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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2004

or

[   ] Transition Report pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission file number:  0-24159

MIDDLEBURG FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

(703) 777-6327

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   X    No       

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes         No   X  

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 3,803,727 shares of common stock, par value $2.50 per share,

outstanding as of November 4, 2004

MIDDLEBURG FINANCIAL CORPORATION

INDEX

Part I.    Financial Information

Page No.

Item 1.

Financial Statements

Consolidated Balance Sheets

3

Consolidated Statements of Income

4

Consolidated Statements of Changes in Shareholders’ Equity

5

Consolidated Statements of Cash Flows

6

Notes to Consolidated Financial Statements

7

 Item 2.

Management’s Discussion and Analysis of Financial

Condition and Results of Operations                    

13

 Item 3.

       Quantitative and Qualitative Disclosures About Market Risk

21

 Item 4.        Controls and Procedures

23

Part II.     Other Information

Item 1.

Legal Proceedings

24

Item 2.  

Unregistered Sales of Equity Securities and Use of Proceeds

24

Item 3.  

Defaults upon Senior Securities

24   

Item 4.

Submission of Matters to a Vote of Security Holders

24

Item 5.  

Other Information

24

Item 6.  

Exhibits

24

Signatures

25

2

PART I.  FINANCIAL INFORMATION

Item 1.  FINANCIAL STATEMENTS

MIDDLEBURG FINANCIAL CORPORATION

Consolidated Balance Sheets

(In Thousands, Except Share Data)

 See Accompanying Notes to Consolidated Financial Statements.

3

MIDDLEBURG FINANCIAL CORPORATION

Consolidated Statements of Income

(In Thousands, Except Per Share Data)

(Unaudited)

 See Accompanying Notes to Consolidated Financial Statements.

4

MIDDLEBURG FINANCIAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity

For the Nine Months Ended September 30, 2004 and 2003

(In Thousands, Except Share Data)

(Unaudited)

See Accompanying Notes to Consolidated Financial Statements.

5

MIDDLEBURG FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(In Thousands)

(Unaudited)

See Accompanying Notes to Consolidated Financial Statements.

6

MIDDLEBURG FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

For the Nine Months Ended September 30, 2004 and 2003

(Unaudited)

Note 1.

General

In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position at September 30, 2004 and the results of operations for the nine month and three month periods ended September 30, 2004 and 2003 and changes in cash flows for the nine months ended September 30, 2004 and 2003.  The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K of Middleburg Financial Corporation (the “Company”) for the year ended December 31, 2003 (the “2003 Form 10-K”).  The results of operations for the nine month and three month periods ended September 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year.

On September 11, 2003, the Board of Directors of the Company approved a 2-for-1 stock split (the “Stock Split”) of the Company’s common stock (“Common Stock”).  The distribution of the additional shares of Common Stock was made on October 17, 2003 to shareholders of record as of October 2, 2003.  All share and per share information for all periods presented in this report has been retroactively restated to reflect the Stock Split.

Note 2.

Stock –Based Employee Compensation Plan

At September 30, 2004, the Company had a stock-based employee compensation plan.  The Company accounts for the plan under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.  

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Note 3.

Securities

Securities being held to maturity at September 30, 2004 are summarized as follows:

Securities available for sale at September 30, 2004 are summarized below:

Note 4.

Loan Portfolio

The consolidated loan portfolio is composed of the following:

The Company had $336,000 in non-performing assets at September 30, 2004.

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Note 5.

Allowance for Loan Losses

The following is a summary of transactions in the allowance for loan losses:

Note 6.  

Earnings Per Share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of potential dilutive common stock.  Potential dilutive common stock has no effect on income available to common shareholders.

Note 7.

Segment Reporting

The Company operates in a decentralized fashion in two principal business activities: banking services and trust and investment advisory services.  Revenue from banking activities consists primarily of interest earned on loans and investment securities and service charges on deposit accounts through Middleburg Bank (the “Bank”).  Through the Bank’s 40% investment in Southern Trust Mortgage, LLC  (“Southern Trust”), the Company also recognizes its share of the net income from the Southern Trust investment in the other income section of the Bank’s income statement.

Revenues from trust and investment advisory activities are comprised mostly of fees based upon the market value of the accounts under administration. The trust and investment advisory services are conducted by two subsidiaries of the Company, Tredegar Trust Company (“Tredegar”) and Gilkison Patterson Investment Advisors, Inc. (“GPIA”).

The banking segment has assets in custody with Tredegar and accordingly pays Tredegar a monthly fee. The banking segment also pays interest to both Tredegar and GPIA on deposit accounts each company has at the Bank. GPIA pays the Company a management fee each month for accounting and

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other services provided.  Transactions related to these relationships are eliminated to reach consolidated totals.

The following tables present segment information for the nine months ended September 30, 2004 and September 30, 2003.

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The following tables present segment information for the three months ended September 30, 2004 and September 30, 2003.

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Note 8.

Defined Benefit Pension Plan

The table below reflects the components of the Net Periodic Benefit Cost.

The Company previously disclosed in the 2003 Form 10-K that it expected to contribute $307,000 to its pension plan in 2004.  As of September 30 2004, no contributions have been made.   The Company plans to make all required contributions for 2004.  

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Item 2.

 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to Consolidated Financial Statements and this section are, to a large 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 the Company’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

The Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  The 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 it is 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.

The Bank’s credit administration department evaluates various loans individually for impairment as required by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, 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 under SFAS No. 5, Accounting for Contingencies (“SFAS 5”), with a group of loans that have similar characteristics.

For loans without individual measures of impairment, the Bank makes estimates of losses for groups of loans as required by SFAS 5.  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 amounts of estimated impairment for individually evaluated loans and groups of loans are added together for a total estimate of loan losses.  This estimate of losses is compared to the allowance for loan losses of the 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

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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.  The 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.  

Intangibles and Goodwill

The Company had approximately $6.3 million in intangible assets and goodwill at September 30, 2004, a decrease of $253,000 since December 31, 2003.  On April 1, 2002, the Bank acquired GPIA, a registered investment advisor, for $6.0 million. Approximately $5.9 million of the purchase price was allocated to intangible assets and goodwill. In connection with this investment, a purchase price valuation (using SFAS Nos. 141 and 142 as a guideline) was completed to determine the appropriate allocation to identified intangibles.  The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years.  Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of seven years.  The remainder of the purchase price has been allocated to goodwill. Approximately $1.0 million of the $6.3 million in intangible assets and goodwill at September 30, 2004 is attributable to the Company’s investment in Tredegar.

The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of GPIA’s management add to the success of the Company.  For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future.  If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the Consolidated Financial Statements could result in a possible impairment of the intangible assets and goodwill or require an acceleration in the amortization expense.

In addition, SFAS No. 142 requires that goodwill be tested annually using a two-step process.  The first step is to identify a potential impairment.  The second step measures the amount of the impairment loss, if any. The Company engages an independent third party to conduct the two-step process as required by SFAS No. 142.  On January 27, 2004, the third party issued an opinion that stated the amount of goodwill carried on the Company’s balance sheet at December 31, 2003 was not impaired.

When the Company completes its ongoing review of the recoverability of intangible assets and goodwill, factors that are considered important to determining whether an impairment might exist include loss of customers acquired or significant withdrawals of the assets currently under management and/or early retirement or termination of key members of management.  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.  

Financial Summary

Net income for the nine months ended September 30, 2004 decreased to $5.6 million from the $6.4 million reported for the nine months ended September 30, 2003.  Core operations have been impacted by a declining net interest margin, marginal decline in net mortgage banking income and slower than expected recovery in the investment sales division.  In addition, gains realized on the sale of investment securities during the first nine months of 2004 decreased $299,000 from those realized during the same period in 2003.  

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Total average assets increased 16.9% from $458 million for the nine months ended September 30, 2003 to $536 million for the same period in 2004.  Average shareholders’ equity increased 10.1% or $4.5 million over the same periods. Annualized returns on average assets and equity for the nine months ended September 30, 2004 were 1.4% and 15.2%, respectively, compared to 1.9% and 19.5% for the same period in 2003.

Total assets for the Company increased to $573.8 million at September 30, 2004, compared to $508.9 million at December 31, 2003, representing an increase of $64.9 million or 12.8%.   Net loans at September 30, 2004 were $309.1 million, an increase of $51.0 million from the December 31, 2003 amount of $258.1 million.  Additional staff, a solid local economy and the relationship with Southern Trust Mortgage Company (“Southern Trust”) have contributed to the loan growth experienced thus far in 2004.  Net recoveries were $41,000 for the nine months ended September 30, 2004.  The provision for loan losses for the nine months ended September 30, 2004 was $508,000 compared to $425,000 for the same period in 2003.  The allowance for loan losses was $3.2 million or 1.0% of total loans outstanding at September 30, 2004.

On April 15, 2003, the Bank acquired a 40% interest in Southern Trust.  In connection with the Bank’s investment in Southern Trust, the Bank’s existing mortgage operation was assumed by Southern Trust and the Bank entered into two loan participation agreements with Southern Trust.  One arrangement is a tri-party agreement among the Bank, Southern Trust and Colonial Bank, Southern Trust’s warehouse line lender.  Under this agreement, the Bank purchases 99.0% of selected loans from Colonial Bank. Currently, the Bank charges Southern Trust a rate equal to the one month LIBOR rate at the time of purchase plus 170 basis points. The LIBOR rate previously had a floor of 1.95%, which was removed on October 1, 2003.  Under the tri-party agreement, the Bank does not intend to hold the purchased loans more than 30 days. Colonial Bank acts as a custodian on behalf of the Bank, and the Bank engages a third party to perform annual testing to validate Colonial Bank’s procedures. At September 30, 2004, the balance of the Bank’s participated mortgages held for sale was $25.5 million.   The tri-party agreement is capped at a balance of $30.0 million.  The LIBOR rate for these loan participations adjusts monthly.     

The Bank also entered into a construction loan participation agreement with Southern Trust.  Under this agreement, the Bank can purchase 93% of selected construction loans and draws, up to $20.0 million in outstanding balances and $30.0 million in commitments. The Bank charges Southern Trust an interest rate equal to the prime rate plus up to 75 basis points on the outstanding participated loans held by the Bank. Adjustments in rate related to movements in the prime rate are made monthly.  There were $3.0 million in outstanding balances of these construction loans at September 30, 2004.    

The investment portfolio decreased 6.8% to $181.4 million at September 30, 2004 compared to $194.6 million at December 31, 2003.  In anticipation of rising interest rates, the Company has held to an investment strategy during the previous 18 months that focuses on keeping the portfolio relatively “short” by purchasing securities with maturities that on average do not exceed three years.  This strategy has negatively impacted the Company’s earnings, but management believes the shorter duration and portfolio run off is more desirable in the current interest rate environment.

Bank premises and equipment increased $4.0 million or 35.9% from $11.3 million at December 31, 2003 to $15.3 million at September 30, 2004. The increase represents the execution of several initiatives in the Company’s branching strategy.  The Company had engaged KDA Holdings, Inc. (“KDA”) to conduct a market analysis within its Northern Virginia market area and develop a strategic retail delivery plan to better position the Company to serve the Northern Virginia market.  KDA presented the Company with a three tier service delivery strategy. The first tier noted market areas that appeared most attractive to the Company based upon KDA’s market analysis results. The second and third tiers also reflected desirable markets that the Company should consider expansion into, but based upon analysis results, were subordinate to those contained in the first tier.

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In consideration of the Company’s recent strategic decision to meet the needs of one of the nation’s fastest growing banking markets, the Company purchased a 1.0 acre parcel of land in Sterling, Virginia, a first tier location, on June 3, 2004. The purchase price of the land was $1.2 million.  The Company intends to construct a financial service center that will be approximately 6,600 square feet in size.  The new financial service center will provide service to clients living and working in eastern Loudoun and western Fairfax Counties.  The center will offer typical banking services including ATM, safe deposit boxes and a full complement of retail products.  The Sterling financial center is expected to open in 2006.  

On July 12, 2004, the Company purchased a 1.3 acre parcel of land located in Warrenton, Virginia, also a first tier market area. The purchase price of the lot was $1.2 million.  Just as in Sterling, the Company plans to construct a full service financial service center on the property.  The facility is expected to be between 6,600 and 8,000 square feet.  The Warrenton financial service center is expected to open in late 2005.  The Company has hired two lending officers for the Warrenton location and plans to soon offer lending services in this market.

On October 7, 2004, the Company purchased a financial service facility in Reston, Virginia.  The purchase price of the facility was $1.4 million.  The Company will lease the land on which the building sits.  The land lease has an original term of 15 years, commencing October 1, 2004, and a minimal annual rent of $200,000 which will increase two percent per annum on each November 1^st during the original lease term. The Company has two options to renew the lease beyond the initial term, each of which is for a period of five years.  The Reston financial services center opened November 8, 2004.  The Company has hired several staff members and loan officers to serve this market.  

Additionally, the Company has planned renovations to double the size of its Purcellville location in order to meet growing demand within the community.  The renovations are estimated to cost $1.6 million.  Construction is anticipated to be complete by the end of 2004.  

On August 31, 2004, the Company purchased $6.0 million of Bank Owned Life Insurance (BOLI). This investment is reflected in the other asset section of the Company’s balance sheet. The Company purchased BOLI to help offset increasing employee benefit costs.  The Company plans to purchase another $5.0 million in BOLI during the fourth quarter of 2004.  The earnings from BOLI will help the Company offset an expected fourth quarter expense related to the restructure of its supplemental retirement plans.

Deposits increased $38.1 million to $408.2 million at September 30, 2004 from $370.0 million at December 31, 2003. The Bank has developed an interest bearing product that integrates the use of the cash within client accounts at Tredegar for overnight funding at the Bank.  The overall balance of this product was $29.5 million at September 30, 2004 and is reflected in both the interest bearing deposit and securities sold under agreement to repurchase amounts on the balance sheet.  Absent the increase from the new deposit product for Tredegar clients, interest and non interest bearing demand deposits have grown by $30.1 million since December 31, 2003.  Time deposits decreased $8.6 million since December 31, 2003 to $95.6 million at September 30, 2004.  Securities sold under agreements to repurchase (Repo Accounts) increased $30.1 million from $13.5 million at December 31, 2003 to $43.7 million at September 30, 2004.  The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000.  Nearly all of this increase is from the new deposit product developed for Tredegar.

Both the cash flow from the investment portfolio and the increase in deposits funded the Company’s asset growth experienced during the nine months ended September 30, 2004, and also allowed for the curtailment of some of the outstanding funds borrowed on an overnight basis. Federal Home Loan Bank overnight advances were $13.6 million at September 30, 2004 compared to $27.3

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million at December 31, 2003.  Federal Home Loan Bank long term advances increased to $38.5 million at September 30, 2004, from $31.0 million at December 31, 2003.  Most of the overnight advances were paid with the funds deposited into the new Tredegar Trust deposit account; however, to reduce additional overnight outstandings, the Company also decided to obtain a termed advance with favorable pricing.

During the fourth quarter of 2003, the Company participated in a pooled offering to issue $5.0 million in trust preferred securities.  Trust preferred securities are long-term securities that are treated as Tier 1 capital for regulatory purposes and debt for income tax purposes, with an associated interest deduction for dividends paid.  The Company issued these trust preferred securities to support the branching strategy.  

Shareholders’ equity was $51.1 million at September 30, 2004.  This amount represents an increase of 8.0% from the December 31, 2003 amount of $47.3 million.  The book value per common share was $13.43 at September 30, 2004 and $12.44 at December 31, 2003.

Net Interest Income

Net interest income is one of the Company’s primary sources of earnings and represents the difference between interest and fees earned on earning assets and the interest expense paid on deposits and other interest bearing liabilities.  Net interest income totaled $15.1 million for the first nine months of 2004 compared to $14.2 million for the same period in 2003, an increase of 6.4%.  Interest income increased 5.3% and interest expense increased 1.7% when comparing the nine months ended September 30, 2004 to September 30, 2003.   Average earning assets increased $71.8 million from $417.5 million for the nine months ended September 30, 2003 to $489.3 million for the nine months ended September 30, 2004.

 Interest income from loans increased $970,000 to $13.3 million for the nine months ended September 30, 2004 compared to $12.3 million for the same period in 2003.  The increase in loan interest income results from the amount of loan growth experienced during the nine month period ended September 30, 2004. Although the weighted average yield of new loans booked during the first nine months of 2004 was nearly 51 basis points lower than that at 2003 year end, the net increase to the portfolio of nearly $51 million during the first nine months of 2004 helped mitigate the impact of record low interest rates to the Company.  Approximately $66.6 million, or 19.8%, of the loan portfolio at September 30, 2004 is tied to the Wall Street Journal prime interest rate. Mortgages held for sale were $25.5 million at September 30, 2004. Mortgages held for sale earn interest at the one month LIBOR rate plus a spread of 170 basis points.  The LIBOR rate for mortgages held for resale adjusts monthly.     

On May 1, 2004, the Company implemented SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans. Implementation of this Statement changes the Company’s previous practice of recognizing loan origination and commitment fees at inception of the loan.  With the implementation of the Statement, these fees are recognized over the life of the related loan as an adjustment of yield.  Since May 1, 2004, the recognition of $239,000 in loan fees has been deferred.  The deferral of such income reduced the yield on the loan portfolio by approximately 12 basis points for the nine month period ended September 30, 2004. As a result, for the same nine month period, the income recognition change negatively affected the net interest margin by nearly eight basis points. Interest income from the investment portfolio remained relatively unchanged at $6.1 million for the nine month periods ended September 30, 2003 and September 30, 2004.

Average deposits increased $28.9 million from $348.9 million for the nine months ended September 30, 2003 to $377.8 million for the nine months ended September 30, 2004. Total interest expense increased $74,000 for the nine months ended September 30, 2004.  Interest expense related to borrowing funds increased nearly $379,000 from $1.8 million for the nine months ended September 30, 2003 to $2.2 million for the nine months ended September 30, 2004.  Both the addition of the new

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Tredegar deposit account and the continued low interest rate environment has contributed to the Company’s stable level of total interest expense. The new Tredegar deposit account earns interest at a rate equal to 75% of the Federal Home Loan Bank of Atlanta’s overnight rate.  The mix of low cost deposits versus time deposits changed slightly to approximately 77% in low cost deposits, versus 23% in higher cost time deposits at September 30, 2004.  At September 30, 2003, the mix had been 73% in low cost deposits, versus 27% in higher cost time deposits.  

The net interest margin, on a tax equivalent basis, was 4.27% for the nine months ended September 30, 2004 compared to 4.75% for the same period in 2003.  The decline is attributed to both the lower yields earned on new loan growth during a period of low interest rates and the Company’s increased reliance on borrowed money to fund the earning asset growth.  The Company’s total average earning assets have increased $71.8 million since September 30, 2003.  The annualized net tax equivalent interest income has increased $1.2 million to $21.0 million for the nine months ended September 30, 2004 from $19.9 million for the same period in 2003.  

Noninterest Income

Noninterest income decreased 15.6% to $6.4 million for the first nine months of 2004 compared to $7.9 million for the same period in 2003.  During the first quarter of 2003, mortgage banking income and certain loan fees related to the Bank’s mortgage banking department were reported on a gross income basis.  All expenses of that department were reported as service charges within the non interest expenses. On April 15, 2003, the Bank acquired a 40% interest in Southern Trust and, as part of the investment in Southern Trust, the Bank’s mortgage banking department was transferred to Southern Trust.  All earnings of that department after April 30, 2003 are being reported within the equity in earnings from affiliate.  As a result, sales fees and service charges from mortgage banking were $0 for the nine months ended September 30, 2004 compared to $981,000 for the same period in 2003.

As agreed upon with the investment in Southern Trust, the Bank received 100% of the net income that had been budgeted for the mortgage operation for the year 2003.  For the amount that exceeded the 2003 budgeted net income level, the Bank received its 40% share. Earnings generated by the Middleburg branch of Southern Trust in years subsequent to 2003 will be split according to the Bank’s ownership percentage of Southern Trust. Equity in earnings from affiliate was $1.4 million for the nine months ended September 30, 2004, which is virtually unchanged from $1.5 million for the nine month period ended September 30, 2003. Because the interest in Southern Trust had been acquired on April 15, 2003, the 2003 amount included earnings from only five and a half months of their operations. Equity in earnings from affiliate comprised 22.5% of total noninterest income for the nine months ended September 30, 2004 compared to 18.7% for the nine months ended September 30, 2003. Southern Trust closed $688.4 million in loans during the first nine months of 2004 with only 34.4% of its production attributable to refinancing volume.

In addition to equity earnings from Southern Trust, the Bank also receives rental and data processing fees and interest on the outstanding balance of loan participations with Southern Trust.  For the nine month periods ending September 30, 2004 and 2003, the rental and data processing income earned from Southern Trust was $82,000 and $50,000, respectively.  These fees reflect an increase of $0.01 to earnings per diluted share.

Commissions and fees from trust and investment advisory activities were $2.8 million for the nine month period ended September 30, 2004 compared to $2.6 million for the same period in 2003. Investment advisory fees provided by GPIA totaled $1.6 million for each of the nine months ended September 30, 2004 and September 30, 2003.   At September 30, 2004, GPIA managed approximately $566.2 million in assets. GPIA recently experienced closings of accounts associated with a former employee that had market values totaling $21.8 million at September 30, 2004. There were no performance issues related to the decision to close the accounts. Utilizing the September 30, 2004 market

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value, it is expected that these accounts closing will result in a decrease of annual fees of approximately $110,000.  Fiduciary fees, provided by Tredegar, increased 17.8% to $1.2 million for the nine months ended September 30, 2004 from $996,000 for the nine months ended September 30, 2003. At September 30, 2004, Tredegar managed nearly $579.2 million in assets, an increase of 13.5% or $68.7 million from assets under administration at September 30, 2003. Fiduciary fees are based upon the market value of the accounts under administration.  

Service charges on deposits decreased 6.4% to $1.1 million for the nine months ended September 30, 2004, compared to $1.2 million for the same period in 2003.  Other service charges, which includes certain loan fees, decreased $138,000 or 31.8% to $297,000 for the nine months ended September 30, 2004.  Approximately $92,000 of the decrease resulted from the Company’s no longer recognizing certain loan fees related to the sale of mortgages following its investment in Southern Trust. Upon the Bank’s investment in Southern Trust, it ended its own mortgage operations.

Investment sales fees decreased 36.0% to $541,000 for the nine months ended September 30, 2004, compared to $845,000 for the nine months ended September 30, 2003. A strategic decision was made late in the third quarter of 2003 to change the broker dealer clearing provider in the investment services department.  This resulted in a decline in revenues. The new clearing relationship has provided better client service, heightened regulatory control and additional growth opportunities, and is anticipated to improve the financial contribution to the Company in the near term.  However, since the system conversion, the investment services department has downsized from five financial consultants to two.  This downsize has significantly impacted the level of revenue generated by the department.  The Company has hired additional consultants during 2004 to assist in efforts to return to pre conversion production levels.  Investment sales fees totaled $196,700 for the three months ended September 30, 2004 compared to $169,100 for the three months ended June 30, 2004.

Noninterest Expense

Total noninterest expense includes employee-related costs, occupancy and equipment expense and other overhead.  Total noninterest expense increased $561,000 from $12.6 million for the nine months ended September 30, 2003 to $13.1 million for the nine months ended September 30, 2004.  The modest increase in noninterest expense has been achieved with cost controls over expenses.

Salaries and employee benefits increased 3.4% when comparing the nine months ended September 30, 2004 to the nine months ended September 30, 2003. Additions to staff to support business development, retail branching and the formation of a wealth management team have contributed to the increase in salaries and employee benefits.  Because the Company hired staff and commercial lenders for its new facility in Reston prior to the November 8, 2004 opening date, nearly $40,000 in salaries and other expenses were expended for that facility during the nine months ended September 30, 2004. With the Company’s implementation of SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans, on May 1, 2004, $160,000 in salary expense has been deferred. Commissions paid on investment sales fees and mortgage banking (included within the salaries and benefits expense) decreased 66.6% to $257,000 for the nine months ended September 30, 2004 from $769,000 for the same period in 2003.  For the nine months ended September 30, 2003, sales commissions included mortgage banking, which accounted for $318,000 of the total.  Mortgage banking sales commissions are now reported within equity in earnings from affiliate.   

Net occupancy expense remained stable at $1.7 million for each of the nine months ended September 30, 2004 and September 30, 2003.  As growth efforts continue to progress, the Company anticipates higher levels of occupancy expense to be incurred. Approximately $27,000 of non-capitalizable costs related to the renovation of the Company’s Purcellville branch have been expensed to net occupancy and equipment expense for the nine month period ended September 30, 2004.  

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Advertising expense increased 28.5% to $243,000 for the nine months ended September 30, 2004 from $189,000 for the nine months ended September 30, 2003. During the first half of 2004, the Company conducted a campaign that was targeted specifically to grow checking accounts.   

 Computer operations expense increased from $470,000 for the nine months ended September 30, 2003 to $556,000 for the nine months ended September 30, 2004.  The increase is related to both the increased cost of computer related maintenance contracts and the increased number of the Company’s clients utilizing its online banking services and the increase in volume of online banking transactions. Clients meeting specific criteria are provided free online banking services by the Company.   

Allowance for Loan Losses

The allowance for loan losses at September 30, 2004 was $3.2 million compared to $2.5 million at September 30, 2003.  The allowance for loan losses was 1.0% of total loans outstanding at September 30, 2004 and 1.0% of total loans outstanding at September 30, 2003.  The provision for loan losses was $508,000 for the nine months ended September 30, 2004.  The provision was $425,000 for the nine months ended September 30, 2003.  For the nine months ended September 30, 2004, net loan recoveries totaled $41,000, compared to net charge offs of $252,000 for the same period in 2003.  Total loans past due 90 days or more at September 30, 2004 were approximately $3,000.  Non-performing loans were .12% of total loans outstanding at September 30, 2004 compared to .19% at September 30, 2003. Management believes that the allowance for loan losses is adequate to cover credit losses inherent in the loan portfolio at September 30, 2004.  Loans classified as loss, doubtful, substandard or special mention are adequately reserved for and are not expected to have a material impact beyond what has been reserved.

Capital Resources

Shareholders’ equity at September 30, 2004 and December 31, 2003 was $51.1 million and $47.3 million, respectively.  Total common shares outstanding at September 30, 2004 were 3,803,727.

At September 30, 2004, the Company’s tier 1 and total risk-based capital ratios were 15.7% and 16.7%, respectively, compared to 14.4% and 15.6% at December 31, 2003.  The Company’s leverage ratio was 10.4% at September 30, 2004 compared to 11.3% at December 31, 2003.  The Company’s capital structure places it above the regulatory guidelines, which affords the Company the opportunity to take advantage of business opportunities while ensuring that it has the resources to protect against risk inherent in its business.

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 that 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.  The Company maintains federal funds lines with large regional and money-center banking institutions.  These available lines total approximately $8 million, of which none was outstanding at September 30, 2004.  Federal funds purchased during the first nine months of 2004 averaged $839,000 compared to an average of $397,000 during the same period in 2003.  At September 30, 2004 and December 31, 2003, the Company had $43.7 million and $13.5 million, respectively, of outstanding

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borrowings pursuant to Repo Accounts, with maturities of one day.  The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000.

The Company has a credit line in the amount of $114.1 million at the Federal Home Loan Bank of Atlanta.  This line may be utilized for short and/or long-term borrowing.  The Company has utilized the credit line for both overnight and long-term funding throughout the first nine months of 2004.  Overnight and long-term advances averaged $8.5 million and $41.7 million, respectively, for the nine months ended September 30, 2004.

At September 30, 2004, cash, interest-bearing deposits with financial institutions, federal funds sold, short-term investments, loans held for sale and securities available for sale were 42.3% 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:

·

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;

·

the ability to continue to attract low cost core deposits to fund asset growth;

·

the successful management of interest rate risk;

·

changes in general economic and business conditions in the Company’s market area;

·

maintaining cost controls and asset qualities as the Company opens or acquires new branches;

·

reliance on the Company’s management team, including its ability to attract and retain key personnel;

·

maintaining capital levels adequate to support the Company’s growth;

·

changes in interest rates and interest rate policies;

·

risks inherent in making loans such as repayment risks and fluctuating collateral values;

·

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;

·

demand, development and acceptance of new products and services;

·

problems with technology utilized by the Company;

·

changing trends in customer profiles and behavior; and

·

changes in banking and other laws and regulations applicable to the Company.

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.

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Item 3.  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 its trust and investment management subsidiaries for their clients are affected by equity and bond price risk and are not considered in the asset/liability management process.  

The ongoing monitoring and management of interest rate 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 annually.  The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee (ALCO) of the 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 100 basis point (bp) downward shift in interest rates and a 200 basis point upward shift.  A parallel and pro rata shift in rates over a 12-month period is assumed.  The following reflects the range of the Company’s net interest income sensitivity analysis during the nine months ended September 30, 2004 as well as the fiscal year of 2003 compared to the 10% Board-approved policy limit.

For the Nine Months Ended September 30, 2004

Rate Change

Estimated Net Interest Income Sensitivity

High

Low

Average

+ 200 bp

(2.05%)

(1.45%)

(1.75%)

- 100 bp

(1.16%)

(0.52%)

(0.94%)

For the Year Ended December 31, 2003

Rate Change

Estimated Net Interest Income Sensitivity

High

Low

Average

+ 200 bp

(2.11%)

.34%

(1.23%)

- 100 bp

.60%

(.28%)

.44%

Since December 31, 2003, the Company’s balance sheet has grown by $64.9 million.  Deposit inflows, investment portfolio cash flows and borrowings from the Federal Home Loan Bank have provided the funding for this growth.  The Company’s interest rate profile has a slightly liability sensitive

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bias for the next 12 months.  The profile then shifts toward intermediate and long term asset sensitivity over a “one to two year” and “beyond two year” time frame, respectively.  The balance sheet growth strategy continues to move the Company towards a less liability sensitive profile; much of the recent loan growth has been of a variable rate, while funding growth has been in less sensitive non-maturity deposits. Based on conservative internal interest rate risk models and the assumption of a sustained rising rate environment, the Company expects net interest income to trend downward slightly throughout the next twelve months as mortgage related assets extend and funding costs rise quickly.  This expected decrease to net interest income could be as much as 2.05% or $429,000 in the first year of rising rates of 200 basis points. During the second year, as funding costs stabilize and the asset base continues to reprice or replace, a widening of the balance sheet spread is predicted, thus causing a benefit to net interest income.    

If interest rates should decline 100 basis points, the expected impact to the Company’s net interest income over the next twelve months would be a decline of approximately $108,000 resulting from falling asset yields exceeding funding cost reductions.

The preceding sensitivity analysis does not represent a 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 such as yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cashflows.  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 4.  CONTROLS AND PROCEDURES

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended.  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic filings with the Securities and Exchange Commission.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

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PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings

None

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.  Defaults upon Senior Securities

None

Item 4.  Submission of Matters to a Vote of Security Holders

None

Item 5.  Other Information

None

Item 6.  Exhibits

31.1

Rule 13a-14(a) Certification of Chief Executive Officer

31.2

Rule 13a-14(a) Certification of Chief Financial Officer

32.1

Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350

24

SIGNATURES

Pursuant to the requirements 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.

MIDDLEBURG FINANCIAL CORPORATION

    (Registrant)

Date:  November 10, 2004     

/s/ Joseph L. Boling

Joseph L. Boling

Chairman of the Board & CEO

Date:  November 10, 2004

/s/ Alice P. Frazier

Alice P. Frazier

Executive Vice President & COO

(Chief Financial Officer)

Date:  November 10, 2004

/s/ Kathleen J. Chappell

Kathleen J. Chappell

Senior Vice President & Controller

(Chief Accounting Officer)

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EXHIBIT INDEX

Exhibits

31.1

Rule 13a-14(a) Certification of Chief Executive Officer

31.2

Rule 13a-14(a) Certification of Chief Financial Officer

32.1

Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350