Attached files

file filename
EX-32.1 - EXHIBIT 32.1 - MIDDLEBURG FINANCIAL CORPmbrg093016ex-321.htm
EX-31.2 - EXHIBIT 31.2 - MIDDLEBURG FINANCIAL CORPmbrg093016ex-312.htm
EX-31.1 - EXHIBIT 31.1 - MIDDLEBURG FINANCIAL CORPmbrg093016ex-311.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 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 Number:  0-24159
MIDDLEBURG FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Virginia
(State or other jurisdiction of
incorporation or organization) 
54-1696103
(I.R.S. Employer
Identification No.)
111 West Washington Street
Middleburg, Virginia
(Address of principal executive offices)
 
20117
(Zip Code)
(703) 777-6327
(Registrant’s telephone number, including area code)

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

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  þ
No  o

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o
 
Accelerated filer þ
 
Non-accelerated filer  o (Do not check if a smaller reporting company)
 
Smaller reporting company  o
 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.  7,207,459 shares of Common Stock as of November 4, 2016.
 
 




 MIDDLEBURG FINANCIAL CORPORATION

INDEX

Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


ITEM 1.
FINANCIAL STATEMENTS

PART I

MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except for per share data)
 
(Unaudited)
 
 
 
September 30,
 
December 31,
 
2016
 
2015
ASSETS
 
 
 
Cash and due from banks
$
5,557

 
$
5,489

Interest bearing deposits with other banks
50,234

 
33,739

Total cash and cash equivalents
55,791

 
39,228

Securities held to maturity, fair value of $10,957 and $4,163, respectively
10,727

 
4,207

Securities available for sale, at fair value
352,618

 
374,571

Restricted securities, at cost
5,562

 
6,411

Loans, net of allowance for loan losses of $11,200 and $11,046, respectively
834,690

 
794,635

Loans held for sale
669

 

Premises and equipment, net
18,755

 
19,531

Goodwill and identified intangibles, net
3,507

 
3,636

Other real estate owned, net of valuation allowance
3,387

 
3,345

Bank owned life insurance
23,761

 
23,273

Accrued interest receivable and other assets
25,535

 
26,026

TOTAL ASSETS
$
1,335,002

 
$
1,294,863

LIABILITIES
 

 
 

Deposits:
 

 
 

Non-interest bearing demand deposits
$
267,017

 
$
235,897

Savings and interest bearing demand deposits
562,954

 
560,328

Time deposits
261,534

 
244,575

Total deposits
1,091,505

 
1,040,800

Securities sold under agreements to repurchase
31,540

 
26,869

Federal Home Loan Bank borrowings
63,500

 
85,000

Subordinated notes
5,155

 
5,155

Accrued interest payable and other liabilities
14,382

 
13,485

TOTAL LIABILITIES
1,206,082

 
1,171,309

Commitments and contingencies

 

SHAREHOLDERS' EQUITY
 

 
 

Common stock ($2.50 par value; 20,000,000 shares authorized; 7,103,358 and 7,085,217 issued and outstanding, respectively)
17,331

 
17,330

Capital surplus
44,186

 
44,155

Retained earnings
64,600

 
60,392

Accumulated other comprehensive income
2,803

 
1,677

TOTAL SHAREHOLDERS' EQUITY
128,920

 
123,554

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
$
1,335,002

 
$
1,294,863

 
See accompanying notes to the consolidated financial statements.


3


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except for per share data)
 
(Unaudited)
 
For the Three Months Ended
September 30,
 
For the Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
INTEREST INCOME
 
 
 
 
 
 
 
Interest and fees on loans
$
8,624

 
$
8,227

 
$
25,397

 
$
24,484

Interest and dividends on securities
 

 
 

 
 
 
 
Taxable
1,585

 
1,938

 
5,650

 
5,636

Tax-exempt
411

 
444

 
1,303

 
1,354

Dividends
82

 
71

 
238

 
196

Interest on deposits with other banks and federal funds sold
35

 
23

 
123

 
84

Total interest and dividend income
10,737

 
10,703

 
32,711

 
31,754

INTEREST EXPENSE
 

 
 

 
 
 
 
Interest on deposits
909

 
877

 
2,670

 
2,580

Interest on securities sold under agreements to repurchase
1

 
2

 
2

 
64

Interest on FHLB borrowings and other debt
210

 
165

 
704

 
507

Total interest expense
1,120

 
1,044

 
3,376

 
3,151

NET INTEREST INCOME
9,617

 
9,659

 
29,335

 
28,603

Provision for (recovery of) loan losses
(297
)
 
(432
)
 
53

 
(407
)
NET INTEREST INCOME AFTER PROVISION FOR (RECOVERY OF) LOAN LOSSES
9,914

 
10,091

 
29,282

 
29,010

NON-INTEREST INCOME
 

 
 

 
 
 
 
Service charges on deposit accounts
303

 
275

 
868

 
803

Trust services income
1,168

 
1,168

 
3,458

 
3,629

ATM fee income, net
190

 
209

 
565

 
593

Gains on sales of loans held for sale, net
11

 
9

 
23

 
3

Gains on sales of securities available for sale, net
138

 

 
511

 
138

Commissions on investment sales
133

 
132

 
417

 
415

Bank owned life insurance
165

 
166

 
488

 
489

Other operating income
136

 
212

 
492

 
1,194

Total non-interest income
2,244

 
2,171

 
6,822

 
7,264

NON-INTEREST EXPENSE
 

 
 

 
 
 
 
Salaries and employee benefits
4,727

 
4,793

 
14,152

 
14,544

Occupancy and equipment
1,262

 
1,323

 
3,937

 
4,054

Amortization
210

 
160

 
628

 
478

Computer operations
605

 
524

 
1,923

 
1,536

Other real estate owned, net
183

 
193

 
339

 
285

Other taxes
237

 
230

 
709

 
684

Federal deposit insurance
215

 
188

 
606

 
583

Audits and exams
136

 
156

 
453

 
472

Other operating expenses
1,599

 
1,524

 
4,192

 
4,083

Total non-interest expense
9,174

 
9,091

 
26,939

 
26,719

Income before income taxes
2,984

 
3,171

 
9,165

 
9,555

Income tax expense
720

 
850

 
2,193

 
2,506

NET INCOME
$
2,264

 
$
2,321

 
$
6,972

 
$
7,049

Earnings per share:
 
 
 
 
 
 
 
Basic
$
0.32

 
$
0.32

 
$
0.98

 
$
0.99

Diluted
$
0.32

 
$
0.32

 
$
0.98

 
$
0.98


See accompanying notes to the consolidated financial statements. 

4


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
 
(Unaudited)
 
For the Three Months Ended
September 30,
 
For the Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net income
$
2,264

 
$
2,321

 
$
6,972

 
$
7,049

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Unrealized holding gains (losses) arising during the period, net of tax, $371, ($102), ($805) and $229, respectively
(724
)
 
198

 
1,561

 
(446
)
Reclassification adjustment for gains included in net income, net of tax, $47, $0, $174 and $47, respectively
(91
)
 

 
(337
)
 
(91
)
Unrealized gains (losses) on interest rate swaps, net of tax, ($44), $66, $51 and $66, respectively
87

 
(128
)
 
(98
)
 
(129
)
Reclassification adjustment for gain on interest rate swap ineffectiveness included in net income, net of tax, $0, $0, $0 and $2, respectively

 

 

 
(4
)
Total other comprehensive income (loss)
(728
)
 
70

 
1,126

 
(670
)
Total comprehensive income
$
1,536

 
$
2,391

 
$
8,098

 
$
6,379


See accompanying notes to the consolidated financial statements.




5


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in thousands, except for per share data)
 (Unaudited)
 
 
 
For the Nine Months Ended September 30, 2016 and 2015
 
Common Stock
 
Capital Surplus
 
Retained Earnings
 
Accumulated Other Comprehensive Income
 
Total
Balance December 31, 2014
$
17,494

 
$
44,892

 
$
55,854

 
$
3,794

 
$
122,034

 
 
 
 
 
 
 
 
 
 
Net income

 

 
7,049

 

 
7,049

Other comprehensive loss, net of tax

 

 

 
(670
)
 
(670
)
Cash dividends declared ($0.33 per share)

 

 
(2,361
)
 

 
(2,361
)
Restricted stock vesting (15,692 shares)
39

 
(39
)
 

 

 

Repurchase of restricted stock (4,577 shares)
(11
)
 
(72
)
 

 

 
(83
)
Share-based compensation

 
443

 

 

 
443

Balance September 30, 2015
$
17,522

 
$
45,224

 
$
60,542

 
$
3,124

 
$
126,412

 
 
 
 
 
 
 
 
 
 
Balance December 31, 2015
$
17,330

 
$
44,155

 
$
60,392

 
$
1,677

 
$
123,554

 
 

 
 

 
 

 
 

 
 

Net income

 

 
6,972

 

 
6,972

Other comprehensive income, net of tax

 

 

 
1,126

 
1,126

Cash dividends ($0.39 per share)

 

 
(2,764
)
 

 
(2,764
)
Exercise of stock options (6,650 shares)
16

 
76

 

 

 
92

Restricted stock vesting (33,691 shares)
84

 
(84
)
 

 

 

Repurchase of restricted stock (12,958 shares)
(32
)
 
(224
)
 

 

 
(256
)
Share-based compensation

 
685

 

 

 
685

Repurchase of common stock (26,800 shares)
(67
)
 
(422
)
 

 

 
(489
)
Balance September 30, 2016
$
17,331

 
$
44,186

 
$
64,600

 
$
2,803

 
$
128,920

 
See accompanying notes to the consolidated financial statements.


6

MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS


 
(Unaudited)
 
For the Nine Months Ended
 
September 30,
(Dollars in thousands)
2016
 
2015
Cash Flows From Operating Activities
 
 
 
Net income
$
6,972

 
$
7,049

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 

Depreciation and amortization
1,956

 
1,736

Provision for (recovery of) loan losses
53

 
(407
)
Originations of mortgage loans held for sale
(2,301
)
 
(287
)
Proceeds from the sales of mortgage loans held for sale
1,655

 
290

Gains on the sales of mortgage loans held for sale, net
(23
)
 
(3
)
Gains on sales of securities available for sale, net
(511
)
 
(138
)
Losses on disposal of assets, net
2

 
65

Premium amortization on securities, net
3,721

 
2,937

Share-based compensation
685

 
443

(Gains) losses on sale of other real estate owned, net
(50
)
 
46

Valuation adjustments on other real estate owned
310

 
177

Increase in bank owned life insurance cash surrender value
(488
)
 
(489
)
Changes in assets and liabilities:
 
 
 
Increase in other assets
(1,041
)
 
(1,365
)
Increase (decrease) in other liabilities
897

 
(135
)
Net cash provided by operating activities
$
11,837

 
$
9,919

Cash Flows from Investing Activities
 
 
 

Proceeds from calls, principal repayments and sales of securities available for sale
$
102,599

 
$
82,336

Purchase of securities available for sale
(82,001
)
 
(110,464
)
Purchase of securities held to maturity
(6,520
)
 

(Purchase) redemption of restricted stock, net
849

 
(70
)
Purchase of bank premises and equipment, net
(250
)
 
(2,756
)
Loan originations, net
(5,021
)
 
(3,859
)
Purchases of loans
(40,025
)
 
(23,988
)
Proceeds from sales of loans
4,412

 
1,127

Proceeds from sale of other real estate owned and repossessed assets
224

 
766

Net cash used in investing activities
$
(25,733
)
 
$
(56,908
)
Cash Flows from Financing Activities
 

 
 

Increase in demand, interest-bearing demand and savings deposits
$
33,746

 
$
42,720

Increase in time deposits
16,959

 
553

Increase (decrease) in securities sold under agreements to repurchase
4,671

 
(14,083
)
Increase (decrease) in FHLB borrowings
(21,500
)
 
5,000

Payment of dividends on common stock
(2,764
)
 
(2,361
)
Proceeds from issuance of common stock, net
92

 

Repurchase of common stock
(745
)
 
(83
)
Net cash provided by financing activities
$
30,459

 
$
31,746

Increase (decrease) in cash and cash equivalents
16,563

 
(15,243
)
Cash and cash equivalents at beginning of the period
39,228

 
55,022

Cash and cash equivalents at end of the period
$
55,791

 
$
39,779

Supplemental Disclosures of Cash Flow Information
 
 
 

Interest paid
$
3,379

 
$
3,158

Income taxes
$
725

 
$
2,560

Supplemental Disclosure of Non-Cash Transactions
 
 
 

Unrealized gains (losses) on securities available for sale
$
1,855

 
$
(813
)
Change in fair value of interest rate swaps
$
(149
)
 
$
(201
)
Transfer of loans to other real estate owned
$
526

 
$
720


See accompanying notes to the consolidated financial statements.

7


MIDDLEBURG FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements

Note 1.        General

In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position at September 30, 2016 and December 31, 2015, the results of operations and comprehensive income, for the three and nine month periods ending September 30, 2016 and September 30, 2015 and changes in shareholders' equity and cash flows for the nine months ended September 30, 2016 and September 30, 2015, in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP").  The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2015 (the “2015 Form 10-K”) of Middleburg Financial Corporation (the “Company”).  The results of operations for the three and nine months ended September 30, 2016 are not necessarily indicative of the results to be expected for the full year.

On October 24, 2016, the Company and Access National Corporation (“Access”) announced a definitive agreement to combine in a strategic merger (the “Merger Agreement”) pursuant to which the Company will merge with and into Access (the “Merger”). As a result of the Merger, the holders of shares of the Company's common stock will receive 1.3314 shares of Access common stock for each share of the Company's common stock held immediately prior to the effective date of the Merger. The transaction is expected to be completed in the second quarter of 2017, subject to approval of both companies' shareholders, regulatory approvals and other customary closing conditions.

In preparing these financial statements, management has evaluated all other subsequent events and transactions for potential recognition or disclosure through the date these financial statements were issued.  Management has concluded there were no additional material subsequent events to be disclosed.

Certain amounts in the 2015 consolidated financial statements have been reclassified to conform to the 2016 presentation. No reclassifications were significant and there was no effect on net income.

Note 2.        Share-Based Compensation Plan

The Company sponsors one share-based compensation plan, the 2006 Equity Compensation Plan, which provided for the granting of stock options, stock appreciation rights, stock awards, performance share awards, incentive awards, and stock units.  The 2006 Equity Compensation Plan was approved by the Company’s shareholders at the Annual Meeting held on April 26, 2006, and succeeded the Company’s 1997 Stock Incentive Plan.  The plan expired by its own terms in February 2016, before which, the Company granted share-based compensation to its directors, officers, employees, and other persons the Company determined to have contributed to the profits or growth of the Company.  The number of shares reserved for issuance totaled 430,000.

For the three months ended September 30, 2016 and 2015, the Company recorded $240,000 and $162,000, respectively, in share-based compensation. For the nine months ended September 30, 2016 and 2015, the Company recorded $685,000 and $443,000, respectively, in share-based compensation expense. As of September 30, 2016, there was $1.9 million of total unrecognized compensation expense related to non-vested restricted awards under the 2006 Equity Compensation Plan. For the three and nine months ended September 30, 2016 and 2015, the Company recorded no compensation expense related to option awards. As of September 30, 2016 all outstanding option awards were previously vested and, accordingly, there was no unrecognized compensation expense as of September 30, 2016.  

The aggregate intrinsic value, noted in the option table below, represents the amount by which the current market value of the underlying stock exceeds the exercise price as of September 30, 2016. Given there is no exercise price for restricted stock, the aggregate value is equal to the current market value of the stock. These amounts change based on changes in the market value of the Company’s common stock.


8


The following table summarizes restricted stock awarded under the 2006 Equity Compensation Plan:
 
September 30, 2016
 
Shares
 
Weighted-Average Grant Date Fair Value
 
Aggregate Value
(in thousands)
Non-vested at December 31, 2015
153,399

 
$
17.17

 
 
Granted
53,500

 
20.76

 
 
Vested
(33,691
)
 
16.49

 
 
Forfeited
(2,250
)
 
19.91

 
 
Non-vested at September 30, 2016
170,958

 
$
18.39

 
$
4,835


The weighted-average remaining contractual term for non-vested restricted stock awards at September 30, 2016, was 2.50 years. 

The following table summarizes options outstanding under the 2006 Equity Compensation Plan and remaining outstanding unexercised options under the 1997 Stock Incentive Plan.  
 
September 30, 2016
 
Shares
 
Weighted-Average Exercise Price
 
Aggregate Intrinsic Value
(in thousands)
Outstanding at December 31, 2015
30,012

 
$
14.00

 
$

Granted

 

 

Exercised
(6,650
)
 
14.00

 

Forfeited

 

 

Outstanding at September 30, 2016
23,362

 
$
14.00

 
$
334

Options exercisable at September 30, 2016
23,362

 
$
14.00

 
$
334


The total intrinsic value of options exercised was $27,000 and $88,000 during the three and nine months ended September 30, 2016, respectively. There were no options exercised for the three and nine months ended September 30, 2015.

As of September 30, 2016, options outstanding and exercisable are summarized as follows:
Exercise Prices
 
Options Outstanding
 
Weighted-Average Remaining Contractual Life (years)
 
Options Exercisable
$
14.00

 
18,362

 
2.47
 
18,362

$
14.00

 
5,000

 
3.10
 
5,000

$
14.00

 
23,362

 
2.61
 
23,362


Note 3.        Securities

Amortized costs and fair values of securities held to maturity are summarized as follows.
 
September 30, 2016
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Held to Maturity
 
 
 
 
 
 
 
Obligations of states and political subdivisions
$
6,477

 
$
180

 
$

 
$
6,657

Corporate securities
4,250

 
50

 

 
4,300

Total
$
10,727

 
$
230

 
$

 
$
10,957



9


 
December 31, 2015
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Held to Maturity
 
 
 
 
 
 
 
Obligations of states and political subdivisions
$
1,457

 
$

 
$
(38
)
 
$
1,419

Corporate securities
2,750

 
24

 
(30
)
 
2,744

Total
$
4,207

 
$
24

 
$
(68
)
 
$
4,163


The amortized cost and fair value of securities held to maturity as of September 30, 2016, by contractual maturity are shown below. 
 
September 30, 2016
(Dollars in thousands)
Amortized
Cost
 
Fair
Value
Held to Maturity
 
 
 
Due after five years through ten years
$
4,250

 
$
4,300

Due after ten years
6,477

 
6,657

Total
$
10,727

 
$
10,957


Amortized costs and fair values of securities available for sale are summarized as follows:
 
September 30, 2016
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available for Sale
 
 
 
 
 
 
 
U.S. government agencies
$
69,635

 
$
827

 
$
(163
)
 
$
70,299

Obligations of states and political subdivisions
66,146

 
2,055

 
(103
)
 
68,098

Mortgage-backed securities:
 
 
 
 
 
 
 
Agency
131,134

 
3,267

 
(513
)
 
133,888

Non-agency
11,273

 
43

 
(94
)
 
11,222

Other asset backed securities
53,085

 
652

 
(465
)
 
53,272

Corporate securities
16,652

 
38

 
(851
)
 
15,839

Total
$
347,925

 
$
6,882

 
$
(2,189
)
 
$
352,618


 
December 31, 2015
(Dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available for Sale
 
 
 
 
 
 
 
U.S. government agencies
$
79,005

 
$
315

 
$
(380
)
 
$
78,940

Obligations of states and political subdivisions
74,071

 
1,956

 
(434
)
 
75,593

Mortgage-backed securities:
 
 
 
 
 
 
 

Agency
129,360

 
3,046

 
(745
)
 
131,661

Non-agency
12,782

 
33

 
(38
)
 
12,777

Other asset backed securities
58,958

 
426

 
(603
)
 
58,781

Corporate securities
17,557

 
22

 
(760
)
 
16,819

Total
$
371,733

 
$
5,798

 
$
(2,960
)
 
$
374,571


The amortized cost and fair value of securities available for sale as of September 30, 2016, by contractual maturity are shown below.  Maturities may differ from contractual maturities in corporate and mortgage-backed securities because the securities and mortgages underlying the securities may be called or repaid without any penalties.  Therefore, these securities are not included in the maturity categories in the following maturity summary.

10


 
September 30, 2016
(Dollars in thousands)
Amortized
Cost
 
Fair
Value
Due in one year or less
$
580

 
$
583

Due after one year through five years
8,964

 
9,266

Due after five years through ten years
24,328

 
24,024

Due after ten years
118,561

 
120,363

Mortgage-backed securities
142,407

 
145,110

Other asset backed securities
53,085

 
53,272

Total
$
347,925

 
$
352,618


Proceeds from sales of securities available for sale during the nine months ended September 30, 2016 and 2015 were $43.9 million and $11.60 million, respectively. Proceeds from calls and principal repayments of securities available for sale during the nine months ended September 30, 2016, and 2015 were $58.7 million and $70.7 million, respectively.  For the nine months ended September 30, 2016 and 2015, gross gains of $534,000 and $175,000 and gross losses of $23,000 and $37,000, respectively, were realized.  The tax expense applicable to these net realized gains amounted to $174,000 and $47,000 for the nine months ended September 31, 2016 and 2015, respectively.

The carrying value of securities pledged to qualify for fiduciary powers, to secure public monies and for other purposes as required by law amounted to $120.0 million and $113.1 million at September 30, 2016 and December 31, 2015, respectively.
Investments in an unrealized loss position that are temporarily impaired are as follows:

(Dollars in thousands)
 
Less than Twelve Months
 
Twelve Months or Greater
 
Total
September 30, 2016
 
Fair Value
 
Gross
Unrealized Losses
 
Fair Value
 
Gross
Unrealized Losses
 
Fair Value
 
Gross
Unrealized Losses
Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
18,090

 
$
(99
)
 
$
5,052

 
$
(64
)
 
$
23,142

 
$
(163
)
Obligations of states and political subdivisions
 
1,334

 
(15
)
 
7,432

 
(88
)
 
8,766

 
(103
)
Mortgage-backed securities:
 
 

 
 

 
 

 
 

 
 

 
 

Agency
 
17,246

 
(90
)
 
12,728

 
(423
)
 
29,974

 
(513
)
Non-agency
 
5,616

 
(84
)
 
1,940

 
(10
)
 
7,556

 
(94
)
Other asset backed securities
 
9,206

 
(178
)
 
20,487

 
(287
)
 
29,693

 
(465
)
Corporate securities
 
1,994

 
(60
)
 
11,266

 
(791
)
 
13,260

 
(851
)
Total
 
$
53,486

 
$
(526
)
 
$
58,905

 
$
(1,663
)
 
$
112,391

 
$
(2,189
)


11


(Dollars in thousands)
 
Less than Twelve Months
 
Twelve Months or Greater
 
Total
December 31, 2015
 
Fair Value
 
Gross Unrealized Losses
 
Fair Value
 
Gross Unrealized Losses
 
Fair Value
 
Gross Unrealized Losses
Held to Maturity
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
 
$
1,419

 
$
(38
)
 
$

 
$

 
$
1,419

 
$
(38
)
Corporate securities
 
1,970

 
(30
)
 

 

 
1,970

 
(30
)
Total
 
$
3,389

 
$
(68
)
 
$

 
$

 
$
3,389

 
$
(68
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
46,000

 
$
(304
)
 
$
4,223

 
$
(76
)
 
$
50,223

 
$
(380
)
Obligations of states and political subdivisions
 
16,559

 
(324
)
 
1,082

 
(110
)
 
17,641

 
(434
)
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 

 
 

Agency
 
27,627

 
(402
)
 
9,911

 
(343
)
 
37,538

 
(745
)
Non-agency
 
7,842

 
(37
)
 
671

 
(1
)
 
8,513

 
(38
)
Other asset backed securities
 
25,399

 
(276
)
 
12,037

 
(327
)
 
37,436

 
(603
)
Corporate securities
 
10,740

 
(378
)
 
4,866

 
(382
)
 
15,606

 
(760
)
Total
 
$
134,167

 
$
(1,721
)
 
$
32,790

 
$
(1,239
)
 
$
166,957

 
$
(2,960
)

A total of 141 securities have been identified by the Company as temporarily impaired at September 30, 2016.  Of the 141 securities, 136 are investment grade and five are speculative grade.  Mortgage-backed securities, other asset backed securities and corporate securities make up the majority of the gross unrealized losses for temporarily impaired securities at September 30, 2016.  Market prices change daily and are affected by conditions beyond the control of the Company.  Although the Company has the ability to hold these securities until the temporary loss is recovered, decisions by management may necessitate a sale before the loss is fully recovered.  No such sales were anticipated or required as of September 30, 2016.  Investment decisions reflect the strategic asset/liability objectives of the Company.  The investment portfolio is analyzed frequently by the Company and managed to provide an overall positive impact to the Company’s consolidated income statement and balance sheet.

At September 30, 2016, the Company evaluated the investment portfolio for possible other-than-temporary impairment losses and concluded that no adverse change in cash flows occurred. Based on this analysis and because the Company does not intend to sell securities in an unrealized loss position and it is more likely than not the Company will not be required to sell any securities before recovery of amortized cost basis, which may be at maturity, the Company does not consider any portfolio securities to be other-than-temporarily impaired. For debt securities related to corporate securities, the Company determined that there was no other adverse change in the cash flows as viewed by a market participant; therefore, the Company does not consider the investments in these assets to be other-than-temporarily impaired at September 30, 2016.  However, there is a risk that the Company’s continuing reviews could result in recognition of other-than-temporary impairment charges in the future. For the three and nine months ended September 30, 2016 and the year ended December 31, 2015, no credit related impairment losses were recognized by the Company.

Restricted securities
The Company’s investment in FHLB stock totaled $3.9 million and $4.7 million at September 30, 2016 and December 31, 2015, respectively.  FHLB stock is generally viewed as a long-term investment and as a restricted security which is carried at cost because there is no market for the stock other than the FHLB or member institutions.  Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value.  The Company does not consider this investment to be other-than-temporarily impaired at September 30, 2016, and no impairment has been recognized.  FHLB stock is shown in restricted securities on the consolidated balance sheets.

The Company also has an investment in Federal Reserve Bank (“FRB”) stock which totaled $1.7 million at September 30, 2016 and December 31, 2015, respectively. The investment in FRB stock is a required investment and is carried at cost since there is no ready market. The Company does not consider this investment to be other-than-temporarily impaired at September 30, 2016, and no impairment has been recognized. FRB stock is shown in restricted securities on the consolidated balance sheets.
 
Note 4.        Loans, Net

The Company segregates its loan portfolio into three primary loan segments:  Real Estate Loans, Commercial Loans, and Consumer Loans.  Real estate loans are further segregated into the following classes: construction loans, loans secured by farmland, loans

12


secured by 1-4 family residential real estate, and other real estate loans.  Other real estate loans include commercial real estate loans.  The consolidated loan portfolio was composed of the following:
 
September 30, 2016
 
December 31, 2015
(Dollars in thousands)
Outstanding
Balance
 
Percent of
Total Portfolio
 
Outstanding
Balance
 
Percent of
Total Portfolio
Real estate loans:
 
 
 
 
 
 
 
Construction
$
32,519

 
3.8
%
 
$
39,673

 
4.9
%
Secured by farmland
16,832

 
2.0

 
19,062

 
2.4

Secured by 1-4 family residential
332,408

 
39.3

 
280,096

 
34.8

Other real estate loans
250,778

 
29.7

 
258,035

 
32.0

Commercial loans
193,826

 
22.9

 
190,482

 
23.6

Consumer loans
19,527

 
2.3

 
18,333

 
2.3

Total gross loans (1)
$
845,890

 
100.0
%
 
$
805,681

 
100.0
%
Less allowance for loan losses
11,200

 
 

 
11,046

 
 
Net loans
$
834,690

 
 

 
$
794,635

 
 

(1) 
Includes net deferred loan costs and premiums of $3.7 million and $3.5 million, respectively.

During the nine months ended September 30, 2016, the Company received $4.4 million in proceeds from the sale of problem loans. Included in the sales were four loans with a recorded investment of $4.3 million, of which $1.2 million were on nonaccrual, as well as 28 loans with no outstanding recorded investment as they had been fully charged-off in prior periods. Gross charge-offs of $513,000 and gross recoveries of $640,000 were recorded through the allowance for loan losses during the nine months ended September 30, 2016, related to the sales of these loans.

The following tables present a contractual aging of the recorded investment in past due loans by class of loans:
 
September 30, 2016
(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days Or Greater
 
Total Past Due
 
Current
 
Total Loans
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$

 
$

 
$

 
$

 
$
32,519

 
$
32,519

Secured by farmland

 

 

 

 
16,832

 
16,832

Secured by 1-4 family residential
287

 

 
3,319

 
3,606

 
328,802

 
332,408

Other real estate loans
315

 
1,089

 
148

 
1,552

 
249,226

 
250,778

Commercial loans
568

 
350

 
495

 
1,413

 
192,413

 
193,826

Consumer loans

 
6

 
1,871

 
1,877

 
17,650

 
19,527

Total
$
1,170

 
$
1,445

 
$
5,833

 
$
8,448

 
$
837,442

 
$
845,890

 
December 31, 2015
(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days Or Greater
 
Total Past Due
 
Current
 
Total Loans
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
Construction
$
69

 
$

 
$

 
$
69

 
$
39,604

 
$
39,673

Secured by farmland

 

 

 

 
19,062

 
19,062

Secured by 1-4 family residential
259

 

 
1,117

 
1,376

 
278,720

 
280,096

Other real estate loans
325

 

 
248

 
573

 
257,462

 
258,035

Commercial loans
1,242

 
15

 
31

 
1,288

 
189,194

 
190,482

Consumer loans
4

 
17

 

 
21

 
18,312

 
18,333

Total
$
1,899

 
$
32

 
$
1,396

 
$
3,327

 
$
802,354

 
$
805,681


13



The following table presents the recorded investment in nonaccrual loans and loans that were past due 90 days or more and still accruing :
 
September 30, 2016
 
December 31, 2015
(Dollars in thousands)
Nonaccrual
 
Past due 90 days or more and still accruing
 
Nonaccrual
 
Past due 90 days or more and still accruing
Real estate loans:
 
 
 
 
 
 
 
Construction
$
29

 
$
11

 
$
204

 
$

Secured by 1-4 family residential
3,308

 

 
4,460

 

Other real estate loans
1,089

 
148

 
1,186

 
248

Commercial loans
406

 
89

 
1,036

 
30

Consumer loans
1,871

 

 
1,898

 

Total
$
6,703

 
$
248

 
$
8,784

 
$
278


If interest on nonaccrual loans had been accrued, such income would have approximated $370,000 and $342,000 for the nine months ended September 30, 2016 and the year ended December 31, 2015, respectively.

The Company utilizes an internal asset classification system as a means of measuring and monitoring credit risk in the loan portfolio.  Under the Company’s classification system, problem and potential problem loans are classified as “Special Mention”, “Substandard”, and “Doubtful”.

Special Mention: Loans with potential weaknesses that deserve management’s close attention.  If left uncorrected, the potential weaknesses may result in the deterioration of the repayment prospects for the credit.

Substandard:  Loans with well-defined weakness that jeopardize the liquidation of the debt.  Either the paying capacity of the borrower or the value of the collateral may be inadequate to protect the Company from potential losses.

Doubtful:  Loans with a very high possibility of loss.  However, because of important and reasonably specific pending factors, classification as a loss is deferred until a more exact status may be determined.

Loss: Loans are deemed uncollectible and are charged off immediately.

The following tables present the recorded investment in loans by class of loan that have been classified according to the internal classification system:
September 30, 2016
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Pass
$
26,934

 
$
8,901

 
$
325,277

 
$
240,168

 
$
187,157

 
$
17,588

 
$
806,025

Special Mention
5,556

 

 
931

 
3,805

 
1,559

 
27

 
11,878

Substandard
29

 
7,931

 
5,976

 
5,716

 
4,704

 
1,911

 
26,267

Doubtful

 

 
126

 
1,089

 
406

 

 
1,621

Loss

 

 
98

 

 

 
1

 
99

Ending Balance
$
32,519

 
$
16,832

 
$
332,408

 
$
250,778

 
$
193,826

 
$
19,527

 
$
845,890

December 31, 2015
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Pass
$
30,114

 
$
10,566

 
$
271,721

 
$
243,768

 
$
183,532

 
$
16,347

 
$
756,048

Special Mention
9,024

 

 
896

 
7,254

 
3,638

 
42

 
20,854

Substandard
535

 
8,496

 
6,818

 
5,827

 
2,301

 
1,943

 
25,920

Doubtful

 

 
661

 
1,186

 
1,011

 

 
2,858

Loss

 

 

 

 

 
1

 
1

Ending Balance
$
39,673

 
$
19,062

 
$
280,096

 
$
258,035

 
$
190,482

 
$
18,333

 
$
805,681


14



The following tables present loans individually evaluated for impairment by class of loan:
 
September 30, 2016
(Dollars in thousands)
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
30

 
$
30

 
$

 
$
31

 
$

Secured by farmland
7,931

 
7,931

 

 
7,917

 
217

Secured by 1-4 family residential
73

 
108

 

 
73

 
2

Other real estate loans
1,089

 
1,089

 

 
1,115

 

Commercial loans
879

 
879

 

 
885

 
15

Consumer loans

 

 

 

 

Total with no related allowance
$
10,002

 
$
10,037

 
$

 
$
10,021

 
$
234

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Real estate loans:
 

 
 

 
 

 
 

 
 

Construction
$

 
$

 
$

 
$

 
$

Secured by farmland

 

 

 

 

Secured by 1-4 family residential
4,289

 
4,341

 
1,214

 
4,323

 
46

Other real estate loans
3,865

 
3,865

 
406

 
3,890

 
139

Commercial loans
406

 
3,406

 
190

 
708

 

Consumer loans
1,871

 
1,871

 
802

 
1,885

 

Total with a related allowance
$
10,431

 
$
13,483

 
$
2,612

 
$
10,806

 
$
185

Total
$
20,433

 
$
23,520

 
$
2,612

 
$
20,827

 
$
419

 
 
December 31, 2015
(Dollars in thousands)
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance
 
Average Recorded Investment
 
Interest Income Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
100

 
$
100

 
$

 
$
106

 
$

Secured by farmland
7,903

 
7,903

 

 
7,903

 
237

Secured by 1-4 family residential
701

 
736

 

 
703

 

Other real estate loans

 

 

 

 

Commercial loans
458

 
493

 

 
490

 
17

Consumer loans

 

 

 

 

Total with no related allowance
$
9,162

 
$
9,232

 
$

 
$
9,202

 
$
254

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Real estate loans:
 

 
 

 
 

 
 

 
 

Construction
$
103

 
$
103

 
$
53

 
$
109

 
$

Secured by farmland

 

 

 

 

Secured by 1-4 family residential
4,426

 
4,478

 
1,120

 
4,547

 
27

Other real estate loans
4,196

 
4,196

 
464

 
4,224

 
157

Commercial loans
1,059

 
4,059

 
27

 
2,315

 
100

Consumer loans
1,898

 
1,898

 
1,000

 
2,449

 

Total with a related allowance
$
11,682

 
$
14,734

 
$
2,664

 
$
13,644

 
$
284

Total
$
20,844

 
$
23,966

 
$
2,664

 
$
22,846

 
$
538

 
The “Recorded Investment” amounts in the table above represent the outstanding principal balance net of charge-offs and nonaccrual payments to principal on each loan represented in the table.  The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged-off on each loan and nonaccrual payments applied to principal.
 
Included in certain loan categories of impaired loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at September 30, 2016 was $14.4 million of which $2.0 million were included in the Company’s nonaccrual loan totals at that date

15


and $12.4 million represented loans performing as agreed according to the restructured terms. This compares with $15.5 million in total restructured loans at December 31, 2015.  The amount of the valuation allowance related to TDRs was $1.1 million and $1.6 million as of September 30, 2016 and December 31, 2015, respectively.
 
Loan modifications that were classified as TDRs during the three and nine months ended September 30, 2016 and 2015 were as follows:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans Modified as TDRs
 
 
For the Three Months Ended September 30,
(Dollars in thousands)
 
2016
 
2015
Class of Loan
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
   Construction
 

 
$

 
$

 

 
$

 
$

   Secured by farmland
 

 

 

 

 

 

   Secured by 1-4 family residential
 
1

 
409

 
406

 

 

 

   Other real estate loans
 

 

 

 

 

 

Total real estate loans
 
1

 
$
409

 
$
406

 

 
$

 
$

Commercial loans
 

 

 

 

 

 

Consumer loans
 

 

 

 

 

 

Total
 
1

 
$
409

 
$
406

 

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans Modified as TDRs
 
 
For the Nine Months Ended September 30,
(Dollars in thousands)
 
2016
 
2015
Class of Loan
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
 
Number of Contracts
 
Pre-Modification Outstanding Recorded Investment
 
Post-Modification Outstanding Recorded Investment
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
   Construction
 

 
$

 
$

 

 
$

 
$

   Secured by farmland
 

 

 

 
1

 
7,903

 
7,903

   Secured by 1-4 family residential
 
2

 
809

 
806

 

 

 

   Other real estate loans
 
1

 
368

 
367

 

 

 

Total real estate loans
 
3

 
$
1,177

 
$
1,173

 
1

 
$
7,903

 
$
7,903

Commercial loans
 

 

 

 

 

 

Consumer loans
 

 

 

 
1

 
3,000

 
2,282

Total
 
3

 
$
1,177

 
$
1,173

 
1

 
$
10,903

 
$
10,185


There were no outstanding commitments to lend additional amounts to troubled debt restructured borrowers at September 30, 2016 or December 31, 2015.

There were no TDR payment defaults during three and nine months ended September 30, 2016 and 2015. For purposes of this disclosure, a TDR payment default occurs when, within 12 months of the original TDR modification, either a full or partial charge-off occurs or a TDR becomes 90 days or more past due.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Note 5.        Allowance for Loan Losses

The following table presents, the total allowance for loan losses, the allowance by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment), the total loans and loans by impairment methodology (individually evaluated for impairment or collectively evaluated for impairment).

16


 
September 30, 2016
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at
December 31, 2015
$
905

 
$
192

 
$
3,341

 
$
3,761

 
$
1,706

 
$
1,141

 
$
11,046

Charge-offs
(388
)
 

 
(7
)
 
(126
)
 
(31
)
 
(17
)
 
(569
)
Recoveries
128

 

 
395

 
27

 
65

 
55

 
670

Provision
238

 
(47
)
 
(112
)
 
(194
)
 
396

 
(228
)
 
53

Balance at
September 30, 2016
$
883

 
$
145

 
$
3,617

 
$
3,468

 
$
2,136

 
$
951

 
$
11,200

Ending allowance:
 

 
 

 
 

 
 

 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$

 
$

 
$
1,214

 
$
406

 
$
190

 
$
802

 
$
2,612

Collectively evaluated for impairment
883

 
145

 
2,403

 
3,062

 
1,946

 
149

 
8,588

Total ending allowance balance
$
883

 
$
145

 
$
3,617

 
$
3,468

 
$
2,136

 
$
951

 
$
11,200

Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
30

 
$
7,931

 
$
4,362

 
$
4,954

 
$
1,285

 
$
1,871

 
$
20,433

Collectively evaluated for impairment
32,489

 
8,901

 
328,046

 
245,824

 
192,541

 
17,656

 
825,457

Total ending loans balance
$
32,519

 
$
16,832

 
$
332,408

 
$
250,778

 
$
193,826

 
$
19,527

 
$
845,890

 
December 31, 2015
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at
December 31, 2014
$
550

 
$
179

 
$
3,966

 
$
3,916

 
$
2,354

 
$
821

 
$
11,786

Charge-offs

 

 
(344
)
 
(9
)
 
(3,281
)
 
(57
)
 
(3,691
)
Recoveries
246

 

 
359

 
28

 
14

 
11

 
658

Provision
109

 
13

 
(640
)
 
(174
)
 
2,619

 
366

 
2,293

Balance at
December 31, 2015
$
905

 
$
192

 
$
3,341

 
$
3,761

 
$
1,706

 
$
1,141

 
$
11,046

Ending allowance:
 

 
 

 
 

 
 

 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
53

 
$

 
$
1,120

 
$
464

 
$
27

 
$
1,000

 
$
2,664

Collectively evaluated for impairment
852

 
192

 
2,221

 
3,297

 
1,679

 
141

 
8,382

Total ending allowance balance
$
905

 
$
192

 
$
3,341

 
$
3,761

 
$
1,706

 
$
1,141

 
$
11,046

Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
203

 
$
7,903

 
$
5,127

 
$
4,196

 
$
1,517

 
$
1,898

 
$
20,844

Collectively evaluated for impairment
39,470

 
11,159

 
274,969

 
253,839

 
188,965

 
16,435

 
784,837

Total ending loans balance
$
39,673

 
$
19,062

 
$
280,096

 
$
258,035

 
$
190,482

 
$
18,333

 
$
805,681



17


 
September 30, 2015
(Dollars in thousands)
Real Estate Construction
 
Real Estate Secured by Farmland
 
Real Estate Secured by 1-4 Family Residential
 
Other Real Estate Loans
 
Commercial
 
Consumer
 
Total
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at
December 31, 2014
$
550

 
$
179

 
$
3,966

 
$
3,916

 
$
2,354

 
$
821

 
$
11,786

Charge-offs

 

 
(100
)
 
(9
)
 
(246
)
 
(46
)
 
(401
)
Recoveries
41

 

 
338

 
23

 
11

 
9

 
422

Provision (recovery)
189

 
12

 
(369
)
 
(200
)
 
(428
)
 
389

 
(407
)
Balance at
September 30, 2015
$
780

 
$
191

 
$
3,835

 
$
3,730

 
$
1,691

 
$
1,173

 
$
11,400

Ending allowance:
 

 
 

 
 

 
 

 
 
 
 
 
 
Ending allowance balance attributable to loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
57

 
$

 
$
1,376

 
$
463

 
$
46

 
$
1,020

 
$
2,962

Collectively evaluated for impairment
723

 
191

 
2,459

 
3,267

 
1,645

 
153

 
8,438

Total ending allowance balance
$
780

 
$
191

 
$
3,835

 
$
3,730

 
$
1,691

 
$
1,173

 
$
11,400

Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
212

 
$
7,903

 
$
5,528

 
$
4,220

 
$
768

 
$
2,302

 
$
20,933

Collectively evaluated for impairment
33,169

 
11,488

 
267,648

 
253,792

 
179,139

 
14,698

 
759,934

Total ending loans balance
$
33,381

 
$
19,391

 
$
273,176

 
$
258,012

 
$
179,907

 
$
17,000

 
$
780,867


Note 6.        Earnings Per Share

The following shows the weighted-average number of shares used in computing earnings per share and the effect on weighted-average number of shares of diluted potential common stock. Nonvested restricted shares are included in basic earnings per share because of dividend participation rights. Potential dilutive common stock had no effect on income available to common stockholders.
 
For the Three Months Ended September 30,
 
2016
 
2015
 
Shares
 
Per Share Amount
 
Shares
 
Per Share Amount
Earnings per share, basic
7,103,235

 
$
0.32

 
7,162,930

 
$
0.32

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options
11,694

 
 
 
6,487

 
 
Warrant
45,235

 
 
 
11,716

 
 
Earnings per share, diluted
7,160,164

 
$
0.32

 
7,181,133

 
$
0.32

 
 
 
 
 
 
 
 
 
For the Nine Months Ended September 30,
 
2016
 
2015
 
Shares
 
Per Share Amount
 
Shares
 
Per Share Amount
Earnings per share, basic
7,092,131

 
$
0.98

 
7,146,495

 
$
0.99

Effect of dilutive securities:
 

 
 

 
 

 
 

Stock options
10,882

 
 
 
6,880

 
 
Warrant
36,193

 
 
 
13,167

 
 
Earnings per share, diluted
7,139,206

 
$
0.98

 
7,166,542

 
$
0.98


The warrant and none of the stock options were considered anti-dilutive as of September 30, 2016 and 2015.

18



Note 7.        Segment Reporting

The Company operates its principal business activities of retail banking services and wealth management services in a decentralized fashion. Revenue from retail banking activity consists primarily of interest and fees earned on loans, including mortgage banking activity, interest earned on investment securities and service charges on deposit accounts. Revenue from the wealth management activities is comprised of fees based upon the market value of the accounts under administration as well as commissions on investment transactions.

Middleburg Bank and the Company have assets in custody with Middleburg Trust Company and accordingly pay Middleburg Trust Company a monthly fee. Middleburg Bank also pays interest to Middleburg Trust Company on deposit accounts with Middleburg Bank. Middleburg Trust Company pays rental and other miscellaneous occupancy expenses to Middleburg Bank. Transactions related to these relationships are eliminated to reach consolidated totals.

The following tables represent reportable segment information for the three and nine months ended September 30, 2016 and 2015, respectively:
 
For the Three Months Ended
 
For the Three Months Ended
 
September 30, 2016
 
September 30, 2015
(In Thousands)
Retail
Banking
Wealth
Management
Intercompany
Eliminations
Consolidated
 
Retail
Banking
Wealth
Management
Intercompany
Eliminations
Consolidated
Revenues:
 
 
 
 
 
 
 
 
 
Interest income
$
10,803

$
3

$
(69
)
$
10,737

 
$
10,700

$
3

$

$
10,703

Trust and investment fee income

1,208

(40
)
1,168

 

1,210

(42
)
1,168

Other income
1,103


(27
)
1,076

 
1,003



1,003

Total operating income
11,906

1,211

(136
)
12,981

 
11,703

1,213

(42
)
12,874

Expenses:
 
 
 
 
 
 
 
 
 
Interest expense
1,189


(69
)
1,120

 
1,044



1,044

Salaries and employee benefits
4,146

581


4,727

 
4,194

599


4,793

Provision for (recovery of) loan losses
(297
)


(297
)
 
(432
)


(432
)
Other
4,286

228

(67
)
4,447

 
4,256

84

(42
)
4,298

Total operating expenses
9,324

809

(136
)
9,997

 
9,062

683

(42
)
9,703

Income before income taxes
2,582

402


2,984

 
2,641

530


3,171

Income tax expense
567

153


720

 
722

128


850

Net Income
$
2,015

$
249

$

$
2,264

 
$
1,919

$
402

$

$
2,321

Total assets
$
1,331,515

$
6,537

$
(3,050
)
$
1,335,002

 
$
1,259,205

$
6,615

$
(4,530
)
$
1,261,290

Capital expenditures
$
153

$

$

$
153

 
$
285

$

$

$
285

Goodwill and other intangibles
$

$
3,507

$

$
3,507

 
$

$
3,679

$

$
3,679


19


 
 
 
 
 
 
 
 
 
 
 
For the Nine Months Ended
 
For the Nine Months Ended
 
September 30, 2016
 
September 30, 2015
(In Thousands)
Retail
Banking
Wealth
Management
Intercompany
Eliminations
Consolidated
 
Retail
Banking
Wealth
Management
Intercompany
Eliminations
Consolidated
Revenues:
 
 
 
 
 
 
 
 
 
Interest income
$
32,772

$
8

$
(69
)
$
32,711

 
$
31,746

$
8

$

$
31,754

Trust and investment fee income

3,582

(124
)
3,458

 

3,753

(124
)
3,629

Other income
3,446


(82
)
3,364

 
3,635



3,635

Total operating income
36,218

3,590

(275
)
39,533

 
35,381

3,761

(124
)
39,018

Expenses:
 
 
 
 
 
 
 
 
 
Interest expense
3,445


(69
)
3,376

 
3,151



3,151

Salaries and employee benefits
12,483

1,669


14,152

 
12,805

1,739


14,544

Provision for (recovery of) loan losses
53



53

 
(407
)


(407
)
Other
12,299

694

(206
)
12,787

 
11,646

653

(124
)
12,175

Total operating expenses
28,280

2,363

(275
)
30,368

 
27,195

2,392

(124
)
29,463

Income before income taxes
7,938

1,227


9,165

 
8,186

1,369


9,555

Income tax expense
1,730

463


2,193

 
2,063

443


2,506

Net Income
$
6,208

$
764

$

$
6,972

 
$
6,123

$
926

$

$
7,049

Total assets
$
1,331,515

$
6,537

$
(3,050
)
$
1,335,002

 
$
1,259,205

$
6,615

$
(4,530
)
$
1,261,290

Capital expenditures
$
250

$

$

$
250

 
$
2,756

$

$

$
2,756

Goodwill and other intangibles
$

$
3,507

$

$
3,507

 
$

$
3,679

$

$
3,679


Note 8.        Capital Purchase Program

On January 30, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008, the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 22,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $2.50 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 208,202 shares of the Company’s common stock, par value $2.50 per share, at an initial exercise price of $15.85 per share. As a result of the completion of a public stock offering in 2009, the number of shares of common stock underlying the Warrant was reduced by one-half to 104,101. The Company subsequently redeemed all 22,000 shares of Preferred Stock pursuant to the Purchase Agreement. During 2011, the Warrant was sold by the U.S. Treasury at public auction and, on November 3, 2016, the warrant was exercised in full for a total cash consideration of $1.65 million.

Note 9.        Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. U.S. GAAP requires that valuation techniques maximize the use of observable inputs and minimize the use of unobservable inputs. U.S. GAAP also establishes a fair value hierarchy which prioritizes the valuation inputs into three broad levels. Based on the underlying inputs, each fair value measurement in its entirety is reported in one of the three levels. The three levels of the fair value hierarchy are as follows:

Level I.
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level II.
Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date.  The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.

Level III.
Assets and liabilities that have little to no pricing observability as of the reported date.  These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.




20


Measured on a recurring basis

The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a recurring basis in the financial statements.

Securities Available for Sale
The Company primarily values its investment portfolio using Level II fair value measurements, but may also use Level I or Level III measurements if required by the composition of the portfolio. If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level II). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified as Level III of the valuation hierarchy.

Interest Rate Swaps and Interest Rate Cap
Interest rate swaps and caps are recorded at fair value based on third party vendors who compile prices from various sources and may determine fair value of identical or similar instruments by using pricing models that consider observable market data (Level II).

The following tables present the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015.
(Dollars in thousands)
 
September 30, 2016
Description
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
70,299

 
$

 
$
70,299

 
$

Obligations of states and political subdivisions
 
68,098

 

 
68,098

 

Mortgage-backed securities:
 
 

 
 

 
 

 
 

Agency
 
133,888

 

 
133,888

 

Non-agency
 
11,222

 

 
11,222

 

Other asset backed securities
 
53,272

 

 
53,272

 

Corporate securities
 
15,839

 

 
15,839

 

Interest rate swaps
 
287

 

 
287

 

Interest rate cap
 
3

 

 
3

 

Liabilities:
 
 
 
 
 
 
 
 
Interest rate swaps
 
733

 

 
733

 

 
(Dollars in thousands)
 
December 31, 2015
Description
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
U.S. government agencies
 
$
78,940

 
$

 
$
78,940

 
$

Obligations of states and political subdivisions
 
75,593

 

 
75,593

 

Mortgage-backed securities:
 
 

 
 

 
 

 
 

Agency
 
131,661

 

 
131,661

 

Non-agency
 
12,777

 

 
12,777

 

Other asset backed securities
 
58,781

 

 
58,781

 

Corporate securities
 
16,819

 

 
16,819

 


Interest rate swaps
 
73

 

 
73

 

Interest rate cap
 
39

 

 
39

 

Liabilities:
 
 
 
 
 
 
 
 
Interest rate swaps
 
370

 

 
370

 


Measured on nonrecurring basis

The Company may be required, from time to time, to measure and recognize certain other assets at fair value on a nonrecurring basis in accordance with U.S. GAAP. The following describes the valuation techniques and inputs used by the Company in determining the fair value of certain assets recorded at fair value on a nonrecurring basis in the financial statements.


21


Loans Held for Sale
Loans held for sale are carried at lower of cost or market value. These loans currently consist of 1-4 family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level II). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the three and nine months ended September 30, 2016. Gains and losses on the sale of loans are recorded as a component of non-interest income on the consolidated statements of income.

Impaired Loans
Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due.  The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral.  Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable.  Any given loan may have multiple types of collateral. The vast majority of the collateral is real estate.  The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level II).  However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level III. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business' financial statements if not considered significant.  Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level III).  Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.

Other Real Estate Owned
Other Real Estate Owned (“OREO”) is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level III. The initial fair value of OREO is based on an appraisal performed at the time of foreclosure. Subsequent fair value adjustments are recorded in the period incurred and included in other real estate owned, net, on the consolidated statements of income.

For the purpose of OREO valuations, appraisals are discounted 10% for selling costs and it is the policy of the Company to obtain annual appraisals for properties held in accordance with the bank's OREO policy.

Repossessed Assets
The value of repossessed assets is determined by the Company based on marketability and other factors and is considered Level III. Any fair value adjustments are recorded in the period incurred and are included in other operating expenses on the consolidated statements of income.
 
The following table summarizes the Company’s non-financial assets that were measured at fair value on a nonrecurring basis during the period.
(Dollars in thousands)
 
September 30, 2016
 
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 
 
 
 
 
 
 
Impaired loans
 
$
7,819

 
$

 
$

 
$
7,819

Other real estate owned
 
$
3,387

 
$

 
$

 
$
3,387

Repossessed assets (1)
 
$
1,043

 
$

 
$

 
$
1,043

 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
December 31, 2015
 
 
Total
 
Level I
 
Level II
 
Level III
Assets:
 
 

 
 

 
 

 
 

Impaired loans
 
$
9,018

 
$

 
$

 
$
9,018

Other real estate owned
 
$
3,345

 
$

 
$

 
$
3,345

Repossessed assets (1)
 
$
1,043

 
$

 
$

 
$
1,043

(1) 
Included in other assets on the consolidated balance sheets.


22


The following table presents quantitative information as of September 30, 2016 and December 31, 2015 about Level III fair value measurements for assets measured at fair value on a nonrecurring basis:
September 30, 2016
 
Fair Value
(in thousands)
 
Valuation Technique
 
Unobservable Inputs
 
Range
(Weighted Average)
Impaired loans
 
$
4,130

 
Appraisals
 
Discount to reflect current market conditions and estimated selling costs
 
0% - 100% (10%)
Impaired loans
 
$
3,689

 
Present value of cash flows
 
Discount rate
 
6% - 7% (6%)
Other real estate owned
 
$
3,387

 
Appraisals
 
Discount to reflect current market conditions and estimated selling costs
 
10%
Repossessed assets
 
$
1,043

 
Market analysis
 
Historical sales activity
 
50%

December 31, 2015
 
Fair Value
(in thousands)
 
Valuation Technique
 
Unobservable Inputs
 
Range
(Weighted Average)
Impaired loans
 
$
5,434

 
Appraisals
 
Discount to reflect current market conditions and estimated selling costs
 
0% - 100% (17%)
Impaired loans
 
$
3,584

 
Present value of cash flows
 
Discount rate
 
6% - 8% (7%)
Other real estate owned
 
$
3,345

 
Appraisals
 
Discount to reflect current market conditions and estimated selling costs
 
10%
Repossessed assets
 
$
1,043

 
Market analysis
 
Historical sales activity
 
50%

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation.  Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Company’s various financial instruments.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.  U.S. GAAP excludes certain financial instruments and all non-financial instruments from its disclosure requirements.  Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments (not previously described) for which it is practicable to estimate that value:

Cash and Cash Equivalents
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Securities held to maturity
Certain debt securities that management has the positive intent and ability to hold until maturity are recorded at amortized cost. Fair values are determined in a manner that is consistent with securities available for sale.

Restricted securities
The restricted security category is comprised of FHLB and Federal Reserve Bank stock. These stocks are classified as restricted securities because their ownership is restricted to certain types of entities and they lack a market. When the FHLB or Federal

23


Reserve Bank repurchases stock, they repurchase at the stock's book value. Therefore, the carrying amounts of restricted securities approximate fair value.

Loans, Net
For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  For fixed rate loans, the fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality.  Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value. Fair value for impaired loans is described above.

Bank Owned Life Insurance
The carrying amount of bank owned life insurance is a reasonable estimate of fair value.

Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate fair values.

Deposits
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date.  For all other deposits, the fair value is determined using the discounted cash flow method.  The discount rate is equal to the rate currently offered on similar products.

Securities Sold Under Agreements to Repurchase
The carrying amounts approximate fair values.

FHLB Borrowings and Subordinated Notes
For variable rate long-term debt, fair values are based on carrying values.  For fixed rate debt, fair values are estimated based on observable market prices and discounted cash flow analysis using interest rates for borrowings of similar remaining maturities and characteristics.  The fair values of the Company's Subordinated Notes are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance Sheet Financial Instruments
The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.  For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.  The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.  At September 30, 2016 and December 31, 2015, the fair values of loan commitments and standby letters of credit were deemed immaterial; therefore, they have not been included in the tables below.

Fair Value of Financial Instruments
The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows:

24


(Dollars in thousands)
September 30, 2016
 
 
 
 
 
Fair value measurements using:
 
Carrying
Amount
 
Total Fair Value
 
Level I
 
Level II
 
Level III
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
55,791

 
$
55,791

 
$
55,791

 
$

 
$

Securities held to maturity
10,727

 
10,957

 

 
10,957

 

Securities available for sale
352,618

 
352,618

 

 
352,618

 

Loans held for sale, net
669

 
669

 

 
669

 

Loans, net
834,690

 
843,307

 

 

 
843,307

Bank owned life insurance
23,761

 
23,761

 

 
23,761

 

Accrued interest receivable
5,030

 
5,030

 

 
5,030

 

Interest rate swaps
287

 
287

 

 
287

 

Interest rate cap
3

 
3

 

 
3

 

Financial liabilities:
 

 
 

 
 
 
 
 
 
Deposits
$
1,091,505

 
$
1,090,406

 
$

 
$
1,090,406

 
$

Securities sold under agreements to repurchase
31,540

 
31,540

 

 
31,540

 

FHLB borrowings
63,500

 
63,655

 

 
63,655

 

Subordinated notes
5,155

 
5,168

 

 
5,168

 

Accrued interest payable
407

 
407

 

 
407

 

Interest rate swaps
733

 
733

 

 
733

 


(Dollars in thousands)
December 31, 2015
 
 
 
 
 
Fair value measurements using:
 
Carrying
Amount
 
Total Fair Value
 
Level I
 
Level II
 
Level III
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
39,228

 
$
39,228

 
$
39,228

 
$

 
$

Securities held to maturity
4,207

 
4,163

 

 
4,163

 

Securities available for sale
374,571

 
374,571

 

 
374,571

 

Loans, net
794,635

 
802,535

 

 

 
802,535

Bank-owned life insurance
23,273

 
23,273

 

 
23,273

 

Accrued interest receivable
5,204

 
5,204

 

 
5,204

 

Interest rate swaps
73

 
73

 

 
73

 

Interest rate cap
39

 
39

 

 
39

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
Deposits
$
1,040,800

 
$
1,040,016

 
$

 
$
1,040,016

 
$

Securities sold under agreements to repurchase
26,869

 
26,869

 

 
26,869

 

FHLB borrowings
85,000

 
85,033

 

 
85,033

 

Subordinated debt
5,155

 
5,157

 

 
5,157

 

Accrued interest payable
410

 
410

 

 
410

 

Interest rate swaps
370

 
370

 

 
370

 

 
The Company assumes interest rate risk as a result of its normal operations.  The fair values of the Company's financial instruments will change when interest rate levels change, which may be either favorable or unfavorable to the Company.  Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk.  However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment.  Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment.  Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.

Note 10.        Recent Accounting Pronouncements

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” This update is intended to provide guidance

25


about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period. If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 to have a material impact 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.” The amendments in ASU 2016-01, among other things: 1) Requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. 2) Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. 3) Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). 4) Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is currently assessing the impact that ASU 2016-02 will have on its consolidated financial statements.

During March 2016, the FASB issued ASU No. 2016-05, “Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships.” The amendments in this ASU clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria remain intact. The amendments are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-05 to have a material impact on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-07, “Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting.” The amendments in this ASU eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The amendments require that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. In addition, the amendments in this ASU require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-07 to have a material impact on its consolidated financial statements.

26



During March 2016, the FASB issued ASU No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company is currently assessing the impact that ASU 2016-09 will have on its consolidated financial statements.

During June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements.

During August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments”, to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The amendments should be applied using a retrospective transition method to each period presented. If retrospective application is impractical for some of the issues addressed by the update, the amendments for those issues would be applied prospectively as of the earliest date practicable. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.

Note 11.        Accumulated Other Comprehensive Income

Changes in accumulated other comprehensive income for the nine months ended September 30, 2016 and 2015 were:
(Dollars in thousands)
Unrealized Gains on Securities
 
Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Balance December 31, 2014
$
3,979

 
$
(185
)
 
$
3,794

Unrealized holding losses (net of tax, $229)
(446
)
 

 
(446
)
Reclassification adjustment (net of tax, $47)
(91
)
 

 
(91
)
Unrealized losses on interest rate swaps (net of tax, $66)

 
(129
)
 
(129
)
Reclassification adjustment (net of tax, $2)

 
(4
)
 
(4
)
Balance September 30, 2015
$
3,442

 
$
(318
)
 
$
3,124

 
 
 
 
 
 
Balance December 31, 2015
$
1,872

 
$
(195
)
 
$
1,677

Unrealized holding gains (net of tax, $805)
1,561

 

 
1,561

Reclassification adjustment (net of tax, $174)
(337
)
 

 
(337
)
Unrealized loss on interest rate swaps (net of tax, $51)

 
(98
)
 
(98
)
Balance September 30, 2016
$
3,096

 
$
(293
)
 
$
2,803


The following table presents information related to reclassifications from accumulated other comprehensive income:


27


Details about Accumulated Other Comprehensive Income
Amount Reclassified from Accumulated Other Comprehensive Income
Affected Line Item in the Consolidated Statements of Income
 
For the Three Months Ended September 30,
 
 
(Dollars in thousands)
2016
 
2015
 
 
Securities available for sale (1):
 
 
 
 
 
Net securities gains reclassified into earnings
$
(138
)
 
$

 
Gain on sales of securities available for sale, net
Related income tax expense
47

 

 
Income tax expense
Net effect on accumulated other comprehensive income for the period
(91
)
 

 
Net of tax
Total reclassifications for the period
$
(91
)
 
$

 
Net of tax
(1) 
For more information related to unrealized gains on securities available for sale, see Note 3, "Securities".

 
 
 
 
 
 
Details about Accumulated Other Comprehensive Income
Amount Reclassified from Accumulated Other Comprehensive Income
Affected Line Item in the Consolidated Statements of Income
 
For the Nine Months Ended September 30,
 
 
(Dollars in thousands)
2016
 
2015
 
 
Securities available for sale (1):
 
 
 
 
 
Net securities gains reclassified into earnings
$
(511
)
 
$
(138
)
 
Gain on sales of securities available for sale, net
Related income tax expense
174

 
47

 
Income tax expense
Derivatives (2):
 
 
 
 
 
(Gain) loss on interest rate swap ineffectiveness

 
(6
)
 
Other operating expenses
Related income tax expense

 
2

 
Income tax expense
Net effect on accumulated other comprehensive income
(337
)
 
(95
)
 
Net of tax
Total reclassifications
$
(337
)
 
$
(95
)
 
Net of tax
(1) 
For more information related to unrealized gains on securities available for sale, see Note 3, "Securities".
(2) 
For more information related to unrealized losses on derivatives, see Note 12, "Derivatives".

Note 12.        Derivatives

The Company utilizes derivative instruments as a part of its asset-liability management program to control fluctuation of market values and cash flows to changes in interest rates associated with certain financial instruments. The Company accounts for derivatives in accordance with ASC 815, "Derivatives and Hedging". Under current guidance, derivative transactions are classified as either cash flow hedges or fair value hedges or they are not designated as hedging instruments. The Company designates each derivative instrument at the inception of the derivative transaction in accordance with this guidance. Information concerning each of the Company's categories of derivatives as of September 30, 2016 and December 31, 2015 is presented below.

Derivatives designated as cash flow hedges

During 2010, the Company entered into an interest rate swap agreement as part of the interest rate risk management process.  The swap was designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s trust preferred capital securities. The swap hedges the cash flow associated with the trust preferred capital notes wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 2.59% to the same counterparty.  The swap is calculated on a notional amount of $5.2 million.  The term of the swap is 10 years and commenced on October 23, 2010.  The Company had cash collateral reserved for this swap in the amount of $400,000 as of September 30, 2016 and December 31, 2015. The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.

During 2013, the Company entered into an interest rate swap agreement as part of the interest rate risk management process.  The swap has been designated as a cash flow hedge intended to hedge the variability of cash flows associated with the Company’s

28


FHLB borrowings. The swap hedges the cash flows associated with the FHLB borrowings wherein the Company receives a floating rate based on LIBOR from a counterparty and pays a fixed rate of 1.43% to the same counterparty.  The swap is calculated on a notional amount of $10.0 million.  The term of the swap is 5 years and commenced on November 25, 2013.  The Company had cash collateral reserved for this swap in the amount of $600,000 and $300,000 as of September 30, 2016 and December 31, 2015, respectively. The swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party.  The Company believes that the credit risk inherent in the contract is not significant.

Amounts receivable or payable are recognized as accrued under the terms of the agreement, with the effective portion of the derivative’s unrealized gain or loss recorded as a component of other comprehensive income.  The ineffective portion of the unrealized gain or loss, if any, would be recorded in other expense.  The Company has assessed the effectiveness of the hedging relationship by comparing the changes in cash flows on the designated hedged item.  As a result of this assessment, there was no hedge ineffectiveness identified for the three and nine months ended September 30, 2016 and 2015. At December 31, 2015 there was no hedge ineffectiveness identified for this interest rate swap.
 
The amounts included in accumulated other comprehensive income as unrealized losses (fair value, net of tax) were $293,000 and $195,000 as of September 30, 2016 and December 31, 2015, respectively.

Information concerning the derivatives designated as a cash flow hedges at September 30, 2016 and December 31, 2015 is presented in the following tables:
 
September 30, 2016
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
5,155

 
$

 
$
308

 
0.71
%
 
2.59
%
 
3.9
Pay fixed - receive floating interest rate swap
1
 
$
10,000

 
$

 
$
138

 
0.44
%
 
1.43
%
 
2.1

 
December 31, 2015
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
5,155

 
$

 
$
226

 
0.32
%
 
2.59
%
 
4.8
Pay fixed - receive floating interest rate swap
1
 
$
10,000

 
$

 
$
71

 
0.23
%
 
1.43
%
 
3.0

Derivatives not designated as hedging instruments

Two-way client loan swaps
During the fourth quarter of 2014 and 2012, the Company entered into certain interest rate swap contracts that are not designated as hedging instruments. These derivative contracts relate to transactions in which we enter into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution. In connection with each swap transaction, the Company agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on an identical notional amount at a fixed interest rate. At the same time, the Company agrees to pay the counterparty the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows our clients to effectively convert a variable rate loan into a fixed rate loan. Because the Company acts as an intermediary for our customers, changes in the fair value of the underlying derivatives contracts offset each other and do not significantly impact our results of operations.

Certain additional risks arise from interest rate swap contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. We do not expect any counterparty to fail to meet its obligations.

Information concerning two-way client interest rate swaps not designated as either fair value or cash flow hedges is presented in the following table:

29


 
September 30, 2016
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1
 
$
3,572

 
$

 
$
156

 
1 month
LIBOR
plus 200 BP

 
3.90
%
 
11.0
Pay fixed - receive floating interest rate swap
1
 
1,674

 

 
131

 
1 month
LIBOR
plus 180 BP

 
4.09
%
 
8.0
Pay floating - receive fixed interest rate swap
1
 
3,572

 
156

 

 
3.90
%
 
1 month
LIBOR
plus 200 BP

 
11.0
Pay floating - receive fixed interest rate swap
1
 
1,674

 
131

 

 
4.09
%
 
1 month
LIBOR
plus 180 BP

 
8.0
Total derivatives not designated
 
 
$
10,492

 
$
287

 
$
287

 
 
 
 
 
 

 
December 31, 2015
 
Positions (#)
 
Notional Amount
(in thousands)
 
Asset
(in thousands)
 
Liability
(in thousands)
 
Receive Rate
 
Pay
Rate
 
Life (Years)
Pay fixed - receive floating interest rate swap
1

 
$
3,760

 
$

 
$
21

 
1 month
LIBOR
plus 200 BP

 
3.90
%
 
11.9
Pay fixed - receive floating interest rate swap
1

 
1,706

 

 
52

 
1 month
LIBOR
plus 180 BP

 
4.09
%
 
8.9
Pay floating - receive fixed interest rate swap
1

 
3,760

 
21

 

 
3.90
%
 
1 month
LIBOR
plus 200 BP

 
11.9
Pay floating - receive fixed interest rate swap
1

 
1,706

 
52

 

 
4.09
%
 
1 month
LIBOR
plus 180 BP

 
8.9
Total derivatives not designated
 
 
$
10,932

 
$
73

 
$
73

 
 
 
 
 


Rate Cap Transaction
At September 30, 2016, the Company had one derivative instrument in the form of an interest rate cap agreement with a notional amount of $10.0 million. The notional amount of the financial derivative instrument does not represent exposure to credit loss. The Company is exposed to credit loss only to the extent the counter-party defaults in its responsibility to pay interest under the terms of the agreement. The credit risk in derivative instruments is mitigated by entering into transactions with highly-rated counterparties that management believes to be creditworthy and by limiting the amount of exposure to each counter-party. We do not expect any counterparty to fail to meet its obligations.

The details of the interest rate cap agreement as of September 30, 2016 and December 31, 2015 are summarized below:

30


September 30, 2016
(Dollars in thousands)
Notional Amount
 
Termination Date
 
3-Month LIBOR Strike Rate
 
Premium Paid
 
Unamortized Premium at
September 30, 2016
 
Fair Value
September 30, 2016
 
Cumulative Cash Flows Received
$
10,000

 
September 8, 2018
 
2.00
%
 
$
70

 
$
70

 
$
3

 
$

December 31, 2015
(Dollars in thousands)
Notional Amount
 
Termination Date
 
3-Month LIBOR Strike Rate
 
Premium Paid
 
Unamortized Premium at December 31, 2015
 
Fair Value
December 31, 2015
 
Cumulative Cash Flows Received
$
10,000

 
September 8, 2018
 
2.00
%
 
$
70

 
$
70

 
$
39

 
$


In the third quarter of 2015, the interest rate cap agreement was purchased to limit the Company's exposure to rising interest rates. Under the terms of the agreement, the Company paid a premium of $70,000 for the right to receive cash flow payments if 3-month LIBOR rises above the cap of 2.00%, thus effectively ensuring interest expense is capped at a maximum rate of 2.00% for the duration of the agreement. The interest rate cap agreement is a derivative not designated as a hedging instrument.

At September 30, 2016 and December 31, 2015, the total fair value of the interest rate cap agreement was $3,000 and $39,000, respectively. The fair value of the interest rate cap agreement is included in other assets on the Company's consolidated balance sheets. Changes in fair value are recorded in earnings in other operating expenses. For the nine months ended September 30, 2016 and the year ended December 31, 2015, $36,000 and $31,000 was recognized in other operating expenses. During the three and nine months ended September 30, 2015, the total fair value of the interest rate cap agreement was $35,000 and $35,000 was recognized in other operating expenses.

The premium paid on the interest rate cap agreement is recognized as a decrease in interest income over the duration of the agreement using the caplet method. For the three and nine months ended September 30, 2016 and for the year ended December 31, 2015, no premium amortization was required.
 
Note 13.        Other Real Estate Owned (OREO)

At September 30, 2016 and December 31, 2015, OREO balances were $3.4 million and $3.3 million, respectively. OREO is primarily comprised of residential properties and non-residential properties, and are located primarily in the state of Virginia. Changes in the balance for OREO, net of valuation allowances, are as follows:
(Dollars in thousands)
September 30, 2016
 
December 31, 2015
Balance at the beginning of year, net
$
3,345

 
$
4,051

Transfers from loans and to premises and equipment, net
526

 
287

Sales proceeds
(224
)
 
(814
)
Gains (losses) on disposition
50

 
(100
)
Less valuation adjustments
(310
)
 
(79
)
Balance at the end of the period, net
$
3,387

 
$
3,345


Expenses applicable to net OREO, including gains and losses on sales as well as valuation adjustments, were $183,000 and $193,000 during the three months ended September 30, 2016 and 2015, respectively and $339,000 and $285,000 during the nine months ended September 30, 2016 and 2015, respectively.

The major classifications of OREO in the consolidated balance sheets at September 30, 2016 and December 31, 2015 were as follows:

31


(Dollars in thousands)
September 30, 2016
 
December 31, 2015
Real estate loans:
 
 
 
Construction
$
858

 
$
853

Secured by farmland

 

Secured by 1-4 family residential
2,169

 
1,958

Other real estate loans
360

 
534

Total real estate loans
$
3,387

 
$
3,345


At September 30, 2016, the Company had no consumer mortgage loans secured by residential real estate for which foreclosure was in process. At December 31, 2015, the Company had one consumer mortgage loan secured by residential real estate that totaled $533,000 for which foreclosure was in process and subsequently transfered to OREO.

Note 14.        Low Income Housing Tax Credits

The Company has invested in four separate housing equity funds at September 30, 2016 and December 31, 2015. The general purpose of these funds is to encourage and assist participants in investing in low-income residential rental properties located in the Commonwealth of Virginia, develop and implement strategies to maintain projects as low-income housing, deliver Federal Low Income Housing Credits to investors, allocate tax losses and other possible tax benefits to investors, and to preserve and protect project assets. The investments in these funds were recorded as other assets on the consolidated balance sheets and were $8.50 million and $9.03 million at September 30, 2016 and December 31, 2015, respectively. The expected terms of these investments and the related tax benefits run through 2033. Tax credits and other tax benefits recognized during the three months ended September 30, 2016 and 2015 were $110,000 and $36,000, respectively, and for the nine months ended September 30, 2016 and 2015, were $345,000 and $178,000, respectively, related to these investments. Total projected tax credits to be received for 2016 are $504,000, which is based on the most recent quarterly estimates received from the funds. Additional capital calls expected for the funds totaled $8.71 million and $9.31 million at September 30, 2016 and December 31, 2015, respectively, and are included in other liabilities on the consolidated balance sheets.


32


ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITON AND RESULTS OF OPERATIONS

The following discussion and analysis of the financial condition at September 30, 2016 and results of operations of the Company for the three and nine months ended September 30, 2016 should be read in conjunction with the Company’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included in this report and in the 2015 Form 10-K. It should also be read in conjunction with the “Caution About Forward Looking Statements” section at the end of this discussion.

Overview

The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc.  Middleburg Bank is a community bank serving the Virginia counties of Prince William, Loudoun, Fairfax, Fauquier, the City of Williamsburg and the City of Richmond with twelve financial service centers and one limited service facility.  Middleburg Investment Group is a non-bank holding company with one wholly owned subsidiary, Middleburg Trust Company.  Middleburg Trust Company is a trust company headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank’s financial service centers.  

The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank.  Net interest income is the difference between interest income and interest expense.  Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon.  Middleburg Bank’s cost of funds is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon.  The quality of the assets further influences the amount of interest income lost on nonaccrual loans and the amount of additions to the allowance for loan losses or potential other-than-temporary impairment of securities.  Middleburg Investment Group’s subsidiary, Middleburg Trust Company, generates fee income by providing investment management and trust services to its clients.  Investment management and trust fees are generally based upon the value of assets under management, and, therefore can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets.  

On October 24, 2016, the Company and Access National Corporation (“Access”) announced a definitive agreement to combine in a strategic merger (the “Merger Agreement”) pursuant to which the Company will merge with and into Access (the “Merger”). As a result of the Merger, the holders of shares of the Company's common stock will receive 1.3314 shares of Access common stock for each share of the Company's common stock held immediately prior to the effective date of the Merger. The completion of the Merger is subject to various closing conditions, including obtaining the approvals of the Company’s and Access' shareholders and receiving certain regulatory approvals. The transaction is expected to close during the second quarter 2017.

Net income for the quarter ended September 30, 2016 decreased by 2.46% to $2.26 million from $2.32 million for the same period in 2015. Earnings per diluted share for the quarter ended September 30, 2016 were $0.32 per share compared to $0.32 per share for the same period in 2015. Net income for the nine months ended September 30, 2016 decreased 1.09% to $6.97 million from $7.05 million over the same period in 2015. Earnings per diluted share for the nine months ended September 30, 2016 and 2015 were $0.98 per share.
 
Annualized return on average assets for the quarter ended September 30, 2016 was 0.68% compared to 0.73% for the same period in 2015. Annualized return on average equity for the quarter ended September 30, 2016 was 7.01% compared to 7.32% for the same period in 2015. Annualized return on average assets for the nine months ended September 30, 2016 was 0.71%, compared to 0.75% for the same period in 2015. Annualized return on average equity for the nine months ended September 30, 2016 was 7.37%, compared to 7.54% for the same period in 2015.
 
The net interest margin, a non-GAAP measure more fully described in the “Results of Operations” section below, decreased from 3.28% for the quarter ended September 30, 2015 to 3.11% for the quarter ended September 30, 2016.  The net interest margin decreased from 3.31% for the nine months ended September 30, 2015 to 3.20% for the nine months ended September 30, 2016.

The Company recorded a recovery of loan losses in the amount of $297,000 for the quarter ended September 30, 2016 compared to the recovery of loan losses of $432,000 for the same period in 2015. The provision for loan losses was $53,000 for the nine months ended September 30, 2016 compared to a recovery of loan losses of $407,000 for the same period in 2015. Refer to the discussion of asset quality in the financial condition section for specific discussion in the movement of asset quality.
 
Non-interest income for the quarter ended September 30, 2016 increased by 3.36% compared to the quarter ended September 30, 2015. Non-interest income for the nine months ended September 30, 2016 decreased by 6.08% compared to the same period in 2015. The Company recorded net gains on securities available for sale of $138,000 and $511,000 the quarter and nine month periods ended September 30, 2016, respectively, as sales were made to fund loan growth. Also, in the first quarter of 2015, there

33


was a substantial recovery of expenses of approximately $500,000 related to a loan that had previously been charged-off. Excluding this recovery, other operating income for the nine month period ended September 30, 2016 would have been relatively flat compared to 2015. Other operating income generally includes revenue from prepayment penalties, safe deposit charges, wire fees and other miscellaneous adjustments.

Non-interest expense increased by 0.91% compared to the quarter ended September 30, 2015. For the nine months ended September 30, 2016, non-interest expense increased by 0.82% compared to the same period in 2015.

The Company’s capital ratios remain well above regulatory minimum capital ratios as of September 30, 2016:
Capital Ratios
 
Actual
September 30, 2016
 
Regulatory Minimum (1)
 
Excess Over Regulatory Minimum
Tier 1 leverage ratio
 
9.6
%
 
4.0
%
 
5.6
%
Common equity tier 1 ratio
 
15.9
%
 
7.0
%
 
8.9
%
Tier 1 risk-based capital ratio
 
16.6
%
 
8.5
%
 
8.1
%
Total risk-based capital ratio
 
17.8
%
 
10.5
%
 
7.3
%
(1) 
Assumes fully phased-in Basel III regulatory capital rules. The Common Equity Ratio, the Tier 1 Ratio and the Total Capital Ratio include a 2.50% Capital Conservation Buffer that must be maintained in order for the bank to remain well capitalized and to avoid restrictions on payments of dividends, bonuses, capital repurchases and restricted payments.

At September 30, 2016, total assets were $1.34 billion, an increase of 3.10% since December 31, 2015.  Gross loans held-for-investment increased by $40.21 million to $845.89 million, an increase of 4.99% since December 31, 2015. Total deposits were $1.09 billion, an increase of 4.87% since December 31, 2015. Non-maturity deposits, including demand, NOW and savings deposits increased by $33.75 million from December 31, 2015 to $829.97 million at September 30, 2016.  Time deposits increased by 6.93% or $16.96 million from December 31, 2015 to $261.53 million at September 30, 2016.  

Critical Accounting Policies

General
The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to some degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of Middleburg Financial Corporation’s financial condition and results of operations.  The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses
Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio.  Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with U.S. GAAP; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting standards.  Loans evaluated individually for impairment include nonperforming loans, such as loans on nonaccrual, loans past due 90 days or more, troubled debt restructurings and other loans selected by management.  If a loan evaluated individually is determined not to be impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics. For loans determined to be impaired, the evaluations are based upon discounted cash flows, collateral valuations or observable market price.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment, if any.  

For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon

34


estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amount of estimated impairment for individually evaluated loans and groups of unimpaired loans is added together for a total estimate of loans losses.  This estimate of losses is compared to the allowance for loan losses as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is appropriately stated.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which may be material to the consolidated financial statements.
 
Goodwill
With the adoption of Accounting Standards Update 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment", the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, we determine that it is more likely than not that the fair value of each applicable reporting unit is less than its carrying amount. If the likelihood of impairment is more than 50%, the Company must perform a test for impairment and may be required to record impairment charges. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value with its carrying amount, including goodwill. If the carrying amount is greater than zero and its fair value exceeds its carrying amount, goodwill is considered not impaired; thus, the second step of the impairment test is unnecessary. If the carrying amount exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value with the carrying amount of that goodwill. If the carrying amount exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is recognized.

Management estimates fair value utilizing multiple methodologies which include discounted cash flows, comparable companies, third-party sale and assets under management analysis. Determining the fair value requires management to make judgments and assumptions related to various items, including estimates of future operating results, allocations of indirect expenses, and discount rates.  Management believes its estimates and assumptions are reasonable; however, the fair value could be different in the future if actual results or market conditions differ from the estimates and assumptions used.

The Company’s forecasted cash flows assume a stable economic environment and consistent long-term growth in assets under management over the projected periods.  Additionally, expenses are assumed to be consistently correlated with projected asset and revenue growth over the time periods projected.  Although we believe the key assumptions underlying the financial forecasts to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond the control of the Company.  Accordingly, there can be no assurance that the forecasted results will be realized and variations from the forecast may be material.  If weak economic conditions continue or worsen for a prolonged period of time, or if the reporting unit loses key personnel, the fair value may be adversely affected which may result in impairment of goodwill or other intangible assets in the future.  Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company’s financial condition and results of operations.

Other-Than-Temporary Impairment (OTTI) for Securities
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a

35


recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.

Results of Operations

The Company's net income for the third quarter of 2016 was $2.26 million, a decrease of $57,000 or 2.46% compared to the third quarter of 2015. For the third quarter of 2016 and 2015, earnings per diluted share were $0.32.

The following tables reflect an analysis of the Company’s net interest income for the quarters ended September 30, 2016 and 2015 using the daily average balances of the Company’s assets and liabilities for the periods indicated. Nonaccrual loans are included in the loan balances.


36


 
Three Months Ended September 30,
 
2016
 
2015
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
(Dollars in thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
314,367

 
$
1,667

 
2.11
%
 
$
320,684

 
$
2,009

 
2.49
%
Tax-exempt (1)
50,914

 
623

 
4.86
%
 
51,252

 
672

 
5.20
%
Total securities
$
365,281

 
$
2,290

 
2.49
%
 
$
371,936

 
$
2,681

 
2.86
%
Loans:
 
 
 
 
 
 
 
 
 
 
 
   Taxable
$
851,030

 
$
8,618

 
4.03
%
 
$
777,039

 
$
8,222

 
4.20
%
   Tax-exempt (1)
577

 
8

 
5.52
%
 
630

 
8

 
5.04
%
Total loans (3)
$
851,607

 
$
8,626

 
4.03
%
 
$
777,669

 
$
8,230

 
4.20
%
Interest on deposits with other banks and federal funds sold
39,315

 
35

 
0.35
%
 
46,671

 
23

 
0.20
%
Total earning assets
$
1,256,203

 
$
10,951

 
3.47
%
 
$
1,196,276

 
$
10,934

 
3.63
%
Less: allowances for loan losses
(11,516
)
 
 
 
 
 
(11,870
)
 
 
 
 
Total nonearning assets
80,465

 
 
 
 
 
77,155

 
 
 
 
Total assets
$
1,325,152

 
 

 
 
 
$
1,261,561

 
 

 
 
Liabilities:
 

 
 

 
 
 
 

 
 

 
 
Interest-bearing deposits:
 

 
 

 
 
 
 

 
 

 


Checking
$
350,110

 
$
194

 
0.22
%
 
$
343,584

 
$
176

 
0.20
%
Regular savings
130,623

 
61

 
0.19
%
 
120,104

 
56

 
0.18
%
Money market savings
76,377

 
49

 
0.26
%
 
66,144

 
32

 
0.19
%
Time deposits:
 
 
 
 
 
 
 
 
 
 
 
$100,000 and over
153,108

 
336

 
0.87
%
 
148,998

 
322

 
0.86
%
Under $100,000
116,061

 
269

 
0.92
%
 
103,897

 
291

 
1.11
%
Total interest-bearing deposits
$
826,279

 
$
909

 
0.44
%
 
$
782,727

 
$
877

 
0.45
%
Securities sold under agreements to repurchase
33,585

 
1

 
0.01
%
 
28,859

 
2

 
0.03
%
FHLB borrowings and other debt
71,731

 
210

 
1.17
%
 
68,416

 
165

 
0.96
%
Total interest-bearing liabilities
$
931,595

 
$
1,120

 
0.48
%
 
$
880,002

 
$
1,044

 
0.47
%
Non-interest bearing liabilities:
 

 
 

 
 
 
 

 
 

 
 
Demand deposits
250,705

 
 
 
 
 
242,983

 
 
 
 
Other liabilities
14,379

 
 
 
 
 
12,815

 
 
 
 
Total liabilities
$
1,196,679

 
 

 
 
 
$
1,135,800

 
 

 
 
Shareholders' equity
128,473

 
 
 
 
 
125,761

 
 
 
 
Total liabilities and shareholders' equity
$
1,325,152

 
 

 
 
 
$
1,261,561

 
 

 
 
Net interest income
 

 
$
9,831

 
 
 
 

 
$
9,890

 
 
Interest rate spread
 

 
 

 
2.99
%
 
 

 
 

 
3.16
%
Cost of Funds
 

 
 

 
0.38
%
 
 

 
 

 
0.37
%
Interest expense as a percent of average earning assets
 

 
 

 
0.35
%
 
 

 
 

 
0.35
%
Net interest margin
 

 
 

 
3.11
%
 
 

 
 

 
3.28
%
(1) 
Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%.
(2) 
All yields and rates have been annualized on a 366 day year for 2016 and 365 day year for 2015.
(3) 
Total average loans include loans on non-accrual status.

The Company's net income for the nine months ended September 30, 2016 was $6.97 million, a decrease of $77,000 or 1.09% from the nine months ended September 30, 2015. For the nine months ended September 30, 2016 and 2015, earnings per diluted share was $0.98.

The following tables reflect an analysis of the Company’s net interest income for the nine months ended September 30, 2016 and 2015 using the daily average balances of the Company’s assets and liabilities for the periods indicated. Nonaccrual loans are included in the loan balances.

37


 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30,
 
2016
 
2015
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
Average
Balance
 
Income/
Expense
 
Yield/
Rate (2)
 
(Dollars in thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
325,562

 
$
5,888

 
2.42
%
 
$
315,507

 
$
5,832

 
2.47
%
Tax-exempt (1)
50,755

 
1,974

 
5.20
%
 
51,680

 
2,051

 
5.31
%
Total securities
$
376,317

 
$
7,862

 
2.79
%
 
$
367,187

 
$
7,883

 
2.87
%
Loans:
 
 
 
 
 
 
 
 
 
 
 
   Taxable
$
832,214

 
$
25,380

 
4.07
%
 
$
764,337

 
$
24,468

 
4.28
%
   Tax-exempt (1)
625

 
26

 
5.56
%
 
620

 
25

 
5.39
%
Total loans (3)
$
832,839

 
$
25,406

 
4.07
%
 
$
764,957

 
$
24,493

 
4.28
%
Interest on deposits with other banks and federal funds sold
42,115

 
123

 
0.39
%
 
52,858

 
84

 
0.21
%
Total earning assets
$
1,251,271

 
$
33,391

 
3.56
%
 
$
1,185,002

 
$
32,460

 
3.66
%
Less: allowances for loan losses
(11,359
)
 
 
 
 
 
(11,894
)
 
 
 
 
Total nonearning assets
80,774

 
 
 
 
 
76,703

 
 
 
 
Total assets
$
1,320,686

 
 

 
 
 
$
1,249,811

 
 

 
 
Liabilities:
 

 
 

 
 
 
 

 
 

 
 
Interest-bearing deposits:
 

 
 

 
 
 
 

 
 

 
 
Checking
$
353,769

 
$
576

 
0.22
%
 
$
342,184

 
$
517

 
0.20
%
Regular savings
129,538

 
180

 
0.19
%
 
117,981

 
164

 
0.19
%
Money market savings
75,762

 
133

 
0.23
%
 
67,314

 
95

 
0.19
%
Time deposits:
 
 
 
 
 
 
 
 
 
 
 
$100,000 and over
148,115

 
980

 
0.88
%
 
136,980

 
900

 
0.88
%
Under $100,000
112,442

 
801

 
0.95
%
 
107,181

 
904

 
1.13
%
Total interest-bearing deposits
$
819,626

 
$
2,670

 
0.44
%
 
$
771,640

 
$
2,580

 
0.45
%
Securities sold under agreements to repurchase
29,966

 
2

 
0.01
%
 
30,578

 
64

 
0.28
%
FHLB borrowings and other debt
87,786

 
704

 
1.07
%
 
69,752

 
507

 
0.97
%
Federal funds purchased
2

 

 
%
 
2

 

 
%
Total interest-bearing liabilities
$
937,380

 
$
3,376

 
0.48
%
 
$
871,972

 
$
3,151

 
0.48
%
Non-interest bearing liabilities:
 

 
 

 
 
 
 

 
 

 
 
Demand deposits
243,020

 
 
 
 
 
239,791

 
 
 
 
Other liabilities
13,896

 
 
 
 
 
13,126

 
 
 
 
Total liabilities
$
1,194,296

 
 

 
 
 
$
1,124,889

 
 

 
 
Shareholders' equity
126,390

 
 
 
 
 
124,922

 
 
 
 
Total liabilities and shareholders' equity
$
1,320,686

 
 

 
 
 
$
1,249,811

 
 

 
 
Net interest income
 

 
$
30,015

 
 
 
 

 
$
29,309

 
 
Interest rate spread
 

 
 

 
3.08
%
 
 

 
 

 
3.18
%
Cost of Funds
 

 
 

 
0.38
%
 
 

 
 

 
0.38
%
Interest expense as a percent of average earning assets
 

 
 

 
0.36
%
 
 

 
 

 
0.36
%
Net interest margin
 

 
 

 
3.20
%
 
 

 
 

 
3.31
%
(1) 
Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%.
(2) 
All yields and rates have been annualized on a 366 day year for 2016 and 365 day year for 2015.
(3) 
Total average loans include loans on non-accrual status.

Net Interest Income
Net interest income represents the principal source of earnings of the Company.  Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets.  Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income was $9.62 million for the quarter ended September 30, 2016.  This is a decrease of 0.43% compared to the same period in 2015.  The net interest margin for the quarter ended September 30, 2016 was 3.11% compared to a net interest margin of 3.28% for the same period in 2015. The net interest income was $29.34 million for the nine months ended September

38


30, 2016. This is an increase of 2.56% over net interest income reported for the same period for 2015. The net interest margin for the nine months ended September 30, 2016 was 3.20% compared to 3.31% for the same period for 2015.

The following factors contributed to the change in the net interest margin:
Yields on earning assets for the quarter decreased by 16 bp compared to the same period for 2015. Yields on earning assets for the nine month period decreased by 10 bp compared to the same period for 2015.
Yields on investment securities decreased by 37 bp compared to the quarter ended September 30, 2015 and decreased by 8 bp compared to the nine month period ended September 30, 2015. The principal reason for the decline in yields was elevated refinancing activity and sales of securities during the quarter.
Yields on loans decreased by 17 bp compared to the quarter ended September 30, 2015 and decreased by 21 bp compared to the nine month period ended September 30, 2015. Loan yields declined in large part due to payoffs and lower yields on new loans added to the balance sheet.
The cost of funds has remained relatively stable at 38 bp, compared to the quarter and nine month periods ended September 30, 2015.

The net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets.  Because a portion of interest income earned is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio.  The tax rate utilized in calculating the tax benefit for each of the reported periods is 34%.  The reconciliation of tax equivalent net interest income, which is not a measurement under U.S. GAAP, to net interest income is reflected in the table below.
 
For the
Three Months Ended
September 30,
 
For the
Nine Months Ended
September 30,
(Dollars in thousands)
2016
 
2015
 
2016
 
2015
GAAP measures:
 
 
 
 
 
 
 
Interest Income - Loans
$
8,624

 
$
8,227

 
$
25,397

 
$
24,484

Interest Income - Investments & Other
2,113

 
2,476

 
7,314

 
7,270

Interest Expense - Deposits
909

 
877

 
2,670

 
2,580

Interest Expense - Other Borrowings
211

 
167

 
706

 
571

Total Net Interest Income
$
9,617

 
$
9,659

 
$
29,335

 
$
28,603

Non-GAAP measures:
 
 
 

 
 
 
 

Tax Benefit Realized on:
 
 
 

 
 
 
 

Non-taxable interest income - municipal securities
212

 
228

 
671

 
697

Non-taxable interest income - loans
2

 
3

 
9

 
9

Total Tax Benefit Realized on Non-Taxable Interest Income
$
214

 
$
231

 
$
680

 
$
706

Total Tax Equivalent Net Interest Income
$
9,831

 
$
9,890

 
$
30,015

 
$
29,309


Based on our internal interest rate risk models and the assumption of a sustained low rate environment, the Company expects net interest income to trend upward slightly throughout the next 12 months as principal paydowns from the securities portfolio are redeployed into higher yielding loans. It is anticipated that targeted growth in earning assets and liability repricing opportunities will help mitigate the impact to the Company’s net interest margin.  The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.

Non-Interest Income
Non-interest income has been and will continue to be an important factor for increasing profitability.  Management recognizes this and continues to review and consider areas where non-interest income can be increased.  Non-interest income includes fees generated by the commercial and retail banking segment and the wealth management segment.  Non-interest income for the quarter ended September 30, 2016 was higher by 3.36% compared to the quarter ended September 30, 2015.  Non-interest income for the nine months ended September 30, 2016 was lower by 6.08% compared to the same period for 2015. A more detailed discussion of non-interest income follows:
Total revenue generated by our wealth management group, Middleburg Investment Group ("MIG") remained unchanged for the quarter at $1.17 million compared to the same period of 2015 and decreased to $3.46 million for the nine month period ended September 30, 2016 from $3.63 million for the same period in 2015. Fee income is based primarily upon the market value of assets under administration which were $2.01 billion at September 30, 2016 and $1.91 billion at September 30, 2015.
Net gains on securities available for sale were $138,000 and zero for the quarters ended September 30, 2016 and 2015, respectively and $511,000 and $138,000 for the nine month periods ended September 30, 2016 and 2015, respectively. Securities were sold in order to fund loan growth.

39


Other operating income was $136,000 for the quarter ended September 30, 2016, a decrease of 35.85% compared to the quarter ended September 30, 2015. Other operating income was $492,000 for the nine months ended September 30, 2016, a decrease of 58.79% compared to the same period in 2015. In the first quarter of 2015, there was a substantial recovery of approximately $500,000 in expenses related to a loan that had previously been charged off that was included in other operating income. Other operating income generally includes revenue from prepayment penalties, safe deposit charges, wire fees and other miscellaneous adjustments.

The following table depicts the changes in non-interest income:
(Dollars in thousands)
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Service charges on deposit accounts
$
303

 
$
275

 
$
868

 
$
803

Trust services income
1,168

 
1,168

 
3,458

 
3,629

ATM fee income, net
190

 
209

 
565

 
593

Gains on sales of loans held for sale, net
11

 
9

 
23

 
3

Gains on sales of securities available for sale, net
138

 

 
511

 
138

Commissions on investment sales
133

 
132

 
417

 
415

Bank owned life insurance
165

 
166

 
488

 
489

Other operating income
136

 
212

 
492

 
1,194

Total non-interest income
$
2,244

 
$
2,171

 
$
6,822

 
$
7,264


Non-Interest Expense
Non-interest expense for the quarter ended September 30, 2016, increased by 0.91% compared to the same period in 2015. Non-interest expense increased by 0.82% compared to the nine months ended September 30, 2015. Principal reasons for the changes in non-interest expenses were the following:
Salaries and employee benefit expenses for the quarter decreased by 1.38% when compared to the same period in 2015. Salaries and employee benefit expenses decreased by 2.70% for the nine month period ended September 30, 2016 when compared to the same period in 2015. The decreases in salaries and employee benefit expenses were primarily due to the Company's continued cost control initiatives.
Costs related to other real estate owned (OREO) decreased for the quarter by $10,000 when compared to the same period in 2015. Costs related to OREO increased $54,000 for the nine month period ended September 30, 2016 when compared to the same period in 2015. The difference was due to an increase in valuation adjustments based on updated appraisals during the nine month period ended September 30, 2016 compared to the same period in 2015.
Computer operations expense for the quarter increased $81,000 when compared to the quarter ended September 30, 2015. Computer operations expense increased by $387,000 for the nine month period ended September 30, 2016 when compared to the same period in 2015. The primary reasons for the increase in expenses are related to the conversion to a new on-line banking platform.
Other operating expenses for the quarter increased by 4.92% when compared to the same period in 2015. Other operating expenses increased by 2.67% for the nine month period ended September 30, 2016 when compared to the same period in 2015. Included in this category were merger related expenses that totaled $165,100 and $236,600 for the quarter and nine months ended September 30, 2016, respectively.

The following table depicts the changes in non-interest expense:

40


(Dollars in thousands)
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
 
2016
 
2015
 
2016
 
2015
Salaries and employee benefits
$
4,727

 
$
4,793

 
$
14,152

 
$
14,544

Occupancy and equipment
1,262

 
1,323

 
3,937

 
4,054

Amortization
210

 
160

 
628

 
478

Computer operations
605

 
524

 
1,923

 
1,536

Other real estate owned, net
183

 
193

 
339

 
285

Other taxes
237

 
230

 
709

 
684

Federal deposit insurance
215

 
188

 
606

 
583

Audits and exams
136

 
156

 
453

 
472

Other operating expenses
1,599

 
1,524

 
4,192

 
4,083

Total non-interest expense
$
9,174

 
$
9,091

 
$
26,939

 
$
26,719


The adjusted efficiency ratio is not a measurement under U.S. GAAP. The Company calculates its efficiency ratio by dividing non-interest expense (adjusted for amortization of intangibles and other real estate expenses) by the sum of tax equivalent net interest income and non-interest income excluding gains and losses on the investment portfolio. The tax rate utilized in calculating tax equivalent amounts is 34%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency.

The calculation of the adjusted efficiency ratio for the three and nine months ended September 30, 2016 and 2015 are as follows:
 
For the
Three Months Ended September 30,
 
For the
Nine Months Ended September 30,
(Dollars in thousands)
2016
 
2015
 
2016
 
2015
Summary of Operating Results:
 
 
 
 
 
 
 
Non-interest expense
$
9,174

 
$
9,091

 
$
26,939

 
$
26,719

Less: Intangible amortization
43

 
43

 
129

 
129

Less: Other real estate owned, net
183

 
193

 
339

 
285

Adjusted non-interest expense
$
8,948

 
$
8,855

 
$
26,471

 
$
26,305

 
 
 
 
 
 
 
 
Net interest income
$
9,617

 
$
9,659

 
$
29,335

 
$
28,603

 
 
 
 
 
 
 
 
Non-interest income
2,244

 
2,171

 
6,822

 
7,264

Less: Gains on sales of securities available for sale, net
138

 

 
511

 
138

Adjusted non-interest income
$
2,106

 
$
2,171

 
$
6,311

 
$
7,126

Tax equivalent adjustment (2)
299

 
317

 
931

 
958

Total net interest income and non-interest income, adjusted
$
12,022

 
$
12,147

 
$
36,577

 
$
36,687

 
 
 
 
 
 
 
 
Efficiency ratio, adjusted
74.43
%
 
72.90
%
 
72.37
%
 
71.70
%
Efficiency ratio, U.S. GAAP (1)
77.35
%
 
76.85
%
 
74.51
%
 
74.49
%
(1) 
Computed by dividing non-interest expense by the sum of net interest income and non-interest income.
(2) 
Includes tax-equivalent interest adjustments on loans and securities as well as tax-equivalent non-interest income adjustments related to the increase in cash surrender value of bank owned life insurance.

Income Taxes
Income taxes on earnings was $720,000 resulting in an effective tax rate of 24.13% for the quarter ended September 30, 2016, compared to $850,000, or 26.81% for the quarter ended September 30, 2015. Income taxes on earnings was $2.19 million, resulting in an effective tax rate of 23.93% for the nine months ended September 30, 2016, compared to $2.51 million, or 26.23% for the nine months ended September 30, 2015. The primary reason for the decline in the effective tax rate was an increased benefit from low income housing tax credits. For a further discussion of low income housing tax credits, see “Note 14. Low Income Housing Tax Credits".







41


Financial Condition

Assets, Liabilities and Shareholders’ Equity

Total consolidated assets at September 30, 2016 were $1.34 billion, an increase of 3.10% from December 31, 2015. Cash balances and deposits at other banks increased by $16.56 million and securities portfolio balances decreased by $15.43 million compared to December 31, 2015. We redeployed principal paydowns and sold some securities to fund higher yielding loans. Loans held-for-investment grew by 4.99% or $40.21 million to $845.89 million as of September 30, 2016 compared to $805.68 million on December 31, 2015.

Total consolidated liabilities at September 30, 2016 were $1.21 billion, an increase of 2.97% from December 31, 2015. Total deposits increased by $50.71 million from December 31, 2015 to $1.09 billion as of September 30, 2016. Federal Home Loan Bank borrowings decreased by $21.50 million to $63.50 million.

Shareholders' equity at September 30, 2016 was $128.92 million, compared to $123.55 million at December 31, 2015. Retained earnings at September 30, 2016 were $64.60 million compared to $60.39 million at December 31, 2015. The book value of the Company’s common stock at September 30, 2016 was $18.15 per share versus $17.44 per share at December 31, 2015.

Loans
The following table summarizes total loans by category:
 
September 30,
 
Years Ended December 31,
(Dollars in thousands)
2016
 
2015
 
2014
 
2013
 
2012
Real estate loans:
 
 
 
 
 
 
 
 
 
Construction
$
32,519

 
$
39,673

 
$
33,050

 
$
36,025

 
$
50,218

Secured by farmland
16,832

 
19,062

 
19,708

 
16,578

 
11,876

Secured by 1-4 family residential
332,408

 
280,096

 
265,216

 
273,384

 
260,620

Other real estate loans
250,778

 
258,035

 
255,236

 
260,333

 
254,930

Commercial loans
193,826

 
190,482

 
163,269

 
129,554

 
118,573

Consumer loans
19,527

 
18,333

 
18,367

 
12,606

 
13,260

Total gross loans
845,890

 
805,681

 
754,846

 
728,480

 
709,477

Less allowance for loan losses
11,200

 
11,046

 
11,786

 
13,320

 
14,311

Net loans
$
834,690

 
$
794,635

 
$
743,060

 
$
715,160

 
$
695,166


Changes in the loan portfolio at September 30, 2016 compared to December 31, 2015 were as follows:
Real estate construction loans primarily consist of pre-sold 1-4 family residential loans along with some commercial construction loans.  This category represented 3.8% of total loans, a decrease of approximately $7.15 million from $39.67 million.  
Loans secured by farmland decreased by $2.23 million from $19.06 million.
Loans secured by 1-4 family residential real estate represented 39.3% of total loans, an increase of $52.31 million.  
Other real estate loans are typically non-farm, non-residential real estate loans which are, in most cases, owner-occupied commercial buildings.  Other real estate loans represented 29.7% of total loans, a decrease of $7.26 million.
Commercial loans, which consist of secured and unsecured loans to small businesses, increased by 1.76%.
Consumer loans increased by $1.19 million or 6.51%.

Asset Quality
Total nonperforming assets continue to decline, totaling $23.77 million as of September 30, 2016 compared to $25.51 million and $26.07 million as of December 31, 2015 and September 30, 2015, respectively. Nonperforming assets include:
Nonaccrual loans declined by 23.69% to $6.70 million as of September 30, 2016 compared to $8.78 million as of December 31, 2015 and declined by 24.06% when compared to $8.83 million as of September 30, 2015. The decline in nonaccrual loans during the nine months ended September 30, 2016 was primarily the result of:
the sale of loans with a recorded investment of approximately $1.36 million;
loan payoffs of approximately $708,000, and;
the transfer of loans to OREO with a recorded investment of approximately $530,000.
Restructured loans that were accruing totaled $12.39 million as of September 30, 2016 compared to $12.06 million and $12.11 million as of December 31, 2015 and September 30, 2015, respectively.
Other real estate owned was $3.39 million as of September 30, 2016, compared to $3.35 million and $3.87 million as of December 31, 2015 and September 30, 2015, respectively.

42


Loans past due for 90+ days and still accruing were $248,000 as of September 30, 2016 compared to $278,000 and $224,000 as of December 31, 2015 and September 30, 2015, respectively.

Total past due loans increased by $5.12 million since December 31, 2015. The increase was largely the result of two previously identified problem loans. These loans were on nonaccrual and considered to be impaired at December 31, 2015 however; they were not contractually past due until 2016. Based on our updated impairment evaluations for the quarter ended September 30, 2016, no additional reserves were required.

Total classified loans decreased from $49.63 million at December 31, 2015 to $39.96 million at September 30, 2016. The primary reason for the decline was due to the overall improvement in asset quality, as well as the sale and payoff of various classified loans.

During the nine months ended September 30, 2016, the Company received $4.41 million in proceeds from the sale of problem loans. Included in the sales were four loans with a recorded investment of $4.29 million, of which $1.25 million were on nonaccrual, as well as 28 loans with no outstanding recorded investment as they had been fully charged-off in prior periods. Gross charge-offs of $513,000 and gross recoveries of $640,000 were recorded through the allowance for loan losses during the nine months ended September 30, 2016, related to the sales of these loans.

The table below summarizes nonperforming assets for the periods indicated.
 
September 30,
 
December 31,
(Dollars in thousands)
2016
 
2015
 
2014
 
2013
 
2012
Nonaccrual loans
$
6,703

 
$
8,784

 
$
9,944

 
$
19,752

 
$
21,664

Restructured loans (1)
12,386

 
12,058

 
4,295

 
4,674

 
5,132

Accruing loans greater than 90 days past due
248

 
278

 
30

 
808

 
1,044

Total nonperforming loans
$
19,337

 
$
21,120

 
$
14,269

 
$
25,234

 
$
27,840

Other real estate owned
3,387

 
3,345

 
4,051

 
3,424

 
9,929

Repossessed assets (2)
1,043

 
1,043

 
1,132

 

 

Total nonperforming assets
$
23,767

 
$
25,508

 
$
19,452

 
$
28,658

 
$
37,769

 
 
 
 
 
 
 
 
 
 
Allowance for loan losses
$
11,200

 
$
11,046

 
$
11,786

 
$
13,320

 
$
14,311

 
 
 
 
 
 
 
 
 
 
Nonperforming loans to total loans
2.29
%
 
2.62
%
 
1.89
%
 
3.46
%
 
3.92
%
Allowance for loan losses to nonperforming loans
57.92
%
 
52.30
%
 
82.60
%
 
52.80
%
 
51.40
%
Nonperforming assets to total assets
1.78
%
 
1.97
%
 
1.59
%
 
2.33
%
 
3.05
%
(1) 
Amount reflects restructured loans that are not included in nonaccrual loans.
(2) 
Included in other assets.
 
Included in nonperforming loans are troubled debt restructurings (“TDRs”). The total balance of TDRs at September 30, 2016 was $14.40 million of which $2.01 million were included in the Company’s nonaccrual loan totals at that date and $12.39 million represented loans performing as agreed to the restructured terms. This compares with $15.50 million in total TDRs at December 31, 2015. The amount of the valuation allowance related to TDRs was $1.11 million and $1.60 million as of September 30, 2016 and December 31, 2015, respectively.
 
The Company requires six timely consecutive monthly payments be made and future payments be reasonably assured, before a restructured loan that has been placed on nonaccrual can be returned to accrual status. The Company does not utilize formal modification programs or packages when loans are considered for restructuring.  Any loan restructuring is based on the borrower’s circumstances and may include modifications to more than one of the terms and conditions of the loan.

The Company has not performed any commercial real estate or other type of loan workout whereby the existing loan would have been structured into multiple new loans.

Allowance For Loan Losses
For a discussion of the Company’s accounting policies with respect to the allowance for loan losses, see “Critical Accounting Policies – Allowance for Loan Losses”.


43


The Company increased its allowance for loan and lease losses ("ALLL") slightly to $11.20 million or 1.32% of total loans at September 30, 2016 compared to $11.05 million or 1.37% of total loans at December 31, 2015. The increase was largely due to loan growth which led to a higher dollar amount of general reserves at September 30, 2016 compared to December 31, 2015. For the year-to-date 2016, recoveries of previously charged-off loans exceeded current year charge-offs by $101,000. The Company recorded a recovery of loan losses of $297,000 for the quarter ended September 30, 2016 compared to a recovery of loan losses of $432,000 for the same period of 2015 dur to improvements in asset quality. The provision for loan losses was $53,000 and a recovery of loan losses of $407,000 was recorded for the nine month periods ended September 30, 2016 and 2015. General reserves declined as the Company experienced negative loan growth during the quarter, which resulted in the recovery of loan losses.

The following table depicts the transactions, in summary form, related to the allowance for loan losses.
 
For the Nine Months Ended
 
For the Year Ended
(Dollars in thousands)
September 30, 2016
 
December 31, 2015
Balance, beginning of period
$
11,046

 
$
11,786

Add: Provision for loan losses 
53

 
2,293

Less: Charge-offs: 
 
 
 

Real estate loans:
 
 
 

Construction 
$
(388
)
 
$

Secured by 1-4 family residential
(7
)
 
(344
)
Other real estate loans
(126
)
 
(9
)
Commercial loans
(31
)
 
(3,281
)
Consumer loans 
(17
)
 
(57
)
Total charge-offs  
$
(569
)
 
$
(3,691
)
Add: Recoveries:
 
 
 

Real estate loans:
 
 
 

Construction 
$
128

 
$
246

Secured by 1-4 family residential
395

 
359

Other real estate loans 
27

 
28

Commercial loans
65

 
14

Consumer loans 
55

 
11

Total recoveries
$
670

 
$
658

Net (charge-offs) recoveries
$
101

 
$
(3,033
)
Balance, end of period
$
11,200

 
$
11,046

 
 
 
 
Allowance for loan losses to total loans
1.32
 %
 
1.37
%
Net (recoveries) charge-offs to average loans
(0.012
)%
 
0.39
%

The allocation of the allowance (dollars in thousands) at September 30, 2016 and December 31, 2015 were:
 
September 30, 2016
 
December 31, 2015
Real estate construction
$
883

 
$
905

Real estate secured by farmland
145

 
192

Real estate secured by1-4 family residential
3,617

 
3,341

Other real estate loans
3,468

 
3,761

Commercial
2,136

 
1,706

Consumer
951

 
1,141

 
$
11,200

 
$
11,046


The Company has allocated the allowance according to the amount deemed reasonably necessary to provide for the probable losses inherent within each loan category.  The allocation of the allowance should not be interpreted as an indication that loan losses in future years will occur in the same proportions that they may have in prior periods or that the allocation indicates future loan loss trends.  Additionally, the proportion allocated to each loan category is not the total amount that may be available for future losses that could occur within such categories since the total allowance is available to absorb losses on the total portfolio.

Securities
The carrying value of the securities portfolio, excluding restricted stock, was $363.35 million at September 30, 2016, compared to $378.78 million at December 31, 2015.  


44


Unrealized losses were $2.19 million and $3.03 million at September 30, 2016 and December 31, 2015, respectively. Unrealized gains were $7.11 million and $5.82 million at September 30, 2016 and December 31, 2015, respectively. At September 30, 2016, the Company evaluated the investment portfolio for possible other-than-temporary impairment and concluded that no adverse change in cash flows occurred and did not consider any securities to be other-than-temporarily impaired. 

Goodwill and Other Identified Intangibles
Goodwill and other identified intangibles decreased by $129,000 from year end 2015 to $3.51 million at September 30, 2016. This decrease is attributable to amortization expense related to intangibles.

Deposits
Total deposits increased by $50.71 million from December 31, 2015 to $1.09 billion as of September 30, 2016, due to strong deposit inflows, specifically in time deposits and non-interest bearing business checking accounts during the period.

Time deposits increased by $16.96 million or 6.93% from December 31, 2015 to $261.53 million at September 30, 2016. Time deposits include $24.45 million and $17.95 million of brokered certificates of deposit and CDARS deposits, respectively. Securities sold under agreements to repurchase (“Repo Accounts”) increased by $4.67 million from $26.87 million at December 31, 2015 to $31.54 million at September 30, 2016. The Repo Accounts include certain long-term commercial checking accounts with average balances that typically exceed $100,000. All repurchase agreement transactions entered into by the Company are accounted for as collateralized financings and not as sales.

FHLB Borrowings
The Company had no overnight advances from the Federal Home Loan Bank of Atlanta (“FHLB”) outstanding at September 30, 2016. FHLB term advances were $63.50 million at September 30, 2016, lower by $21.50 million compared to December 31, 2015.  The majority of FHLB advances have a remaining maturity of less than one year and we expect to replace them with core deposits as the advances mature.

Capital Resources and Dividends

Shareholders' equity was $128.92 million at September 30, 2016 compared to $123.55 million at December 31, 2015. During the quarter and nine month periods ended September 30, 2016, the Company declared common stock dividends of $0.13 per share and $0.39 per share, respectively, compared to $0.13 per share and $0.33 per share for the same periods in 2015. The book value of common stock was $18.15 per share at September 30, 2016 and $17.44 at December 31, 2015.

On September 15, 2015, the Company's Board of Directors authorized the repurchase of up to $10.00 million of the Company’s common stock, or approximately 8% of the Company’s outstanding shares. The repurchase program was effective immediately and runs through December 31, 2017. This program replaces the previous repurchase program adopted in 1999, pursuant to which the Company had 24,084 shares remaining eligible for repurchase. As of September 30, 2016, the Company had repurchased a total of 104,300 shares under the current plan, with a total cost of $1.91 million and for a weighted average price of $18.33, of this 26,800 shares were repurchased during the nine months ended September 30, 2016, with a total cost of $490,100 and for a weighted average price of $18.29.

The Company's capital ratios were well above regulatory minimums as of September 30, 2016 and December 31, 2015:
Total Risk Based Capital ratio of 17.83% and 17.50% at September 30, 2016 and December 31, 2015, respectively.  
Common Equity Tier 1 ratio of 15.92% and 15.60% at September 30, 2016 and December 31, 2015, respectively.
Tier 1 Capital ratio of 16.57% and 16.30% at September 30, 2016 and December 31, 2015, respectively. 
Leverage ratio of 9.59% at September 30, 2016 compared to 9.60% at December 31, 2015.

The Company's capital conservation buffer was 9.83% at the end of the third quarter of 2016.

The Company’s Tier 1 capital and Total capital includes $5.0 million of trust preferred securities. Under the changes to the regulatory capital framework that were approved on July 9, 2013 by the federal banking agencies (Basel III Final Rule), the Company's trust preferred securities will continue to be included in Tier 1 capital and Total capital until they mature, pursuant to a "grandfathering" provision that exempts Middleburg Financial Corporation's securities from the more stringent regulatory capital treatment contained in the Basel III Final Rule for trust preferred securities. In addition to "grandfathering" certain previously outstanding trust preferred securities for community banks, the Basel III Final Rule introduces a new Common Equity Tier 1 capital measure, increases the applicable minimum regulatory capital levels and certain prompt corrective action capital levels, and establishes a capital conservation buffer and new risk weights for certain types of assets. The implementation date of the Basel III capital rules was January 1, 2015 for all US banking organizations not subject to the advanced approaches capital rules and the date for banking organizations to meet the fully phased in Basel III capital ratios is January 1, 2019. The Company is not

45


subject to the advanced approaches capital rules. An advanced approaches banking organization is one that has total assets of $250 billion or more or foreign asset exposure of $10 billion or more (or elects with approval from its primary federal regulator to use the advanced approaches methodology to calculate risk weights).

Furthermore, with the Basel III Final Rule, banks must maintain minimum capital ratios in accordance with the following guidelines:    
Capital Ratios
Basel Rule (2)
 
FDIC PCA (1)
Tier 1 leverage/Average assets ratio
4.0
%
 
5.0
%
Common equity tier 1/Risk weighted assets ratio
7.0
%
 
6.5
%
Tier 1 risk-based capital/Risk weighted assets ratio
8.5
%
 
8.0
%
Total risk-based capital/Risk weighted assets ratio
10.5
%
 
10.0
%
(1) 
Prompt Corrective Action    
(2) 
Assumes fully phased-in Basel III regulatory capital rules. The Common Equity Ratio, the Tier 1 Ratio and the Total Capital Ratio include a 2.50% Capital Conservation Buffer that must be maintained in order for the bank to remain well capitalized and to avoid restrictions on payments of dividends, bonuses, capital repurchases and restricted payments.

A banking organization with a buffer greater than 2.5% would not be subject to limits on capital distributions or discretionary bonus payments. However, a banking organization with a buffer of less than 2.5% would be subject to increasingly stringent limitations as the buffer approaches zero. The Basel III rule also prohibits a banking organization from making distributions or discretionary bonus payments during any quarter if its eligible retained income is negative in that quarter and its capital conservation buffer ratio was less than 2.5% at the beginning of the quarter.

The following table shows the restrictions for various ranges of the buffer:
Capital Conservation Buffer
 
Maximum Payout as a Percentage of Eligible Retained Income
Less than or = 0.625%
 
%
Less than or = 1.25% and greater than 0.625%
 
20.0
%
Less than or = 1.875% and greater than 1.25%
 
40.0
%
Less than or = 2.50% and greater than 1.875%
 
60.0
%
Greater than 2.50%
 
No payment limit applies


The eligible retained income of the Company is defined as its net income for the four calendar quarters preceding the current calendar quarter, based on the Company's quarterly regulatory reports, net of any distributions and associated tax effects not already considered in net income.

Liquidity

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management.  Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, short-term investments, securities classified as available for sale and loans and securities maturing within one year.  As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

The Company also maintains additional sources of liquidity through a variety of borrowing arrangements.  Middleburg Bank maintains federal funds lines with large regional and money-center banking institutions.  These available lines total approximately $45.0 million, none of which had outstanding balances at September 30, 2016.  Middleburg Bank is also able to borrow from the discount window of the Federal Reserve Bank of Richmond.  At September 30, 2016, available borrowing capacity from this source was $42.75 million.  At September 30, 2016, Middleburg Bank had $31.54 million of outstanding borrowings pursuant to securities sold under agreements to repurchase transactions (“Repo Accounts”), with maturities of one day.  The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000.  

The Company has a secured line of credit with the Federal Home Loan Bank of Atlanta. The credit available from this line depends on the total assets of the bank. As of September 30, 2016, the remaining credit availability from this line was $304.07 million, while the amount of eligible collateral, in the form of qualifying real estate secured loans, was $224.32 million. The bank would

46


have to post additional collateral, in the form of eligible securities, if it sought to borrow more than the amount of eligible lending collateral. The Company had $239.04 million of unencumbered securities as of September 30, 2016.

At September 30, 2016, cash, interest-bearing deposits with other banks, federal funds sold, short-term investments and unencumbered securities available for sale were 24.47% of total liabilities.

Off-Balance Sheet Arrangements
As of September 30, 2016, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Caution About Forward Looking Statements

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import.

Such forward-looking statements involve known and unknown risks including, but not limited to, the following factors:
ability to obtain regulatory approvals and meet other closing conditions to the pending merger with Access;
delays in closing the merger with Access;
the inability to recognize cost savings or revenues or to implement integration plans associated with the merger with Access;
deposit attrition, operating costs, customer losses and business disruption in connection with the merger, including adverse effects on relationships with employees;
termination of the merger agreement, or failure to complete the merger, could negatively impact our stock price and our future business and financial results;
further adverse changes in general economic and business conditions in the Company’s market area;
changes in banking and other laws and regulations applicable to the Company;
maintaining asset qualities;
the ability to properly identify risks in our loan portfolio and calculate an adequate loan loss allowance;
risks inherent in making loans such as repayment risks and fluctuating collateral values;
concentration in loans secured by real estate;
changing trends in customer profiles and behavior;
changes in interest rates and interest rate policies;
maintaining cost controls as the Company opens or acquires new facilities;
competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
the ability to continue to attract low cost core deposits to fund asset growth;
the ability to successfully manage the Company’s growth or implement its growth strategies if it is unable to identify attractive markets, locations or opportunities to expand in the future;
reliance on the Company’s management team, including its ability to attract and retain key personnel;
demand, development and acceptance of new products and services;
problems with technology utilized by the Company;
maintaining capital levels adequate to support the Company’s growth; and
other factors described in Item 1A, “Risk Factors,” discussed in more detail in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.

Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices.  The Company’s primary market risk exposure is interest rate risk, though it should be noted that the assets under management by Middleburg Trust Company are affected by equity price risk.  The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability management

47


process, which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee (“ALCO”) of Middleburg Bank.  In this capacity, ALCO develops guidelines and strategies that govern the Company’s asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.

Interest rate risk represents the sensitivity of earnings to changes in market interest rates.  As interest rates change, the interest income and expense streams associated with the Company’s financial instruments also change, affecting net interest income, the primary component of the Company’s earnings.  ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes.  While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also employs additional tools to monitor potential longer-term interest rate risk.  

The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company’s balance sheet.  The simulation model is prepared and updated four times during each year.  This sensitivity analysis is compared to ALCO policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given a 200 basis point (bp) upward shift and a 200 basis point downward shift in interest rates.  The following reflects the range of the Company’s net interest income sensitivity analysis as of September 30, 2016 and December 31, 2015.
Estimated Net Interest Income Sensitivity
Rate Change
 
September 30, 2016
 
December 31, 2015
+ 200 bps
 
7.4%
 
(2.7)%
- 200 bps
 
(12.5)%
 
(13.4)%

At September 30, 2016, the Company’s interest rate risk model indicated that for an immediate 200 basis points increase in interest rates, net interest income was expected to increase by 7.40% over a 12-month period.  For the same time period, the interest rate risk model indicated that, for an immediate 200 basis points decrease in interest rates, net interest income was expected to decrease by 12.5% over a 12-month period.  The results for the down rate scenarios are not very meaningful given the low level of overall interest rates. While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is slightly asset sensitive.

The Company’s specific goal is to lower, where possible, the cost of its borrowed funds by replacing borrowings with lower cost core deposits.

The preceding sensitivity analysis does not represent the Company's forecast and should not be relied upon as being indicative of expected operating results.  These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flows.  While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change.

Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables.  Furthermore, the sensitivity analysis does not reflect actions that the ALCO might take in response to or in anticipation of changes in interest rates.

ITEM 4.    CONTROLS AND PROCEDURES

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended.)  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting.  There were no changes in the Company’s internal control over financial reporting identified in connection with the

48


evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

PART II

ITEM 1.    LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.

ITEM 1A.    RISK FACTORS

Other than the additional items disclosed below, there have been no material changes to the risk factors as previously disclosed in Part I, Item IA of our Annual Report on Form 10K for the fiscal year ended December 31, 2015.

Combining Access and the Company may be more difficult, costly or time-consuming than we expect.
The success of the Merger will depend, in part, on Access’ ability to realize the anticipated benefits and cost savings from combining the businesses of Access and the Company and to combine the businesses of Access and the Company in a manner that permits growth opportunities and cost savings to be realized without materially disrupting the existing customer relationships of the Company or decreasing revenues due to loss of customers. However, to realize these anticipated benefits and cost savings, Access must successfully combine the businesses of Access and the Company. If Access is not able to achieve these objectives, the anticipated benefits and cost savings of the Merger may not be realized fully or at all or may take longer to realize than expected.

Access and the Company have operated, and, until the completion of the Merger, will continue to operate, independently. The success of the Merger will depend, in part, on Access’ ability to successfully combine the businesses of Access and the Company. To realize these anticipated benefits, after the completion of the Merger, Access expects to integrate the Company’s business into its own. The integration process in the Merger could result in the loss of key employees, the disruption of each party’s ongoing business, inconsistencies in standards, controls, procedures and policies that affect adversely either party’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the Merger. The loss of key employees could adversely affect Access’ ability to successfully conduct its business in the markets in which the Company now operates, which could have an adverse effect on Access’ financial results and the value of its common stock. If Access experiences difficulties with the integration process, the anticipated benefits of the Merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be disruptions that cause Access and the Company to lose customers or cause customers to withdraw their deposits from the Company’s or Access’ banking subsidiaries, or other unintended consequences that could have a material adverse effect on Access’ results of operations or financial condition after the Merger. These integration matters could have an adverse effect on the Company during this transition period and on Access for an undetermined period after consummation of the Merger.

The Merger may distract management of the Company from its other responsibilities.
The Merger could cause the management of the Company to focus its time and energies on matters related to the Merger that otherwise would be directed to its business and operations. Any such distraction on the part of the Company’s management, if significant, could affect its ability to service existing business and develop new business and adversely affect the business and earnings of the Company before the Merger, or the business and earnings of Access after the Merger.

Termination of the Merger Agreement could negatively impact the Company.
Each of the Company’s and Access’s obligation to consummate the Merger remains subject to a number of conditions, and there can be no assurance that all of the conditions will be satisfied, or that the Merger will be completed on the proposed terms, within the expected timeframe, or at all. Any delay in completing the Merger could cause us not to realize some or all of the benefits that we expect to achieve if the Merger is successfully completed within its expected timeframe. If the Merger Agreement is terminated, 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. Additionally, if the Merger Agreement is terminated, the market price of the Company’s common stock could decline to the extent that the current market prices reflect a market assumption that the Merger will be completed. If the Merger Agreement is terminated under certain circumstances, including circumstances involving a change in recommendation by the Company's board of directors, the Company may be required to pay to Access a termination fee of $9.9 million.

In addition, 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, we would have to recognize these expenses and would have committed substantial time and resources by our management, without realizing the expected benefits of the

49


Merger. In addition, failure to consummate the Merger also may result in negative reactions from the financial markets or from our customers, vendors and employees. If the Merger is not completed, these risks may materialize and could have a material adverse effect on our stock price, business and cash flows, financial condition and results of operations.

The Merger Agreement limits the ability of the Company to pursue alternatives to the Merger.
The Merger Agreement contains “no-shop” provisions that, subject to limited exceptions, limit the ability of the Company to discuss, facilitate or commit to competing third-party proposals to acquire all or a significant part of the Company. In addition, under certain circumstances, if the Merger Agreement is terminated and the Company, subject to certain restrictions, consummates a similar transaction other than the Merger, the Company must pay to Access a termination fee of $9.9 million. These provisions might discourage a potential competing acquiror that might have an interest in acquiring all or a significant part of the Company from considering or proposing the acquisition even if it were prepared to pay consideration, with respect to the Company, with a higher per share market price than that proposed in 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 by the Company may be challenging while the Merger is pending, as certain employees may experience uncertainty about their future roles with the Company or the combined company following the Merger. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or the combined company following the Merger, the Company’s business, or the business of the combined company following the Merger, could be harmed. In addition, the Company has agreed to operate its business in the ordinary course prior to the closing of the Merger and from taking certain specified actions until the Merger occurs, and the merger agreement restricts us from taking other specified actions until the merger occurs without the consent of Access. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger.

ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
On September 15, 2015, the Company's Board of Directors authorized the repurchase of up to $10 million of the Company’s common stock, or approximately 8% of the Company’s outstanding shares. The repurchase program was effective immediately and runs through December 31, 2017. This program replaces the previous repurchase program adopted in 1999, pursuant to which the Company had 24,084 shares remaining eligible for repurchase.

There were no repurchases of the Company's common stock that occurred during the quarter ended September 30, 2016.
 
 
 
 
 
 
 
 
 
ITEM 3.    DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.    OTHER INFORMATION

None.

ITEM 6.    EXHIBITS
2.1
Agreement and Plan of Reorganization, dated as of October 21, 2016, between Access National Corporation and Middleburg National Corporation (incorporated by reference to Exhibit 2.1 to Current Report on Form 8-K filed on October 25, 2016).
3.1
Bylaws of Middleburg Financial Corporation (restated in electronic format as of July 27, 2016), filed as Exhibit 3.1 to the current report on Form 8-K filed July 28, 2016 and incorporated herein by reference.
31.1
Rule 13a-14(a) Certification of Chief Executive Officer
31.2
Rule 13a-14(a) Certification of Chief Financial Officer

50


32.1
Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350
101
The following materials from the Middleburg Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in Extensible Business reporting Language (XBRL):  (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.



51


SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

MIDDLEBURG FINANCIAL CORPORATION
 
 
 
 
Date:
November 4, 2016
By:
/s/ Gary R. Shook
 
 
 
Gary R. Shook
 
 
 
Chief Executive Officer
 
 
 
 
 
 
 
 
Date:
November 4, 2016
By:
/s/ Raj Mehra
 
 
 
Raj Mehra
 
 
 
Chief Financial Officer
 
 
 
 



52


EXHIBIT INDEX

Exhibits

2.1
Agreement and Plan of Reorganization, dated as of October 21, 2016, between Access National Corporation and Middleburg National Corporation (incorporated by reference to Exhibit 2.1 to Current Report on Form 8-K filed on October 25, 2016).
3.1
Bylaws of Middleburg Financial Corporation (restated in electronic format as of July 27, 2016), filed as Exhibit 3.1 to the current report on Form 8-K filed July 28, 2016 and incorporated herein by reference.
31.1
Rule 13a-14(a) Certification of Chief Executive Officer
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
32.1
Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350
101
The following materials from the Middleburg Financial Corporation Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in Extensible Business reporting Language (XBRL):  (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Changes in Shareholders’ Equity, (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements.