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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: JUNE 30, 2016

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______

Commission File No. 001-37658
SUFFOLK BANCORP
(Exact Name of Registrant as Specified in Its Charter)

NEW YORK
 
11-2708279
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)

4 WEST SECOND STREET, P.O. BOX 9000, RIVERHEAD, NY 11901
(Address of Principal Executive Offices) (Zip Code)

(631) 208-2400
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒    No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐
Accelerated filer ☒
Non-accelerated filer ☐
Smaller reporting company ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐    No ☒

As of July 20, 2016, there were 11,896,302 shares of registrant’s Common Stock outstanding.
 


SUFFOLK BANCORP
Form 10-Q
For the Quarterly Period Ended June 30, 2016

Table of Contents
 
   
Page
 
PART I
 
     
Item 1.
Financial Statements
 
     
 
2
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
Item 2.
28
     
Item 3.
44
     
Item 4.
45
     
 
PART II
 
     
Item 1.
45
     
Item 1A.
45
     
Item 2.
49
     
Item 3.
49
     
Item 4.
49
     
Item 5.
49
     
Item 6.
49
     
 
50

PART I
ITEM 1. – FINANCIAL STATEMENTS
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CONDITION (UNAUDITED)
June 30, 2016 and December 31, 2015
(dollars in thousands, except per share data)
 
   
June 30, 2016
   
December 31, 2015
 
ASSETS
           
Cash and cash equivalents
           
Cash and non-interest-bearing deposits due from banks
 
$
52,396
   
$
75,272
 
Interest-bearing deposits due from banks
   
78,366
     
22,814
 
Total cash and cash equivalents
   
130,762
     
98,086
 
Federal Reserve and Federal Home Loan Bank stock and other investments
   
4,469
     
10,756
 
Investment securities:
               
Available for sale, at fair value
   
215,111
     
247,099
 
Held to maturity (fair value of $31,011 and $63,272, respectively)
   
29,466
     
61,309
 
Total investment securities
   
244,577
     
308,408
 
Loans
   
1,729,874
     
1,666,447
 
Allowance for loan losses
   
20,965
     
20,685
 
Net loans
   
1,708,909
     
1,645,762
 
Loans held for sale
   
2,790
     
1,666
 
Premises and equipment, net
   
25,659
     
23,240
 
Bank-owned life insurance
   
53,074
     
52,383
 
Deferred tax assets, net
   
12,391
     
15,845
 
Accrued interest and loan fees receivable
   
5,893
     
5,859
 
Goodwill and other intangibles
   
2,756
     
2,864
 
Other real estate owned ("OREO")
   
650
     
-
 
Other assets
   
4,445
     
3,723
 
TOTAL ASSETS
 
$
2,196,375
   
$
2,168,592
 
                 
LIABILITIES & STOCKHOLDERS' EQUITY
               
Demand deposits
 
$
863,048
   
$
787,944
 
Savings, N.O.W. and money market deposits
   
860,053
     
768,036
 
Subtotal core deposits
   
1,723,101
     
1,555,980
 
Time deposits
   
225,918
     
224,643
 
Total deposits
   
1,949,019
     
1,780,623
 
Borrowings
   
15,000
     
165,000
 
Unfunded pension liability
   
6,416
     
6,428
 
Capital leases
   
4,333
     
4,395
 
Other liabilities
   
11,300
     
14,888
 
TOTAL LIABILITIES
   
1,986,068
     
1,971,334
 
COMMITMENTS AND CONTINGENT LIABILITIES
               
STOCKHOLDERS' EQUITY                
Common stock (par value $2.50; 15,000,000 shares authorized; issued 14,057,992 and 13,966,292, respectively; outstanding 11,892,254 and 11,800,554, respectively)
   
35,145
     
34,916
 
Surplus
   
47,727
     
46,239
 
Retained earnings
   
138,348
     
130,093
 
Treasury stock at par (2,165,738 shares)
   
(5,414
)
   
(5,414
)
Accumulated other comprehensive loss, net of tax
   
(5,499
)
   
(8,576
)
TOTAL STOCKHOLDERS' EQUITY
   
210,307
     
197,258
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
2,196,375
   
$
2,168,592
 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
For the Three and Six Months Ended June 30, 2016 and 2015
(dollars in thousands, except per share data)
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
INTEREST INCOME
                       
Loans and loan fees
 
$
18,041
   
$
15,995
   
$
35,263
   
$
30,564
 
U.S. Government agency obligations
   
197
     
531
     
615
     
1,072
 
Obligations of states and political subdivisions
   
924
     
1,276
     
1,918
     
2,611
 
Collateralized mortgage obligations
   
100
     
176
     
179
     
358
 
Mortgage-backed securities
   
473
     
443
     
937
     
888
 
Corporate bonds
   
162
     
45
     
308
     
83
 
Federal funds sold, securities purchased under agreements to resell and interest-bearing deposits due from banks
   
29
     
20
     
58
     
43
 
Dividends
   
108
     
90
     
183
     
150
 
Total interest income
   
20,034
     
18,576
     
39,461
     
35,769
 
INTEREST EXPENSE
                               
Savings, N.O.W. and money market deposits
   
510
     
294
     
1,023
     
568
 
Time deposits
   
336
     
353
     
684
     
647
 
Borrowings
   
166
     
108
     
408
     
216
 
Total interest expense
   
1,012
     
755
     
2,115
     
1,431
 
Net interest income
   
19,022
     
17,821
     
37,346
     
34,338
 
Provision for loan losses
   
-
     
-
     
250
     
250
 
Net interest income after provision for loan losses
   
19,022
     
17,821
     
37,096
     
34,088
 
NON-INTEREST INCOME
                               
Service charges on deposit accounts
   
614
     
823
     
1,390
     
1,570
 
Other service charges, commissions and fees
   
684
     
680
     
1,295
     
1,273
 
Net gain on sale of securities available for sale
   
18
     
160
     
24
     
186
 
Net gain on sale of portfolio loans
   
457
     
-
     
457
     
198
 
Net gain on sale of mortgage loans originated for sale
   
73
     
61
     
147
     
205
 
Income from bank-owned life insurance
   
345
     
303
     
691
     
612
 
Other operating income
   
50
     
23
     
129
     
97
 
Total non-interest income
   
2,241
     
2,050
     
4,133
     
4,141
 
OPERATING EXPENSES
                               
Employee compensation and benefits
   
8,482
     
8,516
     
17,148
     
17,122
 
Occupancy expense
   
1,346
     
1,373
     
2,788
     
2,835
 
Equipment expense
   
461
     
404
     
847
     
789
 
Consulting and professional services
   
619
     
544
     
1,102
     
882
 
FDIC assessment
   
291
     
286
     
584
     
576
 
Data processing
   
234
     
514
     
413
     
1,084
 
Other operating expenses
   
1,886
     
1,537
     
3,589
     
2,994
 
Total operating expenses
   
13,319
     
13,174
     
26,471
     
26,282
 
Income before income tax expense
   
7,944
     
6,697
     
14,758
     
11,947
 
Income tax expense
   
2,159
     
1,579
     
4,135
     
2,820
 
NET INCOME
 
$
5,785
   
$
5,118
   
$
10,623
   
$
9,127
 
EARNINGS PER COMMON SHARE - BASIC
 
$
0.49
   
$
0.44
   
$
0.90
   
$
0.78
 
EARNINGS PER COMMON SHARE - DILUTED
 
$
0.48
   
$
0.43
   
$
0.89
   
$
0.77
 
WEIGHTED AVERAGE COMMON SHARES - BASIC
   
11,875,546
     
11,748,068
     
11,852,371
     
11,721,396
 
WEIGHTED AVERAGE COMMON SHARES - DILUTED
   
11,945,719
     
11,822,562
     
11,923,247
     
11,793,307
 

See accompanying notes to unaudited condensed consolidated financial statements.
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
For the Three and Six Months Ended June 30, 2016 and 2015
(in thousands)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
                         
Net income
 
$
5,785
   
$
5,118
   
$
10,623
   
$
9,127
 
Other comprehensive income (loss), net of tax and reclassification adjustments:
                               
Change in unrealized gain (loss) on securities available for sale arising during the period, net of tax of $383, ($1,049), $1,511 and ($346), respectively
   
558
     
(1,604
)
   
2,166
     
(529
)
Change in unrealized gain on securities transferred from available for sale to held to maturity, net of tax of $416, $26, $599 and $53, respectively
   
606
     
40
     
911
     
81
 
Total other comprehensive income (loss), net of tax
   
1,164
     
(1,564
)
   
3,077
     
(448
)
Total comprehensive income
 
$
6,949
   
$
3,554
   
$
13,700
   
$
8,679
 

See accompanying notes to unaudited condensed consolidated financial statements.
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)
For the Six Months Ended June 30, 2016 and 2015
(dollars in thousands, except per share data)

   
Six Months Ended June 30,
 
   
2016
   
2015
 
Common stock
           
Balance, January 1
 
$
34,916
   
$
34,591
 
Dividend reinvestment (49,752 and 15,249 shares issued, respectively)
   
124
     
38
 
Stock options exercised (32,667 shares issued in 2015)
   
-
     
82
 
Stock-based compensation
   
105
     
152
 
Ending balance
   
35,145
     
34,863
 
Surplus
               
Balance, January 1
   
46,239
     
44,230
 
Dividend reinvestment
   
1,129
     
307
 
Stock options exercised
   
-
     
380
 
Stock-based compensation
   
359
     
185
 
Ending balance
   
47,727
     
45,102
 
Retained earnings
               
Balance, January 1
   
130,093
     
116,169
 
Net income
   
10,623
     
9,127
 
Cash dividends on common stock ($0.20 and $0.12 per share, respectively)
   
(2,368
)
   
(1,405
)
Ending balance
   
138,348
     
123,891
 
Treasury stock
               
Balance, January 1
   
(5,414
)
   
(5,414
)
Ending balance
   
(5,414
)
   
(5,414
)
Accumulated other comprehensive loss, net of tax
               
Balance, January 1
   
(8,576
)
   
(6,843
)
Other comprehensive income (loss)
   
3,077
     
(448
)
Ending balance
   
(5,499
)
   
(7,291
)
Total stockholders' equity
 
$
210,307
   
$
191,151
 

See accompanying notes to unaudited condensed consolidated financial statements.
 
SUFFOLK BANCORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the Six Months Ended June 30, 2016 and 2015
(in thousands)

   
Six Months Ended June 30,
 
   
2016
   
2015
 
NET INCOME
 
$
10,623
   
$
9,127
 
ADJUSTMENTS TO RECONCILE NET INCOME
               
TO NET CASH PROVIDED BY OPERATING ACTIVITIES
               
Provision for loan losses
   
250
     
250
 
Depreciation and amortization
   
1,196
     
1,146
 
Stock-based compensation - net
   
464
     
337
 
Net amortization of premiums
   
577
     
583
 
Originations of mortgage loans held for sale
   
(22,578
)
   
(22,689
)
Proceeds from sale of mortgage loans originated for sale
   
21,602
     
22,413
 
Gain on sale of mortgage loans originated for sale
   
(147
)
   
(205
)
Gain on sale of portfolio loans
   
(457
)
   
(198
)
Decrease (increase) in other intangibles
   
108
     
(1
)
Deferred tax expense
   
1,345
     
327
 
Increase in accrued interest and loan fees receivable
   
(34
)
   
(98
)
(Increase) decrease in other assets
   
(722
)
   
256
 
Adjustment to unfunded pension liability
   
(12
)
   
(222
)
Decrease in other liabilities
   
(3,587
)
   
(2,537
)
Income from bank-owned life insurance
   
(691
)
   
(612
)
Net gain on sale and calls of securities available for sale
   
(24
)
   
(186
)
Net cash provided by operating activities
   
7,913
     
7,691
 
CASH FLOWS FROM INVESTING ACTIVITIES
               
Principal payments on investment securities - available for sale
   
5,010
     
2,886
 
Proceeds from sale of investment securities - available for sale
   
-
     
7,003
 
Maturities and calls of investment securities - available for sale
   
43,350
     
20,530
 
Purchases of investment securities - available for sale
   
(13,188
)
   
(6,800
)
Maturities and calls of investment securities - held to maturity
   
33,291
     
1,727
 
Purchases of investment securities - held to maturity
   
-
     
(3,000
)
Decrease in interest-bearing time deposits in other banks
   
-
     
10,000
 
Decrease in Federal Reserve and Federal Home Loan Bank stock and other investments
   
6,287
     
2,423
 
Proceeds from sale of portfolio loans
   
49,184
     
23,986
 
Loan originations - net
   
(112,775
)
   
(120,542
)
Purchases of premises and equipment - net
   
(3,615
)
   
(1,106
)
Net cash provided by (used in) investing activities
   
7,544
     
(62,893
)
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net increase in deposit accounts
   
168,396
     
162,334
 
Net decrease in short-term borrowings
   
(150,000
)
   
(80,000
)
Net increase in long-term borrowings
   
-
     
15,000
 
Proceeds from stock options exercised
   
-
     
462
 
Cash dividends paid on common stock
   
(2,368
)
   
(1,405
)
Proceeds from shares issued under the dividend reinvestment plan
   
1,253
     
345
 
Decrease  in capital lease payable
   
(62
)
   
(56
)
Net cash provided by financing activities
   
17,219
     
96,680
 
NET INCREASE IN CASH AND CASH EQUIVALENTS
   
32,676
     
41,478
 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
   
98,086
     
55,516
 
CASH AND CASH EQUIVALENTS, END OF PERIOD
 
$
130,762
   
$
96,994
 
SUPPLEMENTAL DATA:
               
Interest paid
 
$
2,127
   
$
1,381
 
Income taxes paid
 
$
2,444
   
$
2,561
 
Loans transferred to held-for-sale
 
$
48,670
   
$
-
 
Loans transferred to OREO
 
$
650
   
$
-
 

See accompanying notes to unaudited condensed consolidated financial statements.
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. FINANCIAL STATEMENT PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
Suffolk Bancorp (the “Company”) was incorporated in 1985 as a bank holding company. The Company currently owns all of the outstanding capital stock of Suffolk County National Bank (the “Bank”). The Bank was organized under the national banking laws of the United States in 1890. The Bank formed Suffolk Greenway, Inc. (the “REIT”), a real estate investment trust, and owns 100% of an insurance agency and two corporations used to acquire foreclosed real estate. The insurance agency and the two corporations used to acquire foreclosed real estate are immaterial to the Company’s operations. The unaudited interim condensed consolidated financial statements include the accounts of the Company and the Bank and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Unless the context otherwise requires, references herein to the Company include the Company and the Bank and subsidiaries on a consolidated basis.

On June 26, 2016, the Company entered into an Agreement and Plan of Merger (the “merger agreement”) with People’s United pursuant to which the Company will merge into People’s United (the “merger”). People’s United will be the surviving corporation in the merger. Subject to the terms and conditions of the merger agreement, the Company’s shareholders will have the right to receive 2.225 shares of People’s United common stock in exchange for each share of Company common stock. The merger agreement is subject to approval by the Company’s shareholders as well as regulatory approvals and other customary conditions. Subject to these conditions, it is expected that the merger will close during the fourth quarter of 2016.

In the opinion of the Company’s management, the preceding unaudited interim condensed consolidated financial statements contain all adjustments, consisting of normal accruals, necessary for a fair presentation of the Company’s condensed consolidated statement of condition as of June 30, 2016, its condensed consolidated statements of income for the three and six months ended June 30, 2016 and 2015, its condensed consolidated statements of comprehensive income for the three and six months ended June 30, 2016 and 2015, its condensed consolidated statements of changes in stockholders’ equity for the six months ended June 30, 2016 and 2015 and its condensed consolidated statements of cash flows for the six months ended June 30, 2016 and 2015.

The preceding unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, as well as in accordance with predominant practices within the banking industry. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The results of operations for the three and six months ended June 30, 2016 are not necessarily indicative of the results of operations to be expected for the remainder of the year. For further information, please refer to the audited consolidated financial statements and footnotes thereto included in the Company’s 2015 Annual Report on Form 10-K.

Earnings Per Share - Basic earnings per share is computed based on the weighted average number of common shares and unvested restricted shares outstanding for each period. The Company’s unvested restricted shares are considered participating securities as they contain rights to non-forfeitable dividends and thus they are included in the basic earnings per share computation. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under stock options. In the event a net loss is reported, restricted shares and stock options are excluded from earnings per share computations.

The reconciliation of basic and diluted weighted average number of common shares outstanding for the three and six months ended June 30, 2016 and 2015 follows.

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
                         
Weighted average common shares outstanding
   
11,752,657
     
11,630,056
     
11,733,742
     
11,616,565
 
Weighted average unvested restricted shares
   
122,889
     
118,012
     
118,629
     
104,831
 
Weighted average shares for basic earnings per share
   
11,875,546
     
11,748,068
     
11,852,371
     
11,721,396
 
Additional diluted shares:
                               
Stock options
   
70,173
     
74,494
     
70,876
     
71,911
 
Weighted average shares for diluted earnings per share
   
11,945,719
     
11,822,562
     
11,923,247
     
11,793,307
 
 
Loans and Loan Interest Income Recognition – Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned discounts, deferred loan fees and costs. Unearned discounts on installment loans are credited to income using methods that result in a level yield. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income over the respective term of the loan without anticipating prepayments.
 
Interest income is accrued on the unpaid loan principal balance. Recognition of interest income is discontinued when reasonable doubt exists as to whether principal or interest due can be collected. Loans of all classes will generally no longer accrue interest when over 90 days past due unless the loan is well-secured and in process of collection. When a loan is placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current-year interest income. Interest received on such loans is applied against principal or interest, according to management’s judgment as to the collectability of the principal, until qualifying for return to accrual status. Loans may start accruing interest again when they become current as to principal and interest for at least six months, and when, after a well-documented analysis by management, it has been determined that the loans can be collected in full.  For all classes of loans, an impaired loan is defined as a loan for which it is probable that the lender will not collect all amounts due under 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. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties are considered troubled debt restructurings (“TDRs”) and are classified as impaired. Generally, TDRs are initially classified as non-accrual until sufficient time has passed to assess whether the restructured loan will continue to perform. For impaired, accruing loans, interest income is recognized on an accrual basis with cash offsetting the recorded accruals upon receipt.

Allowance for Loan Losses - The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a quarterly analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company’s own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction and residential mortgages loan classes and all TDRs are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics. These classes are commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The allowance for loan losses consists of specific and general components, as well as an unallocated component. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment or liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on the fair market value of collateral and the estimated time required to recover the Company’s investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan’s effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data. These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors include consideration of the following: levels and trends in various risk rating categories; levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures and practices; experience, ability, and depth of lending management and other relevant staff; local, regional and national economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. These adjustments reflect management’s overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
 
Loans Held For Sale – Loans held for sale are carried at the lower of aggregate cost or fair value, based on observable inputs in the secondary market. Changes in fair value of loans held for sale are recognized in earnings.

Other Real Estate Owned (“OREO”) - Property acquired through foreclosure, or OREO, is initially stated at the lower of cost or fair value less estimated selling costs. Losses arising at the time of the acquisition of property are charged against the allowance for loan losses. Any additional write-downs to the carrying value of these assets that may be required, as well as the cost of maintaining and operating these foreclosed properties, are charged to expense. The Company held OREO amounting to $650 thousand at June 30, 2016 resulting from the addition of one residential property during the first quarter of 2016.

Bank-Owned Life Insurance – Bank-owned life insurance is recorded at the lower of the cash surrender value or the amount that can be realized under the insurance policy and is included as an asset in the consolidated statements of condition. Changes in the cash surrender value and insurance benefit payments are recorded in non-interest income in the consolidated statements of income.

Derivatives - Derivatives are contracts between counterparties that specify conditions under which settlements are to be made. The only derivatives held by the Company are swap contracts with the purchaser of its Visa Class B shares. The Company records its derivatives on the consolidated statements of condition at fair value. The Company’s derivatives do not qualify for hedge accounting. As a result, changes in fair value are recognized in earnings in the period in which they occur. (See also Note 3. Investment Securities contained herein.)

Recent Accounting Guidance – In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, Financial Instruments—Credit Losses (Topic 326), “Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 significantly changes the impairment model for most financial assets that are measured at amortized cost and certain other instruments from an incurred loss model to an expected loss model and provides for recording credit losses on available-for-sale debt securities through an allowance account. The ASU also requires certain incremental disclosures. For public business entities that are U.S. Securities and Exchange Commission filers, like the Company, the amendments are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for all entities beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation—Stock Compensation (Topic 718), “Improvements to Employee Share-Based Payment Accounting.” ASU 2016-09 introduces targeted amendments intended to simplify the accounting for stock compensation. Specifically, the ASU requires all excess tax benefits and tax deficiencies (including tax benefits of dividends on share-based payment awards) to be recognized as income tax expense or benefit in the income statement. The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. An entity also should recognize excess tax benefits, and assess the need for a valuation allowance, regardless of whether the benefit reduces taxes payable in the current period. The ASU also requires excess tax benefits to be classified along with other income tax cash flows as an operating activity in the statement of cash flows. In addition, the ASU elevates the statutory tax withholding threshold to qualify for equity classification up to the maximum statutory tax rates in the applicable jurisdiction(s). The ASU also clarifies that cash paid by an employer when directly withholding shares for tax withholding purposes should be classified as a financing activity. The ASU provides an optional accounting policy election (with limited exceptions), to be applied on an entity-wide basis, to either estimate the number of awards that are expected to vest (consistent with existing U.S. GAAP) or account for forfeitures when they occur. The amendments are effective for public business entities for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The ASU establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of the pending adoption of the ASU on its consolidated financial statements.
 
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10), “Recognition and Measurement of Financial Assets and Financial Liabilities” which requires an entity to: (i) measure equity investments at fair value through net income, with certain exceptions; (ii) present in other comprehensive income the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of available for sale debt securities in combination with other deferred tax assets. This ASU provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes and also requires a qualitative impairment assessment of such equity investments and amends certain fair value disclosure requirements. For public entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Generally, early adoption of the amendments in this ASU is not permitted. The Company believes that adoption in 2018 will not have a material effect on the Company’s consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), “Revenue from Contracts with Customers,” which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of the ASU is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. The ASU defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The FASB subsequently issued ASU 2016-08 which updates the new standard by clarifying the principal versus agent implementation guidance, ASU 2016-10 which clarifies identifying performance obligations and the licensing implementation guidance and ASU 2016-12 which clarifies the guidance on assessing collectability, presenting sales taxes, measuring noncash consideration and certain transition matters, but these do not change the core principle of the new standard. The FASB also subsequently issued ASU 2015-14 to defer the effective date of the new standard by one year. As such, it now takes effect for public entities in fiscal years beginning after December 15, 2017, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting the ASU recognized at the date of adoption (which includes additional footnote disclosures). Early adoption is permitted for any entity that chooses to adopt the new standard as of the original effective date. The Company has not yet determined the method by which it will adopt ASU 2014-09 in 2018 and does not believe that the adoption will have a material effect on the Company’s consolidated financial statements.

2. ACCUMULATED OTHER COMPREHENSIVE INCOME/LOSS (“AOCI”)
The changes in the Company’s AOCI by component, net of tax, for the three and six months ended June 30, 2016 and 2015 follow (in thousands).
 
   
Three Months Ended June 30, 2016
   
Three Months Ended June 30, 2015
 
   
Unrealized
Gains and
Losses on
Available for
Sale Securities
   
Unrealized Losses
on Securities
Transferred from
Available for Sale
to Held to
Maturity
   
Pension and
Post-
Retirement
Plan Items
   
Total
   
Unrealized
 Gains and
 Losses on
 Available for
 Sale Securities
   
Unrealized Losses
on Securities
Transferred from
Available for Sale
 to Held to
Maturity
   
Pension and
Post-
Retirement
Plan Items
   
Total
 
Beginning balance
 
$
3,044
   
$
(1,090
)
 
$
(8,617
)
 
$
(6,663
)
 
$
3,712
   
$
(1,764
)
 
$
(7,675
)
 
$
(5,727
)
Other comprehensive income (loss) before reclassifications
   
568
     
-
     
-
     
568
     
(1,507
)
   
-
     
-
     
(1,507
)
Amounts reclassified from AOCI
   
(10
)
   
606
     
-
     
596
     
(97
)
   
40
     
-
     
(57
)
Net other comprehensive income (loss)
   
558
     
606
     
-
     
1,164
     
(1,604
)
   
40
     
-
     
(1,564
)
Ending balance
 
$
3,602
   
$
(484
)
 
$
(8,617
)
 
$
(5,499
)
 
$
2,108
   
$
(1,724
)
 
$
(7,675
)
 
$
(7,291
)
 

   
Six Months Ended June 30, 2016
   
Six Months Ended June 30, 2015
 
   
Unrealized
Gains and
Losses on
Available for
Sale Securities
   
Unrealized Losses
on Securities
Transferred from
Available for Sale
to Held to
Maturity
   
Pension and
Post-
Retirement
Plan Items
   
Total
   
Unrealized
Gains and
Losses on
Available for
Sale Securities
   
Unrealized Losses
on Securities
Transferred from
Available for Sale
to Held to
Maturity
   
Pension and
Post-
Retirement
Plan Items
   
Total
 
Beginning balance
 
$
1,436
   
$
(1,395
)
 
$
(8,617
)
 
$
(8,576
)
 
$
2,637
   
$
(1,805
)
 
$
(7,675
)
 
$
(6,843
)
Other comprehensive income (loss) before reclassifications
   
2,180
     
-
     
-
     
2,180
     
(417
)
   
-
     
-
     
(417
)
Amounts reclassified from AOCI
   
(14
)
   
911
     
-
     
897
     
(112
)
   
81
     
-
     
(31
)
Net other comprehensive income (loss)
   
2,166
     
911
     
-
     
3,077
     
(529
)
   
81
     
-
     
(448
)
Ending balance
 
$
3,602
   
$
(484
)
 
$
(8,617
)
 
$
(5,499
)
 
$
2,108
   
$
(1,724
)
 
$
(7,675
)
 
$
(7,291
)
 
Reclassifications out of AOCI for the three and six months ended June 30, 2016 and 2015 follow (in thousands).

   
Amount Reclassified from AOCI
   
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
Affected Line Item in the Statement
Details about AOCI Components
 
2016
   
2015
   
2016
   
2015
 
Where Net Income is Presented
Unrealized gains and losses on available for sale securities
 
$
18
   
$
160
   
$
24
   
$
186
 
Net gain on sale of securities available for sale
Unrealized losses on securities transferred from available for sale to held to maturity
   
(1,022
)
   
(67
)
   
(1,510
)
   
(134
)
Interest income - U.S. Government agency obligations
Subtotal, pre-tax
   
(1,004
)
   
93
     
(1,486
)
   
52
   
Income tax effect
   
408
     
(36
)
   
589
     
(21
)
Income tax expense
Total, net of tax
 
$
(596
)
 
$
57
   
$
(897
)
 
$
31
   
 
3. INVESTMENT SECURITIES
At the time of purchase of a security, the Company designates the security as either available for sale, trading or held to maturity, depending upon investment objectives, liquidity needs and intent.

In 2014, investment securities with a fair value of $48 million and an unrealized loss of $3.2 million were transferred from available for sale to held to maturity. In accordance with U.S. GAAP, the securities were transferred at fair value, which became the amortized cost. The discount, equal to the unrealized holding losses at the date of transfer, is being accreted to interest income over the remaining life of the security. The unrealized holding losses at the date of transfer remained in AOCI and are being amortized simultaneously against interest income. Those amounts offset or mitigate each other.
 
The amortized cost, fair value and gross unrealized gains and losses of the Company’s investment securities available for sale and held to maturity at June 30, 2016 and December 31, 2015 were as follows (in thousands):
 
   
June 30, 2016
   
December 31, 2015
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
Available for sale:
                                               
U.S. Government agency securities
 
$
5,000
   
$
-
   
$
-
   
$
5,000
   
$
28,977
   
$
2
   
$
(463
)
 
$
28,516
 
Obligations of states and political subdivisions
   
81,396
     
4,000
     
-
     
85,396
     
100,215
     
4,467
     
-
     
104,682
 
Collateralized mortgage obligations
   
18,945
     
179
     
(15
)
   
19,109
     
15,795
     
2
     
(248
)
   
15,549
 
Mortgage-backed securities
   
94,702
     
2,189
     
-
     
96,891
     
93,719
     
39
     
(1,316
)
   
92,442
 
Corporate bonds
   
9,000
     
-
     
(285
)
   
8,715
     
6,000
     
-
     
(90
)
   
5,910
 
Total available for sale securities
   
209,043
     
6,368
     
(300
)
   
215,111
     
244,706
     
4,510
     
(2,117
)
   
247,099
 
Held to maturity:
                                                               
U.S. Government agency securities
   
12,684
     
820
     
-
     
13,504
     
43,570
     
1,450
     
-
     
45,020
 
Obligations of states and political subdivisions
   
10,782
     
556
     
-
     
11,338
     
11,739
     
536
     
-
     
12,275
 
Corporate bonds
   
6,000
     
169
     
-
     
6,169
     
6,000
     
7
     
(30
)
   
5,977
 
Total held to maturity securities
   
29,466
     
1,545
     
-
     
31,011
     
61,309
     
1,993
     
(30
)
   
63,272
 
Total investment securities
 
$
238,509
   
$
7,913
   
$
(300
)
 
$
246,122
   
$
306,015
   
$
6,503
   
$
(2,147
)
 
$
310,371
 

At June 30, 2016 and December 31, 2015, investment securities carried at $215 million and $261 million, respectively, were pledged primarily for public funds on deposit and as collateral for the Company’s derivative swap contracts.

The amortized cost, contractual maturities and fair value of the Company’s investment securities at June 30, 2016 (in thousands) are presented in the table below. Collateralized mortgage obligations (“CMOs”) and mortgage-backed securities (“MBS”) assume maturity dates pursuant to average lives.

   
June 30, 2016
 
   
Amortized
Cost
   
Fair
Value
 
Securities available for sale:
           
Due in one year or less
 
$
21,694
   
$
21,979
 
Due from one to five years
   
134,731
     
139,477
 
Due from five to ten years
   
52,618
     
53,655
 
Total securities available for sale
   
209,043
     
215,111
 
Securities held to maturity:
               
Due in one year or less
   
2,586
     
2,699
 
Due from one to five years
   
1,624
     
1,693
 
Due from five to ten years
   
14,126
     
14,672
 
Due after ten years
   
11,130
     
11,947
 
Total securities held to maturity
   
29,466
     
31,011
 
Total investment securities
 
$
238,509
   
$
246,122
 
 
The proceeds from sales of securities available for sale and the associated realized gains and losses are shown below (in thousands) for the periods indicated. Realized gains are also inclusive of gains on called securities.
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
                         
Proceeds
 
$
-
   
$
6,472
   
$
-
   
$
7,003
 
                                 
Gross realized gains
 
$
18
   
$
175
   
$
24
   
$
201
 
Gross realized losses
   
-
     
(15
)
   
-
     
(15
)
Net realized gains
 
$
18
   
$
160
   
$
24
   
$
186
 
 
Information pertaining to securities with unrealized losses at June 30, 2016 and December 31, 2015, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows (in thousands):

   
Less than 12 months
   
12 months or longer
   
Total
 
June 30, 2016
 
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
 
Collateralized mortgage obligations
 
$
-
   
$
-
   
$
1,999
   
$
(15
)
 
$
1,999
   
$
(15
)
Corporate bonds
   
2,955
     
(45
)
   
5,760
     
(240
)
   
8,715
     
(285
)
Total
 
$
2,955
   
$
(45
)
 
$
7,759
   
$
(255
)
 
$
10,714
   
$
(300
)
 
   
Less than 12 months
   
12 months or longer
   
Total
 
December 31, 2015
 
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
 
U.S. Government agency securities
 
$
16,744
   
$
(233
)
 
$
9,770
   
$
(230
)
 
$
26,514
   
$
(463
)
Collateralized mortgage obligations
   
1,831
     
(4
)
   
8,200
     
(244
)
   
10,031
     
(248
)
Mortgage-backed securities
   
66,804
     
(884
)
   
17,936
     
(432
)
   
84,740
     
(1,316
)
Corporate bonds
   
8,880
     
(120
)
   
-
     
-
     
8,880
     
(120
)
Total
 
$
94,259
   
$
(1,241
)
 
$
35,906
   
$
(906
)
 
$
130,165
   
$
(2,147
)
 
The CMOs with unrealized losses for twelve months or longer at June 30, 2016 are issued or guaranteed by U.S. Government agencies or sponsored enterprises. The corporate bonds with unrealized losses for twelve months or longer at June 30, 2016 carry investment grade ratings by all major credit rating agencies including Moody’s and Standard & Poor’s. In all cases, the unrealized losses on these bonds were a result of overall market conditions including the current interest rate environment and general market liquidity. The losses were not related to a deterioration of the quality of the issuer or any company-specific adverse events. The Company does not intend to sell and it is not more likely than not that the Company will be required to sell these securities prior to their recovery to a level equal to or greater than amortized cost. Management has determined that no OTTI was present at June 30, 2016.

The Bank was a member of the Visa USA payment network and was issued Class B shares upon Visa’s initial public offering in March 2008. The Visa Class B shares are transferable only under limited circumstances until they can be converted into shares of the publicly traded class of stock. This conversion cannot happen until the settlement of certain litigation, which is indemnified by Visa members. Since its initial public offering, Visa has funded a litigation reserve based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. At its discretion, Visa may continue to increase the conversion rate in connection with any settlements in excess of amounts then in escrow for that purpose and reduce the conversion rate to the extent that it adds any funds to the escrow in the future. Based on the existing transfer restriction and the uncertainty of the litigation, the Company has recorded its Visa Class B shares on its balance sheet at zero value.

In conjunction with the sale of Visa Class B shares in 2013, the Company entered into derivative swap contracts with the purchaser of these Visa Class B shares which provide for settlements between the purchaser and the Company based upon a change in the conversion ratio of Visa Class B shares into Visa Class A shares. The Company’s recorded liability representing the fair value of the derivative was $752 thousand at June 30, 2016 and December 31, 2015.

The present value of estimated future fees to be paid to the derivative counterparty, or carrying costs, calculated by reference to the market price of the Visa Class A shares at a fixed rate of interest are expensed as incurred. For the three months ended June 30, 2016 and 2015, $82 thousand and $71 thousand, respectively, in such carrying costs was expensed. For the six months ended June 30, 2016 and 2015, $156 thousand and $141 thousand, respectively, in such carrying costs was expensed. The Company has pledged U.S. Government agency securities held in its available for sale portfolio, with a market value of approximately $3 million at June 30, 2016 and December 31, 2015, as collateral for the derivative swap contracts.
 
Subjectivity has been used in estimating the fair value of both the derivative liability and the associated fees, but management believes that these fair value estimates are adequate based on available information. However, future developments in the litigation could require potentially significant changes to these estimates.

At June 30, 2016 and December 31, 2015, the Company still owned 38,638 Visa Class B shares subsequent to the sales described here. Upon termination of the existing transfer restriction and settlement of the litigation, and to the extent that the Company continues to own such Visa Class B shares in the future, the Company expects to record its Visa Class B shares at fair value.

4. LOANS
At June 30, 2016 and December 31, 2015, net loans disaggregated by class consisted of the following (in thousands):
 
   
June 30, 2016
   
December 31, 2015
 
Commercial and industrial
 
$
215,960
   
$
189,769
 
Commercial real estate
   
734,586
     
696,787
 
Multifamily
   
426,367
     
426,549
 
Mixed use commercial
   
84,070
     
78,787
 
Real estate construction
   
40,452
     
37,233
 
Residential mortgages
   
178,504
     
186,313
 
Home equity
   
44,655
     
44,951
 
Consumer
   
5,280
     
6,058
 
Gross loans
   
1,729,874
     
1,666,447
 
Allowance for loan losses
   
(20,965
)
   
(20,685
)
Net loans at end of period
 
$
1,708,909
   
$
1,645,762
 
 
There were no loans in the process of foreclosure collateralized by residential real estate property at June 30, 2016.

The following summarizes the activity in the allowance for loan losses disaggregated by class for the periods indicated (in thousands).
 
   
Three Months Ended June 30, 2016
   
Three Months Ended June 30, 2015
 
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
   
Balance at
 beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
 
Commercial and industrial
 
$
1,904
   
$
-
   
$
28
   
$
(118
)
 
$
1,814
   
$
1,998
   
$
-
   
$
693
   
$
(618
)
 
$
2,073
 
Commercial real estate
   
7,290
     
-
     
8
     
448
     
7,746
     
7,352
     
-
     
11
     
(1,363
)
   
6,000
 
Multifamily
   
5,523
     
-
     
-
     
(625
)
   
4,898
     
4,467
     
-
     
-
     
(402
)
   
4,065
 
Mixed use commercial
   
852
     
-
     
-
     
(10
)
   
842
     
273
     
-
     
-
     
192
     
465
 
Real estate construction
   
388
     
-
     
-
     
68
     
456
     
360
     
-
     
-
     
118
     
478
 
Residential mortgages
   
2,210
     
-
     
3
     
(20
)
   
2,193
     
2,618
     
-
     
16
     
(63
)
   
2,571
 
Home equity
   
577
     
(1
)
   
4
     
-
     
580
     
728
     
-
     
5
     
(61
)
   
672
 
Consumer
   
97
     
(8
)
   
1
     
(30
)
   
60
     
155
     
(9
)
   
10
     
(6
)
   
150
 
Unallocated
   
2,089
     
-
     
-
     
287
     
2,376
     
1,374
     
-
     
-
     
2,203
     
3,577
 
Total
 
$
20,930
   
$
(9
)
 
$
44
   
$
-
   
$
20,965
   
$
19,325
   
$
(9
)
 
$
735
   
$
-
   
$
20,051
 
 
   
Six Months Ended June 30, 2016
   
Six Months Ended June 30, 2015
 
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
   
Balance at
beginning of
period
   
Charge-
offs
   
Recoveries
   
(Credit)
provision
for loan
losses
   
Balance at
end of
period
 
Commercial and industrial
 
$
1,875
   
$
-
   
$
73
   
$
(134
)
 
$
1,814
   
$
1,560
   
$
(492
)
 
$
1,036
   
$
(31
)
 
$
2,073
 
Commercial real estate
   
7,019
     
-
     
18
     
709
     
7,746
     
6,777
     
-
     
18
     
(795
)
   
6,000
 
Multifamily
   
4,688
     
-
     
-
     
210
     
4,898
     
4,018
     
-
     
-
     
47
     
4,065
 
Mixed use commercial
   
766
     
-
     
-
     
76
     
842
     
261
     
-
     
-
     
204
     
465
 
Real estate construction
   
386
     
-
     
-
     
70
     
456
     
383
     
-
     
-
     
95
     
478
 
Residential mortgages
   
2,476
     
-
     
5
     
(288
)
   
2,193
     
3,027
     
-
     
27
     
(483
)
   
2,571
 
Home equity
   
639
     
(8
)
   
5
     
(56
)
   
580
     
709
     
-
     
7
     
(44
)
   
672
 
Consumer
   
106
     
(66
)
   
3
     
17
     
60
     
166
     
(10
)
   
15
     
(21
)
   
150
 
Unallocated
   
2,730
     
-
     
-
     
(354
)
   
2,376
     
2,299
     
-
     
-
     
1,278
     
3,577
 
Total
 
$
20,685
   
$
(74
)
 
$
104
   
$
250
   
$
20,965
   
$
19,200
   
$
(502
)
 
$
1,103
   
$
250
   
$
20,051
 

At June 30, 2016 and December 31, 2015, the ending balance in the allowance for loan losses disaggregated by class and impairment methodology is as follows (in thousands). Also in the tables below are total loans at June 30, 2016 and December 31, 2015 disaggregated by class and impairment methodology (in thousands).
 
   
Allowance for Loan Losses
   
Loan Balances
 
June 30, 2016
 
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
   
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
 
Commercial and industrial
 
$
117
   
$
1,697
   
$
1,814
   
$
4,776
   
$
211,184
   
$
215,960
 
Commercial real estate
   
-
     
7,746
     
7,746
     
3,395
     
731,191
     
734,586
 
Multifamily
   
-
     
4,898
     
4,898
     
-
     
426,367
     
426,367
 
Mixed use commercial
   
-
     
842
     
842
     
-
     
84,070
     
84,070
 
Real estate construction
   
-
     
456
     
456
     
-
     
40,452
     
40,452
 
Residential mortgages
   
450
     
1,743
     
2,193
     
4,997
     
173,507
     
178,504
 
Home equity
   
156
     
424
     
580
     
1,661
     
42,994
     
44,655
 
Consumer
   
26
     
34
     
60
     
218
     
5,062
     
5,280
 
Unallocated
   
-
     
2,376
     
2,376
     
-
     
-
     
-
 
Total
 
$
749
   
$
20,216
   
$
20,965
   
$
15,047
   
$
1,714,827
   
$
1,729,874
 
 
   
Allowance for Loan Losses
   
Loan Balances
 
December 31, 2015
 
Individually
evaluated for
impairment
   
Collectively
evaluated for
impairment
   
Ending balance
   
Individually
evaluated for
impairment
   
Collectively
evaluated for
 impairment
   
Ending balance
 
Commercial and industrial
 
$
-
   
$
1,875
   
$
1,875
   
$
2,872
   
$
186,897
   
$
189,769
 
Commercial real estate
   
-
     
7,019
     
7,019
     
4,334
     
692,453
     
696,787
 
Multifamily
   
-
     
4,688
     
4,688
     
-
     
426,549
     
426,549
 
Mixed use commercial
   
-
     
766
     
766
     
-
     
78,787
     
78,787
 
Real estate construction
   
-
     
386
     
386
     
-
     
37,233
     
37,233
 
Residential mortgages
   
559
     
1,917
     
2,476
     
5,817
     
180,496
     
186,313
 
Home equity
   
170
     
469
     
639
     
1,683
     
43,268
     
44,951
 
Consumer
   
48
     
58
     
106
     
379
     
5,679
     
6,058
 
Unallocated
   
-
     
2,730
     
2,730
     
-
     
-
     
-
 
Total
 
$
777
   
$
19,908
   
$
20,685
   
$
15,085
   
$
1,651,362
   
$
1,666,447
 
 
The following table presents the Company’s impaired loans disaggregated by class at June 30, 2016 and December 31, 2015 (in thousands).
 
   
June 30, 2016
   
December 31, 2015
 
   
Unpaid
Principal
Balance
   
Recorded
Balance
   
Allowance
Allocated
   
Unpaid
Principal
Balance
   
Recorded
Balance
   
Allowance
Allocated
 
With no allowance recorded:
                                   
Commercial and industrial
 
$
3,429
   
$
3,429
   
$
-
   
$
2,869
   
$
2,869
   
$
-
 
Commercial real estate
   
3,813
     
3,395
     
-
     
4,753
     
4,334
     
-
 
Residential mortgages
   
2,892
     
2,763
     
-
     
3,076
     
2,947
     
-
 
Home equity
   
1,306
     
1,306
     
-
     
1,233
     
1,233
     
-
 
Consumer
   
124
     
124
     
-
     
207
     
207
     
-
 
Subtotal
   
11,564
     
11,017
     
-
     
12,138
     
11,590
     
-
 
                                                 
With an allowance recorded:
                                               
Commercial and industrial
   
1,347
     
1,347
     
117
     
3
     
3
     
-
 
Residential mortgages
   
2,234
     
2,234
     
450
     
2,870
     
2,870
     
559
 
Home equity
   
372
     
355
     
156
     
586
     
450
     
170
 
Consumer
   
94
     
94
     
26
     
172
     
172
     
48
 
Subtotal
   
4,047
     
4,030
     
749
     
3,631
     
3,495
     
777
 
Total
 
$
15,611
   
$
15,047
   
$
749
   
$
15,769
   
$
15,085
   
$
777
 
 
The following table presents the Company’s average recorded investment in impaired loans and the related interest income recognized disaggregated by class for the three and six months ended June 30, 2016 and 2015 (in thousands). No interest income was recognized on a cash basis on impaired loans for any of the periods presented. The interest income recognized on accruing impaired loans is shown in the following table.

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
   
Average
recorded
investment in
impaired
 loans
   
Interest
income
recognized on
 impaired
 loans
   
Average
 recorded
investment in
 impaired
loans
   
Interest
income
recognized on
impaired
loans
   
Average
recorded
 investment in
 impaired
 loans
   
Interest
 income
recognized on
impaired
 loans
   
Average
 recorded
 investment in
impaired
 loans
   
Interest
 income
 recognized on
impaired
 loans
 
Commercial and industrial
 
$
4,903
   
$
17
   
$
3,170
   
$
226
   
$
3,889
   
$
35
   
$
3,857
   
$
259
 
Commercial real estate
   
4,391
     
41
     
9,461
     
549
     
4,355
     
76
     
9,832
     
599
 
Residential mortgages
   
5,120
     
48
     
5,644
     
41
     
5,406
     
96
     
5,528
     
79
 
Home equity
   
1,646
     
16
     
1,666
     
15
     
1,658
     
31
     
1,664
     
28
 
Consumer
   
259
     
3
     
395
     
3
     
298
     
7
     
389
     
6
 
Total
 
$
16,319
   
$
125
   
$
20,336
   
$
834
   
$
15,606
   
$
245
   
$
21,270
   
$
971
 
 
TDRs are modifications or renewals where the Company has granted a concession to a borrower in financial distress. The Company reviews all modifications and renewals for determination of TDR status. The Company allocated $511 thousand and $534 thousand of specific reserves to customers whose loan terms have been modified as TDRs as of June 30, 2016 and December 31, 2015, respectively. These loans involved the restructuring of terms to allow customers to mitigate the risk of default by meeting a lower payment requirement based upon their current cash flow. These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.

At June 30, 2016 and December 31, 2015, $45 thousand was committed to be advanced in connection with TDRs, representing the amount the Company is legally required to advance under existing loan agreements. These loans are not in default under the terms of the loan agreements and are accruing interest. It is the Company’s policy to evaluate advances on such loans on a case-by-case basis. Absent a legal obligation to advance pursuant to the terms of the loan agreement, the Company generally will not advance funds for which it has outstanding commitments, but may do so in certain circumstances.
 
Outstanding TDRs, disaggregated by class, at June 30, 2016 and December 31, 2015 are as follows (dollars in thousands):
 
   
June 30, 2016
   
December 31, 2015
 
TDRs Outstanding
 
Number of
Loans
   
Outstanding
Recorded
Balance
   
Number of
Loans
   
Outstanding
Recorded
Balance
 
Commercial and industrial
   
14
   
$
847
     
17
   
$
1,116
 
Commercial real estate
   
4
     
2,970
     
5
     
4,131
 
Residential mortgages
   
22
     
4,755
     
22
     
4,653
 
Home equity
   
5
     
1,366
     
5
     
1,362
 
Consumer
   
7
     
218
     
8
     
301
 
Total
   
52
   
$
10,156
     
57
   
$
11,563
 
 
The following presents, disaggregated by class, information regarding TDRs executed during the three and six months ended June 30, 2016 and 2015 (dollars in thousands):

   
Three Months Ended June 30,
 
   
2016
   
2015
 
New TDRs
 
Number
of
Loans
   
Pre-Modification
Outstanding
Recorded
Balance
   
Post-Modification
Outstanding
Recorded
Balance
   
Number
of
Loans
   
Pre-Modification
Outstanding
Recorded
Balance
   
Post-Modification
Outstanding
Recorded
Balance
 
Commercial and industrial
   
-
   
$
-
   
$
-
     
1
   
$
323
   
$
323
 
Total
   
-
   
$
-
   
$
-
     
1
   
$
323
   
$
323
 
 
   
Six Months Ended June 30,
 
   
2016
   
2015
 
New TDRs
 
Number
of
Loans
   
Pre-Modification
Outstanding
Recorded
Balance
   
Post-Modification
Outstanding
Recorded
Balance
   
Number
of
Loans
   
Pre-Modification
Outstanding
Recorded
Balance
   
Post-Modification
Outstanding
Recorded
Balance
 
Commercial and industrial
   
-
   
$
-
   
$
-
     
2
   
$
335
   
$
335
 
Residential mortgages
   
-
     
-
     
-
     
2
     
194
     
199
 
Total
   
-
   
$
-
   
$
-
     
4
   
$
529
   
$
534
 
 
Presented below and disaggregated by class is information regarding loans modified as TDRs that had payment defaults of 90 days or more within twelve months of restructuring during the three and six months ended June 30, 2016 and 2015.

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
Defaulted TDRs
 
Number
of Loans
   
Outstanding
Recorded
Balance
   
Number
of Loans
   
Outstanding
Recorded
Balance
   
Number
of Loans
   
Outstanding
Recorded
Balance
   
Number
of Loans
   
Outstanding
Recorded
Balance
 
Consumer
   
-
   
$
-
     
1
   
$
46
     
-
   
$
-
     
1
   
$
46
 
Total
   
-
   
$
-
     
1
   
$
46
     
-
   
$
-
     
1
   
$
46
 

Not all loan modifications are TDRs. In some cases, the Company might provide a concession, such as a reduction in interest rate, but the borrower is not experiencing financial distress. This could be the case if the Company is matching a competitor’s interest rate.
 
At June 30, 2016 and December 31, 2015, non-accrual loans disaggregated by class were as follows (dollars in thousands):
 
   
June 30, 2016
   
December 31, 2015
 
   
Non-
accrual
loans
   
% of
Total
   
Total Loans
   
% of
Total Loans
   
Non-
accrual
loans
   
% of
Total
   
Total Loans
   
% of Total
Loans
 
Commercial and industrial
 
$
4,118
     
59.7
%
 
$
215,960
     
0.2
%
 
$
1,954
     
35.3
%
 
$
189,769
     
0.1
%
Commercial real estate
   
2,174
     
31.5
     
734,586
     
0.1
     
1,733
     
31.4
     
696,787
     
0.1
 
Multifamily
   
-
     
-
     
426,367
     
-
     
-
     
-
     
426,549
     
-
 
Mixed use commercial
   
-
     
-
     
84,070
     
-
     
-
     
-
     
78,787
     
-
 
Real estate construction
   
-
     
-
     
40,452
     
-
     
-
     
-
     
37,233
     
-
 
Residential mortgages
   
421
     
6.1
     
178,504
     
0.1
     
1,358
     
24.6
     
186,313
     
0.1
 
Home equity
   
185
     
2.7
     
44,655
     
-
     
406
     
7.3
     
44,951
     
-
 
Consumer
   
-
     
-
     
5,280
     
-
     
77
     
1.4
     
6,058
     
-
 
Total
 
$
6,898
     
100.0
%
 
$
1,729,874
     
0.4
%
 
$
5,528
     
100.0
%
 
$
1,666,447
     
0.3
%

Additional interest income of approximately $124 thousand and $83 thousand would have been recorded during the three months ended June 30, 2016 and 2015, respectively, and $222 thousand and $171 thousand during the six months ended June 30, 2016 and 2015, respectively, if non-accrual loans had performed in accordance with their original terms.

At June 30, 2016 and December 31, 2015, past due loans disaggregated by class were as follows (in thousands).

   
Past Due
             
June 30, 2016
 
30 - 59 days
   
60 - 89 days
   
90 days and over
   
Total
   
Current
   
Total
 
Commercial and industrial
 
$
138
   
$
-
   
$
4,118
   
$
4,256
   
$
211,704
   
$
215,960
 
Commercial real estate
   
285
     
-
     
2,174
     
2,459
     
732,127
     
734,586
 
Multifamily
   
-
     
-
     
-
     
-
     
426,367
     
426,367
 
Mixed use commercial
   
-
     
-
     
-
     
-
     
84,070
     
84,070
 
Real estate construction
   
-
     
-
     
-
     
-
     
40,452
     
40,452
 
Residential mortgages
   
348
     
643
     
421
     
1,412
     
177,092
     
178,504
 
Home equity
   
-
     
-
     
185
     
185
     
44,470
     
44,655
 
Consumer
   
1
     
4
     
-
     
5
     
5,275
     
5,280
 
Total
 
$
772
   
$
647
   
$
6,898
   
$
8,317
   
$
1,721,557
   
$
1,729,874
 
% of Total Loans
   
0.1
%
   
0.0
%
   
0.4
%
   
0.5
%
   
99.5
%
   
100.0
%
 
   
Past Due
             
December 31, 2015
 
30 - 59 days
   
60 - 89 days
   
90 days and over
   
Total
   
Current
   
Total
 
Commercial and industrial
 
$
21
   
$
-
   
$
1,954
   
$
1,975
   
$
187,794
   
$
189,769
 
Commercial real estate
   
-
     
-
     
1,733
     
1,733
     
695,054
     
696,787
 
Multifamily
   
-
     
-
     
-
     
-
     
426,549
     
426,549
 
Mixed use commercial
   
-
     
-
     
-
     
-
     
78,787
     
78,787
 
Real estate construction
   
-
     
-
     
-
     
-
     
37,233
     
37,233
 
Residential mortgages
   
512
     
175
     
1,358
     
2,045
     
184,268
     
186,313
 
Home equity
   
336
     
-
     
406
     
742
     
44,209
     
44,951
 
Consumer
   
2
     
-
     
77
     
79
     
5,979
     
6,058
 
Total
 
$
871
   
$
175
   
$
5,528
   
$
6,574
   
$
1,659,873
   
$
1,666,447
 
% of Total Loans
   
0.1
%
   
0.0
%
   
0.3
%
   
0.4
%
   
99.6
%
   
100.0
%
 
The Company utilizes an eight-grade risk-rating system for loans. Loans in risk grades 1- 4 are considered pass loans. The Company’s risk grades are as follows:

Risk Grade 1, Excellent - Loans secured by liquid collateral such as certificates of deposit, reputable bank letters of credit, or other cash equivalents; loans that are guaranteed or otherwise backed by the full faith and credit of the United States government or an agency thereof, such as the Small Business Administration; or loans to any publicly held company with a current long-term debt rating of A or better.
 
Risk Grade 2, Good -  Loans to businesses that have strong financial statements containing an unqualified opinion from a CPA firm and at least three consecutive years of profits; loans supported by un-audited financial statements containing strong balance sheets, five consecutive years of profits, a five-year satisfactory relationship with the Company, and key balance sheet and income statement trends that are either stable or positive; loans secured by publicly traded marketable securities where there is no impediment to liquidation; loans to individuals backed by liquid personal assets, established credit history, and unquestionable character; or loans to publicly held companies with current long-term debt ratings of Baa or better.

Risk Grade 3, Satisfactory - Loans supported by financial statements (audited or un-audited) that indicate average or slightly below average risk and having some deficiency or vulnerability to changing economic conditions; loans with some weakness but offsetting features of other support are readily available; loans that are meeting the terms of repayment, but which may be susceptible to deterioration if adverse factors are encountered. Loans may be graded Satisfactory when there is no recent information on which to base a current risk evaluation and the following conditions apply:

· At inception, the loan was properly underwritten, did not possess an unwarranted level of credit risk, and the loan met the above criteria for a risk grade of Excellent, Good, or Satisfactory.

· At inception, the loan was secured with collateral possessing a loan value adequate to protect the Company from loss.

· The loan has exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance.

· During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants or the borrower is in an industry known to be experiencing problems. If any of these credit weaknesses is observed, a lower risk grade may be warranted.

Risk Grade 4, Satisfactory/Monitored - Loans in this category are considered to be of acceptable credit quality, but contain greater credit risk than satisfactory loans due to weak balance sheets, marginal earnings or cash flow, or other uncertainties. These loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in a Satisfactory/Monitored loan is within acceptable underwriting guidelines so long as the loan is given the proper level of management supervision.

Risk Grade 5, Special Mention - Loans in this category possess potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the institution’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. The key distinctions of a Special Mention classification are that (1) it is indicative of an unwarranted level of risk and (2) weaknesses are considered potential not defined impairments to the primary source of repayment.

Risk Grade 6, Substandard - One or more of the following characteristics may be exhibited in loans classified Substandard:

· Loans which possess a defined credit weakness. The likelihood that a loan will be paid from the primary source of repayment is uncertain. Financial deterioration is under way and very close attention is warranted to ensure that the loan is collected without loss.

· Loans are inadequately protected by the current net worth and paying capacity of the obligor.

· The primary source of repayment is gone, and the Bank is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees.

· Loans have a distinct possibility that the Company will sustain some loss if deficiencies are not corrected.

· Unusual courses of action are needed to maintain a high probability of repayment.

· The borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments.

· The lender is forced into a subordinated or unsecured position due to flaws in documentation.
 
· Loans have been restructured so that payment schedules, terms, and collateral represent concessions to the borrower when compared to the normal loan terms.

· The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan.

· There is a significant deterioration in market conditions to which the borrower is highly vulnerable.

Risk Grade 7, Doubtful - One or more of the following characteristics may be present in loans classified Doubtful:

· Loans have all of the weaknesses of those classified as Substandard. However, based on existing conditions, these weaknesses make full collection of principal highly improbable.

· The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment.

· The possibility of loss is high but because of certain important pending factors which may strengthen the loan, loss classification is deferred until the exact status of repayment is known.

Risk Grade 8, Loss - Loans are considered uncollectible and of such little value that continuing to carry them as assets is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

The Company annually reviews the ratings on all loans greater than $750 thousand. Annually, the Company engages an independent third-party to review a significant portion of loans within the commercial and industrial, commercial real estate, multifamily, mixed use commercial and real estate construction loan classes. Management uses the results of these reviews as part of its ongoing review process.

The following presents the Company’s loan portfolio credit risk profile by internally assigned grade disaggregated by class of loan at June 30, 2016 and December 31, 2015 (in thousands).

   
June 30, 2016
   
December 31, 2015
 
   
Grade
         
Grade
       
   
Pass
   
Special
mention
   
Substandard
   
Total
   
Pass
   
Special
mention
   
Substandard
   
Total
 
Commercial and industrial
 
$
198,676
   
$
11,174
   
$
6,110
   
$
215,960
   
$
180,024
   
$
3,088
   
$
6,657
   
$
189,769
 
Commercial real estate
   
727,489
     
3,688
     
3,409
     
734,586
     
687,210
     
6,109
     
3,468
     
696,787
 
Multifamily
   
426,367
     
-
     
-
     
426,367
     
426,549
     
-
     
-
     
426,549
 
Mixed use commercial
   
84,070
     
-
     
-
     
84,070
     
78,779
     
-
     
8
     
78,787
 
Real estate construction
   
40,452
     
-
     
-
     
40,452
     
37,233
     
-
     
-
     
37,233
 
Residential mortgages
   
177,912
     
-
     
592
     
178,504
     
184,781
     
-
     
1,532
     
186,313
 
Home equity
   
44,470
     
-
     
185
     
44,655
     
44,545
     
-
     
406
     
44,951
 
Consumer
   
5,280
     
-
     
-
     
5,280
     
5,939
     
-
     
119
     
6,058
 
Total
 
$
1,704,716
   
$
14,862
   
$
10,296
   
$
1,729,874
   
$
1,645,060
   
$
9,197
   
$
12,190
   
$
1,666,447
 
% of Total
   
98.5%
 
   
0.9%
 
   
0.6%
   
100.0%
 
   
98.7%
 
   
0.6%
 
   
0.7%
 
   
100.0%
 

5. RETIREMENT PLAN
The Company’s retirement plan is noncontributory and covers substantially all eligible employees. The plan conforms to the provisions of the Employee Retirement Income Security Act of 1974, as amended, and the Pension Protection Act of 2006, which requires certain funding rules for defined benefit plans. The Company’s policy is to accrue for all pension costs and to fund the maximum amount allowable for tax purposes. Actuarial gains and losses that arise from changes in assumptions concerning future events are amortized over a period that reflects the long-term nature of pension expense used in estimating pension costs. Certain provisions of the Company’s retirement plan were amended in 2012. These amendments froze the plan such that no additional pension benefits would accumulate.

The Company did not record any net pension credit or expense for the three months ended June 30, 2016. For the three months ended June 30, 2015, the Company’s net periodic pension credit was $111 thousand, and $13 thousand and $222 thousand, respectively, for the six months ended June 30, 2016 and 2015.
 
In December 2015, the Company made an optional contribution of $1 million for the plan year ended September 30, 2016. No minimum contribution was required. The Company does not presently expect to contribute to its retirement plan in 2016.

6. STOCK-BASED COMPENSATION
Stock Options
Under the terms of the Company’s stock option plans adopted in 1999 and 2009, options have been granted to key employees and directors to purchase shares of the Company’s stock. Options are awarded by the Compensation Committee of the Board of Directors. Both plans provide that the option price shall not be less than the fair value of the common stock on the date the option is granted.

No options have been granted since 2013. Options granted in 2013 and 2012 were exercisable commencing one year from the date of grant at a rate of one-third per year. Options granted prior to 2012 were generally 100% exercisable commencing one year from the date of grant. All options are exercisable for a period of ten years or less.

No options were exercised during the first six months of 2016. The total intrinsic value of options exercised during the first six months of 2015 was $324 thousand. The total cash received from the 2015 option exercises was $462 thousand, excluding the tax benefit realized. In exercising those options, 32,667 shares of the Company’s common stock were issued.

Both plans provide for but do not require the grant of stock appreciation rights (“SARs”) that the holder may exercise instead of the underlying option. At June 30, 2016, there were 6,000 SARs outstanding related to options granted before 2011, with a total intrinsic value of $9 thousand. When the SAR is exercised, the underlying option is canceled. The optionee receives shares of common stock or cash with a fair market value equal to the excess of the fair value of the shares subject to the option at the time of exercise (or the portion thereof so exercised) over the aggregate option price of the shares set forth in the option agreement. The exercise of SARs is treated as the exercise of the underlying option.

A summary of stock option activity follows:
 
     
Number
of Shares 
     
Weighted-Average
 Exercise Price
Per Share 
 
Outstanding, January 1, 2016
   
185,100
   
$
15.73
 
Granted
   
-
     
-
 
Exercised
   
-
     
-
 
Forfeited or expired
   
(3,000
)
 
$
34.95
 
Outstanding, June 30, 2016
   
182,100
   
$
15.41
 
 
The following summarizes shares subject to purchase from stock options outstanding and exercisable as of June 30, 2016:

     
Outstanding
   
Exercisable
 
Range of
Exercise Prices
   
Shares
 
Weighted-Average
 Remaining 
Contractual Life
 
Weighted-Average
Exercise Price
   
Shares
 
 Weighted-Average
Remaining
Contractual Life
 
Weighted-Average
Exercise Price
 
$
10.00 - $14.00
     
90,000
 
 5.6 years
 
$
11.68
     
73,334
 
 5.6 years
 
$
11.88
 
$
14.01 - $20.00
     
83,100
 
 7.1 years
 
$
17.80
     
60,272
 
 7.0 years
 
$
17.56
 
$
20.01 - $30.00
     
3,000
 
 2.6 years
 
$
28.30
     
3,000
 
 2.6 years
 
$
28.30
 
$
30.01 - $40.00
     
6,000
 
 1.1 years
 
$
32.04
     
6,000
 
 1.1 years
 
$
32.04
 
         
182,100
 
 6.1 years
 
$
15.41
     
142,606
 
 5.9 years
 
$
15.47
 
 
Restricted Stock Awards
Under the Company’s Amended and Restated 2009 Stock Incentive Plan (the “2009 Plan”), the Company can award options, SARs and restricted stock. During the first six months of 2016 and 2015, the Company awarded 51,871 and 71,612 shares, respectively, of restricted stock to certain key employees and directors. Generally, the restricted stock awards vest over a three-year period commencing one year from the date of grant at a rate of one-third per year. The fair value at grant date of the 42,633 and 22,213 restricted shares that vested during the first six months of 2016 and 2015, respectively, was $975 thousand and $500 thousand, respectively. Of the vested shares, 8,707 and 4,787, respectively, were withheld to pay taxes due upon vesting. A summary of restricted stock activity for the first six months of 2016 follows:
 
   
Number
of Shares
   
Weighted-Average
Grant-Date
Fair Value
 
Unvested, January 1, 2016
   
108,073
   
$
22.94
 
Granted
   
51,871
   
$
25.33
 
Vested
   
(42,633
)
 
$
22.87
 
Forfeited or expired
   
(1,216
)
 
$
22.72
 
Unvested, June 30, 2016
   
116,095
   
$
24.03
 
 
The Company recognizes compensation expense for the fair value of stock options and restricted stock on a straight line basis over the requisite service period of the grants. Compensation expense related to stock-based compensation amounted to $464 thousand and $337 thousand for the six months ended June 30, 2016 and 2015, respectively. The remaining unrecognized compensation cost of approximately $17 thousand and $2.2 million at June 30, 2016 related to stock options and restricted stock, respectively, will be expensed over the remaining weighted average vesting period of approximately 0.4 years and 1.9 years, respectively.

Under the 2009 Plan, a total of 500,000 shares of the Company’s common stock were reserved for issuance, of which 120,982 shares remained for possible issuance at June 30, 2016. There are no remaining shares reserved for issuance under the 1999 Stock Option Plan.

7. INCOME TAXES
The deferred tax assets and liabilities are netted and presented in a single amount which is included in deferred taxes in the accompanying consolidated statements of condition. The realization of deferred tax assets (“DTAs”) (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carry back losses to available tax years. In assessing the need for a valuation allowance, the Company considers positive and negative evidence, including taxable income in carryback years, scheduled reversals of deferred tax liabilities, expected future taxable income and tax planning strategies. At June 30, 2016, the Company had net operating loss carryforwards of approximately $6.4 million for New York State (“NYS”) income tax purposes, which may be applied against future taxable income. The Company has a full valuation allowance of $285 thousand, tax effected, on the NYS net operating loss carryforward due to the Company’s significant tax-exempt investment income. The valuation allowance may be reversed to income in future periods to the extent that the related DTAs are realized or when the Company returns to consistent, taxable earnings in NYS. The NYS unused net operating loss carryforwards are expected to expire in varying amounts through the year 2032.

The Company had no unrecognized tax benefits at June 30, 2016 and 2015. The Company files income tax returns in the U.S. federal jurisdiction and in New York State. Federal returns are subject to audits by tax authorities. The Company’s Federal tax returns were audited for the tax years 2010 through 2013; there was no significant change in income taxes as a result of these audits.

8. REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s business, results of operations and financial condition. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital requirements that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and the Bank’s classification are also subject to qualitative judgments by the regulators about components, risk weighting and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total, tier 1 and common equity tier 1 capital, as defined in the federal banking regulations, to risk-weighted assets and of tier 1 capital to adjusted average assets (leverage).

The Office of the Comptroller of the Currency (“OCC”), the Company’s primary bank regulator, established higher capital requirements for the Bank than those set forth in its capital regulations that require the Bank to maintain a tier 1 leverage ratio of at least 9%, a tier 1 risk-based capital ratio of at least 11% and a total risk-based capital ratio of at least 12%. At June 30, 2016, the Bank satisfied the OCC’s regulatory capital requirements as well as these individual minimum capital ratios, although there is no guarantee that the Bank will be able to maintain compliance with these heightened capital ratios.
 
In July 2013, the OCC approved new rules on regulatory capital applicable to national banks, implementing Basel III. Most banking organizations were required to apply the new capital rules on January 1, 2015. The final rules set a new common equity tier 1 requirement and higher minimum tier 1 requirements for all banking organizations. The rules revise the prompt corrective action framework to incorporate the new regulatory capital minimums. They also enhance risk sensitivity and address weaknesses identified over recent years with the measure of risk-weighted assets, including through new measures of creditworthiness to replace references to credit ratings, consistent with section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Company’s implementation of the new rules on January 1, 2015 did not have a material impact on its capital needs.

The final capital rules also place limits on capital distributions and certain discretionary bonus payments if a banking organization does not maintain a buffer of common equity tier 1 capital above minimum capital requirements. The capital buffer requirement is being phased in beginning January 1, 2016 at 0.625% per year until it becomes 2.50% in 2019 and thereafter. At June 30, 2016, the Company’s and the Bank’s capital buffers were in excess of both the current and fully phased-in requirements.

The Bank’s capital amounts (in thousands) and ratios are presented in the table that follows. The minimum amounts presented therein reference the minimums required by capital regulations and not the individual minimum capital ratios the OCC established for the Bank.

   
Actual capital ratios
   
Minimum
for capital
adequacy
   
Minimum to be Well
Capitalized under prompt
corrective action provisions
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
June 30, 2016
                                   
Total capital to risk-weighted assets
 
$
232,576
     
13.10
%
 
$
142,039
     
8.00
%
 
$
177,549
     
10.00
%
Tier 1 capital to risk-weighted assets
   
211,371
     
11.90
%
   
106,529
     
6.00
%
   
142,039
     
8.00
%
Common equity tier 1 capital to risk-weighted assets
   
211,371
     
11.90
%
   
79,897
     
4.50
%
   
115,407
     
6.50
%
Tier 1 capital to adjusted average assets (leverage)
   
211,371
     
9.55
%
   
88,562
     
4.00
%
   
110,703
     
5.00
%
                                                 
December 31, 2015
                                               
Total capital to risk-weighted assets
 
$
219,562
     
12.66
%
 
$
138,716
     
8.00
%
 
$
173,395
     
10.00
%
Tier 1 capital to risk-weighted assets
   
198,587
     
11.45
%
   
104,037
     
6.00
%
   
138,716
     
8.00
%
Common equity tier 1 capital to risk-weighted assets
   
198,587
     
11.45
%
   
78,028
     
4.50
%
   
112,706
     
6.50
%
Tier 1 capital to adjusted average assets (leverage)
   
198,587
     
9.58
%
   
82,905
     
4.00
%
   
103,632
     
5.00
%
 
The Company’s tier 1 leverage, common equity tier 1 risk-based, tier 1 risk-based and total risk-based capital ratios were 9.66%, 12.04%, 12.04% and 13.24%, respectively, at June 30, 2016. The Company’s tier 1 leverage, common equity tier 1 risk-based, tier 1 risk-based and total risk-based capital ratios were 9.77%, 11.68%, 11.68% and 12.89%, respectively, at December 31, 2015.

The ability of the Bank to pay dividends to the Company is subject to certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay dividends in an amount greater than its undivided profits or declare any dividends if such declaration would leave the bank inadequately capitalized.

9. FAIR VALUE
Fair value measurement is determined based on the assumptions that market participants would use in pricing the asset or liability in an exchange. The definition of fair value includes the exchange price which is the price in an orderly transaction between market participants to sell an asset or transfer a liability in the principal market for the asset or liability. Market participant assumptions include assumptions about risk, the risk inherent in a particular valuation technique used to measure fair value and/or the risk inherent in the inputs to the valuation technique, as well as the effect of credit risk on the fair value of liabilities. The Company uses three levels of the fair value inputs to measure assets, as described below.

Basis of Fair Value Measurement:

Level 1 – Valuations based on quoted prices in active markets for identical investments.

Level 2 – Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 2 inputs include: (i) quoted prices for similar investments in active markets, (ii) quoted prices for identical investments traded in non-active markets (i.e., dealer or broker markets) and (iii) inputs other than quoted prices that are observable or inputs derived from or corroborated by market data for substantially the full term of the investment.
 
Level 3 – Valuations based on inputs that are unobservable, supported by little or no market activity, and significant to the overall fair value measurement.

The types of instruments valued based on quoted market prices in active markets include most U.S. Treasury securities. Such instruments are generally classified within Level 1 and Level 2 of the fair value hierarchy. The Company does not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include U.S. Government agency securities, state and municipal obligations, MBS, CMOs and corporate bonds. Such instruments are generally classified within Level 2 of the fair value hierarchy.

The types of instruments valued based on significant unobservable inputs that reflect the Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability are generally classified within Level 3 of the fair value hierarchy.

The following table presents the carrying amounts and fair values of the Company’s financial instruments (in thousands).

       
June 30, 2016
   
December 31, 2015
 
   
Level in
Fair Value
Hierarchy
   
Carrying
Amount
     
Fair
Value
     
Carrying
Amount
     
Fair
Value
 
                             
Financial Assets:
                           
Cash and due from banks
 
Level 1
 
$
130,762
   
$
130,762
   
$
98,086
   
$
98,086
 
Federal Reserve and Federal Home Loan Bank stock and other investments
 
Level 2
   
4,469
     
4,469
     
10,756
     
10,756
 
Investment securities held to maturity
 
Level 2
   
29,466
     
31,011
     
61,309
     
63,272
 
Investment securities available for sale
 
Level 2
   
215,111
     
215,111
     
247,099
     
247,099
 
Loans held for sale
 
Level 2
   
2,790
     
2,790
     
1,666
     
1,666
 
Loans, net of allowance
 
Level 2, 3 (1)
   
1,708,909
     
1,714,090
     
1,645,762
     
1,628,169
 
Accrued interest and loan fees receivable
 
Level 2
   
5,893
     
5,893
     
5,859
     
5,859
 
                                     
Financial Liabilities:
                                   
Non-maturity deposits
 
Level 2
   
1,723,101
     
1,723,101
     
1,555,980
     
1,555,980
 
Time deposits
 
Level 2
   
225,918
     
225,927
     
224,643
     
224,408
 
Borrowings
 
Level 2
   
15,000
     
15,258
     
165,000
     
164,827
 
Accrued interest payable
 
Level 2
   
186
     
186
     
198
     
198
 
Derivatives
 
Level 3
   
752
     
752
     
752
     
752
 

 
(1)
Impaired loans are generally classified within Level 3 of the fair value hierarchy.
 
Fair value estimates are made at a specific point in time and may be based on judgments regarding losses expected in the future, risk, and other factors that are subjective in nature. The methods and assumptions used to produce the fair value estimates follow.

For securities held to maturity and securities available for sale, the fair value equals quoted market price if available. If a quoted market price is not available, fair value is estimated using a quoted market price for similar securities. For cash and due from banks, federal funds sold, accrued interest and loan fees receivable, non-maturity deposits and accrued interest payable, the carrying amount is a reasonable estimate of fair value due to the short term nature of these instruments. Determining the fair value of Federal Reserve and Federal Home Loan Bank stock and other investments is not practicable due to restrictions placed on its transferability; thus, carrying amount is a reasonable estimate of fair value. Time deposits and borrowings are valued using a replacement cost of funds approach.

Fair values are estimated for portfolios of loans with similar characteristics. The fair value of performing loans was calculated by discounting projected cash flows through their estimated maturity using market discount rates that reflect the general credit and interest rate characteristics of the loan category. The maturity horizon is based on the Company’s history of repayments for each type of loan and an estimate of the effect of current economic conditions. Assumptions regarding credit risk, cash flows, and discount rates are made using available market information and specific borrower information.
 
Loans identified as impaired are measured using one of three methods: the fair value of collateral less estimated costs to sell, the present value of expected future cash flows or the loan’s observable market price. Those measured using the fair value of collateral or the loan’s observable market price are recorded at fair value. For each period presented, no impaired loans were measured using the loan’s observable market price. If an impaired loan has had a charge-off or if the fair value of the collateral is less than the recorded investment in the loan, the Company establishes a specific reserve and reports the loan as non-recurring Level 3. The fair value of collateral of impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

For the periods presented, loans held for sale were performing and carried at cost. The carrying cost is a reasonable estimate of fair value due to their short-term nature.

OREO properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis. Adjustments to OREO are measured at fair value, less estimated costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as non-recurring Level 3. No valuation allowance was recorded for OREO at June 30, 2016.

In conjunction with the sale of Visa Class B shares in 2013, the Company entered into derivative swap contracts with the purchaser of its Visa Class B shares. The fair value of these derivatives is measured using an internal model that includes the use of probability weighted scenarios for estimates of Visa’s aggregate exposure to the litigation matters, with consideration of amounts funded by Visa into its escrow account for this litigation. At June 30, 2016, the Company estimates a fair value for these derivatives at approximately 10% of the net proceeds from the Company’s sale of the related Visa Class B shares. Since this estimation process requires application of judgment in developing significant unobservable inputs used to determine the possible outcomes and the probability weighting assigned to each scenario, these derivatives have been classified as Level 3 within the valuation hierarchy. (See also Note 3. Investment Securities contained herein.)

The fair value of commitments to extend credit is estimated by either discounting cash flows or using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the current creditworthiness of the counter-parties. The estimated fair value of written financial guarantees and letters of credit is based on fees currently charged for similar agreements. The fees charged for the commitments were not material in amount.

Assets measured at fair value on a non-recurring basis are as follows (in thousands):

Assets:
 
June 30, 2016
   
Fair Value
Measurements Using
Significant Unobservable
Inputs (Level 3)
 
Impaired loans
 
$
3,001
   
$
3,001
 
OREO
   
650
     
650
 
Total
 
$
3,651
   
$
3,651
 
 
Assets:
 
December 31, 2015
   
Fair Value
Measurements Using
Significant Unobservable
 Inputs (Level 3)
 
Impaired loans
 
$
2,715
   
$
2,715
 
Total
 
$
2,715
   
$
2,715
 
 
The Company had no liabilities measured at fair value on a non-recurring basis at June 30, 2016 and December 31, 2015.

The following presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis (dollars in thousands):
 
   
Fair Value at
               
Assets:
 
June 30,
2016
   
December 31,
2015
 
Valuation
Technique
Unobservable
Inputs
 
Discount
 
Impaired loans:
                         
                           
Commercial and industrial
 
$
950
   
$
-
 
Advance rate against inventory and receivables
Discount to financial statement values
 
25% to 50
%
(1
)
                               
Residential mortgages
   
1,784
     
2,311
 
Third party appraisal
Discount to appraised value
   
25
%
(2
)
                                 
Home equity
   
199
     
280
 
Third party appraisal
Discount to appraised value
   
25
%
(2
)
                                 
Consumer
   
68
     
124
 
Third party appraisal
Discount to appraised value
   
25
%
(3
)
Total
 
$
3,001
   
$
2,715
                 
                                 
OREO
 
$
650
   
$
-
 
Third party appraisal
Estimated holding/selling costs
 
 
11
   

(1) The Company makes adjustments based upon evaluation of corporate assets, such as inventory and accounts receivable, and various other information, such as market conditions and other factors. Higher discounts may be applied to certain assets, such as inventory and accounts receivable.
(2) Of which estimated selling costs are approximately 9% - 15% of the total discount.
(3) Of which estimated selling costs are approximately 10% - 12% of the total discount.
 
The following presents fair value measurements on a recurring basis at June 30, 2016 and December 31, 2015 (in thousands):

         
Fair Value Measurements Using
 
Assets:
 
June 30, 2016
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs
(Level 3)
 
U.S. Government agency securities
 
$
5,000
   
$
5,000
   
$
-
 
Obligations of states and political
                       
subdivisions
   
85,396
     
85,396
     
-
 
Collateralized mortgage obligations
   
19,109
     
19,109
     
-
 
Mortgage-backed securities
   
96,891
     
96,891
     
-
 
Corporate bonds
   
8,715
     
8,715
     
-
 
Total
 
$
215,111
   
$
215,111
   
$
-
 
                         
Liabilities:
                       
Derivatives
 
$
752
   
$
-
   
$
752
 
Total
 
$
752
   
$
-
   
$
752
 
 
         
Fair Value Measurements Using
 
Assets:
 
December 31, 2015
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs
(Level 3)
 
U.S. Government agency securities
 
$
28,516
   
$
28,516
   
$
-
 
Obligations of states and political subdivisions
   
104,682
     
104,682
     
-
 
Collateralized mortgage obligations
   
15,549
     
15,549
     
-
 
Mortgage-backed securities
   
92,442
     
92,442
     
-
 
Corporate bonds
   
5,910
     
5,910
     
-
 
Total
 
$
247,099
   
$
247,099
   
$
-
 
                         
Liabilities:
                       
Derivatives
 
$
752
   
$
-
   
$
752
 
Total
 
$
752
   
$
-
   
$
752
 
 
Reconciliations for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) follow (in thousands).

Fair Value Measurements Using Significant Unobservable Inputs (Level 3)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
   
Liabilities
Derivatives
   
Liabilities
Derivatives
   
Liabilities
Derivatives
   
Liabilities
Derivatives
 
Beginning balance
 
$
752
   
$
752
   
$
752
   
$
752
 
Net change
   
-
     
-
     
-
     
-
 
Ending balance
 
$
752
   
$
752
   
$
752
   
$
752
 
 
10. LEGAL PROCEEDINGS
Certain lawsuits and claims arising in the ordinary course of business may be filed or pending against us or our affiliates from time to time. In accordance with applicable accounting guidance, we establish accruals for all lawsuits, claims and expected settlements when we believe it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. When a loss contingency is not both probable and estimable, we do not establish an accrual. Any such loss estimates are inherently uncertain, based on currently available information and are subject to management’s judgment and various assumptions. Due to the inherent subjectivity of these estimates and unpredictability of outcomes of legal proceedings, any amounts accrued may not represent the ultimate resolution of such matters.

To the extent we believe any potential loss relating to such lawsuits and claims may have a material impact on our liquidity, consolidated financial position, results of operations, and/or our business as a whole and is reasonably possible but not probable, we disclose information relating to any such potential loss, whether in excess of any established accruals or where there is no established accrual. We also disclose information relating to any material potential loss that is probable but not reasonably estimable. Where reasonably practicable, we will provide an estimate of loss or range of potential loss. No disclosures are generally made for any loss contingencies that are deemed to be remote.

On July 1, 2016 and July 13, 2016, respectively, actions captioned Thaler/Howell Foundation v. Suffolk Bancorp et al., Index No. 609834/2016 (Sup. Ct., Suffolk Cnty.) and Levy v. Suffolk Bancorp et al., Index No. 610475/2016 (Sup. Ct., Suffolk Cnty.) were filed on behalf of a putative class of the Company’s shareholders against the Company, its current directors and People’s United Financial, Inc. (“People’s United”). The complaints allege that the Company’s board of directors breached its fiduciary duties by agreeing to the merger between the Company and People’s United and certain terms of the merger agreement (which merger and merger agreement are described further elsewhere in this document). The complaints further allege that People’s United aided and abetted those alleged fiduciary breaches. The actions seek, among other things, to enjoin the defendants from completing the merger on the agreed-upon terms, and rescission of the merger and/or awarding of damages to the extent the merger is completed. The Company believes that the claims are without merit.
 
Based upon information available to us and our review of lawsuits and claims filed or pending against us to date, we have not recognized a material accrual liability for these matters. However, the outcome of litigation and other legal and regulatory matters is inherently uncertain, and it is possible that one or more of such matters currently pending or threatened could have an unanticipated material adverse effect on our liquidity, consolidated financial position, results of operations, and/or our business as a whole, in the future.

11. BORROWINGS
The following summarizes borrowed funds at June 30, 2016 and December 31, 2015 (dollars in thousands):
 
As of or for the Six Months Ended
June 30, 2016
 
Federal Home Loan
Bank Borrowings
Short-Term
   
Federal Home Loan
Bank Borrowings
Long-Term
   
Federal Funds
Purchased
 
Daily average outstanding
 
$
95,149
   
$
15,000
   
$
3
 
Total interest cost
   
277
     
131
     
-
 
Average interest rate paid
   
0.57
%
   
1.76
%
   
0.73
%
Maximum amount outstanding at any month-end
 
$
160,000
   
$
15,000
   
$
-
 
Ending balance
   
-
     
15,000
     
-
 
Weighted-average interest rate on balances outstanding
   
-
%
   
1.76
%
   
-
%
 
As of or for the Year Ended
December 31, 2015
 
Federal Home Loan
Bank Borrowings
Short-Term
   
Federal Home Loan
Bank Borrowings
Long-Term
   
Federal Funds
Purchased
 
Daily average outstanding
 
$
63,935
   
$
10,808
   
$
3
 
Total interest cost
   
252
     
190
     
-
 
Average interest rate paid
   
0.39
%
   
1.76
%
   
0.45
%
Maximum amount outstanding at any month-end
 
$
155,000
   
$
15,000
   
$
-
 
Ending balance
   
150,000
     
15,000
     
-
 
Weighted-average interest rate on balances outstanding
   
0.52
%
   
1.76
%
   
-
%
 
Assets pledged as collateral to the Federal Home Loan Bank (“FHLB”), consisting of eligible loans and investment securities, at June 30, 2016 and December 31, 2015 resulted in a maximum borrowing potential of $682 million and $746 million, respectively. The Company had $15 million and $165 million in FHLB borrowings at June 30, 2016 and December 31, 2015, respectively.
 
ITEM 2. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Safe Harbor Statement Pursuant to the Private Securities Litigation Reform Act of 1995 - Certain statements contained in this document are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These can include remarks about the Company, the banking industry, the economy in general, expectations of the business environment in which the Company operates, projections of future performance, and potential future credit experience. These remarks are based upon current management expectations, and may, therefore, involve risks and uncertainties that cannot be predicted or quantified, that are beyond the Company’s control and that could cause future results to vary materially from the Company’s historical performance or from current expectations. These remarks may be identified by such forward-looking statements as “should,” “expect,” “believe,” “view,” “opportunity,” “allow,” “continues,” “reflects,” “typically,” “usually,” “anticipate,” or similar statements or variations of such terms. Factors that could affect the Company include particularly, but are not limited to: the ability to obtain regulatory approvals and meet other closing conditions to the merger with People’s United, including approval by the Company's shareholders on the expected terms and schedule, and including the risk that regulatory approvals required for the merger are not obtained or are obtained subject to conditions that are not anticipated; delay in closing the merger; difficulties and delays in integrating the Company's business or fully realizing cost savings and other benefits of the merger; business disruption following the merger; increased capital requirements mandated by the Company’s regulators, including the individual minimum capital requirements that the OCC established for the Bank; the Bank’s temporary limitation on the growth of its commercial real estate (“CRE”) portfolio and the potentially adverse impact thereof on the Company’s overall business, financial condition and results of operation due to the importance of the Bank’s CRE business to the Company’s overall business, financial condition and results of operation; any failure by the Bank to comply with the individual minimum capital ratios (including as a result of increases to the Bank’s allowance for loan losses), which may result in  regulatory enforcement actions; the duration of the Bank’s limitation on the growth of its CRE portfolio, and the potentially adverse impact thereof on the Company’s overall business, financial condition and results of operation; the cost of compliance and significant amount of time required of management to comply with regulatory  requirements; results of changes in law, regulations or regulatory practices; the Company’s ability to raise capital; competitive factors, including price competition; changes in interest rates; increases or decreases in retail and commercial economic activity in the Company’s market area; variations in the ability and propensity of consumers and businesses to borrow, repay, or deposit money, or to use other banking and financial services; the Company’s ability to attract and retain key management and staff; any failure by the Company to maintain effective internal control over financial reporting; larger-than-expected losses from the sale of assets; and the potential that net charge-offs are higher than expected or for increases in our provision for loan losses. Further, it could take the Company longer than anticipated to implement its strategic plans to increase revenue and manage non-interest expense, or it may not be possible to implement those plans at all. Finally, new and unanticipated legislation, regulation, or accounting standards may require the Company to change its practices in ways that materially change the results of operations. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document. For more information, see the risk factors described in the Company’s Annual Report on Form 10-K and other filings with the Securities and Exchange Commission.
 
Non-GAAP Disclosure - This discussion includes non-GAAP financial measures of the Company’s tangible common equity (“TCE”)  ratio, tangible common equity, tangible assets, core net income, core fully taxable equivalent (“FTE”) net interest income, core FTE net interest margin, core operating expenses, core non-interest income, core FTE non-interest income and core operating efficiency ratio. A non-GAAP financial measure is a numerical measure of historical or future financial performance, financial position or cash flows that excludes or includes amounts that are required to be disclosed in the most directly comparable measure calculated and presented in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). The Company believes that these non-GAAP financial measures provide both management and investors a more complete understanding of the underlying operational results and trends and the Company’s marketplace performance. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the numbers prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other financial institutions.

With respect to the calculations and reconciliations of tangible common equity, tangible assets and the TCE ratio, please see Liquidity and Capital Resources contained herein. For the calculation and reconciliation of core FTE net interest margin, please see Material Changes in Results of Operations contained herein. For all other calculations and reconciliations pertaining to non-GAAP financial measures, please see Executive Summary contained herein.

Recent Development - On June 26, 2016, the Company entered into an Agreement and Plan of Merger (the “merger agreement”) with People’s United pursuant to which the Company will merge into People’s United (the “merger”). People’s United will be the surviving corporation in the merger. Subject to the terms and conditions of the merger agreement, the Company’s shareholders will have the right to receive 2.225 shares of People’s United common stock in exchange for each share of Company common stock. The merger agreement is subject to approval by the Company’s shareholders as well as regulatory approvals and other customary conditions. Subject to these conditions, it is expected that the merger will close during the fourth quarter of 2016.

Executive Summary –The Company is a one-bank holding company incorporated in 1985. The Company operates as the parent for its wholly owned subsidiary, the Bank, a national bank founded in 1890. The income of the Company is primarily derived through the operations of the Bank and the REIT.

The Bank is a full-service bank serving the needs of its local residents through 27 branch offices in Nassau, Suffolk and Queens Counties, New York. The Bank’s 27 branches include business banking centers in Long Island City, Melville and Garden City. In order to expand the Company geographically into western Suffolk, Nassau and Queens Counties and to diversify the lending business of the Company, loan production offices were opened in recent years in Long Island City, Garden City and Melville. As part of the Company’s strategy to move westward, the loan production office and business banking center branch in Long Island City serves Queens and nearby Brooklyn.

The Bank’s primary market area includes Suffolk County, Nassau County and New York City. The Bank offers a full line of domestic commercial and retail banking services. The Bank makes commercial real estate floating and fixed rate loans, multifamily and mixed use commercial loans primarily in the boroughs of New York City, commercial and industrial loans to manufacturers, wholesalers, distributors, developers/contractors and retailers and agricultural loans. The Bank also makes loans secured by residential mortgages, and both floating and fixed rate second mortgage loans with a variety of plans for repayment. Real estate construction loans are also offered.
 
One of the largest community banks headquartered on Long Island, the Company serves clients in its traditional markets on the east end of Long Island, western Suffolk County and in its newer markets of Nassau County and New York City. The Company considers its business to be highly competitive in its market area with numerous competitors for its core niche of small business and middle market clients, as well as retail clients ancillary to these commercial relationships. The Company competes with local, regional and national depository financial institutions, including commercial banks, savings banks, insurance companies, credit unions and money market funds, and other businesses with respect to its lending services and in attracting deposits. Although the New York metropolitan area has a high density of financial institutions, a number of which are significantly larger than the Company, the core deposit franchise the Company has built over its more than 125 years of doing business by focusing its deposit gathering efforts on low cost deposits is unique in the local marketplace and gives it a significant competitive advantage on cost of funds. In addition to serving the banking needs of the communities in its market area, the Company is also known, along with its employees, for its active community involvement.

The Bank finances most of its activities through a combination of deposits, including demand, savings, N.O.W. and money market deposits as well as time deposits, and borrowings which could include federal funds with correspondent banks, securities sold under agreements to repurchase and Federal Home Loan Bank (“FHLB”) short-term and long-term borrowings. The Company’s chief competition includes local banks within its market area, as well as New York City money center banks and regional banks.

During 2016, the Company has become increasingly concerned with conditions in many of its local commercial real estate (“CRE”) markets, particularly those in the boroughs of New York City. The Company sees worrisome signs of markets that are becoming overheated and has also observed deterioration in underwriting standards elsewhere in the industry, which has often translated into borrower expectations for loan terms that the Company is not comfortable with. As it has consistently articulated, the Company will compete fiercely for good deals on price because of the significant cost of funds advantage it has over most of the industry. However, the Company will not compromise on credit quality. As a result of these concerns, the Company stopped accepting new applications for multifamily loans in the boroughs of New York City during the first quarter of 2016. The CRE lending market is also an area which has attracted significant regulatory scrutiny. The OCC, the Company’s primary bank regulator, has publicly expressed broadly applicable concerns over the last year about overheated conditions in many CRE markets. In response, earlier this year, the Company decided to temporarily pull back from the CRE lending markets and target future growth in commercial and industrial (“C&I”) lending and residential mortgage portfolios. While this shift in focus could have a negative impact on the Company’s revenue and earnings growth, the Company believes it is prudent in the current environment.

The Company has recently brought on several relationship managers with experience in C&I lending, and has also enhanced its compliance and technology infrastructure in order to support a higher level of residential mortgage origination for its owned portfolio. In this regard, during the second quarter of 2016, the Company’s C&I portfolio increased approximately $21 million on a linked-quarter basis, an increase of 10.6%. The Company expects this trend to continue, as relationship managers continue to build their books of business. With respect to commercial real estate lending, the Company has spent the last few months implementing enhanced risk management processes in order to remain compliant with applicable regulatory guidance. As a result, the Company anticipates re-entering certain commercial real estate markets that it backed away from earlier this year, although it has no current plans to re-enter the multifamily lending markets in New York City.

The OCC has established individual minimum capital ratios for the Bank that requires it to maintain a tier 1 leverage ratio of at least 9%, a tier 1 risk-based capital ratio of at least 11% and a total risk-based capital ratio of at least 12%. At June 30, 2016, the Bank satisfied these capital ratios, although there is no guarantee that the Bank will be able to maintain compliance with these heightened capital ratios. The Company is exploring various options to ensure that it remains compliant with these capital requirements, including possible sales of selected investment securities and multifamily loans.
 
Financial Performance Summary
As of or for the quarters and six months ended June 30, 2016 and 2015
(dollars in thousands, except per share data)
 
   
Quarters ended June 30,
   
Over/
(under)
     
Six months ended June 30,
   
Over/
(under)
   
   
2016
   
2015
   
2015
     
2016
   
2015
   
2015
   
Revenue (1)
 
$
21,263
   
$
19,871
     
7.0
%
   
$
41,479
   
$
38,479
     
7.8
%
 
Operating expenses
 
$
13,319
   
$
13,174
     
1.1
%
   
$
26,471
   
$
26,282
     
0.7
%
 
Provision for loan losses
 
$
-
   
$
-
     
-
     
$
250
   
$
250
     
-
   
Net income
 
$
5,785
   
$
5,118
     
13.0
%
   
$
10,623
   
$
9,127
     
16.4
%
 
Net income per common share - diluted
 
$
0.48
   
$
0.43
     
11.6
%
   
$
0.89
   
$
0.77
     
15.6
%
 
Return on average assets
   
1.05
%
   
1.06
%
   
(1
)
bp
   
0.97
%
   
0.96
%
   
1
 
bp
Return on average stockholders' equity
   
11.23
%
   
10.88
%
   
35
 
bp
   
10.45
%
   
9.85
%
   
60
 
bp
Tier 1 leverage ratio
   
9.66
%
 
10.10
%
(44
)
bp
9.66
%
10.10
%
(44
)
bp
Common equity tier 1 risk-based capital ratio
   
12.04
%
   
12.01
%
   
3
 
bp
   
12.04
%
   
12.01
%
   
3
 
bp
Tier 1 risk-based capital ratio
   
12.04
%
   
12.01
%
   
3
 
bp
   
12.04
%
   
12.01
%
   
3
 
bp
Total risk-based capital ratio
13.24
%
13.26
%
(2
)
bp
13.24
%
13.26
%
(2
)
bp
Tangible common equity ratio (non-GAAP)
   
9.46
%
   
9.43
%
   
3
 
bp
   
9.46
%
   
9.43
%
   
3
 
bp
Total stockholders' equity/total assets (2)
   
9.58
%
   
9.57
%
   
1
 
bp
   
9.58
%
   
9.57
%
   
1
 
bp
 
bp - denotes basis points; 100 bp equals 1%.
(1)
Represents net interest income plus total non-interest income.
(2)
The ratio of total stockholders' equity to total assets is the most comparable U.S. GAAP measure to the non-GAAP tangible common equity ratio presented herein.
 
At June 30, 2016, the Company, on a consolidated basis, had total assets of $2.2 billion, total deposits of $1.9 billion and total stockholders’ equity of $210 million. The Company recorded net income of $5.8 million, or $0.48 per diluted common share, for the second quarter of 2016, compared to $5.1 million, or $0.43 per diluted common share, for the same period in 2015. The 13.0% increase in second quarter 2016 earnings versus the comparable 2015 period resulted principally from a $1.2 million increase in net interest income coupled with a $191 thousand increase in non-interest income. Partially offsetting these improvements was a $145 thousand increase in total operating expenses and a higher effective tax rate (27.2% versus 23.6%) in 2016 when compared to the second quarter of 2015. The Company did not record a provision for loan losses in either period. Adjusting for the impact of net non-accrual interest received in each period and other real estate owned (“OREO”) expenses in 2016, core net income increased by 31.0% to $5.7 million in the second quarter of 2016 from $4.4 million in the comparable 2015 period. (See also Non-GAAP Disclosure contained herein.)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(in thousands)
 
2016
   
2015
   
2016
   
2015
 
CORE NET INCOME:
                       
Net income, as reported
 
$
5,785
   
$
5,118
   
$
10,623
   
$
9,127
 
                                 
Adjustments:
                               
Net non-accrual interest adjustment
   
(75
)
   
(967
)
   
(126
)
   
(974
)
OREO-related expenses
   
6
     
-
     
96
     
-
 
Total adjustments, before income taxes
   
(69
)
   
(967
)
   
(30
)
   
(974
)
Adjustment for reported effective income tax rate
   
(19
)
   
(228
)
   
(8
)
   
(230
)
Total adjustments, after income taxes
   
(50
)
   
(739
)
   
(22
)
   
(744
)
                                 
Core net income
 
$
5,735
   
$
4,379
   
$
10,601
   
$
8,383
 
 
The Company’s return on average assets and return on average common stockholders’ equity were 1.05% and 11.23%, respectively, in the second quarter of 2016 versus 1.06% and 10.88%, respectively, in the second quarter of 2015.
 
The Company continued its core growth strategy of protecting and enhancing its eastern Suffolk lending franchise while simultaneously expanding west. This strategy allowed the Company to continue to expand into markets in Nassau County and New York City that are very attractive from a demographic standpoint and have an abundance of small and middle market businesses, the kinds of businesses that have comprised the Company’s core customer base throughout its history. Thus far in 2016, despite sales of approximately $48 million in portfolio multifamily loans during the second quarter, the Company has experienced a $63 million or 3.8% increase in the total loan portfolio, from $1.666 billion at December 31, 2015 to $1.730 billion at June 30, 2016. Total loans at June 30, 2016 represented a 17.2% increase from the comparable 2015 date. As the Company has previously articulated, the strong market for the kind of high quality multifamily loans it has originated provided the Company with the flexibility to periodically complete strategic sales of such loans, allowing the Company to generate non-interest income, protect net interest margin and address market and regulatory concerns regarding commercial real estate loan concentration levels. The Company does not anticipate any additional loan sales in 2016.

Credit quality continues to be strong in all categories. Total non-accrual loans at June 30, 2016 were $6.9 million, or 0.40% of total loans, compared to $5.5 million, or 0.33% of total loans at December 31, 2015 and $5.5 million, or 0.37% of total loans, in the comparable quarter a year ago. The increase in total non-accrual loans in 2016 was attributable to management’s decision to place a single relationship on non-accrual status in the first quarter of 2016, notwithstanding the fact that the Company believes it is adequately collateralized and is working with a cooperative borrower who remains current on all payment obligations. All other key credit metrics remain solid and reflect the Company’s commitment to a strong and disciplined credit culture. Early delinquencies (30-89 days past due), which are managed aggressively as a harbinger of future credit issues, remained extremely low at $1.4 million, or 0.08% of total loans at June 30, 2016. Given the continuous improvement the Company has experienced in its credit profile, management believes the Company is well reserved. The allowance for loan losses at June 30, 2016 was $21.0 million, or 1.21% of total loans and 304% of total non-accrual loans.

Total core deposits, consisting of demand, N.O.W., savings and money market accounts of $1.723 billion at June 30, 2016, grew approximately $83 million during the quarter, enabling the Company to fund its quarterly loan production through core deposit growth. Total core deposits represented 88% of total deposits at June 30, 2016. Total deposits, including time deposits, were $1.9 billion at June 30, 2016, representing a 13.4% increase from the comparable quarter a year ago. In addition, at the end of the second quarter, 44% of the Company’s total deposits were non-interest bearing demand deposits, resulting in a cost of funds of 20 basis points and a net interest margin and core net interest margin of 3.87% and 3.86%, respectively. The Company’s cost of funds and resulting margin compared favorably to most of the industry for the same period.

The Company’s management continues to be vigilant in controlling operating expenses and improving efficiency. Total operating expenses in the second quarter of 2016 were $13.3 million, virtually flat to the $13.2 million in the first quarter of 2016 and the $13.2 million incurred in the comparable quarter a year ago. This translated into reductions in the Company’s operating efficiency and core operating efficiency ratios during the second quarter of 2016 to 59.8% and 60.0%, respectively, from 61.4% and 61.5%, respectively, in the first quarter of 2016 and from 63.2% and 66.3%, respectively, in the comparable quarter a year ago. (See also Non-GAAP Disclosure contained herein.)
 

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
(in thousands)
 
2016
   
2015
   
2016
   
2015
 
                         
Core operating expenses:
                       
Total operating expenses
 
$
13,319
   
$
13,174
   
$
26,471
   
$
26,282
 
Adjust for OREO-related expenses
   
(6
)
   
-
     
(96
)
   
-
 
Core operating expenses
   
13,313
     
13,174
     
26,375
     
26,282
 
                                 
Core non-interest income:
                               
Total non-interest income
   
2,241
     
2,050
     
4,133
     
4,141
 
Adjustments
   
-
     
-
     
-
     
-
 
Core non-interest income
   
2,241
     
2,050
     
4,133
     
4,141
 
Adjust for tax-equivalent basis
   
225
     
198
     
451
     
400
 
Core FTE non-interest income
   
2,466
     
2,248
     
4,584
     
4,541
 
                                 
Core net interest income:
                               
FTE net interest income
   
19,829
     
18,760
     
39,008
     
36,255
 
Net non-accrual interest adjustment
   
(75
)
   
(967
)
   
(126
)
   
(974
)
Core FTE net interest income
   
19,754
     
17,793
     
38,882
     
35,281
 
                                 
Core operating efficiency ratio:
                               
Core operating expenses
   
13,313
     
13,174
     
26,375
     
26,282
 
Core FTE net interest income
   
19,754
     
17,793
     
38,882
     
35,281
 
Core FTE non-interest income
   
2,466
     
2,248
     
4,584
     
4,541
 
Adjust for net gain on sale of securities available for sale
   
(18
)
   
(160
)
   
(24
)
   
(186
)
Total FTE revenue
   
22,202
     
19,881
     
43,442
     
39,636
 
Core operating expenses/total FTE revenue
   
59.96
%
   
66.26
%
   
60.71
%
   
66.31
%

Critical Accounting Policies, Judgments and Estimates - The Company’s accounting and reporting policies conform to U.S. GAAP and general practices within the banking industry. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.

Allowance for Loan Losses - One  of  the  most  critical  accounting policies impacting the Company’s financial statements is the evaluation of the allowance for loan losses. The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a quarterly analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company’s own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction and residential mortgages loan classes and all troubled debt restructurings (“TDRs”) are evaluated individually for impairment. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics. These classes are commercial and industrial, commercial real estate, multifamily, mixed use commercial, real estate construction, residential mortgages, home equity and consumer loans.

The allowance for loan losses consists of specific and general components, as well as an unallocated component. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment or liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on the fair market value of collateral and the estimated time required to recover the Company’s investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan’s effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data. These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors include consideration of the following: levels and trends in various risk rating categories; levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures and practices; experience, ability, and depth of lending management and other relevant staff; local, regional and national economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. These adjustments reflect management’s overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
 
Deferred Tax Assets and Liabilities – Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities, computed using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a future benefit will be realized. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.  The realization of deferred tax assets (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carryback losses to available tax years. In assessing the need for a valuation allowance, the Company considers all relevant positive and negative evidence, including taxable income in carryback years, scheduled reversals of deferred tax liabilities, expected future taxable income and available tax planning strategies.

Other-Than-Temporary Impairment (“OTTI”) of Investment Securities – Management evaluates securities for OTTI on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the statement of income and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

Material Changes in Financial Condition - Total assets of the Company were $2.2 billion at June 30, 2016. When compared to December 31, 2015, total assets increased by $28 million. This change was primarily due to loan growth and an increase in total cash and cash equivalents of $63 million and $33 million, respectively, partially offset by a decrease in total investment securities of $64 million.

Total loans were $1.73 billion at June 30, 2016, an increase from $1.67 billion at December 31, 2015. The increase in the loan portfolio was primarily due to growth of C&I and commercial real estate loans of $26 million and $38 million, respectively, in the first half of 2016.

Total investment securities were $245 million at June 30, 2016 and $308 million at December 31, 2015. The decrease largely reflected maturities and calls of municipal obligations and U.S. Government agency securities totaling $77 million, coupled with principal paydowns of collateralized mortgage obligations and mortgage-backed securities of U.S. Government-sponsored enterprises totaling $5 million during the first six months of 2016. These decreases were partially offset by purchases of collateralized mortgage obligations and mortgage-backed securities of U.S. Government-sponsored enterprises and corporate bonds totaling $12 million during the same period. The available for sale securities portfolio had an unrealized pre-tax gain of $6.1 million at June 30, 2016 compared to a gain of $2.4 million at year-end 2015.

At June 30, 2016, total deposits were $1.9 billion, an increase of $168 million when compared to December 31, 2015. This increase was primarily due to higher balances of demand, N.O.W., savings and money market deposits of $75 million, $4 million, $24 million and $64 million, respectively. Additionally, time deposit balances increased $1 million over the same period. Core deposit balances, which consist of demand, savings, N.O.W. and money market deposits, represented 88% of total deposits at June 30, 2016 and 87% of total deposits at December 31, 2015. Demand deposit balances represented 44% of total deposits at June 30, 2016 and December 31, 2015. At June 30, 2016 and December 31, 2015, the Company had $15 million and $165 million, respectively, in borrowings used to fund the growth in the Company’s loan portfolio, including $15 million in five-year FHLB borrowings with a fixed rate of 1.76%.
 
Liquidity and Capital Resources - Liquidity management is defined as both the Company’s and the Bank’s ability to meet their financial obligations on a continuous basis without material loss or disruption of normal operations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, funding new and existing loan commitments and the ability to take advantage of business opportunities as they arise. Asset liquidity is provided by short-term investments, such as fed funds sold, and the marketability of securities available for sale. The Company may also leave excess reserve balances at the Federal Reserve Bank (“FRB”) if the rate being paid is higher than would be available from other short-term investments. Liquid assets, consisting of securities available for sale and balances at the FRB, increased to $292 million at June 30, 2016 compared to $268 million at December 31, 2015. These liquid assets may include assets that have been pledged primarily against municipal deposits or borrowings. In addition, the Company has pledged U.S. Government agency securities held in its available for sale portfolio, with a market value of approximately $3 million at June 30, 2016, as collateral for the derivative swap contracts. Liquidity is also provided by the maintenance of a base of core deposits, maturing short-term assets including cash and due from banks, the ability to sell or pledge marketable assets and access to lines of credit.

Liquidity is continuously monitored, thereby allowing management to better understand and react to emerging balance sheet trends, including temporary mismatches with regard to sources and uses of funds. After assessing actual and projected cash flow needs, management seeks to obtain funding at the most economical cost. These funds can be obtained by converting liquid assets to cash or by attracting new deposits or other sources of funding. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served, loan demand, its asset/liability mix, its reputation and credit standing in its markets and general economic conditions. Borrowings and the scheduled amortization of investment securities and loans are more predictable funding sources. Deposit flows and securities prepayments are somewhat less predictable as they are often subject to external factors. Among these are changes in the local and national economies, competition from other financial institutions and changes in market interest rates.

The Company’s primary sources of funds are cash provided by deposits and borrowings, proceeds from maturities and sales of securities available for sale and cash provided by operating activities. At June 30, 2016, total deposits were $1.9 billion, an increase of $168 million when compared to December 31, 2015. Of the $226 million in total time deposits at June 30, 2016, $197 million are scheduled to mature within the next 12 months. Based on historical experience, the Company expects to be able to replace a substantial portion of those maturing deposits with comparable deposit products. At June 30, 2016 and December 31, 2015, the Company had $15 million and $165 million, respectively, in borrowings used to fund the growth in the Company’s loan portfolio. For the six months ended June 30, 2016 and 2015, proceeds from sales and maturities of securities available for sale totaled $43 million and $28 million, respectively.

The Company’s primary uses of funds are for the origination of loans and the purchase of investment securities. For the six months ended June 30, 2016, the Company had net loan originations for portfolio of $113 million compared to $121 million for the same period in 2015. For the six months ended June 30, 2016 and 2015, the Company purchased investment securities totaling $13 million and $10 million, respectively.

The Bank’s Asset/Liability and Funds Management Policy establishes specific policies and operating procedures governing liquidity levels to assist management in developing plans to address future and current liquidity needs. Management monitors the rates and cash flows from the loan and investment portfolios while also examining the maturity structure and volatility characteristics of liabilities to develop an optimum asset/liability mix. Available funding sources include retail, commercial and municipal deposits, purchased liabilities and stockholders’ equity. At June 30, 2016, access to approximately $682 million in FHLB lines of credit for overnight or term borrowings with maturities of up to thirty years was available. At June 30, 2016, approximately $60 million and $10 million in unsecured and secured lines of credit, respectively, extended by correspondent banks were also available to be utilized, if needed, for short-term funding purposes. At June 30, 2016, $15 million in borrowings were outstanding with the FHLB. No borrowings were outstanding under lines of credit with correspondent banks.

The Bank also has the ability to access the brokered deposit market. Deposits gathered through the Certificate of Deposit Account Registry Service (“CDARS”) are considered for regulatory purposes to be brokered deposits. At June 30, 2016, the Bank had $2.1 million in CDARS deposits outstanding.

The Company strives to maintain an efficient level of capital, commensurate with its risk profile, on which a competitive rate of return to stockholders will be realized over both the short and long term. Capital is managed to enhance stockholder value while providing flexibility for management to act opportunistically in a changing marketplace. Management continually evaluates the Company’s capital position in light of current and future growth objectives and regulatory guidelines. Total stockholders’ equity was $210 million at June 30, 2016 compared to $197 million at December 31, 2015. The increase in stockholders’ equity versus December 31, 2015 was primarily due to net income, net of dividends paid, recorded during 2016.
 
The Company and the Bank are subject to regulatory capital requirements. The Company’s tier 1 leverage, common equity tier 1 risk-based, tier 1 risk-based and total risk-based capital ratios were 9.66%, 12.04%, 12.04% and 13.24%, respectively, at June 30, 2016, exceeding all regulatory requirements. The Bank’s tier 1 leverage, common equity tier 1 risk-based, tier 1 risk-based and total risk-based capital ratios were 9.55%, 11.90%, 11.90% and 13.10%, respectively, at June 30, 2016. Each of these ratios exceeds the regulatory guidelines for a well-capitalized institution, the highest regulatory capital category. Moreover, capital rules also place limits on capital distributions and certain discretionary bonus payments if a banking organization does not maintain a buffer of common equity tier 1 capital above minimum capital requirements. The capital buffer requirement is being phased in beginning January 1, 2016 at 0.625% per year until it becomes 2.50% in 2019 and thereafter. At June 30, 2016, the Company’s and the Bank’s capital buffers were in excess of both the current and fully phased-in requirements.

In addition, the OCC, the Company’s primary bank regulator, established individual minimum capital ratios for the Bank, which requires the Bank to establish and maintain levels of capital greater than those generally required for a “well capitalized” institution, that requires it to maintain a tier 1 leverage ratio of at least 9%, a tier 1 risk-based capital ratio of at least 11% and a total risk-based capital ratio of at least 12%. At June 30, 2016, the Bank satisfied these capital ratios.

The Company did not repurchase any shares of its common stock during the first half of 2016. Repurchase of shares will occur only if management believes that the purchase will be at prices that are accretive to earnings per share and is the most efficient use of the Company’s capital.

The Company’s total stockholders’ equity to total assets ratio and the Company’s tangible common equity to tangible assets ratio  (“TCE ratio”) were 9.58% and 9.46%, respectively, at June 30, 2016 versus 9.10% and 8.98%, respectively, at December 31, 2015 and 9.57% and 9.43%, respectively, at June 30, 2015. The ratio of total stockholders’ equity to total assets is the most comparable U.S. GAAP measure to the non-GAAP TCE ratio presented herein. The ratio of tangible common equity to tangible assets, or TCE ratio, is calculated by dividing total common stockholders’ equity by total assets, after reducing both amounts by intangible assets. The TCE ratio is not required by U.S. GAAP or by applicable bank regulatory requirements, but is a metric used by management to evaluate the adequacy of our capital levels. Since there is no authoritative requirement to calculate the TCE ratio, our TCE ratio is not necessarily comparable to similar capital measures disclosed or used by other companies in the financial services industry. Tangible common equity and tangible assets are non-GAAP financial measures and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with U.S. GAAP. Set forth below are the reconciliations of tangible common equity to U.S. GAAP total common stockholders’ equity and tangible assets to U.S. GAAP total assets at June 30, 2016 (in thousands). (See also Non-GAAP Disclosure contained herein.)
 
                 
Ratios
     
Total stockholders' equity
 
$
210,307
 
Total assets
 
$
2,196,375
     
9.58
%
    (1)
Less: intangible assets
   
(2,756
)
Less: intangible assets
   
(2,756
)
           
Tangible common equity
 
$
207,551
 
Tangible assets
 
$
2,193,619
     
9.46
%
   (2)
 
 
(1)
The ratio of total stockholders' equity to total assets is the most comparable U.S. GAAP measure to the non-GAAP tangible common equity ratio presented herein.
 
(2)
TCE ratio.
 
All dividends must conform to applicable statutory requirements. The Company’s ability to pay dividends to stockholders depends on the Bank’s ability to pay dividends to the Company. Under 12 USC 56-9, a national bank may not pay a dividend on its common stock if the dividend would exceed net undivided profits then on hand. Further, under 12 USC 60, a national bank must obtain prior approval from the OCC to pay dividends on either common or preferred stock that would exceed the bank’s net profits for the current year combined with retained net profits (net profits minus dividends paid during that period) of the prior two years. The ability of the Bank to pay dividends to the Company is subject to certain regulatory restrictions. Generally, dividends declared in a given year by a national bank are limited to its net profit, as defined by regulatory agencies, for that year, combined with its retained net income for the preceding two years, less any required transfer to surplus or to fund for the retirement of any preferred stock. In addition, a national bank may not pay dividends in an amount greater than its undivided profits or declare any dividends if such declaration would leave the bank inadequately capitalized.

The Company’s Board of Directors declared two quarterly cash dividends, each $0.10 per common share, during the first half of 2016. Two quarterly dividends, each $0.06 per common share, were declared during the comparable 2015 period.
 
Off-Balance Sheet Arrangements - The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated financial statements. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer. Collateral required varies, but may include accounts receivable, inventory, equipment, real estate and income-producing commercial properties. At June 30, 2016 and December 31, 2015, commitments to originate loans and commitments under unused lines of credit for which the Bank is obligated amounted to approximately $147 million and $126 million, respectively.

Letters of credit are conditional commitments guaranteeing payments of drafts in accordance with the terms of the letter of credit agreements. Commercial letters of credit are used primarily to facilitate trade or commerce and are also issued to support public and private borrowing arrangements, bond financing and similar transactions. Collateral may be required to support letters of credit based upon management’s evaluation of the creditworthiness of each customer. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Most letters of credit expire within one year. At June 30, 2016 and December 31, 2015, letters of credit outstanding were approximately $14 million and $15 million, respectively.

Material Changes in Results of Operations – Comparison of the Quarters Ended June 30, 2016 and 2015 - The Company recorded net income of $5.8 million during the second quarter of 2016 versus $5.1 million in the comparable quarter a year ago. The 13.0% improvement in second quarter 2016 net income resulted from a $1.2 million increase in net interest income and growth in non-interest income of $191 thousand, largely the result of a $457 thousand net gain on the sales of portfolio loans recorded in 2016. Partially offsetting these positive factors was a $145 thousand increase in total operating expenses and an increase in the effective tax rate to 27.2% in 2016 from 23.6% a year ago. The Company did not record a provision for loan losses in either the second quarter of 2016 or 2015.

The $1.2 million or 6.7% improvement in second quarter 2016 net interest income resulted from a $271 million (15.1%) increase in average total interest-earning assets. Partially offsetting the earning asset growth was a 33 basis point decline in the Company’s net interest margin to 3.87% in 2016 from 4.20% in 2015. Adjusting for the impact of net non-accrual interest received in each period, the Company’s core net interest margin was 3.86% in the second quarter of 2016 versus 3.98% in the comparable 2015 period. (See also Non-GAAP Disclosure contained herein.)

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2016
   
2015
   
2016
   
2015
 
Core net interest margin:
                       
FTE net interest margin
   
3.87
%
   
4.20
%
   
3.84
%
   
4.10
%
Net non-accrual interest adjustment
   
(0.01
)
   
(0.22
)
   
(0.02
)
   
(0.11
)
Core FTE net interest margin
   
3.86
%
   
3.98
%
   
3.82
%
   
3.99
%
 
The Company’s second quarter 2016 average total interest-earning asset yield was 4.07% versus 4.37% in the comparable 2015 quarterly period. The decrease in the interest-earning asset yield in 2016 resulted from a 38 basis point decline in the average loan yield to 4.19% in 2016 principally due to the receipt of $967 thousand in net non-accrual interest in 2015 versus $75 thousand in 2016. The Company’s average balance sheet mix continued to improve as average loans increased by $336 million (23.7%) versus second quarter 2015. The average securities portfolio decreased by $79 million to $269 million in the second quarter of 2016 versus the comparable 2015 period.  The average yield on the investment portfolio was 3.63% in 2016 versus 3.77% a year ago.

The Company’s average cost of total interest-bearing liabilities increased by five basis points to 0.35% in the second quarter of 2016 versus 0.30% in the comparable 2015 quarter. The Company’s total cost of funds, among the lowest in the industry, increased to 0.20% in the second quarter of 2016 versus 0.18% a year ago. Average core deposits increased $253 million (17.8%) to $1.7 billion during the second quarter of 2016 versus the second quarter of 2015, with average demand deposits representing 43% of second quarter 2016 average total deposits. Total deposits increased by $231 million or 13.4% to $1.9 billion at June 30, 2016 versus June 30, 2015. Core deposit balances, which represented 88% of total deposits at June 30, 2016, grew by $247 million or 16.7% during the same period. Average borrowings increased $17 million (23.8%) during the second quarter of 2016 compared to 2015 and were used, in part, to fund the growth in the Company’s loan portfolio.
 
NET INTEREST INCOME ANALYSIS
For the Three Months Ended June 30, 2016 and 2015
(unaudited, dollars in thousands)

   
2016
   
2015
 
   
Average
Balance
   
Interest
 
Average
Yield/Cost
   
Average
Balance
   
Interest
   
Average
Yield/Cost
 
Assets:
                                 
Interest-earning assets:
                                 
Investment securities (1)
 
$
268,740
   
$
2,428
     
3.63
%
 
$
347,895
   
$
3,269
     
3.77
%
Federal Reserve and Federal Home Loan Bank stock and other investments
   
7,606
     
108
     
5.71
     
6,274
     
90
     
5.75
 
Federal funds sold, securities purchased under agreements to resell and interest-bearing deposits due from banks
   
32,420
     
29
     
0.36
     
20,072
     
20
     
0.40
 
Loans and performing loans held for sale (2)
 
 
1,752,568
     
18,276
 
 
 
4.19
     
1,416,310
     
16,136
     
4.57
 
Total interest-earning assets
 
 
2,061,334
   
$
20,841
 
 
 
4.07
%    
1,790,551
   
$
19,515
     
4.37
%
Non-interest-earning assets
   
159,804
                     
146,587
                 
Total assets
 
$
2,221,138
                   
$
1,937,138
                 
                                                 
Liabilities and stockholders' equity:
                                               
Interest-bearing liabilities:
                                               
Savings, N.O.W. and money market deposits
 
$
852,094
   
$
510
     
0.24
%
 
$
700,875
   
$
294
     
0.17
%
Time deposits
   
228,687
     
336
     
0.59
     
233,757
     
353
     
0.61
 
Total savings and time deposits
   
1,080,781
     
846
     
0.31
     
934,632
     
647
     
0.28
 
Borrowings
   
85,897
     
166
     
0.78
     
69,391
     
108
     
0.62
 
Total interest-bearing liabilities
   
1,166,678
     
1,012
     
0.35
     
1,004,023
     
755
     
0.30
 
Demand deposits
   
823,834
                     
721,907
                 
Other liabilities
   
23,507
                     
22,603
                 
Total liabilities
   
2,014,019
                     
1,748,533
                 
Stockholders' equity
   
207,119
                     
188,605
                 
Total liabilities and stockholders' equity
 
$
2,221,138
                   
$
1,937,138
                 
Total cost of funds
                   
0.20
%
                   
0.18
%
Net interest rate spread
               
 
 
3.72
%                    
4.07
%
Net interest income/margin
           
19,829
 
 
 
3.87
%            
18,760
     
4.20
%
Less tax-equivalent basis adjustment
           
(807
)
                   
(939
)
       
Net interest income
         
$
19,022
                   
$
17,821
         
 
(1)
Interest on securities includes the effects of tax-equivalent basis adjustments of $572 and $798 in 2016 and 2015, respectively.
(2)
Interest on loans includes the effects of tax-equivalent basis adjustments of $235 and $141 in 2016 and 2015, respectively.
 
The Company did not record a provision for loan losses in the second quarter of 2016 or 2015. The adequacy of the provision and the resulting allowance for loan losses, which was $21.0 million at June 30, 2016, is determined by management’s ongoing review of the loan portfolio, including identification and review of individual problem situations that may affect a borrower’s ability to repay, delinquency and non-performing loan data including the current status of criticized and classified loans, collateral values and changes in the size and mix of the loan portfolio. (See also Critical Accounting Policies, Judgments and Estimates and Asset Quality contained herein.)

Non-interest income increased by $191 thousand in the second quarter of 2016 versus the comparable 2015 period. This improvement was principally due to an increase in net gain on the sales of portfolio loans (up $457 thousand) in the second quarter of 2016. Partially offsetting this improvement were reductions in service charges on deposits (down $209 thousand) and net gain on the sale of securities available for sale (down $142 thousand). The net gain on the sale of portfolio loans in the second quarter of 2016 resulted from two sales of performing multifamily loans in that period. No portfolio loans were sold in the second quarter of 2015.
 
Non-Interest Income
For the quarters and six months ended June 30, 2016 and 2015
(dollars in thousands)

   
Quarters ended June 30,
   
Over/
(under)
   
Six months ended June 30,
   
Over/
(under)
 
   
2016
   
2015
   
2015
   
2016
   
2015
   
2015
 
Service charges on deposit accounts
 
$
614
   
$
823
     
(25.4
)%
 
$
1,390
   
$
1,570
     
(11.5
)%
Other service charges, commissions and fees
   
684
     
680
     
0.6
     
1,295
     
1,273
     
1.7
 
Net gain on sale of securities available for sale
   
18
     
160
     
(88.8
)    
24
     
186
     
(87.1
)
Net gain on sale of portfolio loans
   
457
     
-
     
N/M
(1)
   
457
     
198
     
130.8
 
Net gain on sale of mortgage loans originated for sale
   
73
     
61
     
19.7
     
147
     
205
     
(28.3
)
Income from bank-owned life insurance
   
345
     
303
     
13.9
     
691
     
612
     
12.9
 
Other operating income
   
50
     
23
     
117.4
     
129
     
97
     
33.0
 
Total non-interest income
 
$
2,241
   
$
2,050
     
9.3
%
 
$
4,133
   
$
4,141
     
(0.2
 
)%

(1)
N/M - denotes % variance not meaningful for statistical purposes.
 
Total operating expenses increased by $145 thousand or 1.1% in the second quarter of 2016 versus 2015 principally the result of growth in other operating expenses of $349 thousand, consulting and professional services expense of $75 thousand and equipment expense of $57 thousand. Partially offsetting these increases was a reduction in 2016 data processing costs of $280 thousand versus the comparable 2015 period. The increase in consulting and professional services expense was largely due to a $69 thousand increase in recruitment fees in 2016, while the increase in other operating expenses reflected a $255 thousand increase in expenses associated with loan appraisal and filing fees incurred during the second quarter of 2016. The improvement in data processing costs resulted from lower core systems expenses in 2016.

The Company’s operating efficiency ratio improved to 59.8% in the second quarter of 2016 from 63.2% a year ago. The Company’s core operating efficiency ratio improved to 60.0% in the second quarter of 2016 from 66.3% a year ago. The core operating efficiency ratio is calculated by making certain adjustments to the operating efficiency ratio calculation. The core operating efficiency ratio is not required by U.S. GAAP or by applicable bank regulatory requirements, but is a metric used by management to evaluate core operating efficiency. Since there is no authoritative requirement to calculate this ratio, our ratio is not necessarily comparable to similar efficiency measures disclosed or used by other companies in the financial services industry. The core operating efficiency ratio is a non-GAAP financial measure and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with U.S. GAAP. The calculation of the core operating efficiency ratio, the reconciliation of core operating expenses to U.S. GAAP total operating expenses, core non-interest income to U.S. GAAP total non-interest income and core FTE net interest income to FTE net interest income are provided elsewhere herein. (See also Non-GAAP Disclosure contained herein.)

Operating Expenses
For the quarters and six months ended June 30, 2016 and 2015
(dollars in thousands)

   
Quarters ended June 30,
   
Over/
(under)
   
Six months ended June 30,
   
Over/
(under)
 
   
2016
   
2015
   
2015
   
2016
   
2015
   
2015
 
Employee compensation and benefits
 
$
8,482
   
$
8,516
     
(0.4
)%
 
$
17,148
   
$
17,122
     
0.2
%
Occupancy expense
   
1,346
     
1,373
     
(2.0
)
   
2,788
     
2,835
     
(1.7
)
Equipment expense
   
461
     
404
     
14.1
     
847
     
789
     
7.4
 
Consulting and professional services
   
619
     
544
     
13.8
     
1,102
     
882
     
24.9
 
FDIC assessment
   
291
     
286
     
1.7
     
584
     
576
     
1.4
 
Data processing
   
234
     
514
     
(54.5
)
   
413
     
1,084
     
(61.9
)
Other operating expenses
   
1,886
     
1,537
     
22.7
     
3,589
     
2,994
     
19.9
 
Total operating expenses
 
$
13,319
   
$
13,174
     
1.1
%
 
$
26,471
   
$
26,282
     
0.7
%
 
The Company recorded income tax expense of $2.2 million in the second quarter of 2016 resulting in an effective tax rate of 27.2% versus an income tax expense of $1.6 million and an effective tax rate of 23.6% in the comparable period a year ago. The increase in the 2016 effective tax rate resulted from growth in pre-tax income taxed at the 35% federal rate, coupled with a reduction in tax-exempt securities income versus the comparable 2015 period.

Material Changes in Results of Operations – Comparison of the Six Months Ended June 30, 2016 and 2015 - The Company recorded net income of $10.6 million during the first six months of 2016 versus $9.1 million in the comparable 2015 period.  The improvement in 2016 net income resulted principally from a $3.0 million increase in net interest income in the first half of 2016, partially offset by a $189 thousand increase in total operating expenses and an increase in the Company’s effective tax rate in 2016.

The $3.0 million or 8.8% improvement in June year-to-date 2016 net interest income resulted from a $259 million increase in average total interest-earning assets, offset in part by a 26 basis point contraction of the Company’s net interest margin to 3.84% in 2016 from 4.10% in 2015. The Company’s June year-to-date 2016 average total interest-earning asset yield was 4.05% versus 4.26% in the comparable 2015 year-to-date period. A lower average yield on the Company’s loan portfolio in the first half of 2016 versus the comparable 2015 period, down 25 basis points to 4.19%, was the primary driver of the reduction in the interest-earning asset yield.  Excluding the impact of net non-accrual interest received in each year-to-date period, the Company’s core net interest margin was 3.82% in 2016 versus 3.99% in 2015. The Company’s average loan portfolio increased by $317 million (22.6%) versus June year-to-date 2015 while the average securities portfolio decreased by $67 million (19.0%) to $287 million in the same period. The average yield on the investment portfolio was 3.61% in this 2016 period versus 3.79% a year ago.

The Company’s average cost of total interest-bearing liabilities increased by eight basis points to 0.36% in the first six months of 2016 versus 0.28% in the comparable 2015 period. The Company’s total cost of funds increased by five basis points to 0.22% in the first half of 2016 versus 2015. Average core deposits increased by $248 million to $1.6 billion during the first six months of 2016 versus the comparable 2015 period, with average demand deposits representing 43% of year-to-date 2016 average total deposits. Average total deposits increased by $251 million or 15.5% to $1.9 billion during the first half of 2016 versus 2015. Average core deposit balances represented 88% of average total deposits during the same period. Average borrowings increased by $14 million during the first half of 2016 compared to 2015 and represented 6% of total average funding during the June 2016 year-to-date period.
 
NET INTEREST INCOME ANALYSIS
For the Six Months Ended June 30, 2016 and 2015
(unaudited, dollars in thousands)

   
2016
   
2015
 
   
Average
Balance
   
Interest
   
Average
Yield/Cost
   
Average
Balance
   
Interest
   
Average
Yield/Cost
 
Assets:
                                   
Interest-earning assets:
                                   
Investment securities (1)
 
$
286,539
   
$
5,143
     
3.61
%
 
$
353,622
   
$
6,647
     
3.79
%
Federal Reserve and Federal Home Loan Bank stock and other investments
   
8,492
     
183
     
4.33
     
7,299
     
150
     
4.14
 
Federal funds sold, securities purchased under agreements to resell and interest-bearing deposits due from banks
   
30,976
     
58
     
0.38
     
23,101
     
43
     
0.38
 
Loans and performing loans held for sale (2)
 
 
1,716,730      
35,739
   
 
4.19      
1,399,776
     
30,846
     
4.44
 
Total interest-earning assets
 
 
2,042,737    
$
41,123
   
 
4.05 %    
1,783,798
   
$
37,686
     
4.26
%
Non-interest-earning assets
 
 
161,807                      
137,549
                 
Total assets
 
$
2,204,544
                   
$
1,921,347
                 
                                                 
Liabilities and stockholders' equity:
                                               
Interest-bearing liabilities:
                                               
Savings, N.O.W. and money market deposits
 
$
843,274
   
$
1,023
     
0.24
%
 
$
694,785
   
$
568
     
0.16
%
Time deposits
   
227,288
     
684
     
0.61
     
224,510
     
647
     
0.58
 
Total savings and time deposits
   
1,070,562
     
1,707
     
0.32
     
919,295
     
1,215
     
0.27
 
Borrowings
   
110,152
     
408
     
0.74
     
96,600
     
216
     
0.45
 
Total interest-bearing liabilities
   
1,180,714
     
2,115
     
0.36
     
1,015,895
     
1,431
     
0.28
 
Demand deposits
   
794,993
                     
695,407
                 
Other liabilities
   
24,449
                     
23,261
                 
Total liabilities
   
2,000,156
                     
1,734,563
                 
Stockholders' equity
   
204,388
                     
186,784
                 
Total liabilities and stockholders' equity
 
$
2,204,544
                   
$
1,921,347
                 
Total cost of funds
                   
0.22
%
                   
0.17
%
Net interest rate spread
                 
 
3.69 %                    
3.98
%
Net interest income/margin
           
39,008
   
 
3.84 %            
36,255
     
4.10
%
Less tax-equivalent basis adjustment
           
(1,662
)
                   
(1,917
)
       
Net interest income
         
$
37,346
                   
$
34,338
         

(1)
Interest on securities includes the effects of tax-equivalent basis adjustments of $1,186 and $1,635 in 2016 and 2015, respectively.
(2)
Interest on loans includes the effects of tax-equivalent basis adjustments of $476 and $282 in 2016 and 2015, respectively.
 
The Company recorded a provision for loan losses of $250 thousand during the first six months of 2016 and 2015.

Total non-interest income decreased 0.2% during the first half of 2016 versus the comparable 2015 period. Reductions in service charges on deposits (down $180 thousand), net gain on sale of securities available for sale (down $162 thousand) and net gain on sale of mortgage loans originated for sale (down $58 thousand) were partially offset by increases in net gain on sale of portfolio loans and income from bank-owned life insurance of $259 thousand and $79 thousand, respectively.

Total operating expenses increased by $189 thousand (0.7%) in the first half of 2016 versus 2015 as the result of growth in other operating expenses (up $595 thousand) and consulting and professional services (up $220 thousand), offset in part by a $671 thousand reduction in data processing costs. The Company’s operating efficiency ratio improved to 60.5% in the first six months of 2016 from 64.7% a year ago. The Company’s core operating efficiency ratio improved to 60.7% in the first half of 2016 from 66.3% a year ago. (See also Non-GAAP Disclosure contained herein.)

The Company recorded income tax expense of $4.1 million in the year-to-date June 2016 period resulting in an effective tax rate of 28.0% versus an income tax expense of $2.8 million and an effective tax rate of 23.6% in the comparable period a year ago.
 
Asset Quality - Non-accrual loans totaled $6.9 million or 0.40% of loans outstanding at June 30, 2016 versus $5.5 million or 0.33% of loans outstanding at December 31, 2015 and $5.5 million or 0.37% of total loans outstanding at June 30, 2015. The allowance for loan losses as a percentage of total non-accrual loans amounted to 304%, 374% and 363% at June 30, 2016, December 31, 2015 and June 30, 2015, respectively. Total accruing loans delinquent 30 days or more amounted to $1.4 million or 0.08% of loans outstanding at June 30, 2016 compared to $1.0 million or 0.06% of loans outstanding at December 31, 2015 and $4.6 million or 0.31% of loans outstanding at June 30, 2015.
 
Total criticized and classified loans were $25 million at June 30, 2016 versus $21 million at December 31, 2015 and $33 million at June 30, 2015. Criticized loans are those loans that are not classified but require some degree of heightened monitoring. Classified loans were $10 million at June 30, 2016 as compared to $12 million at December 31, 2015 and $18 million at June 30, 2015. The allowance for loan losses as a percentage of total classified loans was 204%, 170% and 114%, respectively, at the same dates.

At June 30, 2016, the Company had $10 million in TDRs, primarily consisting of commercial and industrial loans, commercial real estate loans, residential mortgages and home equity loans totaling $1 million, $3 million, $5 million and $1 million, respectively. The Company had TDRs amounting to $12 million and $13 million at December 31, 2015 and June 30, 2015, respectively.

At June 30, 2016, the Company’s allowance for loan losses amounted to $21.0 million or 1.21% of period-end loans outstanding. The allowance as a percentage of loans outstanding was 1.24% at December 31, 2015 and 1.36% at June 30, 2015. The Company recorded net loan recoveries of $35 thousand in the second quarter of 2016 versus net loan charge-offs of $5 thousand in the first quarter of 2016 and net loan recoveries of $726 thousand in the second quarter of 2015. As a percentage of average total loans outstanding, these net amounts represented, on an annualized basis, (0.01%) for the second quarter of 2016, 0.00% for the first quarter of 2016 and (0.21%) for the second quarter of 2015.

The Company held OREO amounting to $650 thousand at June 30, 2016 resulting from the addition of one residential property during the first quarter of 2016. The Company held no OREO at December 31 and June 30, 2015.
 

The Company did not record a provision for loan losses in the second quarter of 2016 or 2015.

For the three months ended June 30, 2016, the ending balance of the Company’s allowance for loan losses increased by $35 thousand when compared to March 31, 2016. During the second quarter of 2016, the Company increased its allowance for loan losses allocated to commercial real estate (“CRE”) by $456 thousand and decreased its allowance for loan losses allocated to multifamily loans and residential mortgages by $625 thousand and $17 thousand, respectively. At June 30 and March 31, 2016, the Company’s allowance for loan losses included an unallocated portion totaling $2.4 million and $2.1 million, respectively, representing 11.3% and 10.0%, respectively, of the Company’s total allowance for loan losses. The Company’s unallocated portion of the allowance for loan losses at June 30, 2016 increased $287 thousand when compared to March 31, 2016, as growth in some of the Company’s loan segments may produce future credit stress and the unallocated reserve component is considered to be a judicious mitigating factor.

The increase in the allowance for loan losses allocated to CRE loans during the second quarter of 2016 largely reflected growth of $17 million in unimpaired pass rated CRE loans, coupled with an increase of 0.04% in the average combined historical loss and environmental factors rates on such unimpaired pass rated loans. The decreases in the allowance for loan losses allocated to multifamily loans and residential mortgages during the second quarter of 2016 were primarily due to decreases of $54 million and $3 million in unimpaired pass rated multifamily loans and residential mortgages, respectively.

The loss factors rates incorporate a rolling twelve quarter look back period used in calculating historical losses for each loan segment. In an effort to more accurately represent the Company’s incurred and probable losses by individual loan segment, a twelve quarter period is used to improve the granularity of individual loan segment charge-off history and reduce the volatility associated with improperly weighting short-term trends in the calculation.

Management has determined that the current level of the allowance for loan losses, including the unallocated portion, is adequate in relation to the probable inherent losses present in the portfolio. Management considers many factors in this analysis, among them credit risk grades, delinquency trends, concentrations within segments of the loan portfolio, recent charge-off experience, local and national economic conditions, current real estate market conditions in geographic areas where the Company’s loans are located, changes in the trend of non-performing loans, changes in interest rates and loan portfolio growth. Changes in one or a combination of these factors may adversely affect the Company’s loan portfolio resulting in increased delinquencies, loan losses and future levels of loan loss provisions. Due to these uncertainties, management expects to record loan charge-offs in future periods. (See also Critical Accounting Policies, Judgments and Estimates contained herein.)
 
ANALYSIS OF NON-PERFORMING ASSETS
AND THE ALLOWANCE FOR LOAN LOSSES
June 30, 2016 versus December 31, 2015 and June 30, 2015
(dollars in thousands)

NON-PERFORMING ASSETS BY TYPE:
 
   
At
 
   
6/30/2016
   
12/31/2015
   
6/30/2015
 
Non-accrual loans
 
$
6,898
   
$
5,528
   
$
5,529
 
Non-accrual loans held for sale
   
-
     
-
     
-
 
Loans 90 days or more past due and still accruing
   
-
     
-
     
-
 
OREO
   
650
     
-
     
-
 
Total non-performing assets
 
$
7,548
   
$
5,528
   
$
5,529
 
TDRs accruing interest
 
$
8,125
   
$
9,239
   
$
10,091
 
TDRs non-accruing
 
$
2,031
   
$
2,324
   
$
2,841
 
                         
Gross loans outstanding
 
$
1,729,874
   
$
1,666,447
   
$
1,476,626
 
Total loans held for sale
 
$
2,790
   
$
1,666
   
$
3,132
 

ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES:

   
Quarter Ended
 
   
6/30/2016
   
12/31/2015
   
6/30/2015
 
Beginning balance
 
$
20,930
   
$
20,315
   
$
19,325
 
Provision
   
-
     
-
     
-
 
Charge-offs
   
(9
)
   
(3
)
   
(9
)
Recoveries
   
44
     
373
     
735
 
Ending balance
 
$
20,965
   
$
20,685
   
$
20,051
 

KEY  RATIOS:

   
At
 
   
6/30/2016
   
12/31/2015
   
6/30/2015
 
Allowance as a % of total loans (1)
   
1.21
%
   
1.24
%
   
1.36
%
                         
Non-accrual loans as a % of total loans (1)
   
0.40
%
   
0.33
%
   
0.37
%
                         
Non-performing assets as a % of total loans, loans held for sale and OREO
   
0.44
%
   
0.33
%
   
0.37
%
                         
Allowance for loan losses as a % of non-accrual loans (1)
   
304
%
   
374
%
   
363
%
                         
Allowance for loan losses as a % of non-accrual loans and loans 90 days or more past due and still accruing (1)
   
304
%
   
374
%
   
363
%
 
(1)
Excludes loans held for sale.

ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company originates and invests in interest-earning assets and solicits interest-bearing deposit accounts. The Company’s operations are subject to market risk resulting from fluctuations in interest rates to the extent that there is a difference between the amounts of interest-earning assets and interest-bearing liabilities that are prepaid, withdrawn, mature, or repriced in any given period of time. The Company’s earnings or the net value of its portfolio will change under different interest rate scenarios. The principal objective of the Company’s asset/liability management program is to maximize net interest income within an acceptable range of overall risk, including both the effect of changes in interest rates and liquidity risk. The Company’s assessment of market risk at June 30, 2016 indicated there were no material changes in the quantitative and qualitative disclosures from those in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.
 
ITEM 4. – CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”), as of the end of the period covered by this report.

Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of June 30, 2016, the Company’s disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to the Company’s management, including the Company’s principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. There have been no changes in the Company’s internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, internal controls subsequent to the date the Company carried out its evaluation.

Changes in Internal Control Over Financial Reporting

There were no changes to the Company’s internal control over financial reporting as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act that occurred in the second quarter of 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Limitations on Effectiveness of Controls and Procedures

In designing and evaluating the disclosure controls and procedures, the Company’s management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that the Company’s management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
 
PART II

ITEM 1. - LEGAL PROCEEDINGS
 
See the information set forth in Note 10. Legal Proceedings in the Notes to Unaudited Condensed Consolidated Financial Statements under Part I, Item I, which information is incorporated by reference in response to this item.

ITEM 1A. – RISK FACTORS

There are no material changes from the risks disclosed in the Risk Factors section of our Annual Report on Form 10-K for the year ended December 31, 2015, except as discussed below.

The Company’s results may be adversely affected if it suffers higher than expected losses on its loans or is required to increase its allowance for loan losses.

The Company assumes credit risk from the possibility that it will suffer losses because borrowers, guarantors and related parties fail to perform under the terms of their loans. Management tries to minimize and monitor this risk by adopting and implementing what management believes are effective underwriting and credit policies and procedures, including how the Company establishes and reviews the allowance for loan losses. The allowance for loan losses is determined by continuous analysis of the loan portfolio and the analytical process is regularly reviewed and adjustments may be made based on the assessments of internal and external influences on credit quality. Those policies and procedures may still not prevent unexpected losses that could adversely affect the Company’s results. Weak economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of collateral securing those loans. In particular, the Company sees worrisome signs of certain commercial real estate markets becoming overheated, and a decline in property values could materially and adversely affect the value of the collateral securing the Company’s commercial real estate loans. In addition, deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, changes in regulation and regulatory interpretation and other factors, both within and outside of the Company’s control, may require an increase in the allowance for loan losses.
 
The Company operates in a highly regulated environment and its operations and income may be affected adversely by changes in laws and regulations governing its operations. The Company may be unable to satisfy the individual minimum capital requirements imposed by the OCC, and lack of compliance may result in regulatory enforcement actions and adversely impact the Company’s business, financial condition or results of operations.

The Company is subject to extensive regulation and supervision by the Federal Reserve Board, the OCC and the FDIC. Such regulators govern the activities in which the Company may engage. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose restrictions on a bank’s operations, limit growth rates, reclassify assets, determine the adequacy of a bank’s allowance for loan losses and determine the level of deposit insurance premiums assessed. Any change in such regulation and oversight, whether in the form of regulatory policy, new regulations or legislation or additional deposit insurance premiums could materially and adversely impact on the Company’s business, financial condition or results of operations. Any new laws, rules and regulations could also make compliance more difficult or expensive or otherwise materially and adversely affect the Company’s business, financial condition or results of operations. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things.

As a result of its commercial real estate concentrations, the OCC established individual minimum capital ratios for the Bank that require it to maintain a tier 1 leverage ratio of at least 9%, a tier 1 risk-based capital ratio of at least 11% and a total risk-based capital ratio of at least 12%. There is no guarantee that the Bank will be able to maintain compliance with these heightened capital ratios. Any failure by the Bank to comply with these individual minimum capital ratios (including as a result of increases to the Bank’s allowance for loan losses), may result in regulatory enforcement actions and adversely impact the Company’s business, financial condition or results of operations.

The Company’s loan portfolio has a high concentration of commercial real estate loans (inclusive of multifamily and mixed use commercial loans), and its business may be adversely affected by credit risk associated with commercial real estate and a decline in property values. The Company’s recently imposed limitation on the growth of its commercial real estate loan portfolio due to the Company’s concentrated position in such assets could materially and adversely affect the Company’s ability to generate interest income and the Company’s business, financial condition and results of operations.

At June 30, 2016, $1.2 billion, or 72% of the Company’s total gross loan portfolio, was comprised of commercial real estate (inclusive of multifamily and mixed use commercial loans). This type of lending is generally sensitive to regional and local economic conditions. Unlike larger national or regional banks that serve a broader and more diverse geographic region, the Company’s business depends significantly on general economic conditions in the New York metropolitan and Long Island markets, where the majority of the properties securing the multifamily and commercial real estate loans the Company originates, and the businesses of the customers to whom the Company makes its C&I loans, are located. Accordingly, the ability of borrowers to repay their loans, and the value of the collateral securing such loans, may be significantly affected by economic conditions in this region, including changes in the local real estate market, making loan loss levels difficult to predict and increasing the risk that the Company would incur material losses if borrowers default on their loans. A decline in general economic conditions could therefore have an adverse effect on the Company’s business, financial condition and results of operations. In addition, because multifamily and CRE loans represent the large majority of the Company’s loan portfolio, a decline in tenant occupancy or rents could adversely impact the ability of borrowers to repay their loans on a timely basis, which could have a negative impact on the Company’s net income, as well as the Company’s ability to maintain or increase the level of cash dividends it currently pays to its stockholders. While the Company seeks to minimize these risks through its underwriting policies, which generally require that such loans be qualified on the basis of the collateral property’s cash flows, appraised value and debt service coverage ratio, among other factors, there can be no assurance that the Company’s underwriting policies will protect it from credit-related losses or delinquencies.

Furthermore, during 2016, the Company has become increasingly concerned with conditions in many of its local CRE markets, particularly those in the boroughs of New York City. The Company sees worrisome signs of markets that are becoming overheated. The CRE lending market is also an area which has attracted significant regulatory scrutiny. The OCC, the Company’s primary bank regulator, has publicly expressed broadly applicable concerns over the last year about overheated conditions in many CRE markets. The OCC established individual minimum capital ratios for the Bank as a result of its concentration of CRE loans. In response, earlier this year, the Company decided to temporarily pull back from the CRE lending markets, which could have a material and adverse impact on the Company’s net income and the Company’s business, financial condition and results of operation. The Company has begun to re-enter certain commercial real estate markets that it backed away from earlier this year, although it has no plans to re-enter the multifamily lending markets in New York City.
 
Because the market price of People’s United common stock will fluctuate, the Company’s shareholders cannot be certain of the market value of the merger consideration they will receive.

Upon completion of the merger, each outstanding share of Company common stock (except for certain shares specified in the merger agreement) will be converted into the right to receive 2.225 shares of People’s United common stock. The market value of the People’s United common stock to be issued in the merger will depend upon the market price of People’s United common stock. This market price may vary from the closing price of People’s United common stock on the date the merger was announced, on the date that the proxy statement/prospectus relating to the merger is mailed to the Company’s shareholders and on the date on which Company shareholders vote on a proposal to adopt the merger agreement at a special meeting of shareholders. There will be no adjustment to the consideration paid to Company shareholders in the merger for changes in the market price of either shares of People’s United common stock or Company common stock.

The market price of People’s United common stock could be subject to significant fluctuations due to changes in sentiment in the market regarding People’s United’s operations or business prospects, including market sentiment regarding People’s United’s entry into the merger agreement. These risks may be affected by:

· operating results that vary from the expectations of People’s United’s management or of securities analysts and investors;

· developments in People’s United’s business or in the financial services sector generally;

· regulatory or legislative changes affecting People’s United’s industry generally or its business and operations;

· operating and securities price performance of companies that investors consider to be comparable to People’s United;

· changes in estimates or recommendations by securities analysts or rating agencies;

· announcements of strategic developments, acquisitions, dispositions, financings and other material events by People’s United or its competitors; and

· changes in global financial markets and economies and general market conditions, such as interest or foreign exchange rates, stock, commodity, credit or asset valuations or volatility.

Accordingly, at the time Company shareholders must decide whether to adopt the merger agreement at the special meeting, they will not necessarily know or be able to calculate the value of the merger consideration they would be entitled to receive upon completion of the merger. Company shareholders are encouraged to obtain current market quotations for both People’s United common stock and Company common stock.

The merger agreement may be terminated in accordance with its terms, and the merger may not be completed.

The merger agreement is subject to a number of conditions that must be fulfilled in order to complete the merger. These conditions to the closing of the merger may not be fulfilled in a timely manner or at all, and, accordingly, the merger may be delayed or may not be completed. In addition, if the merger is not completed by June 26, 2017, either People’s United or the Company may choose not to proceed with the merger, and the parties may mutually decide to terminate the merger agreement at any time. In addition, People’s United and the Company may elect to terminate the merger agreement in certain other circumstances and the Company may be required to pay a termination fee.

Failure to complete the merger could negatively impact the stock price, future business and financial results of the Company.

If the merger is not completed, the ongoing business of the Company may be adversely affected, and the Company will be subject to several risks, including the following:

· the Company may be required, under certain circumstances, to pay People’s United a termination fee of $16 million under the merger agreement;

· the Company will be required to pay certain costs relating to the merger, whether or not the merger is completed, such as legal, accounting, financial advisor and printing fees;
 
· under the merger agreement, the Company is subject to certain restrictions on the conduct of its business prior to completing the merger, which may adversely affect its ability to execute certain of its business strategies; and

· matters relating to the merger may require substantial commitments of time and resources by Company management, which could otherwise have been devoted to other opportunities that may have been beneficial to the Company.

In addition, if the merger is not completed, the Company may experience negative reactions from the financial markets and from its customers and employees. For example, the Company’s business may be impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger. The market price of Company common stock could decline to the extent that the current market price reflects a market assumption that the merger will be completed. The Company also could be subject to litigation related to any failure to complete the merger or to proceedings commenced against the Company to perform its obligations under the merger agreement. If the merger is not completed, the Company cannot assure its shareholders that the risks described above will not materialize and will not materially affect the business, financial results and stock price of the Company.

Lawsuits challenging the merger have been filed against the Company, the Company’s board of directors and People’s United, and an adverse judgment in any such lawsuit or any future similar lawsuits may prevent the merger from becoming effective or from becoming effective within the expected timeframe.

The Company, its board of directors and People’s United are named as defendants in two purported class action lawsuits in the Supreme Court of the State of New York, Suffolk County, challenging the merger and seeking, among other things, to enjoin the defendants from completing the merger on the agreed-upon terms, and rescission of the merger and/or awarding of damages to the extent the merger is completed. Additional plaintiffs may also file lawsuits against the Company or People’s United and/or their directors and officers in connection with the merger. The outcome of any such litigation is uncertain. If the cases are not resolved, these lawsuits could prevent or delay completion of the merger and result in substantial costs to the Company, including any costs associated with the indemnification of directors and officers.

One of the conditions to the closing of the merger is that no order, injunction or decree issued by any court or agency of competent jurisdiction or other legal restraint or prohibition that prevents the consummation of the merger or any of the other transactions contemplated by the merger agreement be in effect. If any plaintiff were successful in obtaining an injunction prohibiting the Company or People’s United from completing the merger on the agreed upon terms, then such injunction may prevent the merger from becoming effective or from becoming effective within the expected timeframe.

The merger is subject to the receipt of consents and approvals from governmental entities that may delay the date of completion of the merger or impose conditions that could have an adverse effect on the combined company following the merger.

Before the merger may be completed, various approvals or consents must be obtained from governmental authorities. Satisfying the requirements of these governmental entities may delay the date of completion of the merger. In addition, these governmental entities may include conditions on the completion of the merger or require changes to the terms of the merger. While the Company does not currently expect that any such conditions or changes would result in a material adverse effect on the combined company following the merger, there can be no assurance that they will not, and such conditions or changes could have the effect of delaying completion of the merger or imposing additional costs on or limiting the revenues of the combined company following the merger, any of which might have a material adverse effect on the combined company following the merger.

The Company will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on the Company. These uncertainties may impair the Company’s ability to attract, retain and motivate key personnel until the merger is completed and could cause customers and others that deal with the Company to seek to change existing business relationships with the Company. Retention of certain employees may be challenging while the merger is pending, as certain employees may experience uncertainty about their future roles with the combined company. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the combined company, the Company’s business could be harmed. In addition, the merger agreement restricts the Company from making certain acquisitions and taking other specified actions until the merger occurs without the consent of People’s United. These restrictions may prevent the Company from pursuing attractive business opportunities that may arise prior to the completion of the merger.
 
If the merger is not completed, the Company will have incurred substantial expenses without realizing the expected benefits of the merger.

The Company has incurred and will incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the merger agreement. If the merger is not completed, the Company would have to recognize these expenses without realizing the expected benefits of the merger.

ITEM 2. – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. – DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. – MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. – OTHER INFORMATION

Not applicable.

ITEM 6. – EXHIBITS

31.1
Certification of principal executive officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2
Certification of principal financial officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1
Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2
Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
101.INS
XBRL Instance Document
   
101.SCH
XBRL Taxonomy Extension Schema Document
   
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
   
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
   
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
   
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

SUFFOLK BANCORP
   
Dated: August 2, 2016
/s/ Howard C. Bluver
 
Howard C. Bluver
 
President & Chief Executive Officer
 
(principal executive officer)
   
Dated: August 2, 2016
/s/ Brian K. Finneran
 
Brian K. Finneran
 
Executive Vice President & Chief Financial Officer
 
(principal financial and accounting officer)
 
EXHIBIT INDEX

Exhibit
Number
Description
   
Certification of principal executive officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
Certification of principal financial officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
101.INS
XBRL Instance Document
   
101.SCH
XBRL Taxonomy Extension Schema Document
   
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
   
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
   
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
   
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document