generally accepted accounting principles and to accepted practice within the banking industry.
Principles of Consolidation
The consolidated financial statements of Middleburg Financial Corporation and its wholly owned subsidiaries, Middleburg Bank, Middleburg Investment Group, Inc., Middleburg Trust Company and Middleburg Bank Service Corporation include the accounts of all companies. Also included in the consolidation are Southern Trust Mortgage LLC and MFC Capital Trust II. At December 31, 2013, the Company owned 62.3% of the issued and outstanding membership interest units of Southern Trust Mortgage, through its subsidiary, Middleburg Bank. The issued and outstanding interest of Southern Trust Mortgage not held by the Company is reported as Non-Controlling Interest in Consolidated Subsidiary. Accounting Standards Codification Topic 810, Consolidation, requires that the Company no longer eliminate through consolidation the equity investment in MFC Capital Trust II, which approximated $155,000 for each of the years ended December 31, 2013 and 2012. The subordinate debt of the trust preferred entity is reflected as a liability of the Company. All material intercompany balances and transactions have been eliminated in consolidation.
Securities
Investments in debt securities with readily determinable fair values are classified as either held to maturity, available for sale, or trading based on management’s intent. Currently all debt securities are classified as available for sale. Equity investments in the FHLB and the Federal Reserve Bank of Richmond are separately classified as restricted securities and are carried at cost. Available for sale securities are carried at estimated fair value with the corresponding unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss). Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities.
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the intent is to sell the security or (ii) it is more likely than not that it will be necessary to sell the security prior to recovery of its amortized cost. If, however, management’s intent is not to sell the security and it is not more than likely that management will be required to sell the security before recovery, management must determine what portion of the impairment is attributable to credit loss, which occurs when the amortized cost of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income (loss).
For equity securities carried at cost as restricted securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in income. We regularly review each security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, the intention with regards to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.
Loans
The Company grants mortgage, commercial, and consumer loans to clients. The loan portfolio is segmented into commercial loans, real estate loans, and consumer loans. Real estate loans are further divided into the following classes: construction; farmland; 1-4 family residential; and other real estate loans. Descriptions of the Company’s loan classes are as follows:
Commercial Loans: Commercial loans are typically secured with non-real estate commercial property. The Company makes commercial loans primarily to middle market businesses located within our market area.
Real Estate Loans - Construction: The Company originates construction loans for the acquisition and development of land and construction of condominiums, townhomes, and 1-4 family residences. This class also includes acquisition, development and construction loans for retail and other commercial purposes, primarily in our market areas.
Real Estate Loans- Farmland: Loans secured by agricultural property and not included in Real Estate - Other.
Real Estate Loans - 1-4 Family: This class of loans includes loans secured by 1-4 family homes. The Company’s general practice is to sell the majority of its newly originated fixed-rate residential real estate loans in the secondary mortgage market through its wholly owned subsidiary, Southern Trust Mortgage, and to hold in its portfolio adjustable rate residential real estate loans and loans in close proximity to its financial service centers.
Real Estate Loans - Other: This loan class consists primarily of loans secured by multi-unit residential property and owner and non-owner occupied commercial and industrial property. This class also includes loans secured by real estate which do not fall into other classifications.
Consumer Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used auto loans, unsecured loans, lines of credit and home equity loans and lines of credit.
The ability of the debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.
For all classes of loans, the Company considers loans to be past due when a payment is not received by the payment due date according to the contractual terms of the loan. The Company monitors past due loans according to the following categories: less than 30 days past due, 30 - 59 days past due, 60 - 89 days past due, and 90 days or greater past due. The accrual of interest on all classes of loans is discontinued at the time the loans are 90 days delinquent unless they are well-secured and in the process of collection.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Deferred fees and costs include discounts and premiums on syndicated and guaranteed loans purchased. Interest income is accrued on the unpaid principal balance. Loan origination and commitment fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the loan yield over the life of the related loan.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Allowance for Loan Losses
The allowance for loan losses reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the allowance for losses each quarter. To determine the total allowance for loan losses, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and loans analyzed on a pooled basis. The allowance for loan losses consists of amounts applicable to: (i) the commercial loan portfolio; (ii) the real estate portfolio; and (iii) the consumer loan portfolio.
To determine the allowance for loan losses, loans are pooled by portfolio segment and losses are modeled using historical experience, and quantitative and other mathematical techniques over the loss emergence period. Each class of loan requires exercising significant judgment to determine the estimation that fits the credit risk characteristics of its portfolio segment. The Company uses internally developed models in this process. Management must use judgment in establishing additional input metrics for the modeling processes. The models and assumptions used to determine the allowance are independently validated and reviewed to
ensure that their theoretical foundation, assumptions, data integrity, computational processes, reporting practices, and end user controls are appropriate and properly documented.
The establishment of the allowance for loan losses relies on a consistent process that requires multiple layers of management review and judgment and responds to changes in economic conditions, customer behavior, and collateral value, among other influences. From time to time, events or economic factors may affect the loan portfolio, causing management to provide additional amounts to or release balances from the allowance for loan losses. Qualitative factors considered in the allowance for loan losses evaluation include the levels and trends in delinquencies and nonperforming loans, trends in volume and terms of loans, the effects of any changes in lending policies, the experience, ability, and depth of management, national and local economic trends and conditions, concentrations of credit, the quality of the Company’s loan review system, competition and regulatory requirements. The Company’s allowance for loan losses is sensitive to risk ratings assigned to individually evaluated loans and economic assumptions and delinquency trends driving statistically modeled reserves. Individual loan risk ratings are evaluated based on each situation by experienced senior credit officers.
Management monitors differences between estimated and actual incurred loan losses. This monitoring process includes periodic assessments by senior management of loan portfolios and the models used to estimate incurred losses in those portfolios. Additions to the allowance for loan losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged off amounts are credited to the allowance for loans losses.
Loan Charge-off Policies
Commercial and consumer loans are generally charged off when:
•they are 90 days past due;
•the collateral is repossessed; or
•the borrower has filed bankruptcy.
All classes of real estate loans are charged down to the net realizable value when the Company determines that the sole source of repayment is liquidation of the collateral.
Impaired Loans
For all classes of loans, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
For all classes of loans, impairment is measured on a loan-by-loan basis by comparing the loan balance to 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. Any variance in values is charged off when determined.
Troubled Debt Restructurings
In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a troubled debt restructuring (“TDR”). Management strives to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans. All identified TDRs are considered to be impaired loans.
Management considers troubled debt restructurings and subsequent defaults in restructured loans in the determination of the adequacy of the Company's allowance for loan losses. When identified as a TDR, a loan is evaluated for potential loss as noted above for impaired loans. Loans identified as TDRs frequently are on nonaccrual status at the time of the restructuring and, in
some cases, partial charge-offs may have already been taken against the loan and a specific allowance may have already been established for the loan. As a result of any modification as a TDR, the specific reserve associated with the loan may be increased. Additionally, loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future defaults. If loans modified in a TDR subsequently default, the Company evaluates them for possible further impairment. As a result, any specific allowance may be increased, adjustments may be made in the allocation of the total allowance balance, or partial charge-offs may be taken to further write-down the carrying value of the loan. Management exercises significant judgment in developing estimates for potential losses associated with TDRs.
Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at the lower of aggregate cost or fair value. The fair value of mortgage loans held for sale is determined using current secondary market prices for loans with similar coupons, maturities, and credit quality and fair value of loans committed at year-end.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation of property and equipment is computed principally on the straight-line method over the following estimated useful lives:
Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale, or other disposition of property and equipment, the cost and accumulated depreciation are eliminated from the accounts and gain or loss is included in income.
Other Real Estate Owned
Real estate acquired by foreclosure is carried at fair market value less an allowance for estimated selling expenses on the future disposition of the property. Revenue and expenses from operations and changes in the valuation are included in the net expenses from other real estate owned.
Goodwill and Intangible Assets
With the adoption of Accounting Standards Update (ASU) 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment", the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, the Company determines that it is more likely than not that the fair value is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and may be required to record impairment charges. The Company completed an annual test for impairment during the fourth quarter of 2013 and determined there was goodwill impairment of $500,000 related to the Company's subsidiary, Southern Trust Mortgage.
Additionally, acquired intangible assets (customer relationships) are separately recognized and amortized over their useful life of 15 years.
Bank-Owned Life Insurance
The Company owns insurance on the lives of a certain group of key employees. The policies were purchased to help offset the increase in the costs of various fringe benefit plans, including healthcare. The cash surrender value of these policies is included as an asset on the consolidated balance sheets, and any increase in cash surrender value is recorded as other income on the consolidated statements of income. In the event of the death of an insured individual under these policies, the Company would receive a death benefit which would be recorded as other income.
Income Taxes
Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50% likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the consolidated statements of income. No liabilities for unrecognized tax benefits have been recognized as of December 31, 2013 or 2012.
Trust Company Assets
Securities and other properties held by Middleburg Trust Company in a fiduciary or agency capacity are not assets of the Company and are not included in the accompanying consolidated financial statements.
Earnings Per Share
Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, warrants and non-vested restricted stock awards, and are determined using the treasury stock method.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. Generally, federal funds are sold and purchased for one-day periods.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, goodwill and intangible assets, other real estate owned, other-than-temporary impairment of securities, and the valuation of financial instruments.
Advertising Costs
The Company follows the policy of charging the costs of advertising to expense as incurred.
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, changes in the fair value of interest rate swaps, and pension liability adjustments, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income (loss).
Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. The Company does not account for repurchase agreement transactions as sales. All repurchase agreement transactions entered into by the Company are accounted for as collateralized financings. The Company may be required to provide additional collateral based on the fair value of the underlying securities.
Derivative Financial Instruments
The Company utilizes derivative financial instruments as a part of its asset-liability management program to control exposure to interest rate changes and fluctuations in market values and cash flows associated with certain financial instruments. The Company accounts for derivatives in accordance with ASC 815, "Derivatives and Hedging". Under current guidance, derivative transactions are classified as either cash flow hedges or fair value hedges or they are not designated as hedging instruments. The Company designates each transaction at its inception.
The Company documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value hedges or cash flow hedges to specific assets or liabilities on the balance sheet. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are effective in offsetting changes in fair values or cash flows of hedged items.
As of December 31, 2013, the Company had both fair value hedges and cash flow hedges on its balance sheet as well as derivative financial instruments that have not been designated as hedging instruments. The derivatives are reported at fair value as of each balance sheet date. For designated cash flow hedges, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income (loss) and are recognized in the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings as are changes in market value of derivatives not designated as hedging instruments.
Information concerning each of the Company's categories of derivatives as of December 31, 2013 and 2012 is presented in Note 24 to the consolidated financial statements.
Reclassifications
Certain reclassifications have been made to prior period balances to conform to current year presentation. No reclassifications were significant.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Share-Based Employee Compensation Plan
At December 31, 2013, the Company had a share-based employee compensation plan which is described more fully in Note 8 to the consolidated financial statements. Compensation cost relating to share-based payment transactions is recognized in the consolidated financial statements. That cost is measured based on the fair value of the equity instruments issued and recognized over the applicable vesting period. The Company recognized $492,000, $440,000, and $471,000 in compensation expense during 2013, 2012, and 2011, respectively, as a result of partially vested stock grants and vested stock options.
Recent Accounting Pronouncements
In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) - Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.
In July 2012, the FASB issued ASU 2012-02, “Intangibles - Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” The amendments in this ASU apply to all entities that have indefinite-lived intangible assets, other than goodwill, reported in their financial statements. The amendments in this ASU provide an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a
quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.
In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU clarify the scope for derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either offset or subject to netting arrangements. An entity is required to apply the amendments for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.
In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Company has included the required disclosures from ASU 2013-02 in the consolidated financial statements.
In July 2013, the FASB issued ASU 2013-10, “Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes.” The amendments in this ASU permit the Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to interest rates on direct Treasury obligations of the U.S. government and the London Interbank Offered Rate. The amendments also remove the restriction on using different benchmark rates for similar hedges. The amendments apply to all entities that elect to apply hedge accounting of the benchmark interest rate under Topic 815. The amendments are effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.
In July 2013, the FASB issued ASU 2013-11, “Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.” The amendments in this ASU provide guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The adoption of the new guidance did not have a material impact on the Company's consolidated financial statements.
In January 2014, the FASB issued ASU 2014-01, “Investments-Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in this ASU should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this ASU are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company is currently assessing the impact that ASU 2014-01 will have on its consolidated financial statements.
In January 2014, the FASB issued ASU 2014-04, “Receivables-Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company is currently assessing the impact that ASU 2014-04 will have on its consolidated financial statements.
Note 2.
Securities
Amortized costs and fair values of securities available for sale as of December 31, 2013 and 2012, are summarized as follows:
The amortized cost and fair value of securities available for sale as of December 31, 2013, by contractual maturity are shown below. Maturities may differ from contractual maturities in corporate and mortgage-backed securities because the securities and mortgages underlying the securities may be called or repaid without any penalties. Therefore, these securities are not included in the maturity categories in the following maturity summary.
Proceeds from sales of securities during 2013, 2012, and 2011 were $24.2 million, $41.0 million, and $37.6 million, respectively. Gross gains of $732,000, $743,000, and $476,000, and gross losses of $314,000, $298,000, and $16,000, were realized on those sales, respectively. There were no losses recognized for impaired securities in 2013 and 2012. During 2011, $25,000 in losses were recognized for impaired securities. The tax expense applicable to these net realized gains, losses, and impairment charges amounted to $142,000, $151,000, and $148,000, respectively.
The carrying value of securities pledged to qualify for fiduciary powers, to secure public monies and for other purposes as required by law amounted to $102.3 million and $142.2 million at December 31, 2013 and 2012, respectively.
At December 31, 2013 and 2012, investments in an unrealized loss position that are temporarily impaired are as follows:
A total of 132 securities have been identified by the Company as temporarily impaired at December 31, 2013. Of the 132 securities, 131 are investment grade and one is speculative grade. Mortgage-backed securities and municipal securities make up the majority of temporarily impaired securities at December 31, 2013. Market prices change daily and are affected by conditions beyond the
control of the Company. Although the Company has the ability to hold these securities until the temporary loss is recovered, decisions by management may necessitate a sale before the loss is fully recovered. No such sales were anticipated or required as of December 31, 2013. Investment decisions reflect the strategic asset/liability objectives of the Company. The investment portfolio is analyzed frequently by the Company and managed to provide an overall positive impact to the Company’s income statement and balance sheet.
Trust preferred securities
As of December 31, 2013 and 2012 the Company held no trust preferred securities in its investment portfolio.
The Company previously held trust preferred securities that were identified as other-than-temporarily impaired. These securities were sold during the second quarter of 2012 with a recognized net loss of approximately $142,000. Additionally, these securities incurred cumulative other-than-temporary credit losses recognized in prior period earnings of approximately $2.4 million through December 31, 2011.
The Company also previously held one trust preferred security that was not considered other-than-temporarily impaired while held in its investment portfolio. The security was sold during the third quarter of 2012 with a recognized net loss of approximately $149,000. No credit losses were recognized on this security while held.
Other-than-temporary impairment losses
At December 31, 2013, the Company evaluated the investment portfolio for possible other-than-temporary impairment losses and concluded that no adverse change in cash flows occurred and did not consider any portfolio securities to be other-than-temporarily impaired. Based on this analysis and because the Company does not intend to sell securities prior to maturity and it is more likely than not the Company will not be required to sell any securities before recovery of amortized cost basis, which may be at maturity. For debt securities related to corporate securities, the Company determined that there was no other adverse change in the cash flows as viewed by a market participant; therefore, the Company does not consider the investments in these assets to be other-than-temporarily impaired at December 31, 2013. However, there is a risk that the Company’s continuing reviews could result in recognition of other-than-temporary impairment charges in the future. For the years ended December 31, 2013 and December 31, 2012, no credit related impairment losses were recognized by the Company.
The Company’s investment in FHLB stock totaled $5.1 million at December 31, 2013. FHLB stock is generally viewed as a long-term investment and as a restricted security which is carried at cost because there is no market for the stock other than the FHLB or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider this investment to be other-than-temporarily impaired at December 31, 2013, and no impairment has been recognized. FHLB stock is shown in restricted securities on the consolidated balance sheets and is not part of the available for sale portfolio.
Note 3.
Loans, Net
The Company segregates its loan portfolio into three primary loan segments: Real Estate Loans, Commercial Loans, and Consumer Loans. Real estate loans are further segregated into the following classes: construction loans, loans secured by farmland, loans secured by 1-4 family residential real estate, and other real estate loans. Other real estate loans include commercial real estate loans. The consolidated loan portfolio was composed of the following:
(1)
Gross loan balances at December 31, 2013 and 2012 are net of deferred loan costs of $2.4 million and $2.1 million, respectively.
Loans presented in the table above exclude loans held for sale. The Company had $33.2 million and $82.1 million in mortgages held for sale at December 31, 2013 and 2012, respectively.
The following tables present a contractual aging of the recorded investment in past due loans by class of loans as of December 31, 2013 and December 31, 2012.
The following table presents the recorded investment in nonaccrual loans and loans past due ninety days or more and still accruing by class of loans as of December 31 of the indicated year:
If interest on nonaccrual loans had been accrued, such income would have approximated $1.8 million, $1.4 million, and $1.5 million for the years ended December 31, 2013, 2012, and 2011, respectively.
The Company utilizes an internal asset classification system as a means of measuring and monitoring credit risk in the loan portfolio. Under the Company’s classification system, problem and potential problem loans are classified as “Special Mention”, “Substandard”, and “Doubtful”.
Special Mention: Loans with potential weaknesses that deserve management’s close attention. If left uncorrected, the potential weaknesses may result in the deterioration of the repayment prospects for the credit.
Substandard: Loans with well-defined weakness that jeopardize the liquidation of the debt. Either the paying capacity of the borrower or the value of the collateral may be inadequate to protect the Company from potential losses.
Doubtful: Loans with a very high possibility of loss. However, because of important and reasonably specific pending factors, classification as a loss is deferred until a more exact status may be determined.
Loss: Loans are deemed uncollectible and are charged off immediately.
The following tables present the recorded investment in loans by class of loan that have been classified according to the internal classification system as of December 31 of the indicated year:
The following tables present loans individually evaluated for impairment by class of loan as of and for the year ended December 31, 2013 and 2012:
The “Recorded Investment” amounts in the table above represent the outstanding principal balance on each loan represented in the table. The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged-off on each loan.
Included in certain loan categories of impaired loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at December 31, 2013 was $15.6 million of which $10.9 million were included in the Company’s nonaccrual loan totals at that date and $4.7 million represented loans performing as agreed according to the restructured terms. This compares with $12.0 million in total restructured loans at December 31, 2012. The amount of the valuation allowance related to TDRs was $2.8 million and $2.0 million as of December 31, 2013 and 2012 respectively.
Loan modifications that were classified as TDRs during the years ended December 31, 2013 and 2012 were as follows:
Of the 23 contracts classified as TDRs during 2013, the terms were extended for 18 loans, the interest rates were lowered for 18 loans and 12 loans were placed on interest only payment methods. During 2012, of the 15 loans that were considered to be TDRs, the terms were extended for 3 loans, the interest rates were lowered for 9 loans and 3 loans were placed on interest only payment methods.
During the year ended December 31, 2013, the Company identified as TDRs 13 loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying these loans as TDRs, the Company evaluated them for impairment. The accounting amendments require prospective application of the impairment measurement guidance for those loans newly identified as impaired. As of December 31, 2013, the recorded investment in the loans restructured during 2013 for which the allowance was previously measured under a general allowance methodology was $3.5 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss was $1.3 million.
During the year ended December 31, 2012, the Company identified as TDRs, five loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying these loans as TDRs, the Company evaluated them for impairment. As of December 31, 2012, the recorded investment in the loans restructured during 2012 for which the allowance was previously measured under a general allowance methodology was $1.7 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss was $341,000.
One loan modified as TDR during the year ended December 31, 2013 with a year end balance of $132,000 subsequently defaulted (i.e. 90 days or more past due following a restructuring) during the year. Three loans modified as TDRs during the year ended December 31, 2012 with a year end balance of $851,000 subsequently defaulted (i.e. 90 days or more past due following a restructuring) during 2013. One loan, secured by 1-4 family residential real estate, was modified as TDR prior to 2013 and charged-off during the year. The amount of the charge-off was $293,000.
Note 4.
Allowance for Loan Losses
The following table presents, the total allowance for loan losses, the allowance by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment), the total loans and loans by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment).
Note 5.
Premises and Equipment, Net
Premises and equipment consists of the following:
Depreciation expense was $1.8 million, for the years ended December 31, 2013, and 2012, respectively and $1.6 million for the year ended December 31, 2011.
Pursuant to the terms of non-cancelable lease agreements in effect at December 31, 2013, pertaining to banking premises and equipment, future minimum rent commitments (in thousands) under various operating leases are as follows:
Rent expense was $3.7 million, $3.6 million, and $3.3 million for the years ended December 31, 2013, 2012, and 2011, respectively.
Note 6.
Deposits
The Company has developed an interest bearing product that integrates the use of the cash within client accounts at Middleburg Trust Company for overnight funding at Middleburg Bank. The overall balance of this product was $42.1 million and $56.9 million at December 31, 2013 and 2012, respectively.
The aggregate amount of jumbo time deposits, each with a minimum denomination of $100,000, was approximately $146.0 million and $160.7 million at December 31, 2013 and 2012, respectively.
At December 31, 2013, the scheduled maturities of time deposits (in thousands) are as follows:
At December 31, 2013 and 2012, overdraft demand deposits reclassified to loans totaled $133,000 and $312,000, respectively.
At December 31, 2013, one depositor, with $31.7 million, held approximately 3.2% of the total deposits at Middleburg Bank.
Middleburg Bank obtains certain deposits through the efforts of third-party brokers. At December 31, 2013 and 2012, brokered deposits totaled $61.0 million and $65.1 million, respectively, and were included in time deposits.
Note 7.
Borrowings
As of December 31, 2013, Middleburg Bank had remaining credit availability in the amount of $282.8 million at the Federal Home Loan Bank of Atlanta. This line may be utilized for short and/or long-term borrowing. Advances on the line are secured by all of the Company’s first lien residential real estate loans on 1-4 unit, single-family dwellings; home equity lines of credit; and eligible commercial real estate loans. The amount of the available credit is limited to a percentage of the estimated market value of the loans as determined periodically by the FHLB of Atlanta. Any borrowings in excess of the qualifying collateral require pledging of additional assets.
The Company had $80.0 million of Federal Home Loan Bank advances outstanding as of December 31, 2013. The interest rates on these advances ranged from 0.17% to 1.98% and the weighted-average rate was 1.13%. The Company’s Federal Home Loan Bank advances totaled $77.9 million at December 31, 2012. The weighted-average interest rate on these advances at December 31, 2012 was 1.17%.
The contractual maturities of the Company’s long-term debt are as follows:
The outstanding balances and related information for Securities Sold Under Agreements to Repurchase, and Short-term Borrowings are summarized as follows:
At December 31, 2013, Southern Trust Mortgage closed and did not renew their revolving line of credit with a regional bank which was primarily used to fund its mortgages held for sale. At December 31, 2013, this line of credit had a zero balance. This line of credit had a credit limit of $24 million at December 31, 2012 and was guaranteed by Middleburg Bank up to $10 million.
Southern Trust Mortgage also has a $75 million line of credit for financing mortgage notes it originates until such time the mortgage notes can be sold and a $5 million line of credit for operating purposes with Middleburg Bank, of which $32.3 million and $89,000, respectively, were outstanding at December 31, 2013. These lines of credit are eliminated in the consolidation process and are not reflected in the consolidated financial statements of the Company.
The Company also has a line of credit with the Federal Reserve Bank of Richmond of $43.1 million of which there was no outstanding balance at December 31, 2013.
The Company has an additional $24 million in lines of credit available from other institutions at December 31, 2013.
Note 8.
Share-Based Compensation Plan
The Company sponsors one share-based compensation plan, the 2006 Equity Compensation Plan, which provides for the granting of stock options, stock appreciation rights, stock awards, performance share awards, incentive awards, and stock units. The 2006 Equity Compensation Plan was approved by the Company’s shareholders at the Annual Meeting held on April 26, 2006, and has succeeded the Company’s 1997 Stock Incentive Plan. Under the plan, the Company may grant share-based compensation to its directors, officers, employees, and other persons the Company determines have contributed to the profits or growth of the Company. During 2013, the Company's Board of Directors and shareholders approved an amendment to this Plan to increase the number of shares reserved for issuance from 255,000 shares to 430,000 shares, an increase of 175,000 shares.
The Company granted 28,500 shares of restricted stock on May 1, 2013 to certain employees and executive officers. The restricted stock award is a hybrid performance and service-based award that contains performance-based acceleration provisions if certain financial performance targets are met during pre-defined monitoring periods. If the performance targets are not met during the monitoring periods, only 50% of the awarded shares will vest on December 31, 2018. Under the terms of the award, vesting may be accelerated on a partial basis after December 31, 2015 depending on financial results for the years 2013 through 2015. Vesting may be accelerated each year thereafter until December 31, 2017 based on financial results as compared to a selected peer group for the preceding three years. If the stock award is not vested through acceleration, 50% of any unvested shares will become vested on December 31, 2018. All unearned restricted stock grants are forfeited if the employee leaves the Company prior to
vesting. Additionally, on May 1, 2013, 4,000 shares of restricted stock were awarded to members of the board of directors. The shares will vest at 100% on April 30, 2014.
For the years ended December 31, 2013, 2012, and 2011, the Company recorded $492,000, $440,000, and $471,000, respectively, in share-based compensation expense related to restricted stock and option grants. The total income tax benefit related to share-based compensation was $54,000, $79,000, and $111,000 in 2013, 2012, and 2011, respectively.
The following table summarizes restricted stock service awards awarded under the 2006 Equity Compensation Plan:
The weighted-average remaining contractual term for non-vested service award grants at December 31, 2013, 2012, and 2011 was 3.9 , 4.3, and 4.5 years, respectively. As of December 31, 2013, there was $1.4 million of total unrecognized compensation expense related to the non-vested service award grants under the 2006 Equity Compensation Plan.
For the years ended December 31, 2013, 2012, and 2011, the Company recorded $412,000, $362,000, and $217,000, respectively, in compensation expense for service-based restricted stock awards
The aggregate intrinsic value represents the amount by which the current market value of the underlying stock exceeds the exercise price. This amount changes based on changes in the market value of the Company’s common stock.
The following table summarizes restricted stock performance awards awarded under the 2006 Equity Compensation Plan:
There were no performance-based restricted stock granted during the years ended December 31, 2013, 2012 and 2011. As of December 31, 2013, there was no unrecognized compensation expense related to the non-vested performance awards under the 2006 Equity Compensation Plan.
Performance-based restricted stock awards vest based on the target levels being reached over a three-year period. Compensation expense is recognized based on the grant-date fair value of the awards and the estimated forfeiture rate associated with achieving the target result level. For the years ended December 31, 2013, 2012 and 2011, the Company recorded $80,000, $64,000, and $206,000 respectively, in compensation expense related to performance-based restricted stock awards.
Stock options may be granted periodically to certain officers and employees under the Company’s share-based compensation plan at prices equal to the market value of the stock on the date the options are granted. Options granted vest over a three-year time period over which 25% vests on each of the first and second anniversaries of the grant and 50% on the third anniversary of the grant. As of December 31, 2013, all outstanding option awards were vested and, accordingly, there was no unrecognized compensation expense related to unvested stock-based option awards. The Company recorded $14,000 and $49,000 in compensation expense for the years ended December 31, 2012 and 2011, respectively, related to previously issued stock option awards. Shares issued in connection with stock option exercises may be issued from available treasury shares or from market purchases. There were no stock option awards granted during the years ended December 31, 2013, 2012 or 2011.
The following table summarizes options outstanding under the 2006 Equity Compensation Plan and remaining outstanding unexercised options under the 1997 Stock Incentive Plan at the end of the reportable periods.
The total intrinsic value of options exercised was $11,100 at December 31, 2013. There was $160,300 aggregate intrinsic value of options outstanding at December 31, 2013 and no aggregate intrinsic value of options outstanding at 2012 and 2011.
As of December 31, 2013, options outstanding and exercisable are summarized as follows:
Note 9.
Employee Benefit Plans
The Company sponsored a noncontributory, defined benefit pension plan covering substantially all full-time employees of Middleburg Bank and Middleburg Trust Company. The defined benefit pension plan was terminated in February of 2011, and all plan assets were distributed to participants as of December 31, 2011. When the plan was active, the Company funded pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act. Benefit accruals and eligibility were frozen as of September 30, 2009. Information about the plan follows:
401(k) Plan
The Company has a 401(k) plan whereby a majority of employees participate in the plan. Employees may contribute up to 100% of their compensation subject to certain limits based on federal tax laws. The Company makes matching contributions equal to 50% of the first 6% of an employee’s compensation contributed to the plan. Matching contributions vest to the employee equally over a five year period. For the years ended December 31, 2013, 2012, and 2011, expense attributable to the plan amounted to $355,000, $308,000 and $250,000, respectively.
Money Purchase Pension Plan (MPPP)
The Middleburg Financial Corporation Defined Benefit Pension Plan was replaced by a Money Purchase Pension Plan effective on January 1, 2010. Employees who have attained age 21 and completed one year of service are eligible to participate in the plan as of the first day of the month following the completion of such eligibility provisions. Employees earn a year of service if they complete one thousand hours of service in a plan year. Service with Middleburg Financial Corporation and its subsidiaries prior to the effective date of the Plan counts toward a participant's initial eligibility to participate in the plan.
Each year, a participant receives an allocation of an employer contribution equal to 6.5% of total compensation (up to the statutory maximum) plus an additional contribution of 2.75% of compensation in excess of the Social Security taxable wage base (up to the statutory maximum). To receive an allocation, the participant must complete one thousand hours of service in the plan year and be employed on the last day of the plan year. The requirement to be employed on the last day of the plan year does not apply if a participant dies, retires, or becomes disabled during the plan year.
Participants become vested in their employer contributions according to a schedule which allows for graduated vesting and full vesting after five years of service. Service with Middleburg Financial Corporation and its subsidiaries prior to the effective date of the Plan count toward a participant's vested percentage.
Assets are held in a pooled investment account managed by Middleburg Trust Company, a wholly owned subsidiary of the Company. Distributions may be made upon termination of employment, death or disability.
The plan is administered by the Benefits Committee of the Company. The plan may be amended from time to time by the Board or its delegate and may be terminated by the Board at any time for any reason.
For the years ended December 31, 2013 , 2012, and 2011 expense attributable to the plan was $1.0 million, $940,000, and $826,000, respectively.
Deferred Compensation Plans
The Company has adopted several deferred compensation plans; including a defined benefit SERP, an elective deferral plan for the Chairman, and a defined contribution SERP for certain Executive Officers. The two plans for the Chairman made installment payouts in 2013, 2012 and 2011. The defined contribution SERP for Executive Officers includes a vesting schedule, and is currently credited at a rate using the 10-year treasury plus 1.5%. The deferred compensation expense for 2013, 2012, and 2011, was $210,000, $204,000, and $133,000, respectively. The plans are unfunded; however, life insurance has been acquired on the life of the employees in amounts sufficient to help meet the costs of the obligations.
Note 10.
Income Taxes
The Company files income tax returns in the U.S. federal jurisdiction and the state of Virginia and various other states. With few exceptions, the Company is no longer subject to U.S. federal or state income tax examinations by tax authorities for years prior to 2010.
The Company believes it is more likely than not that the benefit of deferred tax assets will be realized. Consequently, no valuation allowance for deferred tax assets is deemed necessary at December 31, 2013 and 2012.
Net deferred tax assets consist of the following components as of December 31, 2013 and 2012:
The provision for income taxes charged to operations for the years ended December 31, 2013, 2012, and 2011, consists of the following:
The income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2013, 2012, and 2011, due to the following:
Note 11.
Related Party Transactions
The Company’s commercial and retail banking segment has, and may be expected to have in the future, banking transactions in the ordinary course of business with directors, principal officers, their immediate families and affiliated companies in which they are principal stockholders, commonly referred to as related parties. Any loans made to related parties were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time of origination for comparable loans with persons not related to the lender; and did not involve more than the normal risk of collectability or present other unfavorable features. Loans outstanding to directors and executive officers at December 31, 2013 and 2012 were:
Additionally, unused commitments to extend credit to related parties were $2.3 million at December 31, 2013 and $1.7 million at December 31, 2012.
Related party deposits totaled $11.6 million and $8.8 million at December 31, 2013 and 2012, respectively.
Note 12.
Contingent Liabilities and Commitments
In the normal course of business, there are various outstanding commitments and contingent liabilities, which are not reflected in the accompanying consolidated financial statements. The Company does not anticipate any material loss as a result of these transactions.
See Note 15 with respect to financial instruments with off-balance sheet risk.
The Company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the years ended December 31, 2013 and 2012, the aggregate amount of gross daily average required reserves was approximately $2.1 million and $9.1 million, respectively.
Note 13.
Earnings Per Share
The following shows the weighted-average number of shares used in computing earnings per share and the effect on weighted-average number of shares of diluted potential common stock. Potential dilutive common stock had no effect on income available to common stockholders.
In 2013, 2012, and 2011, stock options and restricted grants representing approximately 11,900, 37,700 and 163,900 shares, respectively, ranging in price from $22.00 to $39.40, were not included in the calculation of earnings per share because they would have been anti-dilutive. In 2011, warrants to purchase 104,101 common shares with an exercise price of $15.85 were not included in the calculation of earnings per share because to do so would have been anti-dilutive.
Note 14.
Retained Earnings
Transfers of funds from the banking subsidiary to the Parent Company in the form of loans, advances, and cash dividends are restricted by federal and state regulatory authorities. Federal regulations limit the payment of dividends to the sum of a bank’s current net income and retained net income of the three prior years. During the year ended December 31, 2011, the Company was required to and received approval from federal and state regulatory authorities to transfer amounts in excess of dividend restrictions. As of December 31, 2013, the subsidiary bank had approximately $15.0 million in excess of regulatory limitations available for transfer to the Parent Company.
Note 15.
Financial Instruments With Off-Balance Sheet Risk and Credit Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, and interest rate swaps. Those instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. See Note 24 for more information regarding the Company’s use of derivatives.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
A summary of the contract amount of the Company's exposure to off-balance sheet risk as of December 31, 2013 and 2012, is as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income producing commercial properties.
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which the Company is committed.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary.
The Company has approximately $2.0 million in deposits in financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at December 31, 2013.
Note 16.
Fair Value Measurements
The Company follows ASC 820, "Fair Value Measurements" to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:
Level I.
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
Level II.
Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.
Level III.
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
Measured on a recurring basis
The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a recurring basis in the financial statements.
Securities Available for Sale
The Company primarily values its investment portfolio using Level II fair value measurements, but may also use Level I or Level III measurements if required by the future composition of the portfolio. If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level II). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified as Level III of the valuation hierarchy.
Loans Held for Sale
Loans held for sale are carried at market value. These loans currently consist of 1-4 family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data (Level II). Gains and losses on the sale of loans are recorded within income from mortgage banking activities on the consolidated statements of income.
Mortgage Interest Rate Locks
The Company recognizes mortgage interest rate locks at fair value. Fair value is based on either (i) the price of the underlying loans obtained from an investor for loans that will be delivered on a best efforts basis or (ii) the observable price for individual loans traded in the secondary market for loans that will be delivered on a mandatory basis. All of the Company's mortgage interest rate locks are classified as Level II.
Mortgage Banking Hedge Instruments
Mortgage banking hedge instruments are used to mitigate interest rate risk for residential mortgage loans held for sale and interest rate locks. These instruments are considered derivatives and are recorded at fair value, based on (i) committed sales prices from investors for commitments to sell mortgage loans or (ii) observable market data inputs for commitments to sell mortgage backed securities. The Company's mortgage banking hedge instruments are classified as Level II.
Interest Rate Swaps
Interest rate swaps are recorded at fair value and are based on third party vendors who compile prices from various sources and may determine fair value of identical or similar instruments by using pricing models that consider observable market data (Level II).
Mortgage Servicing Rights
The Company obtains the fair value of mortgage servicing rights from an independent valuation service. The model used by the independent service to value mortgage servicing rights incorporates inputs and assumptions such as loan characteristics, contractually specified servicing fees, prepayment speeds, delinquency rates, late charges, escrow income, other ancillary revenue, costs to service and other economic factors. Fair value estimates from the model are adjusted for recent market activity, actual experience and, when available, other observable market data (Level II).
The following tables present the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 and 2012.
The following table presents quantitative information as of December 31, 2013 related to Level III fair value measurements for financial assets measured at fair value on a recurring basis:
Measured on nonrecurring basis
The Company may be required, from time to time, to measure and recognize certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a nonrecurring basis in the financial statements.
Impaired Loans
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business
assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level II). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level III. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business's financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level III). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.
When collateral-dependent loans are performing in accordance with the original terms of their contract, the Company continues to use the appraisal that was performed at origination as the basis for the collateral value. When collateral-dependent loans are considered nonperforming, they are reviewed to determine the next appropriate course of action, either foreclosure or modification with forbearance agreement. The loans would then be reappraised prior to foreclosure or before a forbearance agreement is executed. This process does not vary by loan type.
The Company's procedure to monitor the value of collateral for collateral-dependent impaired loans between the receipt of the original appraisal and an updated appraisal is to review annual tax assessment records. At this time, adjustments are made, if necessary. Information considered in the determination not to order an updated appraisal includes the availability and reliability of tax assessment records and significant changes in capitalization rates for income properties. Other facts and circumstances on a case-by-case basis may be considered relative to a decision not to order an updated appraisal. If, in the judgment of management, a reliable collateral value cannot be obtained by an alternative method, an updated appraisal would be obtained.
Circumstances that may warrant a reappraisal for nonperforming loans might include foreclosure proceedings or a material adverse change in the borrower's condition or that of the collateral underlying the loan. In some cases, management may decide that an updated appraisal for a nonperforming loan is not necessary, In such cases, an estimate of the fair value of the collateral would be made by management by reference to current tax assessments, the latest appraised value, and knowledge of collateral value fluctuations in a loan's market area. If, in management's judgment, a reliable collateral value cannot be obtained by an alternative method, an updated appraisal would be obtained.
For the purpose of evaluating the allowance for loan losses, new appraisals are discounted 10% for estimated selling costs when determining the amount of specific reserves. Thereafter, for collateral-dependent impaired loans, we consider each loan on a case-by-case basis to determine whether or not the recorded values are appropriate given current market conditions. When necessary, new appraisals are obtained. If an appraisal is less than 12 months old, the only adjustment made is the 10% discount for selling costs. If an appraisal is older than 12 months, management will use judgment based on knowledge of current market values and specific facts surrounding any particular property to determine if an additional valuation adjustment may be necessary.
Other Real Estate Owned
The value of other real estate owned (“OREO”) is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level II). For other real estate owned properties that may be in construction, the Company’s policy is to obtain “as-is” appraisals on an annual basis as opposed to “as-completed” appraisals. This approach provides current values without regard to completion of any construction or renovation that may be in process. Accordingly, the Company considers the valuations to be Level II valuations even though some properties may be in process of renovation or construction. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability or other factors, then the fair value is considered Level III. Any initial fair value adjustment is charged against the Allowance for Loan Losses. Any subsequent fair value adjustments are recorded in the period incurred and included in other non-interest expense on the consolidated statements of income.
For the purpose of OREO valuations, appraisals are discounted 10% for selling and holding costs and it is the policy of the Company to obtain annual appraisals for properties held in OREO. Any fair value adjustments are recorded in the period incurred as loss on other real estate owned on the consolidated statements of income.
The following table summarizes the Company’s non-financial assets that were measured at fair value on a nonrecurring basis during the period.
The following table presents quantitative information as of December 31, 2013 and 2012 about Level III fair value measurements for financial assets measured at fair value on a non-recurring basis:
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. U.S. generally accepted accounting principles excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Cash Equivalents
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.
Loans, Net
For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality. Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value. Fair value for impaired loans is described above.
Bank Owned Life Insurance
The carrying amount of bank owned life insurance is a reasonable estimate of fair value.
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate fair values.
Deposits
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. For all other deposits, the fair value is determined using the discounted cash flow method. The discount rate is equal to the rate currently offered on similar products.
Securities Sold Under Agreements to Repurchase and Short-Term Debt
The carrying amounts approximate fair values.
FHLB Borrowings and Subordinated Debt
For variable rate long-term debt, fair values are based on carrying values. For fixed rate debt, fair values are estimated based on observable market prices and discounted cash flow analysis using interest rates for borrowings of similar remaining maturities and characteristics. The fair values of the Company's Subordinated Debentures are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.
Off-Balance Sheet Financial Instruments
The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 2013 and 2012, the fair values of loan commitments and standby letters of credit were deemed immaterial; therefore, they have not been included in the tables below.
Fair Value of Financial Instruments
The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows:
The Company assumes interest rate risk as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change, which may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.
Note 17.
Capital Requirements
The Company, on a consolidated basis, and Middleburg Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Middleburg Bank must meet specific capital guidelines that involve quantitative measures of the Company's and Middleburg Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Company and Middleburg Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets. Management believes, as of December 31, 2013 and 2012, that the Company and Middleburg Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2013, the most recent notification from the Federal Reserve Bank categorized Middleburg Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
The Company’s and Middleburg Bank’s actual capital amounts and ratios are also presented in the following table.
Note 18.
Goodwill and Intangibles Assets
Goodwill and intangible assets relate to the Company’s acquisition of Middleburg Trust Company and Middleburg Investment Advisors and the consolidation of Southern Trust Mortgage. Goodwill is not amortized, but is tested at least annually for impairment by the Company. In light of the declining profitability in the mortgage business and increasing regulatory burdens, the Company recorded a $500,000 goodwill impairment charge related to Southern Trust Mortgage. This charge is reflected on the consolidated statements of income for 2013. There was no impairment of goodwill or intangible assets for 2012, or 2011. Identifiable intangible assets are being amortized over the period of expected benefit, which is 15 years. Information concerning goodwill and intangible assets is presented in the following table:
Amortization expense of intangible assets for each of the three years ended December 31, 2013, 2012, and 2011 totaled $171,000. Estimated amortization expense of identifiable intangibles for the years ended December 31 follows:
Note 19.
Trust-Preferred Capital Notes
On December 12, 2003, MFC Capital Trust II, a wholly owned subsidiary of the Company, was formed for the purpose of issuing redeemable Capital Securities. On December 19, 2003, $5 million of trust-preferred securities were issued through a pooled underwriting totaling approximately $344 million. The securities have a LIBOR-indexed floating rate of interest.
During 2013, the interest rates ranged from 3.09% to 3.15%. For the year ended December 31, 2013, the weighted-average interest rate was 3.12%. The securities have a mandatory redemption date of January 23, 2034, and are subject to varying call provisions beginning January 23, 2009. The principal asset of the trust is $5.2 million of the Company’s junior subordinated debt securities with like maturities and like interest rates to the Capital Securities. See Note 24 for information regarding an interest rate swap entered into by the Company to manage the cash flows associated with these trust preferred securities.
The trust-preferred securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 Capital after its inclusion. The portion of the trust-preferred securities not considered as Tier 1 Capital may be included in Tier 2 Capital. On December 31, 2013, all of the Company’s trust-preferred securities are included in Tier I Capital.
The obligations of the Company with respect to the issuance of the Capital Securities constitute a full and unconditional guarantee by the Company of the trusts’ obligations with respect to the Capital Securities.
Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Capital Securities. There were no deferred interest payments on our junior subordinated debt securities at December 31, 2013, 2012 and 2011.
Note 20.
Consolidation of Southern Trust Mortgage
In May 2008, Middleburg Bank acquired the membership interest units of one of the partners of Southern Trust Mortgage for $1.6 million. As a result, the Company’s ownership interest exceeded 50% of the issued and outstanding membership units. At December 31, 2013, the Company owned 62.3% of the issued and outstanding membership interest units of Southern Trust Mortgage, through its subsidiary, Middleburg Bank.
Note 21.
Condensed Financial Information - Parent Corporation Only
Note 22.
Segment Reporting
The Company operates in a decentralized fashion in three principal business activities: retail banking services; wealth management services; and mortgage banking services.
•
Revenue from retail banking activity consists primarily of interest earned on loans and investment securities and service charges on deposit accounts.
•
Revenue from the wealth management activities is comprised of fees based upon the market value of the accounts under administration as well as commissions on investment transactions. The wealth management services are conducted by Middleburg Investment Group.
•
Revenue from the mortgage banking activities is comprised of interest earned on loans and fees received as a result of the mortgage origination process. The Company recognizes gains on the sale of loans as part of other income. The mortgage banking services are conducted by Southern Trust Mortgage, LLC.
Middleburg Bank and the Company have assets in custody with Middleburg Trust Company and accordingly pay Middleburg Trust Company a monthly fee. Middleburg Bank also pays interest to Middleburg Trust Company on deposit accounts with Middleburg Bank. Middleburg Bank provides a warehouse line and office space, data processing and accounting services to Southern Trust Mortgage for which it receives income. Transactions related to these relationships are eliminated to reach consolidated totals.
Information about reportable segments and reconciliation to the consolidated financial statements follows:
Note 23.
Capital Purchase Program and Stock Warrant
On January 30, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008, the Company entered into a Letter Agreement and Securities Purchase Agreement-Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 22,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $2.50 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 208,202 shares of the Company’s common stock, par value $2.50 per share, at an initial exercise price of $15.85 per share. As a result of the completion of a public stock offering in 2009, the number of shares of common stock underlying the Warrant was reduced by one-half to 104,101 and the Company redeemed all 22,000 shares of Preferred Stock pursuant to the Purchase Agreement. During 2011, the Warrant was sold by the U.S. Treasury at public auction and has not been exercised as of December 31, 2013.
Note 24.
Derivatives
The Company utilizes derivative instruments as a part of its asset-liability management program to control fluctuation of market values and cash flows to changes in interest rates associated with certain financial instruments. The Company accounts for derivatives in accordance with ASC 815, "Derivatives and Hedging". Under current guidance, derivative transactions are classified as either cash flow hedges or fair value hedges or they are not designated as hedging instruments. The Company designates each derivative instrument at the inception of the derivative transaction in accordance with this guidance. Information concerning each of the Company's categories of derivatives as of December 31, 2013 and 2012 is presented below.
Derivatives designated as cash flow hedges
During 2010, the Company entered into an interest rate swap agreement as part of the interest rate risk management process. The swap was designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s trust preferred capital securities described in Note 19, “Trust-Preferred Capital Notes”. The swap hedges the cash flow associated with the trust preferred capital notes wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 2.59% to the same counterparty. The swap is calculated on a notional amount of $5.2 million. The term of the swap is 10 years and commenced on October 23, 2010. The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant.
Amounts receivable or payable are recognized as accrued under the terms of the agreement, with the effective portion of the derivative’s unrealized gain or loss recorded as a component of other comprehensive income. The ineffective portion of the unrealized gain or loss, if any, would be recorded in other expense. The Company has assessed the effectiveness of the hedging relationship by comparing the changes in cash flows on the designated hedged item. As a result of this assessment, no hedge ineffectiveness for this swap was identified during 2013 or 2012. At December 31, 2013 and December 31, 2012, the fair value of the swap agreement was an unrealized loss of $72 and $461 respectively. The values represent the amounts the Company would have expected to pay if the contract was terminated on those dates.
During 2013, the Company entered into an interest rate swap agreement as part of the interest rate risk management process. The swap has been designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s FHLB borrowings described in Note 7, “Borrowings”. The swap hedges the cash flows associated with the FHLB borrowings wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 1.43% to the same counterparty. The swap is calculated on a notional amount of $10 million. The term of the swap is 5 years and commenced on November 25, 2013. The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant.
Amounts receivable or payable are recognized as accrued under the terms of the agreement, with the effective portion of the derivative’s unrealized gain or loss recorded as a component of other comprehensive income. The ineffective portion of the unrealized gain or loss, if any, would be recorded in other income or other expense. The Company has assessed the effectiveness of the hedging relationship by comparing the changes in cash flows on the designated hedged item. As a result of this assessment, hedge ineffectiveness for this interest rate swap was identified during 2013. At December 31, 2013, the fair value of the swap agreement was an unrealized gain of $102,000. The values represent the amounts the Company would have expected to pay or receive if the contract was terminated on those dates.
The amounts included in accumulated other comprehensive income (loss) as unrealized losses (market value net of tax) were $29,100 and $304,000 as of December 31, 2013 and 2012, respectively.
Information concerning the derivative designated as a cash flow hedge at December 31, 2013 and 2012 is presented in the following tables:
Derivatives designated as fair value hedges
The Company will from time to time utilize derivatives to limit exposure to the variability of fair market values of certain financial instruments. Information below is presented on derivatives designated as fair value hedges as of December 31, 2013.
Mortgage banking activities
As part of its mortgage banking activities, our mortgage subsidiary enters into interest rate lock commitments which are commitments to originate loans whereby the interest rate on the loan is determined prior to funding and the customers have locked the interest rate. The period of time between the origination of a loan commitment and closing and sale of the loan generally ranges from 60 to 120 days. Our subsidiary will either lock the loan and associated rate in with an investor and commit to deliver the loan only if settlement occurs ("best efforts delivery") or it will commit to deliver the locked loan in a binding ("mandatory") delivery program with an investor. Because of the high correlation between best efforts delivery contracts and interest rate lock commitments, no gain or loss is recognized on best efforts contracts and any resulting interest rate risk associated with these transactions is borne by the ultimate purchaser of the loan. Accordingly, the Company has not designated best efforts delivery contracts and the related interest rate lock commitments as hedging instruments (See discussion below under "Derivatives not designated as hedging instruments").
Mandatory delivery of mortgage loans
For the portion of interest rate lock commitments that are designated to be delivered under a mandatory delivery method, the Company bears the risk of changes in value of the commitment from the time a rate is locked with the mortgage customer until a loan is closed and ultimately sold to an investor. To mitigate this risk, the Company enters into forward sales contracts of mortgage backed securities ("MBS") with similar characteristics to the rate lock commitments. Both the rate lock commitments and the associated forward sales contracts have been designated as fair value hedges by the Company.
Rate lock commitments and forward sales contracts of MBS are recorded at fair value with changes in fair value recorded through non-interest income on the consolidated statements of income.
The notional amount of interest rate lock commitments related to mandatory delivery methods totaled $22.2 million and $8.8 million at December 31, 2013 and 2012, respectively. This represented a total of 110 and 41 open interest rate lock commitments under mandatory delivery at December 31, 2013 and 2012. The fair value of the open interest rate lock commitments under mandatory delivery at December 31, 2013 and 2012 were $16,000 and $35,000, respectively.
At December 31, 2013 and 2012, the mortgage subsidiary had open forward sales contracts of MBS with a notional value of $33.0 million and $9.1 million, respectively. At December 31, 2013 and 2012, the mortgage subsidiary had 27 and 11, respectively, of
open forward sales contracts of MBS. The fair value of these open forward sales contracts was $202,000 and $39,000 at December 31, 2013 and 2012, respectively. Certain additional risks arise from these forward delivery contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. We do not expect any counterparty to fail to meet its obligations. Additional risks inherent in mandatory delivery programs include the risk that if the mortgage subsidiary does not close the loans subject to interest rate lock commitments, they will be obligated to deliver MBS to the counterparty under the forward sales agreement. Should this be required, the mortgage subsidiary could incur significant costs in acquiring replacement loans or MBS.
Derivatives not designated as hedging instruments
Best efforts delivery mortgage banking derivatives
Interest rate lock commitments under best efforts delivery and the resulting commitments to deliver loans to investors on a best efforts basis are considered derivatives. For loans to be delivered under a best efforts delivery method, the Company mitigates any risk from changes in interest rates through the use of best effort forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the investor has assumed interest rate risk on the loan. As a result, the Company is not exposed to losses nor will it realize gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitment and the best efforts contracts is very high.
As of December 31, 2013 and 2012, the notional amount of open best efforts interest rate lock commitments was $103.5 million and $93.8 million respectively. The related notional amounts of open forward sales commitments to investors as of December 31, 2013 and 2012 was $114.4 million and $167.2 million respectively.
The market value of best effort rate lock commitments and best efforts forward delivery contracts is not readily ascertainable with
precision because the rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments.
Since the time between when a loan is locked under a best efforts contract and delivery of that loan to an investor is short, and the investor has committed to purchase the loan at an agreed-upon price, if it settles, we have concluded that the difference between the fair value of the loans and the fair value of the best efforts commitments is not expected to be material.
Two-way client loan swaps
During the fourth quarter of 2012, the Company entered into certain interest rate swap contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which we enter into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each swap transaction, the Company agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on an identical notional amount at a fixed interest rate. At the same time, the Company agrees to pay the counterparty the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our clients to effectively convert a variable rate loan into a fixed rate loan. Because the Company acts as an intermediary for our customers, changes in the fair value of the underlying derivatives contracts offset each other and do not significantly impact our results of operations. The aggregate notional amount of these swap agreements with counterparties was $4.2 million and $4.5 million as of December 31, 2013 and December 31, 2012, respectively. The Company had no undesignated interest rate swaps at December 31, 2013 and December 31, 2012.
Certain additional risks arise from interest rate swap contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. We do not expect any counterparty to fail to meet its obligations.
Information concerning two-way client interest rate swaps not designated as either fair value or cash flow hedges is presented in the following table:
Note 25. Accumulated Other Comprehensive Income (Loss)
The following table presents information on changes in accumulated other comprehensive income (loss) for the periods indicated:
The following table presents information related to reclassifications from accumulated other comprehensive income (loss):
(1) For more information related to unrealized gains on securities available for sale, see Note 3, "Securities".