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Washington, D.C. 20549





For the fiscal year ended: December 31, 2010





Commission file number: 001-34292


(Exact name of registrant as specified in its charter)


Pennsylvania   23-2530374
(State or other jurisdiction of incorporation or organization   (I.R.S. Employer Identification No.)

77 East King Street, P. O. Box 250,

Shippensburg, Pennsylvania

(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (717) 532-6114

Securities registered pursuant to Section 12(b) of the Act:


Title of each class


Name of Each Exchange on which Registered

Common Stock, No Par Value   NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  ¨    No  x

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 has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232,405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer  ¨


Accelerated filer  x


Non-accelerated filer  ¨


Smaller reporting company  ¨

(Do not check if a smaller reporting company)


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)  Yes  ¨    No  x

Aggregate market value of the common stock held by non-affiliates computed by reference to the price at which the common equity was last sold on June 30, 2010 was $171,393,309.

Number of shares outstanding of the registrant’s common stock as of March 1, 2011: 7,989,556.


Portions of the Proxy Statement for the 2011 Annual Meeting of Shareholders are incorporated by reference in Part III of this Form 10-K.

Table of Contents






Part I


Item 1.




Item 1A


Risk Factors


Item 1B


Unresolved Staff Comments


Item 2.




Item 3.


Legal Proceedings


Item 4.


Removed and Reserved


Part II


Item 5.


Market for Registrant’s Common Equity, Related Security Holder Matters and Issuer Purchases of Equity Securities


Item 6.


Selected Financial Data


Item 7.


Management’s Discussion and Analysis of Financial Condition and Results of Operation


Item 7A.


Quantitative and Qualitative Disclosures about Market Risk


Item 8.


Financial Statements and Supplementary Data


Item 9.


Changes in and Disagreements with Accountants on Accounting and Financial Disclosure


Item 9A.


Controls and Procedures


Item 9B.


Other Information


Part III


Item 10.


Directors, Executive Officers and Corporate Governance


Item 11.


Executive Compensation


Item 12.


Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters


Item 13.


Certain Relationships and Related Transactions, and Director Independence


Item 14.


Principal Accounting Fees and Services


Part IV


Item 15.


Exhibits, Financial Statement Schedules





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Orrstown Financial Services, Inc. (the Company) is a financial holding company registered under the Gramm-Leach-Bliley Act. The executive offices of Orrstown Financial Services, Inc. are located at 77 East King Street, Shippensburg, Pennsylvania, 17257. Orrstown Financial Services, Inc. was organized on November 17, 1987, under the laws of the Commonwealth of Pennsylvania for the purpose of acquiring Orrstown Bank, Shippensburg, Pennsylvania, and such other banks and bank related activities as are permitted by law and desirable. Orrstown Bank is engaged in providing banking and bank related services in South Central Pennsylvania, principally Franklin, Perry and Cumberland Counties in Pennsylvania and in Washington County, Maryland. The twenty offices of Orrstown Bank are located in Shippensburg (2), Carlisle (4), Spring Run, Orrstown, Chambersburg (3), Greencastle, Mechanicsburg (2), Camp Hill, Newport (2), Duncannon, and New Bloomfield, Pennsylvania and Hagerstown, Maryland.

The Company files periodic reports with the Securities and Exchange Commission (SEC) in the form of quarterly reports on Form 10-Q, annual reports on Form 10-K, annual proxy statements and current reports on Form 8-K for any significant events that may arise during the year. Copies of these reports, and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, may be obtained free of charge through the SEC’s internet site at or by accessing the Company’s website at as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. Information on our website shall not be considered a part of this Form 10-K.

History and Acquisitions

Orrstown Bank was originally organized in 1919 as a state-chartered bank. On March 8, 1988, in a bank holding company reorganization transaction, Orrstown Financial Services, Inc. acquired 100% ownership of Orrstown Bank, issuing 131,455 shares of Orrstown Financial Services, Inc.’s common stock to the former Orrstown Bank shareholders.

On May 1, 2006, the Company completed its acquisition of The First National Bank of Newport (First National), a national banking institution with $120 million in assets at the time of the acquisition. The final consideration paid in the transaction to stockholders of First National consisted of approximately 699,949 shares of the Company’s common stock and $8.9 million in cash. The transaction was valued at approximately $34 million in the aggregate. As a result of this transaction, the Company added four branches located in Perry County, Pennsylvania, $120 million in assets, $72 million in loans and $106 million in deposits to its franchise. First National remained a separate subsidiary banking institution of the Company until June 15, 2007 when First National merged with and into Orrstown Bank with Orrstown Bank as the surviving institution.


Orrstown Financial Services, Inc.’s primary activity consists of owning and supervising its subsidiary, Orrstown Bank (the Bank). The day-to-day management of the Bank is conducted by the subsidiary’s officers. Orrstown Financial Services, Inc. derives a majority of its current income through dividends from Orrstown Bank. As of December 31, 2010, the Company, on a consolidated basis, had total assets of approximately $1.512 billion, total shareholders’ equity of approximately $160 million and total deposits of approximately $1.188 billion.

Orrstown Financial Services, Inc. has no employees. Its five officers are employees of its subsidiary bank. On December 31, 2010, Orrstown Bank had 275 full-time and 36 part-time employees.

The Bank is engaged in commercial banking and trust business as authorized by the Pennsylvania Banking Code of 1965. This involves accepting demand, time and savings deposits, and granting loans. The Bank grants


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commercial, residential, consumer and agribusiness customers in its market area of Franklin, Perry and Cumberland Counties of Pennsylvania and Washington County, Maryland. The concentrations of credit by type of loan are set forth in Note 4, “Loans Receivable and Allowance for Loan Losses” filed herewith in Part II, Item 8, “Financial Statements and Supplementary Data”. The Bank maintains a diversified loan portfolio and evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon the extension of credit, is based on management’s credit evaluation of the customer and collateral standards established in the Bank’s lending policies and procedures.


All secured loans are supported with appraisals or evaluations of collateral. Business equipment and machinery, inventories, accounts receivable, and farm equipment are considered appropriate security, provided they meet acceptable standards for liquidity and marketability. Loans secured by equipment and/or other non real estate collateral generally do not exceed 70% of appraised value or cost, whichever is lower. Loans secured by residential real estate generally do not exceed 80% of the appraised value of the property. Loan to collateral values are monitored as part of the loan review process, and appraisals are updated as deemed appropriate under the circumstances.

Commercial Lending

A majority of the Company’s loan assets are loans for business purpose. Approximately 75% of the loan portfolio is comprised of commercial loans. The Bank makes commercial real estate, equipment, working capital and other commercial purpose loans as required by the broad range of borrowers across the Bank’s various markets. The average size loan in the Bank’s commercial loan portfolio is approximately $259,000.

The Bank’s loan policy dictates the underwriting requirements for the various types of loans the Bank would extend to borrowers. The policy covers such requirements as debt coverage ratios, advance rate against different forms of collateral LTV and maximum term.

Approximately 47% of the Bank’s commercial portfolio is owner occupied or non owner occupied commercial real estate loans including multi family. The typical loan in this type is secured by a commercial property with a maximum LTV of 75% of the appraised value of the property. The maximum term and amortization typically does not exceed 20 years. Interest rates charged on these loans are primarily fixed for a period of 3 to 7 years and then adjust to an index and spread after the fixed rate period. The average size of a loan in this type is approximately $406,000.

Approximately 37% of the Bank’s commercial portfolio are loans for general commercial purpose and include permanent working capital, short term working capital, machinery and equipment financing. These types of loans can either be in the form of lines of credit or term loans. These loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a majority of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. The personal guarantee of the business owner is also to be taken. In the case of term loans, the average term of a loan would be primarily driven by the use of the loan proceeds and the useful life of the collateral. Interest rates charged are either fixed or variable. If the interest rate is or will become variable at any point in the loans life, an interest rate floor is placed on the loan. The average size of a loan in this type is approximately $160,000.

Consumer Lending

The Bank provides home equity loans, home equity lines of credit and other consumer loans through its branch network. A large majority of the consumer loans are secured by either a first or second lien position on the borrower’s primary residential real estate. The Bank requires a LTV of no greater than 90% of the value of the real estate being taken as collateral. Underwriting standards typically require a borrower have a debt to income ratio of 38% or less.


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Residential Lending

The Bank provides residential mortgages throughout its various markets through a network of mortgage loan officers. A majority of the residential mortgages originated are sold to secondary market investors, primarily Fannie Mae and the Federal Home Loan Bank of Pittsburgh. All mortgages, regardless of being sold or held in the Bank’s portfolio, are underwritten to secondary market industry standards for prime mortgages. The Bank requires a LTV of no greater than 80% of the value of the real estate being taken as collateral, without the borrower obtaining private mortgage insurance.

Loan Review

Administration and supervision over the lending process is provided by the Bank’s Credit Administration Committee which is comprised of outside directors. Executive officers and loan department personnel regularly meet with and report to the Credit Administration Committee. The loan review process is continuous, commencing with the approval of a loan. Each new loan is reviewed by the Loan Department for compliance with banking regulations and lending policy requirements for documentation, collateral standards, and approvals. Orrstown Bank employs a Loan Review Officer, who is independent from the loan origination function and reports directly to the Credit Administration Committee. The Loan Review Officer continually monitors and evaluates loan customers utilizing risk-rating criteria established in the Loan Policy in order to spot deteriorating trends and detect conditions which might indicate potential problem loans. The Loan Review Officer reports the results of the loan reviews at least quarterly to the Credit Administration Committee for approval and provides the basis for evaluating the adequacy of the allowance for loan losses.

During 2010, we implemented a centralized consumer underwriting solution, which enables us to process loans more efficiently, providing our customers with faster turnaround times. As a result, we increased our mortgage origination sales force and plan to add additional talent in 2011. Our team is supported by a state of the art system that enables them to take applications at the customer’s home or business via laptop. Additionally, we added several new mortgage products including Federal Home Administration (FHA), Veterans Administration (VA) and USDA Guaranteed Rural Housing programs. During 2010, customers now have the ability to apply for mortgages electronically. Consumer loan pre-approvals are instant, and most loan decisions are made within 24 hours. After approval, the entire process is simplified and expedited, enabling Orrstown Bank to handle a much larger volume of lending without significant increases in support staff.

A new website is also slated for 2011 that will provide the platform for the new consumer loan and mortgage products and other enhancements to improve the customer experience. A customer relationship management (CRM) system will also be implemented which will enable our sales staff to more effectively meet all our customers’ needs. The new system will provide real time sales management tools and metrics to support the growth of all our lines of business.

Orrstown Financial Advisors (OFA)

Through its trust department, Orrstown Bank renders services as trustee, executor, administrator, guardian, managing agent, custodian, investment advisor, and other fiduciary activities authorized by law under the trade name “Orrstown Financial Advisors.” OFA offers retail brokerage services through a third party broker/dealer arrangement with Financial Network Investment Company (FNIC). As of December 31, 2010, trust assets under management were $570 million.

Regulation and Supervision

Orrstown Financial Services, Inc. is a financial holding company, and is registered as such with the Board of Governors of the Federal Reserve System (the Federal Reserve Board). As a registered bank holding company and financial holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956 and to inspection, examination, and supervision by the Federal Reserve Board.


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The operations of the Bank are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, and to banks whose deposits are insured by the Federal Deposit Insurance Company. The Bank’s operation is also subject to regulations of the Pennsylvania Department of Banking, the Federal Reserve Board and the Federal Deposit Insurance Company (FDIC).

Several of the more significant regulatory provisions applicable to banks and financial holding companies to which the Company and its subsidiary are subject, are discussed below, along with certain regulatory matters concerning the Company and its subsidiary. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and its subsidiary.

Financial and Bank Holding Company Activities

As a financial holding company, the Company may engage in, and acquire companies engaged in, activities that are considered “financial in nature”, as defined by the Gramm-Leach-Bliley Act and Federal Reserve Board interpretations. These activities include, among other things, securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, and merchant banking. If any banking subsidiary of the Company ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other things, place limitations on the Company’s ability to conduct the broader financial activities permissible for financial holding companies or, if the deficiencies persist, require the Company to divest the banking subsidiary. In addition, if any banking subsidiary of the Company receives a Community Reinvestment Act rating of less than satisfactory, the Company would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies. The Company may engage directly or indirectly in activities considered financial in nature, either de novo or by acquisition, as long as it gives the Federal Reserve Board after-the-fact notice of the new activities.

Interstate Banking and Branching

As a bank holding company, the Company is required to obtain prior Federal Reserve Board approval before acquiring more than 5% of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act (the “Riegle-Neal Act”), subject to certain concentration limits and other requirements, bank holding companies such as the Company may acquire banks and bank holding companies located in any state. The Riegle-Neal Act also permits banks to acquire branch offices in other states, and establish de novo branch offices in other states, contingent upon the host state having adopted legislation “opting in” to those provisions of the Riegle-Neal Act. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), banks now may acquire or establish branch offices in another state to the same extent as a bank chartered in that state would be permitted to establish branch offices. The Company has expanded its market south into Hagerstown, Maryland with its first branch opening in March 2006.

FDIC Insurance and Assessments

The Bank’s deposits are insured to applicable limits by the FDIC. Under the Dodd-Frank Act, the maximum deposit insurance amount has been permanently increased from $100,000 to $250,000 and unlimited deposit insurance has been extended to non-interest-bearing transaction accounts until December 31, 2012. Prior to the Dodd-Frank Act, the FDIC had established a Temporary Liquidity Guarantee Program under which, for the payment of an additional assessment by insured banks that did not opt out, the FDIC fully guaranteed all non-interest-bearing transaction accounts until December 31, 2010 (the “Transaction Account Guarantee Program”) and all senior unsecured debt of insured depository institutions or their qualified holding companies issued between October 14, 2008 and October 31, 2009, with the FDIC’s guarantee expiring by December 31,


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2012 (the “Debt Guarantee Program”). The Company and the Bank opted out of the Debt Guarantee Program. The Bank did not opt out of the Transaction Account Guarantee Program.

The FDIC has adopted a risk-based premium system that provides for quarterly assessments based on an insured institution’s ranking in one of four risk categories based on regulatory capital ratios and other supervisory factors. The Bank is currently in Risk Category 1, the lowest risk category.

Starting in 2009, the FDIC significantly raised the assessment rate in order to restore the reserve ratio of the Deposit Insurance Fund to the statutory minimum of 1.15%. For the quarter beginning January 1, 2009, the FDIC raised the base annual assessment rate for institutions in Risk Category 1 to between 12 and 14 basis points. For the quarter beginning April 1, 2009 the FDIC set the base annual assessment rate for institutions in Risk Category 1 to between 12 and 16 basis points. An institution’s assessment rate could be lowered by as much as five basis points based on the ratio of its long-term unsecured debt to deposits or, for smaller institutions, based on the ratio of certain amounts of Tier 1 capital to adjusted assets. The assessment rate may be adjusted for Risk Category 1 institutions that have a high level of brokered deposits and have experienced higher levels of asset growth (other than through acquisitions).

The FDIC imposed a special assessment equal to five basis points of assets less Tier 1 capital as of June 30, 2009, payable on September 30, 2009, and reserved the right to impose additional special assessments. Instead of imposing additional special assessments during 2009, the FDIC required all insured depository institutions to prepay their estimated risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012 on December 30, 2009. For purposes of estimating the future assessments, each institution’s base assessment rate in effect on September 30, 2009 was used, increased by three basis points beginning in 2011, and the assessment base was increased at a 5% annual growth rate. The prepaid assessment will be applied against actual quarterly assessments until exhausted. Any funds remaining after June 30, 2013 will be returned to the institution. This prepaid assessment does not preclude the FDIC from changing assessment rates or from further revising the risk-based assessment system.

The Dodd-Frank Act requires the FDIC to take such steps as necessary to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020. In setting the assessments, the FDIC is required to off set the effect of the higher reserve ratio against insured depository institutions with total consolidated assets of less than $10 billion. The Dodd-Frank Act also broadens the base for FDIC insurance assessments so that assessments will be based on the average consolidated total assets less average tangible equity capital of a financial institution rather than on its insured deposits. The FDIC has adopted a new restoration plan to increase the reserve ratio to 1.15% by September 30, 2020 with additional rulemaking scheduled for 2011 regarding the method to be used to achieve a 1.35% reserve ratio by 2020 and offset the effect on institutions with assets less than $10 billion in assets. Pursuant to the new restoration plan, the FDIC will forgo the 3 basis point increase in assessments scheduled to take effect on January 1, 2011. The FDIC has proposed new assessment regulations that would redefine the assessment base as average consolidated assets less average tangible equity. The proposed regulations would use the current assessment rate schedule with modifications to the unsecured debt and brokered deposit adjustments and the elimination of the secured liability adjustment.

In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the Federal Savings and Loan Insurance Corporation. The FICO assessment rates, which are determined quarterly, averaged .0108% of insured deposits on an annualized basis in fiscal year 2009. These assessments will continue until the FICO bonds mature in 2017.

Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act is intended to effect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new


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Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act additionally creates a new independent federal regulator to administer federal consumer protection laws. The Dodd-Frank Act is expected to have a significant impact on our business operations as its provisions take effect. Among the provisions that may affect us are the following:

Holding Company Capital Requirements. The Dodd-Frank Act requires the Federal Reserve Board to apply consolidated capital requirements to depository institution holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Dodd-Frank Act additionally requires capital requirements to be countercyclical so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction, consistent with safety and soundness. The capital requirements that the Company and Bank are currently subject to are noted in “Note 14. Shareholders’ Equity and Regulatory Capital”, in the Notes to the Consolidated Financial Statements included under Item 8 of this Report.

Corporate Governance. The Dodd-Frank Act will require publicly traded companies to give stockholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter (“Say-On-Pay”) and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders. The new legislation also authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials. Additionally, the Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether the company is publicly traded or not. The Dodd-Frank Act gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

Prohibition Against Charter Conversions of Troubled Institutions. Effective one year after enactment, the Dodd-Frank Act prohibits a depository institution from converting from a state to federal charter or vice versa while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state authority that issued the enforcement action and that agency does not object within 30 days. The notice must include a plan to address the significant supervisory matter. The converting institution must also file a copy of the conversion application with its current federal regulator which must notify the resulting federal regulator of any ongoing supervisory or investigative proceedings that are likely to result in an enforcement action and provide access to all supervisory and investigative information relating hereto.

Limits on Derivatives. Effective 18 months after enactment, the Dodd-Frank Act prohibits state-chartered banks from engaging in derivatives transactions unless the loans to one borrower limits of the state in which the bank is chartered takes into consideration credit exposure to derivatives transactions. For this purpose, a derivatives transaction includes any contract, agreement, swap, warrant, note or option that is based in whole or in part on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices or other assets.

Transactions with Affiliates and Insiders. Effective one year from the date of enactment, the Dodd-Frank Act expands the definition of affiliate for purposes of quantitative and qualitative limitations of Section 23A of the Federal Reserve Act to include mutual funds advised by a depository institution or its affiliates. The Dodd-Frank Act will apply section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transactions that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries will be


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eliminated. The Dodd-Frank Act will additionally prohibit an insured depository institution from purchasing an asset from or selling an asset to an insider unless the transaction is on market terms and, if representing more than 10% of capital, is approved in advance by the disinterested directors.

Debit Card Interchange Fees. Effective July 21, 2011, the Dodd-Frank Act requires that the amount of any interchange fee charged by a debit card issuer with respect to a debit card transaction must be reasonable and proportional to the cost incurred by the issuer. Within nine months of enactment, the Federal Reserve Board is required to establish standards for reasonable and proportional fees which may take into account the costs of preventing fraud. The restrictions on interchange fees, however, do not apply to banks that, together with their affiliates, have assets of less than $10 billion.

Interest on Demand Deposits. Effective July 21, 2011, the Dodd-Frank Act repealed all federal prohibitions on the ability of financial institutions to pay interest on demand deposits.

Consumer Financial Protection Bureau. The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted 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 will have examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB will have authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

Control Acquisitions

The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company, unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a reputable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as the Company, would, under the circumstances set forth in the presumption, constitute acquisition of control of the bank holding company. In addition, a company is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of outstanding voting stock of a bank holding company, or otherwise obtaining control or a “controlling influence” over that bank holding company.

Liability for Banking Subsidiaries

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to their support. This support may be required at times when the bank holding company may not have the resources to provide it. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act, the FDIC can hold any FDIC-insured depository institution liable for any loss suffered or anticipated by the FDIC in connection with (1) the “default” of a commonly controlled FDIC-insured depository institution; or (2) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution “in danger of default”.


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Capital Requirements

Information concerning the Company and its subsidiary with respect to capital requirements is incorporated by reference from Note 14, “Shareholders’ Equity and Regulatory Capital”, of the “Notes to Consolidated Financial Statements” included under Item 8 of this report, and from the “Capital Adequacy and Regulatory Matters” section of the “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations”, included under Item 7 of this report.


The Federal Deposit Insurance Company Improvement Act of 1991 (FDICIA), and the regulations promulgated under FDICIA, among other things, established five capital categories for insured depository institutions—well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized—and requires federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements based on these categories. Unless a bank is well capitalized, it is subject to restrictions on its ability to offer brokered deposits and on certain other aspects of its operations. An undercapitalized bank must develop a capital restoration plan and its parent bank holding company must guarantee the bank’s compliance with the plan up to the lesser of 5% of the bank’s assets at the time it became undercapitalized and the amount needed to comply with the plan. As of December 31, 2010, the Bank was considered well capitalized based on the guidelines implemented by the bank’s regulatory agencies.

Dividend Restrictions

The Company’s funding for cash distributions to its shareholders is derived from a variety of sources, including cash and temporary investments. One of the principal sources of those funds is dividends received from its subsidiary, Orrstown Bank. Various federal and state laws limit the amount of dividends the Bank can pay to the Company without regulatory approval. In addition, federal bank regulatory agencies have authority to prohibit the Bank from engaging in an unsafe or unsound practice in conducting its business. The payment of dividends, depending upon the financial condition of the bank in question, could be deemed to constitute an unsafe or unsound practice. The ability of the Bank to pay dividends in the future is currently, and could be further, influenced by bank regulatory policies and capital guidelines. The Federal Reserve Board in 2009 notified all bank holding companies that dividends should be eliminated, deferred or significantly reduced if the bank holding company’s net income for the past four quarters, net of dividends paid during that period, is not sufficient to fully fund the dividends; the bank holding company’s prospective rate of earnings retention is not consistent with the bank holding company’s capital needs and overall, current and prospective financial conditions; or the bank holding company will not meet, or is in danger of meeting, its minimum regulatory capital adequacy ratios. Additional information concerning the Company and its banking subsidiary with respect to dividends is incorporated by reference from Note 15, “Restrictions on Dividends, Loans and Advances”, of the “Notes to Consolidated Financial Statements” included under Item 8 of this report, and the “Capital Adequacy and Regulatory Matters” section of “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations”, included under Item 7 of this report.

Deposit or Preference Statute

In the “liquidation or other resolution” of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over the general unsecured claims against that institution, including federal funds and letters of credit.


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Other Federal Laws and Regulations

The Company’s operations are subject to additional federal laws and regulations applicable to financial institutions, including, without limitation:



Privacy provisions of the Gramm-Leach-Bliley Act and related regulations, which require us to maintain privacy policies intended to safeguard customer financial information, to disclose the policies to our customers and to allow customers to “opt out” of having their financial service providers disclose their confidential financial information to non-affiliated third parties, subject to certain exceptions;



Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;



Consumer protection rules for the sale of insurance products by depository institutions, adopted pursuant to the requirements of the Gramm-Leach-Bliley Act; and



USA Patriot Act, which requires financial institutions to take certain actions to help prevent, detect and prosecute international money laundering and the financing of terrorism.

Sarbanes-Oxley Act of 2002

On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered or that file reports under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) new and increased civil and criminal penalties for violations of the securities laws. Many of the provisions were effective immediately while other provisions become effective over a period of time and are subject to rulemaking by the SEC. Because the Company’s common stock is registered with the SEC, it is subject to this Act. As an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934, the Company was subject to section 404 of the Sarbanes-Oxley Act starting in the year ended December 31, 2004.

Government Actions and Legislation

The Emergency Economic Stabilization Act of 2008 (the “EES Act”), effective October 2008, allocated up to $700 billion towards purchasing and insuring assets held by financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Pursuant to authority granted under the EES Act, the U.S. Treasury announced the Capital Purchase Program whereby the U.S. Treasury agreed to purchase senior preferred shares from qualifying U.S. financial institutions. Each participating institution may sell to the U.S. Treasury an amount of senior preferred shares ranging from 1.0 percent to 3.0 percent of its September 30, 2008 risk-weighted assets. The preferred shares are generally nonvoting and pay an initial dividend rate of 5.0 percent per year for the first five years, increasing to 9.0 percent per year after year five. As part of the consideration for the shares, the U.S. Treasury requires the receipt of Warrants to acquire common stock from the participating institution having an aggregate market price equal to 15.0 percent of the amount of capital invested by the U.S. Treasury in the senior preferred shares, at an exercise price equal to the average trailing 20-trading day market price of the institution’s common stock at the time of issuance. Participating institutions must agree to certain limitations on executive compensation, repurchases of junior preferred or common stock and increases in common stock dividend payments. The Company, after careful analysis, chose not to participate in the Capital Purchase Program.

The government has also implemented the Homeowner Affordability and Stability Plan (“HASP”), a $75 billion federal program intended to support recovery in the housing market and ensure that eligible homeowners


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are able to continue to fulfill their mortgage obligations. HASP includes the following initiatives: (i) a refinance option for homeowners that are current in their mortgage payments and whose mortgages are owned by Fannie Mae or Freddie Mac; (ii) a homeowner stability initiative to prevent foreclosures and help eligible borrowers stay in their homes by offering loan modifications that reduce mortgage payments to more sustainable levels; and (iii) an increase in U.S. Treasury funding to Fannie Mae and Freddie Mac to allow them to lower mortgage rates. HASP also offers monetary incentives to mortgage holders for certain modifications of at-risk loans and would establish an insurance fund designed to reduce foreclosures.

Future Legislation

Changes to the laws and regulations in the states where the Company and the Bank do business can affect the operating environment of both the bank holding company and its subsidiaries in substantial and unpredictable ways. The Company cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company. This is also true of federal legislation particularly given the current volatile environment.

NASDAQ Capital Market

The Company’s common stock is listed on The NASDAQ Capital Market under the trading symbol “ORRF” and is subject to NASDAQ’s rules for listed companies.

Forward Looking Statements

Additional information concerning the Company and its banking subsidiaries with respect to forward looking statements is incorporated by reference from the “Important Factors Relating to Forward Looking Statements” section of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in this Report under Item 7.


The Bank’s principal market area consists of Franklin County, Perry County and Cumberland County, Pennsylvania, with a presence in Washington County, Maryland. It services a substantial number of depositors in this market area, with the greatest concentration within a radius of Chambersburg, Shippensburg, and Carlisle, Pennsylvania.

The Bank, like other depository institutions, has been subjected to competition from less heavily regulated entities such as credit unions, brokerage firms, money market funds, consumer finance and credit card companies, and other commercial banks, many of which are larger than the Bank. The principal methods of competing effectively in the financial services industry include improving customer service through the quality and range of services provided, improving efficiencies and pricing services competitively. Orrstown Bank is competitive with the financial institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.

The Bank continues to implement strategic initiatives focused on expanding our core businesses and to explore, on an ongoing basis, acquisition, divestiture, and joint venture opportunities. We analyze each of our products and businesses in the context of customer demands, competitive advantages, industry dynamics, and growth potential.


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Our financial conditions and results of operations may be adversely affected by various factors, many of which are beyond our control. These risk factors include the following:

Unfavorable economic and market conditions due to the current global financial crisis may materially and adversely affect us.

Economic and market conditions in the United States and around the world have deteriorated significantly and may remain depressed for the foreseeable future. Conditions such as slowing or negative growth and the sub-prime debt devaluation crisis have resulted in a low level of liquidity in many financial markets and extreme volatility in credit, equity and fixed income markets. These economic developments could have various effects on us, including insolvency of major customers and a negative impact on the investment income we are able to earn on our investment portfolio.

Since lending money is an essential part of our business, due to the current economic conditions, customers may be unable or unwilling to borrow money or repay funds already borrowed. The risk of non-payment is affected by credit risks of a particular customer, changes in economic conditions, the duration of the loan and, in the case of a collateralized loan, uncertainties as to the future value of the collateral and other factors. The potential effects of the current global financial crisis are difficult to forecast and mitigate. As a consequence, our operating results for a particular period are difficult to predict. The impact of this situation, together with concerns regarding the financial strength of financial institutions, has led to distress in credit markets and liquidity issues for financial institutions. Some financial institutions around the world have failed; others have been forced to seek acquisition partners. The United States and other governments have taken unprecedented steps to try to stabilize the financial system, including investing in financial institutions. Our business and our financial condition and results of operations could be adversely affected by (1) continued or accelerated disruption and volatility in financial markets, (2) continued capital and liquidity concerns regarding financial institutions generally and our counterparties specifically, (3) limitations resulting from further governmental action in an effort to stabilize or provide additional regulation of the financial system, or (4) recessionary conditions that are deeper or last longer than currently anticipated.

We operate in a highly regulated environment and may be adversely affected by changes in laws or regulations.

We are subject to extensive regulation and supervision under federal and state laws and regulations. The requirements and limitations imposed by such laws and regulations limit the manner in which we conduct our business, undertake new investments and activities and obtain financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit our shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is within our control. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied or enforced. We cannot predict the substance or impact of pending or future legislation, regulation or the application thereof. Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner.

The Dodd-Frank Wall Street Reform and Consumer Protection Act may affect our financial condition, results of operations, liquidity and stock price.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was signed into law. The Dodd-Frank Act includes provisions affecting large and small financial institutions, including several provisions that will profoundly affect how community banks and bank holding companies will be regulated in the future. Among other things, these provisions relax rules regarding interstate


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branching, allow financial institutions to pay interest on business checking accounts, change the scope of federal deposit insurance coverage and impose new capital requirements on bank holding companies. In addition, there is significant uncertainty about the full impact of the Dodd-Frank Act because many of its provisions require subsequent regulatory rule making.

The Dodd-Frank Act establishes the Bureau of Consumer Financial Protection as an independent entity within the Federal Reserve, which will be given authority to promulgate consumer protection regulations applicable to all entities offering financial services or products, including banks. Additionally, the Dodd-Frank Act includes a series of provisions covering mortgage loan origination standards affecting, among other things, originator compensation, minimum repayment standards and pre-payments.

The Dodd-Frank Act contains numerous other provisions affecting financial institutions of all types, many of which may have an impact on the Company’s operating environment in substantial and unpredictable ways. Consequently, the Dodd-Frank Act is likely to affect our cost of doing business, it may limit or expand the activities in which Orrstown permissibly may engage and it may affect the competitive balance within the Company’s industry and market areas.

The Dodd-Frank Act and the regulations to be adopted thereunder are expected to subject Orrstown and other financial institutions to additional restrictions, oversight and costs that may have an adverse impact on its business, financial condition, results of operations or the price of Orrstown common stock and the Company’s ability to continue to conduct business consistent with historical practices.

The recent repeal of federal prohibitions on the payment of interest on demand deposits could increase our interest expense and reduce our net interest margin.

All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could commence offering interest on demand deposits to compete for clients. We do not know what interest rates or products other institutions may offer. Our interest expense could increase and our net interest margin could decrease if we begin offering interest on demand deposits to attract additional customers or maintain current customers. Consequently, our business, financial condition or results of operations could be adversely affected.

We may be required to make further increases in our provisions for loan losses and to charge off additional loans in the future, which could materially adversely affect us.

There is no precise method of predicting loan losses. We can give no assurance that our allowance for loan losses is or will be sufficient to absorb actual loan losses. We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, that represents management’s best estimate of probable incurred losses within the existing portfolio of loans. The level of the allowance reflects management’s evaluation of, among other factors, the status of specific impaired loans, trends in historical loss experience, delinquency trends, credit concentrations and economic conditions within our market area. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require us to increase our allowance for loan losses. Increases in nonperforming loans have a significant impact on our allowance for loan losses.

In addition, bank regulatory agencies periodically review our allowance for loan losses and may require us to increase the provision for loan losses or to recognize further loan charge-offs, based on judgments that differ from those of management. If loan charge-offs in future periods exceed our allowance for loan losses, we will need to record additional provisions to increase our allowance for loan losses. Furthermore, growth in our loan


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portfolio would generally lead to an increase in the provision for loan losses. Generally, increases in our allowance for loan losses will result in a decrease in net income and stockholders’ equity, and may have a material adverse effect on our financial condition, results of operations and cash flows.

Our allowance for loan losses was 1.66% of total loans and 106% of non-performing loans at December 31, 2010, compared to 1.26% of total loans and 259% of non-performing loans at December 31, 2009. Material additions to our allowance could materially decrease our net income. In addition, at December 31, 2010, our top 25 lending relationships individually had commitments in excess of $6,600,000, and a total outstanding loan balance of $189,335,000, or nearly 20% of the loan portfolio. The deterioration of one or more of these loans could result in a significant increase in our nonperforming loans and our provisions for loan losses, which would negatively impact our results of operations.

Changes in interest rates could adversely impact our financial condition and results of operations.

Our operating income, net income and liquidity depend to a great extent on our net interest margin, i.e., the difference between the interest yields we receive on loans, securities and other interest earning assets and the interest rates we pay on interest-bearing deposits, borrowings and other liabilities. These rates are highly sensitive to many factors beyond our control, including competition, general economic conditions and monetary and fiscal policies of various governmental and regulatory authorities, including the Board of Governors of the Federal Reserve System, or the Federal Reserve. If the rate of interest we pay on our interest-bearing deposits, borrowings and other liabilities increases more than the rate of interest we receive on loans, securities and other interest earning assets, our net interest income, and therefore our earnings, and liquidity could be materially adversely affected. Our earnings and liquidity could also be materially adversely affected if the rates on our loans, securities and other investments fall more quickly than those on our deposits, borrowings and other liabilities. Our operations are subject to risks and uncertainties surrounding our exposure to change in interest rate environment.

Additionally, based on our analysis of the interest rate sensitivity of our assets, an increase in the general level of interest rates will negatively affect the market value of our investment portfolio because of the relatively long duration of the securities included in our investment portfolio.

Changes in interest rates also can affect: (1) our ability to originate loans; (2) the value of our interest-earning assets, which would negatively impact stockholders’ equity, and our ability to realize gains from the sale of such assets; (3) our ability to obtain and retain deposits in competition with other available investment alternatives; and (4) the ability of our borrowers to repay adjustable or variable rate loans.

Increases in FDIC insurance premiums may have a material adverse effect on our results of operations.

During the past few years, higher levels of bank failures have dramatically increased resolution costs of the Federal Deposit Insurance Company, or the FDIC, and depleted the deposit insurance fund. In addition, the FDIC and the U.S. Congress have taken action to increase federal deposit insurance coverage, placing additional stress on the deposit insurance fund.

In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC increased assessment rates of insured institutions uniformly by seven cents for every $100 of deposits beginning with the first quarter of 2009, with additional changes beginning April 1, 2009, which require riskier institutions to pay a larger share of premiums by factoring in rate adjustments based on secured liabilities and unsecured debt levels.

To further support the rebuilding of the deposit insurance fund, the FDIC imposed a special assessment on each insured institution, equal to five basis points of the institution’s total assets minus Tier 1 capital as of September 30, 2009. For Orrstown Bank, this represented an aggregate charge of approximately $515,000. In


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lieu of imposing an additional special assessment, the FDIC required all institutions to prepay their assessments for all of 2010, 2011 and 2012, which for us totaled $4.4 million. The FDIC has indicated that future special assessments are possible, although it has not determined the magnitude or timing of any future assessments.

In 2011, the FDIC finalized its new assessment for insurance, as required by the Dodd-Frank Act. The final rule, which takes effect April 1, 2011, bases the assessment on what the Bank holds in assets, minus tangible equity, instead of the current method which is based on deposit holdings.

We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums. Our expenses for the year ended December 31, 2010, have been significantly and adversely affected by these increased premiums and the special assessment. These increases and assessment and any future increases in insurance premiums or additional special assessments may materially adversely affect our results of operations.

We are a holding company dependent for liquidity on payments from Orrstown Bank, our sole our subsidiary, which are subject to restrictions.

We are a holding company and depend on dividends, distributions and other payments from Orrstown Bank, our only subsidiary to fund dividend payments and to fund all payments on obligations. Orrstown Bank is subject to laws that restrict dividend payments or authorize regulatory bodies to block or reduce the flow of funds from it to us. Restrictions or regulatory action of that kind could impede access to funds that we need to make payments on our obligations, dividend payments or stock repurchases. In addition, our right to participate in a distribution of assets upon our subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.

Because our business is concentrated in South Central Pennsylvania and Washington County, Maryland, our financial performance could be materially adversely affected by economic conditions and real estate values in these market areas.

Our operations and the properties securing our loans are primarily in South Central Pennsylvania (principally Franklin, Perry and Cumberland Counties) and in Washington County, Maryland. Our operating results depend largely on economic and real estate valuations in these and surrounding areas. A further deterioration in the economic conditions in these market areas could materially adversely affect our operations and increase loan delinquencies, increase problem assets and foreclosures, increase claims and lawsuits, decrease the demand for our products and services and decrease the value of collateral securing loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with nonperforming loans and collateral coverage.

Our commercial real estate lending may expose us to a greater risk of loss and hurt our earnings and profitability.

Our business strategy involves making loans secured by commercial real estate. These types of loans generally have higher risk-adjusted returns and shorter maturities than traditional one-to-four family residential mortgage loans. At December 31, 2010, our loans secured by commercial real estate totaled approximately $340 million, which represented 35% of total loans. Loans secured by commercial real estate properties are generally for larger amounts and may involve a greater degree of risk than one-to-four family residential mortgage loans. Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties. Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy. In addition, many economists believe that deterioration in income producing commercial real estate is likely to worsen as vacancy rates continue to rise and absorption rates of existing square footage continue to decline.


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Because of the current general economic slowdown, these loans represent higher risk, could result in an increase in our total net-charge offs and could require us to increase our allowance for loan losses, which could have a material adverse effect on our financial condition or results of operations. While we seek to minimize these risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.

Our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio.

Construction financing typically involves a higher degree of credit risk than financing on improved, owner-occupied real estate. Risk of loss on a construction loan is largely dependent upon the accuracy of the initial estimate of the property’s value at completion of construction and the bid price and estimated cost (including interest) of construction. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of the value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project whose value is insufficient to assure full repayment. When lending to builders, the cost of construction breakdown is provided by the builder, as well as supported by the appraisal. Although our underwriting criteria are designed to evaluate and minimize the risks of each construction loan, there can be no guarantee that these practices will safeguard against material delinquencies and losses to our operations. At December 31, 2010, we had loans of approximately $117 million, or 12% of total loans, outstanding to finance construction and land development. Construction and land development loans are dependent on the successful completion of the projects they finance, however, in many cases such construction and development projects in our primary market areas are not being completed in a timely manner, if at all.

We are required to make a number of judgments in applying accounting policies and different estimates and assumptions in the application of these policies could result in a decrease in capital and/or other material changes to our reports of financial condition and results of operations. Also, changes in accounting standards can be difficult to predict and can materially impact how we record and report our financial condition and results of operations.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and reserve for unfunded lending commitments and the fair value of certain financial instruments (securities, derivatives, and privately held investments). While we have identified those accounting policies that are considered critical and have procedures in place to facilitate the associated judgments, different assumptions in the application of these policies could result in a decrease to net income and, possibly, capital and may have a material adverse effect on our financial condition and results of operations.

Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time, the Financial Accounting Standards Board changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations.

Competition from other banks and financial institutions in originating loans, attracting deposits and providing various financial services may adversely affect our profitability and liquidity.

We have substantial competition in originating loans, both commercial and consumer, in our market area. This competition comes principally from other banks, savings institutions, mortgage banking companies and other lenders. Some of our competitors enjoy advantages, including greater financial resources and access to capital, stronger regulatory ratios, and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income and liquidity by decreasing the number and size of loans that we originate and the interest rates we may charge on these loans.


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In attracting business and consumer deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Some of our competitors enjoy advantages, including greater financial resources and access to capital, stronger regulatory ratios, stronger asset quality and performance, more aggressive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could materially adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.

Impairment of investment securities, goodwill, other intangible assets, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.

In assessing the impairment of investment securities, we consider the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuers, and our intent and ability to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are no longer amortized but, instead, are assessed for impairment periodically or when impairment indicators are present. Assessment of goodwill and such other intangible assets could result in circumstances where the applicable intangible asset is deemed to be impaired for accounting purposes. Under such circumstances, the intangible asset’s impairment would be reflected as a charge to earnings in the period during which such impairment is identified. In assessing the reliability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.

Our business strategy includes the continuation of moderate growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

Our assets increased $910.3 million, or 151%, from $601.5 million at January 1, 2006, to $1.511 billion at December 31, 2010, primarily due to our acquisition of First National in 2006 and organic growth through increases in residential mortgage loans and commercial real estate loans and securities available for sale funded by growth in deposits. Over the long term, we expect to continue to experience growth in the amount of our assets, the level of our deposits and the scale of our operations. However, achieving our growth targets requires us to successfully execute our business strategies, which include continuing to grow our loan portfolio thereby recognizing the value of our investments in personnel in that area. Our ability to successfully grow will also depend on the continued availability of loan opportunities that meet our stringent underwriting standards. In addition, we may consider the acquisition of other financial institutions and branches within or outside of our market area, the success of which will depend on a number of factors, including our ability to integrate the acquired branches into the current operations of the Company, our ability to limit the outflow of deposits held by customers of the acquired institution or branch locations, our ability to control the incremental increase in non-interest expense arising from any acquisition and our ability to retain and integrate the appropriate personnel of the acquired institution or branches. While we believe we have the resources and internal systems in place to successfully achieve and manage our future growth, there can be no assurance growth opportunities will be available or that we will successfully manage our growth. If we do not manage our growth effectively, we may not be able to achieve our business plan, and our business and prospects could be harmed.


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If we want to, or are compelled to, raise additional capital in the future, that capital may not be available when it is needed and on terms favorable to current shareholders.

Federal banking regulators require us and our banking subsidiaries to maintain adequate levels of capital to support our operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by our management and board of directors based on capital levels that, they believe, are necessary to support our business operations. At December 31, 2010, all three capital ratios for us and our banking subsidiary were above “well capitalized” levels under current bank regulatory guidelines. To be “well capitalized,” banking companies generally must maintain a tier 1 leverage ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total risk-based capital ratio of at least 10%. However, our regulators may require us or our banking subsidiary to operate with higher capital levels. For example, regulators recently have required some banks to attain a Tier 1 leverage ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 10%, and a total risk-based capital ratio of at least 12%.

Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital on terms and time frames acceptable to us or to raise additional capital at all. If we cannot raise additional capital in sufficient amounts when needed, our ability to comply with regulatory capital requirements could be materially impaired. Additionally, the inability to raise capital in sufficient amounts may adversely affect our operations, financial condition and results of operating. Our ability to borrow could also be impaired by factors that are nonspecific to us, such as severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole as evidenced by recent turmoil in the domestic and worldwide credit markets. If we raise capital through the issuance of additional shares of our common stock or other securities, we would likely dilute the ownership interests of current investors and could dilute the per share book value and earnings per share of our common stock. Furthermore, a capital raise through issuance of additional shares may have an adverse impact on our stock price.

We may be adversely affected by technological advances.

Technological advances impact our business. The banking industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in operations. Many competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or successfully market such products and services to its customers.

The soundness of other financial institutions could adversely affect us.

Our ability to engage in routine funding and other 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. 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, losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience increases in deposits and assets as a result of other banks’ difficulties or failure, which would increase the capital we need to support such growth.

A substantial decline in the value of our Federal Home Loan Bank of Pittsburgh common stock may adversely affect our financial condition.

We own common stock of the Federal Home Loan Bank of Pittsburgh, or the FHLB, in order to qualify for membership in the Federal Home Loan Bank system, which enables us to borrow funds under the Federal Home


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Loan Bank advance program. The carrying value and fair market value of our FHLB common stock was approximately $7.0 million as of December 31, 2010.

Published reports indicate that certain member banks of the Federal Home Loan Bank system may be subject to asset quality risks that could result in materially lower regulatory capital levels. In December 2008, the FHLB had notified its member banks that it had suspended dividend payments and the repurchase of capital stock until further notice is provided. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLB, could be substantially diminished or reduced to zero. Consequently, given that there is no market for our FHLB common stock, we believe that there is a risk that our investment could be deemed other-than-temporarily impaired at some time in the future. If this occurs, it may adversely affect our results of operations and financial condition. If the FHLB were to cease operations, or if we were required to write-off our investment in the FHLB, our business, financial condition, liquidity, capital and results of operations may be materially adversely affected.

An interruption or breach in security with respect to our information system, or our outsourced service providers, could adversely impact our reputation and have an adverse impact on our financial condition or results of operations.

We rely on software, communication, and information exchange on a variety of computing platforms and networks and over the Internet. Despite numerous safeguards, we cannot be certain that all of our systems are entirely free from vulnerability to attack or other technological difficulties or failures. We rely on the services of a variety of vendors to meet our data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and we could be exposed to claims from customers. Any of these results could have a material adverse effect on our financial condition, results of operations or liquidity.

If we fail to maintain an effective system of internal control over financial reporting and disclosure controls and procedures, we may be unable to accurately report our financial results and comply with the reporting requirements under the Securities Exchange Act of 1934. As a result, current and potential shareholders may lose confidence in our financial reporting and disclosure required under the Securities Exchange Act of 1934, which could adversely affect our business and could subject us to regulatory scrutiny.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, referred to as Section 404, we are required to include in our Annual Reports on Form 10-K, our management’s report on internal control over financial reporting. While we have reported no “material weaknesses” in the Form 10-K for the fiscal year ended December 31, 2010, we cannot guarantee that we will not have any “material weaknesses” reported in our management’s report on internal control or by our independent registered public accounting firm in the future. Compliance with the requirements of Section 404 is expensive and time-consuming. If, in the future, we fail to complete this evaluation in a timely manner, or if our independent registered public accounting firm cannot timely attest to our evaluation, we could be subject to regulatory scrutiny and a loss of public confidence in our internal control over financial reporting. In addition, any failure to establish an effective system of disclosure controls and procedures could cause our current and potential shareholders and customers to lose confidence in our financial reporting and disclosure required under the Securities Exchange Act of 1934, which could adversely affect our business.




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Orrstown Bank owns and leases properties in Cumberland, and Franklin Counties, Pennsylvania and Washington County, Maryland as branch banking offices, and an operations center. The Company and Orrstown Bank maintain headquarters at the Bank’s King Street Office in Shippensburg, Pennsylvania. A summary of these properties is as follows:


Office and Address



Properties Owned


Orrstown Office


3580 Orrstown Road


Orrstown, PA 17244


Lurgan Avenue Office


121 Lurgan Avenue


Shippensburg, PA 17257


King Street Office


77 E. King Street


Shippensburg, PA 17257


Stonehedge Office


427 Village Drive


Carlisle, PA 17015


Path Valley Office


16400 Path Valley Road


Spring Run, PA 17262


Norland Avenue Office


625 Norland Avenue


Chambersburg, PA 17201


Silver Spring Office


3 Baden Powell Lane


Mechanicsburg, PA 17050


Seven Gables Office


1 Giant Lane


Carlisle, PA 17013


Lincoln Way East Office


1725 Lincoln Way East


Chambersburg, PA 17202


Greencastle Office


308 Carolle Street


Greencastle, PA 17225


Simpson Street Office


1110 East Simpson Street


Mechanicsburg, PA 17055


Office and Address



Newport Office


Center Square


Newport, PA 17074


Duncannon Office


403 North Market Street


Duncannon, PA 17020


New Bloomfield Office


1 South Carlisle Street


New Bloomfield, PA 17068


Eastern Blvd. Office


1020 Professional Court


Hagerstown, MD 21740


North Pointe Business (Operations) Center


2695 Philadelphia Avenue


Chambersburg, PA 17201


Land Lease / Premises Owned


Orchard Drive Office


1355 Orchard Drive


Chambersburg, PA 17201


Red Hill Office


18 Newport Plaza


Newport, PA 17074




Hanover Street


22 S. Hanover St.


Carlisle, PA 17013


North Middleton Office


2250 Spring Road


Carlisle, PA 17013


Camp Hill


3045 Market St.


Camp Hill, PA 17011



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Orrstown Financial Services, Inc. is an occasional party to legal actions arising in the ordinary course of its business. In the opinion of management, the Company has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect the Company’s operations or financial position.




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Market Information

Our common stock began trading on The NASDAQ Capital Market under the symbol “ORRF” as of April 28, 2009, and continues to be listed there as of the date hereof. Before such listing, our common stock was quoted on the OTC Bulletin Board (“OTCBB”). The OTCBB is a regulated quotation service that displays real-time quotes, last-sale prices and volume information in over-the-counter equity securities. Unlike The NASDAQ Capital Market, the OTCBB does not impose listing standards and does not provide automated trade executions. Historical trading in the Company’s stock has not been extensive and such trades cannot be characterized as constituting an active trading market. At the close of business on March 7, 2011, there were approximately 3,111 shareholders of record.

The following table sets forth, for the fiscal periods indicated, the high and low sales prices or closing bid prices for our common stock for the two most recent fiscal years. The quotations for the periods in which our common stock traded on the OTCBB reflect inter-dealer prices, without retail mark-up, markdown or commission and may not represent actual transactions. Trading prices are based on published financial sources.


     2010      2009  
     Market Price      Quarterly
     Market Price      Quarterly
     High      Low         High      Low     

First quarter

   $ 36.50       $ 24.92       $ 0.22       $ 29.25       $ 23.50       $ 0.22   

Second quarter

     26.64         20.45         0.22         40.00         22.00         0.22   

Third quarter

     24.59         20.00         0.225         39.00         34.26         0.22   

Fourth quarter

     27.95         22.82         0.225         39.39         27.77         0.22   
         $ 0.89             $ 0.88   

The Company expects to continue its policy of paying regular cash dividends declared from time to time by the Board of Directors, although there is no assurance as to future dividends because they depend on future earnings, capital requirements, financial condition and other factors deemed relevant by the Board of Directors. See Note 15, “Restrictions on Dividends, Loans and Advances,” in the “Notes to Consolidated Financial Statements” included in Item 8 for the year ended December 31, 2010 for restrictions on the payment of dividends.


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Issuer Purchases of Equity Securities

The table below summarizes the Company’s repurchase of common equity securities during the quarter ended December 31, 2010. The maximum number of shares that may yet be purchased under the plan is 191,926 shares at December 31, 2010.


    Total Number of
Shares Purchased
    Average Price Paid
per Share
    Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs(1)
    Maximum Number of Shares
that may Yet be Purchased
Under the Plans or

10/1/10 through 10/31/10

    0      $ 0        0        193,001   

11/1/10 through 11/30/10

    0        0        0        193,001   

12/1/10 through 12/31/10

    1,075        25.36        1,075        191,926   


    1,075      $ 25.36       



On April 27, 2006, Orrstown Financial Services, Inc. announced a Stock Repurchase Plan approving the purchase of up to 150,000 shares as conditions allow. 106,999 shares were repurchased pursuant to that program. On September 23, 2010, Orrstown Financial Services, Inc. announced an extension of the Stock Repurchase Plan authorizing the repurchase of an additional 150,000 shares, including the 43,001 shares remaining to be purchased under the plan as originally approved. The plan may be suspended at any time without prior notice and has no prescribed time limit in which to fill the authorized repurchase amount. As of December 31, 2010, 108,074 shares have been purchased under the program.


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The following graph shows a five-year comparison of the cumulative total return on the Company’s common stock as compared to other indexes: the SNL index of banks with assets between $1 billion and $5 billion, the S&P 500 Index, and the NASDAQ Composite index. Shareholder returns on the Company’s common stock are based upon trades on the NASDAQ Stock Market. The shareholder returns shown in the graph are not necessarily indicative of future performance.

Orrstown Financial Services, Inc.



     Period Ending  


   12/31/05      12/31/06      12/31/07      12/31/08      12/31/09      12/31/10  

Orrstown Financial Services, Inc.

     100.00         108.24         95.62         88.58         117.84         95.85   

SNL Bank $1B-$5B

     100.00         115.72         84.29         69.91         50.11         56.81   

S&P 500

     100.00         115.79         122.16         76.96         97.33         111.99   

NASDAQ Composite

     100.00         110.39         122.15         73.32         106.57         125.91   

In accordance with the rules of the SEC, this section captioned “Performance Graph” shall not be incorporated by reference into any of our future filings made under the Securities Exchange Act of 1934 or the Securities Act of 1933. The Performance Graph and its accompanying table are not deemed to be soliciting material or to be filed under the Exchange Act or the Securities Act.

Recent Sales of Unregistered Securities

The Company has not sold any securities within the past three years which were not registered under the Securities Act of 1933.


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     Year Ended December 31,  

(Dollars in thousands)

   2010      2009      2008     2007      2006**  

Summary of Operations


Interest income

   $ 58,423       $ 53,070       $ 52,313      $ 53,106       $ 44,788   

Interest expense

     12,688         16,500         19,408        22,986         17,371   

Net interest income

     45,735         36,570         32,905        30,120         27,417   

Provision for loan losses

     8,925         4,865         1,450        750         390   

Net interest income after provision for loan losses

     36,810         31,705         31,455        29,370         27,027   

Securities gains (losses)

     3,636         1,661         (27     58         41   

Other operating income

     20,157         16,024         15,322        13,186         10,984   

Other operating expenses

     37,552         31,967         28,165        24,859         21,570   

Income before income taxes

     23,051         17,423         18,585        17,755         16,482   

Income tax expense

     6,470         4,050         5,482        5,197         4,850   

Net income

   $ 16,581       $ 13,373       $ 13,103      $ 12,558       $ 11,632   

Per Common Share Data*


Income before taxes

   $ 3.03       $ 2.72       $ 2.89      $ 2.76       $ 2.66   

Applicable income taxes

     0.85         0.63         0.85        0.81         0.78   

Net income

     2.18         2.09         2.04        1.95         1.87   

Diluted net income

     2.17         2.07         2.03        1.94         1.86   

Cash dividend paid

     0.89         0.88         0.87        0.82         0.743   

Book value at December 31

     20.10         17.21         16.18        14.97         13.88   

Tangible book value at December 31

     17.50         13.96         12.87        11.64         10.53   

Average shares outstanding—basic

     7,609,933         6,406,106         6,421,022        6,428,853         6,201,978   

Average shares outstanding—diluted

     7,637,824         6,458,752         6,466,391        6,480,710         6,257,647   

Stock Price Statistics*



   $ 27.41       $ 34.88       $ 27.00      $ 30.00       $ 34.81   


     36.50         40.00         33.96        36.19         37.14   


     20.00         22.00         27.00        28.00         30.29   

Price earnings ratio at close

     12.6         16.7         13.2        15.4         18.6   

Diluted price earnings ratio at close

     12.6         16.8         13.3        15.5         18.7   

Price to book at close

     1.4         2.0         1.7        2.0         2.5   

Price to tangible book at close

     1.6         2.5         2.1        2.6         3.3   

Year-End Balance Sheet Data


Total assets

   $ 1,511,722       $ 1,196,432       $ 1,051,783      $ 884,979       $ 809,031   

Total loans

     966,986         881,074         820,468        701,964         618,827   

Total investment securities

     440,570         204,309         128,353        96,355         91,393   

Deposits—noninterest bearing

     104,646         90,676         84,261        91,365         85,420   

Deposits—interest bearing

     1,083,731         824,494         673,107        554,991         553,299   

Total deposits

     1,188,377         915,170         757,368        646,356         638,719   

Repurchase agreements

     87,850         64,614         63,407        55,580         40,953   

Borrowed money

     65,178         64,858         118,887        78,453         33,190   

Total shareholders’ equity

     160,484         110,886         103,347        96,124         89,388   

Trust assets under management—market value

   $ 570,000       $ 414,000       $ 354,000      $ 415,000       $ 404,000   


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     Year Ended December 31,  

(Dollars in thousands)

   2010     2009     2008     2007     2006**  

Performance Statistics


Average equity / average assets

     10.76     9.55     10.45     10.98     10.66

Return on average equity

     11.22     12.48     13.20     13.64     15.10

Return on average tangible equity

     13.19     15.73     17.02     18.02     18.98

Return on average assets

     1.21     1.19     1.38     1.50     1.61

Return on average tangible assets

     1.23     1.23     1.43     1.56     1.66



Per share amounts have been restated to reflect a 5% stock dividend paid June 15, 2007.

Supplemental Reporting of Non-GAAP-Based Financial Measures

Return on average tangible assets and return on average tangible equity is a non-GAAP-based financial measure calculated using non-GAAP-based amounts. The most directly comparable measure is return on average assets and return on average equity, which are calculated using GAAP-based amounts. The Company calculates the return on average tangible assets and equity by excluding the balance of intangible assets and their related amortization expense from the calculation of return on average assets and equity. Management uses the return on average tangible assets and equity to assess the Company’s core operating results and believes that this is a better measure of our operating performance as it is based on the Company’s tangible assets and capital. Further we believe that by excluding the impact of purchase accounting adjustments it allows for a meaningful comparison with the Company’s peers, particularly those that may not have acquired other companies. In addition, this is consistent with the treatment by bank regulatory agencies, which exclude goodwill and other intangible assets from the calculation of risk-based capital ratios. However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures. A reconciliation of return on average assets and equity to the return on average tangible assets and equity, respectively, is set forth below.


     Year Ended December 31,  
     2010     2009     2008     2007     2006  

Return on average assets (GAAP basis)

     1.21     1.19     1.38     1.50     1.61

Effect of excluding average intangible assets and related amortization, net of tax

     0.02     0.04     0.05     0.06     0.05

Return on average tangible assets

     1.23     1.23     1.43     1.56     1.66

Return on average equity (GAAP basis)

     11.22     12.48     13.20     13.64     15.10

Effect of excluding average intangible assets and related amortization, net of tax

     1.97     3.25     3.82     4.38     3.88

Return on average tangible equity

     13.19     15.73     17.02     18.02     18.98

Tangible book value is computed by dividing shares outstanding into tangible common equity. Management uses tangible book value per share because it believes such ratio is useful in understanding the Company’s capital position and ratios. See reconciliation of book value per share to tangible book value per share below.


     Year Ended December 31,  

(Dollars in thousands, except per share data)

   2010      2009      2008      2007      2006  

Shareholders’ equity

   $ 160,484       $ 110,886       $ 103,347       $ 96,124       $ 89,388   

Less: Intangible assets

     20,698         20,938         21,186         21,368         21,567   

Tangible equity

   $ 139,786       $ 89,948       $ 82,161       $ 74,756       $ 67,821   

Book value per share

   $ 20.10       $ 17.21       $ 16.18       $ 14.97       $ 13.88   

Less: Intangible assets per share

     2.60         3.25         3.31         3.33         3.35   

Tangible book value per share

   $ 17.50       $ 13.96       $ 12.87       $ 11.64       $ 10.53   


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The following is a discussion of our consolidated financial condition and results of operations for each of the three years ended December 31, 2010, 2009 and 2008. The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in this report to assist in the evaluation of Orrstown Financial Services, Inc.’s 2010 performance. Certain prior period amounts, presented in this discussion and analysis, have been reclassified to conform to current period classifications.

Important Factors Relating to Forward Looking Statements

This Report contains statements that are considered “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. In addition, the Company may make other written and oral communications, from time to time, that contain such statements. Forward-looking statements, including statements as to industry trends, future expectations and other matters that do not relate strictly to historical facts, are based on certain assumptions by management, and are often identified by words or phrases such as “anticipated”, “believe”, “expect”, “intend”, “seek”, “plan”, “objective”, “trend”, and “goal”. Forward-looking statements are subject to various assumptions, risks, and uncertainties, which change over time, and speak only as of the date they are made.

In addition to factors mentioned elsewhere in this Report or previously disclosed in our SEC reports (accessible on the SEC’s website at or on our website at, the following factors, among others, could cause actual results to differ materially from forward-looking statements and future results could differ materially from historical performance:



general political and economic conditions may be less favorable than expected;



developments concerning credit quality in various corporate lending industry sectors as well as consumer and other types of credit, may result in an increase in the level of our provision for credit losses, nonperforming assets, net charge-offs and reserve for credit losses;



customer borrowing, repayment, investment, and deposit practices generally may be less favorable than anticipated; and interest rate and currency fluctuations, equity and bond market fluctuations, and inflation may be greater than expected;



changes in interest rates or the mix of interest rates and maturities of our interest earning assets and interest bearing liabilities (primarily loans and deposits) may be less favorable than expected;



competitive product and pricing pressures among financial institutions within our markets may increase;



legislative or regulatory developments, including changes in laws or regulations concerning taxes, banking, securities, capital requirements and risk-based capital guidelines, reserve methodologies, deposit insurance and other aspects of the financial services industry, may adversely affect the businesses in which we are engaged or our financial results;



legal and regulatory proceedings, included changes resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act and related matters with respect to the financial services industry, including those directly involving the Company and its subsidiaries, could adversely affect the Company or the financial services industry generally;



pending and proposed changes in accounting rules, policies, practices, and procedures could adversely affect our financial results;


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instruments and strategies used to manage exposure to various types of market and credit risk could be less effective than anticipated, and we may not be able to effectively mitigate our risk exposures in particular market environments or against particular types of risk;



terrorist activities or other hostilities, including the situation surrounding Iraq, may adversely affect the general economy, financial and capital markets, specific industries, and the Company; and



technological changes may be more difficult or expensive than anticipated.

The Company undertakes no obligation to update any forward-looking statements. Actual results could differ materially from those anticipated in forward-looking statements and future results could differ materially from historical performance.

Critical Accounting Policies

Orrstown’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP) and follow general practices within the financial services industry in which it operates. Management, in order to prepare the Company’s consolidated financial statements, is required to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date through the date the financial statements are filed with the Commission. As this information changes, the consolidated financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources.

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, the Company has identified the adequacy of the allowance for loan losses, evaluation of goodwill for potential impairment, and accounting for income taxes as critical accounting policies.

The allowance for loan losses represents Management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet.

Goodwill and other intangible assets have been recorded on the books of the Company in connection with its acquisitions. Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment. Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. Various market valuation methodologies are used to determine the fair value of the


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reporting unit. If the fair values of the reporting units exceed their book values, no write-downs of recorded goodwill are necessary. If the fair value of the reporting unit is less than its book value, an impairment expense may be required to be recorded to write down the related goodwill to the proper carrying value. To date, the Company has not had to take an impairment charge on its goodwill.

The Company recognizes deferred tax assets and liabilities for the future effects of temporary differences and tax credits. Enacted tax rates are applied to cumulative temporary differences based on expected taxable income in the periods in which the deferred tax asset or liability is anticipated to be realized. Future tax rate changes could occur that would require the recognition of income or expense in the statement of operations in the period in which they are enacted. Deferred tax assets must be reduced by a valuation allowance if in management’s judgment it is “more likely than not” that some portion of the asset will not be realized. Management may need to modify their judgments in this regard from one period to another should a material change occur in the business environment, tax legislation, or in any other business factor that could impair the Company’s ability to benefit from the asset in the future. As of December 31, 2010, Management has concluded that a valuation allowance is not needed on its net deferred tax asset.

Readers of the consolidated financial statements should be aware that the estimates and assumptions used in the Company’s current financial statements may need to be updated in future financial presentations for changes in circumstances, business or economic conditions in order to fairly represent the condition of the Company at that time.

Corporate Profile and Significant Developments

Orrstown Financial Services, Inc. is a financial holding company headquartered in Shippensburg, Pennsylvania with consolidated assets of $1.512 billion at December 31, 2010. The consolidated financial information presented herein reflects the Company and its wholly-owned commercial bank subsidiary, Orrstown Bank.

Orrstown Bank, with total assets of $1.491 billion at December 31, 2010, is a Pennsylvania chartered commercial bank with 20 offices. Nineteen of those offices are located in Pennsylvania and one in Maryland. On May 21, 2006, the Company acquired The First National Bank of Newport, located in Perry County, Pennsylvania. On June 15, 2007, The First National Bank of Newport was merged into Orrstown Bank. Orrstown Bank’s deposit services include a variety of checking, savings, time and money market deposits along with related debit card and merchant services. Lending services include commercial loans, residential loans, commercial mortgages and various forms of consumer lending. Orrstown Financial Advisors, a division of Orrstown Bank, offers a diverse line of financial services to our customers, including, but not limited to, brokerage, mutual funds, trusts, estate planning, investments and insurance products. At December 31, 2010, approximately $929 million of assets under management were serviced by Orrstown Financial Advisors.

At the May 2008, annual shareholders’ meeting President and Chief Executive Officer, Kenneth R. Shoemaker announced his retirement effective after the May 5, 2009 annual shareholder’s meeting. On February 13, 2009, it was announced that Thomas R. Quinn, Jr. had been selected to succeed Mr. Shoemaker effective May 5, 2009.

On October, 29, 2007, Orrstown Bank purchased a facility to utilize as its Operations Center located at 2605 – 2695 Philadelphia Avenue, Chambersburg, Pennsylvania, in the North Pointe Business Center. During May 2008, this facility was completed. The loan operations, EFT department, deposit operations, information technology, human resources and other support staff moved into the renovated building. The reclamation and refurbishment of the largely unoccupied former strip shopping center has been positively recognized in the Chambersburg area.

On September 2, 2008, Orrstown Bank opened its flagship office in Hagerstown, Maryland at 1020 Professional Court, off Eastern Boulevard. Growth in Hagerstown has been above expectations and justified a flagship office.


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The Company achieved a milestone during 2010’s fourth quarter by surpassing $1.5 billion in assets.

Orrstown Financial Services, Inc. moved from the OTC Bulletin Board to The NASDAQ Capital Market during 2009. Trading began on The NASDAQ Capital Market under the symbol “ORRF” on April 28, 2009.

The Company joined the broad market Russell 3000 ® Index on June 26, 2009 when Russell Investments reconstituted its U.S. and global indexes. The Company is also part of the Russell 2000 Index, a subset of the Russell 3000 that measures the performance of companies ranked 1,001 – 3,000 by market capitalization.

Economic Climate, Inflation and Interest Rates

During 2008, the U.S. economy faced significant challenges resulting in an overall economic downturn. Poor economic conditions, which were initially evident within the residential housing market beginning in 2007, spread throughout most sectors of the economy in 2008. The economic malaise has continued through the early stages of 2011.

The majority of the assets and liabilities of a financial institution are monetary in nature, and therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. Inflationary pressures over the last five years have been modest, although the potential for future inflationary pressure is present given changing trends in the economy.

As the Company’s balance sheet consists primarily of financial instruments, interest income and interest expense is greatly influenced by the interest rates and the slope of the interest rate curve. During the five years presented in this financial statement review, interest rates were relatively high when the economy was perceived as strong; however, as the national and local economy began experiencing financial difficulties and higher levels of unemployment, rates decreased quickly. One example of this is the prime lending rate, which reached a high during the five-year period of 8.25% in September 2007. However, the prime lending rate was reduced 500 basis points over a 15 month period, coinciding with the country’s economic struggles, and ended 2008 with a published prime lending rate of 3.25%. The published prime lending rate remains at 3.25% at December 31, 2010. Management recognizes that asset/liability management, including the effect of rate changes on interest earning assets and interest bearing liabilities, is of critical importance.

Despite the challenging economic conditions during 2009 and into 2010, the Company believes it is positioned to withstand these conditions through its strong capital and liquidity positions, high quality loan and debt securities portfolios and prudent management of credit and interest rate risk.

Results of Operations

For the year ended December 31, 2010, the Company recorded net income of $16,581,000, an increase of 24.0% over 2009 earnings of $13,373,000, which was a 2.06% increase over net income of $13,103,000 realized in 2008. Basic earnings per share have increased over the last three years from $2.04 in 2008 to $2.09 in 2009 and $2.18 in 2010. Diluted earnings per share have increased as well, from $2.03 in 2008, to $2.07 in 2009 and to $2.17 in 2010.

The Company’s earnings performance continues to exceed peer group averages as measured by various ratio analyses. Two widely recognized performance indicators are the return on average assets (ROA) and the return on average equity (ROE). The average publicly traded banking company and the average $1 billion to $5 billion in assets banking company generated ROAs of approximately 0.50% and 0.55%, respectively, during 2010 per SNL Financial, a provider of financial information for the banking industry. The average return on equity for the average traded banking company and the average $1 billion to $5 billion in assets was 4.72% and 5.16%, respectively. The Company’s ROA and ROE compares favorably to this peer information. Return on average


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tangible assets (ROTA) and return on average tangible equity (ROTE) ratios exclude intangibles from the balance sheet and related amortization and tax expense from net income and is also presented. The Company has goodwill and intangibles from the acquisition of companies and purchased deposits. The following table compares the last three years’ performance ratios.


Performance Statistics

   2010     2009     2008  

Return on average assets

     1.21     1.19     1.38

Return on average tangible assets

     1.23     1.23     1.43

Return on average equity

     11.22     12.48     13.20

Return on average tangible equity

     13.19     15.73     17.02

Average equity / average assets

     10.76     9.55     10.45

Net Interest Income

The primary component of the Company’s revenue is net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing liabilities. Earning assets include loans, securities and federal funds sold. Interest bearing liabilities include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate tax rate.

Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities and the composition of those assets and liabilities. The “net interest spread” and “net interest margin” (NIM) are two common statistics related to changes in net interest income. The net interest rate spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the ratio of net interest income to average earning assets. Through the use of demand deposits and stockholders’ equity, the net interest margin exceeds the net interest rate spread, as these funding sources are non-interest bearing.

The “Analysis of Net Interest Income” table presents net interest income on a fully taxable equivalent basis, net interest rate spread and net interest margin for the years ending December 31, 2010, 2009 and 2008. The “Changes in Taxable Equivalent Net Interest Income” below analyzes the changes in net interest income for the same periods broken down by their rate and volume components.

2010 versus 2009

For the year ended December 31, 2010 net interest income, measured on a full tax equivalent basis, increased $9,828,000, or 26.0%, to $47,676,000 from $37,848,000 in 2009. The primary reason for the increase in net interest income was an increase in average earning assets from $1,033,105,000 in 2009 to $1,280,530,000 in 2010. Supplementing the growth in volume, was an increase in net interest margin of 7 basis points (b. p.), from 3.66% in 2009 to 3.73% for 2010. As summarized on the rate/volume table, $7,338,000 of the growth in net interest income was achieved from volume, and $2,490,000 was achieved through an increase in NIM.

The largest portion of the increase in interest income was the result of interested earned on the securities portfolio, which totaled $10,927,000 for the year ended December 31, 2010, an increase of $4,861,000, or 80%, over 2009. Year-over-year, average securities increased $181,344,000, or 111%. Partially offsetting the increase on securities earnings due to volume was a reduction in the interest rate earned of 3.72% in 2009 to 3.17% in 2010.

The growth in securities was funded principally through the growth in money market and time deposit accounts. Average interest bearing deposits increased $201,216,000, or 22.0%, resulting from the Company’s overall customer service model, its market position in several attractive markets, and due to the favorable rating


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the Bank has received from IDC Financial Publishing, Inc. (IDC), an independent bank safety rating agency which uses its unique rankings of financial ratios to determine the quality ratings of financial institutions. This strong rating facilitates the Company’s ability to attract time deposits and brokered deposits. Despite an increase in the average balance of time deposits of $145,349,000 for the year ended December 31, 2010 compared to 2009, the total interest expense was lowered by $1,108,000. The average volume resulted in an increase of interest expense of $3,635,000, which was more than offset by a decrease in interest expense that resulted from a decrease in the yield paid on time deposits, of 93 basis points from 2009 to 2010, of $4,743,000. The Company recognizes that brokered funds are more volatile funding source than core deposits. However, given the current interest rate environment and the steepness of the interest rate curve, the Company elected to collect these funds and earn a spread on them in order to enhance net interest income. Given the increased volatility in brokered deposits, the Company invested a large portion of these amounts in mortgage backed securities, which provide a regular stream of monthly cash flows, which can be used to meet the maturity needs of time and brokered deposits. We have matched cash flows from the debt securities portfolio with nontraditional cash flows to enable us to unwind the strategy if loan demand continues to increase or if the yield curve flattens.

The growth in the loan portfolio also contributed to the increase in net interest income. Year-over-year, average loans increased $61,676,000, or 7.3%, from the year ended December 31, 2009 to December 31, 2010. The increase in average loans is the result of the Company’s desire to continue to grow its loan portfolio and deploy its capital. This growth has come principally in some of the Company’s less mature markets, in which we have hired additional lending officers, which has increased opportunities in these markets served. The growth experienced in the loan portfolio was achieved primarily in the second half of the year, in which approximately two-thirds of the 2010 growth was achieved. The $61,676,000 growth in average balance in loans contributed $3,600,000 in additional interest income in 2010 compared to 2009. However, the rate earned on loans of 5.42% was 26 b.p. less than in 2009, and offset interest income by $2,492,000. The Company continues to have $30,000,000 in notional amount of interest rate swaps which serve as a hedge against variable rate commercial loans linked to prime and converts them to a fixed rate of interest. The interest rate swaps that the Company had outstanding during 2010 yielded $778,000, which was credited and included as commercial loan interest income.

As noted above, the Company has been able to increase its deposit base. As a result, less reliance has been placed on more costly long-term borrowings. Interest expense on long-term debt has decreased $2,065,000 from $3,584,000 for the year ended December 31, 2009 to $1,519,000 in 2010. Reduction in average daily balance of $48,458,000 for 2010 compared to 2009 reduced interest expense by $1,731,000, and the reduction in the rate paid on long-term borrowing of 64 b.p. reduced interest expense by $334,000.

The growth that the Company has experienced, and its ability to lower its cost of funding by an amount greater than its reduction in rates earned on interest-earning assets, has resulted in a slight improvement in both the interest rate spread and net interest margin. The average rates earned on assets were 4.71% for the year ended December 31, 2010 compared to 5.26% in 2009, whereas the rates paid on interest bearing liabilities declined from 1.60% in 2009 to 0.98% in 2010. This resulted in a net interest rate spread of 3.57% in 2010 compared to 3.46% in 2009.

2009 versus 2008

For the year ended December 31, 2009 net interest income, measured on a fully tax equivalent basis, increased $3,941,000, or 11.6%, to $37,848,000 from $33,907,000 in 2008. The primary reason for the increase in net interest income was an increase in average earning assets from $864,780,000 in 2008 to $1,033,105,000 in 2009. Offsetting the growth in volume was a decrease in net interest margin of 27 basis points from 3.93% to 3.66%. Net interest margin compacted appreciably beginning in the fourth quarter of 2008 given the Federal Reserve Bank’s significant cut to the federal funds rates. Those cuts served to lower the prime lending rate by similar amounts and the Company had approximately one-third of its assets tied to Wall Street Journal Prime. Actions taken by management at that time included the installation of interest rate floors on all new commercial loans, and the placement of $60,000,000 notional amount of prime for fixed interest rate swaps. The Company was able to stabilize its net interest margin during the latter half of 2009 as a result of the actions taken, which continued through 2010.


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Going forward, the Company’s ability to maintain its historically strong growth trend in net interest income will be challenged by expected pressure in net interest income. This pressure could be attributable to the following factors:



The cash flows that result from deposit maturities will not experience the same magnitude of downward re-pricing experienced in 2008 and 2009, as many of these deposits have matured once already in the low rate environment.



Presently the interest rate yield curve is relatively steep, with the spread between the two and ten year treasuries being 2.69% at December 31, 2010. If the yield curve were to flatten some, net interest margin could be negatively impacted.

The Company expects to mitigate these factors by continuing to improve the mix of earning assets through loan growth and a disciplined approach to the pricing of loans and deposits.


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The following table presents interest income on a fully taxable equivalent basis, net-interest spread and net interest margin for the years ended December 31:


    2010     2009     2008  

(Dollars in thousands)




Federal funds sold and interest bearing bank balances

  $ 25,864      $ 116        0.45   $ 21,459      $ 69        0.32   $ 10,356      $ 227        2.19

Taxable securities

    290,328        7,744        2.67        135,851        4,260        3.14        76,413        2,862        3.75   

Tax-exempt securities

    53,940        3,183        5.90        27,073        1,806        6.67        23,679        1,692        7.15   

Total securities

    344,268        10,927        3.17        162,924        6,066        3.72        100,092        4,554        4.55   

Taxable loans

    874,226        46,958        5.37        822,054        46,370        5.64        738,552        47,362        6.41   

Tax-exempt loans

    36,172        2,363        6.53        26,668        1,843        6.91        15,780        1,172        7.43   

Total Loans

    910,398        49,321        5.42        848,722        48,213        5.68        754,332        48,534        6.43   

Total interest-earning assets

    1,280,530        60,364        4.71        1,033,105        54,348        5.26        864,780        53,315        6.17   

Cash and due from banks

    13,230            13,950            13,857       

Bank premises and equipment

    28,662            30,382            29,144       

Other assets

    65,157            51,973            48,542       

Allowance for loan losses

    (13,562         (7,618         (6,421    


  $ 1,374,017          $ 1,121,792          $ 949,902       

Liabilities and Shareholders’ Equity


Interest bearing demand deposits

  $ 400,474      $ 2,517        0.63      $ 307,968      $ 3,171        1.03      $ 251,547      $ 3,845        1.53   

Savings deposits

    63,763        167        0.26        60,494        204        0.34        61,881        618        1.00   

Time deposits

    509,426        7,998        1.57        364,077        9,106        2.50        279,127        9,558        3.42   

Short term borrowings

    91,872        487        0.53        83,322        435        0.52        67,175        1,248        1.86   

Long term debt

    51,886        1,519        2.93        100,344        3,584        3.57        94,737        4,139        4.37   

Total interest bearing liabilities

    1,117,421        12,688        1.14        916,205        16,500        1.80        754,467        19,408        2.57   

Demand deposits

    99,636            89,797            87,537       


    9,229            8,652            8,657       

Total Liabilities

    1,226,286            1,014,654            850,661       

Shareholders’ Equity

    147,731            107,138            99,241       


  $ 1,374,017          0.98   $ 1,121,792          1.60      $ 949,902          2.24

Net interest income (FTE)/ net interest spread

      47,676        3.57          37,848        3.46          33,907        3.60

Net interest margin

        3.73         3.66         3.93

Tax-equivalent adjustment

      (1,941         (1,278         (1,002  

Net interest income

    $ 45,735          $ 36,570          $ 32,905     


Note: Yields and interest income on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate. For yield calculation purposes, nonaccruing loans are included in the average loan balance.


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The following table analyzes the changes in tax equivalent net interest income for the periods presented, broken down by their rate and volume components:


     2010 Versus 2009 Increase (Decrease)
Due to Change in
    2009 Versus 2008 Increase (Decrease)
Due to Change in

(Dollars in thousands)

    Total Increase
    Total Increase

Interest Income


Federal funds sold & interest bearing deposits

   $ 14      $ 33      $ 47      $ 243      $ (402   $ (159


     3,600        (2,492     1,108        6,163        (6,484     (321

Taxable securities

     4,844        (1,360     3,484        2,226        (828     1,398   

Tax-exempt securities

     1,792        (415     1,377        243        (130     113   

Total interest income

     10,250        (4,234     6,016        8,875        (7,844     1,031   

Interest Expense


Interest bearing demand deposits

     952        (1,606     (654     861        (1,535     (674

Savings deposits

     11        (48     (37     (14     (400     (414

Time deposits

     3,635        (4,743     (1,108     2,909        (3,361     (452

Short-term borrowings

     45        7        52        300        (1,113     (813

Long-term debt

     (1,731     (334     (2,065     245        (802     (557

Total interest expense

     2,912        (6,724     (3,812     4,301        (7,211     (2,910

Net Interest Income

   $ 7,338      $ 2,490      $ 9,828      $ 4,574      $ (633   $ 3,941   


Note: The change attributed to volume is calculated by taking the average change in average balance times the prior year’s average rate and the remainder is attributable to rate.

Provision for Loan Losses

The provision for loan losses has increased from $4,865,000 for the year ended December 31, 2009 to $8,925,000 for the same period in 2010, an increase of 83.5%, or $4,060,000. In 2009, the provision for loan losses increased $3,415,000 from that expensed in 2008, which totaled $1,450,000.

The increases that the Company has experienced in its provision for loan losses have partially resulted from the growth it has experienced in its loan portfolio. In addition, the increase in the provision for loan losses for the periods presented can be attributed to declining asset quality and higher charge-offs during his time period. Increases in non-performing assets and charge-offs has been an industry wide trend both at the national and local levels.

See further discussion in the Asset Quality and Credit Risk Management section of this Management’s Discussion and Analysis.


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Other Income

The following provides information regarding noninterest income changes over the past three years.


                         % Change  

(Dollars in thousands)

   2010      2009      2008     2010-2009     2009-2008  

Service charges on deposit accounts

   $ 7,506       $ 6,905       $ 6,758        8.7     2.2

Other service charges, commissions and fees

     3,878         3,186         2,473        21.7     28.8

Trust department income

     3,606         2,645         2,840        36.3     -6.9

Brokerage income

     1,450         1,327         1,413        9.3     -6.1

Gains on sale of loans

     1,304         832         461        56.7     80.5

Earnings on life insurance

     1,192         745         683        60.0     9.1

Other income

     1,221         384         694        218.0     -44.7

Subtotal before securities gains

     20,157         16,024         15,322        25.8     4.6

Securities gains (losses)

     3,636         1,661         (27     118.9     Not meaningful   

Total other income

   $ 23,793       $ 17,685       $ 15,295        34.5     15.6

2010 v. 2009’s Results

Noninterest income increased to $23,793,000 for the twelve months ended December 31, 2010, as compared to $17,685,000 in the same prior year period. Excluding the increase in securities gains of $1,975,000 in 2010 compared to 2009, noninterest income increased $4,133,000, or 25.8%. Noninterest income generation increased across all business lines including Orrstown Financial Advisors, mortgage originations and retail fees generated from deposit accounts. These business lines have been able to capitalize on favorable market conditions, which include:



The Company continues to see an increase in its deposit accounts and other customer related services, which has resulted in an increase in service charges. Total service charges totaled $11,384,000 for the twelve months ended December 31, 2010, an increase of $1,293,000, or 12.8% over 2009. An increase in customer use of the Mastermoney debit card program contributed $383,000 of the favorable increase. Consumer habits continued to change and the popularity of the reward checking product increased. This product requires a minimum number of debit card transactions to qualify for the highest interest rate and the accordance of certain account and transaction related fees, resulting in an increase in non-interest income when minimums are not met.



An increase in trust department and brokerage income of $1,084,000, or 27.3% for the twelve months ended December 31, 2010 compared to 2009 were the result of increases in trust and brokerage activity as the stock market has started to show signs of recovery, and additional trust and brokerage assets under management, which increased from $740,028,000 at December 31, 2009 to $929,327,000 at December 31, 2010.



The continued decline in mortgage interest rates has led to an increase in new mortgage loan applications as well as refinancing activities. Given these low interest rates, the Company generally sells its 30-year conforming loans to investors. The increase in activity has resulted in gains on sales of loans increasing to $1,304,000 for the twelve months ended December 31, 2010 compared to $832,000 in 2009.



Earnings on life insurance increased 60%, from $745,000 for the year ended December 31, 2009 to $1,192,000 in 2010. The increase was principally the result of $296,000 in life insurance death benefits that was realized upon the deaths of former directors in 2010, with no similar gains noted in 2009.



Included in other income for the twelve months ended December 31, 2010 was the gain on the sale of a fixed for prime floating rate swap, with a notional value of $30,000,000, that was recorded in the second quarter totaling $778,000. In connection with the Company’s asset liability management, it was


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determined this swap would be settled in order to protect earnings in the event interest rates would rise. No similar gain on the settlement of swaps occurred in 2009.



The Company continued to harvest gains on securities available for sale when it was strategically determined that the gains afforded on certain securities was more beneficial than the interest rate earned. Accordingly, gains on securities were $3,636,000 for the year ended December 31, 2010 compared to $1,661,000 in 2009.

The Company continues to advertise and market itself in order for consumers to recognize the broad range of financial services and products the Company has to offer, and to increase its brand recognition. Through the use of enhanced technology, the Company expects it will be able to reach a broader market which will allow it to continue to grow its customer base. In the fourth quarter of 2010, the Company began offering its mortgage product through on-line applications.

The Dodd-Frank bill currently contains provisions that may limit the Company’s ability to earn debit card interchange fees in the second half of 2010. Despite the fact the Bank is below $10 billion in assets and would not be subject to limitations on fees charged to customers, its service provider exceeds the $10 billion threshold. In the event the service provider is not able to differentiate between banks above and below the threshold, interchange fee income would be negatively impacted. The Company continues to discuss this matter with the service provider, and is exploring other alternatives in the event a satisfactory resolution to the matter is not achieved. In addition, because the Company’s competitors having assets in excess of $10 billion will not be able to charge debit card interchange fees, competitive pressures may cause the Company to reduce or eliminate its interchange fee charges.

2009 v. 2008’s Results

Total other income increased by $2,390,000, or 15.6% in 2009 compared to 2008’s results. Securities gains were a large reason for the increase, which increased from a loss of $27,000 in 2008 to gains of $1,661,000. Gains from the available for sale securities portfolio were strategically exercised at times to support other corporate initiatives. The Company increased its deposit accounts and other customer related services, which has resulted in an increase in service charges. Total service charges totaled $10,091,000 for the year ended December 31, 2009, an increase of $860,000, or 9.3% over 2009. The Company began seeing an increase in customer’s use of the Mastermoney debit card program in order to allow customers to earn a higher interest rate on their deposits. This change in consumer habits contributed $277,000 to the increase in customer service charges. Gains on sales of loans increased $371,000, or 80.5% for the year ended December 31, 2009 compared to 2008. Mortgage originators were added during 2009 to take advantage of the refinancing boom that resulted from lower interest rates.


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Other Expenses

The following provides information regarding noninterest expense over the past three years.


                          % Change  

(Dollars in thousands)

   2010      2009      2008      2010-2009     2009-2008  

Salaries and employee benefits

   $ 19,120       $ 16,040       $ 14,315         19.2     12.1

Occupancy expense

     2,200         2,169         1,964         1.4     10.4

Furniture and equipment

     2,742         2,637         2,287         4.0     15.3

Data processing

     1,278         1,077         999         18.7     7.8


     730         731         679         -0.1     7.7

Advertising and bank promotions

     1,208         1,111         1,238         8.7     -10.3

FDIC insurance

     1,798         1,278         296         40.7     331.8

Professional services

     856         667         560         28.3     19.1

Taxes other than income

     764         554         577         37.9     -4.0

Intangible asset amortization

     240         252         251         -4.8     0.4

Other operating expenses

     6,616         5,451         4,999         21.4     9.0

Total operating expenses

   $ 37,552       $ 31,967       $ 28,165         17.5     13.5

2010 v. 2009’s Results

As a result of the growth the Company has experienced, other expenses rose from $31,967,000 during the first twelve months of 2009 to $37,552,000 for the same period in 2010, an increase of $5,585,000, or 17.5%. The following contributed to the increase in other expenses.



The largest increase was in salaries and employee benefits, which was $19,120,000 for the twelve months ended December 31, 2010, an increase of $3,080,000 over 2009’s results. The increase was attributable to the growth in the number of staff, which grew from 262 full-time equivalents at December 31, 2009 to 275 at December 31, 2010. The addition of these employees directly contributed to the revenue growth the Company experienced, as many were revenue producers. Additional support staff was also required to handle the additional business volume. Additional increases in employee benefits were noted, particularly health and welfare costs, which increased consistent with national trends. Further, the Company recorded expense related to its share-based compensation for employees of $360,000 for the twelve months ended December 31, 2010, compared to $113,000 in 2009.



Advertising and bank promotions increased $97,000 in 2010 compared to 2009. The increase was the result of the Company continuing to enhance its brand in the markets it serves. Contributions, included in advertising and bank promotions expense, for the year ended December 31, 2010 totaled $332,000, or $37,000 higher than in 2009. The increase in expense is a result of commitments to the communities that the Bank serves as we continue to build relationships and expand our presence in these market areas.



FDIC insurance totaled $1,798,000 for the twelve months ended December 31, 2010, an increase of 40.7%, or $520,000 over 2009. The increase is the result of additional deposits that the Bank has been able to generate in 2010, combined with higher assessments in 2010 than in 2009. The Company expects that FDIC insurance will continue to increase in 2011.



Collection and real estate owned expenses, included in other operating expenses, increased approximately $424,000 from $258,000 for the twelve months ended December 31, 2009 to $682,000 for the same period in 2010. The increase is commensurate with the increase in risk assets discussed in the provision and allowance for loan losses section.



In the third quarter of 2010, the Bank incurred additional expenses associated with its investments in low-income housing projects. This resulted in incremental expense of $166,000 recorded in the year ended December 31, 2010 over the same period in 2009. These charges are included in other operating expenses.


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Fees associated with the Bank’s Mastermoney Card totaled $605,000 for the year ended December 31, 2010, an increase of $124,000 over 2009’s expense. The increase in expense is consistent with an increase in Mastermoney fee income of $383,000. These expenses are included in other operating expenses.



The remainder of the increase in other expenses is primarily the result of the growth experienced by the Company.

Despite an increase in the other expenses, the Company was able to improve on its efficiency ratio, which was 54.9% for the twelve months ended December 31, 2010, compared to 58.9% in 2009.

2009 v. 2008’s Results

Other expenses rose $3,802,000, or 13.5%, for year ended December 31, 2009 over 2008’s results. A new operations center in Chambersburg, PA and a new flagship branch in Hagerstown, MD were brought online during 2008, resulting in a full twelve months of occupancy expense in these facilities in 2009. Systems were upgraded in connection with these new facilities, which led to a 15.3% increase in furniture and equipment expense for the year ended 2009 compared to the same period in 2008. Employees were added to handle the growth, leading to an increase in salaries and employee benefits expense from $14,315,000 in 2008 to $16,040,000 in 2009.

The largest increase in noninterest expense in percentage terms was the 331.8% increase in FDIC insurance premiums, which increased from $296,000 for the year ended December 31, 2008 to $1,278,000 in 2009. The insurance assessment included a special assessment of $515,000 that the Company expensed in 2009, which was on top of the increase in quarterly assessments to the Company. The increased FDIC insurance expense burdened the entire banking industry during 2009.

Federal Income Taxes

The Company recognized income taxes of $6,470,000, $4,050,000 and $5,482,000 for the years ended December 31, 2010, 2009 and 2008. The fluctuation in income tax expense is consistent with the increase in pretax income in 2010 over 2009’s results, and a decrease in pretax income from 2008 to 2009.

A more meaningful comparison is the effective tax rate, a measurement of income tax expense as a percent of pretax income, which was 28.1%, 23.2%, and 29.5% for the years ended December 31, 2010, 2009 and 2008. The Company’s effective tax rate is less than the 35% federal statutory rate, primarily due to tax-exempt loan and security income, life insurance earnings and tax credits associated with low-income housing and historic projects, offset by certain non-deductible expenses and state income taxes.

The 23.2% effective tax rate in 2009 was pushed down due to $620,000 of historic credits that resulted from a senior housing project in our market area. The Company has made contributions and additional commitments to 2 additional low income housing projects during 2009/2010. However, the tax credits on these two projects will not be realized until 2011, when the properties are placed in service and available for lease. The Company actively seeks tax free investment opportunities, when the yield, on a tax equivalent basis, is favorable compared to taxable investments.

Financial Condition

The quality of the Company’s asset structure continues to be strong. A substantial amount of time is devoted by management to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and minimization of risk associated with such investments.


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Securities Available for Sale

The Company utilizes securities available for sale as a tool for managing interest rate risk, enhancing income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings. As of December 31, 2010, securities available for sale were $431,772,000, a $235,519,000 increase from the December 31, 2009 balance of $196,253,000.

The Company has established investment policies and an asset management policy to assist in administering its investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, securitization of deposits and repurchase agreements and other factors while obtaining the maximum return on the investments. Under generally accepting accounting principles, the Company may segregate its investment portfolio into three categories: “securities held to maturity”, “trading securities” and “securities available for sale”. Management has classified the full securities portfolio as available for sale. Securities available for sale are to be accounted for at their current market value with unrealized gains and losses on such securities to be excluded from earnings and reported as a net amount in other comprehensive income.

The Company’s securities available for sale include debt and equity instruments that are subject to varying degrees of credit and market risk. This risk arises from general market conditions, factors impacting specific industries, as well as corporate news that may impact specific issues. Management continuously monitors its debt securities, including updates of credit ratings, monitoring market, industry and segment news, as well as volatility in market prices. The Company uses various indicators in determining whether a debt security is other-than- temporarily-impaired, including the extent of time the security has been in an unrealized loss position, and the extent of the unrealized loss. In addition, management assesses whether it is likely the Company will have to sell the security prior to recovery, or if it is able to hold the security until the price recovers. For those debt securities in which management concludes the security is other than temporarily impaired, it will recognize the credit component of an other-than-temporary impairment in earnings and the remaining portion in other comprehensive income. Given the strong asset quality of the debt security portfolio, management has not had to take an other than temporary impairment charge in 2010.

For equity securities, when the Company has decided to sell an impaired available-for-sale security and does not expect the fair value of the security to fully recover before the expected time of sale, the security is deemed other-than-temporarily impaired in the period in which the decision to sell is made. The Company recognizes an impairment loss when the impairment is deemed other than temporary even if a decision to sell has not been made. The Company recorded $0, $36,000 and $84,000 of other than temporary impairment expense on equity securities for the years ended December 31, 2010, 2009 and 2008.

The following table shows the fair value of securities available for sale at December 31:


(Dollars in thousands)

   2010      2009      2008  

U.S. Government Sponsored Enterprises (GSE)

   $ 120,286       $ 119,416       $ 59,399   

States and political subdivisions

     97,148         37,384         23,426   

GSE residential mortgage-backed securities

     212,176         37,873         36,482   

Total debt securities

     429,610         194,673         119,307   

Equity securities

     2,162         1,580         1,333   


   $ 431,772       $ 196,253       $ 120,640   

As noted in the net interest income discussion above, the Company has significantly increased its securities available for sale portfolio in order to enhance net interest income given the current interest rate environment and slope to the interest rate yield curve. The growth in the securities portfolio was the result of $515,381,000 of securities purchased, offset by maturities repayments and calls of $68,412,000 and the sales of securities totaling


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$210,687,000 during the year ended December 31, 2010. Sales of securities were taken in anticipation of rising interest rates, in order to protect earnings. In addition, given the growth in the portfolio, management had to reposition a portion of its portfolio for interest rate risk management purposes.

The majority of the growth in the securities available for sale portfolio was in the U.S. Government sponsored enterprises residential mortgage-backed securities, which grew from $37,873,000 at December 31, 2009 to $212,176,000, an increase of $174,303,000. Given the increased volatility in brokered deposits that were used to fund the growth in securities, the Company invested a large portion of these amounts in residential mortgage backed securities, which provide a regular stream of cash flows, which can be used to meet the maturity needs of the time and brokered deposits.

The following table shows the maturities of investment securities at book value as of December 31, 2010, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 35% federal income tax rate.


(Dollars in thousands)

   Within 1
    After 1
year but
within 5
    After 5
years but
within 10
    After 10
    Total     Average
(in years)

U.S. Government Sponsored Enterprises (GSE)

   $ 6,015      $ 12,344      $ 88,553      $ 13,406      $ 120,318        7.0         2.87

States and political subdivisions

     5,241        9,451        16,305        67,136        98,133        11.3         5.02

GSE Residential Mortgage-backed securities

     1        299        20,884        191,076        212,260        18.6         2.15

Total amortized cost

   $ 11,257      $ 22,094      $ 125,742      $ 271,618      $ 430,711        13.7         3.00

Percentage of total portfolio

     2.61     5.13     29.19     63.07     100.00     

Weighted average yield

     1.79     2.28     3.15     3.08     3.00     

The above maturity is based on contractual terms of the debt or mortgage backed securities, and does not factor in required repayments or anticipated prepayments that may exist. As of December 31, 2010, the weighted average estimated life of the residential mortgage-backed securities portfolio is less than 4 years based on current interest rates and anticipated prepayment speeds.

Loan Portfolio

The Company offers various products to meet the credit needs of our borrowers, and principally consists of commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans securitized by residential properties, and to a lesser extent, installment loans. Generally speaking, the Company follows conservative lending practices and continues to carry a high quality loan portfolio with no unusual or undue concentrations of credit. No loans are extended to non domestic borrowers or governments.

With certain exceptions, we are permitted under applicable law to make loans to single borrowers (including certain related persons and entities) in aggregate amounts of up to 15% of the sum of total capital and the allowance for loan losses. The Company’s legal lending limit to one borrower was approximately $19,000,000 at December 31, 2010; however, our largest exposure to any one borrower as of that date was approximately $16,000,000.

The Company’s loan portfolio is broken down into segments to an appropriate level of disaggregation to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio. In 2010, management incorporated the provisions of ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses, resulting in the refinement in its portfolio segregation. Consistent with this standard, the segments were further broken down into classes, to allow for differing risk characteristics within a segment.


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Management feels that non-owner occupied commercial real estate, consisting of nonresidential properties, pose a greater risk than owner-occupied and multi-family residential properties. Likewise, a 1-4 family residential construction class is broken out of the acquisition and development loan segment, leaving a commercial and land development class that presents a higher risk profile. In commercial and land development projects, many times the ultimate buyer of the property is not known at the time the project is started, and the real estate collateral cannot generally be subdivided into smaller parcels to diversify the developer’s risk. First lien residential mortgage loans generally are less susceptible to loss than home equity loans, which generally have higher loan-to-values associated with them.

Balances as of December 31, 2009 have been reclassified to be consistent with 2010’s presentation. However, 2006 – 2008 have not been reclassified, and are presented separately.

The loan portfolio, excluding residential loans held for sale, broken out by classes as of December 31 is as follows:


(Dollars in thousands)

   2010      2009  

Commercial real estate:



   $ 172,000       $ 149,149   

Non-owner occupied

     143,372         122,287   


     24,649         24,898   

Acquisition and development:


1-4 family residential construction

     29,297         21,977   

Commercial and land development

     88,105         88,902   

Commercial and industrial

     263,943         246,335   

Residential mortgage:


First lien

     119,450         100,413   

Home equity—term

     40,818         55,993   

Home equity—Lines of credit

     71,547         58,146   

Installment and other loans

     11,112         12,380   
   $ 964,293       $ 880,480   

In addition to the Company monitoring its loan portfolio by type, it also monitors concentrations to one industry. The Bank’s Lending Policy defines an industry concentration as one that exceeds 25% of the Bank’s shareholders’ equity. The following industries meet the concentration criteria defined by the Bank’s Lending Policy at December 31, 2010:


(Dollars in thousands)

   Balance      % of
    % of

Land subdivision

   $ 72,380         8     53

Lessors of residential buildings and dwellings

     138,680         14     101

Lessors of nonresidential buildings

     117,707         12     86

Hotels (except casinos and motels)

     55,528         6     40


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The loan portfolio as of December 31, 2008, 2007 and 2006, generally broken down by the underlying security of the loans, is as follows:


(Dollars in thousands)

   2008      2007      2006  

Commercial, financial and agricultural

   $ 78,880       $ 55,698       $ 59,593   

Real estate—Commercial

     250,485         243,210         221,460   

Real estate—Construction

     131,509         92,050         46,947   

Real estate—Mortgage

     351,426         302,419         281,902   


     8,168         8,587         8,925   

Total loans

   $ 820,468       $ 701,964       $ 618,827   

The loan portfolio at December 31, 2010 has grown 9.5% from December 31, 2009, from $880.5 million to $964.3 million. The Company continued to experience growth in its commercial real estate and commercial portfolios, which grew 14.7% and 7.1% in 2010. Several experienced lenders have joined the Company in the past two years, which has led to additional opportunities in some of the Company’s emerging markets. First-lien residential mortgage loans have grown $19.0 million from $100.4 million at December 31, 2009 to $119.5 million at December 31, 2010. This growth is principally the result of management’s intention to retain some of the shorter lived mortgages, generally with maturities of 10-20 years, in its portfolio. This strategy is to help diversify the loan portfolio, and as these mortgages earn more attractive rates than alternative investments, including federal funds sold and securities available for sale. Longer termed residential mortgage loans continue to be sold on the secondary market, as they present greater interest rate risk. Installment loans and combined home equity loans have decreased since 2009, as consumer spending and related borrowing has declined in this uncertain economy.

Presented below are the approximate maturities of the loans types specified, and whether they are fixed-rate-adjustable floating rates as of December 31, 2010.


     Due In      Total  

(Dollars in Thousands)

   One Year
or Less
     Year Through
Five Years
     After Five

Acquisition and development:


1-4 family residential construction


Fixed rate

   $ —         $ —         $ —         $ —     

Adjustable and floating rate

     16,105         3,683         9,509         29,297   


     16,105         3,683         9,509         29,297   

Commercial and land development


Fixed rate

     3,061         220         5,872         9,153   

Adjustable and floating rate

     26,979         26,441         25,532         78,952   


     30,040         26,661         31,404         88,105   

Commercial and industrial


Fixed rate

     1,317         17,230         30,465         49,012   

Adjustable and floating rate

     48,444         9,126         157,361         214,931   


     49,761         26,356         187,826         263,943   
   $ 95,906       $ 56,700       $ 228,739       $ 381,345   

The variable rate loans shown above include semi-fixed loans that contractually will adjust with prime after the interest lock period which may be up to seven years. At December 31, 2010 there were approximately $114,274,000 of such loans.


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Asset Quality

Risk Elements

The Company’s loan portfolios are subject to varying degrees of credit risk. Credit risk is mitigated through conservative underwriting standards, on-going credit review, and monitoring asset quality measures. Additionally, loan portfolio diversification, limiting exposure to a single industry or borrower, and requiring collateral also mitigate the Company’s risk of credit loss.

The Company’s loan portfolio is principally to borrowers in south central Pennsylvania and Washington County, Maryland. As the majority of loans are concentrated in this geographic region, a substantial portion of the debtor’s ability to honor their obligations may be affected by the level of economic activity in the market area.

Nonperforming assets include nonaccrual and restructured loans and foreclosed real estate. In addition, loans past due 90 days or more and still accruing are also deemed to be a risk asset. The accrual of interest income on loans ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is generally reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectability of principal. Past due status is based on contract terms of the loan. A loan is considered restructured if the terms of a loan, such as the interest rate or repayment schedule, or both, are modified to terms that the Company would not have granted originally due to the financial difficulties of the borrower.

The following table presents the Company’s risk elements, including information concerning the aggregate balances of nonaccrual, restructured, loans past due 90 days or more, and foreclosed real estate as of December 31. Additionally, relevant asset quality ratios are also presented.


(Dollars in thousands)

   2010     2009     2008     2007     2006  

Nonaccrual loans (cash basis)

   $ 13,896      $ 4,267      $ 341      $ 118      $ 120   

Restructured loans

     1,180        0        0        0        0   

Total nonperforming loans

     15,076        4,267        341        118        120   

Foreclosed real estate

     1,112        1,065        608        199        318   

Total nonperforming assets

     16,188        5,332        949        317        438   

Loans past due 90 days or more and still accruing

     2,248        6,155        6,176        3,586        1,084   

Total risk assets

   $ 18,436      $ 11,487      $ 7,125      $ 3,903      $ 1,522   

Asset quality ratios:


Nonperforming loans to loans

     1.56     0.48     0.04     0.02     0.02

Nonperforming assets to assets

     1.07     0.45     0.09     0.04     0.05

Total risk assets to total loans and foreclosed real estate

     1.90     1.30     0.87     0.56     0.25

Total risk assets to total assets

     1.22     0.96     0.68     0.44     0.19

Allowance for loan losses to nonperforming loans

     106.26     259.36     2093.84     5204.24     4600.00


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A further breakdown of nonaccrual loans and loans past due 90 days or more still accruing as of December 31, 2010 and 2009 is as follows:


     Nonaccrual Loans      Past Due 90 Days or
More Still Accruing
     2010      2009          2010              2009      

Commercial real estate:



   $ 686       $ 403       $ 466       $ 2,884   

Non-owner occupied

     2,064         1,115         0         237   


     90         —           0         —     

Acquisition and development:


Commercial and land development

     93         —           0         245   

Commercial and industrial

     10,625         2,644         420         1,713   

Residential mortgage:


First lien

     279         43         1,095         620   

Home equity

     58         58         217         447   

Installment and other loans

     1         4         50         9   
   $ 13,896       $ 4,267       $ 2,248       $ 6,155   

As noted in the above tables, the Company has experienced an increase in risk assets from 2006 – 2010, which coincides with the downturn in the state and local economy, and softness that has been experienced in the real estate market. Improvement was made since March 2010 principally through the reduction in the level of non-accrual loans, loans past due 90 or more days and still accruing, and total delinquency. The Company continues to be diligent in its handling of nonperforming and other risk assets and has been able to reduce the level of risk assets from a high of $32,822,000 at March 31, 2010 to $18,436,000 at December 31, 2010. Total risk assets have increased $6,949,000 from December 31, 2009. Two large credits, totaling $7,600,000 million, have been worked off the books since March 2010, which resulted in a $2.0 million charge-off in the second quarter of 2010.

As a result of the increase in risk assets, the Company has experienced an increase in its ratio of total risk assets to total assets from 0.96% at December 31, 2009 to 1.22% at December 31, 2010. Increases in risk assets have been experienced by financial institutions both at a national and local level and the Company has seen increases as well. It should be noted that the ratio of total risk assets to total assets reached its high of 2.49% at March 31, 2010, and the Company has been able to continue to work through its problem assets.

As of December 31, 2010, the Company has 11 commercial relationships that are included in the nonaccrual loan balance of $13,896,000. The largest of these relationships has total outstanding loan balances of $8,598,000, consisting of advances under a line of credit to a company that finances interim construction financing for mortgages, residential manufactured, modular and site-built homes. As a result of the downturn in the housing market, the company experienced financial difficulties and declared bankruptcy in the first quarter of 2010. The Bank is in the process of pursuing a recovery of the amounts owed to it in the Bankruptcy Court proceedings as well as through other avenues of recovery that may be available to it including, without limitation, the guarantees provided by the principals and other potential claims against third parties.

A second relationship in nonaccrual status at December 31, 2010, with an outstanding loan balance of $1,258,000, is to a professional service firm that provides services in the construction industry. Again, as result of the downturn in the economy, this firm has experienced financial difficulties and has not been able to meet their debt service requirements, resulting in the loan being placed in nonaccrual status. The Bank is in process of working out this relationship with the borrower, and will pursue recovery methods. The loan is secured by the commercial real estate, personal residences of the guarantors and UCC filings on the Company’s assets.


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A third relationship at December 31, 2010 included in the nonaccrual balance consists of a mixed use building, consisting of residential apartments and commercial retail space that has had difficulties in securing leases from tenants that will enable it to meet its debt service requirements. The Bank is working with the borrower through the lease up period, in order to allow sufficient time to increase the building’s occupancy. This loan is secured by the commercial real estate property and has a loan balance at December 31, 2010 of $1,100,000.

A fourth relationship consists of a motel which is presently closed, but has a pending contract on the sale of the property. The Company continues to work through this loan, with a balance of $964,000 at December 31, 2010.

The Company believes through the combination of the collateral securing the loans and the reserves allocated for these nonaccrual loans totaling $4,343,000, it has provided for the potential losses that it may incur on these relationships as of December 31, 2010. However, as additional time passes on these relationships, additional information may become known that could result in additional reserve allocations, or, alternatively, it may be deemed that the reserve allocations exceed that which is needed.

In 2010, the Company restructured two residential mortgages in order to assist the borrowers who were experiencing financial difficulties. The restructured loans resulted in concessions that the Bank made in interest rates for a short (less than twelve months) period of the remaining amortization schedule, and resulted in a reduction of the discounted cash flows of the loans, based on the original loans’ interest rate, of approximately $20,000.

The Company experienced a slight increase in foreclosed real estate balances at December 31, 2010 of $1,112,000, compared to December 31, 2009 of $1,065,000. As of December 31, 2010, nine properties are owned by the Company, two of which are commercial properties and total $492,000, and the remaining seven consisting of residential properties and total $620,000. Of the seven residential properties, four were owned by the Company for over 16 months. For the year ended December 31, 2010, the Company updated its fair value assessment of these four properties which have been owned for over 16 months, and recorded a lower of cost or market adjustment of $123,000. As of December 31, 2010, the Company believes the value of foreclosed assets represents their fair values, but if the real estate market continues to remain soft, additional charges may be needed.

Credit Risk Management

Allowance for Loan Losses

Historically, the Company has had an enviable record regarding its control of loan losses, but lending is a banking service that inherently contains elements of risk. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The Company maintains the allowance for loan losses at a level believed adequate by management to absorb losses inherent in the portfolio. It is established and maintained through a provision for loan losses charged to earnings. Quarterly, management assesses the adequacy of the allowance for loan losses utilizing a defined methodology, which considers specific credit evaluation of impaired loans as discussed above, past loan loss


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historical experience, and qualitative factors. Management believes the approach properly addresses the requirements of ASC Section 310-10-35 for loans individually identified as impaired, and ASC Subtopic 450-20 for loans collectively evaluated for impairment, and other bank regulatory guidance.

In order to monitor ongoing risk associated with its loan portfolio and specific credits within the segments, management uses an eight point internal grading system. The first four rating categories, representing the lowest risk to the bank, are combined and given a “Pass” rating. The “Special Mention” category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank’s position at some future date. These assets pose elevated risk, but their weakness does not yet justify a more severe, or criticized rating. Bank’s management generally follows regulatory definitions in assigning criticized ratings to loans, including substandard, doubtful or loss. “Substandard” loans are classified as they have a well-defined weakness, or weaknesses that jeopardize the liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Generally loans greater than 90 days past due are assigned a “substandard” rating. A “doubtful” loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification of loss is deferred. “Loss” assets are considered uncollectible, as the underlying borrowers are often in bankruptcy, have suspended debt repayments, or ceased business operations. Once a loan is classified as “Loss”, there is little prospect of collecting the loan’s principal or interest and it is generally written off.

The Bank has a loan review policy and program which is designed to reduce and control risk in the lending function. The Credit Administration Committee, comprised of members of the Board, is charged with the overall credit quality and risk exposure of the Company’s loan portfolio. This includes the monitoring of the lending activities of all bank personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. The loan review program provides the Bank with an internal, independent review of the Bank’s loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.

The Loan Review department performs annual reviews of all commercial relationships with a committed loan balance in excess of $750,000, with ratification of the rating from the Board of Directors’ Credit Administration Committee for loans between $750,000 – $1,000,000. Loans reviewed in excess of $1,000,000 are presented to the Credit Administration Committee with a formal review and rating. All relationships rated Substandard, Doubtful or Loss are reviewed by the Credit Administration Committee on a quarterly basis, including reaffirmation of the rating, review of detailed collateral analysis and the development of an action plan.


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The following summarizes the Bank’s ratings based on its internal risk rating system as of December 31, 2010:


(Dollars in thousands)

   Pass      Special
     Substandard      Doubtful      Loss      Total  

Commercial real estate:



   $ 162,968       $ 2,035       $ 6,311       $ 686       $      —         $ 172,000   

Non-owner occupied

     120,633         4,274         18,465         —           —           143,372   


     20,030         676         3,853         90            24,649   

Acquisition and development:


1-4 family residential construction

     24,199         2,297         2,801         —           —           29,297   

Commercial and land development

     79,391         2,487         6,227         —           —           88,105   

Commercial and industrial:

     221,111         17,062         24,762         1,008         —           263,943   

Residential mortgage:


First lien

     117,607         —           1,843               119,450   

Home equity—term

     39,279         —           1,539         —           —           40,818   

Home equity—lines of credit

     71,364         —           183         —           —           71,547   

Installment and other loans

     11,062         —           50         —           —           11,112   
   $ 867,644       $ 28,831       $ 66,034       $ 1,784       $ —         $ 964,293   

Classified loans may also be evaluated for impairment. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the 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. During the year, the Bank modified its criteria for identifying impaired loans, as performing substandard loans were no longer considered impaired.

Larger groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.


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The following summarizes impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required as of December 31:


    Impaired Loans with a Specific Allowance     Impaired Loans with No Specific Allowance  

(Dollars in thousands)

on Cash
on Cash Basis

December 31, 2010


Commercial real estate:



  $ 686      $ 687      $ 181      $ 0      $ 0      $ 0      $ 0   

Non-owner occupied

    2,064        2,065        980        0        0        0        0   


    90        90        90        0        0        0        0   

Commercial and industrial

    9,600        10,191        3,232        0        1,118        1,118        6   

Residential mortgage:


First lien

    470        470        12        32        0        0        0   

Home equity—term

    711        711        8        44        0        0        0   
  $ 13,621      $ 14,214      $ 4,503      $ 76      $ 1,118      $ 1,118      $ 6   


     Impaired Loans with
Specific Allowance
Loans  with

No Specific

(Dollars in thousands)


December 31, 2009


Commercial real estate:



   $ 2,399       $ 214       $ 4,192   

Non-owner occupied

     1,267         537         934   


     642         15         114   

Acquisition and development:


1-4 family residential construction

     —           —           —     

Commercial and land development

     5,063         2,000         3,191   

Commercial and industrial

     6,132         2,035         7,766   
   $ 15,503       $ 4,801       $ 16,197   

The following presents impaired loans that are troubled debt restructurings as of December 31, 2010. The Bank did not have any troubled debt restructurings at December 31, 2009.


     Troubled Debt Restructurings
at December 31, 2010
     New Troubled Debt Restructurings
During Current YTD Period

(Dollars in thousands)

   Number of
     Number of

Residential mortgage:


First lien

     1       $ 470         1       $ 470   

Home equity—term

     1         711         1         711   
     2       $ 1,181         2       $ 1,181   

No additional commitments have been made to borrowers whose loans are considered trouble debt restructurings.

Potential problem loans are defined as performing loans, which have characteristics that cause management to have serious doubts as to the ability of the borrower to perform under present loan repayment terms and which


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may result in the reporting of these loans as non-performing loans in the future. Generally, management feels that “substandard” loans that are currently performing and not considered impaired, result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan, and represent potential problem loans.

Management further monitors the performance and credit quality of the loan portfolio by analyzing the length of time a portfolio is past due, by aggregating loans based on its delinquencies. The following table presents the classes of loan portfolio summarized by aging categories of performing loans and nonaccrual loans as of December 31, 2010:


    Current     Days Past Due     Total Past
(still accruing)
    Non-Accrual     Total

(Dollars in thousands)

    30-59     60-89     90+

Commercial real estate:



  $ 169,030      $ 986      $ 832      $ 466      $ 2,284      $ 686      $ 172,000   

Non-owner occupied

    141,095        213        —          —          213        2,064        143,372   


    24,559        —          —          —          —          90        24,649   

Acquisition and development:


1-4 family residential construction

    29,297        —          —          —          —          —          29,297   

Commercial and land development

    87,995        1        16        —          17        93        88,105   

Commercial and industrial

    252,144        287        466        420        1,173        10,625        263,943   

Residential mortgage:


First lien

    116,182        1,359        535        1,095        2,989        279        119,450   

Home equity—term

    40,503        161        62        75        298        17        40,818   

Home equity—Lines of credit

    71,215        60        89        142        291        41        71,547   

Installment and other loans

    10,793        251        17        50        318        1        11,112   
  $ 942,813      $ 3,318      $ 2,017      $ 2,248      $ 7,584      $ 13,896      $ 964,293   

General allowances are provided for loans that are collectively evaluated for impairment, which is based on quantitative factors, principally historical loss trends for the respective loan class, adjusted for qualitative factors. As of December 31, 2010, the historical loss trend is based on rolling 8 quarters with a two-third weight to the most recent four quarters, and a one-third weight for the furthest four quarters. Prior to December 31, 2010, the historical loss factor was based on an equally weighted rolling 12 quarters. Additional qualitative factors are used by management to adjust the historical loss percentage to the anticipated losses within the portfolio, and include: national and local economic trends, levels and trends of delinquency rates and nonaccrual loans; effects of changes in underwriting policies; experience, ability and depth of lending and loan review staff, trends in values of underlying collateral including the real estate market; and concentrations of credit from loan type, or shifts in industry or geographic region.


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A summary of the activity in the allowance for loan losses, for the years ended before December 31, 2010 based on the updated segmentation, is as follows:


Balance, beginning of year

   $  11,067   

Loans charged off:


Commercial real estate:




Acquisition and development:


Commercial and land development


Commercial and industrial


Residential mortgage:


First lien


Home equity


Installment and other loans


Total loans charged- off


Recoveries of loans previously charged off:


Commercial real estate:




Commercial and industrial


Residential mortgage:


First lien


Home equity


Installment and other loans


Total recoveries


Provision for loan losses


Balance, end of year

   $ 16,020   

Ratio of net charge-offs to average loans outstanding


Provision for loan losses to net charge-offs


Ratio of reserve to gross loans outstanding at December 31



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A summary of the activity in the allowance for loan losses, for the years ended before December 31, 2010 based on the prior approach, is as follows:


(Dollars in thousands)

   2009     2008     2007     2006  

Balance, beginning of year

   $ 7,140      $ 6,141      $ 5,520      $ 4,428   

Loans charged off:


Commercial, financial and agricultural

     470        2        8        12   

Real estate—Commercial

     0        228        0        0   

Real estate—Mortgage

     416        187        53        0   


     72        80        120        85   

Total loans charged off

     958        497        181        97   

Recoveries of loans previously charged off:


Commercial, financial and agricultural

     2        0        3        50   

Real estate—Commercial

     1        3        0        1   

Real estate—Mortgage

     6        16        13        6   


     11        27        36        22   

Total recoveries

     20        46        52        79   

Provision for loan losses

     4,865        1,450        750        390   

Additions established for acquired credit risk

     0        0        0        720   

Balance, end of year

   $ 11,067      $ 7,140      $ 6,141      $ 5,520   

Ratio of net charge-offs to average loans outstanding

     0.11     0.06     0.02     0.00

Provision for loan losses to net charge-offs

     518.66     321.51     581.40     2166.67

Ratio of reserve to gross loans outstanding at December 31

     1.26     0.87     0.87     0.89

Consistent with the trends in the national and local economies, as well as declines in real estate values in the Company’s market, the allowance for loan losses has continued to grow for the period from 2006 through 2010, consistent with the increase in the ratio of net charge-offs to average loans outstanding. Net charge-offs increased from $938,000 for the year ended December 31, 2009 to $3,972,000 for the year ended December 31, 2010, with the majority of the charge-offs coming in the commercial and industrial, commercial real estate and commercial and land development loan portfolios.

During 2010, the Company recorded provision for loan losses totaling $8,925,000, as compared to $4,865,000 for the year ended December 31, 2009. The increase in the 2010 provision was a direct result of the higher level of net charge-offs, combined with the growth that Company has experienced in its loan portfolio. The provision for loan losses covered 2010’s net charge-offs 2.25 times. Management believes the resultant level of provision for and allowance for loan losses to be adequate, given the growth in the Company’s loan portfolio, level of credit quality indicators, and related mix of loans.


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The allocation of the allowance for loan losses, as well as the percent of each loan type in relation to the total loan balance, is as follows:


     2010     2009  

(Dollars in thousands)

   Amount      % of Loan
Type to
Total Loans
    Amount      % of Loan
Type  to

Total Loans

Commercial real estate:



   $ 1,852         18   $ 1,660         18

Non-owner occupied

     3,034         15     932         14


     438         3     15         3

Acquisition and development:


1-4 family residential construction

     314         3     364         2

Commercial and land development

     1,453         9     2,339         10

Commercial and industrial

     6,795         27     2,518         28

Residential mortgage:


First lien

     1,033         12     1,234         11

Home equity

     830         12     647         13

Installment and other loans

     106         1     96         1


     165           1,262      
   $ 16,020         100   $ 11,067         100


     2008     2007     2006  

(Dollars in thousands)

   Amount      % of Loan
Type to
Total Loans
    Amount      % of Loan
Type to
Total Loans
    Amount      % of Loan
Type to
Total Loans

Commercial, financial and agricultural

   $ 319         10   $ 1,227         8   $ 1,206         10

Real estate—Commercial

     2,393         30     1,990         35     1,584         36

Real estate—Construction

     598         16     45         13     42         8

Real estate—Mortgage

     2,567         43     2,115         43     1,553         45


     265         1     30         1     13